**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, DC 20549**

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**Form 10-K**

**FORANNUAL AND TRANSITION REPORTSPURSUANT TO SECTIONS 13 OR 15(d)OF THE SECURITIES EXCHANGE ACT OF 1934**

 
| **(Mark One)**                                                                                                                                                           | ** ** | ** **                                                                                    |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------|
| ** **                                                                                                                                                               | ** ** | ** **                                                                                    |
| ý                                                                                                                                                                   | ** ** | **ANNUAL  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**     |
|                                                                                                                                                                     | ** ** | ** **                                                                                    |
| **For the fiscal year ended December 31, 2005**                                                                                                                     |
| ** **                                                                                                                                                               |
| o                                                                                                                                                                        | ** ** | **TRANSITION  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|                                                                                                                                                                     | ** ** | ** **                                                                                    |
| **For the transition period from           to           ** |

 

**Commission file number: 000-50785**

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**METABASISTHERAPEUTICS, INC.**

(Exact name of registrant as specified in its charter)

 

| **Delaware**                                    | ** ** | **33-0753322**                       |
|-------------------------------------------------|------------|--------------------------------------|
| (State or other jurisdiction                    |       | (I.R.S. Employer Identification No.) |
| of incorporation or organization)               |       |                                 |
|                                            |       |                                 |
| **11119 North Torrey Pines Road, La Jolla, CA** | ** ** | **92037**                            |
| (Address of principal executive offices)        |       | (Zip Code)                           |

 

**(858) 587-2770**

(Registrant’s telephone number, including area code)

 

**Securities registered pursuant to Section 12(b) ofthe Act:**

 

| **Title of Each Class** | ** ** | **Name of Each Exchange on Which Registered** |
|----------------------------------------|------------|-----------------------------------------------------------------------------|
| None                                   |       | None                                                                        |

 

**Securities registered pursuant to Section 12(g) ofthe Act:**

**Common Stock, par value $0.001 per share**

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Indicate by check mark whether the registrant is awell-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes o No ý

Indicate by check mark if the registrant is notrequired to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes o No ý

Indicate by check mark whether the registrant:(1) has filed all reports required to be filed by Section 13 or 15(d)of the Securities Exchange Act of 1934 during the preceding 12 months (orfor such shorter period that the registrant was required to file such reports),and (2) has been subject to such filing requirements for the past90 days. Yes ý  No o

Indicate by check mark if disclosure of delinquentfilers pursuant to Item 405 of Regulation S-K is not contained herein, andwill not be contained, to the best of the registrant’s knowledge, in definitiveproxy or information statements incorporated by reference in Part III ofthis Form 10-K or any amendment to this Form 10-K. o

Indicate by check mark whether the registrant is alarge accelerated filer, an accelerated filer, or a non-accelerated filer. Seedefinition of “accelerated filer and large accelerated filer” in Rule 12b-2 ofthe Exchange Act (Check one):

Largeaccelerated filer o Accelerated filer o Non-accelerated filer ý

Indicateby check mark whether the registrant is a shell company (as defined in Rule12b-2 of the Exchange Act). Yes o  No ý

As of June 30, 2005, the last business day ofthe registrant’s most recently completed second fiscal quarter, the aggregatemarket value of the registrant’s common stock held by non-affiliates of theregistrant was approximately $16.0 million, based on the closing price ofthe registrant’s common stock on the Nasdaq National Market on June 30,2005 of $3.15 per share. Shares of common stock held by executive officers,directors and 10% or greater stockholders of the registrant have been excludedin that such persons or entities may be deemed to be affiliates. Thisdetermination of affiliate status is not necessarily a conclusive determinationfor other purposes.

Thenumber of outstanding shares of the registrant’s common stock, par value $0.001per share, as of March 1, 2006 was 25,325,605.

**DOCUMENTS INCORPORATED BY REFERENCE**

 

Portionsof the registrant’s definitive Proxy Statement to be filed with the Securitiesand Exchange Commission within 120 days after the end of the registrant’sfiscal year ended December 31, 2005 are incorporated by reference intoPart III of this report.

 

 

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**METABASIS THERAPEUTICS, INC.**

 

**FORM 10-K—ANNUAL REPORT**

**FOR THE YEAR ENDED DECEMBER 31, 2005**

 

**TABLE OF CONTENTS**

 

 
| **PART I**     |                                                                                                               |   |
|----------------|--------------------------------------------------------------------------------------------------------------------|--------|
| Item 1         | Business                                                                                                           |   |
| Item 1A        | Risk Factors                                                                                                       |   |
| Item 1B        | Unresolved Staff Comments                                                                                          |   |
| Item 2         | Properties                                                                                                         |   |
| Item 3         | Legal Proceedings                                                                                                  |   |
| Item 4         | Submission of Matters to a Vote of Security  Holders                                                               |   |
| **PART  II**   |                                                                                                               |   |
| Item 5         | Market for Registrant’s Common Equity,  Related Stockholder Matters and Issuer Purchases of Equity Securities |   |
| Item 6         | Selected Financial Data                                                                                            |   |
| Item 7         | Management’s Discussion and Analysis of  Financial Condition and Results of Operations                        |   |
| Item 7A        | Quantitative and Qualitative Disclosures  About Market Risk                                                        |   |
| Item 8         | Financial Statements and Supplementary Data                                                                        |   |
| Item 9         | Changes in and Disagreements With  Accountants on Accounting and Financial Disclosures                             |   |
| Item 9A        | Controls and Procedures                                                                                            |   |
| Item 9B        | Other Information                                                                                                  |   |
| **PART  III**  |                                                                                                               |   |
| Item 10        | Directors and Executive Officers of the  Registrant                                                                |   |
| Item 11        | Executive Compensation                                                                                             |   |
| Item 12        | Security Ownership of Certain Beneficial  Owners and Management and Related Stockholder Matters                    |   |
| Item 13        | Certain Relationships and Related  Transactions                                                                    |   |
| Item 14        | Principal Accountant Fees and Services                                                                             |   |
| **PART  IV**   |                                                                                                               |   |
| Item 15        | Exhibits and Financial Statement Schedules                                                                         |   |
| **SIGNATURES** |                                                                                                               |

 

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**PART I**

 

**Item 1.Business**

 

**Forward-Looking Statements**

 

This annual report on Form 10-K contains forward-lookingstatements that are based on our management’s beliefs and assumptions and oninformation currently available to our management. Forward-looking statementsinclude information concerning our possible or assumed future results ofoperations, business strategies, financing plans, competitive position,industry environment, potential growth opportunities, the effects of futureregulation and the effects of competition. Forward-looking statements includeall statements that are not historical facts and can be identified by termssuch as “anticipates,” “believes,” “could,” “estimates,” “expects,” “intends,” “may,”“plans,” “potential,” “predicts,” “projects,” “should,” “will,” “would” orsimilar expressions.

 

Forward-looking statements involve known and unknown risks,uncertainties and other factors which may cause our actual results, performanceor achievements to be materially different from any future results,performances or achievements expressed or implied by the forward-lookingstatements. We discuss these risks in greater detail in the “Risk Factors”section below and in our other filings with the Securities and ExchangeCommission. Our actual results may differ materially from those anticipated inthese forward-looking statements. Readers are cautioned not to place unduereliance on forward-looking statements. The forward-looking statements speakonly as of the date on which they are made, and we undertake no obligation toupdate such statements to reflect events that occur or circumstances that existafter the date on which they are made.

 

**Overview**

 

Weare a biopharmaceutical company focused on the discovery, development and commercializationof novel drugs to address some of the world’s most widespread and costlychronic diseases involving pathways in the liver.  These diseasesinclude metabolic diseases such as diabetes, hyperlipidemia, a diseaseinvolving elevated levels of lipids such as cholesterol, and obesity, amongothers, and liver diseases such as hepatitis and primary liver cancer.  Wehave established a broad and growing product pipeline targeting large marketswith significant unmet medical needs. We have discovered all of ourproduct candidates internally using our proprietary technologies.

 

We currently have the following four product candidates in clinicaltrials in descending order from our most advanced product, pradefovir:

 

•                  *Pradefovir, a product candidatefor the treatment of hepatitis B that has successfully completed Phase IIclinical trials and is scheduled to enter Phase III clinical trials in 2006*. Pradefovir uses our HepDirect technology to targetthe active form of Hepsera, a marketed anti-viral drug indicated for thetreatment of hepatitis B, selectively to the liver. The active form of Hepserais known as adefovir. Hepsera delivers adefovir throughout the body, ratherthan selectively to the liver. We believe that Hepsera, which is indicated forthe treatment of hepatitis B, is used at a suboptimal dose due to an increasedrisk of kidney toxicity at higher doses. Because pradefovir targets adefovir tothe liver while limiting the amount that reaches other organs, we believe thathigher liver levels of the active drug may be achieved without causing kidneytoxicity, thereby providing greater efficacy. In July 2004 ValeantPharmaceuticals International, with whom we are collaborating with respect tothe development of pradefovir and to whom we have licensed worldwidecommercialization rights, commenced a 48 week dose-ranging Phase II clinicaltrial of pradefovir, the purpose of which was to evaluate safety and efficacyand select an appropriate dose for potential Phase III clinical trials. Basedon the decision to initiate this Phase II clinical trial, we earned a$1 million milestone payment from Valeant. In the clinical trial, which wascompleted in 2005 and met its primary efficacy end-point, Valeant reported thatpradefovir produced greater viral load reductions than Hepsera and was safe andwell tolerated with no evidence of renal toxicity. Based on the promising resultsseen in the Phase II clinical trial and after discussions with the U.S. Foodand Drug Administration, or FDA, Valeant has informed us that it intends toinitiate the Phase III clinical trials for pradefovir in 2006. (Pradefovir wasformerly called remofovir and before that, Hepavir B.)

 

•                  *CS-917, a product candidate forthe treatment of type 2 diabetes that is currently in Phase II clinical trials*. CS-917 is being developed in collaboration withDaiichi Sankyo Co., Ltd. In addition to having responsibility for clinicaldevelopment of the drug, Daiichi Sankyo has worldwide commercialization rights.We have retained co-promotion rights for CS-917 in North America. We believeCS-917, which we discovered using our NuMimetic 

 

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technology,inhibits a metabolic pathway in the liver that is responsible for producing thesugar called glucose. In type 2 diabetic patients, this pathway producesexcessive amounts of glucose, a process that contributes to high blood glucoselevels which in turn may lead to morbidity and death. Daiichi Sankyo reportsthat results from a 14-day Phase II clinical trial and a 28-day Phase IIclinical trial, both in type 2 diabetic subjects, demonstrated that CS-917 iscapable of significantly lowering blood glucose levels. Based on the results ofthe 28-day clinical trial, we earned a $3.5 million milestone payment fromDaiichi Sankyo. CS-917 is currently in a Phase IIb clinical trial designed toallow measurement of the regulatory endpoint hemoglobin A1c, a standard measureof long-term glucose control, after 3 months of dosing.

 

•                  *MB07133, a product candidate for thetreatment of primary liver cancer that is currently in a Phase I/II clinical trialdesigned to evaluate safety and preliminary efficacy in a limited number ofpatients.*MB07133 uses ourHepDirect technology to target the active form of araC to the liver whiledecreasing levels of the active form of the drug in tissues outside of theliver. AraC is a marketed anti cancer drug used to treat leukemia. We believeMB07133’s unique liver-targeting property will enhance efficacy in the liverwhile minimizing the toxicities associated with araC therapy. MB07133 iscurrently being studied in patients with primary liver cancer to identify themaximum tolerated dose. Once this dose is identified, we plan to study MB07133at that dose in a limited number of patients in order to evaluate its potentialefficacy. We retain all rights to MB07133.

 

•                  *MB07803, a product candidate for thetreatment of type 2 diabetes that is currently in a Phase I clinical trial.* We consider MB078703 to be a second generationinhibitor of the metabolic pathway in the liver that is responsible forproducing glucose and is designed to work by the same mechanism as CS-917. Inearly 2006 we began a Phase I clinical trial with MB07083 to assess its safetyin healthy human volunteers. We retain all rights to MB07803.

 

In additionto these product candidates, we have a clinical development candidate, MB07811,which we have recommended for clinical development for the treatment of highcholesterol and possibly obesity. Recommendation for clinical developmentrefers to an internal process involving our analysis of relevant pre-clinicaldata and selection of compounds suitable for clinical development by us. MB07811is designed to act by controlling the expression of certain genes in the liverthat are important for making or using cholesterol as well as genes involved inthe control of energy expenditure. We plan to file an Investigational New Drugapplication, or IND, for MB07811 and to commence clinical trials of MB07811 in2006 if the preclinical data is supportive and the proposed clinical trials arecleared by the FDA.

 

We have expertise in liver diseases and in the pathways and proteinsresiding in the liver that significantly contribute to certain metabolicdiseases or that are important for transporting drugs into the liver, actingupon them and expelling them from the body. These processes are referred to asdrug uptake, metabolism and excretion, respectively. With this knowledge, wedeveloped proprietary technologies, including two which we called NuMimetic andHepDirect, which we have used to develop our current product candidates andwhich we expect to use to expand our product pipeline in the future.

 

We use ourNuMimetic technology to discover molecules that bind effectively andspecifically to certain regulatory sites, called nucleotide binding sites,residing on proteins called enzymes that control the output of cellularpathways involved in metabolic diseases, or metabolic pathways. We havedeveloped a library of these unique molecules, known as nucleotide mimetics,and have used this library to discover compounds that we believe will lowerglucose, cholesterol or lipid levels. We used our NuMimetic technology todiscover CS-917 and MB07803, and we are also using it in certain of ouradvanced research programs, in which we have identified lead drug compounds andshown them to have efficacy in animal models. In addition to our internalprograms that use the NuMimetic technology, we are using this technology in acollaboration with Merck & Co., Inc. to discover new treatments formetabolic diseases such as type 2 diabetes (by a different mechanism thanCS-917 and MB07803), hyperlipidemia and a disease associated with fatty livers,known as non-alcoholic steatohepatitis, by inhibiting cholesterol and lipidproduction in the liver by activating a protein kinase in the liver known asAMPK.

 

We use our HepDirect technology to target drugs selectively to theliver, resulting in increased levels of the active form of the drug in theliver and decreased levels in non-liver tissues. We believe thisliver-targeting property may significantly improve drug efficacy and safety whencompared to non liver-targeting therapies. Our HepDirect technology canpotentially be used to improve certain currently marketed drugs or applied tocertain drug candidates, resulting in new, proprietary drugs that may then bemarketed by us or by companies we collaborate with that have compounds thatwould benefit from this approach. Pradefovir and MB07133 use our HepDirecttechnology, as do several of our advanced research programs. In addition to ourinternal programs that use the HepDirect technology, we have collaborated withMerck to discover new treatments for hepatitis C by applying our HepDirecttechnology and other liver-targeting technology to certain compounds suppliedby Merck.

 

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Our research programs focus on metabolic diseases linked to pathways inthe liver such as type 2 diabetes, hyperlipidemia and obesity, as well as liverdiseases such as hepatitis C and liver fibrosis. Our goal is to expand ourclinical development pipeline by continuing to recommend additional new drugcompounds for clinical development. We believe that a broad product pipelinewill provide strong growth potential and reduce our reliance on the success ofany single product candidate. We may also in-license technologies and productsto complement our internal discovery efforts. We believe our advanced researchprograms have the potential to yield additional clinical developmentcandidates. Once we recommend a drug compound for clinical development, theclinical development candidate undergoes pre-clinical development includingscale-up, toxicology and formulations development. Successful compounds wouldthen enter human clinical testing.

 

Our advanced research programs include:

 

•                  a program that has used our HepDirect and otherliver-targeting technology in a collaboration with Merck to identify drugs totreat hepatitis C infection. The funded research phase of this collaborationhas ended. Merck is currently evaluating and/or may evaluate drug compoundsdiscovered under the research phase of the collaboration to determine if one ormore will be recommended for clinical development,

 

•                  a program using our NuMimetic technology in acollaboration with Merck to treat metabolic diseases such as type 2 diabetes (bya different mechanism than CS-917 and MB07803), hyperlipidemia and a diseaseassociated with fatty livers, known as non-alcoholic steatohepatitis, byinhibiting cholesterol and lipid production in the liver, and

 

•                  a programusing our HepDirect technology to treat liver fibrosis by inhibiting theoverproduction of collagen in the liver.

 

Our goal is to be a leading biopharmaceutical company developing andcommercializing novel drugs. We intend to accomplish this goal by executing ourstrategy of

 

•                  advancing the development of our product candidates anddeveloping a broad product pipeline,

 

•                  continuing to enhance our expertise in liver pathways andmetabolism and our related intellectual property rights,

 

•                  pursuing a diversified development andcommercialization strategy for our product candidates,

 

•                  establishing additional partnerships based on HepDirect or ourother proprietary liver-targeting technologies, and

 

•                  becoming a fully-integrated pharmaceutical company.

 

**Disease Backgrounds**

 

Liver diseases such as hepatitis B, hepatitis C, primary liver cancerand liver cirrhosis represent some of the most widespread and serious diseasesin the world. Metabolic diseases such as type 2 diabetes, hyperlipidemia,obesity and non-alcoholic steatohepatitis are major healthcare problemsworldwide, but are especially prevalent in the U.S. and Europe. We believe thatthese metabolic diseases can be treated by targeting metabolic pathways thatreside in the liver, such as the pathways responsible for the production ofglucose, cholesterol and fat molecules. As a group, liver and metabolicdiseases represent one of the largest pharmaceutical markets with worldwidesales of drugs targeting these diseases exceeding $30 billion annually.

 

Liver diseases are generally poorly treated with current drugtherapies. Moreover, these marketed drugs generally show significantlimitations, including poor tolerability, safety risks or inadequate efficacyin certain patients. Some existing anti-viral and anti-cancer drugs are noteffective against diseases of the liver due to the liver’s inability toeffectively convert them to their active forms. The use of existing drugs forthe treatment of liver diseases is further limited in some cases bydose-limiting toxicities which may occur when high levels of the drugaccumulate in tissues outside the liver.

 

In contrast to liver diseases, many more drugs are available fortreating metabolic diseases either alone or in combination with other drugs.However, while effective drug therapies exist for some patients, most areinadequately treated or controlled. 

 

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Over 60% of patients treated for type 2 diabetes remain above thetargeted levels for glucose set by the American Diabetes Association. Inaddition, over 80% of patients with coronary heart disease, which is associatedwith hyperlipidemia, remain above the targeted levels for cholesterol set bythe National Cholesterol Education Program. Obese patients or patients withnon-alcoholic steatohepatitis are even more poorly treated with few drugs onthe market showing suitable efficacy and safety for these patients. As aresult, we believe more effective drugs are needed to treat these diseases.

 

**Our Pipeline**

 

The following table summarizes our product candidates currently inclinical development, our clinical development candidate and our advancedresearch programs in descending order from our most advanced product candidate,pradefovir:

 

 

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(1)          Noneof our product candidates have received regulatory approval in the U.S. or inforeign countries.

(2)          PhaseIII clinical trials expected to commence in 2006.

(3)          PhaseI clinical trials expected to commence in 2006.

(4)          Weare collaborating with Merck to apply our HepDirectTM and other liver-targeting technologies to certaincompounds for the treatment of hepatitis C infection.

 

**Pradefovir: A HepDirect prodrug of adefovirfor the treatment of hepatitis B**

 

Pradefovir is an oral product candidate that has successfully completedPhase II clinical trials to evaluate its potential to treat hepatitis B, aserious liver infection. Although several marketed drugs target hepatitis B,the disease remains poorly treated. One currently marketed hepatitis B drug isHepsera, a non-liver specific prodrug of the antiviral compound adefovir. Aprodrug is a drug to which a chemical modification has been made that rendersit inactive until enzymes in the body convert it to its active form. Hepseraoffers advantages over existing drugs because it is not associated with a highincidence of viral resistance, but toxicity issues limit the doses at which itcan be administered and therefore its efficacy in treating this disease.Pradefovir, on the other hand, is designed using our proprietary HepDirecttechnology to deliver high concentrations of adefovir to the liver, whilelimiting the amount of adefovir generated outside of the liver, thereby potentiallysignificantly reducing dose-related toxicities. In pre-clinical studies,pradefovir has been shown to result in higher levels of the active form ofHepsera, adefovir, in the liver without significantly increased levels ofadefovir in the bloodstream or kidney. In clinical studies conducted to date,pradefovir has reduced hepatitis B virus levels to a greater extent thanHepsera at doses that are associated with lower circulating adefovir levels. Inthese studies, pradefovir also appeared to be safe and well tolerated. We aredeveloping pradefovir in partnership with Valeant, to whom we licensed worldwidecommercialization rights. Pradefovir was formerly called remofovir and beforethat, Hepavir B.

 

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*Hepatitis B*

 

Hepatitis B is a viral disease that causes inflammation of the liver.Hepatitis B is transmitted by contact with the blood or other body fluids of aninfected person. Hepatitis B infection is often difficult to diagnose because,depending upon the severity of the infection, patients can either beasymptomatic or experience only general flu-like symptoms such as fatigue,nausea or vomiting. Without appropriate treatment, continued inflammation ofthe liver leads to progressive scarring, or fibrosis, and eventually may leadto liver cancer, resulting in death.

 

Hepatitis B is the most common serious liver infection in the world.Over two billion people worldwide, or approximately one-third of the world’spopulation, have been infected at some time with hepatitis B, and approximately400 million of those people are chronic carriers of the virus. Approximately1.2 million deaths per year worldwide are hepatitis B related. The Centersfor Disease Control and Prevention reports that, in the U.S., over1.2 million people are chronically infected with hepatitis B and nearly80,000 new infections occur every year.

 

Sales of anti-viral drugs for the treatment of hepatitis B in the sevenlargest pharmaceutical markets, which are comprised of the U.S., France,Germany, Italy, Japan, Spain and the U.K., are expected to nearly triplebetween 2000 and 2010. There is also an opportunity for substantial additionalgrowth from potential sales of anti-viral drugs for hepatitis B in emergingmarkets including Eastern Europe and Asia. These regions have some of thehighest rates of chronic hepatitis B infection in the world. There arecurrently over 300 million people with chronic hepatitis B infection inthese emerging markets, representing greater than 75% of the total chronicinfections worldwide.

 

*Current Treatments*

 

In the U.S., until recently, there were three approved treatments forchronic hepatitis B: Intron A, Epivir-HBV, also referred to as Zeffix(lamivudine) and Hepsera. Each of these therapies has limitations in thetreatment of patients with Hepatitis B. For example, Intron A is effective onlyin a small fraction of hepatitis B patients and is generally poorly tolerated.Patients taking Epivir-HBV or Zeffix can develop significant resistance tolamivudine, the drug’s active ingredient. We believe that induction of viralresistance is also a significant issue for certain hepatitis B productcandidates that are currently in late stage clinical development. Hepsera, onthe other hand, shows limited propensity to induce virus mutations that areresistant to drug therapy and has proven effective against lamivudine-resistantstrains of hepatitis B. However, potential kidney toxicities limit the level atwhich Hepsera can be dosed. In March 2005, a fourth drug called BaracludeÔ(entecavir) was approved. To date, Baraclude has not been shown to inducesignificant viral resistance in drug naïve patients. However, based on clinicaldata, lamivudine resistant patients respond less effectively to Baracludetherapy and exhibit a higher rate of viral resistance.

 

Hepsera, lamivudine and Baraclude all decrease virus levels, asmeasured by hepatitis B DNA in the blood serum. Nevertheless, further decreasesare desirable since these reductions are not considered sufficient to cure theinfection in the majority of patients. In 2003, the New England Journal ofMedicine reported that a three-fold higher dose (30 mg) of Hepsera led to amore than ten-fold greater reduction in hepatitis B DNA in the blood serum ofpatients and consistent trends toward improvement in all measures of liverinjury. However, this higher dose caused elevation in markers of kidneytoxicity that prevented further development at that dose. As a result, webelieve the approved dose of Hepsera (10 mg) may be suboptimal for thereduction of virus levels.

 

*Pradefovir*

 

Pradefovir and Hepsera are both prodrugs of 9, -[2 (Phosphonomethoxy)ethyl] adenine (PMEA), or adefovir. When the prodrug is converted to adefovirin patients with hepatitis B, it acts in the liver and leads to decreased virallevels. Pradefovir is a HepDirect prodrug that after oral administration isabsorbed rapidly after which it is taken up by the liver and converted to theactive form, adefovir. Hepsera, on the other hand, is converted to adefovirthroughout the bloodstream. As a result of this difference in distribution,higher dosing of pradefovir is possible due to the reduced systemic and renaladefovir levels, providing potentially improved efficacy relative to Hepsera inthe treatment of hepatitis B, based on results of a Phase II clinical trial,which is further discussed in the clinical trials section below.

 

*Clinical Trials*

 

Under our agreement with Valeant, Valeant is responsible for conductingand reporting the results of clinical studies of pradefovir, and is responsiblefor making all regulatory filings related to the product, including submissionof INDs and other regulatory submissions to the FDA. The following informationis based on information provided to us by Valeant in connection with ouragreement, or otherwise announced by Valeant.

 

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Valeant has completed two single-dose Phase I clinical trials ofpradefovir in 47 healthy volunteers. Pradefovir was safe and well tolerated atall dose levels studied. These clinical trials evaluated the pharmacokineticprofile of pradefovir, indicating that pradefovir appeared to be converted toits desired form, adefovir, in humans.

 

Pradefovir was also studied in two 28-day, randomized, placebo-controlled,double-blind, dose-escalation Phase I clinical trials designed to evaluatesafety and preliminary efficacy in 80 hepatitis B patients in the U.S. andTaiwan.

 

The hepatitis B patients in the 28-day U.S. Phase I clinical trial weredivided into groups that received 5, 10, 30 or 60 milligrams of pradefovir or aplacebo administered orally once a day. The patients in the 28-day TaiwanesePhase I clinical trial were divided into groups that received 5, 10, 20 or 30milligrams of pradefovir or a placebo administered orally once a day. In eachof the dose groups evaluated, pradefovir was safe and well tolerated, andpatients treated with pradefovir exhibited a statistically significantreduction, as determined by a p-value of less than 0.05, in hepatitis B viruslevels compared to patients treated with a placebo. The reduction in medianhepatitis B virus levels, which was determined by measuring viral DNA, and theoverall distribution of adefovir throughout the body were consistent withresults expected for our HepDirect technology based on pre-clinical studies.

 

Based on these initial results, in July 2004 Valeant commenced a12-month dose-ranging Phase II clinical trial of pradefovir the purpose ofwhich was to select appropriate doses for Phase III clinical trials. This PhaseII clinical trial was fully enrolled as of November 2004 and 24 week interimresults which showed evidence of safety and efficacy were first reported byValeant in July 2005 and presented at the American Association for the Study ofLiver Diseases, or AASLD, meeting in November 2005. Initial results of thecompleted Phase II clinical trial were announced by Valeant and Metabasis inMarch 2006, and detailed results of the completed Phase II clinical trial willbe presented at the 41st Annual Meeting of the European Associationfor the Study of the Liver in April 2006 in Vienna, Austria.

 

The Phase II clinical trial conducted byValeant was an open-label, randomized, multiple dose clinical trial with 242patients enrolled at 21 sites in the United States, Taiwan, Singapore and SouthKorea. Approximately half of the patients had been previously treatedineffectively with other drugs. Patients that have been previously treatedineffectively are considered to be more difficult to treat. The Phase IIclinical trial consisted of five treatment groups: pradefovir — 5, 10, 20 and30 mg administered once a day (called QD administration), and Hepsera — 10 mg(QD), with an overall treatment duration of 48 weeks.

 

 The data from the Phase II clinical trial showed that the patient groupthat received 30 mg (QD) pradefovir achieved a 5.54 log (10) drop in hepatitisB viral (HBV) DNA, a measure of viral load, from baseline as compared to a 4.19log (10) drop in the 10 mg (QD) Hepsera (adefovir dipivoxil) group (p<0.001).Pradefovir at doses of 10 and 20 mg (QD) also showed a statisticallysignificant greater reduction in viral load compared to Hepsera. The followingchart illustrates these results:

 

Pradefovir Phase 2 – Week 48Results (all patients)

Mean Log(10) HBV DNA DeclineFrom Baseline

(Intent-to-Treat Analysis)

 
| ** ** | ** ** | ** **   | ** ** | ** **         | ** ** | **Baseline Mean** | ** ** | ** **                    | ** ** | **p-Value**          | ** ** |
|------------|------------|--------------|------------|--------------------|------------|------------------------|------------|-------------------------------|------------|----------------------|------------|
| ** ** | ** ** | ** **   | ** ** | ** **         | ** ** | **HBV DNA**       | ** ** | **Week 48**              | ** ** | **Compared to** | ** ** |
| ** ** | ** ** | ** **   | ** ** | **Number of** | ** ** | **(Log (10)**     | ** ** | **Mean Decline in** | ** ** | **Hepsera**          | ** ** |
| ** ** | ** ** | **Dose**     | ** ** | **Patients**       | ** ** | **copies/mL)**         | ** ** | **HBV DNA**              | ** ** | **Control**          | ** ** |
|       |       |         |       |               |       |                   |       |                          |       |                 |       |
| Hepsera    |       | 10  mg QD    |       | 50                 |       | 8.0                    |       | -4.19                         |       | N/A                  |       |
|       |       |         |       |               |       |                   |       |                          |       |                 |       |
| Pradefovir |       | 5  mg QD     |       | 47                 |       | 7.9                    |       | -4.09                         |       | 0.83                 |       |
|       |       | 10  mg QD    |       | 49                 |       | 7.9                    |       | -4.84                         |       | 0.007                |       |
|       |       | 20  mg QD    |       | 48                 |       | 8.0                    |       | -4.89                         |       | 0.007                |       |
| ** ** | ** ** | **30 mg QD** | ** ** | **48**             | ** ** | **8.2**                | ** ** | **-5.54**                     | ** ** | **<0.001**        | ** ** |

 

The percentage of patients in the 30 mg (QD)pradefovir cohort achieving undetectable HBV DNA (<400 c/mL) was almostdouble that of patients receiving 10 mg (QD) of Hepsera. The percentage ofpatients with HBV DNA of less than 400 c/mL were 45 percent, 63 percent, 56percent, and 71 percent for the pradefovir 5, 10, 20, and 30 mg (QD) groups,respectively, and 36 percent for the Hepsera group.

 

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No patient demonstrated an increase in serumcreatinine levels over baseline of greater than or equal to 0.5 mg/dL. Serumcreatinine levels are a marker for renal toxicity that has been associated withhigher doses of adefovir. Renal safety was comparable between all treatmentgroups. There were no serious adverse events related to treatment. The mostfrequently reported adverse events were similar across all treatment groups,including Hepsera. No dose-related trends regarding safety were identified andno events resulted in a patient being withdrawn prematurely from treatment.

 

Valeant has reviewed results from the PhaseII clinical trial with the FDA and intends to initiate Phase III clinical trialsin 2006.

 

*Pre-clinical Studies*

 

Together with Valeant, we conducted pre-clinical studies of pradefovirin rats, mice and monkeys. These studies showed that animals treated with anoral dose of pradefovir exhibited higher levels of adefovir and itsbiologically active form, adefovir diphosphate, in the liver and lower levelsof adefovir and adefovir diphosphate in tissues outside of the liver, includingthe kidney and gastrointestinal tract, relative to animals treated with asimilar dose of Hepsera. Results from one of these studies are depicted in thechart below, which shows the profile of adefovir diphosphate levels, measuredby nanomoles per gram, over a 24 hour period in the livers and kidneys ofrats administered an oral dose of either pradefovir or Hepsera at a level of 30milligrams per kilogram.

 

 

**CS-917: A gluconeogenesis inhibitor for thetreatment of type 2 diabetes**

 

CS-917 is an oral product candidate for type 2 diabetes that wediscovered using our proprietary NuMimetic technology. Data generated to dateindicate that CS-917 inhibits a metabolic pathway in the liver calledgluconeogenesis, which is responsible for the excessive production of glucoseby patients with type 2 diabetes. We believe that CS-917 is the first productcandidate to be studied in human clinical trials that is designed to directlyblock this pathway. In pre-clinical studies and two completed clinical trials,CS-917 has shown a statistically significant reduction in elevated bloodglucose levels of the type that characterize type 2 diabetes. CS-917 is beingdeveloped in partnership with Daiichi Sankyo, and we retain co-promotion rightsin North America.

 

*Diabetes*

 

There are two forms of diabetes: type 1 (insulin-dependent,juvenile-onset diabetes) and type 2 (adult-onset diabetes). Approximately 90%of diabetes patients have type 2 diabetes. Elevated blood glucose levels intype 2 diabetic patients result from decreased glucose metabolism combined withincreased glucose production. Decreased glucose metabolism arises from arelative 

 

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underproduction of the hormone insulin by the pancreas, along with adecrease in the sensitivity of the body’s tissues, such as muscle, liver andfat, to insulin action. Increased glucose production is caused by increasedsynthesis of glucose by the gluconeogenesis pathway in the liver. Over time,the chronically elevated blood glucose levels in type 2 diabetics can lead tomany long-term complications such as coronary heart disease, stroke, blindness,peripheral vascular disease, kidney disease and nerve damage. Diabetes is aleading cause of death in the U.S.

 

Type 2 diabetes afflicts over 170 million people worldwide, withover 18 million afflicted in the U.S. Global sales of oral diabetes drugscurrently exceed $10 billion annually, with the U.S. accounting for over 65%of the total sales.

 

*Current Treatments*

 

The United Kingdom Prospective Diabetes Study, a landmark 20-yearclinical study completed in 1996, demonstrated that stringent control of bloodglucose levels reduces the risk of the serious complications associated withtype 2 diabetes. As a result of this study, the American Diabetes Associationnow recommends that levels of hemoglobin A1c be maintained under 7% in type 2diabetic patients. However, at present no single marketed drug is capable oflowering hemoglobin A1c levels into the targeted range for a sustained periodof time in the majority of patients with type 2 diabetes.

 

Drugs from each of the three major classes of oral diabetes drugs notonly exhibit limited efficacy, but also are associated with less than desiredtolerability and significant mechanism-based side effects. These drug classesinclude:

 

•                  insulin secretion enhancers, which lower glucoselevels by inducing insulin secretion from the pancreas. This drug class hasbeen associated with a significant risk of hypoglycemia,

 

•                  insulin sensitizers, which lower glucose levels byenhancing insulin sensitivity. This drug class has been associated with fluidretention, weight gain, and a risk of congestive heart failure, and

 

•                  hepatic glucose output inhibitors, which lowerglucose levels by inhibiting liver glucose production. The only drug in thisclass is metformin, which, based on a study reported in the medical journalDiabetes, inhibits glucose production by the liver by only approximately20-25%, even when administered at doses higher than the commonly prescribeddaily dose. Therefore, a more effective hepatic glucose output inhibitor mayimprove efficacy over metformin. Metformin therapy has been associated with anincreased risk of lactic acidosis in certain patient populations, especiallypatients with kidney dysfunction. In addition, metformin therapy can lead totransient gastrointestinal disturbances such as nausea, diarrhea and vomiting,which can compromise patient compliance.

 

Certain widely used insulin secretion enhancers and insulinsensitizers, but not metformin, are also associated with increased weight gain.Since weight gain is known to exacerbate diabetes, physicians often prescribemetformin as a first line therapy to obese patients, who according to a recentstudy published in the medical journal Diabetes & Endocrinologycomprise more than 90% of newly diagnosed type 2 diabetic patients. In theUnited Kingdom Prospective Diabetes Study, obese patients treated with maximumdoses of metformin or an insulin secretion enhancer showed a steady rise inhemoglobin A1c levels above the targeted range at three years. Progressivelyfewer patients were able to maintain baseline hemoglobin A1c levels at sixyears and nine years, respectively.

 

Once treatment with a single oral drug fails to adequately controlglucose levels, diabetic patients typically are treated with one or moreadditional oral drugs. It is estimated that more than 75% of type 2 diabeticpatients will require multiple oral drug therapies to attain adequate glucosecontrol and just over 30% of type 2 diabetic patients will ultimately advanceto a stage that requires daily insulin injections. We believe that because ofthe limitations in currently marketed drugs, the diabetes market is receptiveto new drugs, and new therapeutic approaches have the potential to experiencerapid clinical acceptance.

 

*CS-917*

 

Studies show that the elevated blood glucose levels that characterizetype 2 diabetic patients are correlated with the overproduction of glucose bythe liver, which arises from an increased rate of flow through thegluconeogenesis pathway. We believe that CS-917 is the first product candidateto be studied in human clinical trials that is designed to directly block thegluconeogenesis pathway by inhibiting an enzyme calledfructose-1,6-bisphosphatase, or FBPase. We believe that FBPase represents animportant control point within this pathway and a suitable target for inhibitingthe overproduction of glucose found in type 2 diabetic patients. Pharmaceuticalcompanies have tried to find inhibitors of FBPase, but to our knowledge havethus far 

 

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failed to discover compounds of sufficient potency and specificity tobe considered as product candidates. Using our NuMimetic technology, we haveidentified molecules that effectively bind to the nucleotide-binding site onFBPase and potently and specifically inhibit FBPase activity in animal models.

 

We believe that CS-917 may be effective across a broad patientpopulation because glucose overproduction by the liver is common to all type 2diabetics regardless of disease stage or body mass. Unlike insulin sensitizersand certain insulin secretion enhancers, CS-917 does not cause weight gain inanimals and is therefore expected to be appropriate for effective treatment ofobese diabetics. Studies also show that CS-917 is effective in animal models oflean diabetes and that glucose lowering occurs independent of insulin levels. Takentogether these characteristics may make CS-917 useful:

 

•                  inadvanced diabetics, a patient population commonly resistant to therapiesdependent on insulin production such as insulin sensitizers and insulinsecretion enhancers,

 

•                  inearly stage diabetes, and

 

•                  inprediabetics where CS-917 may be effective in preventing or delaying the onsetof diabetes.

 

*Clinical Trials*

 

To date, our partner Daiichi Sankyo has completed a number of Phase Iclinical trials of CS-917 in healthy volunteers as well as Phase I and Phase IIclinical trials of CS-917 in type 2 diabetic patients.

 

Results from two Phase II clinical trials provide evidence that CS-917is capable of significantly lowering blood glucose levels in humans. The firstPhase II clinical trial completed involved treatment of 39 type 2 diabeticsubjects with CS-917 or a placebo once daily for 14 days using arandomized, placebo-controlled, double-blind clinical trial design. Thepatients were divided into groups that received 50, 100, 200 or 400 milligramsof CS-917 or a placebo. Patients were dosed in the morning following a ten hourovernight fast and then fasted an additional six hours. The efficacy endpointof the clinical trial was a comparison of cumulative glucose levels over thesix-hour fasting period following administration on day 14 relative to baselinelevels (which are cumulative glucose levels determined for the same periodprior to clinical trial initiation) in patients treated with CS-917, as comparedto the change from baseline levels in patients treated with a placebo. CS-917 appearedto be safe and well tolerated and the primary efficacy endpoint of the clinicaltrial, demonstration of a statistically significant reduction in thesecumulative glucose levels as determined by a p-value of less than 0.05 inpatients treated with the highest dose of CS-917, was achieved. A p-value ofless than or equal to 0.05 is generally considered to signify a statisticallysignificant result, which means a result is unlikely to occur by chance.Furthermore, the reduction in glucose levels seen on day 14 compared tobaseline levels was greater in all groups treated with CS-917 than that seen inthe placebo-treated groups.

