**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, DC 20549**

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**Form 10-K**

**FOR ANNUAL ANDTRANSITION REPORTSPURSUANT TO SECTIONS 13 OR 15(d)OF THE SECURITIES EXCHANGE ACT OF 1934**

(Mark One)

**x**                               ANNUAL REPORT PURSUANT TO SECTION 13OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

**For the fiscal year endedDecember 31, 2006**

**o**                                  TRANSITION REPORT PURSUANT TOSECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

**For the transition periodfrom           to           **

**Commission file number: 000-50785**

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**METABASIS THERAPEUTICS, INC.**(Exact name ofregistrant 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)**

**Securitiesregistered pursuant to Section 12(b) of the Act:**

| **Title of Each Class**    |   | **Name of Each Exchange on Which Registered** |
|-------------------------------------------|--------|-----------------------------------------------------------------------------|
| Common Stock, par  value $0.001 per share |   | The Nasdaq Stock  Market                                                    |

 

**Securities registeredpursuant to Section 12(g) of the Act:**

**None**

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Indicate by check markwhether the registrant is a well-known seasoned issuer, as defined in Rule 405of the Securities Act. Yes o   No x

Indicate by check mark ifthe registrant is not required to file reports pursuant to Section 13 or Section 15(d) ofthe Act. Yes o   No x

Indicate by check markwhether the registrant: (1) has filed all reports required to be filed by Section 13or 15(d) of the Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the registrant was required tofile such reports), and (2) has been subject to such filing requirementsfor the past 90 days. Yes x   No o

Indicate by check mark ifdisclosure of delinquent filers pursuant to Item 405 of Regulation S-K isnot contained herein, and will not be contained, to the best of the registrant’sknowledge, in definitive proxy or information statements incorporated byreference in Part III of this Form 10-K or any amendment tothis Form 10-K. o

Indicate by check markwhether the registrant is a large accelerated filer, an accelerated filer, or anon-accelerated filer. See definition of “accelerated filer and largeaccelerated filer” in Rule 12b-2 of the Exchange Act (Check one):

Large accelerated filer o   Accelerated filer x   Non-acceleratedfiler o

Indicate by check markwhether the registrant is a shell company (as defined in Rule 12b-2of the Exchange Act). Yes o   No x

As of June 30, 2006,the last business day of the registrant’s most recently completed second fiscalquarter, the aggregate market value of the registrant’s common stock held bynon-affiliates of the registrant was approximately $ 84.1 million, basedon the closing price of the registrant’s common stock on the Nasdaq Stock Marketon June 30, 2006 of $7.63 per share. Shares of common stock held byexecutive officers, directors and 10% or greater stockholders of the registranthave been excluded in that such persons or entities may be deemed to beaffiliates. This determination of affiliate status is not necessarily a conclusivedetermination for other purposes.

The number of outstandingshares of the registrant’s common stock, par value $0.001 per share, as of March 1,2007 was 30,505,043.

**DOCUMENTSINCORPORATED 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, 2006 are incorporated by reference into Part IIIof this report.

 

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**METABASISTHERAPEUTICS, INC.**

**FORM 10-K—ANNUAL REPORT**

**FOR THE YEAR ENDEDDECEMBER 31, 2006**

**TABLEOF CONTENTS**

| **PART I**   |   | 3                                                                                                                  |
|-------------------|--------|--------------------------------------------------------------------------------------------------------------------|
| Item 1            |   | Business                                                                                                           |   | 3 |
| Item 1A           |   | Risk Factors                                                                                                       |   | 41 |
| Item 1B           |   | Unresolved Staff Comments                                                                                          |   | 66 |
| Item 2            |   | Properties                                                                                                         |   | 66 |
| Item 3            |   | Legal Proceedings                                                                                                  |   | 66 |
| Item 4            |   | Submission of Matters to a Vote of Security Holders                                                                |   | 66 |
| **PART II**  |   | 67                                                                                                                 |
| Item 5            |   | Market for Registrant’s Common Equity, Related  Stockholder Matters and Issuer Purchases of Equity Securities |   | 67 |
| Item  6           |   | Selected  Financial Data                                                                                           |   | 69 |
| Item 7            |   | Management’s Discussion and Analysis of Financial  Condition and Results of Operations                        |   | 70 |
| Item 7A           |   | Quantitative and Qualitative Disclosures About Market  Risk                                                        |   | 80 |
| Item 8            |   | Financial Statements and Supplementary Data                                                                        |   | 80 |
| Item 9            |   | Changes in and Disagreements With Accountants on  Accounting and Financial Disclosures                             |   | 80 |
| Item 9A           |   | Controls and Procedures                                                                                            |   | 81 |
| Item  9B          |   | Other  Information                                                                                                 |   | 83 |
| **PART III** |   | 84                                                                                                                 |
| Item 10           |   | Directors, Executive Officers and Corporate Governance                                                             |   | 84 |
| Item 11           |   | Executive Compensation                                                                                             |   | 84 |
| Item 12           |   | Security Ownership of Certain Beneficial Owners and  Management and Related Stockholder Matters                    |   | 84 |
| Item 13           |   | Certain Relationships and Related Transactions, and  Director Independence                                         |   | 84 |
| Item 14           |   | Principal Accountant Fees and Services                                                                             |   | 84 |
| **PART IV**  |   | 85                                                                                                                 |
| Item 15           |   | Exhibits and Financial Statement Schedules                                                                         |   | 85 |
| **SIGNATURES**    |   | 89                                                                                                                 |

 

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**PART I**

**Item 1.**                        Business

**Forward-LookingStatements**

This annual report on Form 10-K containsforward-looking statements that are based on our management’s beliefs andassumptions and on information currently available to our management. Forward-lookingstatements include information concerning our possible or assumed futureresults of operations, business strategies, financing plans, competitiveposition, industry environment, potential growth opportunities, the effects offuture regulation and the effects of competition. Forward-lookingstatements include all statements that are not historical facts and can beidentified by terms such as “anticipates,” “believes,” “could,” “estimates,” “expects,”“intends,” “may,” “plans,” “potential,” “predicts,” “projects,” “should,” “will,”“would” or similar expressions.

Forward-lookingstatements involve known and unknown risks, uncertainties and other factorswhich may cause our actual results, performance or achievements to bematerially different from any future results, performances or achievementsexpressed or implied by the forward-looking statements. We discuss theserisks in greater detail in the “Risk Factors” section below and in our otherfilings with the Securities and Exchange Commission. Our actual results maydiffer materially from those anticipated in these forward-lookingstatements. Readers are cautioned not to place undue reliance on forward-lookingstatements. The forward-looking statements speak only as of the date onwhich they are made, and we undertake no obligation to update such statementsto reflect events that occur or circumstances that exist after the date onwhich they are made.

**Overview**

We are a biopharmaceutical company focused on thediscovery, development and commercialization of novel drugs by applying ourproprietary technology, scientific expertise and unique capabilities fortargeting the liver and liver pathways. These diseases include metabolicdiseases such as diabetes, obesity and hyperlipidemia, among others, and liverdiseases such as hepatitis and primary liver cancer. We have established abroad and growing product pipeline of product candidates and advanced researchprograms targeting large markets with significant unmet medical needs. We havediscovered all of our product candidates internally using our proprietarytechnologies.

We currently have fiveproduct candidates in clinical trials. These five product candidates, bycategory, and in order from the most advanced in clinical trials within eachcategory, are as follows:

**Metabolic Diseases**

·       *CS-917, a product candidate for the treatmentof type 2 diabetes that is currently in a Phase 2b clinical trial*.   CS-917,which was discovered using our NuMimeticTM technology, is being developed incollaboration with Daiichi Sankyo Co., Ltd. CS-917 inhibits a metabolic pathway in the liver calledgluconeogenesis, which is responsible for the excessive production of glucoseby patients with type 2 diabetes. CS-917 has successfullycompleted a number of Phase 1 and Phase 2 clinical studies. Daiichi Sankyo iscurrently conducting a Phase 2b clinical trial of CS-917 which is fullyenrolled and is designed to evaluate the safety and tolerability of CS-917as well as its effect on blood levels of the molecule hemoglobin A1c, animportant measure of long-term glucose control in patients with type 2diabetes, after twice daily administration of CS-917 over three months. Ifsuccessful, the trial should support selection of a dose for pivotal Phase 3clinical trials which we believe Daiichi Sankyo could initiate in the secondhalf of 2007 or early 2008.