 

In the second Phase II clinical trial, 146 type 2 diabetic subjectswere treated with CS-917 or a placebo administered two or three times per dayfor 28 days using a randomized, placebo-controlled, double-blind clinicaltrial design. The primary efficacy endpoint of the clinical trial was the changefrom baseline in the plasma glucose level measured after an overnight fast,often called the fasting plasma glucose level, on the morning of day 29following the last dose on the evening of day 28, as compared to the changemeasured in the patients that received a placebo over the same time period. Ineach case, the group of patients who received CS-917 showed a statisticallysignificant reduction in fasting plasma glucose levels compared to thecorresponding dose group that received a placebo, as determined by a p-value ofless than 0.05.

 

The results of clinical trials to date indicate that CS-917 may need tobe administered more than once daily, although this has not been definitively determined.

 

The inhibition of gluconeogenesis can cause elevated levels of lacticacid, or lactate, which, if high and sustained, under certain conditions canlead to lactic acidosis, a serious and potentially fatal condition. However,metformin, which reduces liver glucose production through an unknown mechanism,also raises lactate above normal levels in about 4% of patients with noapparent adverse clinical consequences. In the 14-day Phase II clinical trialof CS-917, two patients treated with the highest dose of CS-917 (400milligrams) exhibited lactate levels above the normal range on each day theyreceived CS-917. Lactate levels in both patients returned to normal levelsprior to administration of the next scheduled dose. In the 28-day Phase IIclinical trial of CS-917, isolated instances of lactate elevation significantlyabove the normal range were seen in some patients in both CS-917- andplacebo-treated groups over the course of the 28 days. No patientexhibited sustained lactate levels significantly above the normal range over aperiod of consecutive days during the clinical trial. However, one patient whoreceived 200 milligrams of CS-917 twice a day was withdrawn from the clinicaltrial by the investigator on day 15 due to concerns over elevated lactatelevels measured the previous day.

 

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A larger and longer-term Phase II clinical trial designed to furtherevaluate the safety and effectiveness of CS-917 and to determine dosing levelsfor potential Phase III clinical trials was initiated in December 2004. Inaddition, a second clinical trial that involved administration of a relativelyhigh dose of CS-917 to evaluate the timing of dose administration was alsoinitiated at that time. Additional Phase I clinical trials evaluating concomitantadministration of CS-917 with other drugs were also initiated, including aclinical trial evaluating the interaction of CS-917 with the marketed diabetesdrug metformin.

 

In March 2005, we were notified by Daiichi Sankyo that two seriousadverse events involving lactic acidosis had occurred in two patients in aPhase I clinical trial evaluating the interaction of CS-917 with metformin. Theserious adverse events were resolved after medical intervention. After theadverse events occurred, the three clinical trials that were ongoing at thattime were stopped by Daiichi Sankyo, while one Phase I clinical trial which didnot combine CS-917 with metformin continued and was completed.

 

It was subsequently determined that the two patients that experiencedthe lactic acidosis had blood levels of metformin that were elevated comparedto other patients in the clinical trial that received metformin beforeadministration of CS-917. After CS-917 administration, when the two patientswere being administered metformin and CS-917 the metformin blood levelsincreased significantly, into a range that is associated with lactic acidosis. CS-917blood levels also rose higher than expected. A high blood level of metformin isbelieved to cause mitochondrial toxicity which can cause lactic acidosis. Thesedangerous levels are known to occur in patients with significant renaldysfunction who are inappropriately given metformin. Consequently, metformin iscontraindicated for use in patients with significant renal dysfunction.

 

The reason for the unexpectedly high blood levels of both drugs inthese two patients is unknown at this time. In July 2005, after completinga comprehensive review of the program and the events and data surrounding thetwo serious adverse events, we and Daiichi Sankyo concluded that the lacticacidosis observed in the two patients was likely due to the significantlyincreased blood levels of metformin described above which in turn likely led tomitochondrial toxicity. Subsequently, Daiichi Sankyo decided that Phase IIbclinical trials of CS-917 as a mono-therapy could safely resume withprecautions to assure that patients do not take CS-917 in combination withmetformin.

 

In February 2006, based on reports from Daiichi Sankyo, aftersubmission of the proposed clinical trial protocol to the FDA and approval bythe institutional review board, or IRB, a Phase IIb clinical trial of CS-917was initiated. This Phase IIb clinical trial will allow measurement of theregulatory endpoint, the blood level of hemoglobin A1c. Daiichi Sankyo hasconducted and will likely conduct additional studies combining CS-917 withother diabetes drugs to assess both the safety and eventually the potential forenhanced efficacy with the combination. However, further combination of CS-917and metformin will be avoided unless additional data suggests that theelevation of metformin blood levels as seen in the two patients can be avoidedthrough patient exclusion or through the administration of CS-917 at lowerdoses or through other means. Should CS-917 eventually be approved andcombination with metformin remains an issue, the FDA may require additionalmeasures be taken during marketing, such as prominent warning labels known as “black-box”warnings, physician education programs and/or other steps regarding concomitantuse of CS-917 and metformin.

 

*Pre-clinical Studies*

 

Results from clinical trials of CS-917 are consistent with the glucose-loweringeffect observed in pre-clinical studies we conducted with Daiichi Sankyo inseveral animal models of diabetes. Studies in rats showed that daily oraladministration of CS-917 lowered blood glucose when dosed chronically, or overan extended period of time. Moreover, maximum glucose lowering in these studieswas better than or equal to the glucose lowering effects of insulin sensitizersand insulin secretion enhancers. CS-917 also lowered glucose in both obese andlean diabetes animal models. Like metformin, but unlike the insulin sensitizersand certain insulin secretion enhancers, CS-917 induced no weight gain intreated animals relative to untreated animals.

 

Pre-clinical studies indicated that the combination of maximallyeffective doses of an insulin sensitizer with an FBPase inhibitor may result ingreater efficacy than either drug alone. The following chart shows the resultsof a study in which we administered to an animal model of obese diabetes eitherno drug, referred to as control, or maximally effective doses of the insulinsensitizer troglitazone, CS-917 or a combination of troglitazone and CS-917.Blood glucose levels were monitored over three weeks, measured as milligramsper deciliter of blood, and shown to decrease similarly between animals treatedwith troglitazone and CS-917. The drug combination, however, led to nearnormalization of blood glucose levels, which is approximately 150 milligramsper deciliter:

 

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In addition to troglitazone, which is no longer marketed because ofsafety concerns, we have evaluated the combination of FBPase inhibitors withother currently marketed insulin sensitizers with similar results.

 

Pre-clinical studies in diabetes animal models support the use ofCS-917 in advanced diabetic patients. As in humans, animal models with diabetesshow increased glucose production as they age and their diabetes worsens. Ourstudies demonstrated that these animals respond poorly to insulin sensitizersand insulin secretion enhancers. In contrast, these animals respond well toCS-917, indicating glucose-lowering effects in both advanced stage and earlystage animal models of the disease.

 

In addition, Daiichi Sankyo has shown that chronic dosing of CS-917decreases the insulin dose required to maintain a target glucose level in amouse model of diabetes. Based on these studies and other pre-clinical data,including glucose-lowering effects in non-human primates and oralbioavailability data and toxicology results from studies in both rats andnon-human primates, Daiichi Sankyo moved CS-917 into clinical trials inJuly 2001.

 

**MB07133: A HepDirect prodrug for thetreatment of primary liver cancer**

 

MB07133 is an intravenously administered product candidate in a PhaseI/II clinical trial designed to evaluate safety and preliminary efficacy in alimited number of patients with primary liver cancer. Few treatment optionsexist, and no drug has been approved for treatment of primary liver cancer.MB07133 uses our HepDirect technology to target the active form of araC to theliver while decreasing levels of the active form of the drug in tissues outsideof the liver. AraC is a marketed anti cancer drug used to treat leukemia. AraC’santi-cancer activity is associated with its ability to be converted to itsbiologically active form, araCTP. Treatment with araC does not result in thegeneration of efficacious levels of araCTP in the liver due to the failure ofaraC to be converted to an intermediate form called araCMP. Using our HepDirecttechnology we designed MB07133 to deliver araCMP to the liver thereby providinga means to treat primary liver cancer. We retain all rights to MB07133.

 

*Primary Liver Cancer*

 

Primary liver cancer is a malignancy originating in the liver thatoften kills patients within six months after diagnosis with less than 10% ofpatients surviving for five years or more. Metastatic liver cancer, on theother hand, originates in other organs and then progresses to the liver. In theU.S., the American Cancer Society reports that primary liver cancer is theninth leading cause of cancer mortality in men and is the twelfth leading causeof cancer mortality in women. The American Cancer Society estimates thatapproximately 18,500 new cases of primary liver cancer will be diagnosed in theU.S in 2006. Primary liver cancer is responsible for over 500,000 deaths peryear worldwide.

 

While the definitive cause of primary liver cancer is unknown, it iswell-recognized that patients with chronic liver diseases such as hepatitis B,hepatitis C, alcoholic cirrhosis and iron overload are at high risk fordeveloping liver cancer over a 

 

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30-year period. In the U.S., Europe and Japan, hepatitis C isconsidered to be one of the leading risk factors associated with primary livercancer. The incidence of primary liver cancer in these countries is expected toincrease over the next 10 to 15 years due to the large number of peoplepreviously infected with hepatitis C whose disease has or will advance to livercirrhosis. In the U.S. alone, the National Institutes of Health projects afour-fold increase over this period in patients with chronic hepatitis C.

 

We believe that given the current and projected primary liver cancerincidence levels, and the cost of similar cancer therapeutics, an approved drugfor primary liver cancer could present a substantial worldwide commercialopportunity.

 

*Current Treatments*

 

Treatment methods for patients with primary liver cancer are typicallydetermined by the stage of the disease at diagnosis. Patients are generallyclassified as eligible for surgical tumor resection, inoperable and non-terminal,or terminal. According to the American Cancer Society, on average, over aten-year period, over 16% of patients have been treated by surgical tumorresection. Additionally, over 50% of patients are inoperable and non-terminaland 26% of patients are terminal. Patients who undergo successful tumorresection have a future life expectancy of about five years, whereas all otherpatients have an average life expectancy of less than one year. Treatment forinoperable and non-terminal patients is dependent on many factors. Livertransplantation represents the only method that can cure the disease, but fewtransplants are possible due to the severe shortage in liver donors and thehigh cost. Other alternatives involve non-surgical therapies that use eitherradioactive microscopic beads (such as TheraSpheres) or chemotherapy (known asTranscatheter Arterial Chemoembolization (**TACE**))injected through a catheter directly into the liver. Other treatments includeregional tumor destruction and chemotherapy. However, we believe the diseaseremains poorly treated, and there are no currently approved drug therapies forprimary liver cancer.

 

*MB07133*

 

MB07133 uses our HepDirect technology to target the active form of araCto the liver while decreasing levels of the active form of the drug in tissuesoutside of the liver. AraC is a marketed anti cancer drug used to treatleukemia. AraC is effective against leukemia but not solid tumors, includingprimary liver cancer, in large part because the enzymes required for conversionof araC to araCTP exist predominantly in leukemic cells and bone marrow cells.Conversion of araC to araCTP in bone marrow results in the dose-limitingtoxicity that is traditionally associated with araC therapy.

 

Using our HepDirect technology, we developed MB07133, a productcandidate that produces higher levels of araCTP in the liver with little to noaraCTP produced in the bone marrow. MB07133 causes higher levels of araCTP inthe liver because it effectively bypasses the first step in the metabolicpathway used to convert araC to araCTP, which otherwise requires an enzyme thatis present only at relatively low levels in the liver. At the same time,MB07133 produces low levels of araCTP in the bone marrow because it is notreadily converted to araCTP in bone marrow and blood. We believe that thischange in distribution of araCTP will maximize MB07133’s potential therapeuticeffect on liver tumors while minimizing its toxicity.

 

*Clinical Trials*

 

In September 2003 we initiated a Phase I/II clinical trialdesigned to evaluate the safety and preliminary efficacy of MB07133 innon-terminal patients with inoperable primary liver cancer tumors in the U.S.,Hong Kong and Taiwan. The clinical trial is an open label, dose escalationPhase I/II clinical trial in patients with confirmed primary liver cancertumors involving continuous intravenous infusion of MB07133 for seven daysfollowed by a 21-day recovery period. Patients may receive infusions untiltreatment failure up to a total of six infusions of MB07133. The goal of thisclinical trial is to establish the maximum tolerated dose. In addition tosafety, we are monitoring changes in tumor size, physical well-being andchanges in blood chemistry. Once the maximum tolerated dose is identified, weplan to study MB07133 at that dose in a limited number of patients in order toevaluate its potential efficacy.

 

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*Pre-clinical Studies*

 

MB07133 has been studied in animals and shown to produce asignificantly different distribution of araC and araCTP when compared toanimals treated with araC alone. In one study, rats treated with MB07133demonstrated significantly higher levels of araCTP in the liver andsignificantly lower levels of araC and araCTP in the blood and bone marrow,respectively, than rats treated with only araC. The following charts show theresults achieved in this study:

 

 

In another study, MB07133 and araC were continuously infused into ratsfor two days, after which the levels of araCTP in the liver and bone marrowwere determined. The MB07133-treated rats showed high levels of araCTP in theliver, whereas araCTP was not detected in the livers of animals treated witharaC alone. The opposite was observed in bone marrow, where araCTP levels werehigh in the rats treated with araC alone and not detected in theMB07133-treated rats. The level of araCTP achieved in the liver with MB07133 inthese studies is above the levels of araCTP shown to kill human primary livercancer cells in culture.

 

The differencesin liver and bone marrow araCTP levels produced by MB07133 as compared to araCalone result in significant improvement in animal toxicology. Mice treated forfive days with araC alone produced a dose-dependent decrease in body weight anda dose-dependent loss of bone marrow cells, whereas mice treated for the sameperiod with MB07133 showed no loss in weight or bone marrow cells except at thehighest dose, where a partial decrease in bone marrow cells was noted. Webelieve these results suggest that relative to araC, MB07133 may be able todeliver therapeutically active levels of araCTP to human primary liver cancertumors with less toxicity.

 

**MB07803: A second-generation gluconeogenesis inhibitor for thetreatment of type 2 diabetes**

 

Like CS-917, MB07803 is an oral productcandidate for type 2 diabetes that we discovered using our proprietaryNuMimetic technology. MB07803 is designed to have the same mechanism of actionas CS-917 - it blocks the gluconeogenesis pathway in the liver by inhibitingFBPase. MB07803 is targeted to the same market and to have advantages overcurrent therapies that are similar to those expected with CS-917. We retain allrights to MB07803.

 

In April 2002, upon completion of the discovery research portion of ourcollaboration with Daiichi Sankyo, we began work on a program designed todiscover and develop second generation gluconeogenesis inhibitors. The goal ofthe second generation program was to discover and develop compounds withpharmaceutical properties that were improved over those seen to date withCS-917. One or more of these improvements, if they are demonstrated in subsequent clinical trials, maygive second generation compounds certain advantages over CS-917. Should CS-917prove to be an important new therapy for type 2 diabetes we believe the secondgeneration could expand the use of this class further.

 

InOctober 2002, we entered into an exclusive option agreement with DaiichiSankyo, under which Daiichi Sankyo paid us a non-refundable $8.5 millionoption fee that gave Daiichi Sankyo the right to negotiate a new agreement forthe discovery, 

 

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development and licensing of second generation gluconeogenesisinhibitors, and an option to license an additional back-up compound discoveredduring the option period. In August 2003, Daiichi Sankyo exercised itsright under the option agreement to designate an additional back-up compoundand chose not to exercise its option to negotiate a new agreement for thediscovery, development and licensing of second generation gluconeogenesisinhibitors, at which time the option expired. As a result, Daiichi Sankyo hasno rights to compounds discovered under the second generation program andtherefore we may develop these compounds on our own or in collaboration withanother company.

 

In 2004, we recommended MB07803 for clinical development from thissecond generation program and in February 2006, we initiated a Phase I clinicaltrial of MB07803.

 

**MB07811: A compound for the treatment of hyperlipidemia and possiblyobesity**

 

We currentlyhave a clinical development candidate, MB07811, which we have recommended forclinical development for the potential treatment of high cholesterol andpossibly obesity. MB07811 is the outgrowth of our efforts to find ways to controlthe expression of certain genes in the liver that are important for making orusing cholesterol as well as genes involved in the control of energyexpenditure. MB07811 is currently undergoing pre-clinical development includingscale-up, toxicology (animal studies) and formulations development. It isanticipated that, if these efforts are successful, we would then enter MB07811into human clinical testing.

 

Hyperlipidemiais a disease characterized by an elevation of lipids, such as cholesterol ortriglycerides, in the bloodstream. Patients with hyperlipidemia have a greaterrisk of suffering heart attacks and other forms of heart disease. Global salesof cholesterol and triglyceride reducers used to treat hyperlipidemia currentlyexceed $20 billion, with over 60% of these sales occurring in NorthAmerica. A person is generally considered obese under National Institutes ofHealth guidelines if he or she is 30 pounds or more overweight for his or herage, height, sex and bone structure. Approximately 60 million adults inthe U.S. suffer from obesity. Obesity significantly raises the risk of illnessor death from serious medical conditions including hypertension, type 2diabetes, cardiovascular disease, stroke and certain cancers. In the U.S.,obesity-related costs exceed $75 billion per year.

 

We havediscovered a series of compounds that exhibit high liver specificity in animalsand data indicate that these compounds can lower cholesterol in animals withoutcausing toxicities associated with previously discovered compounds in the sameclass. The most advanced compound from this series, MB07811, was recommendedfor clinical development in 2005. Data generated in numerous preclinical modelsacross six species indicate that MB07811 may be able to effectively lower serumcholesterol. Data from tests in a primate model indicate that MB07811 may lowerserum cholesterol as effectively as the most widely prescribed statin, Lipitor®(atorvastatin) (see Chart A below) and is additive with Lipitor (see Chart Bbelow).

 

 
| Chart A | Chart B |   |
|---------|---------|--------|

 

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We plan tofile an IND for MB07811 and to commence clinical trials of MB07811 in 2006 if additionalpreclinical data is supportive and the proposed clinical trials are cleared bythe FDA. We retain all rights to MB07811.

 

**Our Research Programs**

 

We are expanding our product pipeline by using our proprietarytechnologies, our knowledge of liver diseases, and our expertise in pathwaysand proteins residing in the liver that significantly contribute to metabolicdiseases. We have additional expertise in processes in the liver that areimportant for drug uptake, metabolism and excretion, all of which are importantfor targeting drugs to the liver with high specificity. We have used thisknowledge to develop our proprietary NuMimetic and HepDirect technologies,which we use in several of our research programs. We also have expertise instructure-based drug design and we have developed novel computational methodsuseful for predicting drug binding effectiveness and specificity. These methodshave aided our design and discovery of novel nucleotide mimetics. Our goal isto expand our clinical development pipeline by continuing to recommendadditional compounds for clinical development.

 

Our advanced research programs include:

 

*A viral enzyme inhibitor for the treatment ofhepatitis C*

 

Hepatitis C is a viral disease that causes inflammation of the liverthat may lead to cirrhosis, primary liver cancer and other long-term complications.Roughly 3% of the world population has been infected with hepatitis C. In theU.S., nearly 4 million people are infected with hepatitis C, of whom2.7 million are chronically infected.

 

We have had a collaboration with Merck to create liver-targetingprodrugs of certain compounds that Merck is supplying to us. These compoundstarget the hepatitis C virus residing in the liver. The funded research phaseof this collaboration has ended. Merck is currently evaluating the drugcompounds discovered during the collaboration to determine if one or more willbe recommended for clinical development. Merck is solely responsible forconducting and funding all development work for compounds resulting from thiscollaboration and for commercializing any resulting products.

 

*A nucleotide mimetic targeting a proteinkinase for the treatment of type 2 diabetes, hyperlipidemia and non-alcoholicsteatohepatitis*

 

Non-alcoholic steatohepatitis results from fatty liver disease, acondition associated with type 2 diabetes and obesity, and can ultimately leadto liver fibrosis and later cirrhosis. Based on the number of obese people inthe U.S., it is projected that over 6.0 million people currently sufferfrom non-alcoholic steatohepatitis.

 

Using our NuMimetic technology, we have discovered a highly potent andselective nucleotide mimetic that activates a protein kinase found in the liverknown as AMPK, which regulates cholesterol and fat levels. We have shown inanimal models that our lead compound from this research program can inhibitcholesterol and fat synthesis. We believe that this compound or a relatedcompound using our NuMimetic technology may be useful for the treatment ofmetabolic diseases such as type 2 diabetes (by a different mechanism thanCS-917 and MB07803), hyperlipidemia (by a different mechanism than MB07811),and a disease associated with fatty livers, known as non-alcoholicsteatohepatitis, by inhibiting cholesterol and lipid production in the liver. Wehave entered into a second collaboration with Merck to research, develop andcommercialize novel small molecule therapeutics that activate AMPK.

 

*A liver-specific collagen inhibitor for thetreatment of liver fibrosis*

 

Liver fibrosis is a life-threatening disease characterized by excessivescarring of the liver, typically caused by chronic hepatitis B or hepatitis Cinfections or alcoholism, which in turn results in compromised liver function,or cirrhosis. It is estimated that at least 25,000 deaths are caused by chronicliver disease and liver cirrhosis each year in the U.S., almost half of which areattributable to alcoholism.

 

Liver fibrosis involves an overproduction in the liver of a proteincalled collagen. This overproduction leads to changes in liver structure andfunction, and ultimately to liver failure. Using our HepDirect technology, wehave developed compounds that target an enzyme controlling collagen productionin the liver and showed in animal models of liver disease that our approach ledto reduced liver fibrosis.

 

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We retain worldwide commercialization rights to all of the compoundsgenerated from our advanced research programs with the exception of thecompounds covered under our collaborations with Merck.

 

**Our Proprietary Technologies**

 

We have developed proprietary technologies that we have used to developour current product candidates and which we expect to help us expand ourproduct pipeline in the future. Our NuMimetic technology encompasses know-howand compound libraries that are useful in the discovery of molecules that bindeffectively and specifically to nucleotide binding sites on certain key enzymescontrolling important metabolic pathways. We used this technology to identifyCS-917 and MB07803 and may continue to use it to help discover productcandidates in other areas. Our HepDirect technology is a proprietary technologyused to target drugs to the liver. We applied this technology to developpradefovir and MB07133 and will continue to use it in programs focused on thediscovery of drugs for liver diseases such as hepatitis C and liver fibrosis aswell as metabolic diseases.

 

*NuMimetic Technology*

 

The liver plays a central role in many metabolic diseases. Metabolicpathways that reside in the liver are responsible for much of the body’sgeneration of products such as cholesterol, glucose and lipids. This productionis normally dependent on an individual’s nutritional and hormonal status.However, in individuals with metabolic diseases, these pathways are improperlycontrolled, leading to excessive production of cholesterol, glucose and lipids.

 

We are studying enzymes found in the liver that directly or indirectlycontrol the flux, or rate of flow, through these pathways. We believe that manyof these enzymes use compounds called nucleotides as a signal for switchingflow on or off. While nucleotides are more typically known as a cell’s primarychemical energy form and its building blocks for DNA synthesis, they are also recognizedas important regulators of metabolic pathways.

 

We believe that certain nucleotide-binding enzymes represent importantdrug targets. Nucleotides that bind to these enzymes affect enzymatic activityand therefore the flux through certain metabolic pathways. Certain enzymesimportant to glucose, cholesterol and fat production and metabolism are knownto contain a nucleotide-binding site. It is likely that successful drugcompounds targeting these sites will need to exhibit both high binding affinityand high enzyme specificity. Over the past two decades, efforts to find suchcompounds by screening large compound libraries have failed in large part dueto the physical characteristics of these sites.

 

We have extensively studied the structure of certain nucleotide-bindingsites to determine the structural elements that are important for binding andspecificity. Through these efforts, we have discovered proprietary compoundsthat bind to these sites and simulate the action of the natural nucleotides. Wehave generated large libraries of these compounds, which are known asnucleotide mimetics. These libraries and the know-how generated from ourstudies constitute our NuMimetic technology.

 

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The following diagram illustrates how ourNuMimetic technology works:

 

 

*HepDirect Technology*

 

Developing drugs to treat diseases of the liver has been a majorchallenge for the pharmaceutical industry. Although companies have worked fordecades to develop drugs that treat chronic liver diseases, relatively fewdrugs are commercially available. In addition, currently marketed drugsapproved for chronic liver diseases generally show poor tolerability, havesignificant safety risks or are ineffective in the majority of patients. Webelieve a primary reason for these limitations is that many drugs cannot bedelivered to the liver in sufficient quantities to be effective without leadingto serious toxicity in other tissues.

 

Our HepDirect technology addresses these problems by delivering highconcentrations of the biologically active forms of target drugs to the liverwhile simultaneously reducing drug exposure in other tissues. We accomplishthis process by making a simple chemical modification that renders the targetdrug biologically inactive and more readily available to cells. We refer to themodified drug as a HepDirect prodrug. The following diagram illustrates how aHepDirect prodrug works:

 

 

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Administration of HepDirect prodrugs results in their distributionthroughout the body. HepDirect prodrugs, unlike most other prodrug classes, aregenerally stable in the blood and tissues outside the liver. Because of thelimited capacity of non-liver tissues to metabolize and convert HepDirectprodrugs to their active forms, distribution into these tissues leads to rapidreappearance of the prodrugs into the blood stream and ultimately diffusion ofthe prodrugs from the blood into the liver. In the liver, HepDirect prodrugsare metabolized by an enzyme expressed predominantly in the liver (CYP3A4)which converts the prodrug to the biologically active form of the target drug.Because HepDirect prodrugs are metabolized primarily in the liver, highertarget drug levels are achieved in the liver while target drug levels outsideof the liver are diminished.

 

Our HepDirect technology is broadly applicable to a wide variety ofdrugs. In some cases, the technology may enable the use of drugs that areotherwise ineffective or poorly effective in a particular liver disease due tothe drug’s failure to achieve therapeutic levels in the liver or due to theinability to administer doses that achieve therapeutic levels as a consequenceof drug-related toxicities outside of the liver.

 

We have shown that our HepDirect technology can deliver compounds withanti-viral, anti-cancer, or anti-fibrotic activity, and we are continuing touse this technology to discover innovative new products for treating liverdiseases, and to deliver compounds that affect pathways in the liverresponsible for metabolic diseases. For example, we are using this technologyand other liver-targeting technologies in a collaboration with Merck in whichwe are creating prodrugs of certain compounds to target the hepatitis C virusresiding in the liver. The funded research phase of this collaboration hasended. Merck is currently evaluating the drug compounds discovered under theresearch phase of the collaboration to determine if one or more will berecommended for clinical development.

 

*Other Technologies*

 

We have developed other proprietary technologies useful for discoveringnew candidates for treating diseases. These include additional proprietarymethods for targeting the liver and structure-based drug design technologies.We continue to develop and refine our capabilities for identifying importantnew drugs.

 

**Our Business Strategy**

 

Our goal is to be a leading biopharmaceutical company developing andcommercializing novel drugs. Important elements of our business strategyinclude:

 

•                  *Advancing the development of ourproduct candidates*. We currentlyhave four product candidates in clinical trials, pradefovir for the treatmentof hepatitis B, CS-917 and MB07803 for the treatment of type 2 diabetes andMB07133 for the treatment of primary liver cancer. We were responsible for thediscovery and initial development of each of these product candidates. Valeantand Daiichi Sankyo are primarily responsible for further clinical developmentof pradefovir and CS-917, respectively. We participate on joint developmentteams, and we retain significant commercial interest in both product candidates,including North American co-promotion rights for CS-917. We are solelyresponsible for the development of, and have all rights to, both MB07803 andMB07133.

 

•                  *Continuing to develop a broadproduct pipeline*. We areaggressively seeking to expand our pipeline of product candidates. Our goal isto expand our clinical development pipeline by continuing to recommend new drugcompounds for clinical development. In 2005, we recommended the clinicaldevelopment of MB07811, a clinical development candidate for the treatment ofhigh cholesterol and possibly obesity. In addition, we have entered into acollaboration with Merck to create liver-targeting prodrugs of certaincompounds that Merck is supplying to us. These compounds target the hepatitis Cvirus residing in the liver. We also have an advanced research program for thetreatment of type 2 diabetes (by a different mechanism than CS-917 and MB07803)and the treatment of hyperlipidemia (by a different mechanism than MB07811)which is covered under our AMPK collaboration with Merck. These advancedresearch programs may yield additional drug compounds for clinical development.We retain worldwide commercialization rights to MB07811and all of the compoundsgenerated from our advanced research programs, with the exception of compoundscovered by our collaborations with Merck. Using our internal drug discoverycapabilities and our HepDirect, NuMimetic and other proprietary technologies,we intend to discover and develop new drug compounds for the treatment ofmetabolic diseases, liver diseases and certain other diseases linked topathways in the liver. In addition, at the appropriate time, and as resourcesallow, we may seek to expand our product pipeline by acquiring products or 

 

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businesses orin-licensing technologies that we believe are a strategic fit with our businessand complement our existing product candidates and research programs.

 

•                  *Continuing to enhance ourexpertise in liver pathways and metabolism and related intellectual propertyrights*. Our near-term strategy isto continue to develop proprietary drugs and technologies for the potentialtreatment of metabolic diseases, cancer and certain other diseases linked topathways in the liver. We have extensive expertise in liver diseases, as wellas pathways and proteins residing in the liver that significantly contribute tocertain metabolic diseases or that are important for drug uptake, metabolismand excretion. We intend to continue to invest in our know-how andcapabilities, including our HepDirect, NuMimetic and other technologies. Ourexpertise in this area gives us a competitive advantage for continuing to builda broad product pipeline. We will continue to pursue comprehensive intellectualproperty protection of our technologies and product candidates whenappropriate.

 

•                  *Pursuing a diversified development and commercializationstrategy for our product candidates.*We have implemented a development and commercializationstrategy that combines collaborative partnerships with our own internal productdevelopment and commercialization efforts. The revenues from license fees,milestone payments and research funding associated with these arrangements,combined with reduced clinical development expenses, will allow us to bettermanage our resources and focus on building new opportunities. At the same time,as appropriate, we retain rights that allow us to participate in thecommercialization of our product candidates. This strategy is designed todevelop and distribute our products as broadly and as effectively as possiblewhile still allowing us to establish our own sales and marketing infrastructureas appropriate. For example, with CS-917, we have a strategic alliance wherebyDaiichi Sankyo is responsible for conducting clinical trials, but we haveretained an option to co-promote CS-917 in North America, while with MB07133and MB07803, we are solely responsible for development of the product candidateand have retained all rights. Merck is responsible for conducting futureclinical trials under our AMPK collaboration while we have retained the optionto co-promote any resulting products in the United States. Our goal for futurecollaborations is to seek to establish them after we have demonstrated high valuefor the subject candidate, a strategy which we believe will allow us to retaingreater control over development, participation and commercialization.

 

•                  *Establishing additional partnershipsbased on HepDirect or our other proprietary liver-targeting technologies*. Our HepDirect and other proprietary technologiescan help overcome some of the challenges faced in developing drugs for liverand metabolic diseases. We believe these technologies are broadly applicable toa wide variety of drug targets.We may partner these technologies with other biopharmaceutical companies whoseproducts would benefit from improved liver-targeting. For example, in 2003 weentered into a collaboration with Merck to discover new treatments forhepatitis C. We created liver-targeted versions of certain compounds providedby Merck that target the hepatitis C virus residing in the liver. The fundedresearch portion of this collaboration was recently completed. Merck iscurrently evaluating the drug compounds discovered under the research phase ofthe collaboration to determine if one or more will be recommended for clinicaldevelopment.

 

•                  *Becoming a fully-integratedpharmaceutical company*. We plan tobecome a fully-integrated pharmaceutical company. In time and as resources allow, we expect to rely less oncollaborative arrangements with other pharmaceutical companies and more on ourown internal development, marketing and sales capabilities. We have relied andcontinue to rely on our partners for the development of our first two productcandidates, pradefovir and CS-917. In contrast, we have managed the earlyclinical development of MB07133 and MB07803 entirely on our own. Still, we havenot built an extensive and expensive infrastructure for this effort. Instead,we have relied on a network of consultants and contract research organizationsto carry out this development program. We are expanding our internalinfrastructure and intend to continue to do so over time as our pipeline expandsand we further develop products internally.

 

**Strategic Alliances**

 

In some cases, we use strategic alliances and collaborativepartnerships with pharmaceutical and biotechnology companies to augment ourinternal drug discovery and development capabilities, and to assist thecommercialization of our products globally. The revenues from license fees,milestone payments and research funding associated with these arrangements,combined with clinical development expenses assumed by our partners, haveallowed us to better manage our resources and focus on building newopportunities. We have generally structured our alliances and partnerships tolicense specific products, rather than technology, or to apply our technologyto a partner’s product, and we intend to continue this practice in the future.

 

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*Valeant*

 

In October 2001, we entered into a development and licenseagreement with Valeant for the development and commercialization of pradefovir.Under the agreement, we granted Valeant exclusive worldwide rights to developand commercialize pradefovir during the term of the agreement. We also agreedthat, for so long as Valeant is continuing to develop or commercializepradefovir, neither we nor our affiliates will develop or commercializechemically similar compounds that use our HepDirect technology. We furtheragreed that if Valeant determines that further development of pradefovir is notdesirable, Valeant will have the right to substitute one of these compounds, ifavailable, for pradefovir (or the compound that is then under development byValeant under our agreement). Valeant paid us a license fee of $2 millionunder the agreement and will be obligated to make milestone payments to us uponthe occurrence of specified development, regulatory and commercial milestones.Valeant will pay royalties to us on sales, if any, of products licensed toValeant under the agreement for the longer of (1) ten years from the firstcommercial sale or (2) the term of any valid patent right of pradefovir.If all development, regulatory and commercial milestones are achieved, andincluding the $2 million license fee, we may be entitled to payments whichtotal up to $20 million, plus royalties. In addition, Valeant is solelyresponsible for conducting and funding all development work, although a jointdevelopment committee composed of representatives of Valeant and Metabasis isresponsible for overseeing those development efforts. In the third quarter of2002, Valeant initiated clinical testing of pradefovir for the treatment ofhepatitis B. As of December 31, 2005, we had received $2 million inmilestone payments under the agreement.

 

During the first five years of the agreement, if we decide to developwith a third party a compound using our HepDirect technology (other than thecompound licensed to Valeant) for the treatment of hepatitis B in humans,Valeant will have a right of first participation to obtain rights in thecompound. If Valeant exercises its right of first participation, we have agreedto negotiate in good faith during a limited negotiation period regarding theterms upon which we would grant Valeant those rights. These terms would includean upfront payment, research funding, development and regulatory milestonepayments and royalty payments on sales of products, all of which are specifiedin the development and license agreement. If Valeant does not exercise itsright of first participation or we are unable to negotiate the terms on whichwe would grant Valeant these rights, we may develop the compound with the thirdparty. In addition, under the agreement, Valeant has a ten-year option toobtain an exclusive license to develop and commercialize any other HepDirectcompound that we own or control that contains a certain anti-viral drug ownedand controlled by Valeant and a five-year option to enter into additionalcollaborative arrangements with us relating to the application of our HepDirecttechnology to drug compounds for the treatment of hepatitis B that Valeant hasa right to commercialize.

 

The term of the development and license agreement will continue untilall of Valeant’s royalty payment obligations have expired, unless the agreementis earlier terminated. The agreement may be terminated entirely or on a countryby country basis by either party only for material breach of the other partywhich remains uncured.

 

*Daiichi Sankyo*

 

In April 1997, we established a multi-year research, developmentand commercialization collaboration with Daiichi Sankyo to discover, develop andcommercialize FBPase inhibitors for the treatment of diabetes. The discoveryresearch portion of the collaboration was extended in February 2000 andMarch 2001 and ended in April 2002. Under this agreement, our drugdiscovery efforts were fully funded by Daiichi Sankyo. Daiichi Sankyo had theright to select compounds discovered during the discovery period and isresponsible for conducting and funding the clinical development of any compoundselected for development. Daiichi Sankyo has exclusive, worldwidecommercialization rights to products developed under the agreement. DaiichiSankyo selected CS-917 as a clinical candidate in 1999 and initiated Phase Iclinical trials of CS-917 in July 2001. A joint development committeecomposed of members from both Daiichi Sankyo and Metabasis oversees clinicaldevelopment. Compounds that Daiichi Sankyo develops during the five-year periodfollowing completion of the drug discovery phase of the collaboration, whichtarget type 1 or type 2 diabetes and act by direct suppression of hepaticgluconeogenesis by inhibiting FBPase, are also subject to the collaborationagreement.

 

As part of the collaboration, Daiichi Sankyo paid us license fees andsponsored research totaling $20.3 million over the five-year discoveryresearch portion of the collaboration and made an investment of $7.3 millionin our Series A preferred stock. As of December 31, 2005, DaiichiSankyo had made three milestone payments totaling $6.5 million and isobligated to make additional payments based on the achievement of futureclinical and regulatory milestones. If all clinical and regulatory milestonesare achieved, and including the $20.3 million in license fees andsponsored research, the $7.3 million investment in our Series Apreferred stock and the $8.5 million option fee referred to below, we maybe entitled to payments which total up to $54.5 million. In addition,Daiichi Sankyo will pay us a royalty on net sales, in countries where we havenot exercised our co-promotion rights, of any product developed under thecollaboration 

 

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agreement for the longer of (1) ten years from the firstcommercial sale or (2) the term of any valid patent right of a product. Inkeeping with our partnering strategy, we have the option to co-promote CS-917or any other product developed under the collaboration in North America onterms and conditions to be negotiated after we exercise the option. We have thecontractual right to exercise our co-promotion option for CS-917 prior to thefiling of a New Drug Application, or NDA, for CS-917.

 

In October 2002, we entered into an exclusive option agreementwith Daiichi Sankyo, under which Daiichi Sankyo paid us a non-refundable$8.5 million option fee that gave Daiichi Sankyo the right to negotiate anew agreement for the discovery, development and licensing of second generationgluconeogenesis inhibitors, and an option to license an additional back-upcompound discovered during the option period. In August 2003, DaiichiSankyo exercised its rights under the option agreement to designate anadditional back-up compound, which Daiichi Sankyo will have the option tolicense only in the event that the development of CS-917 and the currentback-up compound are discontinued. Daiichi Sankyo has the right to terminatedevelopment of CS-917 and the current back-up compound and to substitute theadditional back-up compound for CS-917 and the current back-up compound underthe terms of our collaboration agreement. Also in August 2003, DaiichiSankyo chose not to exercise its option to negotiate a new agreement for thediscovery, development and licensing of second generation gluconeogenesisinhibitors, at which time the option expired. As a result, Daiichi Sankyo hasno rights to MB07803, and we may therefore develop MB07803 on our own or incollaboration with another company. Because MB07803 may be directly competitivewith CS-917 should they both be developed and because Daiichi Sankyo has nocommercial or other rights to MB07803, the information that Metabasis receivesfrom Daiichi Sankyo regarding CS-917 has been reduced.

 

The term of our collaboration agreement, including the license of theadditional back-up compound under our option agreement, will continue until allof Daiichi Sankyo’s royalty payment obligations have expired, unless theagreement is earlier terminated. The agreement may be terminated by eitherparty only for material breach which remains uncured or for bankruptcy of theother party. In addition, on a country-by-country basis, we will be entitled toregain rights to CS-917 from Daiichi Sankyo if it does not diligently developand market CS-917 in a particular country.

 

*Merck*

 

In December 2003, we entered into a collaboration agreement withMerck to discover new treatments for hepatitis C. Under this collaboration, weare creating liver-targeting prodrugs of certain compounds that Merck issupplying to us. These compounds target the hepatitis C virus residing in theliver. The research term of the collaboration was initially for one year and inJanuary 2005, was extended for an additional year throughDecember 2005. At the same time, the scope of the technology that we applyto the Merck compounds was expanded. As part of this collaboration, Merck paidus an upfront fee of $500,000 and research support totaling $2.7 million during2004 and 2005. Merck is also obligated to pay pre-clinical and clinicalmilestone payments if specified development and regulatory events occur androyalties on sales of products resulting from the collaboration. If allpre-clinical and clinical milestones are achieved, and including the $500,000upfront fee and the $1.4 million in research support for each of the firsttwo research years, we may be entitled to payments which total up to $93.3 million,plus royalties. Merck is solely responsible for conducting and funding alldevelopment work for compounds resulting from the collaboration and forcommercializing any resulting products.

 

During the initial one-year research term we agreed to work exclusivelywith Merck on research and development of compounds using our HepDirecttechnology for hepatitis C, except that our agreement with Merck allowed us tocontinue our internal hepatitis C research program during that time. Until thefirst anniversary of the date of our agreement, Merck had an option to extendthis exclusivity period by paying us an exclusivity fee of $3.0 million.In January 2005, Merck informed us that it did not wish to exercise thisoption. The funded research phase of this collaboration has ended. Merck iscurrently evaluating the drug compounds discovered under the research phase ofthe collaboration to determine if one or more will be recommended for clinicaldevelopment.

 

In addition, for a specified period following the effective date of theagreement, Merck has an exclusive option to obtain a license to develop andcommercialize certain compounds from our internal program to discover antiviralcompounds to treat hepatitis C. The parties have agreed upon the principalfinancial terms of any such license. If Merck exercises its option, the partieshave agreed to negotiate in good faith during a limited negotiation period aseparate written agreement that includes these financial terms, as well asother commercially reasonable terms to be negotiated by the parties. If Merckdoes not exercise its option to license a development candidate from ourinternal program before its expiration, or if, despite good faith negotiations,the parties do not enter into a separate written license agreement before theexpiration of the negotiation period, then we retain all rights to thatcandidate including the right to license to another strategic partner.

 

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The term of the collaboration agreement will continue until all ofMerck’s royalty payment obligations have expired, unless the agreement isearlier terminated. The agreement may be terminated by either party formaterial breach or insolvency of the other party. Merck also has the right toterminate the agreement without cause at any time after the end of the researchterm upon 90 days’ advance written notice to us.

 

In June 2005, we entered into acollaboration agreement with Merck to research, develop and commercialize novelsmall molecule therapeutics with the potential to treat several metabolicdiseases including type 2 diabetes, hyperlipidemia and obesity by activatingAMPK. As part of this collaboration, Merck paid an initial non-refundablelicense fee of $5.0 million in July 2005 and agreed to provide researchsupport funding of a minimum of $2.1 million each year during the three-yearresearch term. The three-year research term is subject to renewal for oneadditional year upon the parties’ mutual agreement. Our level of researchactivities, and the minimum research support funding, may be increased duringthe term upon mutual agreement of both parties. Merck is also obligated to paymilestone payments if specified preclinical and clinical development andregulatory events occur and to pay royalties on sales of any product resultingfrom this collaboration. We would also have the option to co-promote any suchproduct in the United States. If all pre-clinical and clinical milestones areachieved on multiple indications, then including the $5.0 million initial,non-refundable license fee and the minimum $6.3 million in research supportfunding, we may be entitled to payments which total up to $74.3 million, plusroyalties. Merck is solely responsible for conducting and funding alldevelopment work for compounds resulting from this collaboration.

 

The term of the collaboration agreement will continue until all ofMerck’s royalty payment obligations have expired, unless the agreement isearlier terminated. The agreement may be terminated by either party formaterial breach or insolvency of the other party. Merck also has the right toterminate the agreement without cause at any time after the end of thetwenty-first month following the effective date upon 90 days’ advancewritten notice to us.

 

*Sicor*

 

As part of our June 1999 corporate restructuring, we agreed to paySicor Inc., now an indirect wholly-owned subsidiary of Teva PharmaceuticalIndustries Ltd., a 2% royalty on our direct sales of products that wouldinfringe one of our patents, patent applications, discoveries or inventions inexistence as of our corporate restructuring, and 10% of any royalties wereceive from licenses of these patents, patent applications, discoveries orinventions. We also agreed to pay Sicor a 1% royalty on our direct sales ofproducts that use, contain or are based on our trade secrets, know-how andother proprietary rights in existence as of our corporate restructuring thatare not covered by the 2% royalty, and 5% of any royalties we receive fromlicenses of these trade secrets, know-how and other proprietary rights that arenot covered by the 10% royalty. Some or all of our current product candidatesand drug compounds from our research programs may be subject to these royaltyprovisions.

 

**Intellectual Property**

 

Our success will depend in large part on our ability to:

 

•                  obtain and maintain patent and other legalprotections for the proprietary technology, inventions and improvements weconsider important to our business,

 

•                  prosecute and defend our patents,

 

•                  preserve our trade secrets, and

 

•                  operate withoutinfringing the patents and proprietary rights of third parties.

 

We intend to continue to seek appropriate patent protection for ourlead compounds, our proprietary technologies and their uses by filing patentapplications in the U.S. and selected other countries. We intend for thesepatent applications to cover, where possible, claims for composition of matter,medical uses, processes for preparation and formulations.

 

As of February 1, 2006, we owned a total of 30 issued U.S. patents, 17 pending U.S.utility applications, and seven pending U.S. provisional applications. Inforeign countries, as of the same date, we owned a total of 118 issued patents,five allowed applications and 171 pending applications.

 

Of the above applications and patents, we co-own one pending U.S.utility application, 18 foreign pending applications and oneforeign allowed application with Daiichi Sankyo. We co-own one pending U.S. utilityapplication, one pending U.S.

 

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provisional application, and one foreign pendingapplication with Merck. As of the same date, we held rights to a total of fourin-licensed U.S. patents and 16 in-licensed foreign patents.

 

We believe we have a strong intellectual property position, including 13issued U.S. patents, 23 pending U.S. applications, 76 foreign issued patents,five foreign allowed and 165 foreign pending applications that relate toproprietary technologies and compounds used in our current business. Ourcurrently issued patents that relate to proprietary technologies and compoundsused in our current business will expire between 2018 through 2021. Theremaining currently issued patents that relate to our proprietary technologiesand compounds that are no longer a primary focus of our current business willexpire between 2006 and 2020.

 

Although we believe our rights under patents and patent applicationsprovide a competitive advantage, the patent positions of pharmaceutical andbiotechnology companies are highly uncertain and involve complex legal andfactual questions. We may not be able to develop patentable products orprocesses, and may not be able to obtain patents from pending applications. Evenif patent claims are allowed, the claims may not issue or, in the event ofissuance, may not be sufficient to protect the technology owned by or licensedto us. Any patents or patent rights that we obtain may be circumvented,challenged or invalidated by our competitors.

 

We also rely on trade secrets, proprietary know-how and continuinginnovation to develop and maintain our competitive position, especially when wedo not believe that patent protection is appropriate or can be obtained. Ourpolicy is to require each of our employees, consultants and advisors to executea proprietary information and inventions agreement before they begin providingservices to us. Among other things, this agreement obligates the employee,consultant or advisor to refrain from disclosing any of our confidentialinformation received during the course of providing services and, with someexceptions, to assign to us any inventions conceived or developed during thecourse of these services. We also require confidentiality agreements from thirdparties that receive our confidential information.

 

The biotechnology and biopharmaceutical industries are characterized bythe existence of a large number of patents and frequent litigation based onallegations of patent infringement. As our current and potential productcandidates and others based upon our proprietary technologies progress towardcommercialization, the possibility of an infringement claim against usincreases. While we attempt to be certain that our products and proprietary technologiesdo not infringe other parties’ patents and other proprietary rights,competitors or other parties may assert that we infringe on their proprietaryrights.

 

We have conducted searches of U.S. and foreign patents, but cannotguarantee that the searches were comprehensive and therefore whether any of ourproduct candidates or the methods of using, making or identifying our productcandidates infringe the patents searched, or that other patents do not existthat cover our product candidates or these methods. There may also be pendingpatent applications related to these patents that are unknown to us and mayprevent us from marketing our product candidates. Other product candidates thatwe may develop, either internally or in collaboration with others, could besubject to similar delays and uncertainties.

 

For a more detailed discussion of risks and uncertainties concerningintellectual property protection for our product candidates and proprietarytechnologies, see the section in “Risk Factors” entitled *“Risks Related to Our Intellectual Property.”*

 

**Sales and Marketing**

 

We do not currently have internal sales or marketing capabilities. Inorder to commercially market our product candidates if we obtain regulatoryapproval, we must either develop a sales and marketing infrastructure orcollaborate with third parties with sales and marketing capabilities. We havegranted Daiichi Sankyo and Valeant worldwide marketing and commercializationrights for CS-917 and pradefovir, respectively. However, we have retained aco-promotion option to directly market CS-917 in North America. In addition, atthis point we have retained exclusive rights to MB07133, MB07803 and MB07811,as well as the compounds from our advanced research programs, with theexception of compounds that are covered by our collaborations with Merck.

 

We intend to make decisions regarding direct marketing of the productcandidates for which we retain commercialization rights based on the dataderived from our development and research programs in the future. If we proceedwith direct marketing of any product candidates, we anticipate building a salesforce designed to call on specialists that would be expected to prescribe thelargest market share of the product candidate.

 

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**Competition**

 

The biotechnology and biopharmaceutical industries are characterized byrapidly advancing technologies, intense competition and a strong emphasis onproprietary products. We face competition from many different sources,including commercial pharmaceutical and biotechnology enterprises, academicinstitutions, government agencies and private and public research institutions.Due to the high demand for treatments for liver and metabolic diseases,research is intense and new treatments are being sought out and developed byour competitors.

 

We are aware of many competitive products currently marketed or underdevelopment that are used to treat some of the diseases we have targeted. IfCS-917 and/or MB07803 are ultimately determined safe and effective and approvedfor marketing, they may face significant competition from various formulationsof metformin and products containing metformin. Metformin is a drug that, likeCS-917 and MB07803, inhibits liver glucose production, albeit through anunknown mechanism. Because it does not cause weight gain, metformin is oftenprescribed as a first-line therapy to obese diabetic patients, who are reportedto comprise more than 90% of newly diagnosed type 2 subjects. In addition, inexpensivegeneric forms of metformin are available. Accordingly, unless CS-917 and/orMB07803 demonstrate a significant benefit over metformin or demonstrate thatthey can be used in the patient population who do not tolerate and/oradequately respond to metformin treatment, the price required to effectivelycompete with the generic form of metformin may be so low that it becomesuneconomical for us or Daiichi Sankyo to market CS-917 or for us to marketMB07803.

 

Other currently marketed drugs that may compete with CS-917 and/orMB07803 include, but are notlimitedto the following classes:

 

•                    sulfonylureas– increase the secretion of insulin by the pancreas, thereby lowering the levelof the sugar glucose in the blood,

 

•                    insulins– mimic the naturally occurring hormone “insulin” made by the pancreas tocontrol blood glucose levels,

 

•                    peroxisomeproliferator-activated receptor agonists - improve insulin sensitivity byactivating certain genes involved in fat synthesis and carbohydrate metabolism,

 

•                    incretinmimetics – mimic the naturally occurring hormone “incretin”. Incretin reducesblood glucose levels by increasing the secretion of insulin from the pancreas,slowing absorption of glucose from the gut, and reducing the action of glucagon(glucagon is a hormone that increases glucose production by the liver),

 

•                    alpha-glucosidaseinhibitors - decrease the absorption of carbohydrates from the intestine,resulting in a slower and lower rise in blood glucose throughout the day,

 

•                    glinides- stimulate the pancreas’ beta-cells to produce insulin, and

 

•                    metformincombination therapies – combines metformin with members of the above-mentionedclasses, particularly sulfonylureas and PPARs.

 

In addition, many companies are developing novel therapies that target diabetes. These companies may develop and introduce products competitive with or superior to CS-917 and/or MB07803.

 

Currently approved treatments for hepatitis B in the U.S. that maycompete with pradefovir are included in the following classes:

 

•                    interferons- mimic the naturally occurring “interferon”. Interferon is aninfection-fighting immune            substance produced bythe body,

 

•                    nucleosideanalogues - chemically engineered nucleoside compounds structurally similar tothe building blocks of DNA and RNA that interferes with the replication of HBV,and

 

•                    nucleotideanalogues - chemically engineered nucleotide compounds structurally similar tothe building blocks of DNA and RNA that interferes with the replication of HBV.

 

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A competitor to pradefovir will be Hepsera (adefovir dipivoxil), whichis a nucleotide analogue marketed in the U.S. by Gilead Sciences, Inc.Pradefovir and Hepsera are prodrugs of the same active drug, and therefore willdirectly compete. In order to effectively compete with Hepsera, pradefovir mayhave to be significantly more beneficial or less expensive than Hepsera. Inaddition, marketed products approved to treat HIV infections are beingevaluated for their effectiveness in treating hepatitis B infections.

 

There are no currently approved drugs for primary liver cancer.However, a few companies are developing novel therapies specifically forprimary liver cancer. In addition, companies are developing therapies for othersolid tumors which may be efficacious in treating primary liver cancer. Thesecompanies may develop and introduce products competitive with or superior to MB07133.

 

If MB07811 is ultimately determined safe and effective and approved formarketing, it would compete with products marketed by several largepharmaceutical companies that currently comprise a very large share of thehyperlipidemia market. The major classes of hyperlipidemia drugs include, butare not limited to:

 

•                    statins- reduce serum cholesterol levels by inhibiting a key enzyme involved in thebiosynthesis of cholesterol,

 

•                    fibrates–reduce the amount of cholesterol and triglycerides (fatty substances) inblood,

 

•                    nicotinicacid derivatives (NADs) - lowercholesterol and triglycerides. NADs decrease low density lipoproteins andincrease high density lipoproteins,

 

•                    cholesterolabsorption inhibitors - inhibit the absorption of dietary and biliarycholesterol,

 

•                    bileacid sequestrants –bind with cholesterol-containing bile acids in theintestines and remove them in bowel movements, and

 

•                    statincombination therapies - combine statins with members of the above-mentionedclasses, particularly CAIs.

 

These large pharmaceutical companies are also developing novel therapies that target hyperlipidemia. These companies may develop and introduce products competitive with or superior to MB07811. Lipitor (atorvastatin; a statin marketed by Pfizer) is currently the best selling prescription medicine. In addition, generic statins (cholesterol-reducers) have recently been approved in the major pharmaceutical markets, which would also compete with MB07811.

 

In addition, many other companies are developing products for thetreatment of the diseases we are targeting and if successful, these productscould compete with our products. If we receive approval to market and sell anyof our product candidates, we may compete with these companies and theirproducts as well as others in varying stages of development.

 

Many of our competitors have significantly greater financial resourcesand expertise in research and development, manufacturing, pre-clinical testing,clinical trials, regulatory approvals and marketing approved products than wedo. Smaller or early-stage companies may also prove to be significantcompetitors, particularly through collaborative arrangements with large andestablished companies. Our competitors may succeed in developing technologiesand therapies that are more effective, better tolerated or less costly than anywhich we are developing, or that would render our product candidates obsoleteand noncompetitive. Our competitors may succeed in obtaining approvals from theFDA and foreign regulatory authorities for their products sooner than we do forours. We will also face competition from these third parties in recruiting andretaining qualified scientific and management personnel, establishing clinicaltrial sites and patient registration for clinical trials, and in acquiring andin-licensing technologies and products complementary to our programs oradvantageous to our business.

 

**Manufacturing**

 

Valeant and Daiichi Sankyo are responsible for all clinical andcommercial manufacturing of pradefovir and CS-917, respectively. We rely onseveral suppliers to produce sufficient quantities of MB07133 and MB07803 foruse in clinical studies and intend to rely on these or other suppliers toproduct sufficient quantities of MB07811 for use in future clinical studies. Wecurrently intend to continue this practice for any future clinical trials andthe possible large-scale commercialization of MB07133 and MB07803 and for anyother potential products for which we retain significant development andcommercialization rights. All of our current product candidates are smallmolecule drugs. These drugs are historically simpler and less expensive to 

 

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manufacture than biologic drugs. We believe our focus on small moleculedrugs gives us a manufacturing advantage over companies that develop andmanufacture biologic drugs.

 

**Government Regulation and Product Approval**

 

*Our Product Candidates*

 

Pradefovir, CS-917, MB07133, MB07803 and any other product candidatesthat we or our collaborators develop will require regulatory approval beforethey can be commercialized. Valeant and Daiichi Sankyo are responsible forclinical development and regulatory approval of pradefovir and CS-917,respectively, although we jointly oversee the clinical development of theseproduct candidates through our participation in joint development committees.Although our collaborations with Merck have not yet yielded a productcandidate, should either of them be successful, we will be dependent on Merckfor clinical development and regulatory approval of any resulting productcandidate. We are solely responsible for clinical development and regulatoryapproval of MB07133 and MB07803.

 

*Product Regulation*

 

Governmental authorities in the U.S. and foreign countries regulate,among other things, the pre-clinical and clinical testing, manufacturing,labeling, storage, record-keeping, advertising, promotion, export, marketingand distribution of drug products. In the U.S., pharmaceutical products areregulated by the FDA under the Federal Food, Drug, and Cosmetic Act, itsimplementing regulations and other federal laws and regulations. Both beforeand after the FDA approves a product, the manufacturer and the holder of theproduct approval are subject to comprehensive regulatory oversight. Violationsof regulatory requirements at any stage, including the pre-clinical andclinical testing process, the NDA approval process, or the post-FDA-approvalmarketing of the product, may result in various adverse consequences. Theseadverse consequences may include a clinical hold on an ongoing study, the FDA’sdelay in approving or refusal to approve a product, suspension of manufacturingor withdrawal of an approved product from the market, seizure or recall of aproduct or the imposition of criminal or civil penalties against themanufacturer or the holder of the product approval. In addition, laterdiscovery of previously unknown problems may result in restrictions on aproduct, its manufacturer, or the NDA holder, or market restrictions throughlabeling changes or product withdrawal. Also, new government requirements maybe established that could delay or prevent regulatory approval of our productsunder development.

 

The steps required before a new drug may be approved for marketing inthe U.S. generally include:

 

•                    conductingappropriate pre-clinical laboratory tests and pre-clinical studies in animalsin compliance with the FDA’s Good Laboratory Practice, or GLP, requirements,

 

•                    thesubmission of the results of these evaluations and studies to the FDA, alongwith manufacturing information and analytical data, in an IND for humanclinical testing, which must become effective before human clinical trials maycommence,

 

•                    obtainingapproval of institutional review boards, or IRBs, to introduce the product intohumans in clinical studies,

 

•                    conductingadequate and well-controlled human clinical trials to establish the safety andefficacy of the product, in compliance with FDA’s Good Clinical Practice, orGCP requirements,

 

•                    thesubmission of the results of pre-clinical studies, clinical studies, andadequate data on chemistry, manufacturing and control information to the FDA inan NDA, and

 

•                    FDAreview and approval of the NDA, including potential pre-approval inspections ofmanufacturing and testing facilities to assess compliance with the FDA’scurrent Good Manufacturing Practice, or CGMP, requirements and other FDAregulations.

 

Pre-clinical studies generally include animal studies to evaluate theproduct’s mechanism of action, safety and efficacy. Compounds must be producedaccording to applicable CGMP requirements, and pre-clinical safety tests mustbe conducted in compliance with FDA’s GLP and similar internationalregulations. The results of the pre-clinical tests, together with manufacturinginformation and analytical data, are generally submitted to the FDA as part ofan IND, which must become 

 

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effective before human clinical trials may be commenced. The INDautomatically becomes effective 30 days after receipt by the FDA, unlessthe FDA before that time requests an extension or raises concerns about theconduct of the clinical trials described in the application. The sponsor of theapplication and the FDA must resolve any outstanding concerns before clinicaltrials can proceed. Clinical trials involve the administration of the investigationalproduct to healthy volunteers or to patients with the disease or disorder beingtested, under the supervision of a qualified principal investigator, and mustbe conducted in accordance with good clinical practices and other requirements,including the informed consent of human test subjects. Clinical trials areconducted in accordance with protocols that detail many items, including:

 

•                  the objectivesof the study,

 

•                  the parametersto be used to monitor safety, and

 

•                  the efficacycriteria to be evaluated.

 

Each protocol must be submitted to the FDA as part of the IND. Further,each clinical study must be reviewed and approved by an IRB at each institutionat which the study will be commenced, prior to the recruitment of subjects. TheIRB will consider, among other things, ethical factors, the safety of humansubjects and the possible liability of the institution.

 

Clinical trials typically are conducted in three sequential phases, butthe phases may overlap. In Phase I, the initial introduction of the drug intohuman subjects, the drug is tested in healthy volunteers or, on occasion, inpatients, for safety and, as appropriate, for absorption, metabolism,distribution, excretion, pharmacodynamics, pharmacokinetics and otherpreliminary measures of efficacy. Phase II usually involves initial studiesdesigned to identify doses of the drug that result in suitable efficacy, safetyand tolerance in patients with the targeted disease. A clinical trial designedto generate efficacy data but that is not expected to satisfy FDA criteria forNDA approval is sometimes referred to as a Phase IIb study. Phase III clinicaltrials, commonly referred to as pivotal studies, are undertaken to provideproof of clinical efficacy and to provide sufficient evidence of safety tojustify FDA approval, typically within an expanded and diverse patientpopulation at multiple, geographically dispersed clinical study sites. Phase I,Phase II or Phase III testing may not show sufficient safety or efficacy withinany specific time period, if at all, with respect to any products being tested.Furthermore, the sponsor, the FDA or the IRB may suspend clinical trials at anytime on various grounds, including a finding that the healthy volunteers orpatients are being exposed to an unacceptable health risk.

 

The results of the pre-clinical studies and clinicaltrials, together with detailed information on the manufacture and compositionof the product, are submitted to the FDA as part of an NDA requesting approvalfor the marketing of the product. The cost of preparing and submitting an NDAis substantial.

 

The FDA has 60 days from its receipt of an NDA todetermine whether the application will be accepted for filing based on theagency’s threshold determination that the NDA is sufficiently complete topermit substantive review. Once the submission is accepted for filing, the FDAbegins an in-depth review of the NDA. Under federal law, the FDA has agreed tocertain performance goals in the review of NDAs. The goal for review of mostsuch applications for non-priority drug products is ten months and for prioritydrug products is six months. The review process is often significantly extendedby FDA requests for additional information or clarification regardinginformation already provided in the submission. The FDA may also referapplications for novel drug products or drug products which present difficultquestions of safety or efficacy to an advisory committee, typically a panelthat includes clinicians and other experts, for review, evaluation and arecommendation as to whether the application should be approved. The FDA is notbound by the recommendation of an advisory committee.

 

If FDA evaluations of the NDA and the manufacturingfacilities are favorable, the FDA may issue an approval letter, or, in somecases, an approvable letter followed by an approval letter. An approvableletter generally contains a statement of specific conditions that must be metin order to secure final approval of the NDA. If and when those conditions havebeen met to the FDA’s satisfaction, the FDA will typically issue an approvalletter. An approval letter authorizes commercial marketing of the drug withspecific prescribing information for specific indications. As a condition ofNDA approval, the FDA may require post approval testing and surveillance tomonitor the drug’s safety or efficacy and may impose other conditions,including labeling restrictions which can materially impact the potentialmarket and profitability of the drug. Once granted, product approvals may bewithdrawn if compliance with regulatory standards is not maintained or problemsare identified following initial marketing.

 

Once the NDA is approved, a product will be subject tocertain post-approval requirements, including requirements for adverse eventreporting and submission of periodic reports. Additionally, the FDA alsostrictly regulates the promotional 

 

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claims that may be made about prescription drug products. Inparticular, the FDA requires substantiation of any claims of superiority of oneproduct over another including, in many cases, requirements that such claims beproven by adequate and well controlled head-to-head clinical trials. To theextent that market acceptance of our products may depend on their superiorityover existing therapies, any restriction on our ability to advertise orotherwise promote claims of superiority, or requirements to conduct additionalexpensive clinical trials to provide proof of such claims, could negativelyeffect the sales of our products and/or our costs.

 

If the FDA’s evaluation of the NDA submission ormanufacturing facilities is not favorable, the FDA may refuse to approve theNDA or issue a not approvable letter.

 

The not approvable letter outlines the deficiencies inthe submission and often requires additional testing or information in orderfor the FDA to reconsider the application. Even with submission of thisadditional information, the FDA ultimately may decide that the application doesnot satisfy the regulatory criteria for approval. With limited exceptions, FDAmay withhold approval of an NDA regardless of prior advice it may have providedor commitments it may have made to the sponsor.

 

FDA approval of any application may entail many delays or never begranted. Moreover, if regulatory approval of a product is granted, the approvalmay include limitations on the uses or patient populations for which theproduct may be marketed. Further, product approvals may be withdrawn ifcompliance with regulatory standards is not maintained or if safety ormanufacturing problems occur following initial marketing. Finally, if there areany modifications to the drug, including changes in indications, labeling ormanufacturing processes or facilities, we or our collaborators may be requiredto submit and obtain FDA approval of a new NDA or NDA supplement, which mayrequire the development of additional data or the conduct of additionalpre-clinical studies and clinical trials.

 

Among the conditions for approval is the requirement that theprospective manufacturer’s quality control, recordkeeping and manufacturingprocedures conform to CGMP requirements enforced by the FDA through itsfacilities inspection program. In addition, product manufacturing facilities inCalifornia are subject to licensing requirements of the California Departmentof Health Services. These requirements must be followed at all times in themanufacture of the approved product, and manufacturing facilities are subjectto inspection by the FDA and the California Department of Health, or otherapplicable governmental authorities, at any time. In complying with theserequirements, manufacturers must continue to expend time, money and effort inthe area of production and quality control to be certain of full compliance.The applicable requirements are complex, can be subject to differinginterpretations and are subject to change without clear advance notice orguidance from the FDA. Any failure to comply with these requirements maysubject manufacturers to, among other things, notices or letters detailingalleged deviations and demanding corrective actions, actions seeking fines andcivil penalties, suspension or delay in product approvals, product seizure orrecall, suspension of manufacturing, or withdrawal of product approval.

 

Once an NDA is approved, the product covered therebybecomes a “listed drug” which can, in turn, be cited by potential competitorsin support of approval of an abbreviated NDA, or ANDA. An ANDA provides formarketing of a drug product that has the same active ingredients in the samestrengths and dosage form as the listed drug and has been shown throughbioequivalence testing to be therapeutically equivalent to the listed drug. Thereis no requirement, other than the requirement for bioequivalence testing, foran ANDA applicant to conduct or submit results of pre-clinical or clinicaltests to prove the safety or effectiveness of its drug product. Drugs approvedin this way are commonly referred to as “generic equivalents” to the listeddrug, are listed as such by the FDA, and can often be substituted bypharmacists under prescriptions written for the original listed drug.

 

There are limitations on the timing of FDA’s ability to approve an ANDAfor a generic equivalent of a listed drug. In the event that the sponsor of the listed drug has properly informedFDA of patents covering its listed drug, applicants submitting an ANDAreferencing that drug are required to certify whether they intend to markettheir generic products prior to expiration of those patents.  If an ANDA applicant certifies that itbelieves one or more listed patents are invalid or not infringed, it isrequired to provide notice of its filing to the NDA sponsor and the patentholder.  If the patent holder then initiatesa suit for patent infringement against the abbreviated NDA sponsor within 45days of receipt of the notice, FDA cannot grant effective approval of the ANDAuntil either 30 months has passed or there has been a court decision holdingthat the patents in question are invalid or not infringed.  A holding that a valid and enforceable listedpatent is infringed will preclude approval of the ANDA until the expiration ofthat patent.  If the ANDA applicantcertifies that it does not intend to market its generic product before some orall listed patents on the listed drug expire, then FDA cannot grant effectiveapproval of the ANDA until those patents expire.  Under Federal law, the term of a patentcovering a new chemical entity can be extended by up to five years, for aneffective patent life of up to 14 years after approval, based on restoration ofpart of the patent life lost during clinical testing and FDA review.

 

Federal law also provides for periods of non-patent exclusivity thatalso limit the timing of potential approval of an ANDA for a generic equivalentto a listed drug.  These include a periodof three years of non-patent exclusivity following approval of a listed drugthat contains previously approved active ingredients but is approved in a new dosage,dosage form, route of administration or combination, or for a new use, theapproval of which was required to be supported by new clinical trials conductedby or for the sponsor, during which such three year period FDA cannot granteffective approval of an ANDA based on that listed drug.  Federal law also provides a period of fiveyears following approval of a drug containing no previously approved activeingredients, during which an ANDA for a generic equivalent cannot be submittedunless the submission accompanies a challenge to a listed patent, in which casethe submission may be made four years following the original product approval.

 

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The first abbreviated new drug applicant submitting a substantiallycomplete application certifying that listed patents for a particular productare invalid or not infringed may qualify for a period of 180 days after a courtdecision of invalidity or non-infringement or after it begins marketing itsproduct, whichever occurs first, during which subsequently submittedabbreviated NDAs cannot be granted effective approval. Similar non-patent exclusivityrestrictions and patent certification requirements apply to so-called 505(b)(2)NDA applications which rely, in part or in whole, on data generated by or forparties other than the applicant to support an NDA approval.

 

FDA also imposes a number of complex requirements and restrictions onentities that advertise and promote prescription drugs, which include, amongothers, standards for and regulations of print and in-person promotion, productsampling, direct-to-consumer advertising, off-label promotion, industrysponsored scientific and educational activities, and promotional activitiesinvolving the Internet. The FDA has very broad enforcement authority under theFederal Food, Drug and Cosmetic Act, and failure to abide by FDA requirementscan result in penalties and other enforcement actions, including the issuanceof warning letters or other letters objecting to violations and directing thatdeviations from FDA standards be corrected, total or partial suspension ofproduction, and state and federal civil and criminal investigations andprosecutions.

 

Federal regulations and FDA policies prohibit a sponsor or investigator,or any person acting on behalf of a sponsor or investigator, from representingin a promotional context that an investigational new drug is safe or effectivefor the purposes for which it is under investigation. Prior to approval of aproduct candidate, any assertion that one of our product candidates is safe oreffective for any purpose or that it is superior to any currently approvedproduct could result in regulatory action by FDA and could delay approval ofthe product candidate.

 

Avariety of Federal and state laws apply to the sale, marketing and promotion ofpharmaceuticals that are paid for, directly or indirectly, by Federal or statehealth care programs, such as Medicare and Medicaid. The restrictions imposedby these laws are in addition to those imposed by the FDA and correspondingstate agencies. Some of these laws significantly restrict or prohibit certaintypes of sales, marketing and promotional activities by pharmaceuticalmanufacturers. Violation of these laws can result in significant criminal,civil, and administrative penalties, including imprisonment of individuals,fines and penalties and exclusion or debarment from Federal and state healthcare and other programs. Many private health insurance companies also prohibitpayment to entities that have been sanctioned, excluded, or debarred by Federalagencies. We are also subject to various laws and regulations regardinglaboratory practices, the experimental use of animals, and the use and disposalof hazardous or potentially hazardous substances in connection with ourresearch. In each of these areas, as above, the FDA and other agencies havebroad regulatory and enforcement powers, including the ability to impose finesand civil penalties, suspend or delay issuance of approvals, seize or recallproducts, and withdraw approvals, any one or more of which could have amaterial adverse effect upon us.

 

*Other Regulations*

 

We are also subject to regulation by the Occupational Health and SafetyAdministration and state and federal environmental protection agencies, and toregulation under the Toxic Substances Control Act. We may in the future besubject to additional federal, state or local regulations. The OccupationalHealth and Safety Administration or these environmental protection agencies maypromulgate regulations that may affect our research and development programs.We cannot predict whether any agency will adopt any regulation which couldlimit or impede our operations.

 

**Environmental and Safety Matters**

 

We use hazardous chemicals, biological agents and various radioactiveisotopes and compounds in our research and development activities. Accordingly,we are subject to regulations under federal, state and local laws regardingemployee safety, environmental protection and hazardous substance control, andto other present and possible future federal, state and local regulations. Wemay also incur significant costs complying with environmental laws andregulations adopted in the future.

 

Also, although we believe our current safety procedures for handlingand disposing of hazardous materials comply with federal, state and local lawsand regulations, we cannot entirely eliminate the risk of accidental injury orcontamination from the use, storage, handling or disposal of these materials.In the event of contamination or injury, we could be held liable for damages orpenalized with fines in an amount exceeding our resources, and our clinicaltrials or regulatory approvals could be suspended.

 

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**Employees**

 

As of December 31, 2005, we employed 95 full-time employees,consisting of 72 employees in research, development and regulatory affairs and23 in management, administration, finance, receiving and facilities. As of thesame date, 35 of our employees had a Ph.D. or M.D. degree. None of ouremployees is subject to a collective bargaining agreement. We consider ourrelationship with our employees to be good.

 

**Scientific Advisory Board**

 

We have established a scientific advisory board consisting of medicalprofessors and industry experts with knowledge of our target markets. Ourscientific advisors generally meet once a year as a group to assist us informulating our research, development and clinical strategies. Some individualscientific advisors consult with and meet informally with us on a more frequentbasis. We have entered into consulting agreements with all of our scientificadvisors, but they are not our employees and may have commitments to, orconsulting or advisory contracts with, other entities that may limit theiravailability to us. In addition, our scientific advisors may have arrangementswith other companies to assist those companies in developing products ortechnologies that may compete with ours.

 

**Corporate Information**

 

We were incorporated in Delaware in April 1997 as a wholly ownedsubsidiary of Gensia Sicor Inc., now Sicor Inc., which became an indirectwholly owned subsidiary of Teva Pharmaceutical Industries Limited in January2004. In December 1997, Sicor assigned to us specified assets and liabilitiesrelating to its then existing business of discovering and developingproprietary pharmaceutical products. Although we established a new businessplan, pursued new opportunities and discovered new products and technologiesfollowing our inception, many of the assets we obtained in the transfer servedas a foundation upon which we built our technologies and know how. In June,1999 we completed a corporate restructuring and management stock purchase inwhich we became an independent company. We have a wholly owned subsidiary,Aramed, Inc., which was transferred to us by Sicor and does not conduct anactive business.

 

**Available Information**

 

We make available free of charge on or through our Internet website ourannual report on Form 10-K, quarterly reports on Form 10-Q, currentreports on Form 8-K, and amendments to those reports, as soon aspracticable after we electronically file these materials with, or furnish themto, the Securities and Exchange Commission. The address of our website ishttp:/ /www.mbasis.com. The information contained in, or that can be accessedthrough, our website is not part of this annual report on Form 10-K.

 

**Item1A. Risk Factors**

 

*You should consider carefully the followinginformation about the risks described below, together with the otherinformation contained in this annual report on Form 10-K and in our otherfilings with the Securities and Exchange Commission, before you decide to buyor maintain an investment in our common stock. We believe the risks describedbelow are the risks that are material to us as of the date of this annualreport. If any of the following risks actually occur, our business, financialcondition, results of operations and future growth prospects would likely bematerially and adversely affected. In these circumstances, the market price ofour common stock could decline, and you may lose all or part of the money youpaid to buy our common stock.*

 

**Risks Related to our Business**

 

***We are dependent onthe success of one or more of our current product candidates and clinicaldevelopment candidate, and we cannot be certain that any of them will receiveregulatory approval or be commercialized.***

 

We have expended significant time, money and effort in the developmentof our four current product candidates, pradefovir, CS-917, MB07133 andMB07803, and our current clinical development candidate, MB07811. Clinicaltrials conducted to date in patients treated with pradefovir have providedevidence of efficacy as measured by various parameters that we believe to beclinically and statistically significant. However, no pivotal, adequate andwell-controlled clinical investigations designed to provide clinical andstatistically adequate proof of efficacy, or to provide sufficient evidence ofsafety to justify approval, have been completed with any of our products. Allof our product candidates will require 

 

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additional development, clinical trials and regulatory clearancesbefore they can be commercialized. Positive results from pre-clinical studiesand early clinical trials do not necessarily mean later clinical trials willsucceed. Our product development efforts may not lead to commercial drugs,either because our product candidates or clinical development candidates failto be safe and effective in clinical trials or because we have inadequatefinancial or other resources to pursue our product candidates through theclinical trial and approval processes. If any of our product candidates fail todemonstrate safety or efficacy at any time or during any phase of development,we would experience potentially significant delays in, or be required toabandon, development of the product candidate.

 

We do not anticipate that any of our current product candidates orclinical development candidate will be eligible to receive regulatory approvaland begin commercialization for a number of years, if at all. Even if we wereultimately to receive regulatory approval for these product candidates orclinical development candidates, we and/or our partners, as applicable, may beunable to commercialize them successfully for a variety of reasons. Theseinclude, for example, the availability of alternative treatments, lack of costeffectiveness, the cost of manufacturing the product on a commercial scale andthe effect of competition with other drugs. The success of our productcandidates or clinical development candidates may also be limited by theprevalence and severity of any adverse side effects. If we fail to commercializeone or more of our current product candidates or clinical developmentcandidates, we may be unable to generate sufficient revenues to attain ormaintain profitability, and our reputation in our industry and the investmentcommunity may be damaged.

 

***If clinical trialsof our product candidates do not produce successful results, we and ourcommercialization collaborators, as applicable, will be unable to commercializethese products.***

 

To receive regulatory approval for the commercialization of pradefovir,CS-917, MB07133, MB07803 or any other product candidates that we may develop,adequate and well-controlled clinical trials must be conducted to demonstratesafety and efficacy in humans to the satisfaction of the FDA in the U.S. andother regulatory agencies elsewhere in the world. In order to support marketingapproval, these agencies typically require successful results in one or morePhase III clinical trials, which our current product candidates have not yetreached and may never reach. Clinical testing is expensive, can take many yearsand has an uncertain outcome. Failure can occur at any stage of the testing. Wemay experience numerous unforeseen events during, or as a result of, theclinical trial process that could delay or prevent commercialization of ourcurrent or future product candidates, including the following:

 

•                    clinical trials mayproduce negative or inconclusive results,

 

•                    patient recruitment and enrollment inclinical trials may be slower than we anticipate,

 

•                    costs of clinical trialsmay be greater than we anticipate,

 

•                    our product candidates maycause undesirable side effects that delay or preclude regulatory approval orlimit their commercial use or market acceptance if approved,

 

•                    collaborators who are responsible forclinical trials of our product candidates may not devote sufficient resourcesto these clinical trials or conduct them in a timely manner, or

 

•                    we may face delays in obtaining regulatoryapprovals to commence a clinical trial.

 

Success in pre-clinical testing and early clinical trials does not meanthat later clinical trials will be successful because product candidates inlater-stage clinical trials may fail to demonstrate sufficient safety andefficacy despite having progressed through initial clinical testing. Our clinicalexperience with our product candidates is limited, and to date our productcandidates have been tested in less than the number of patients that willlikely need to be studied to gain regulatory approval. The data collected fromclinical trials with larger patient populations may not demonstrate sufficientsafety and efficacy to support regulatory approval of these product candidates.