·       *MB07803, a product candidate for the treatment of type 2 diabetes thatis expected to enter Phase 2 clinical trials in the first half of 2007*.   MB07803is a second-generation gluconeogenesis inhibitor for 

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the treatment of type 2diabetes that was also discovered using our NuMimetic technology. MB07803 hascompleted four Phase 1 clinical trials in healthy volunteers, the most advancedof which was a 14-day rising multiple dose clinical trial, and isexpected to enter Phase 2 clinical trials in the second quarter of 2007. We arecurrently independently developing this product candidate.

·       *MB07811, aproduct candidate for the management of hyperlipidemia, including reduction ofelevated cholesterol levels and triglycerides, or TGs, that is currently in aPhase 1 clinical trial.*   MB07811 uses our HepDirect® prodrug technology and other structuralcharacteristics to target a beta-subtype-selective thyroid hormone receptor, orTRß, agonist to the liver to reduce cholesterol and TGs. Preclinical datasuggest that MB07811 could be as effective at lowering cholesterol as the drugclass known as “statins”, and have an additive effect in reducing cholesterolwhen used with statins. MB07811 has successfully completed a rising single dosePhase 1 clinical trial in healthy volunteers. We expect to initiate a risingmultiple dose Phase 1 clinical trial designed to evaluate the safety andtolerability of MB07811 in healthy volunteers with elevated cholesterol aftersubmitting the results of the first Phase 1 clinical trial and additional preclinicalstudies to the U.S. Food and Drug Administration, or FDA and after obtainingthe FDA’s agreement to proceed. We are currently independently developing thisproduct candidate.

**Liver Diseases**

·       *Pradefovir, a product candidate for the treatment ofhepatitis B that has completed Phase 2 clinical trials*.   Priorto January 2007 pradefovir had been developed in collaboration withValeant Pharmaceuticals International. In April 2006 Valeant announcedplans to out-license pradefovir as part of an overall restructuring of itsoperations. As a result of this restructuring plan Valeant, with our consent,assigned its development and commercial rights to pradefovir in January 2007to Schering Corporation, a subsidiary of Schering-Plough Corporation, and we entered into an amended and restatedlicense agreement for pradefovir with Schering-Plough. Pradefovir usesour HepDirect technology to target the active form of Hepsera, a marketedanti-viral drug indicated for the treatment of hepatitis B, specifically to theliver. Because pradefovir targets adefovir to the liver while limiting theamount that reaches other organs, we believe that higher liver levels of activedrug may be achieved with pradefovir without causing kidney toxicity, therebyproviding greater efficacy. Pradefovir has successfully completed a number ofPhase 1 and Phase 2 clinical trials in healthy volunteers and patients whichwere designed to evaluate safety and efficacy, as applicable. Based on theresults of the Phase 2b clinical trial and an end of Phase 2 meeting with theFDA, we believe that pradefovir is ready to commence Phase 3 clinical trials. However,the ultimate decision to proceed with Phase 3 clinical trials is theresponsibility of Schering-Plough.

·       *MB07133, a product candidate for the treatment of primary liver cancerthat has completed a Phase 1/2 clinical trial and is expected to enter a Phase2 clinical trial in 2007*.   Few treatment options exist, and nodrug has been approved, for treatment of primary liver cancer. Cytarabine, oraraC, is a marketed anti-cancer drug used to treat leukemia. AraC has shownonly limited success in solid tumors such as primary liver cancer because theliver lacks a particular protein, or kinase, necessary for converting it to animportant intermediate form known as araCMP.  MB07133 uses our HepDirect technology todeliver this intermediate form of araC to the liver where it is then readily convertedby a different liver kinase into its anti-cancer form, known as araCTP. Thisapproach bypasses the need for the first kinase which the liver lacks. Inaddition, araC, when systemically delivered is readily converted to araCTP intissues such as the bone marrow where it can cause toxicity. MB07133 appears toavoid this potential toxicity because the HepDirect prodrug version of araCMPis not converted to araCTP in tissues outside the liver. We believe the uniqueability of MB07133 to deliver araCMP selectively to the liver where it can bereadily converted into its anti-cancer form will enhance efficacy whileminimizing the toxicities associated with systemic araC 