 

The targeted endpoints for clinical trials of pradefovir and CS-917have been, and will continue to be, primarily established by Valeant andDaiichi Sankyo, respectively. We are solely responsible for establishing thetargeted endpoints for clinical trials of MB07133 and MB07803, as well asMB07811 should we initiate clinical trials of that clinical developmentcandidate, as we currently expect. These targeted endpoints may be inadequateto demonstrate the safety and efficacy levels required for regulatoryapprovals. Even if we believe data collected from clinical trials of ourproduct candidates are promising, such data may not be sufficient to supportmarketing approval by the FDA or other regulatory agencies abroad. Further,pre-clinical and clinical data can be interpreted in different ways, and theFDA or other foreign regulatory agencies may interpret such data in differentways than us or our collaborators. Our failure to adequately demonstrate thesafety and efficacy of our product candidates would prevent our receipt ofregulatory approval, and ultimately the commercialization of these productcandidates.

 

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***Our productcandidates may cause undesirable side effects that could delay or prevent theirregulatory approval or commercialization or******have other significant adverse implications on ourbusiness.***

 

Prior to receiving regulatory approval, undesirable side effects causedby our product candidates could interrupt, delay or halt clinical trials andcould result in the denial of regulatory approval by the FDA or otherregulatory authorities for any or all targeted indications, and in turn preventus from commercializing our product candidates and generating revenues fromtheir sale.

 

For example, the inhibition of gluconeogenesis can cause elevatedlevels of lactic acid, or lactate, which, if high and sustained under certainconditions, could lead to lactic acidosis, a serious and potentially fatalcondition. Certain pre-clinical animal studies have shown that CS-917 raiseslactate levels two- to three-fold in some but not all animal models. Elevatedlactate levels have also been observed in certain human clinical trials ofCS-917. For example, in a 28-day Phase II clinical trial of CS-917, isolatedinstances of lactate elevation significantly above the normal range were seenin some patients in both CS-917 and placebo treated groups over the course ofthe 28 days. No patient exhibited sustained lactate levels significantlyabove the normal range over a period of consecutive days during the clinicaltrial. However, one patient who received 200 milligrams of CS-917 twice a daywas withdrawn from the clinical trial by the investigator on day 15 due toconcerns over consistently elevated lactate levels measured the previous day. Otherincidences of elevated lactate levels have been observed and will likely occurin the future.

 

Our drugs could also exhibit adverse interactions with other drugs. Forinstance, in March 2005, we were notified by Daiichi Sankyo that twoserious adverse events involving lactic acidosis had occurred in two patientsin a Phase I clinical trial evaluating the interaction of CS-917 withmetformin. The serious adverse events were resolved after medical intervention.The two patients were administered CS-917 in combination with metformin. Athigh blood levels, metformin is believed to cause mitochondrial toxicity, acellular toxicity, which can cause lactic acidosis. These dangerous levels areknown to occur in patients with significant renal dysfunction who areinappropriately given metformin. Consequently, metformin is contraindicated foruse in patients with significant renal dysfunction. After the adverse eventsoccurred, three clinical trials that were ongoing at the time were stoppedwhile one Phase I clinical trial which did not combine CS-917 with metformincontinued and was completed. It was subsequently determined that the twopatients that experienced the lactic acidosis had blood levels of metforminthat were elevated compared to other patients in the clinical trial thatreceived metformin before administration of CS-917. After CS-917 administration,when the two patients were being administered metformin and CS-917, themetformin blood levels increased significantly into a range that is associatedwith mitochondrial toxicity and subsequent lactic acidosis. CS-917 blood levelsalso rose higher than expected.

 

The reason for the unexpectedly high blood levels of both drugs inthese two patients is unknown at this time. In July 2005, after completinga comprehensive review of the program and the events and data surrounding thetwo serious adverse events, we and Daiichi Sankyo concluded that the lacticacidosis observed in the two patients was likely due to the significantlyincreased blood levels of metformin described above which in turn likely led tomitochondrial toxicity. Subsequently, Daiichi Sankyo decided that Phase IIbclinical trials of CS-917 could safely resume. In February 2006, based onreports from Daiichi Sankyo, after submission of the proposed clinical trialprotocol to the FDA and approval by the IRB, a Phase IIb clinical trial ofCS-917 was initiated. This Phase IIb clinical trial provides for measurement ofthe regulatory endpoint, HbA1c. Daiichi Sankyo has conducted and will likelyconduct additional studies combining CS-917 with other diabetes drugs to assessboth the safety and eventually the potential for enhanced efficacy with thecombination. However, further combination of CS-917 and metformin will beavoided unless additional data suggests that the elevation of metformin bloodlevels as seen in the two patients can be avoided through patient exclusion orthrough the administration of CS-917 at lower doses or through other means. ShouldCS-917 eventually be approved and combination with metformin remains an issue,the FDA may require additional measures be taken during marketing, such asprominent warning labels known as “black-box” warnings, physician educationprograms and/or other steps regarding concomitant use of CS-917 and metformin.

 

In February 2006, we initiated Phase I clinical trials of oursecond-generation product candidate for diabetes, MB07803, which is intended towork by the same mechanism as CS-917.

 

It is also possible that CS-917 and MB07803 may cause other sideeffects. In certain pre-clinical studies, as expected based on the mechanism ofthese compounds, fasted animals treated with CS-917 showed pronouncedhypoglycemia, a condition involving abnormally low blood glucose levels thatcan lead to coma or death. Hypoglycemia has been observed in one patientparticipating in a clinical trial that involved multi-day administration of thehighest dose tested to date in patients (400 milligrams twice a day). This doseis above what is expected to be used in Phase III clinical trials if warranted.However, 

 

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we cannot yet rule out the possibility that CS-917 may increase apatient’s susceptibility to hypoglycemia, including the potential for severehypoglycemia, by inhibiting gluconeogenesis, especially in elderly patients whoare already prone to develop this condition. Some rodent models of diabetesstudied in pre-clinical trials of CS-917 demonstrated, at glucose loweringdoses, increased levels of fat molecules known as triglycerides, which areassociated with an increased risk of cardiovascular disease. Elevated triglyceridelevels have not been observed in human clinical trials to date. Other sideeffects observed during early clinical trials of CS-917 included nausea andvomiting.

 

We apply our HepDirect technology to make liver-specific prodrugs ofcertain compounds. A prodrug is a drug to which a chemical modification hasbeen made that renders it inactive until enzymes in the body convert it to itsactive form. When converted by the body to their active forms, HepDirectprodrugs produce a byproduct that is within a class of compounds that have thepotential of causing toxicity, genetic mutations and cancer. We are unaware ofany byproduct-related toxicities demonstrated to date in clinical trials ofeither pradefovir or MB07133. However, we cannot be certain that this byproductwill not cause adverse effects in current or future clinical trials of theseproduct candidates or other HepDirect prodrugs we may develop. In addition,because our current product candidates are in early stages of development andhave been tested in relatively small populations, additional side effects maybe observed as their development progresses.

 

In addition, undesirable side effects seen in the clinical trials ofour product candidates may have other significant adverse implications on ourbusiness, for example:

 

•                    we may be unable to obtainadditional financing on acceptable terms, if at all,

 

•                    our stock price coulddecline,

 

•                    our collaborators mayultimately terminate development of our partnered products, may further decidenot to develop backup product candidates and may terminate our agreements,

 

•                    if these agreements wereterminated we may determine not to further develop the affected productcandidates due to resource constraints and may not be able to establishadditional collaborations for their further development on acceptable terms, ifat all,

 

•                    if we were to latercontinue the clinical trials of these product candidates and receive regulatoryapproval, earlier findings may significantlylimit their marketability and thus significantly lower our potential futurerevenues from their sale,

 

•                    we may be subject to product liability orstockholder litigation, and

 

•                    we may be unable to attract and retain keyemployees.

 

In addition, if any of our product candidates receive marketingapproval and we or others later identify undesirable side effects caused by theproduct:

 

•                    regulatory authorities maywithdraw their approval of the product, or we may decide to cease marketing andsale of the product voluntarily,

 

•                    we may be required to change the way the product isadministered, conduct additional clinical trials, change the labeling of the product, or change the product’smanufacturing facilities, and

 

•                    our reputation may suffer.

 

Any of these events could prevent us from achieving or maintainingmarket acceptance of the affected product or could substantially increase thecosts and expenses of commercializing the product, which in turn could delay orprevent us from generating significant revenues from the sale of the product.

 

***We are dependent onour collaborations with Valeant and Daiichi Sankyo for development ofpradefovir and CS-917, respectively, and events involving these collaborations,our collaborations with Merck, or any future collaborations could prevent usfrom developing and commercializing our product candidates and achieving orsustaining profitability.***

 

We have entered into collaborations with Valeant and Daiichi Sankyo forthe development and commercialization of pradefovir and CS-917, respectively. Valeantand Daiichi Sankyo have agreed to finance the clinical trials for pradefovirand CS-917, respectively, and, if they are approved, manufacture and marketthem. Accordingly, we are dependent on Valeant and Daiichi Sankyo to gain FDAand other foreign regulatory agency approval of, and to commercialize, pradefovirand CS-917. We have also entered into two collaborations with Merck. The firstcollaboration with Merck seeks to develop and

 

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commercialize new products for the treatment of hepatitis C infectionand the second seeks to develop and commercializenew products to treat several metabolic diseases including type 2 diabetes,hyperlipidemia and obesity. Although our collaborations with Merck havenot yet yielded any product candidates, should a candidate ultimately beselected, we will be dependent on Merck for further development andcommercialization of any resulting product candidates. In addition, since we donot currently possess the resources necessary to independently develop andcommercialize all of the potential products that may be based upon ourtechnologies, including MB07133, MB07803 and MB07811 we may need to enter intoadditional collaborative agreements to assist in the development andcommercialization of some of these potential products. However, our discussionswith potential collaborators may not lead to the establishment of newcollaborations on acceptable terms, if at all, or it may take longer thanexpected to establish new collaborations, leading to development andcommercialization delays.

 

We have limited control over the amount and timing of resources that Valeant,Daiichi Sankyo, Merck or any future collaborators devote to our programs orpotential products. These collaborators may breach or terminate theiragreements with us or otherwise fail to conduct their collaborative activitiessuccessfully and in a timely manner. Further, our collaborators may not developproducts that arise out of our collaborative arrangements or devote sufficientresources to the development, manufacture, marketing or sale of these products.In the event that one of our collaborations is terminated, and we believe thatthe continued development or commercialization of a product candidate or drugcompound covered by the collaboration is warranted, we would seek to obtainrights to develop and commercialize the product candidate or drug compound, ifwe did not already have those rights. We would then determine whether tocontinue the development or commercialization of the product candidate or drugcompound independently or together with a new collaborator. However, in theevent that we do not have sufficient resources to independently develop orcommercialize the product candidate or drug compound, and we cannot establish anew collaboration on acceptable terms, we would be forced to discontinue itsdevelopment or commercialization.

 

Our agreement with Daiichi Sankyo contains certain rights andrestrictions regarding our access to and use of confidential data and informationgenerated by Daiichi Sankyo. We have initiated Phase I clinical trials ofMB07803, a second-generation gluconeogenesis inhibitor to which Daiichi Sankyohas no rights and that may be a direct competitor to CS-917. Because of thiscompetitive situation and with our consent, the transfer to us of confidentialinformation and data related to CS-917 from Daiichi Sankyo has already beenreduced and we expect that further reductions in information flow will occur.This situation may limit our ability to (i) provide information regardingclinical results unless they are publicly released by Daiichi Sankyo,(ii) influence decisions made at Daiichi Sankyo regarding CS-917 and(iii) accurately track Daiichi Sankyo’s diligence on the developmentprogram

 

We and our present and future collaborators may fail to develop oreffectively commercialize products or drug compounds covered by our present andfuture collaborations if:

 

•                    we do not achieve ourobjectives under our collaboration agreements,

 

•                    we are unable to obtain patent protection for theproduct candidates or proprietary technologies we discover in ourcollaborations,

 

•                    we are unable to manage multiple simultaneous product discovery anddevelopment collaborations,

 

•                    our potential collaborators are lesswilling to expend their resources on our programs due to their focus on otherprograms or as a result of general market conditions,

 

•                    our collaborators become competitors ofours or enter into agreements with our competitors,

 

•                    we or our collaborators encounterregulatory hurdles that prevent commercialization of our product candidates,

 

•                    we develop products and processes or enter into additionalcollaborations that conflict with the business objectives of our othercollaborators,

 

•                    consolidation in our target marketslimits the number of potential collaborators, or

 

•                    we are unable to negotiate additionalcollaboration agreements under terms satisfactory to us.

 

If we are unable to develop or commercialize our products as a resultof the occurrence of any of these events, we may not be able to generatesufficient revenues to achieve or maintain profitability.

 

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***Because ourcollaborations with Merck may involve Merck’s proprietary compounds, if Merckterminates development of product candidates we may not have the right topursue development of these product candidates on our own.***

 

The objective of our hepatitis C collaboration with Merck has been todiscover product candidates for the treatment of this disease by applying ourtechnology to certain compounds. The funded research phase of thiscollaboration has ended. Merck has evaluated and may continue to evaluate thedrug compounds discovered under the research phase of the collaboration todetermine if one or more will be recommended for clinical development. If Merckso designates a product candidate and then subsequently terminates thiscollaboration before a defined stage of development of that product candidate,which it may do without cause at any time upon 90 days’ advance writtennotice to us, we will not have any right to develop or commercialize thatproduct candidate. In addition, if this collaboration with Merck terminates andMerck successfully develops products based on these proprietary compoundswithout applying our technology, we will not be entitled to milestone paymentsor royalties with respect to those products.

 

Our agreement with Merck to develop and commercialize new products to treat several metabolic diseases includingtype 2 diabetes, hyperlipidemia and obesity may include the developmentof compounds owned or controlled by Merck. Accordingly, if Merck terminatesthis collaboration it may prove difficult for us to continue development ofsuch compounds.

 

***Conflicts may arisebetween us and any of our collaborators that could delay or prevent thedevelopment or commercialization of our product candidates.***

 

Conflicts may arise between our collaborators and us, such as conflictsconcerning the interpretation of clinical data, the achievement of milestonesor the ownership of intellectual property developed during the collaboration.If any conflicts arise with Valeant, Daiichi Sankyo, Merck or any futurecollaborators, they may act in their self-interest, which may be adverse to ourbest interests. Any such disagreement between us and a collaborator couldresult in one or more of the following, each of which could delay or preventthe development or commercialization of our product candidates, and in turnprevent us from generating sufficient revenues to achieve or maintainprofitability:

 

•                    unwillingness on the partof a collaborator to pay us research funding, milestone payments or royaltieswe believe are due to us under our collaboration agreement,

 

•                    uncertainty regardingownership of intellectual property rights arising from our collaborativeactivities, which could prevent us from entering into additionalcollaborations, or disagreements with our collaborators regarding theprotection of intellectual property rights,

 

•                    unwillingness on the partof a collaborator to keep us informed regarding the progress of its developmentand commercialization activities or to permit public disclosure of the resultsof those activities, or

 

•                    slowing or cessation of acollaborator’s development or commercialization efforts with respect to ourproduct candidates.

 

***Our efforts todiscover product candidates beyond our current product candidates may notsucceed, and any product candidates we recommend for clinical development maynot actually begin clinical trials.***

 

Weintend to use our proprietary technologies and our knowledge and expertise to develop and commercialize **novel drugs to address some of the world’s mostwidespread and costly chronic diseases** involvingpathways in the liver. Our goal is to expand our clinical developmentpipeline by continuing to recommend new drug compounds for clinicaldevelopment. However, the process of researching and discovering drug compoundsis expensive, time-consuming and unpredictable. Data from our current researchprograms may not support the clinical development of our lead compounds orother compounds from these programs, and we may not identify any additionaldrug compound suitable for recommendation for clinical development. Moreover,any drug compounds we recommend for clinical development may not demonstrate,through pre-clinical testing, indications of safety and potential efficacy,that such drug compounds warrant advancement into clinical trials. Suchfindings would potentially impede our ability to maintain or expand ourclinical development pipeline. Our ability to identify new drug compounds andadvance them into clinical development also depends upon our ability to fundour research and development operations, and we cannot be certain thatadditional funding will be available on acceptable terms, or at all.

 

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***Delays in thecommencement or completion of clinical testing could result in increased coststo us and delay our ability to generate significant revenues.***

 

Delays in the commencement or completion of clinical testing couldsignificantly impact our product development costs. We do not know whetherplanned clinical trials will begin on time or be completed on schedule, if atall. The commencement of clinical trials can be delayed for a variety ofreasons, including delays in:

 

•                    obtaining regulatoryapproval to commence a clinical trial,

 

•                    reaching agreement on acceptable terms withprospective contract research organizations and clinical trial sites,

 

•                    manufacturing sufficient quantities ofa product candidate,

 

•                    obtaining institutional reviewboard approval to conduct a clinical trial at a prospective site, and

 

•                    recruiting and enrolling patients toparticipate in a clinical trial.

 

In addition, once a clinical trial has begun, it may be suspended orterminated by us, our collaborators, the FDA or other regulatory authoritiesdue to a number of factors, including:

 

•                    failure to conduct the clinical trial inaccordance with regulatory requirements or clinical protocols,

 

•                    inspection of the clinicaltrial operations or clinical trial site by the FDA or other regulatoryauthorities resulting in the imposition of a clinical hold,

 

•                    unforeseen safety issues,or

 

•                    lack of adequate funding to continue theclinical trial.

 

If we experience significant delays in the commencement or completionof clinical testing, our product development costs may increase, we may loseany competitive advantage associated with early market entry and our ability togenerate significant revenues may be delayed. For example, events in early 2005related to CS-917 have delayed our clinical timeline for CS-917 as well as oursecond-generation gluconeogenesis inhibitor, MB07803. In addition, many of thefactors that cause, or lead to, a delay in the commencement or completion ofclinical trials may also ultimately lead to the denial of regulatory approvalof a product candidate.

 

***We rely on thirdparties to conduct our clinical trials. If these third parties do notsuccessfully meet their obligations under our agreements, we may not be able toobtain regulatory approval for or commercialize our product candidates.***

 

Valeant and Daiichi Sankyo are responsible for conducting clinicaltrials of pradefovir and CS-917, respectively. Although our collaborations withMerck to discover product candidates for the treatment of hepatitis C and metabolic diseases including type 2 diabetes,hyperlipidemia and obesity have not yet yielded product candidates,should they be successful, we will be dependent on Merck to conduct clinicaltrials of any resulting product candidates. We intend to rely on other thirdparties, such as contract research organizations, medical institutions,clinical investigators and contract laboratories, to conduct our clinicaltrials of MB07133, MB07803, MB07811 and any other product candidates that wemay develop for which a collaborator is not responsible for clinicaldevelopment. If Valeant, Daiichi Sankyo, Merck or these other third parties donot successfully meet their obligations under our agreements, or if the qualityor accuracy of the clinical data they obtain is compromised due to the failureto adhere to clinical protocols or for other reasons, clinical trials may beextended, delayed or terminated, and these product candidates may not receiveregulatory approval or be successfully commercialized.

 

***Because our productcandidates, research programs and collaborative efforts depend on ourproprietary technologies, adverse events affecting our proprietary technologiesmay delay or prevent the commercialization of our product candidates.***

 

We used our HepDirect technology to discover pradefovir, MB07133 and incertain other programs and our NuMimetic technology to identify CS-917 andMB07803. We intend to use these and future proprietary technologies to expandour product pipeline in the future. We also may leverage our HepDirect andother liver-targeting technology through strategic alliances and collaborationswith other companies, such as our hepatitis C collaboration with Merck in whichwe applied our technology to certain Merck compounds. Our proprietarytechnologies are subject to many of the same risks as our product candidates,including risks related to:

 

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•                    obtaining and maintainingpatent and trade secret protection for these technologies,

 

•                    avoiding infringement of theproprietary rights of third parties,

 

•                    the development of competing technologiesby others, and

 

•                    in HepDirect’s case, the safety and effectiveness of thistechnology in humans.

 

Because certain of our product candidates and research programs aredependent on our proprietary technologies, adverse events affecting ourproprietary technologies may in turn delay or prevent the development orcommercialization of our product candidates, which could impede our ability togenerate revenues and achieve or maintain profitability.

 

***Our productcandidates are subject to extensive regulation, which can be costly and timeconsuming, cause unanticipated delays or prevent the receipt of the requiredapprovals to commercialize our product candidates.***

 

The clinical development, manufacturing, labeling, storage,record-keeping, advertising, promotion, export, marketing and distribution ofour product candidates are subject to extensive regulation by the FDA and otherregulatory agencies in the U.S. and by comparable governmental authorities inforeign markets. In the U.S., neither we, nor our collaborators, are permittedto market our product candidates until we or our collaborators receive approvalof an NDA from the FDA or receive similar approvals abroad. The process ofobtaining these approvals is expensive, often takes many years, and can varysubstantially based upon the type, complexity and novelty of the productcandidates involved. Approval policies or regulations may change. In addition,as a company, we have not previously filed NDAs with the FDA or filed similarapplications with other foreign regulatory agencies. This lack of experiencemay impede our ability to obtain FDA or other foreign regulatory agencyapproval in a timely manner, if at all, for our product candidates for whichdevelopment and commercialization is our responsibility.

 

Despite the time and expense invested, regulatory approval is neverguaranteed. The FDA or other foreign regulatory agencies can delay, limit ordeny approval of a product candidate for many reasons, including:

 

•                    a product candidate maynot be safe and effective,

 

•                    FDA or other foreignregulatory agency officials may not find the data from pre-clinical testing andclinical trials sufficient,

 

•                    the FDA or other foreign regulatoryagency may not approve of our third-party manufacturers’ processes orfacilities, or

 

•                    theFDA or other foreign regulatory agency may change its approval policies oradopt new regulations.

 

Any delay in obtaining, or inability to obtain, these approvals wouldprevent us from commercializing our product candidates.

 

***Even if any of ourproduct candidates receive regulatory approval, our product candidates maystill face future development and regulatory difficulties.***

 

If any of our product candidates receive regulatory approval, the FDAor other foreign regulatory agencies may still impose significant restrictionson the indicated uses or marketing of the product candidates or impose ongoingrequirements for potentially costly post-approval studies. In addition,regulatory agencies subject a product, its manufacturer and the manufacturer’sfacilities to continual review and periodic inspections. If a regulatory agencydiscovers previously unknown problems with a product, including adverse eventsof unanticipated severity or frequency, or problems with the facility where theproduct is manufactured, a regulatory agency may impose restrictions on that product,our collaborators or us, including requiring withdrawal of the product from themarket. Our product candidates will also be subject to ongoing FDA and otherforeign regulatory agency requirements for the labeling, packaging, storage,advertising, promotion, record-keeping and submission of safety and otherpost-market information on the drug. If our product candidates fail to complywith applicable regulatory requirements, a regulatory agency may:

 

•              issue warning letters orother notices of possible violations,

 

•              impose civil or criminalpenalties or seek disgorgement of revenue or profits,

 

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•              suspend regulatory approval,

 

•              suspend any ongoing clinicaltrials,

 

•              refuse to approve pending applicationsor supplements to approved applications filed by us or our collaborators,

 

•              impose restrictions onoperations, including costly new manufacturing requirements, or

 

•              seize or detain productsor require a product recall.

 

In order to market any products outside of the U.S., we and ourcollaborators must establish and comply with numerous and varying regulatoryrequirements of other countries regarding safety and efficacy. Approvalprocedures vary among countries and can involve additional product testing andadditional administrative review periods. The time required to obtain approvalin other countries might differ from that required to obtain FDA approval. Theregulatory approval process in other countries may include all of the risksregarding FDA approval in the U.S. Regulatory approval in one country does notensure regulatory approval in another, but a failure or delay in obtainingregulatory approval in one country may negatively impact the regulatory processin others. Failure to obtain regulatory approval in other countries or anydelay or setback in obtaining such approval could have the same adverse impactregarding FDA approval in the U.S., including the risk that our productcandidates may not be approved for all indications requested, which could limitthe uses of our product candidates and adversely impact potential royalties andproduct sales, and that such approval may be subject to limitations on theindicated uses for which the product may be marketed or require costly,post-marketing follow-up studies.

 

If we and our collaborators fail to comply with applicable foreignregulatory requirements, we and our collaborators may be subject to fines,suspension or withdrawal of regulatory approvals, product recalls, seizure ofproducts, operating restrictions and criminal prosecution.

 

***If our competitorshave products that are approved faster, marketed more effectively ordemonstrated to be more effective than ours, our commercial opportunity will bereduced or eliminated.***

 

The biotechnology and biopharmaceutical industries are characterized byrapidly advancing technologies, intense competition and a strong emphasis onproprietary products. We face competition from many different sources,including commercial pharmaceutical and biotechnology enterprises, academicinstitutions, government agencies and private and public research institutions.Due to the high demand for treatments for liver and metabolic diseases,research is intense and new treatments are being sought out and developed byour competitors.

 

We are aware of many competitive products currently marketed or under development that are used to treat some of the diseases we have targeted. If CS-917 and/or MB07803 are ultimately determined safe and effective and approved for marketing, these products may compete for market share with established therapies from a number of competitors, including large pharmaceutical companies such as GlaxoSmithKline, Bristol-Myers Squibb, Eli Lilly, sanofi-aventis Group, Novo Nordisk and Takeda Pharmaceuticals. Such marketed products include, but are not limited to the following classes:

 

•                    metformin - members of the biguanide drug class, related to guanidine and the standard of care for type 2 diabetes,

 

•                    sulfonylureas – increase the secretion of insulin by the pancreas, thereby lowering the level of the sugar glucose in the blood,

 

•                    insulins – mimic the naturally occurring hormone “insulin” made by the pancreas to control blood glucose levels,

 

•                    peroxisome proliferator-activated receptor agonists - improve insulin sensitivity by activating certain genes involved in fat synthesis and carbohydrate metabolism,

 

•                    incretin mimetics – mimic the naturally occurring hormone “incretin”. Incretin reduces blood glucose levels by increasing the secretion of insulin from the pancreas, slowing absorption of glucose from the gut, and reducing the action of glucagon (glucagon is a hormone that increases glucose production by the liver),

 

•                    alpha-glucosidase inhibitors - decrease the absorption of carbohydrates from the intestine, resulting in a slower and lower rise in blood glucose throughout the day,

 

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•                    glinides - stimulate the pancreas’ beta-cells to produce insulin, and

 

•                    metformin combination therapies – combines metformin with members of the above-mentioned classes, particularly sulfonylureas and PPARs.

 

Of particular note, metformin is a drug that, like CS-917 and MB07803, inhibits liver glucose production, albeit through an unknown mechanism. Because it does not cause weight gain, metformin is often prescribed as a first line therapy to obese diabetics, who are reported to comprise more than 90% of newly diagnosed type 2 diabetics. Generic forms of metformin have recently become available. Accordingly, unless CS-917 and MB-7803 demonstrate significant benefits over metformin or demonstrate that they can be used in the patient population who do not tolerate and/or adequately respond to metformin treatment, the price required to effectively compete with the generic form of metformin may be so low that it becomes uneconomical for us or Sankyo to market CS-917 and/or for us to market MB07803. Moreover, if the combination of CS-917 with metformin is contraindicated for safety reasons the market potential of CS-917 could be reduced and/or selling expenses could be increased. Should CS-917 eventually be approved and combination with metformin remains an issue, the FDA may require additional measures be taken during marketing, such as prominent warning labels known as “black-box” warnings, physician education programs and/or other steps regarding concomitant use of CS-917 and metformin.

 

In addition, many companies are developing novel therapies that target diabetes. These companies may develop and introduce products competitive with or superior to CS-917 and/or MB7803.

 

If pradefovir is ultimately determined safe and effective and approved for marketing, it may compete for market share with established therapies from a number of competitors, including large pharmaceutical companies such as GlaxoSmithKline, Schering-Plough Corporation, Bristol-Myers Squibb, and Hoffman-La Roche. Such marketed products include, but are not limited to the following classes:

 

•                    interferons- mimic the naturally occurring “interferon”.Interferon is an infection-fighting immune substance produced by the body,

 

•                    nucleosideanalogues - chemically engineerednucleoside compounds structurally similar to the building blocks of DNA and RNAthat interferes with the replication of HBV, and

 

•                    nucleotideanalogues - chemically engineerednucleotide compounds structurally similar to the building blocks of DNA and RNAthat interferes with the replication of HBV.

 

A competitor to pradefovir will be Hepsera (adefovir dipivoxil), whichis a nucleotide analogue marketed in the U.S. by Gilead Sciences, Inc.Pradefovir and Hepsera are prodrugs of the same active drug, and therefore willdirectly compete. In order to effectively compete with Hepsera, pradefovir mayhave to be significantly more beneficial or less expensive than Hepsera. Inaddition, marketed products approved to treat HIV infections are beingevaluated for their effectiveness in treating hepatitis B infections.

 

There are no currently approved drugs for primary liver cancer.However, a few companies are developing novel therapies specifically forprimary liver cancer. In addition, companies are developing therapies for othersolid tumors which may be efficacious in treating primary liver cancer. Thesecompanies may develop and introduce products competitive with or superior toMB7133.

 

If MB07811 is ultimately determined safe and effective and approved formarketing, it would compete with products marketed by several largepharmaceutical companies that currently comprise a large share of thehyperlipidemia market. Major classes of hyperlipidemia drugs include, but arenot limited to:

 

•                    statins - reduce serum cholesterol levels byinhibiting a key enzyme involved in the biosynthesis of cholesterol,

 

•                    fibrates –reduce the amount of cholesterol and triglycerides(fatty substances) in blood,

 

•                    nicotinic acid derivatives (NADs) - ****lower cholesterol andtriglycerides. NADs decrease low density lipoproteins and increase high densitylipoproteins,****

 

•                    cholesterolabsorption inhibitors - inhibit the absorption of dietary and biliarycholesterol,

 

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•                    bileacid sequestrants –bind withcholesterol-containing bile acids in the intestines and remove them in bowelmovements, and

 

•                    statincombination therapies - combine statins with members of the above-mentionedclasses, particularly CAIs.

 

These large pharmaceutical companies are also developing novel therapies that target hyperlipidemia. These companies may develop and introduce products competitive with or superior to MB07811. Lipitor (atorvastatin; a statin marketed by Pfizer) is currently the best selling prescription medicine. In addition, generic statins (cholesterol-reducers) have recently been approved in the major pharmaceutical markets, which would also compete with MB07811.

 

In addition, many other competitors are developing products for thetreatment of the diseases we are targeting and if successful, these productscould compete with our products. If we receive approval to market and sell anyof our product candidates, we may compete with these companies and theirproducts as well as others in varying stages of development.

 

Many of our competitors have significantly greater financial resourcesand expertise in research and development, manufacturing, pre-clinical testing,clinical trials, regulatory approvals and marketing approved products than wedo. Smaller or early-stage companies may also prove to be significantcompetitors, particularly through collaborative arrangements with large andestablished companies. Our competitors may succeed in developing technologiesand therapies that are more effective, better tolerated or less costly than anywhich we are developing, or that would render our product candidates obsoleteand noncompetitive. Our competitors may succeed in obtaining approvals from theFDA and foreign regulatory authorities for their products sooner than we do forours. We will also face competition from these third parties in recruiting andretaining qualified scientific and management personnel, establishing clinicaltrial sites and patient registration for clinical trials, and in acquiring andin-licensing technologies and products complementary to our programs oradvantageous to our business.

 

***We do not haveinternal manufacturing capabilities, and if we fail to develop and maintainsupply relationships with collaborators or other third-party manufacturers, wemay be unable to develop or commercialize our products.***

 

Our ability to develop and commercialize our products depends in parton our ability to manufacture, or arrange for collaborators or other thirdparties to manufacture, our products at a competitive cost, in accordance withregulatory requirements and in sufficient quantities for clinical testing andeventual commercialization. Valeant and Daiichi Sankyo are responsible for allclinical and commercial manufacturing of pradefovir and CS-917, respectively.We have relied on a number of suppliers to manufacture sufficient quantities ofMB07133 and MB07803 for use in our current clinical trials. Although none ofour current product candidates has been manufactured on a commercial scale ourhistorical suppliers have manufactured other companies’ products on acommercial scale. However, we have not yet determined if our suppliers arecapable of manufacturing our products on a commercial scale. Similarly, we relyon outside manufacturing for MB07811. We, our collaborators and third-partymanufacturers may encounter difficulties with the small- and large-scaleformulation and manufacturing processes required to manufacture our productcandidates, resulting in delays in our clinical trials and regulatorysubmissions, in the commercialization of our product candidates or, if any ofour product candidates is approved, in the recall or withdrawal of the productfrom the market. Further, development of large-scale manufacturing processesmay require additional validation studies, which the FDA and other foreignregulatory agencies must review and approve. Our inability to enter into ormaintain agreements with collaborators or capable third-party manufacturers onacceptable terms could delay or prevent the commercialization of our products,which would adversely affect our ability to generate revenues and could preventus from achieving or maintaining profitability.

 

We currently expect that in any future clinical trials of MB07133,MB07803 and MB07811, we will rely on our current suppliers to manufacture thesecompounds. However, we do not have long-term supply agreements with these thirdparties, and we may not be able to enter into new supply agreements with themin a timely manner or on acceptable terms, if at all. These third parties mayalso be subject to capacity constraints that would cause them to limit theamount of these compounds that we can purchase. While we believe alternativesources to manufacture these compounds are readily available, in the event wehave to seek such alternative sources we will incur costs associated withidentifying and qualifying one or more alternate suppliers. In addition, anyresulting interruption or delay we experience in the supply of MB07133, MB07803or MB07811 may impede the clinical development of these compounds.

 

In addition, we, our collaborators or other third-party manufacturersof our products must comply with CGMP requirements enforced by the FDA andother foreign regulatory agencies through their facilities inspection programs.These requirements include quality control, quality assurance and themaintenance of records and documentation. In addition, product manufacturingfacilities in California are subject to licensing requirements of theCalifornia Department of Health Services and may be inspected by the CaliforniaDepartment of Health Services, and other applicable regulatory authorities, at 

 

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any time. We, our collaborators or other third-party manufacturers ofour products may be unable to comply with these CGMP requirements and withother FDA, state and foreign regulatory requirements. We have little controlover third-party manufacturers’ compliance with these regulations andstandards. A failure to comply with these requirements may result in fines andcivil penalties, suspension of production, suspension or delay in productapproval, product seizure or recall, or withdrawal of product approval.

 

***If we are unable toestablish sales and marketing capabilities or enter into agreements with thirdparties to sell and market our product candidates, we may be unable to generatesignificant revenues.***

 

We do not have a sales and marketing organization, and we have noexperience as a company in the sales, marketing and distribution ofpharmaceutical products. Valeant and Daiichi Sankyo are responsible forworldwide marketing and commercialization for pradefovir and CS-917,respectively, although we have an option to co-promote CS-917 in North Americawith Daiichi Sankyo. Although our hepatitis C and metabolic diseasecollaborations with Merck have not yet yielded product candidates, should theybe successful, Merck will be responsible for worldwide marketing andcommercialization of any resulting product candidates (subject to, in the caseof our metabolic disease collaboration, our option to co-promote the product inthe U.S. with certain financial assistance from Merck). In order to co-promoteany of these products, or to commercialize MB07133, MB07803, MB07811 or anyfuture product candidates, we must develop our sales, marketing anddistribution capabilities, or make arrangements with a third party to performthese services. Even though we may receive financial assistance from Merck ifwe exercise our co-promotion option under the metabolic disease collaborationdeveloping a sales force for any resulting product or any product resultingfrom any of our other product candidates is expensive, and time consuming andcould delay any product launch. We may be unable to establish and manage aneffective sales force in a timely or cost-effective manner, if at all, and anysales force we do establish may not be capable of generating sufficient demandfor our product candidates. To the extent that we enter into arrangements withcollaborators or other third parties to perform sales and marketing services,our product revenues are likely to be lower than if we directly marketed andsold our product candidates. If we are unable to establish adequate sales andmarketing capabilities, independently or with others, we may not be able togenerate significant revenues and may not become profitable.

 

***The commercialsuccess of our product candidates depends upon their market acceptance amongphysicians, patients, healthcare payors and the medical community.***

 

Even if our product candidates obtain regulatory approval, ourproducts, if any, may not gain market acceptance among physicians, patients,healthcare payors and the medical community. The degree of market acceptance ofany of our approved product candidates will depend on a number of factors,including:

 

•                    our ability to provideacceptable evidence of safety and efficacy,

 

•                    relative convenience andease of administration,

 

•                    the prevalence andseverity of any adverse side effects,

 

•                    restrictions on use incombination with other products,

 

•                    availability of alternativetreatments,

 

•                    pricing and costeffectiveness,

 

•                    effectiveness of our or our partners’sales and marketing strategy, and

 

•                    our ability to obtainsufficient third-party coverage or reimbursement.

 

If approved, CS-917 may have to be administered several times daily.Additionally, it may result in variable drug levels in different patientpopulations, which could complicate its use and limit its marketability. SinceCS-917 is eliminated from the body through the kidney, it may be of limited usein diabetics with kidney dysfunction. In addition, CS-917 and HepDirectprodrugs such as pradefovir and MB07133 may also exhibit interactions withother marketed drugs that could limit their combination with those drugs.Serious adverse events observed in early 2005 in a Phase I clinical trial ofCS-917 in combination with metformin have raised questions about the safety ofthe potential use of CS-917 and metformin in combination. Therefore, even ifCS-917 receives regulatory approval, its combination with metformin may berestricted which may reduce its market potential. In addition, various riskmanagement strategies may be required to minimize inadvertent use withmetformin including prominent warning labels known “as black-box” warnings,physician education programs and/or other steps designed to more tightlycontrol the sale and use of CS-917. Such strategies and programs, if required,will likely 

 

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adversely impact the sales of CS-917 and may incur additional sellingexpenses thereby reducing profits. In addition, primarily because the number oftreatable patients in the U.S. with primary liver cancer is relatively small,we expect to market MB07133, if approved, at a relatively high price in theU.S. in order to generate sufficient revenues to recoup our costs and provide areturn on our investment. This could limit or prevent us from achieving themarket acceptance of MB07133 in the U.S. The number of treatable patientsoutside of the U.S. is much larger than the number of treatable patients in theU.S. However, because third party reimbursement in many of these countries isuncertain, we may be unable to recoup our costs or generate sufficient returnson our investment in these countries. If any of our product candidates isapproved but does not achieve an adequate level of acceptance by physicians,healthcare payors and patients, we may not generate sufficient revenue fromthis product candidate and we may not become or remain profitable.

 

***We are subject touncertainty relating to health care reform measures and reimbursement policieswhich, if not favorable to our product candidates, could hinder or prevent ourproduct candidates’ commercial success.***

 

The continuing efforts of the government, insurance companies, managedcare organizations and other payers of health care costs to contain or reducecosts of health care may adversely affect:

 

•                    our ability to set a pricewe believe is fair for our products,

 

•                    our ability to generaterevenues and achieve or maintain profitability,

 

•                    thefuture revenues and profitability of our potential customers, suppliers andcollaborators, and

 

•                    the availability of capital.

 

In certain foreign markets, the pricing of prescription drugs issubject to government control. In the U.S., given recent federal and stategovernment initiatives directed at lowering the total cost of health care,Congress and state legislatures will likely continue to focus on health carereform, the cost of prescription drugs and the reform of the Medicare andMedicaid systems. For example, the Medicare Prescription Drug, Improvement andModernization Act of 2003 was recently enacted. This legislation provides a newMedicare prescription drug benefit that began in 2006 and mandates otherreforms. While we cannot predict the full outcome of the implementation of thislegislation, it is possible that the new Medicare prescription drug benefit,which will be managed by private health insurers and other managed careorganizations, will result in decreased reimbursement for prescription drugs,which may further exacerbate industry-wide pressure to reduce prescription drugprices. This could harm our ability to market our products and generaterevenues. It is also possible that other similar proposals will be adopted.

 

Our ability to commercialize our product candidates successfully willdepend in part on the extent to which governmental authorities, private healthinsurers and other organizations establish appropriate coverage andreimbursement levels for the cost of our products and related treatments.Third-party payors including state governments are increasingly challenging theprices charged for medical products and services. Also, the trend towardmanaged health care in the U.S., which could significantly influence thepurchase of health care services and products, as well as legislative proposalsto reform health care or reduce government insurance programs, may result inlower prices for our product candidates or exclusion of our product candidatesfrom coverage and reimbursement programs. The cost containment measures thathealth care payors and providers are instituting and the effect of any healthcare reform could significantly reduce our revenues from the sale of anyapproved product.

 

***We will need toincrease the size of our organization, and we may experience difficulties inmanaging growth.***

 

Since we became an independent company in 1999, we have increased thenumber of our full-time employees from 50 to 95 as of December 31, 2005.We may need to continue to expand our managerial, operational, financial and otherresources in order to manage and fund our operations and clinical trials,continue our research and development and collaborative activities, andcommercialize our product candidates. It is possible that our management andscientific personnel, systems and facilities currently in place may not beadequate to support this future growth. Our need to effectively manage ouroperations, growth and various projects requires that we continue to improveour operational, financial and management controls, reporting systems andprocedures and to attract and retain sufficient numbers of talented employees.We may be unable to successfully implement these tasks on a larger scale and,accordingly, may not achieve our research, development and commercializationgoals.

 

***If we fail toattract and keep key management and scientific personnel, we may be unable tosuccessfully develop or commercialize our product candidates.***

 

Our success depends on our continued ability to attract, retain andmotivate highly qualified management and scientific personnel. The loss of theservices of certain principal members of our management or scientific staff coulddelay or 

 

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prevent the commercialization of our product candidates. We employthese individuals on an “at-will” basis and their employment can be terminatedby us or them at any time, for any reason and with or without notice, subjectto the terms of their stock restriction agreements and severance agreements.

 

Competition for qualified personnel in the biotechnology field isintense. We will need to hire additional personnel as we establish and/or expandour sales, manufacturing, research and development activities in the future. Wemay not be able to attract and retain quality personnel on acceptable termsgiven the competition for such personnel among biotechnology, pharmaceuticaland other companies.

 

We have established a scientific advisory board, the members of whichassist us in formulating our research, development and clinical strategies.These scientific advisors are not our employees and may have commitments to, orconsulting or advisory contracts with, other entities that may limit theiravailability to us. In addition, our scientific advisors may have arrangements withother companies to assist those companies in developing products ortechnologies that may compete with ours.

 

***We have limitedexperience in identifying, completing and integrating acquisition targets, andif we do not successfully integrate any future acquisitions, we may incurunexpected costs and disruptions to our business.***

 

An important part of our business strategy is to continue to develop abroad pipeline of product candidates. In addition to our internal drugdevelopment efforts, we may seek to expand our product pipeline, at theappropriate time and as resources allow, by acquiring products or businesses orin-licensing technologies that we believe are a strategic fit with our businessand complement our existing product candidates and research programs. Futureacquisitions, however, may entail numerous operational and financial risksincluding:

 

•                    exposure to unknownliabilities,

 

•                    disruption of our businessand diversion of our management’s time and attention to developing acquiredproducts or technologies,

 

•                    incurrence of substantial debt ordilutive issuances of securities to pay for acquisitions,

 

•                    higher than expected acquisitionand integration costs,

 

•                    increased amortization expenses,

 

•                    difficulty and cost in combining theoperations and personnel of any acquired businesses with our operations andpersonnel,

 

•                    impairment of relationships with keysuppliers or customers of any acquired businesses due to changes in managementand ownership, and

 

•                    inability to retain keyemployees of any acquired businesses.

 

We have limited experience in identifying acquisition targets,successfully completing potential acquisitions and integrating any acquiredproducts, businesses or technologies into our current infrastructure. Moreover,we may devote resources to potential acquisitions that are never completed orfail to realize the anticipated benefits of any acquisition.

 

**Risks Related to our Finances and CapitalRequirements**

 

***We have a history ofnet losses, which we expect to continue for the foreseeable future, and we areunable to predict the extent of future losses or when we will becomeprofitable, if ever.***

 

We have incurred net losses from our inception. As of December 31,2005, we had an accumulated deficit of approximately $74.9 million. We expectto increase our operating expenses over the next several years as we continueand expand our research and development activities, including conductingclinical trials for our product candidates and further developing our productpipeline, acquiring or in-licensing products, technologies or businesses, andfunding other working capital and general corporate purposes. As a result, weexpect to continue to incur significant and increasing operating losses for theforeseeable future. Because of the numerous risks and uncertainties associatedwith our product development efforts, we are unable to predict the extent ofany future losses or when we will become profitable, if ever.

 

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***We currently lack asignificant continuing revenue source and may not become or remain profitable.***

 

Our ability to become and remain profitable depends upon our ability togenerate continuing revenues. To date, our product candidates and strategiccollaborations have not generated any significant revenues, other than one-timeor time-limited payments associated with our collaborations such as milestonepayments and option fees. Our ability to generate significant continuingrevenues depends on a number of factors, including:

 

•                  successful completion of ongoing clinical trials forour product candidates,

 

•                  achievement of regulatory approval for our product candidates,

 

•                  successful completion of our current and future strategiccollaborations, and

 

•                  successful sales, manufacturing, distribution and marketing ofour products.

 

We do not anticipate that we will generate significant continuingrevenues for several years. If we are unable to eventually generate significantcontinuing revenues, we will not become or remain profitable, and we may beunable to continue our operations.

 

***We will needsubstantial additional funding and may be unable to raise capital when needed,which would force us to delay, reduce or eliminate our research and developmentprograms or commercialization efforts and affect our ability to continue as agoing concern.***

 

We believe that our existing cash, cash equivalents and short-terminvestments will be sufficient to meet our projected operating requirementsthrough at least the next twelve months. Because we do not anticipate that wewill generate significant continuing revenues for several years, if at all, wewill need to raise substantial additional capital to finance our operations inthe future. Our additional funding requirements will depend on, and could increasesignificantly as a result of, many factors, including:

 

•                  the rateof progress and cost of our clinical trials and other research and developmentactivities,

 

•                  the scope,prioritization and number of clinical development and research programs we pursue,

 

•                  the costsof expanding our operations,

 

•                  the terms and timing of any collaborative, licensingand other arrangements that we may establish,

 

•                  the costs of filing, prosecuting, defending andenforcing any patent claims and other intellectual property rights,

 

•                  the costsand timing of regulatory approvals,

 

•                  the costs of establishing or contracting for salesand marketing capabilities,

 

•                  the effect of competing technological and marketdevelopments, and

 

•                  the extent to which we acquire or in-license newproducts, technologies or businesses.

 

Until we can generate significant continuing revenues, if ever, weexpect to satisfy our future cash needs through public or private equityofferings, debt financings or corporate collaboration and licensingarrangements, as well as through interest income earned on cash balances. Wecannot be certain that additional funding will be available on acceptableterms, or at all. If adequate funds are not available, we may be required todelay, reduce the scope of or eliminate one or more of our research anddevelopment programs or our commercialization efforts and we may be unable tocontinue as a going concern.

 

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***Raising additionalfunds by issuing securities or through collaboration and licensing arrangementswill cause dilution to existing stockholders, restrict our operations orrequire us to relinquish proprietary rights.***

 

We will raise additional funds through public or private equityofferings, debt financings or corporate collaboration and licensingarrangements. For example, we have an effective shelf registrationstatement on file with the SEC which allows us to issue shares of our commonstock and warrants to purchase our common stock for an aggregate initialoffering price of up to $75 million. We may sell any of these securities fromtime to time in one or more offerings in amounts, at prices and on terms thatwe will determine at the time of the offering. To the extent that weraise additional capital by issuing equity securities, pursuant to oureffective shelf registration statement or otherwise, our existing stockholders’ownership will be diluted.

 

Any debt financing we enter into may involve covenants that restrictour operations. These restrictive covenants may include limitations onadditional borrowing, specific restrictions on the use of our assets as well asprohibitions on our ability to create liens, pay dividends, redeem our stock ormake investments. In addition, if we raise additional funds throughcollaboration and licensing arrangements, it may be necessary to relinquishpotentially valuable rights to our potential products or proprietarytechnologies, or grant licenses on terms that are not favorable to us.

 

***Our quarterlyoperating results and stock price may fluctuate significantly.***

 

We expect our operating results to be subject to quarterlyfluctuations. The revenues we generate, if any, and our operating results willbe affected by numerous factors, including:

 

•                  the developmentstatus of our product candidates, including results of our clinical trials,

 

•                  our recommendationof additional drug compounds for clinical development,

 

•                  our addition or termination of research programs or funding support,

 

•                  variations in the level of expenses related to our product candidates or researchprograms, and

 

•                  our execution of collaborative, licensing or otherarrangements, and the timing of payments we may make or receive under thesearrangements.

 

Quarterly fluctuations in our operating results may, in turn, cause theprice of our stock to fluctuate substantially. We believe that quarterlycomparisons of our financial results are not necessarily meaningful and shouldnot be relied upon as an indication of our future performance.

 

**Risks Related to our Intellectual Property**

 

***Our success dependsupon our ability to protect our intellectual property, including theproprietary technologies and compounds used in our business.***

 

Our commercial success depends on obtaining and maintaining patentprotection and/or trade secret protection of our product candidates,proprietary technologies and their uses, as well as successfully defending anypatents that issue against third-party challenges. We may only be able toprotect our product candidates, proprietary technologies and their uses fromunauthorized use by third parties to the extent that valid and enforceablepatents or trade secrets cover them.

 

The filing, prosecution and defense of patents at pharmaceutical andbiotechnology companies can be highly uncertain and involve complex legal andfactual questions for which important legal principles remain unresolved. Noconsistent policy regarding the breadth of claims allowed in biotechnologypatents has emerged to date in the U.S. The biotechnology patent situationoutside the U.S. is even more uncertain. We may be particularly affected bythis because we expect that pradefovir and MB07133, if approved, will bemarketed in foreign countries with high incidences of hepatitis B and primaryliver cancer, respectively. Decisions or actions regarding patent filing and/orchanges in either the patent laws or in interpretations of patent laws in theU.S. and other countries may diminish the value of our intellectual property.

 

Decisions or actions regarding patent filing are complex and we may notbe successful in protecting our products from competition. Patent positions forproducts are highly uncertain and involve complex legal and factual questionswhich may ultimately be decided to the detriment of our products’ competitivepositions’ in the U.S. and these other countries. We may not be 

 

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able to develop patentable products or processes in the U.S. and theseother countries, and may not be able to obtain patents from pendingapplications. Even if patent claims are allowed in the U.S. and these othercountries, the claims may not issue, or in the event of issuance, may not besufficient to protect the technology owned by or licensed to us. Any patents orpatent rights that we obtain in the U.S. and other countries may becircumvented, challenged or invalidated by our competitors. In addition, we aredependent on outside patent firms for advice and action regarding our effortsto secure patents. Should these firms fail to take appropriate action to secureor enforce our patents in a timely manner, or should they provide us withincorrect or inappropriate advice it could be detrimental to our patentpositions.

 

Accordingly, we cannot predict the breadth of claims that may beallowed or enforced in our patents or in third-party patents in the U.S. andother countries.

 

The degree of future protection for our proprietary rights is uncertainbecause legal means afford only limited protection and may not adequatelyprotect our rights or permit us to gain or keep our competitive advantage. Forexample:

 

•                  we might not have been the first to make theinventions covered by each of our pending patent applications and issuedpatents,

 

•                  we might not have been the first to file patentapplications for these inventions,

 

•                  others may independently develop similar or alternativetechnologies or duplicate any of our technologies,

 

•                  it is possiblethat none of our pending patent applications will result in issued patents,

 

•                  our issuedpatents may not provide a basis for commercially viable products, may notprovide us with any competitive advantages, or may be challenged by thirdparties,

 

•                  our issuedpatents may not be valid or enforceable,

 

•                  we may not develop additional proprietary technologiesthat are patentable, or

 

•                  the patentsof others may have an adverse effect on our business.

 

Proprietary trade secrets and unpatented know-how are also veryimportant to our business. Although we have taken steps to protect our tradesecrets and unpatented know-how, including entering into proprietaryinformation and inventions agreements with our employees and consultants andentering into confidentiality agreements with other third parties to whom wedisclose our proprietary information, third parties may still obtain thisinformation without our knowledge and consent. Enforcing a claim that a thirdparty illegally obtained and is using our trade secrets or unpatented know-howis expensive and time consuming, and the outcome is unpredictable. In addition,courts outside the U.S. may be less willing to protect this information.Moreover, our competitors may independently develop equivalent knowledge,methods and know-how.

 

***If we are sued forinfringing intellectual property rights of third parties, it will be costly andtime consuming, and an unfavorable outcome in that litigation would have amaterial adverse effect on our business.***

 

Our commercial success depends upon our ability and the ability of ourcollaborators to develop, manufacture, market and sell our product candidatesand use our proprietary technologies without infringing the proprietary rightsof third parties. Numerous U.S. and foreign issued patents and pending patentapplications, which are owned by third parties, exist in the fields in which weand our collaborators are developing products. Because patent applications cantake many years to issue, there may be currently pending applications, unknownto us, which may later result in issued patents that our product candidates orproprietary technologies may infringe. We have not conducted a complete searchof existing patents to identify existing patents that our product candidates orproprietary technologies may inadvertently infringe.

 

We may be exposed to future litigation by the companies holding thesepatents or other third parties based on claims that our product candidatesand/or proprietary technologies infringe their intellectual property rights. Ifone of these patents was found to cover our product candidates, proprietarytechnologies or their uses, we or our collaborators could be required to paydamages and could be unable to commercialize our product candidates or use ourproprietary technologies unless we or they obtained a license to the patent. Inaddition, while we are not currently subject to pending litigation nor are weaware of any threatened litigation, third parties may contact us or ourcollaborators in the ordinary course of business to bring certain patents toour 

 

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attention. Weand our collaborators evaluate all such communications on a case-by-case basisto assess whether such patents cover our product candidates or proprietarytechnologies and if so, whether to seek a license from such third parties. Alicense may not be available to us or our collaborators on acceptable terms, ifat all.

 

There is a substantial amountof litigation involving patent and other intellectual property rights in thebiotechnology and biopharmaceutical industries generally. If a third partyclaims that we or our collaborators infringe on its technology, we may face anumber of issues, including:

 

•                  infringementand other intellectual property claims which, with or without merit, may beexpensive and time-consuming to litigate and may divert our management’sattention from our core business,

 

•                  substantialdamages for infringement, including treble damages and attorneys’ fees, as wellas damages for products developed using allegedly infringing drug discoverytools or methods, which we may have to pay if a court decides that the productor proprietary technology at issue infringes on or violates the third party’srights,

 

•                  acourt prohibiting us from selling or licensing the product or using theproprietary technology unless the third party licenses its technology to us,which it is not required to do,

 

•                  if alicense is available from the third party, we may have to pay substantialroyalties, fees and/or grant cross licenses to our technology, and

 

•                  redesigningour products or processes so they do not infringe, which may not be possible ormay require substantial funds and time.

 

We have conducted searches ofU.S. and foreign patents, but cannot guarantee that the searches werecomprehensive and therefore whether any of our product candidates or themethods of using, making or identifying our product candidates infringe thepatents searched, or that other patents do not exist that cover our productcandidates or these methods. There may also be pending patent applications thatare unknown to us and may prevent us from marketing our product candidates.Other product candidates that we may develop, either internally or incollaboration with others, could be subject to similar delays anduncertainties.

 

***Existing patents andpatent applications covering adefovir or prodrugs of adefovir in the U.S. andforeign countries may prevent the commercialization of pradefovir in thefuture.***

 

Our product candidate pradefovir is a prodrug of adefovir. A thirdparty, Gilead, has rights to another product called Hepsera that is a non-liverspecific prodrug of adefovir. Adefovir is covered by U.S. and foreign patentsthat are scheduled to expire in April 2006. On their face, these patentsare assigned to Gilead. We currently anticipate that, if approved, pradefovirwill not be commercialized until after April 2006, and therefore shouldnot infringe upon these patents. However, in some cases, the terms of U.S. andforeign patents covering drug products approved for commercialization may beextended if the holder of the patents requests an extension within a specifiedperiod following the date of regulatory approval and the request for extensionis approved by the appropriate agencies. We are not aware that the term of theU.S. patents covering adefovir was extended following regulatory approval ofHepsera in the U.S., and the period in which extensions may have been requestedhas ended. The extension of any patent covering adefovir may prevent thecommercialization of pradefovir in the relevant country until the expiration ofthe extended patent term, unless we or Valeant obtained a license to thispatent. We are not aware of any request for an extension of patents coveringadefovir in Europe.

 

We are aware of third party patents and patent applications in the U.S.and in European and other foreign countries with claims to prodrugs ofadefovir. These patents are scheduled to expire in September 2011 overseasand in 2014 in the U.S. Although we do not believe that any valid claim coverspradefovir, we cannot guarantee this. If it is determined that patent claimsare valid and cover pradefovir, we may not be able to commercialize pradefovirin such countries, including those in Europe. Further, we are aware that apatent term extension of one of these prodrug patents has been granted inmultiple European countries based on the regulatory approval of Hepsera therebyextending protection of Hepsera in those countries to September 2016.Additional third party patents covering Hepsera or adefovir may exist, and mayexpire later than our expected date of regulatory approval in the country wherethe patent is in force.

 

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**Risks Related to Other Legal Matters**

 

***We may incursignificant costs complying with environmental laws and regulations.***

 

We use hazardous materials, including chemicals, biological agents andradioactive isotopes and compounds that could be dangerous to human health andsafety or the environment. As appropriate, we store these materials and wastesresulting from their use at our facility pending their ultimate use ordisposal. We currently contract with a third party to dispose of thesematerials and wastes. We are subject to a variety of federal, state and locallaws and regulations governing the use, generation, manufacture, storage,handling and disposal of these materials and wastes. We may also incursignificant costs complying with environmental laws and regulations adopted inthe future.

 

***We may incursubstantial liabilities from any product liability claims if our insurancecoverage for those claims is inadequate.***

 

We face aninherent risk of product liability exposure related to the testing of ourproduct candidates in human clinical

trials, and will face an evengreater risk if we sell our product candidates commercially. For example, twocases of lactic acidosis were recently observed in a clinical trial combiningCS-917 with metformin.  As a result,unless further data changes the situation, the combination of CS-917 andmetformin is contraindicated and the inadvertent combination of the drugs couldput patients at risk for lactic acidosis. Therefore, even if CS-917 receives regulatory approval the FDA mayrequire that additional measures be taken during marketing, such as prominentwarning labels known as “black-box” warnings, physician education programsand/or other steps regarding concomitant use of metformin and CS-917.  However, none of these programs can beassured of eliminating the possibility of the inadvertent use of CS-917 withmetformin and the consequent risk of lactic acidosis.  Therefore, these programs may not effectivelyprotect us from a liability claim.

 

An individual may bring a liability claim against us if one of ourproduct candidates causes, or merely appears to have caused, an injury. If wecannot successfully defend ourselves against the product liability claim, wewill incur substantial liabilities. Regardless of merit or eventual outcome,liability claims may result in:

 

•      decreased demandfor our product candidates,

 

•      injury to ourreputation,

 

•      withdrawal ofclinical trial participants,

 

•      costs of relatedlitigation,

 

•      substantialmonetary awards to patients or other claimants,

 

•      loss ofrevenues, and

 

•      the inability tocommercialize our product candidates.

 

We have product liability insurance that covers our clinical trials, upto an annual aggregate limit of $10 million. We intend to expand ourinsurance coverage to include the sale of commercial products if marketingapproval is obtained for any of our product candidates. However, insurancecoverage is increasingly expensive. We may not be able to maintain insurancecoverage at a reasonable cost and we may not be able to obtain insurancecoverage that will be adequate to satisfy any liability that may arise.

 

***If we use biologicaland hazardous materials in a manner that causes injury, we may be liable fordamages.***

 

Our research and development and manufacturing activities involve theuse of biological and hazardous materials. Although we believe our safetyprocedures for handling and disposing of these materials comply with federal,state and local laws and regulations, we cannot entirely eliminate the risk ofaccidental injury or contamination from the use, storage, handling or disposalof these materials. If one of our employees was accidentally injured from theuse, storage, handling or disposal of these materials, the medical costsrelated to his or her treatment would be covered by our workers’ compensationinsurance policy. However, we do not carry specific biological or hazardouswaste insurance coverage and our property and casualty and general liabilityinsurance policies specifically exclude coverage for damages and fines arisingfrom biological or hazardous waste 

 

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exposure or contamination. Accordingly, in the event of contaminationor injury, we could be held liable for damages or penalized with fines in anamount exceeding our resources.

 

**Risks Related to the Securities Markets andInvestment in our Common Stock**

 

***Market volatilitymay affect our stock price and the value of your investment.***

 

The market price for our common stock has been and is likely tocontinue to be volatile. In addition, the market price of our common stock mayfluctuate significantly in response to a number of factors, most of which wecannot control, including:

 

•      changes in theregulatory status of our product candidates, including the status and resultsof our clinical trials,

 

•      events affectingValeant, Daiichi Sankyo, Merck or any future collaborators,

 

•      announcements ofnew products or technologies, commercial relationships or other events by us orour competitors,

 

•      regulatorydevelopments in the U.S. and foreign countries,

 

•      fluctuations instock market prices and trading volumes of similar companies,

 

•      variations inour quarterly operating results,

 

•      changes insecurities analysts’ estimates of our financial performance,

 

•      changes inaccounting principles,

 

•      issuances of newequity securities by us, pursuant to our effective shelf registration statementor otherwise,

 

•      sales of largeblocks of our common stock, including sales by our executive officers,directors and significant stockholders,

 

•      additions ordepartures of key personnel, and

 

•      discussion of usor our stock price by the financial and scientific press and in online investorcommunities.

 

***Anti-takeoverprovisions in our charter documents and under Delaware law could make anacquisition of us, which may be beneficial to our stockholders, more difficultand may prevent attempts by our stockholders to replace or remove our currentmanagement.***

 

Provisions in our amended and restated certificate of incorporation andbylaws may delay or prevent an acquisition of us or a change in our management.These provisions include a classified board of directors, a prohibition onactions by written consent of our stockholders, and the ability of our board ofdirectors to issue preferred stock without stockholder approval. In addition,because we are incorporated in Delaware, we are governed by the provisions ofSection 203 of the Delaware General Corporation Law, which prohibitsstockholders owning in excess of 15% of our outstanding voting stock frommerging or combining with us. Although we believe these provisions collectivelyprovide for an opportunity to receive higher bids by requiring potentialacquirers to negotiate with our board of directors, they would apply even ifthe offer may be considered beneficial by some stockholders. In addition, theseprovisions may frustrate or prevent any attempts by our stockholders to replaceor remove our current management by making it more difficult for stockholdersto replace members of our board of directors, which is responsible forappointing the members of our management.

 

***We may incurincreased costs as a result of changes in laws and regulations relating tocorporate governance matters.***

 

Changes in the laws and regulations affecting public companies,including the provisions of the Sarbanes-Oxley Act of 2002 and rules adopted orproposed by the Securities and Exchange Commission and by the Nasdaq StockMarket, will result in increased costs to us as we continue to evaluate theimplications of these laws and regulations and respond to their requirements. 

 

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These laws and regulations could make it moredifficult or more costly for us to obtain certain types of insurance, includingdirector and officer liability insurance, and we may be forced to acceptreduced policy limits and coverage or incur substantially higher costs toobtain the same or similar coverage. The impact of these events could also makeit more difficult for us to attract and retain qualified persons to serve onour board of directors, our board committees or as executive officers. We arepresently evaluating and monitoring developments with respect to these laws andregulations and cannot predict or estimate the amount or timing of additionalcosts we may incur to respond to their requirements.

 

***Investor confidence and share value may be adverselyimpacted if our independent auditors are unable to provide us with theattestation of the adequacy of our internal controls over financial reporting,as required by Section 404 of the Sarbanes-Oxley Act of 2002.***

 

Beginningwith our annual report on Form 10-K for the fiscal year ending December 31,2006, we will be required pursuant to Section 404 of the Sarbanes-Oxley Act of2002 to include in our annual reports on Form 10-K an assessment by ourmanagement of the effectiveness of our internal controls over financialreporting.  In addition, our independent auditors must attest to andreport on our management’s assessment.  How companies are implementingthese new requirements including internal control reforms, if any, and how independentauditors are applying these new requirements and testing internal controls,remain subject to some uncertainty.  In addition, any control system,regardless of how well designed, operated and evaluated, can provide onlyreasonable, not absolute, assurance that its objectives will be met.  If,during any year, our independent auditors are not satisfied with our internalcontrols over financial reporting or the level at which these controls aredocumented, designed, operated, tested or assessed, or if our independentauditors interpret the applicable requirements, rules or regulationsdifferently than we do, then they may decline to attest to management’sassessment or may issue a report that is qualified.  This could result inan adverse reaction in the financial marketplace due to a loss of investorconfidence in the reliability of our financial statements, which couldnegatively impact the market price of our common stock.

 

***If our executiveofficers, directors and largest stockholders choose to act together, they maybe able to control our operations and act in a manner that advances their bestinterests and not necessarily those of other stockholders.***

 

Our executive officers, directors and holders of 5% or more of ouroutstanding common stock, beneficially owned approximately 71% of our commonstock as of December 31, 2005. As a result, these stockholders, actingtogether, are able to control all matters requiring approval by ourstockholders, including the election of directors and the approval of mergersor other business combination transactions. The interests of this group ofstockholders may not always coincide with our interests or the interests ofother stockholders, and they may act in a manner that advances their bestinterests and not necessarily those of other stockholders.

 

***Future sales of ourcommon stock may cause our stock price to decline.***

 

A largeportion of our shares are held by a small number of persons and investmentfunds.  In addition, these persons andfunds hold warrants to purchase 3,797,176 shares of common stock that, ifexercised, will result in these additional shares becoming available for sale.Moreover, several of our stockholders and warrant holders have rights, subjectto some conditions, to require us to file registration statements covering theunregistered shares they currently hold or may acquire upon exercise ofwarrants, or to include these shares in registration statements that we mayfile for ourselves or other stockholders. For example, the Securities and ExchangeCommission recently declared effective a registration statement we filedcovering the resale of the shares of common stock we issued in our recentprivate placement and the shares of common stock issuable upon exercise of thewarrants issued in the private placement.  Sales by these stockholders or warrant holders of a substantial numberof shares could significantly reduce the market price of our common stock.

 

**Item 1B. Unresolved Staff Comments**

 

Not applicable.

 

**Item 2.Properties**

 

We lease approximately 82,000 square feet of space in La Jolla,California. We perform all of our research, development, management,administrative and other activities in this facility.  The initial term of the lease expires in2015.  We have options to extend thelease for two renewal periods of five years each.

 

We believe that our facilities are adequate for our current needs.

 

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**Item 3.Legal Proceedings**

 

We are currently not a party to any material legal proceedings.

 

**Item 4. Submission of Matters to a Vote of Security Holders**

 

Not applicable.

 

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**PARTII**

 

**Item 5.****    Market for Registrant’s CommonEquity, Related Stockholder Matters and Issuer Purchases of Equity Securities**

 

**Market Information**

 

Our common stock has been traded on the Nasdaq National Market sinceJune 16, 2004 under the symbol MBRX. Prior to such time, there was nopublic market for our common stock. The following table sets forth the high andlow sales prices for our common stock as reported on the Nasdaq National Marketfor the periods indicated.

 
| ** **                        | ** ** | **High** | ** ** | **Low** | ** ** |
|-----------------------------------|------------|----------|------------|---------|------------|
| **Year  Ended December 31, 2005** |       |     |       |    |       |
| Fourth  Quarter                   |       | $        | 8.43       |    | $          | 5.03 |   |
| Third  Quarter                    |       | $        | 6.75       |    | $          | 3.10 |   |
| Second  Quarter                   |       | $        | 3.68       |    | $          | 2.32 |   |
| First Quarter                     |       | $        | 8.09       |    | $          | 3.00 |   |

 
| ** **                                | ** ** | **High** | ** ** | **Low** | ** ** |
|-------------------------------------------|------------|----------|------------|---------|------------|
| **Year  Ended December 31, 2004**         |       |     |       |    |       |
| Fourth  Quarter                           |       | $        | 7.25       |    | $          | 5.11 |   |
| Third  Quarter                            |       | $        | 6.95       |    | $          | 5.15 |   |
| Second  Quarter (beginning June 16, 2004) |       | $        | 7.13       |    | $          | 5.75 |   |

 

As of March 1, 2006, there were approximately 127 holders ofrecord of our common stock.

 

**Dividend Policy**

 

We have never declared or paid cash dividends on our capital stock. Wecurrently intend to retain all available funds and any future earnings for usein the operation and expansion of our business and do not anticipate paying anycash dividends in the foreseeable future.

 

**Recent Sales of Unregistered Securities andUse of Proceeds**

 

Our initial public offering of our common stock, par value $0.001, waseffected through a Registration Statement onForm S-1 (File No. 333-112437) that was declared effective by theSecurities and Exchange Commission on June 15, 2004. The RegistrationStatement covered the offer and sale of up to 5,750,000 shares of our commonstock for an aggregate offering price of $40.3 million. Our initial publicoffering commenced on June 15, 2004. On June 21, 2004, 5,000,000shares of our common stock were sold for an aggregate offering price of$35.0 million. On July 20, 2004, 75,000 shares of our common stockwere sold for an aggregate offering price of $525,000 upon the partial exerciseof the underwriters’ over-allotment option. Our initial public offeringterminated following the sale of all of the securities registered on theregistration statement and the expiration of the underwriters’ over-allotmentoption. Our initial public offering resulted in aggregate proceeds to us ofapproximately $31.1 million, net of underwriting discounts and commissionsof approximately $2.5 million and offering expenses of approximately $1.9 million,through a syndicate of underwriters managed by SG Cowen & Co., LLC,Deutsche Bank Securities Inc., Thomas Weisel Partners LLC, and Legg MasonWood Walker, Incorporated.

 

No offering expenses were paid directly or indirectly to any of ourdirectors or officers (or their associates) or person owning ten percent ormore of any class of our equity securities or to any other affiliates. Alloffering expenses were paid directly to others.

 

As of December 31, 2005, we had used approximately $15.4 millionof the initial public offering proceeds for investments in medium-term,interest-bearing obligations, investment-grade instruments, or guaranteedobligations of the U.S. government.  Asof December 31, 2005, we had used approximately $15.7 million of the initialpublic offering proceeds for operating expenses.

 

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The foregoing payments were direct payments made to third parties whowere not our directors or officers (or their associates), persons owning tenpercent or more of any class of our equity securities or any other affiliate,except that the proceeds used for working capital included regular compensationfor officers and directors. The use of proceeds does not represent a materialchange from the use of proceeds described in the prospectus we filed pursuantto Rule 424(b)(4) of the Securities Act of 1933, as amended, with theSecurities and Exchange Commission on June 16, 2004.

 

In October 2005, we raisedapproximately $41.3 million in a private placement of common stock and theconcurrent issuance of warrants for the purchase of common stock. Placementfees and other expenses were approximately $2.3 million. Under the terms of thefinancing, we sold 7.0 million shares of common stock at $5.86 per share, the closingbid price for our common stock immediately preceding the entering into of thebinding agreement for the transaction. We also issued warrants to purchaseapproximately 2.5 million shares of our common stock at an exercise price of$6.74 per share. At the closing, investors in the financing paid an additionalprice equal to $0.125 per each share issuable upon exercise of thewarrants.  The common stock and warrantsto purchase our common stock issued in the private placement were issued inreliance on the exemption from registration contained in Section 4(2) of theSecurities Act of 1933, as amended, and/or Regulation D, Rule 506 promulgatedunder the Securities Act of 1933, as amended, in that the issuance did notinvolve a public offering.  Each investorin the private placement represented that it was an accredited investor asdefined in Regulation D and that it was acquiring the common stock and warrantsfor investment only and with a view to or for a sale in connection with anydistribution thereof.   On October 14, 2005, we filed aregistration statement with the Securities and Exchange Commission covering theresale of the shares of common stock issued in the private placement and theshares of common stock issuable upon exercise of the warrants issued in theprivate placement.  This registrationstatement was declared effective by the Securities and Exchange Commission onOctober 27, 2005.

** **

**Equity Compensation Plan Information**

 

The information required to be disclosed by Item 201(d) ofRegulation S-K, “Securities Authorized for Issuance Under EquityCompensation Plans,” is incorporated by reference to Item 12 of Part IIIof this Form 10-K.

 

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**Item 6.Selected Financial Data**

 

Thestatement of operations data and balance sheet data presented below should beread in conjunction with Item 7, Management’s Discussion and Analysis ofFinancial Condition and Results of Operations, and the financial statements andrelated notes appearing elsewhere in this Form 10-K.

 
| ** **                                                    | ** ** | **Years Ended December 31,**                 | ** ** |
|---------------------------------------------------------------|------------|----------------------------------------------|------------|
| ** **                                                    | ** ** | **2005**                                     | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** |
| ** **                                                    | ** ** | **(In thousands, except per share amounts)** | ** ** |
| **Statements  of Operations Data:**                           |       |                                         |       |   |   |   |   |   |   |   |   |
| Revenues                                                      |       | $                                            | 3,771      |   | $ | 6,837 |   | $ | 9,124 |   | $ | 2,278 |   | $ | 7,664 |   |
| Operating  expenses:                                          |       |                                         |       |   |   |   |   |   |   |   |   |
| Research and development                                      |       | 21,460                                       |       | 16,675 |   | 15,048 |   | 12,609 |   | 9,464 |   |
| General and administrative                                    |       | 5,283                                        |       | 3,804 |   | 2,955 |   | 2,531 |   | 2,131 |   |
| Amortization of employee stock-based  compensation(1)         |       | 1,695                                        |       | 1,633 |   | 504 |   | 23 |   | — |   |
| Total  operating expenses                                     |       | 28,438                                       |       | 22,112 |   | 18,507 |   | 15,163 |   | 11,595 |   |
| Loss from  operations                                         |       | (24,667                                      | )          | (15,275 | ) | (9,383 | ) | (12,885 | ) | (3,931 | ) |
| Other income  (expense), net                                  |       | 1,087                                        |       | 303 |   | (46 | ) | 88 |   | 249 |   |
| Net loss(2)                                                   |       | (23,580                                      | )          | (14,972 | ) | (9,429 | ) | (12,797 | ) | (3,682 | ) |
| Preferred  stock deemed dividend(3)                           |       | —                                       |       | — |   | (24,900 | ) | — |   | — |   |
| Net loss  applicable to common stockholders                   |       | $                                            | (23,580    | ) | $ | (14,972 | ) | $ | (34,329 | ) | $ | (12,797 | ) | $ | (3,682 | ) |
| Basic and  diluted net loss per share:(2)                     |       |                                         |       |   |   |   |   |   |   |   |   |
| Historical                                                    |       | $                                            | (1.20      | ) | $ | (1.49 | ) | $ | (23.84 | ) | $ | (10.12 | ) | $ | (4.44 | ) |
| Pro forma                                                     |       | $                                            | (1.20      | ) | $ | (0.98 | ) | $ | (3.74 | ) |   |   |   |   |
| Shares used to compute basic and diluted  net loss per share: |       |                                         |       |   |   |   |   |   |   |   |   |
| Historical                                                    |       | 19,706                                       |       | 10,034 |   | 1,440 |   | 1,265 |   | 830 |   |
| Pro forma                                                     |       | 19,706                                       |       | 15,254 |   | 9,187 |   |   |   |   |   |

 

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(1)           The amortization of employee stock-based compensation is composed of$1,170,000 and $1,138,000 related to research and development activities and$525,000 and $495,000 related to general and administrative activities for theyears ended December 31, 2005 and 2004, respectively.

 

(2)           Please see Note 1 to our financial statements for an explanationof the method used to calculate the historical and pro forma net loss per shareand the number of shares used in the computation of the per share amounts.

 

(3)           As disclosed in Note 7 to our financial statements, we recorded adeemed dividend in connection with the issuance of our Series E preferredstock.

 
| ** **                                                | ** ** | **As of December 31,** | ** ** |
|-----------------------------------------------------------|------------|------------------------|------------|
| ** **                                                | ** ** | **2005**               | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** |
| ** **                                                | ** ** | **(In thousands)**     | ** ** |
| **Balance  Sheet Data:**                                  |       |                   |       |   |   |   |   |   |   |   |   |
| Cash, cash equivalents and securities  available-for-sale |       | $                      | 66,893     |   | $ | 43,855 |   | $ | 25,257 |   | $ | 19,562 |   | $ | 25,572 |   |
| Working  capital                                          |       | 59,691                 |       | 40,906 |   | 22,342 |   | 13,693 |   | 24,539 |   |
| Total assets                                              |       | 73,878                 |       | 47,860 |   | 29,110 |   | 21,733 |   | 28,438 |   |
| Long-term obligations (including current  portion)        |       | 3,168                  |       | 2,226 |   | 1,820 |   | 2,854 |   | 3,907 |   |
| Accumulated  deficit                                      |       | (74,945                | )          | (51,365 | ) | (36,393 | ) | (26,964 | ) | (14,167 | ) |
| Total  stockholders’ equity                          |       | 59,582                 |       | 41,864 |   | 23,437 |   | 8,756 |   | 21,475 |   |
|                                                           |            |                        |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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**Item 7.Management’s Discussion and Analysis of Financial Condition and Results ofOperations**

 

*You should read the following discussion and analysistogether with our audited financial statements and the notes to thosestatements included elsewhere in this annual report on Form 10-K. Thisdiscussion contains forward-looking statements that involve risks anduncertainties. See “Forward-Looking Statements” in Part I, Item 1 of thisannual report on Form 10-K.*

 

**Overview**

 

Weare a biopharmaceutical company focused on the discovery, development andcommercialization of novel drugs to address some of the world’s most widespreadand costly chronic diseases involving pathways in the liver.  Thesediseases include metabolic diseases such as diabetes, hyperlipidemia, a diseaseinvolving elevated levels of lipids such as cholesterol, and obesity, amongothers, and liver diseases such as hepatitis and primary liver cancer.  Wehave established a broad and growing product pipeline targeting large markets withsignificant unmet medical needs. We have discovered all of our productcandidates internally using our proprietary technologies.

 

We currently have four product candidates in clinical trials, pradefovir,CS-917, MB07133 and MB07803.  Pradefovirand MB07133 are being developed for the treatment of hepatitis B and primaryliver cancer, respectively.  CS-917 andMB07803 both work by the same mechanism and both are being developed for thetreatment of type 2 diabetes.