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therapy. MB07133 hascompleted a Phase 1/2 clinical trial in 28 patients with primary liver cancerin which it was well tolerated and showed evidence of anti-tumor activity. MB07133is expected to enter Phase 2 clinical trials in 2007. We are currentlyindependently developing this product candidate.

We have expertise in liver diseases and in thepathways and proteins residing in the liver that significantly contribute tocertain metabolic diseases or that are important for transporting drugs intothe liver, acting upon them and expelling them from the body, processesreferred to as drug uptake, metabolism and excretion, respectively. With thisknowledge, we developed proprietary technologies, including two named NuMimeticand HepDirect, 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 our NuMimetic technology to discover moleculesthat bind effectively and specifically to certain regulatory sites, callednucleotide binding sites, residing on proteins called enzymes that control theoutput of cellular pathways involved in metabolic diseases, or metabolicpathways. We have developed a library of these unique molecules, known asnucleotide mimetics, and have used this library to discover compounds that webelieve will lower glucose, cholesterol or lipid levels. We used our NuMimetictechnology to discover CS-917 and MB07803, and we may also use it incertain of our internal research programs. In addition to our internal programsthat may be using the NuMimetic technology, we are using this technology in a collaborationwith Merck & Co., Inc. to discover new treatments for metabolicdiseases such as type 2 diabetes (by a different mechanism than CS-917and MB07803), hyperlipidemia and a disease associated with fatty livers, knownas non-alcoholic steatohepatitis or NASH, by inhibiting cholesterol and lipidproduction in the liver by activating a type of liver enzyme known as a proteinkinase that is called AMPK.

We use our HepDirect technology to target drugs 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 safetywhen compared to other non liver-targeting therapies. Our HepDirecttechnology can potentially be used to improve certain currently marketed drugsor applied to certain drug candidates, resulting in new, proprietary drugs thatmay then be marketed by us or by companies with which we collaborate that havecompounds that would benefit from this approach. Pradefovir, MB07133 andMB07811 use our HepDirect technology, as do some of our internal researchprograms. In addition to our internal programs, we have collaborations withMerck and Idenix Pharmaceuticals, Inc. to discover new treatments forhepatitis C by applying our HepDirect technology and other liver-targetingtechnology to compounds that they have supplied to us.

Our research programs focus on metabolic diseases suchas type 2 diabetes and hyperlipidemia as well as liver diseases such ashepatitis C. Our goal is to expand our clinical development pipeline bycontinuing to develop and move additional new drug compounds into clinicaldevelopment. We believe that a broad product pipeline will provide stronggrowth potential and reduce our reliance on the success of any single productcandidate. We may also in-license technologies and products to complement ourinternal discovery efforts. We believe our advanced research programs have thepotential to yield additional clinical development candidates. Once a drugcompound is recommended for clinical development it undergoes preclinicaldevelopment including scale up, toxicology and formulations development.Successful compounds would then enter human clinical testing.

We have severalinternal and collaborative advanced research programs that we believe have thepotential to yield additional clinical development candidates. These advancedresearch programs include:

·       asecond generation TRß agonist to reduce cholesterol and TGs for the managementof hyperlipidemia,

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·       aprogram using our HepDirect and other liver-targeting technology in acollaboration with Merck to identify drug candidates to treat hepatitis Cinfection,

·       aprogram using our HepDirect technology in a collaboration with Idenix toidentify drug candidates to treat hepatitis C infection, and

·       ametabolic disease program to identify drug candidates to treat type 2 diabetesvia a mechanism other than those used in our other type 2 diabetes programs.