 

Wehave incurred annual net losses since inception. As of December 31, 2005,our accumulated deficit was approximately $74.9 million. We expect toincur substantial and increasing losses for the next several years as we:

 

•      continue to develop current and future clinical developmentcandidates,

 

•      commercialize our product candidates, if any, that receiveregulatory approval,

 

•      continue and expand our research and development programs,and

 

•      acquire or in-license products, technologies or businessesthat are complementary to our own.

 

Wehave a limited history of operations and, to date, we have not generated anyproduct revenues. In addition to our initial public offering in June 2004and our private placement of common stock and warrants in October 2005, we havefinanced our operations and internal growth through private placements ofpreferred stock as well as direct payments of sponsored research funding,license fees, milestone payments and equity investments from our collaborativepartners. We have received additional funding through equipment financingarrangements and Small Business Innovation Research, or SBIR, grants.

 

Ouragreements with collaborators may include joint marketing or promotionarrangements of our products or products licensed from our collaborators. Forexample, we have retained co-promotion rights for CS-917 in North America withDaiichi Sankyo. Alternatively, we may grant exclusive marketing rights to ourcollaborators in exchange for up-front fees, milestones and royalties on futuresales, if any. We have licensed worldwide commercialization rights forpradefovir to Valeant. We have retained rights to MB07133, MB07803, MB07811 andall of the compounds generated from our current research programs, with theexception of product candidates covered by our collaborations with Merck. Weintend to eventually market one or more of the product candidates for which weretain commercialization rights through our own sales force or with aco-promotion partner in the U.S. and through strategic collaborations abroad.

 

Wewill rely on our partners or third-party manufacturers to produce sufficientquantities of these products for pre-clinical and clinical studies and large-scalecommercialization upon their approval.

 

Ourbusiness is subject to significant risks, including the risks inherent in ourongoing clinical trials and the regulatory review and approval process, theresults of our research and development efforts, reliance on third parties forthe development and commercialization of our product candidates, competitionfrom other products and uncertainties associated with obtaining and enforcingpatent rights.

 

**Research and Development**

 

Ourresearch and development expenses consist primarily of compensation and otherexpenses for research and development personnel, costs associated withpre-clinical development and clinical trials of our product candidates,facility costs,

 

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supplies and materials, costs for consultants and related contractresearch and depreciation. We charge all research and development expenses tooperations as they are incurred.

 

Our research and developmentactivities are primarily focused on the clinical development of MB07133,MB07803 and the potential further advanced pre-clinical development andpotential clinical trials of MB07811. In addition, research and developmentactivities include work on lead compounds in our other research programs.  In February 2006, we began a Phase I clinicaltrial of MB07803.  We plan to file an INDfor MB07811 and to commence clinical trials of MB07811 in 2006 if the pre-clinicaldata is supportive and the proposed clinical trials are cleared by the FDA.  We are responsible for all costsincurred in our research programs with the exception of the AMPK programpartnered with Merck. Under the terms of our collaboration agreements withMerck, we had received approximately $4.4 million in research fundingthrough December 31, 2005.  Valeant and Daiichi Sankyo are responsible forthe costs of clinical development of pradefovir and CS-917, respectively.

 

Atthis time, due to the risks inherent in the clinical trial process and giventhe early stage of development of our product candidates and lead compoundsfrom our research programs, we are unable to estimate with any certainty the costswe will incur in the continued development of our product candidates forcommercialization. Due to these same factors, we are unable to determine theanticipated completion dates for our current research and development projects.However, we expect our research and development costs to be substantial and toincrease as we continue the development of our current product candidates, aswell as continue and expand our research programs.

 

Generally,Phase I clinical trials can be expected to last from 6 to 18 months, PhaseII clinical trials can be expected to last from 12 to 24 months and PhaseIII clinical trials can be expected to last from 18 to 36 months. However,clinical development timelines vary widely, as do the likelihood of success andtotal costs of clinical trials. Although we are currently focused primarily onadvancing MB07133 and MB07803 through clinical development and MB07811 intoclinical development, we anticipate that we will make determinations as towhich research and development projects to pursue and how much funding todirect to each project on an ongoing basis in response to the scientific andclinical success of each product candidate, as well as an ongoing assessment ofits market potential.

 

Thelengthy process of seeking regulatory approvals for our product candidates, andthe compliance with applicable regulations, require the expenditure ofsubstantial resources. Any failure by us to obtain, or any delay in obtaining,regulatory approvals could cause our research and development expenditures toincrease and, in turn, have a material unfavorable effect on our results ofoperations. We cannot be certain when or if any net cash inflow due to sales ofany of our current product candidates will commence.

 

**General and Administrative**

 

Generaland administrative expenses consist primarily of salaries and other relatedcosts for personnel in executive, finance, accounting, business development,investor relations and human resource functions. Other costs include facilitycosts not otherwise included in research and development expenses andprofessional fees for legal and accounting services.

 

Weanticipate continued increases in general and administrative expenses forinvestor relations and other activities associated with operating as a publicly-tradedcompany. These increases will also likely include the hiring of additionalpersonnel.

 

**Other Income, Net**

 

Otherincome, net includes interest earned on our cash, cash equivalents andsecurities available-for-sale, net of interest expense.

 

**Critical Accounting Policies**

 

Ourdiscussion and analysis of our financial condition and results of operationsare based on our audited financial statements, which have been prepared inaccordance with U.S. generally accepted accounting principles, or GAAP. Thepreparation of these financial statements requires us to make estimates andjudgments that affect the reported amounts of assets, liabilities, revenues andexpenses and related disclosure of contingent assets and liabilities. We reviewour estimates on an on-going basis. We base our estimates on historicalexperience and on various other assumptions that we believe to be reasonableunder the circumstances, the results of which form the basis for makingjudgments about the carrying values of assets and

 

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liabilities. Actual results may differ from these estimates underdifferent assumptions or conditions. We believe the following accountingpolicies to be critical to the judgments and estimates used in the preparationof our financial statements.

 

*Revenue Recognition.*  Ourrevenue recognition policies are in accordance with Securities and ExchangeCommission Staff Accounting Bulletin, or SAB 104, *Revenue Recognition*, and Emerging Issues Task Force*,* or EITF, Issue 00-21, *Revenue Arrangements with Multiple Deliverables*.Our agreements generally contain multiple elements, including downstreammilestones and royalties. All fees are nonrefundable. Revenue from milestonesis recognized when earned, provided that:

 

•      the milestone event is substantive and its achievabilitywas not reasonably assured at the inception of the agreement, and

 

•      collaborator funding, if any, of our performanceobligations after the milestone achievement will continue at a level comparableto before the milestone achievement.

 

Ifboth of these criteria are not met, the milestone payment is recognized overthe remaining minimum period of our performance obligations under theagreement. Upfront, nonrefundable fees under our collaborations are recognizedover the period the related services are provided. Nonrefundable upfront feesnot associated with our future performance are recognized when received.Amounts received for research funding are recognized as revenues as theservices are performed. Amounts received for research funding for a specificnumber of full-time researchers are recognized as revenue as the services areprovided, as long as the amounts received are not refundable regardless of theresults of the research project.

 

*Clinical Trial Expenses.*  Ourclinical trials are often conducted under contracts with multiple researchinstitutions and clinical research organizations that conduct and manageclinical trials on our behalf. The financial terms of these agreements aresubject to negotiation and vary from contract to contract and may result inuneven payment flows. Generally, these agreements set forth the scope of workto be performed at a fixed fee or unit price. Payments under the contractsdepend on factors such as the successful enrollment of patients or thecompletion of clinical trial milestones. Expenses related to clinical trialsgenerally are accrued based on contracted amounts applied to the actual levelof patient enrollment and activity according to the protocol. Other incidentalcosts related to patient enrollment are accrued when known. If contractedamounts are modified based upon changes in the clinical trial protocol or scopeof work to be performed, we modify our accruals accordingly on a prospectivebasis.

 

**Recently Issued Accounting Pronouncements**

 

In December 2004, the Financial Accounting Standards Board (“FASB”)issued SFAS No. 123R, *Share BasedPayment*. This statement is a revision to SFAS No. 123 andsupersedes APB 25 and amends FASB Statement No. 95, *Statement of Cash Flows*. This statementrequires a public entity to expense the cost of employee services received inexchange for an award of equity instruments. This statement also providesguidance on valuing and expensing these awards, as well as disclosurerequirements of these equity arrangements. This statement is effective for usin the first quarter of 2006.

 

SFAS No. 123R permits public companies to choose between thefollowing two adoption methods:

 

1.             A“modified prospective” method in which compensation cost is recognizedbeginning with the effective date (a) based on the requirements of SFASNo. 123R for all share-based payments granted after the effective date and(b) based on the requirements of SFAS No. 123 for all awards granted toemployees prior to the effective date of SFAS No. 123R that remainunvested on the effective date, or

 

2.             A“modified retrospective” method which includes the requirements of the modifiedprospective method described above, but also permits entities to restate basedon the amounts previously recognized under SFAS No. 123 for purposes ofpro forma disclosures either (a) all prior periods presented or(b) prior interim periods of the year of adoption.

 

As permitted by SFAS No. 123, we currently account for share-basedpayments to employees using APB 25’s intrinsic value method and, as such, wegenerally recognize no compensation cost for employee stock options. The impactof the adoption of SFAS No. 123R cannot be predicted at this time becauseit will depend on levels of share-based payments granted in the future.However, valuation of employee stock options under SFAS No. 123R issimilar to SFAS No. 123, with minor exceptions. The impact on our resultsof operations and earnings per share had we adopted SFAS No. 123 is describedin Note 1 to our audited financial statements accompanying this AnnualReport on Form 10-K.  Accordingly, theadoption of SFAS No. 123R’s fair value method will have a significantimpact on our results of operations, although it will have no impact on ouroverall financial 

 

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position. SFAS No. 123R also requiresthe benefits of tax deductions in excess of recognized compensation cost to bereported as a financing cash flow, rather than as an operating cash flow asrequired under current literature. This requirement will reduce net operatingcash flows and increase net financing cash flows in periods after adoption.

 

InMarch 2004, the EITF reached a final consensus on Issue No. 03-1, *The Meaning of Other-Than-Temporary Impairment andIts Application to Certain Investments*. EITF Issue No. 03-1requires that when the fair value of an investment security is less than itscarrying value, an impairment exists for which the determination must be madeas to whether the impairment is other-than-temporary. The EITF IssueNo. 03-1 impairment model applies to all investment securities accountedfor under SFAS No. 115, *Accounting forCertain Investments in Debt and Equity Securities* and to investmentsecurities accounted for under the cost method to the extent an impairmentindicator exists. Under the guidance, the determination of whether animpairment is other-than-temporary and therefore would result in a recognizedloss depends on market conditions and management’s intent and ability to holdthe securities with unrealized losses. In September 2004, the FASBapproved FASB Staff Position (“FSP”) EITF 03-1-1, which defers the effectivedate for recognition and measurement guidance contained in EITF IssueNo. 03-1 until certain issues are resolved. In November 2005, theFASB issued FSP FAS 115-1. FSP FAS 115-1 replaces the impairment evaluationguidance of EITF Issue No. 03-1 with references to the existingother-than-temporary impairment guidance. EITF 03-1’s disclosure requirementsremain in effect. The FSP also supersedes EITF Topic No. D-44, *Recognition of Other-Than-Temporary Impairment uponthe Planned Sale of a Security Whose Cost Exceeds Fair Value*,” andclarifies that an investor should recognize an impairment loss no later thanwhen the impairment is deemed other-than-temporary, even if a decision to sellan impaired security has not been made. The guidance in this FSP will beapplied in the first quarter of 2006. We not expect the adoption of EITF IssueNo. 03-1 or FSP FAS 115-1 to have a material effect on our liquidity,results of operations and financial condition.

 

**Results of Operations**

 

*Comparison of the Years Ended December 31, 2005 and2004*

 

*Revenues.*  Revenues were $3.8 million forthe year ended December 31, 2005, compared with $6.8 million for theyear ended December 31, 2004. The $3.0 million decrease was mainlydue to a decline in milestone revenue of approximately $4.5 million whichwas attributable primarily to a $3.5 million payment earned in the prior yearperiod under our collaboration agreement with Daiichi Sankyo. This decrease waspartially offset by an additional collaboration agreement entered into with Merckin June 2005 which included sponsored research revenue of $1.1 million andpayments earned under license revenue of $0.4 million.

 

*Research and Development Expenses.* Research and development expenses were $21.5 million for the yearended December 31, 2005, compared with $16.7 million for the yearended December 31, 2004. The $4.8 million increase was mainly due toincreased spending of $1.3 million in payroll and related benefits as a resultof a higher average number of employees in 2005, a $1.1 million increase inpre-clinical development expense for MB07803, increased research and developmentservices expense of $1.1 million, increased occupancy costs related to our newfacility of $0.7 million and increased travel, supplies and insurance expenseof $0.6 million.

 

*General and Administrative Expenses.* General and administrative expenses were $5.3 million for the yearended December 31, 2005, compared with $3.8 million for the yearended December 31, 2004. The $1.5 million increase reflected mainly anincrease in professional services expense of $0.4 million, higher payroll andrelated benefits costs of $0.5 million as a result of a higher average numberof employees in 2005, an increase in corporate promotion expense of $0.3million, and increased travel, occupancy and public company costs of $0.3million.

 

*Amortization of Employee Stock-based Compensation.*  Inconnection with the grant of stock options to employees and directors, werecorded amortization of deferred stock-based compensation of approximately$1.7 and $1.6 million for the years ended December 31, 2005 and 2004,respectively. As of December 31, 2005, we had approximately$2.9 million of deferred stock-based compensation.  Prior to the adoption of SFAS 123(R) in 2006,deferred compensation is presented as a separate component of stockholders’equity.

 

In 2003, our board ofdirectors authorized a transaction, effective June 30, 2003, calling forthree of our executive officers to agree to tender 487,702 shares of theirpreviously vested common stock and subject them to a new monthly vestingschedule over a four-year period commencing on June 30, 2003. Thistransaction was entered into as repayment for outstanding principal and accruedinterest on loans we made to those executive officers in connection with theirpurchase of our common

 

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stockin June 1999. We recorded $711,000 of deferred compensation atJune 30, 2003, to be amortized over the four-year vesting period of theunderlying common stock. We recorded amortization of deferred compensation ofapproximately $178,000 and $178,000 for the years ended December 31, 2005and 2004, respectively.  Prior to theadoption of SFAS 123(R) in 2006, deferred compensation is presented as aseparate component of stockholders’ equity.

 

*Other Income, Net.*  Net interest income was $1.1 millionfor the year ended December 31, 2005, compared to net interest income of$0.3 million for the year ended December 31, 2004. The $0.8 million netincrease was mainly due to higher levels of invested cash in 2005 resultingfrom the proceeds of our private placement in October 2005 as well as higherinvestment yields.

 

*Comparison of the Years Ended December 31, 2004 and2003*

 

Revenueswere $6.8 million for the year ended December 31, 2004, compared with$9.1 million for the year ended December 31, 2003. The$2.3 million decrease was mainly due to a decline in license fee revenueof approximately $7.2 million which was attributable to a one-time paymentassociated with an exclusive option agreement with Daiichi Sankyo that expiredin 2003. This decrease was partially offset by higher milestone revenue in 2004,which included $3.5 million earned under our collaboration agreement with DaiichiSankyo. Additionally, we realized a $1.4 million increase in sponsoredresearch resulting from the initiation in 2004 of the research portion of ourcollaboration agreement with Merck.

 

*Research and Development Expenses.* Research and development expenses were $16.7 million for the yearended December 31, 2004, compared with $15.0 million for the yearended December 31, 2003. The $1.7 million increase was mainly due toincreased spending of $0.7 in payroll and related benefits as a result of ahigher average number of employees in 2004, a $0.6 million increase inpre-clinical development expense for MB07803 and a $0.4 million increase inclinical trials expenses related to MB07133.

 

*General and Administrative Expenses.* General and administrative expenses were $3.8 million for the yearended December 31, 2004, compared with $3.0 million for the yearended December 31, 2003. The $0.8 million increase reflected mainly anincrease in professional services expense of $0.4 million and higher payrolland related benefits costs of $0.4 million as a result of a higher averagenumber of employees in 2004.

 

*Amortization of Employee Stock-based Compensation.*  Inconnection with the grant of stock options to employees and directors, werecorded amortization of deferred stock-based compensation of approximately$1.6 million and $0.5 million for the years ended December 31, 2004and 2003, respectively. As of December 31, 2004, we had approximately$4.9 million of deferred stock-based compensation.

 

*Other Income, Net.*  Net interest income was$303,000 for the year ended December 31, 2004, compared to net interestexpense of $46,000 for the year ended December 31, 2003. The $349,000 netincrease was mainly due to higher invested cash resulting from the proceeds ofour initial public offering in June 2004.

 

**Liquidity and Capital Resources**

 

In October 2005, we raised approximately$41.3 million in a private placement of common stock and the concurrentissuance of warrants for the purchase of common stock.  Placement agent fees and other offeringexpenses were approximately $2.3 million. Under the terms of the financing, wesold 7.0 million shares of common stock at $5.86 per share, the closing bidprice for our common stock immediately preceding the entering into of thebinding agreement for the transaction. We also issued warrants to purchase approximately 2.5 million shares ofour common stock at an exercise price of $6.74 per share.  At the closing, investors in thefinancing paid an additional purchase price equal to $0.125 per each shareissuable upon exercise of the warrants.

 

OnJune 21, 2004, we completed an initial closing of our initial publicoffering in which we sold 5.0 million shares of common stock for proceedsof $30.6 million, net of underwriting discounts and commissions andoffering expenses. In addition, on July 20, 2004, we completed anadditional closing of our initial public offering in which we sold anadditional 75,000 shares of common stock pursuant to the exercise by theunderwriters of an over-allotment option which resulted in proceeds of$0.5 million, net of underwriting discounts and commissions.

 

59

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Asof December 31, 2005, we have financed through leases and loans thepurchase of equipment and leasehold improvements totaling approximately$4.7 million, of which $3.2 million was outstanding at that date. Theloans are collateralized with the purchased equipment, bear interest at ratesranging from approximately 8.0% to 12.85%, and are due in monthly installmentsthrough October 2015. Additionally, we have received cumulative SBIR grantfunding of approximately $1.4 million through December 31, 2005.

 

Asof December 31, 2005, we had $66.9 million in cash and cashequivalents and securities available-for-sale as compared to $43.9 millionas of December 31, 2004, an increase of $23.0 million. The increasemainly reflected net proceeds of $39.0 million raised from our privateplacement in October 2005 and a $5.0 million non-refundable license paymentunder our AMPK collaboration with Merck which was offset by net cash used inoperations of $14.0 million and net cash used in investing activities of $4.6 millionfor the year ended December 31, 2005 resulting from net purchases ofinvestments of $1.4 million and $3.2 million of equipment purchases.

 

Thefollowing summarizes our long-term contractual obligations as ofDecember 31, 2005 (in thousands):

 
| ** **                   | ** ** | ** ** | ** ** | **Payments Due by Period** | ** ** |
|------------------------------|------------|------------|------------|----------------------------|------------|
| **Contractual  Obligations** | ** ** | **Total**  | ** ** | **Less  than  1 Year**     | ** ** | **1 to 3  Years** | ** ** | **4 to 5  Years** | ** ** | **After 5  Years** | ** ** |
| Operating  leases            |       | $          | 27,759     |                       | $          | 1,554 |   | $ | 4,065 |   | $ | 5,868 |   | $ | 16,272 |   |
| Capital  leases              |       | 91         |       | 25                         |       | 50 |   | 16 |   | — |   |
| Equipment  financing         |       | 3,652      |       | 1,285                      |       | 1,717 |   | 439 |   | 211 |   |
| Total                        |       | $          | 31,502     |                       | $          | 2,864 |   | $ | 5,832 |   | $ | 6,323 |   | $ | 16,483 |   |

 

Wealso enter into agreements with clinical sites and contract researchorganizations for the conduct of our clinical trials. We will make payments tothese sites and organizations based upon the number of patients enrolled andthe length of their participation in the clinical trials. At this time, due tothe variability associated with these agreements, we are unable to estimatewith certainty the future patient enrollment costs we will incur.

 

Ourfuture capital uses and requirements depend on numerous forward-lookingfactors. These factors may include but are not limited to the following:

 

•      the rate of progress and cost of our clinical trials andother research and development activities,

 

•      the scope, prioritization and number of clinicaldevelopment and research programs we pursue,

 

•      the costs of expanding our operations,

 

•      the terms and timing of any collaborative, licensing andother arrangements that we may establish,

 

•      the costs of filing, prosecuting, defending and enforcingany patent claims and other intellectual property rights,

 

•      the costs and timing of regulatory approvals,

 

•      the costs of establishing or contracting for manufacturing,sales and marketing capabilities,

 

•      the effect of competing technological and marketdevelopments, and

 

•      the extent to which we acquire or in-license new products,technologies or businesses.

 

Webelieve that our existing cash, cash equivalents and short-term investmentswill be sufficient to meet our projected operating requirements through atleast the next twelve months.

 

Untilwe can generate significant continuing revenues, we expect to continue tosatisfy our future cash needs through public or private equity offerings, debtfinancings or corporate collaboration and licensing arrangements, as well asthrough government grants and interest earned on cash balances.   For example, we have an effective shelfregistration statement on file with the SEC which allows us to issue shares ofour common stock and warrants to purchase our common stock for an

 

60

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aggregate initial offering price of up to $75million.  We may sell any of thesesecurities from time to time in one or more offerings in amounts, at prices andon terms that we will determine at the time of the offering.

 

Tothe extent that we raise additional capital by issuing equity securities, ourexisting stockholders’ ownership will be diluted.  Any debt financing we enter into may involvecovenants that restrict our operations. These restrictive covenants may include limitations on additionalborrowing, specific restrictions on the use of our assets as well asprohibitions on our ability to create liens, pay dividends, redeem our stock ormake investments. In addition, if we raise additional funds throughcollaboration and licensing arrangements, it may be necessary to relinquishpotentially valuable rights to our potential products or proprietarytechnologies, or grant licenses on terms that are not favorable to us.

 

Wecannot be sure that our existing cash, cash equivalents and short-terminvestment resources will be adequate or that additional financing will beavailable when needed or that, if available, financing will be obtained onterms favorable to us or our stockholders.  Having insufficient funds may require us to delay, scale back oreliminate some or all of our research or development programs or to relinquishgreater or all rights to product candidates at an earlier stage of developmentor on less favorable terms than we would otherwise choose. Failure to obtainadequate financing also may adversely affect our ability to operate as a goingconcern.

 

**Off-Balance SheetArrangements**

 

Asof December 31, 2005, we did not have any relationships withunconsolidated entities or financial partnerships, such as entities oftenreferred to as structured finance or special purpose entities, which would havebeen established for the purpose of facilitating off-balance sheet arrangementsor other contractually narrow or limited purposes. In addition, we do notengage in trading activities involving non-exchange traded contracts. As such,we are not materially exposed to any financing, liquidity, market or creditrisk that could arise if we had engaged in these relationships.

 

**Related Party Transactions**

 

For a description of our related party transactions, see Item 13 ofPart III of this Form 10-K, “Certain Relationships and RelatedTransactions.”

 

**Item 7A. Quantitative and Qualitative Disclosures About Market Risk**

 

Our primary exposure to market risk is interest income sensitivity,which is affected by changes in the general level of U.S. interest rates,particularly because the majority of our investments are in short-termmarketable securities. Due to the nature of our short-term investments, webelieve that we are not subject to any material market risk exposure. We do nothave any foreign currency or other derivative financial instruments.

 

Our long-term capital lease obligations bears interest at fixed ratesand therefore we do not have significant market risk exposure with respect tothese obligations.

 

**Item 8. Financial Statements and Supplementary Data**

 

The information required to be disclosed herein is incorporated byreference to Item 15 of Part III of this Form 10-K.

 

**Item 9. Changes in and Disagreements with Accountants on Accounting andFinancial Disclosures**

 

Not applicable.

 

**Item 9A. Controls and Procedures**

 

We maintain disclosure controls and procedures that are designed toensure that information required to be disclosed in our Exchange Act reports isrecorded, processed, summarized and reported within the time periods specifiedin the Securities and Exchange Commission’s rules and forms and that suchinformation is accumulated and communicated to our management, including ourchief executive officer and chief financial officer, as appropriate, to allowfor timely decisions regarding required disclosure. In designing and evaluatingthe disclosure controls and procedures, management recognizes that any controlsand procedures, no matter how well designed and operated, can provide onlyreasonable assurance of achieving the desired control 

 

61

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objectives, and management is required toapply its judgment in evaluating the cost-benefit relationship of possiblecontrols and procedures.

 

As required by Securities and Exchange Commission Rule 13a-15(b),we carried out an evaluation, under the supervision and with the participationof our management, including our chief executive officer and chief financialofficer, of the effectiveness of the design and operation of our disclosurecontrols and procedures as of the end of the period covered by this report.Based on the foregoing, our chief executive officer and chief financial officerconcluded that our disclosure controls and procedures were effective at thereasonable assurance level.

 

There was no change in our internal control over financial reportingduring the fourth fiscal quarter of the period covered by this report that hasmaterially affected, or is reasonably likely to materially affect, our internalcontrol over financial reporting.

 

**Item 9B.Other Information**

 

OnMarch 19, 2006, the compensation committee of our board of directors approvedincreases in base salary and the grant of additional stock options for certainof our executive officers.  The following table sets forth the 2006 basesalary and the number of shares of common stock underlying the stock optiongrants for these executive officers:

 
| **Name**                           | ** ** | **2006 Base Salary** | ** ** | **Stock Options** | ** ** |
|------------------------------------|------------|----------------------|------------|-------------------|------------|
| Paul K.  Laikind, Ph.D.            |       | $                    | 361,000    |              | 125,000    |   |
| Mark D.  Erion , Ph.D.             |       | $                    | 305,000    |              | 75,000     |   |
| John W.  Beck, C.P.A.              |       | $                    | 243,000    |              | 50,000     |   |
| Edgardo  Baracchini, Ph.D., M.B.A. |       | $                    | 251,000    |              | 37,300     |   |

 

Thestock options described above (i) were granted pursuant to our Amended andRestated 2001 Equity Incentive Plan, (ii) terminate ten years after March19, 2006, the date of grant, or earlier in the event the optionholder’s serviceto us is terminated and (iii) have an exercise price per share of $9.03,or the closing price of our common stock as reported on the Nasdaq NationalMarket for Friday, March 17, 2006.  Subject to the optionholder’scontinued service to us, 25% of the shares of common stock subject to suchstock options vest on the first anniversary of the date of grant, and theremaining shares vest monthly over the following three years.

 

Alsoon March 19, 2006, the compensation committee reviewed our achievement of thecorporate and individual goals set for 2005 and based on that review, thecompensation committee approved 2005 incentive cash bonuses to certain of our executiveofficers as follows:

 
| **Name**                           | ** ** | **2005 Bonus** | ** ** |
|------------------------------------|------------|----------------|------------|
| Paul K.  Laikind, Ph.D.            |       | $              | 99,015     |   |
| Mark D.  Erion , Ph.D.             |       | $              | 71,885     |   |
| John W.  Beck, C.P.A.              |       | $              | 57,658     |   |
| Edgardo  Baracchini, Ph.D., M.B.A. |       | $              | 58,284     |   |

 

62

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**PART III**

 

**Item 10.      Directors and ExecutiveOfficers of the Registrant**

 

The information required by this item will be set forth in the sectionsentitled “Election of Directors”, “Code of Business Conduct and Ethics”, “ExecutiveOfficers” and “Section 16(a) Beneficial Ownership Reporting Compliance” inour definitive proxy statement to be filed with the Securities and ExchangeCommission in connection with the Annual Meeting of our Stockholders (the “ProxyStatement”), which is expected to be filed not later than 120 days afterthe end of our fiscal year ended December 31, 2005, and is incorporated inthis report by reference.

 

**Item 11.      Executive Compensation**

 

The information required by this item will be set forth in the sectionentitled “Compensation of Executive Officers” in the Proxy Statement and isincorporated in this report by reference.

 

**Item 12.      Security Ownershipof Certain Beneficial Owners and Management and Related Stockholder Matters**

 

The information required by this item will be set forth in the sectionsentitled “Security Ownership of Certain Beneficial Owners and Management” and “EquityCompensation Plan Information” in the Proxy Statement and is incorporated inthis report by reference.

 

**Item 13.      Certain Relationshipsand Related Transactions**

 

The information required by this item will be set forth in the sectionentitled “Certain Relationships and Related Transactions” in the ProxyStatement and is incorporated in this report by reference.

 

**Item 14.      PrincipalAccountant Fees and Services**

 

The information required by this item will be set forth in the sectionentitled “Ratification of Selection of Independent Registered Public AccountingFirm” in the Proxy Statement and is incorporated in this report by reference.

 

63

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**PART IV**

 

**Item 15.      Exhibits and FinancialStatement Schedules**

 

(a)           The following documentsare filed as part of this report:

 

1)             Thefollowing financial statements of Metabasis Therapeutics, Inc. areincluded in this report beginning on page F-1 hereto:

 

•      Report ofIndependent Registered Public Accounting Firm

•      Balance sheets asof December 31, 2005 and 2004

•      Statements ofoperations for the years ended December 31, 2005, 2004 and 2003

•      Statements ofstockholders’ equity for the years ended December 31, 2005, 2004 and 2003

•      Statements of cashflows for the years ended December 31, 2005, 2004 and 2003

•      Notes tofinancial statements

 

2)             Listof financial statement schedules. All financial statement schedules are omittedbecause they are not applicable or the required information is shown in thefinancial statements or notes thereto.

 

3)             Listof exhibits required by Item 601 of Regulation S-K. See part (b)below.

 

(b)           Exhibits.The following exhibits are filed as a part of this report:

 
| **Exhibit  Number** | ** ** | **Description**                                                                                                                                 |
|---------------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------|
|                |       |                                                                                                                                            |
| 2.1(1)              |       | Asset and  Liability Transfer Agreement dated December 17, 1997 between the Company and  Gensia Sicor Inc.                                      |
|                |       |                                                                                                                                            |
| 2.2(1)              |       | Master  Agreement dated June 30, 1999 among the Company, Sicor Inc., Paul K. Laikind,  Mark D. Erion and John W. Beck.                          |
|                |       |                                                                                                                                            |
| 3.1(1)              |       | Amended and  Restated Certificate of Incorporation of the Company.                                                                              |
|                |       |                                                                                                                                            |
| 3.2(1)              |       | Amended and  Restated Bylaws of the Company.                                                                                                    |
|                |       |                                                                                                                                            |
| 4.1(1)              |       | Form of  Common Stock Certificate.                                                                                                              |
|                |       |                                                                                                                                            |
| 4.2(1)              |       | Stock  Purchase Warrant dated February 6, 2001 issued to GATX Ventures, Inc.                                                                    |
|                |       |                                                                                                                                            |
| 4.3(1)              |       | Warrant to  Purchase 26,000 Shares of Series C Preferred Stock dated February 6, 2001  issued to GATX Ventures, Inc., as amended July 26, 2001. |
|                |       |                                                                                                                                            |
| 4.4(1)              |       | Warrant to  Purchase 19,000 Shares of Series C Preferred Stock dated July 26, 2001,  issued to GATX Ventures, Inc.                              |
|                |       |                                                                                                                                            |
| 4.5(1)              |       | Warrant to  Purchase 30,666 Shares of Series D Preferred Stock dated April 8, 2002,  issued to GATX Ventures, Inc.                              |
|                |       |                                                                                                                                            |
| 4.6(1)              |       | Form of  Stock Purchase Warrant issued to participants in the Company’s Series C  Preferred Stock financing dated July 18, 2000.           |
|                |       |                                                                                                                                            |
| 4.7(1)              |       | Form of  Stock Purchase Warrant issued to participants in the Company’s Series D  Preferred Stock financing dated October 18, 2001.        |
|                |       |                                                                                                                                            |
| 4.8(1)              |       | Form of  letter agreement entered into between the Company and its warrantholders.                                                              |
|                |       |                                                                                                                                            |
| 4.9(1)              |       | Letter  agreement dated October 18, 2001 entered into between the Company and Sprout  Capital IX, L.P. and its affiliates.                      |
|                |       |                                                                                                                                            |
| 4.10(1)             |       | Series E  Preferred Stock Purchase Agreement dated October 28, 2003 between the Company  and certain of its stockholders.                       |
|                |       |                                                                                                                                            |
| 4.11(1)             |       | Amended and  Restated Investors’ Rights Agreement dated October 28, 2003 between the  Company and certain of its stockholders.             |

 

64

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| **Exhibit  Number** | ** ** | **Description**                                                                                                                                                                                                |
|---------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                |       |                                                                                                                                                                                                           |
| 4.12(6)             |       | Securities Purchase  Agreement dated September 30, 2005, by and among the Company. and the  individuals and entities identified on Exhibit A thereto (the “***Securities Purchase Agreement***”).    |
|                |       |                                                                                                                                                                                                           |
| 4.13(6)             |       | Form of  Warrant issued pursuant to the Securities Purchase Agreement.                                                                                                                                         |
|                |       |                                                                                                                                                                                                           |
| 10.1(1)+            |       | Form of  Indemnity Agreement.                                                                                                                                                                                  |
|                |       |                                                                                                                                                                                                           |
| 10.2(1)+            |       | Amended and  Restated 2001 Equity Incentive Plan and Form of Stock Option Agreement  thereunder.                                                                                                               |
|                |       |                                                                                                                                                                                                           |
| 10.3(1)+            |       | 2004 Non-Employee  Directors’ Stock Option Plan and Form of Stock Option Agreement thereunder.                                                                                                            |
|                |       |                                                                                                                                                                                                           |
| 10.4(1)+            |       | 2004  Employee Stock Purchase Plan and Form of Offering Document thereunder.                                                                                                                                   |
|                |       |                                                                                                                                                                                                           |
| 10.5(1)+            |       | Employment  offer letter dated March 17, 1998 between the Company and John W. Beck.                                                                                                                            |
|                |       |                                                                                                                                                                                                           |
| 10.6(1)+            |       | Employment  offer letter dated March 31, 2002 between the Company and Edgardo Baracchini.                                                                                                                      |
|                |       |                                                                                                                                                                                                           |
| 10.8(1)+            |       | Stock  Restriction Agreement dated June 30, 2003 between the Company and Paul K.  Laikind.                                                                                                                     |
|                |       |                                                                                                                                                                                                           |
| 10.9(1)+            |       | Stock  Restriction Agreement dated June 30, 2003 between the Company and Mark D.  Erion.                                                                                                                       |
|                |       |                                                                                                                                                                                                           |
| 10.10(1)+           |       | Stock  Restriction Agreement dated June 30, 2003 between the Company and John W.  Beck.                                                                                                                        |
|                |       |                                                                                                                                                                                                           |
| 10.11(1)+           |       | Severance  Agreement dated April 3, 2002 between the Company and Edgardo Baracchini.                                                                                                                           |
|                |       |                                                                                                                                                                                                           |
| 10.12(1)+           |       | Severance  Agreement dated June 30, 2003 between the Company and Paul K. Laikind.                                                                                                                              |
|                |       |                                                                                                                                                                                                           |
| 10.13(1)+           |       | Severance  Agreement dated June 30, 2003 between the Company and Mark D. Erion.                                                                                                                                |
|                |       |                                                                                                                                                                                                           |
| 10.14(1)+           |       | Severance  Agreement dated June 30, 2003 between the Company and John W. Beck.                                                                                                                                 |
|                |       |                                                                                                                                                                                                           |
| 10.15(1)            |       | License  Agreement dated June 30, 1999 between the Company and Sicor Inc.                                                                                                                                      |
|                |       |                                                                                                                                                                                                           |
| 10.17(1)*           |       | Amended and  Restated Collaborative Research and Development and License Agreement dated  June 30, 1999 between the Company and Daiichi Sankyo Company, Ltd., as  amended February 9, 2000 and March 22, 2001. |
|                |       |                                                                                                                                                                                                           |
| 10.18(1)*           |       | Exclusive  Option Agreement dated October 21, 2002 between the Company and Daiichi  Sankyo Company, Ltd.                                                                                                       |
|                |       |                                                                                                                                                                                                           |
| 10.19(2)            |       | Development  and License Agreement dated October 1, 2001 between the Company and Valeant  Pharmaceuticals International.                                                                                       |
|                |       |                                                                                                                                                                                                           |
| 10.20(1)            |       | Letter  agreement dated March 8, 2002 among the Company, Valeant Pharmaceuticals  International and Ribapharm Inc.                                                                                             |
|                |       |                                                                                                                                                                                                           |
|                |       |                                                                                                                                                                                                           |
| 10.21(1)            |       | Equipment  Loan and Security Agreement dated February 6, 2001 between the Company and  GATX Ventures, Inc., as amended July 26, 2001 and April 8, 2002.                                                        |
|                |       |                                                                                                                                                                                                           |
| 10.22(1)            |       | Master  Security Agreement dated August 27, 2003 between the Company and Oxford  Finance Corporation.                                                                                                          |
|                |       |                                                                                                                                                                                                           |
| 10.23(1)*           |       | Exclusive  License and Research Collaboration Agreement dated December 23, 2003 between  the Company and Merck & Co., Inc.                                                                                 |
|                |       |                                                                                                                                                                                                           |
| 10.26(3)            |       | Lease  Agreement dated December 21, 2004 between the Company and CarrAmerica Realty,  L.P.                                                                                                                     |
|                |       |                                                                                                                                                                                                           |
| 10.27(4)*           |       | Amendment dated  January 21, 2005 to Exclusive License and Research Collaboration  Agreement dated December 23, 2003 between the Company and  Merck & Co., Inc.                        |
|                |       |                                                                                                                                                                                                           |
| 10.28(5)*           |       | License and  Collaboration Agreement dated June 22, 2005 between the Company and  Merck & Co., Inc.                                                                                         |
|                |       |                                                                                                                                                                                                           |
|                |       |                                                                                                                                                                                                           |
| 10.29 ^             |       | Amendment dated August  29, 2005 to Exclusive License and Research Collaboration Agreement dated  December 23, 2003 between the Company and Merck & Co., Inc.                                    |
|                |       |                                                                                                                                                                                                           |
| 10.30 ^             |       | Amendment dated  November 2, 2005 to Exclusive License and Research Collaboration Agreement  dated December 23, 2003 between the Company and Merck &  Co., Inc.                                  |
|                |       |                                                                                                                                                                                                           |
| 21.1(1)             |       | Subsidiaries  of the Company.                                                                                                                                                                                  |
|                |       |                                                                                                                                                                                                           |
| 23.1                |       | Consent of  Independent Registered Public Accounting Firm.                                                                                                                                                     |
|                |       |                                                                                                                                                                                                           |
| 31.1                |       | Certification  of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act  of 2002.                                                                                                          |

 

65

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| **Exhibit  Number** | ** ** | **Description**                                                                                                                         |
|---------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------|
|                |       |                                                                                                                                    |
| 31.2                |       | Certification  of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act  of 2002.                                   |
|                |       |                                                                                                                                    |
| 32                  |       | Certifications  of Chief Executive Officer and Chief Financial Officer pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002. |

 

----

+              Indicatesmanagement contract or compensatory plan.

 

*              Confidentialtreatment has been granted with respect to certain portions of this exhibit.Omitted portions have been filed separately with the Securities and ExchangeCommission.

 

^              Confidentialtreatment has been requested with respect to certain portions of thisexhibit.  Omitted portions have beenfiled separately with the Securities and Exchange Commission.

 

(1)           Incorporatedby reference to the exhibit of the same number to the Company’s RegistrationStatement on Form S-1 (No. 333-112437), originally filed onFebruary 3, 2004.

 

(2)           Incorporatedby reference to Exhibit 10.18 to the Registration Statement onForm S-1 (No. 333-39350), originally filed on June 15, 2000 byRibapharm Inc., now a wholly-owned subsidiary of Valeant PharmaceuticalsInternational.

 

(3)           Incorporatedby reference to Exhibit 99.1 to the Company’s Current Report onForm 8-K filed on December 23, 2004.

 

(4)           Incorporatedby reference to Exhibit 10.27 to the Company’s Quarterly Report onForm 10-Q for the quarterly period ended March 31, 2005.

 

(5)           Incorporatedby reference to Exhibit 10.28 to the Company’s Quarterly Report onForm 10-Q for the quarterly period ended June 30, 2005.

 

(6)           Incorporated byreference to the exhibit of the same number to the Company’s Current Report onForm 8-K filed on October 5, 2005.

 

66

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**SIGNATURES**

 

Pursuant to the requirements of Section 13 or 15(d) of theSecurities and Exchange Act of 1934, the registrant has duly caused this reportto be signed on its behalf by the undersigned, thereunto duly authorized.

 
|                        | METABASIS  THERAPEUTICS, INC. |
|-----------------------------|------------------------------------|
|                        |                               |
| Dated:  March 23, 2006 | By:                                | /s/ Paul K. Laikind  |
|                        |                               | Paul K.  Laikind, Ph.D. |
|                        |                               | *Chief Executive Officer and President* |

 

 

Pursuant to the requirements of the Securities Exchange Act of 1934,this report has been signed below by the following persons on behalf of theregistrant and in the capacities and on the dates indicated.

 
| **Signature**             | ** ** | **Title**                                          | ** ** | **Date**            |
|---------------------------|------------|----------------------------------------------------|------------|---------------------|
| ** **                | ** ** | ** **                                         | ** ** | ** **          |
| /s/ Paul K. Laikind       |       | Chairman of  the Board, Chief Executive Officer,   |       | March 23, 2006 |
| Paul K. Laikind, Ph.D.    |       | President and Secretary (Principal Executive       |       |                |
|                      |       | Officer)                                           |       |                |
|                      |       |                                               |       |                |
| /s/ John W. Beck          |       | Senior Vice  President of Finance, Chief Financial |       | March 23, 2006 |
| John W. Beck, C.P.A.      |       | Officer and Treasurer (Principal Financial and     |       |                |
|                      |       | Accounting Officer)                                |       |                |
|                      |       |                                               |       |                |
| /s/ Daniel D. Burgess     |       | Director                                           |       | March 23, 2006 |
| Daniel D. Burgess, M.B.A. |       |                                               |       |                |
|                      |       |                                               |       |                |
| /s/ Mark D. Erion         |       | Executive  Vice President of Research and          |       | March 23, 2006 |
| Mark D. Erion, Ph.D.      |       | Development, Chief Scientific Officer and          |       |                |
|                      |       | Director                                           |       |                |
|                      |       |                                               |       |                |
| /s/ Luke B. Evnin         |       | Director                                           |       | March 23, 2006 |
| Luke B. Evnin, Ph.D.      |       |                                               |       |                |
|                      |       |                                               |       |                |
| /s/ David F. Hale         |       | Director                                           |       | March 23, 2006 |
| David F. Hale             |       |                                               |       |                |
|                      |       |                                               |       |                |
| /s/ Arnold L. Oronsky     |       | Director                                           |       | March 23, 2006 |
| Arnold L. Oronsky, Ph.D.  |       |                                               |       |                |
|                      |       |                                               |       |                |
| /s/ William R. Rohn       |       | Director                                           |       | March 23, 2006 |
| William R. Rohn           |       |                                               |       |                |

 

67

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**METABASIS THERAPEUTICS, INC.**

**INDEX TO FINANCIAL STATEMENTS**

 
| ** **                                                                                    | ** ** |
|-----------------------------------------------------------------------------------------------|------------|
| Report of Independent Registered Public  Accounting Firm                                      |       |
| Balance Sheets as of December 31, 2005 and  2004                                              |       |
| Statements of Operations for the years  ended December 31, 2005, 2004 and 2003                |       |
| Statements of Stockholders’ Equity for the years  ended December 31, 2005, 2004 and 2003 |       |
| Statements of Cash Flows for the years ended December 31, 2005, 2004  and 2003                |       |
| Notes to Financial Statements                                                                 |       |

 

F-1

----

 

**REPORT OF INDEPENDENT REGISTERED PUBLICACCOUNTING FIRM**

 

The Board ofDirectors and Stockholders of

MetabasisTherapeutics, Inc.

 

We have audited the accompanying balance sheets of MetabasisTherapeutics, Inc. as of December 31, 2005 and 2004, and the relatedstatements of operations, stockholders’ equity and cash flows for each of thethree years in the period ended December 31, 2005. These financial statementsare the responsibility of the Company’s management. Our responsibility is toexpress an opinion on these financial statements based on our audits.

 

We conducted our audits in accordance with the standards of the PublicCompany Accounting Oversight Board (United States). Those standards requirethat we plan and perform the audit to obtain reasonable assurance about whetherthe financial statements are free of material misstatement. We were not engagedto perform an audit of the Company’s internal control over financial reporting.Our audit included consideration of internal control over financial reportingas a basis for designing audit procedures that are appropriate in thecircumstances, but not for the purpose of expressing an opinion on the effectivenessof the Company’s internal control over financial reporting. Accordingly, weexpress no such opinion. An audit includes examining, on a test basis, evidencesupporting the amounts and disclosures in the financial statements.  An audit also includes assessing theaccounting principles used and significant estimates made by management, aswell as evaluating the overall financial statement presentation. We believethat our audits provide a reasonable basis for our opinion.

 

In our opinion, the financial statements referred to above presentfairly, in all material respects, the financial position of MetabasisTherapeutics, Inc. at December 31, 2005 and 2004 and the results ofits operations and its cash flows for each of the three years in the periodended December 31, 2005, in conformity with U.S. generally acceptedaccounting principles.

 
|                                      | /s/ Ernst & Young LLP |   |
|-------------------------------------------|---------------------------|--------|
|                                      |                      |
| San Diego,  California  February 16, 2006 |                      |

 

F-2

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**METABASIS THERAPEUTICS, INC.**

**BALANCESHEETS**

**(in thousands, except par value data)**

 
| ** **                                                                                                                                                                                                       | ** ** | **December 31,** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------|------------|
| ** **                                                                                                                                                                                                       | ** ** | **2005**         | ** ** | **2004** | ** ** |
| **Assets**                                                                                                                                                                                                       |       |             |       |   |   |
| Current  assets:                                                                                                                                                                                                 |       |             |       |   |   |
| Cash and cash equivalents                                                                                                                                                                                        |       | $                | 32,597     |   | $ | 10,921 |   |
| Securities available-for-sale                                                                                                                                                                                    |       | 34,296           |       | 32,934 |   |
| Accounts receivable                                                                                                                                                                                              |       | 928              |       | 525 |   |
| Other current assets                                                                                                                                                                                             |       | 1,241            |       | 1,126 |   |
| Total  current assets                                                                                                                                                                                            |       | 69,062           |       | 45,506 |   |
| Property and  equipment, net                                                                                                                                                                                     |       | 4,664            |       | 2,354 |   |
| Other assets                                                                                                                                                                                                     |       | 152              |       | — |   |
| Total assets                                                                                                                                                                                                     |       | $                | 73,878     |   | $ | 47,860 |   |
| **Liabilities  and stockholders’ equity**                                                                                                                                                                   |       |             |       |   |   |
| Current  liabilities:                                                                                                                                                                                            |       |             |       |   |   |
| Accounts payable                                                                                                                                                                                                 |       | $                | 1,745      |   | $ | 864 |   |
| Accrued liabilities                                                                                                                                                                                              |       | 4,392            |       | 2,835 |   |
| Deferred rent                                                                                                                                                                                                    |       | —           |       | 67 |   |
| Deferred revenue, current portion                                                                                                                                                                                |       | 2,192            |       | — |   |
| Current portion of capital lease  obligations, net of discount                                                                                                                                                   |       | 1,042            |       | 834 |   |
| Total  current liabilities                                                                                                                                                                                       |       | 9,371            |       | 4,600 |   |
| Deferred  revenue, net of current portion                                                                                                                                                                        |       | 2,463            |       | — |   |
| Deferred  rent                                                                                                                                                                                                   |       | 330              |       | — |   |
| Other long-term  liabilities                                                                                                                                                                                     |       | 6                |       | 4 |   |
| Capital  lease obligations, net of current portion and discount                                                                                                                                                  |       | 2,126            |       | 1,392 |   |
| Stockholders’  equity:                                                                                                                                                                                      |       |             |       |   |   |
| Preferred stock, $0.001 par value; 5,000  shares authorized at December 31, 2005 and December 31, 2004, no shares  issued or outstanding                                                                    |       | —           |       | — |   |
| Common stock, $.001 par value; 100,000  shares authorized at December 31, 2005 and December 31, 2004; 25,313 and  18,169 shares issued and outstanding at December 31, 2005 and December 31,  2004, respectively |       | 25               |       | 18 |   |
| Additional paid-in capital                                                                                                                                                                                       |       | 137,822          |       | 98,602 |   |
| Deferred compensation                                                                                                                                                                                            |       | (3,266           | )          | (5,337 | ) |
| Accumulated deficit                                                                                                                                                                                              |       | (74,945          | )          | (51,365 | ) |
| Accumulated other comprehensive loss                                                                                                                                                                             |       | (54              | )          | (54 | ) |
| Total  stockholders’ equity                                                                                                                                                                                 |       | 59,582           |       | 41,864 |   |
| Total  liabilities and stockholders’ equity                                                                                                                                                                 |       | $                | 73,878     |   | $ | 47,860 |   |

 

*See accompanying notes.*

 

F-3

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**METABASIS THERAPEUTICS, INC.**

**STATEMENTS OF OPERATIONS**

**(in thousands, except per share data)**

 
| ** **                                                                  | ** ** | **Years Ended December 31,** | ** ** |
|-----------------------------------------------------------------------------|------------|------------------------------|------------|
| ** **                                                                  | ** ** | **2005**                     | ** ** | **2004** | ** ** | **2003** | ** ** |
| Revenues:                                                                   |       |                         |       |   |   |   |   |
| Sponsored research                                                          |       | $                            | 2,493      |   | $ | 1,375 |   | $ | — |   |
| Milestones                                                                  |       | —                       |       | 4,500 |   | 1,000 |   |
| License fees                                                                |       | 871                          |       | 458 |   | 7,631 |   |
| Other revenue                                                               |       | 407                          |       | 504 |   | 493 |   |
| Total  revenues                                                             |       | 3,771                        |       | 6,837 |   | 9,124 |   |
| Operating  expenses:                                                        |       |                         |       |   |   |   |   |
| Research and development                                                    |       | 21,460                       |       | 16,675 |   | 15,048 |   |
| General and administrative                                                  |       | 5,283                        |       | 3,804 |   | 2,955 |   |
| Amortization of employee stock-based  compensation                          |       | 1,695                        |       | 1,633 |   | 504 |   |
| Total  operating expenses                                                   |       | 28,438                       |       | 22,112 |   | 18,507 |   |
| Loss from  operations                                                       |       | (24,667                      | )          | (15,275 | ) | (9,383 | ) |
| Other income  (expense):                                                    |       |                         |       |   |   |   |   |
| Interest income                                                             |       | 1,297                        |       | 531 |   | 177 |   |
| Interest expense                                                            |       | (210                         | )          | (228 | ) | (226 | ) |
| Other, net                                                                  |       | —                       |       | — |   | 3 |   |
| Total other  income (expense)                                               |       | 1,087                        |       | 303 |   | (46 | ) |
| Net loss                                                                    |       | (23,580                      | )          | (14,972 | ) | (9,429 | ) |
| Deemed  dividend-beneficial conversion feature for Series E preferred stock |       | —                       |       | — |   | (24,900 | ) |
| Net loss  applicable to common stockholders                                 |       | $                            | (23,580    | ) | $ | (14,972 | ) | $ | (34,329 | ) |
| Basic and  diluted net loss per share (1)                                   |       | $                            | (1.20      | ) | $ | (1.49 | ) | $ | (23.84 | ) |
| Shares used  to compute basic and diluted net loss per share (1)            |       | 19,706                       |       | 10,034 |   | 1,440 |   |
| The  composition of employee stock-based compensation is as follows:        |       |                         |       |   |   |   |   |
| Research and development                                                    |       | $                            | 1,170      |   | $ | 1,138 |   | $ | 358 |   |
| General and administrative                                                  |       | 525                          |       | 495 |   | 146 |   |
|                                                                        |       | $                            | 1,695      |   | $ | 1,633 |   | $ | 504 |   |

 

----

(1)           Asa result of the conversion of our preferred stock into 11.0 million sharesof our common stock upon completion of our initial public offering onJune 21, 2004, there is a lack of comparability in the basic and dilutednet loss per share amounts between the year ended December 31, 2003 and thesubsequent periods presented above. Please reference Note 1 for anunaudited pro forma basic and diluted net loss per share calculation for theperiods presented.

 

*See accompanying notes.*

 

F-4

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** **

**METABASIS THERAPEUTICS, INC.**

**STATEMENTS OF STOCKHOLDERS’ EQUITY**

**(in thousands)**

** **
|                                                                                                          | ** ** | **Convertible  Preferred Stock** | ** ** | **Common  Stock** | ** ** | **Additional  Paid-In** | ** ** | **Deferred** | ** ** | **Notes  Receivable  From** | ** ** | **Accumulated**  | ** ** | **Accumulated  Other  Comprehensive** | ** ** | **Total  Stockholders’** | ** ** |
|---------------------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|-------------------|------------|-------------------------|------------|--------------|------------|-----------------------------|------------|------------------|------------|---------------------------------------|------------|-------------------------------|------------|
| ** **                                                                                                    | ** ** | **Shares**                       | ** ** | **Amount**        | ** ** | **Shares**              | ** ** | **Amount**   | ** ** | **Capital**                 | ** ** | **Compensation** | ** ** | **Stockholders**                      | ** ** | **Deficit**                   | ** ** | **Income  (Loss)** | ** ** | **Equity** | ** ** |
| Balance at December 31, 2002                                                                                  |       | 39,600                           |       | 40                |       | 1,706                   |       | 2            |       | 36,340                      |       | (238             | )          | (425                                  | )          | (26,964                       | )          | 1 |   | 8,756 |   |
| Net loss                                                                                                      |       | —                           |       | —            |       | —                  |       | —       |       | —                      |       | —           |       | —                                |       | (9,429                        | )          | — |   | (9,429 | ) |
| Unrealized loss  on short-term investments                                                                    |       | —                           |       | —            |       | —                  |       | —       |       | —                      |       | —           |       | —                                |       | —                        |       | (7 | ) | (7 | ) |
| Net comprehensive loss                                                                                        |       | —                           |       | —            |       | —                  |       | —       |       | —                      |       | —           |       | —                                |       | —                        |       | — |   | (9,436 | ) |
| Issuance of  common stock for option exercises                                                                |       | —                           |       | —            |       | 67                      |       | —       |       | 45                          |       | —           |       | —                                |       | —                        |       | — |   | 45 |   |
| Issuance of  Series E preferred stock, net of offering costs of approximately $1,137                          |       | 24,032                           |       | 24                |       | —                  |       | —       |       | 23,739                      |       | —           |       | —                                |       | —                        |       | — |   | 23,763 |   |
| Beneficial  conversion feature for Series E preferred stock                                                   |       | —                           |       | —            |       | —                  |       | —       |       | 24,900                      |       | —           |       | —                                |       | —                        |       | — |   | 24,900 |   |
| Deemed dividend  for Series E convertible preferred stock                                                     |       | —                           |       | —            |       | —                  |       | —       |       | (24,900                     | )          | —           |       | —                                |       | —                        |       | — |   | (24,900 | ) |
| Deferred employee  stock-based compensation                                                                   |       | —                           |       | —            |       | —                  |       | —       |       | 5,209                       |       | (5,209           | )          | —                                |       | —                        |       | — |   | — |   |
| Adjustment to  deferred compensation for cancellation of options                                              |       | —                           |       | —            |       | —                  |       | —       |       | (80                         | )          | 80               |       | —                                |       | —                        |       | — |   | — |   |
| Amortization of  deferred employee stock-based compensation                                                   |       | —                           |       | —            |       | —                  |       | —       |       | —                      |       | 504              |       | —                                |       | —                        |       | — |   | 504 |   |
| Shares tendered  in exchange for notes receivable from stockholders                                           |       | —                           |       | —            |       | —                  |       | —       |       | —                      |       | —           |       | 425                                   |       | —                        |       | — |   | 425 |   |
| Issuance of stock  options for services                                                                       |       | —                           |       | —            |       | —                  |       | —       |       | 2                           |       | —           |       | —                                |       | —                        |       | — |   | 2 |   |
| Deferred  compensation from tendered shares subject to vesting                                                |       | —                           |       | —            |       | —                  |       | —       |       | —                      |       | (711             | )          | —                                |       | —                        |       | — |   | (711 | ) |
| Amortization of  deferred compensation from tendered shares subject to vesting                                |       | —                           |       | —            |       | —                  |       | —       |       | —                      |       | 89               |       | —                                |       | —                        |       | — |   | 89 |   |
| Balance at December 31, 2003                                                                                  |       | 63,632                           |       | 64                |       | 1,773                   |       | 2            |       | 65,255                      |       | (5,485           | )          | —                                |       | (36,393                       | )          | (6 | ) | 23,437 |   |
| Net loss                                                                                                      |       | —                           |       | —            |       | —                  |       | —       |       | —                      |       | —           |       | —                                |       | (14,972                       | )          | — |   | (14,972 | ) |
| Unrealized loss  on short-term investments                                                                    |       | —                           |       | —            |       | —                  |       | —       |       | —                      |       | —           |       | —                                |       | —                        |       | (48 | ) | (48 | ) |
| Net comprehensive loss                                                                                        |       | —                           |       | —            |       | —                  |       | —       |       | —                      |       | —           |       | —                                |       | —                        |       | — |   | (15,020 | ) |
| Issuance of  common stock in initial public offering and follow-on offering, net of  offering costs of $1,894 |       | —                           |       | —            |       | 5,075                   |       | 5            |       | 31,139                      |       | —           |       | —                                |       | —                        |       | — |   | 31,144 |   |
| Conversion of  convertible preferred stock into common stock                                                  |       | (63,632                          | )          | (64               | )          | 11,036                  |       | 11           |       | 53                          |       | —           |       | —                                |       | —                        |       | — |   | — |   |
| Issuance of  common stock for option exercises                                                                |       | —                           |       | —            |       | 255                     |       | —       |       | 314                         |       | —           |       | —                                |       | —                        |       | — |   | 314 |   |
| Issuance of  common stock pursuant to the Employee Stock Purchase Plan                                        |       | —                           |       | —            |       | 30                      |       | —       |       | 178                         |       | —           |       | —                                |       | —                        |       | — |   | 178 |   |
| Deferred employee  stock-based compensation                                                                   |       | —                           |       | —            |       | —                  |       | —       |       | 1,705                       |       | (1,705           | )          | —                                |       | —                        |       | — |   | — |   |
| Adjustment to  deferred compensation for cancellation of options                                              |       | —                           |       | —            |       | —                  |       | —       |       | (42                         | )          | 42               |       | —                                |       | —                        |       | — |   | — |   |
| Amortization of  deferred employee stock-based compensation                                                   |       | —                           |       | —            |       | —                  |       | —       |       | —                      |       | 1,633            |       | —                                |       | —                        |       | — |   | 1,633 |   |
| Amortization of  deferred compensation from tendered shares subject to vesting                                |       | —                           |       | —            |       | —                  |       | —       |       | —                      |       | 178              |       | —                                |       | —                        |       | — |   | 178 |   |
| Balance at December 31, 2004                                                                                  |       | —                           |       | —            |       | 18,169                  |       | 18           |       | 98,602                      |       | (5,337           | )          | —                                |       | (51,365                       | )          | (54 | ) | 41,864 |   |
| Net loss                                                                                                      |       | —                           |       | —            |       | —                  |       | —       |       | —                      |       | —           |       | —                                |       | (23,580                       | )          | — |   | (23,580 | ) |
| Unrealized loss  on short-term investments                                                                    |       | —                           |       | —            |       | —                  |       | —       |       | —                      |       | —           |       | —                                |       | —                        |       | — |   | — |   |
| Net comprehensive loss                                                                                        |       | —                           |       | —            |       | —                  |       | —       |       | —                      |       | —           |       | —                                |       | —                        |       | — |   | (23,580 | ) |
| Issuance of  common stock in private placement offering net of offering costs of $2,280                       |       | —                           |       | —            |       | 7,000                   |       | 7            |       | 39,039                      |       | —           |       | —                                |       | —                        |       | — |   | 39,046 |   |
| Issuance of  common stock for option exercises                                                                |       | —                           |       | —            |       | 40                      |       | —       |       | 54                          |       | —           |       | —                                |       | —                        |       | — |   | 54 |   |
| Issuance of stock  options for services                                                                       |       | —                           |       | —            |       | —                  |       | —       |       | 65                          |       | —           |       | —                                |       | —                        |       | — |   | 65 |   |
| Issuance of  common stock pursuant to the Employee Stock Purchase Plan                                        |       | —                           |       | —            |       | 104                     |       | —       |       | 280                         |       | —           |       | —                                |       | —                        |       | — |   | 280 |   |
| Repurchase  unvested common stock                                                                             |       | —                           |       | —            |       | —                  |       | —       |       | (20                         | )          | —           |       | —                                |       | —                        |       | — |   | (20 | ) |
| Adjustment to  deferred compensation for cancellation of options                                              |       | —                           |       | —            |       | —                  |       | —       |       | (198                        | )          | 198              |       | —                                |       | —                        |       | — |   | — |   |
| Amortization of  deferred employee stock-based compensation                                                   |       | —                           |       | —            |       | —                  |       | —       |       | —                      |       | 1,695            |       | —                                |       | —                        |       | — |   | 1,695 |   |
| Amortization of  deferred compensation from tendered shares subject to vesting                                |       | —                           |       | —            |       | —                  |       | —       |       | —                      |       | 178              |       | —                                |       | —                        |       | — |   | 178 |   |
| Balance at December 31, 2005                                                                                  |       | —                           |       | $                 | —     |                    | 25,313     |         | $          | 25                          |       | $                | 137,822    |                                  | $          | (3,266                        | )          | $ | — |   | $ | (74,945 | ) | $ | (54 | ) | $ | 59,582 |   |
|                                                                                                               |            |                                  |            |                   |            |                         |            |              |            |                             |            |                  |            |                                       |            |                               |            |  |  |  |  |  |  |  |  |  |  |  |  |

 

*See accompanying notes.*

 

F-5

----

 

**METABASIS THERAPEUTICS, INC.**

**STATEMENTS OF CASH FLOWS**

**(in thousands)**

 
| ** **                                                                                                  | ** ** | **Years ended December 31,** | ** ** |
|-------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                                                  | ** ** | **2005**                                    | ** ** | **2004** | ** ** | **2003** | ** ** |
| **Operating activities**                                                                                    |       |                                        |       |   |   |   |   |
| Net loss                                                                                                    |       | $                                           | (23,580    | ) | $ | (14,972 | ) | $ | (9,429 | ) |
| Adjustments to reconcile net loss to net  cash used in operating activities:                                |       |                                        |       |   |   |   |   |
| Amortization of deferred employee  stock-based compensation                                                 |       | 1,695                                       |       | 1,633 |   | 504 |   |
| Amortization of deferred compensation on  tendered shares                                                   |       | 178                                         |       | 178 |   | 89 |   |
| Deferred rent                                                                                               |       | 263                                         |       | (55 | ) | (10 | ) |
| Depreciation and amortization                                                                               |       | 910                                         |       | 699 |   | 564 |   |
| Amortization of discount on equipment loan                                                                  |       | 5                                           |       | 15 |   | 15 |   |
| Stock options issued for services                                                                           |       | 65                                          |       | — |   | 2 |   |
| Change in operating assets and liabilities:                                                                 |       |                                        |       |   |   |   |   |
| Accounts receivable                                                                                         |       | (403                                        | )          | 432 |   | (778 | ) |
| Other current assets                                                                                        |       | (115                                        | )          | (660 | ) | (205 | ) |
| Other assets                                                                                                |       | (152                                        | )          | 199 |   | 50 |   |
| Deferred revenue                                                                                            |       | 4,655                                       |       | (458 | ) | (7,175 | ) |
| Accounts payable                                                                                            |       | 881                                         |       | 97 |   | 6 |   |
| Accrued liabilities and other long-term  liabilities                                                        |       | 1,559                                       |       | 333 |   | 638 |   |
| Net cash flows used in operating activities                                                                 |       | (14,039                                     | )          | (12,559 | ) | (15,729 | ) |
| **Investing activities**                                                                                    |       |                                        |       |   |   |   |   |
| Purchases of securities available-for-sale                                                                  |       | (36,795                                     | )          | (40,327 | ) | (15,215 | ) |
| Sales/maturities of securities  available-for-sale                                                          |       | 35,433                                      |       | 21,585 |   | 8,450 |   |
| Purchases of property and equipment                                                                         |       | (3,220                                      | )          | (1,326 | ) | (898 | ) |
| Net cash flows used in investing activities                                                                 |       | (4,582                                      | )          | (20,068 | ) | (7,663 | ) |
| **Financing activities**                                                                                    |       |                                        |       |   |   |   |   |
| Issuance of preferred stock, net                                                                            |       | —                                      |       | — |   | 23,763 |   |
| Issuance of common stock, net                                                                               |       | 39,380                                      |       | 32,140 |   | 45 |   |
| Payments under capital lease obligations                                                                    |       | (870                                        | )          | (788 | ) | (413 | ) |
| Repurchase unvested common stock                                                                            |       | (20                                         | )          | — |   | — |   |
| Payments on notes payable                                                                                   |       | —                                      |       | — |   | (1,500 | ) |
| Proceeds from capital lease obligations                                                                     |       | 1,807                                       |       | 1,179 |   | 864 |   |
| Prepaid offering costs                                                                                      |       | —                                      |       | — |   | (430 | ) |
| Net cash flows provided by financing  activities                                                            |       | 40,297                                      |       | 32,531 |   | 22,329 |   |
| Increase (decrease) in cash and cash  equivalents                                                           |       | 21,676                                      |       | (96 | ) | (1,063 | ) |
| Cash and cash equivalents at beginning of  year                                                             |       | 10,921                                      |       | 11,017 |   | 12,080 |   |
| Cash and cash equivalents at end of period                                                                  |       | $                                           | 32,597     |   | $ | 10,921 |   | $ | 11,017 |   |
| **Supplemental disclosure of cash flow  information:**                                                      |       |                                        |       |   |   |   |   |
| Interest paid                                                                                               |       | $                                           | 205        |   | $ | 214 |   | $ | 232 |   |
| **Supplemental schedule of noncash investing  and financing activities:**                                   |       |                                        |       |   |   |   |   |
| Shares tendered from stockholders for  repayment of the principal and accrued interest of stockholder loans |       | $                                           | —     |   | $ | — |   | $ | 514 |   |
| Conversion of convertible preferred stock  to common stock upon initial public offering                     |       | $                                           | —     |   | $ | 64 |   | $ | — |   |
| Deemed beneficial conversion feature for  Series E preferred stock                                          |       | $                                           | —     |   | $ | — |   | $ | 24,900 |   |

* *

*See accompanying notes.*

 

F-6

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**METABASIS THERAPEUTICS, INC.**

**NOTES TO FINANCIAL STATEMENTS**

 

**1.****             Organizationand Summary of Significant Accounting Policies**

 

*Organization and Business*

 

Metabasis Therapeutics, Inc. (“Metabasis” or the “Company”) is a biopharmaceuticalcompany focused on the discovery, development and commercialization of noveldrugs to address some of the world’s most widespread and costly chronicdiseases involving pathways in the liver.

 

*Use of Estimates*

 

The preparation of financial statements in conformity with U.S.generally accepted accounting principles requires management to make estimatesand assumptions that affect the reported amounts of assets and liabilities anddisclosures of contingent assets and liabilities at the date of the financialstatements. Estimates also affect the reported amounts of revenues and expensesduring the reporting period. Actual results could differ from those estimates.

 

*Cash and Cash Equivalents*

 

Cash and cash equivalents consist of cash and highly liquid instrumentswith original maturities of three months or less when purchased.

 

*Securities Available-For-Sale*

 

Short-term investments are classified as available-for-sale and arecarried at fair value, with unrealized gains and losses reported instockholders’ equity. The amortized cost of debt securities in this category isadjusted for amortization of premiums and accretion of discounts to maturity.Such amortization is included in interest income. Realized gains and losses anddeclines in value judged to be other-than-temporary, if any, onavailable-for-sale securities are included in other income. The cost ofsecurities sold is based on the specific-identification method. Interest anddividends on securities classified as available-for-sale are included ininterest income.

 

*Fair Value of Financial Instruments*

 

The carrying amount of cash and cash equivalents, securitiesavailable-for-sale, accounts receivable, accounts payable and accrued liabilitiesare considered to be representative of their respective fair values because ofthe short-term nature of those instruments. Based on the borrowing ratescurrently available to the Company for loans with similar terms, managementbelieves the fair value of the long-term obligations approximate their carryingvalue.

 

*Concentration of Credit Risks and MajorPartners*

 

Financial instruments that potentially subject the Company to asignificant concentration of credit risk consist primarily of cash and cashequivalents and securities available-for-sale. The Company invests its excesscash in U.S. government securities, asset backed securities and debtinstruments of financial institutions and corporations with strong creditratings. The Company has established guidelines relative to diversification ofits cash investments and their maturities that are intended to secure safetyand liquidity. These guidelines are periodically reviewed and modified to takeadvantage of trends in yields and interest rates and changes in the Company’soperations and financial position. To date, the Company has not experienced anyimpairment losses on its cash equivalents or securities available-for-sale.

 

F-7

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One collaborative partner individually accounted for 90% of totalrevenues during the year ended December 31, 2005, and a different collaborativepartner individually accounted for 51% and 83% of total revenues during theyears ended December 31, 2004 and 2003 (see Note 5).

 

*Property and Equipment*

 

Property and equipment is carried at cost less accumulateddepreciation. Depreciation is computed on the straight-line method anddepending on asset classification, over a period of three to five years.Leasehold improvements are amortized over the estimated useful life of theasset or the lease term, whichever is shorter.

 

*Impairment of Long-Lived Assets*

 

The Company assesses potential impairments to its long-lived andintangible assets in accordance with Statement of Financial AccountingStandards (“SFAS”) No. 144, *Accountingfor the Impairment or Disposal of Long-Lived Assets* when there isevidence that events or changes in circumstances indicate that the carryingamount of an asset may not be recovered. There have been no indicators ofimpairment through December 31, 2005.

 

*Revenue Recognition*

 

The Company’s revenue recognition policies are in accordance with theSecurities and Exchange Commission Staff Accounting Bulletin (“SAB”) 104, *Revenue Recognition,* and Emerging IssuesTask Force (“EITF”) Issue No. 00-21, *RevenueArrangements with Multiple Deliverables*. Many of the Company’srevenues are primarily related to collaborations with pharmaceutical companies.The Company’s agreements generally contain multiple elements, including sponsoredresearch funding, future milestone payments and royalties. All fees arenonrefundable.

 

Upfront, nonrefundable fees under the Company’s collaborations andadvance payments for sponsored research, which are in excess of amounts earnedare classified as deferred revenue and are recognized as income over the periodthe related services are provided. Nonrefundable upfront fees, which do notrequire the Company’s continuing involvement, or which do not contain futureperformance obligations, are recognized when received.

 

Amounts received for sponsored research funding are recognized asrevenues as the services are performed. These agreements are on a best-effortsbasis and do not require scientific achievement as a performance obligation andprovide for payment to be made when costs are incurred or the services areperformed.

 

Revenue from milestones is recognized when earned, provided that(i) the milestone event is substantive and its achievability was notreasonably assured at the inception of the agreement, and(ii) collaborator funding (if any) of the Company’s performanceobligations after the milestone achievement will continue at a level comparableto before the milestone achievement. If both of these criteria are not met, themilestone payment is recognized as revenue over the remaining minimum period ofthe Company’s performance obligations under the agreement.

 

*Research and Development*

 

All costs of research and development, including those incurred inrelation to the Company’s collaborative agreements, are expensed in the periodincurred. Research and development costs primarily consist of salaries andrelated expenses for personnel, outside service providers, fees paid toconsultants and materials used in clinical trials and research and development.The Company reviews and accrues clinical trials expenses based on workperformed, which relies on estimates of total costs incurred based oncompletion of patient studies and other events. The Company follows this methodsince reasonably dependable estimates of the costs applicable to various stagesof a research agreement or clinical trial can be made. Accrued clinicaldevelopment costs are subject to revisions as trials progress to completion.Revisions are charged to expense in the period in which the facts that giverise to the revision become known.

 

F-8

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*Comprehensive Loss*

 

SFAS No. 130, *ReportingComprehensive Income*, requires that all components of comprehensiveloss, including net loss, be reported in the financial statements in the periodin which they are recognized. Comprehensive loss is defined as the change inequity during a period from transactions and other events and circumstancesfrom nonowner sources. The Company’s other comprehensive loss forDecember 31, 2005, 2004 and 2003 consisted of unrealized gains and losseson available-for-sale securities and is reported in stockholders’ equity.

 

*Stock-Based Compensation*

 

The Company has elected to follow Accounting Principles Board Opinion No. 25(“APB 25”), *Accounting for Stock Issued toEmployees*, and related interpretations in accounting for itsemployee and director stock options. Under APB 25, if the exercise price of theCompany’s employee and director stock options equals or exceeds the estimatedfair value of the underlying stock on the date of grant, no compensationexpense is recognized. In conjunction with the Company’s initial publicoffering completed in June 2004, the Company reviewed its historical exerciseprices through June 15, 2004 and, as a result, revised the estimate offair value for the stock underlying all stock options granted subsequent toJune 30, 2002. The weighted average exercise price for the 930,000 optionsgranted to the Company’s employees and directors during July 2002 throughJune 15, 2004 was $1.46. With respect to employee and director optionsgranted, the Company has deferred stock compensation balances of $2.9 millionand $4.9 million at December 31, 2005 and 2004, respectively, for thedifference between the original exercise price per share determined by theBoard of Directors and the revised estimate of fair value per share at therespective grant dates. Deferred stock compensation is recognized and amortizedon a straight-line basis over the vesting period of the related options,generally four years. Compensation expense related to stock options granted tothe Company’s employees and directors was approximately $1.7 million, $1.6 million,and $0.5 million for the twelve months ended December 31, 2005, 2004and 2003, respectively. SFAS No. 123R is discussed in *RecentAccounting Pronouncements*.

 

Options or stock awards issued to nonemployees have been valued inaccordance with SFAS No. 123, *Accountingfor Stock-Based Compensation*, and EITF Issue No. 96-18, *Accounting for Equity Instruments that are Issued toOther than Employees for Acquiring, or in Conjunction with Selling Goods orServices*, and expensed over the period the services are provided.Deferred charges for options granted to non-employees are periodicallyremeasured as the options vest. The Company granted stock options andstock awards to non-employees as follows: 72,832, 987 and 0 for the years endedDecember 31, 2005, 2004 and 2003, respectively. Compensation expenserelated to non-employee stock option grants and stock awards was $65,000, $0and $0 million for the years ended December 31, 2005, 2004 and 2003,respectively. The options and stock awards were valued using the Black-Scholesoption pricing model with the following weighted-average assumptions for theyear ended December 31, 2005: (a) risk free interest rate of 3.8%;(b) dividend yield of 0%; (c) expected volatility of 70%; and(d) expected life of five years.

 

As required under SFAS No. 123, the pro forma effects of stock-basedcompensation on net loss were estimated at the date of grant using the minimum-valuemethod for all grants made through June 16, 2004, the effective date ofthe Company’s registration statement for its initial public offering, and theBlack-Scholes method thereafter. The Company completed its initial publicoffering on June 21, 2004, and accordingly began using the Black-Scholesvaluation model in accordance with SFAS No. 123. The minimum-value methodand the Black-Scholes valuation model were developed for use in estimating thefair value of publicly traded options that have no vesting restrictions and arefully transferable. Because the Company’s employee and director stock optionshave characteristics significantly different from those of publicly traded options,and because changes in the subjective input assumptions can materially affectthe fair value estimate, in management’s opinion, these existing models do notnecessarily provide a reliable single measure of the fair value of the Company’semployee and director stock options. The fair value of options issued toemployees were estimated at the date of grant using the Black-Scholes optionvaluation model or the minimum-value method, as described above, with thefollowing weighted average assumptions for the years ended December 31,2005, 2004 and 2003: (a) risk-free interest rates of 4.2%, 3.5% and 3.1%;(b) expected dividend yield of 0% for all periods; (c) volatilityfactor of 70% for all periods; and (d) five-year estimated life of theoptions for all periods. The estimated weighted average fair value of stockoptions granted during 2005 and 2004 was $2.38, $6.32 and $9.34 respectively.

 

F-9

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For purposes of pro forma disclosures, the estimated fair value of theoptions is amortized to expense over the vesting period of such stock options.The Company’s pro forma information is as follows:

 
| ** **                                                                            | ** ** | **Years Ended December 31,**                           | ** ** |
|---------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|
| ** **                                                                            | ** ** | **2005**                                                              | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                                                            | ** ** | **(in thousands, except per share amounts)** | ** ** |
| Net loss applicable to common stockholders  as reported                               |       | $                                                                     | (23,580    | ) | $ | (14,972 | ) | $ | (34,329 | ) |
| Add: Stock-based employee compensation  expense included in reported net loss         |       | 1,695                                                                 |       | 1,633 |   | 504 |   |
| Deduct: Stock-based employee compensation  expense determined under fair value method |       | (2,459                                                                | )          | (1,802 | ) | (537 | ) |
| Pro forma net loss applicable to common  stockholders                                 |       | $                                                                     | (24,344    | ) | $ | (15,141 | ) | $ | (34,362 | ) |
| Basic and diluted net loss per share as  reported                                     |       | $                                                                     | (1.20      | ) | $ | (1.49 | ) | $ | (23.84 | ) |
| Pro forma basic and diluted net loss per  share                                       |       | $                                                                     | (1.24      | ) | $ | (1.51 | ) | $ | (23.86 | ) |

 

*Net Loss Per Share*

 

The Company calculated net loss per share in accordance with SFASNo. 128, *Earnings Per Share*.Basic earnings per share (“EPS”) is calculated by dividing the net loss by theweighted average number of common shares outstanding for the period, withoutconsideration for common stock equivalents. Diluted EPS is computed by dividingthe net loss by the weighted average number of common share equivalentsoutstanding for the period determined using the treasury-stock method. Forpurposes of this calculation, common stock subject to repurchase by theCompany, options, and warrants are considered to be common stock equivalentsand are only included in the calculation of diluted earnings per share whentheir effect is dilutive.

 

The actual net loss per share amounts for the years endedDecember 31, 2005 and 2004 were computed based on the shares of commonstock outstanding during these years. The number of common shares outstandingfor the year ended December 31, 2004 includes 11.0 million shares of theCompany’s common stock issued upon conversion of the Company’s preferred stockin conjunction with the initial public offering. As a result of the conversion,there is a lack of comparability in the basic and diluted net loss per shareamounts between the year ended December 31, 2003 and subsequent periodspresented. In order to provide a more relevant measure of operating results,the following unaudited pro forma net loss per share calculation has beenincluded. The shares used to compute unaudited pro forma basic and diluted netloss per share represent the weighted average common shares outstanding for theperiod, reduced by the weighted average unvested common shares subject torepurchase, and including the assumed conversion of all outstanding shares ofpreferred stock into shares of common stock using the as-if converted method asof the beginning of each year presented or the date of issuance, if later.

 

F-10

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| ** **                                                                                                   | ** ** | **Years Ended December 31,**                           | ** ** |
|--------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|
| ** **                                                                                                   | ** ** | **2005**                                                              | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                                                                                   | ** ** | **(in thousands, except per share amounts)** | ** ** |
| **Actual:**                                                                                                  |       |                                                                  |       |   |   |   |   |
| *Numerator:*                                                                                                 |       |                                                                  |       |   |   |   |   |
| Net loss                                                                                                     |       | $                                                                     | (23,580    | ) | $ | (14,972 | ) | $ | (9,429 | ) |
| Deemed dividend-beneficial conversion  feature for Series E preferred stock                                  |       | —                                                                |       | — |   | (24,900 | ) |
| Net loss applicable to common stockholders                                                                   |       | $                                                                     | (23,580    | ) | $ | (14,972 | ) | $ | (34,329 | ) |
| *Denominator:*                                                                                               |       |                                                                  |       |   |   |   |   |
| Weighted average common shares                                                                               |       | 19,981                                                                |       | 10,452 |   | 1,731 |   |
| Weighted average unvested common shares  subject to repurchase                                               |       | (275                                                                  | )          | (418 | ) | (291 | ) |
| Denominator for basic and diluted net loss  per share                                                        |       | 19,706                                                                |       | 10,034 |   | 1,440 |   |
| Basic and diluted net loss per share                                                                         |       | $                                                                     | (1.20      | ) | $ | (1.49 | ) | $ | (23.84 | ) |
| **Pro forma:**                                                                                               |       |                                                                  |       |   |   |   |   |
| *Numerator:*                                                                                                 |       |                                                                  |       |   |   |   |   |
| Pro forma net loss                                                                                           |       | $                                                                     | (23,580    | ) | $ | (14,972 | ) | $ | (34,329 | ) |
| *Denominator:*                                                                                               |       |                                                                  |       |   |   |   |   |
| Shares used above                                                                                            |       | 19,706                                                                |       | 10,034 |   | 1,440 |   |
| Pro forma adjustments to reflect assumed  weighted average effect of conversion of preferred stock           |       | —                                                                |       | 5,220 |   | 7,747 |   |
| Pro forma shares used to compute basic net  loss per share                                                   |       | 19,706                                                                |       | 15,254 |   | 9,187 |   |
| Pro forma basic and diluted net loss per  share                                                              |       | $                                                                     | (1.20      | ) | $ | (0.98 | ) | $ | (3.74 | ) |
| **Historical outstanding antidilutive  securities not included in diluted net loss per share calculation*:** |       |                                                                  |       |   |   |   |   |
| Preferred stock                                                                                              |       | —                                                                |       | — |   | 63,632 |   |
| Common stock subject to repurchase                                                                           |       | 207                                                                   |       | 459 |   | 437 |   |
| Options to purchase common stock                                                                             |       | 1,406                                                                 |       | 1,108 |   | 951 |   |
| Warrants                                                                                                     |       | 3,797                                                                 |       | 1,347 |   | 8,016 |   |
|                                                                                                         |       | 5,410                                                                 |       | 2,914 |   | 73,036 |   |

----

*              Representsthe historical amount of the securities and not the common stock equivalent numberof shares.

 

*Recent Accounting Pronouncements*

 

In December 2004, the Financial Accounting Standards Board (“FASB”)issued SFAS No. 123R, *Share BasedPayment*. This statement is a revision to SFAS No. 123 andsupersedes APB 25 and amends FASB Statement No. 95, *Statement of Cash Flows*. This statementrequires a public entity to expense the cost of employee services received inexchange for an award of equity instruments. This statement also providesguidance on valuing and expensing these awards, as well as disclosurerequirements of these equity arrangements. This statement is effective for theCompany in the first quarter of 2006.

 

SFAS No. 123R permits public companies to choose between thefollowing two adoption methods:

 

1.             A“modified prospective” method in which compensation cost is recognizedbeginning with the effective date (a) based on the requirements of SFASNo. 123R for all share-based payments granted after the effective date and(b) based on the requirements of SFAS No. 123 for all awards granted toemployees prior to the effective date of SFAS No. 123R that remainunvested on the effective date, or

 

2.             A“modified retrospective” method which includes the requirements of the modifiedprospective method described above, but also permits entities to restate basedon the amounts previously recognized under SFAS No. 123 for purposes ofpro forma disclosures either (a) all prior periods presented or(b) prior interim periods of the year of adoption.

 

As permitted by SFAS No. 123, the Company currently accounts forshare-based payments to employees using APB 25’s intrinsic value method and, assuch, the Company generally recognizes no compensation cost for employee stockoptions.

 

F-11

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The impact of the adoption of SFAS No. 123R cannot be predicted atthis time because it will depend on levels of share-based payments granted inthe future. However, valuation of employee stock options under SFAS No. 123Ris similar to SFAS No. 123, with minor exceptions. The impact on theresults of operations and earnings per share had the Company adopted SFAS No. 123,is described in stock based compensation section of Note 1 above.Accordingly, the adoption of SFAS No. 123R’s fair value method will have asignificant impact on the Company’s results of operations, although it willhave no impact on the Company’s overall financial position. SFAS No. 123Ralso requires the benefits of tax deductions in excess of recognizedcompensation cost to be reported as a financing cash flow, rather than as anoperating cash flow as required under current literature. This requirement willreduce net operating cash flows and increase net financing cash flows inperiods after adoption.

 

InMarch 2004, the EITF reached a final consensus on Issue 03-1, *The Meaning of Other-Than-Temporary Impairment andIts Application to Certain Investments*. EITF Issue No. 03-1requires that when the fair value of an investment security is less than itscarrying value, an impairment exists for which the determination must be madeas to whether the impairment is other-than-temporary. The EITF IssueNo. 03-1 impairment model applies to all investment securities accountedfor under SFAS No. 115, *Accounting forCertain Investments in Debt and Equity Securities* and to investmentsecurities accounted for under the cost method to the extent an impairmentindicator exists. Under the guidance, the determination of whether animpairment is other-than-temporary and therefore would result in a recognizedloss depends on market conditions and management’s intent and ability to holdthe securities with unrealized losses. In September 2004, the FASBapproved FASB Staff Position (“FSP”) EITF 03-1-1, which defers the effectivedate for recognition and measurement guidance contained in EITF IssueNo. 03-1 until certain issues are resolved. In November 2005, theFASB issued FSP FAS 115-1. FSP FAS 115-1 replaces the impairment evaluationguidance of EITF Issue No. 03-1 with references to the existingother-than-temporary impairment guidance. EITF 03-1’s disclosure requirementsremain in effect. The FSP also supersedes EITF Topic No. D-44, *Recognition of Other-Than-Temporary Impairment uponthe Planned Sale of a Security Whose Cost Exceeds Fair Value*,” andclarifies that an investor should recognize an impairment loss no later thanwhen the impairment is deemed other-than-temporary, even if a decision to sellan impaired security has not been made. The guidance in this FSP will beapplied in the Company’s first quarter of 2006. The Company does not expect theadoption of EITF Issue No. 03-1 or FSP FAS 115-1 to have a material effecton its liquidity, results of operations and financial condition.

 

**2.****             SecuritiesAvailable-For-Sale**

 

Securities available-for-sale consists of the following (in thousands):

 
| ** **                | ** ** | **December 31, 2005** | ** ** |
|---------------------------|------------|---------------------------------|------------|
| ** **                | ** ** | **Amortized  Cost**             | ** ** | **Gross  Unrealized  Gains** | ** ** | **Gross  Unrealized  Losses** | ** ** | **Estimated  Fair  Value** | ** ** |
| Corporate debt securities |       | $                               | 27,845     |   | $ | — |   | $ | (49 | ) | $ | 27,796 |   |
| Asset-backed securities   |       | 6,505                           |       | — |   | (5 | ) | 6,500 |   |
| Total                     |       | $                               | 34,350     |   | $ | — |   | $ | (54 | ) | $ | 34,296 |   |

 
| ** **                | ** ** | **December 31, 2004** | ** ** |
|---------------------------|------------|---------------------------------|------------|
| ** **                | ** ** | **Amortized  Cost**             | ** ** | **Gross  Unrealized  Gains** | ** ** | **Gross  Unrealized  Losses** | ** ** | **Estimated  Fair  Value** | ** ** |
| Corporate debt securities |       | $                               | 32,988     |   | $ | — |   | $ | (54 | ) | $ | 32,934 |   |
| Total                     |       | $                               | 32,988     |   | $ | — |   | $ | (54 | ) | $ | 32,934 |   |

 

Gross realized gains and losses on available-for-sale securities wereimmaterial during the years ended December 31, 2005 and 2004. All of theavailable-for-sale securities have a contractual maturity at December 31, 2005of one year or less.

 

F-12

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**3.****             Propertyand Equipment**

 

Property and equipment consisted of the following (in thousands):

 
| ** **                                       | ** ** | **December 31,** | ** ** |
|--------------------------------------------------|------------|-----------------------|------------|
| ** **                                       | ** ** | **2005**              | ** ** | **2004** | ** ** |
| Laboratory equipment                             |       | $                     | 7,561      |   | $ | 6,420 |   |
| Computers and electronics                        |       | 2,322                 |       | 2,200 |   |
| Office furniture and fixtures                    |       | 987                   |       | 643 |   |
| Leasehold improvements                           |       | 943                   |       | 145 |   |
| Construction in progress                         |       | 456                   |       | 66 |   |
|                                             |       | 12,269                |       | 9,474 |   |
| Less: accumulated depreciation and  amortization |       | (7,605                | )          | (7,120 | ) |
|                                             |       | $                     | 4,664      |   | $ | 2,354 |   |

 

Depreciation and amortization expenses, which include assets held undercapital leases, were $910,000, $699,000 and $564,000 for the years endedDecember 31, 2005, 2004 and 2003, respectively. Assets held under capitalleases totaled approximately $4.5 million and $4.0 million at December 31,2005 and 2004, respectively. The related accumulated amortization was approximately$2.4 million and $2.0 million at December 31, 2005 and 2004,respectively.

 

**4.****             AccruedLiabilities**

 

Accrued liabilities consisted of the following (in thousands):

 
| ** **                    | ** ** | **December 31,** | ** ** |
|-------------------------------|------------|-----------------------|------------|
| ** **                    | ** ** | **2005**              | ** ** | **2004** | ** ** |
| Accrued employee benefits     |       | $                     | 1,207      |   | $ | 1,077 |   |
| Bonus accrual                 |       | 700                   |       | 654 |   |
| Accrued development expenses  |       | 1,008                 |       | 610 |   |
| Accrued legal and patent fees |       | 613                   |       | 286 |   |
| Other accrued liabilities     |       | 864                   |       | 208 |   |
|                          |       | $                     | 4,392      |   | $ | 2,835 |   |

 

**5.****             CollaborativeResearch and Development Agreements**

 

*Valeant*

 

In October 2001, the Company entered into a development andlicense agreement with Valeant Pharmaceuticals International (“Valeant”) forthe development and commercialization of pradefovir for the treatment ofhepatitis type B. Under the agreement, Valeant was granted exclusive worldwiderights to develop and commercialize pradefovir. Valeant is solely responsiblefor conducting and funding all development work. The Company will continue toreceive certain payments upon Valeant’s achievement of specified development,regulatory and commercial milestones and to receive royalties on any productsales that result from the collaboration. As of December 31, 2005, theCompany had achieved developmental milestones triggering a total of$2.0 million in payments from Valeant. The first milestone was earned inApril 2003 and the second milestone was earned in July 2004. If alldevelopment, regulatory and commercial milestones are achieved, and includingthe $2.0 million license fee received to date under the agreement, theCompany may be entitled to payments which total up to $20.0 million, plusroyalties.

 

*Daiichi Sankyo*

 

The Company has a research, development and commercialization agreementwith Daiichi Sankyo Company, Ltd., (“Daiichi Sankyo”) to develop novel FBPaseinhibitors for the treatment of diabetes.  The research period ended in April 2002.  Daiichi Sankyo isresponsible for funding any clinical development compounds or compoundsselected for development under the agreement. The Company will receivecertain payments upon the achievement of specified milestones under thedevelopment portion of the collaboration. As of December 31, 2005, the Companyhad achieved three developmental milestones triggering a total of $6.5 millionin payments, including $3.5 millionreceived in 2004 from Daiichi

 

F-13

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Sankyo.  In 2003, theCompany recognized $7.6 million related to an option fee as license revenue as DaiichiSankyo chose not to exercise an option with the Company to negotiate a newagreement for next generation compounds to treat diabetes and therefore,because there were no future performance obligations of the Company, theCompany recognized the remaining unamortized option fee.  Under theDaiichi Sankyo collaboration agreement, the Company has recognized $0, $3.5million and $7.6 million in revenues for the years ended December 31, 2005,2004 and 2003, respectively.   If all clinical and regulatory milestonesare achieved, and including the $36.0 million in license fees, sponsoredresearch payments and an equity investment received to date under theagreement, the Company may be entitled to payments which total up to$54.5 million.

 

Assuming a compound is successfully developed and commercialized, theCompany would receive royalties on net sales. Daiichi Sankyo will haveexclusive, worldwide commercialization rights to those products selected fordevelopment and subsequently licensed. The Company would also have co-promotionrights in North America to any commercialized product, on terms to benegotiated.

 

*Merck*

 

In December 2003, the Company entered into a collaborationagreement with Merck to discover new treatments for hepatitis C. Under thiscollaboration, the Company is creating liver-targeting prodrugs of certaincompounds that Merck is supplying to us. These compounds target the hepatitis Cvirus residing in the liver. The research term of the collaboration wasinitially for one year and in January 2005, was extended for an additionalyear through December 2005. At the same time, the scope of the technologythat the Company applies to the Merck compounds was expanded. As part of thiscollaboration, Merck paid an upfront fee of $500,000 which was recognized asrevenue over the initial one-year term of the agreement and paid researchsupport total of $2.7 million during 2004 and 2005. Revenue recognizedunder the agreement was $1.4 million, $1.8 million and $0 for the years endedDecember 31, 2005, December 31, 2004 and December 31, 2003, respectively. Merckis also obligated to pay pre-clinical and clinical milestone payments ifspecified development and regulatory events occur and royalties on sales ofproducts resulting from the collaboration. If all pre-clinical and clinicalmilestones are achieved, and including the $500,000 upfront fee, the $2.7 millionin research support and an additional exclusive option, the Company may beentitled to payments which total up to $93.3 million, plus royalties. Merckis solely responsible for conducting and funding all development work forcompounds resulting from the collaboration and for commercializing anyresulting products.

 

**In June 2005, the Company entered into a secondcollaboration agreement with Merck to research, develop and commercializenovel small molecule therapeutics with the potential to treat several metabolicdiseases including type 2 diabetes, hyperlipidemia and obesity by activating anenzyme in the liver called AMP-activated Protein Kinase. As part of thiscollaboration, Merck paid an initial non-refundable license fee of $5.0 millionin July 2005 and will provide research support funding of a minimum of$2.1 million each year during the three year research term. The three yearresearch term is subject to renewal for one additional year by mutual agreementof the Company and Merck. The Company’s level of research activities, and theminimum research support funding, may be increased during the term upon mutualagreement of both parties. Merck is also obligated to pay milestone payments ifspecified pre-clinical and clinical development and regulatory events occur andto pay royalties on sales of any product resulting from this collaboration. Asof December 31, 2005, the Company has not achieved any developmentalmilestones and thus, no payments have been received for milestones fromMerck.  The Company would also have the option to co-promote any suchproduct in the United States.  If all pre-clinical and clinical milestonesare achieved on multiple indications, and including the $5.0 million initial,non-refundable license fee and the minimum $6.3 million in research supportfunding, the Company may be entitled to payments which total up to $74.3million, plus royalties.  Merck is solely responsible for conducting andfunding all development work for compounds resulting from thiscollaboration.  Under the agreement, the Company recognized revenue of $1.9million for the year ended December 31, 2005. The Company has deferred revenueof $ 4.7 million under the agreement as of December 31, 2005.**

** **

**6.****             Commitments**

 

The Company leases its office and research facilities and certainlaboratory and electronic equipment under operating and capital leaseagreements. In December 2004, the Company entered into an operating leaseagreement pursuant to which the Company leased approximately 82,000 square feetof real estate space in La Jolla, California consisting of laboratory andoffice space. The lease commenced in October 2005 and has an initial term of10 years unless extended or sooner terminated. The Company has options toextend the lease for two renewal periods of five years each. The Company’saggregate lease payments through 2015 will be $27.8 million. The facilitylease provides for various forms of rent abatement during the first 48 monthsof the lease and annual rent increases of 3.0%. The difference between thestraight-line expense over the term of the lease and actual

 

F-14

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amounts paid are recorded as deferred rent. Prior to October 2005, theCompany leased its office and research facilities under a different operatinglease.

 

Rent expense was approximately $1.4 million, $1.3 million and$1.3 million for each of the years ended December 31, 2005, 2004 and2003.

 

In connection with the facility lease which commenced in October 2005,the Company agreed to a $300,000 loan for tenant improvements. The term of theloan corresponds to the initial 10 year term of the lease. The interest rate is8.0% per annum.

 

In 2001, the Company entered into a $650,000 equipment loan agreementwith a financing company. This agreement was subsequently amended two times toincrease the loan amount to approximately $2.1 million. The proceeds wereused to finance laboratory equipment, computer and electronic equipment, tenantimprovements and furniture. The Company made drawdowns of approximately$1.7 million before the amended equipment loan agreement ended onDecember 31, 2002. The equipment loan was collateralized by the relatedequipment acquired with the loan. Each drawdown had a payment term of48 months with the interest rate being fixed at the funding date of eachdrawdown (9.58% to 12.05%).

 

In conjunction with the initial equipment loan and first amendment,warrants to purchase up to 53,938 shares of Series C Convertible PreferredStock (“Series C Preferred”) at $1.25 per share were issued, of which45,000 shares are exercisable at any time through June 16, 2007. Theremaining warrant to purchase 8,938 shares of Series C Preferred isexercisable at any time through December 31, 2007. The cash exercise ofthese warrants would result in the issuance of 8,877 shares of the Company’scommon stock.

 

In conjunction with the second amendment to the initial equipment loan,the Company issued warrants to purchase 30,666 shares of Series DConvertible Preferred Stock (“Series D Preferred”). The warrants have anexercise price of $1.50 per share and are exercisable at any time throughJune 16, 2007. The cash exercise of these warrants would result in theissuance of 5,290 shares of the Company’s common stock.

 

The warrants issued by the Company in connection with the equipmentloan and related amendments were accounted for under APB 14, *Accounting for Convertible Debt and Debt Issued withStock Purchase Warrants* and EITF Issue No. 96-18, which requires thewarrants to be recorded at their fair value. The fair value of the warrants wasaccounted for under SFAS No. 123 using the Black Scholes Valuation Model.The warrants were valued at $59,000 using the following assumptions: risk-freeinterest rates of 4.59% to 4.97%, respectively; dividend yield of 0%; expectedvolatility of 70%; and a term of 1.7 to 5 years. The fair market value wasrecorded as a discount on the equipment loan and is being amortized to interestexpense over the term of the equipment loan. The unamortized discount was$1,000 and $9,000 at December 31, 2005 and 2004, respectively.

 

In August 2003, the Company entered into an additional$1.4 million equipment loan agreement with a different financing company.This agreement was subsequently amended to increase the amount to$5.8 million. The proceeds are used to finance lab equipment, computer andelectronic equipment and furniture. The loan is collateralized by the relatedequipment acquired with the loan. As of December 31, 2005, the Company haddrawn down approximately $3.5 million under the equipment loan agreement. Eachdrawdown had a payment term of 48 months with the interest rate beingfixed at the funding date of each drawdown (8.62% to 10.40%). No warrants wereissued in connection with the equipment loan agreement.

 

F-15

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Future minimum rental payments under capitaland operating leases as of December 31, 2005, are as follows (inthousands):

 
| ** **                                                           | ** ** | **Capital  Leases** | ** ** | **Operating  Leases** | ** ** |
|----------------------------------------------------------------------|------------|---------------------|------------|-----------------------|------------|
| 2006                                                                 |       | $                   | 1,310      |                  | $          | 1,554 |   |
| 2007                                                                 |       | 1,054               |       | 1,760                 |       |
| 2008                                                                 |       | 713                 |       | 2,305                 |       |
| 2009                                                                 |       | 406                 |       | 2,781                 |       |
| 2010                                                                 |       | 49                  |       | 3,087                 |       |
| Thereafter                                                           |       | 211                 |       | 16,272                |       |
| Total minimum lease payments, excluding  discount                    |       | 3,743               |       | $                     | 27,759     |   |
| Less amount representing interest                                    |       | (575                | )          |                  |       |
| Present value of net minimum payments                                |       | 3,168               |       |                  |       |
| Less current portion, excluding discount of  $1                      |       | (1,042              | )          |                  |       |
| Long-term obligation under capital leases,  excluding discount of $1 |       | $                   | 2,126      |                  |       |   |

 

**7.****             Stockholders’Equity**

 

*Common Stock*

 

In October 2005, theCompany raised approximately $41.3 million in a private placement of commonstock and the concurrent issuance of warrants for the purchase of common stock.Placement fees and other expenses were approximately $2.3 million. Under theterms of the financing, the Company sold 7.0 million shares of common stock at$5.86 per share, the closing bid price for the Company’s common stockimmediately preceding the entering into of the binding agreement for thetransaction.

 

On June 21, 2004, the Company completedan initial closing of its initial public offering in which it sold5.0 million shares of common stock for proceeds of $30.6 million, netof underwriting discounts and commissions and offering expenses. In addition,on July 20, 2004, the Company completed an additional closing of itsinitial public offering in which it sold an additional 75,000 shares of commonstock pursuant to the exercise by the underwriters of an over-allotment optionwhich resulted in proceeds of $0.5 million, net of underwriting discountsand commissions.

 

*Convertible Preferred Stock*

 

Effective immediately prior to the initial closing of the Company’sinitial public offering, shares of outstanding subordinated and Series A,C, D and E convertible preferred stock then outstanding were automaticallyconverted into 11.0 million shares of common stock.

 

*Series E Preferred Stock Deemed Dividend*

 

The Series E Preferred financing, which closed inOctober 2003, involved the sale of preferred stock at a price per sharebelow the initial public offering price contemplated in the Company’s 2004initial public filing. Accordingly, pursuant to EITF 98-5, *Accounting for Convertible Securities with BeneficialConversion Features*, the Company in 2003 recorded a deemed dividendon the Series E Preferred of $24.9 million, which was the differencebetween the gross proceeds from the Series E Preferred offering and theunderlying value of the conversion shares (adjusted for a conversion priceadjustment feature and limited to the proceeds allocated to the convertibleinstrument). The $24.9 million deemed dividend was entirely recognized asan adjustment to net loss applicable to common stockholders since the preferredstock was convertible, at any time, at the option of the holder. In accordancewith EITF 00-27, *Application of IssueNo. 98-5 to Certain Convertible Instruments*, the Companycalculated the deemed dividend of $24.9 million using the most favorableconversion price of $3.12 per conversion share.

 

*Warrants*

 

In conjunction with the October 2005 private placement offering, the Company issued warrants to purchaseapproximately 2.5 million shares of its common stock at an exercise price of$6.74 per share. At the closing of the private placement offering, investors inthe financing paid an additional price equal to $0.125 per each share issuableupon exercise

 

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of the warrants whichcan be exercised until September 30, 2010.

 

In conjunction with the Series C Preferred offering, the Companysold warrants to the Series C investors to purchase 4.5 millionshares of Series C Preferred at a purchase price of $0.01 per warrantresulting in proceeds of approximately $45,000. The stock purchase warrants havean exercise price of $1.00 per share and shall terminate December 31,2007. The cash exercise of these warrants would result in the issuance of735,670 shares of the Company’s common stock

 

In conjunction with the Series D Preferred offering, the Companysold warrants to the Series D investors to purchase 3.5 millionshares of Series D Preferred at a purchase price of $0.01 per warrantresulting in proceeds of approximately $35,000. The stock purchase warrantshave an exercise price of $1.50 per share and can be exercised until theearlier of October 18, 2008, or after the Company’s common stock trades ona securities exchange or the Nasdaq National Market and the average closingprice of such common stock over any consecutive 20-trading day period equals orexceeds $27.34 (adjusted to reflect subsequent stock dividends, stock splits orrecapitalizations). The cash exercise of these warrants would result in theissuance of 597,339 shares of the Company’s common stock.

 

Additional warrants were issued in connection with the issuance of theequipment loans (see Note 6).

 

None of the above issued warrants had been exercised throughDecember 31, 2005.

 

*Equity Incentive Plan*

 

On June 21, 2004, the Company authorized 2,213,995 shares of itscommon stock for issuance upon exercise of options or restricted stock grantedunder the 2001 Equity Incentive Plan (the “Plan”). On January 1, 2005,approximately 619,000 shares were added to the plan pursuant to an “evergreen”provision contained in the Plan. The Plan provides for the grant of stockoptions and restricted stock to officers, directors, and employees of, andconsultants and advisors to, the Company. Options under the Plan may bedesignated as incentive stock options or nonstatutory stock options, generallyvest over four years and expire ten years from the date of grant. In addition,incentive stock options may not be granted at prices less than 100% of the fairvalue on the date of grant. The number of vested options available for exerciseas of December 31, 2005 and 2004 were approximately 580,000 and 374,000,respectively.

 

*Directors’ Stock Option Plan*

 

On June 21, 2004, the Company authorized 300,000 shares of itscommon stock for issuance upon exercise of options or restricted stock grantedunder the 2004 Non-Employee Directors’ Stock Option Plan (the “Directors’ Plan”).On January 1, 2005, 100,000 shares were added to the plan pursuant to an “evergreen”provision contained in the Directors’ Plan. The Directors’ Plan provides forthe grant of stock options and restricted stock to directors of the Company.Options under the Directors’ Plan are designated as nonstatutory stock options,generally vest from one to two years, and expire ten years from the date ofgrant. In addition, options granted under the Directors’ Plan may not begranted at prices less than 100% of the fair value on the date of grant. Thenumber of vested options available for exercise as of December 31, 2005 and2004 were approximately 109,000 and 23,000, respectively.

 

The weighted-average remaining contractual life of the optionsoutstanding under both plans at December 31, 2005 was approximately 8.1.The estimated weighted average fair value of stock options granted during 2005,2004 and 2003 was $2.38, $6.32 and $9.84, respectively.

 

At December 31, 2005, a total of approximately 1,407,000 shares ofcommon stock remained available for issuance under both plans.

 

F-17

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The following is a further breakdown of theoptions outstanding as of December 31, 2005 (in thousands, except pershare data):

 
| ** **                               | ** ** | ** **                  | ** ** | **Options Outstanding**                        | ** ** | **Options Vested and  Exercisable** | ** ** |
|------------------------------------------|------------|-----------------------------|------------|-----------------------------------------------------|------------|-----------------------------------------------|------------|
| **Ranges of  Exercise Prices** | ** ** | **Number of  Options** | ** ** | **Weighted  Average  Remaining  Contractual  Life** | ** ** | **Weighted  Average  Exercise  Price**        | ** ** | **Number  of  Options** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
| $0.00 to $0.91                           |       | 30                          |       | 4.0                                                 |       | $                                             | 0.30       |   | 30 |   | $ | 0.30 |   |
| $0.91 to $1.82                           |       | 702                         |       | 7.5                                                 |       | 1.44                                          |       | 452 |   | 1.43 |   |
| $1.82 to $2.73                           |       | 146                         |       | 9.4                                                 |       | 2.65                                          |       | 61 |   | 2.65 |   |
| $2.73 to $3.64                           |       | 80                          |       | 6.8                                                 |       | 3.01                                          |       | 29 |   | 3.04 |   |
| $3.64 to $4.56                           |       | 11                          |       | 9.6                                                 |       | 4.00                                          |       | — |   | — |   |
| $5.46 to $6.38                           |       | 206                         |       | 9.2                                                 |       | 5.63                                          |       | 36 |   | 5.57 |   |
| $6.38 to $7.29                           |       | 159                         |       | 8.7                                                 |       | 6.70                                          |       | 81 |   | 6.59 |   |
| $7.29 to $8.20                           |       | 71                          |       | 10.0                                                |       | 7.65                                          |       | — |   | — |   |
| Total                                    |       | 1,405                       |       | 8.1                                                 |       | $                                             | 3.17       |   | 689 |   | $ | 2.38 |   |

 

The following table summarizes stock option activity as follows (inthousands, except per share amounts):

 
| ** **                       | ** ** | **Shares** | ** ** | **Weighted-average  exercise price** | ** ** |
|----------------------------------|------------|------------|------------|-------------------------------------------|------------|
| Outstanding at December 31, 2002 |       | 505        |       | $                                         | 1.22       |   |
| Granted                          |       | 540        |       | $                                         | 1.46       |   |
| Exercised                        |       | (66        | )          | $                                         | 0.67       |   |
| Canceled                         |       | (28        | )          | $                                         | 1.50       |   |
| Outstanding at December 31, 2003 |       | 951        |       | $                                         | 1.39       |   |
| Granted                          |       | 445        |       | $                                         | 4.19       |   |
| Exercised                        |       | (255       | )          | $                                         | 1.24       |   |
| Canceled                         |       | (34        | )          | $                                         | 1.45       |   |
| Outstanding at December 31, 2004 |       | 1,107      |       | $                                         | 2.54       |   |
| Granted                          |       | 509        |       | $                                         | 4.39       |   |
| Exercised                        |       | (40        | )          | $                                         | 1.35       |   |
| Canceled                         |       | (171       | )          | $                                         | 3.12       |   |
| Outstanding at December 31, 2005 |       | 1,405      |       | $                                         | 3.18       |   |

 

As of December 31, 2005 and 2004, respectively, there wereapproximately 24,000 and 56,000 shares of common stock outstanding pursuant tooption exercises that were subject to repurchase by the Company.

 

*Employee Stock Purchase Plan*

 

On June 21, 2004, the Company authorized 500,000 shares of itscommon stock for issuance under the 2004 Employee Stock Purchase Plan (“ESPP”).On January 1, 2005, approximately 206,000 shares were added to the planpursuant to an “evergreen” provision contained in the ESPP. The ESPP providesfor all eligible employees to purchase shares of common stock at 85% of thelower of the fair market value on the first day of each two year offeringperiod or any purchase date during such offering period (generally held everysix months during such period). Employees may authorize the Company to withholdup to 15% of their total compensation during each six-month purchase period,subject to certain limitations to pay for the ESPP shares. During the yearended December 31, 2004, approximately 30,000 shares were issued under theplan at a purchase price of $5.95 per share. During the year ended December 31,2005, approximately 104,000 shares were issued under the plan at a purchaseprice of $2.67 per share, and approximately 572,000 shares were reserved forfuture issuance.

 

F-18

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*Shares Reserved For Future Issuance*

 

The following shares of common stock were reserved for future issuanceat December 31, 2005 (in thousands):

 
| Warrants to purchase shares in conjunction  with Series C Preferred |   | 745    |   |
|---------------------------------------------------------------------|--------|--------|--------|
| Warrants to purchase shares in conjunction  with Series D Preferred |   | 603    |   |
| Warrants to purchase shares in conjunction  with private placement  |   | 2,450  |   |
| Common stock options:                                               |   |   |   |
| Granted and outstanding                                             |   | 1,405  |   |
| Reserved for future issuance                                        |   | 1,407  |   |
| Employee stock purchase plan                                        |   | 572    |   |
|                                                                |   | 7,182  |   |

 

**8.****             IncomeTaxes**

 

Significant components of the Company’s deferred tax assets as ofDecember 31, 2005 and 2004 are shown below (in thousands). A valuationallowance of $32.9 million and $22.9 million has been established atDecember 31, 2005 and 2004, respectively, to offset the net deferred taxassets as realization is uncertain.

 
| ** **                                  | ** ** | **December 31,** | ** ** |
|---------------------------------------------|------------|-----------------------|------------|
| ** **                                  | ** ** | **2005**              | ** ** | **2004** | ** ** |
| Deferred tax assets:                        |       |                  |       |   |   |
| Net operating loss carryforwards            |       | $                     | 27,874     |   | $ | 19,087 |   |
| Research and development credits            |       | 4,601                 |       | 3,523 |   |
| Deferred revenue                            |       | —                |       | — |   |
| Other, net                                  |       | 557                   |       | 422 |   |
| Total deferred tax assets                   |       | 33,032                |       | 23,032 |   |
| Deferred tax liabilities:                   |       |                  |       |   |   |
| Deferred compensation                       |       | (97                   | )          | (174 | ) |
| Total deferred tax liabilities              |       | (97                   | )          | (174 | ) |
| Valuation allowance for deferred tax assets |       | (32,935               | )          | (22,858 | ) |
| Net deferred assets                         |       | $                     | —     |   | $ | — |   |

 

At December 31, 2005, the Company had federal and California netoperating loss carryforwards of $68.4 million and $68.7 million,respectively, which will begin to expire in 2020 and 2008, respectively, unlesspreviously utilized. The Company also had federal and state research anddevelopment tax credit carryforwards of approximately $2.8 million and $2.6 millionrespectively. The federal research and development tax credit carryforwardswill begin expiring in 2020 unless previously utilized and the state credits donot expire.

 

Pursuant to Section 382 of the Internal Revenue Code, use of theCompany’s net operating loss and credit carryforwards may be limited sincecumulative changes in ownership of more than 50% have occurred.

 

**9.****             RelatedParty**

 

In June 1999, the Company entered into an agreement with Sicorcalled the Master Agreement under which, among other things, the Company agreedto pay Sicor a 2% royalty on sales of products that would infringe on one ofthe Company’s patents, patent applications, discoveries or inventions inexistence as of the Company’s restructuring, and 10% on any royalties theCompany receives from licenses of these patents, patent applications,discoveries or inventions. The Company also agreed to pay Sicor a 1% royalty onsales of products that use, contain or are based on the Company’s tradesecrets, know-how and other proprietary rights in existence as of the Company’srestructuring that are not covered by the 2% royalty, and 5% of any royaltiesthe Company receives from licenses of these trade secrets, know-how and otherproprietary rights that are not covered by the 10% royalty. Some or all of theCompany’s current product candidates and drug compounds from our researchprograms may be subject to these royalty provisions.

 

In June 1999, the Company extended approximately $425,000 in fullrecourse promissory notes (the “Notes”) to John Beck, Mark Erion, and PaulLaikind (the “Founders”) the Founders related to the purchase of an aggregateof 1,646,248 shares of

 

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the Company’s common stock (the “Shares”). The Notes accrued interestat a rate of 5.22% per annum. The entire principal balance of the Notes,together with all accrued and unpaid interest, was due on June 30, 2003.

 

In 2003, the Board of Directors authorized a transaction, effectiveJune 30, 2003, calling for the Founders to agree to tender 487,702 sharesof their previously vested common stock and subject them to a new monthlyvesting schedule over a four-year period commencing on June 30, 2003. Thistransaction was entered into as repayment for outstanding principal and accruedinterest on the Notes of approximately $514,000 and related taxes paid on theirbehalf by the Company. The amount of shares tendered was based upon the thenfair value for the common stock as determined by the Board of Directors. TheCompany recorded approximately $711,000 of deferred compensation atJune 30, 2003, to be amortized over the four-year vesting period of theunderlying common stock. The Company has deferred compensation balancesassociated with this transaction of approximately $267,000 and $444,000 atDecember 31, 2005 and 2004, respectively. The Company recordedamortization of deferred compensation of approximately $178,000, $178,000 and$89,000 for the years ended December 31, 2005, 2004 and 2003, respectively.As of December 31, 2005, the unvested balance of shares subject torepurchase by the Company was 28,112, 74,414 and 80,368 held by Mr. Beckand Drs. Erion and Laikind, respectively.

 

**10.****            EmployeeBenefit Plan**

 

The Company established a defined contribution employee retirement plan(the “401(k) Plan”) effective January 1, 1999, conforming toSection 401(k) of the Internal Revenue Code (“IRC”). All full-timeemployees (as defined in the 401(k) Plan) may elect to have a portion of theirsalary deducted and contributed to the 401(k) Plan up to the maximum allowablelimitations of the IRC, which may be matched by the Company in an amountdetermined by the Board of Directors. No such Company matching contributionshave been approved or made since the inception of the 401(k) Plan.

 

**11.          Subsequent Event**

 

On February 3,2006, the Company filed a shelf registration statement on Form S-3 with theSecurities and Exchange Commission covering the sale of the Company’s commonstock and/or warrants to purchase shares of the Company’s common stock in oneor more offerings with a total offering price of up to $75 million from time totime in amounts, at prices and on terms to be determined at the time of theapplicable offering.

 

**12.****            Summaryof Quarterly Financial Data (Unaudited)**

 

The following is a summary of the quarterly results of operations for theyears ended December 31, 2005 and 2004 (in thousands, except for net lossper share data):

 
| ** **                                 | ** ** | **Quarters Ended** | ** ** | ** **          | ** ** |
|--------------------------------------------|------------|-------------------------|------------|---------------------|------------|
| ** **                                 | ** ** | **First  Quarter**      | ** ** | **Second  Quarter** | ** ** | **Third  Quarter** | ** ** | **Fourth  Quarter** | ** ** | **Year Ended  Dec 31 (1)** | ** ** |
| **2005**                                   |       |                    |       |                |       |   |   |   |   |   |   |
| Revenues                                   |       | $                       | 397        |                | $          | 617 |   | $ | 1,395 |   | $ | 1,362 |   | $ | 3,771 |   |
| Total operating expenses                   |       | 6,837                   |       | 6,549               |       | 6,710 |   | 8,342 |   | 28,438 |   |
| Net loss applicable to common stockholders |       | (6,235                  | )          | (5,734              | )          | (5,107 | ) | (6,504 | ) | (23,580 | ) |
| Basic and diluted net loss per share:      |       | (0.35                   | )          | (0.32               | )          | (0.28 | ) | (0.26 | ) | (1.20 | ) |
| **2004**                                   |       |                    |       |                |       |   |   |   |   |   |   |
| Revenues                                   |       | $                       | 4,170      |                | $          | 1,771 |   | $ | 470 |   | $ | 426 |   | $ | 6,837 |   |
| Total operating expenses                   |       | 4,691                   |       | 5,414               |       | 5,638 |   | 6,369 |   | 22,112 |   |
| Net loss applicable to common stockholders |       | (512                    | )          | (3,633              | )          | (5,052 | ) | (5,775 | ) | (14,972 | ) |
| Basic and diluted net loss per share:      |       | (0.37                   | )          | (1.17               | )          | (0.29 | ) | (0.32 | ) | (1.49 | ) |

 

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(1)           The sum of the fourquarters may not necessarily agree to the year total due to rounding within aquarter.

 

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