Our goal is to be aleading biopharmaceutical company developing and commercializing novel drugs.We intend to accomplish this goal by executing our strategy of

·       advancingthe development of our product candidates and developing a broad productpipeline,

·       continuingto enhance our expertise in liver pathways and metabolism and our relatedintellectual property rights,

·       pursuinga diversified development and commercialization strategy for our productcandidates,

·       establishingadditional collaborations, and

·       becoming a fully-integratedpharmaceutical company.

**Disease Backgrounds**

*Metabolic Diseases*

Metabolic diseases such astype 2 diabetes, hyperlipidemia, obesity and NASH 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 in theliver, such as the pathways responsible for the production and/or metabolism ofglucose, cholesterol and fat molecules. Many drugs are currently 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. Over 60% of patients treated for type 2diabetes remain above the targeted levels for glucose set by the AmericanDiabetes Association. In addition, over 80% of patients with coronary heartdisease, which is associated with hyperlipidemia, remain above the targetedlevels for cholesterol set by the National Cholesterol Education Program. Obesepatients are also poorly treated with few drugs on the market showing suitableefficacy and safety for these patients and there currently are no approvedtreatments for NASH. As a result, we believe more effective drugs are needed totreat these diseases.

*Liver Diseases*

Liver diseases such as hepatitis B, hepatitis C andprimary liver cancer represent some of the most widespread and serious diseasesin the world. Liver diseases are generally poorly treated with current drugtherapies. Moreover, these marketed drugs generally show significantlimitations, including poor tolerability, safety risks or inadequate efficacyin the majority of patients. Some existing anti-viral and anti-cancer drugs,while effective outside of the liver, are not effective against diseases of theliver due to the liver’s inability to effectively convert them to their activeforms. The use of existing drugs for the treatment of liver diseases is furtherlimited in some cases by dose-limiting toxicities which may occur when highlevels of the drug accumulate in tissues outside the liver.

As a group, liver andmetabolic diseases represent one of the largest pharmaceutical markets withworldwide sales of drugs targeting these diseases exceeding $30 billionannually.

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**OurPipeline-Metabolic Diseases**

Thefollowing table summarizes our metabolic disease product candidates currentlyin clinical development and advanced research programs, in order from the mostadvanced in clinical development:

| **Product Candidates/Programs(1)** | ** ** | **Disease/Condition** | ** ** | **Partner**    | ** ** | **Our Commercial Rights**          | ** ** | **Status** |
|------------------------------------|------------|-----------------------|------------|----------------|------------|----------------------------------------------|------------|------------|
| CS-917                             |       | Diabetes              |       | Daiichi Sankyo |       | Royalties, North America Co-promotion Option |       | Phase 2b   |
| MB07803                            |       | Diabetes              |       | None           |       | Worldwide                                    |       | Phase 1    |
| MB07811                            |       | Hyperlipidemia        |       | None           |       | Worldwide                                    |       | Phase 1    |
| Unnamed                            |       | Hyperlipidemia        |       | None           |       | Worldwide                                    |       | Discovery  |
| Unnamed                            |       | Diabetes              |       | None           |       | Worldwide                                    |       | Discovery  |

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

**CS-917: Agluconeogenesis inhibitor for the treatment of type 2 diabetes**

CS-917is an oral product candidate for type 2 diabetes that we discovered using ourproprietary NuMimetic technology. Data generated to date indicate that CS-917inhibits a metabolic pathway in the liver called gluconeogenesis, which isresponsible for the excessive production of glucose by patients with type 2diabetes. We believe that CS-917 is the first product candidate to bestudied in human clinical trials that is designed to directly block thispathway. In preclinical studies and two completed Phase 2a clinical trials, CS-917has shown a statistically significant reduction in elevated glucose levelscompared to placebo-treated patients. CS-917 is being developed inpartnership with Daiichi Sankyo, and we retain co-promotion rights in NorthAmerica.

*Diabetes*

There are two forms ofdiabetes: type 1 (insulin-dependent; juvenile onset diabetes), and type 2(non-insulin dependent; adult onset diabetes). Approximately 90% of diabetespatients have type 2 diabetes. Elevated blood glucose levels in patients withtype 2 diabetes are the result of decreased glucose metabolism combined withincreased glucose production. Decreased glucose metabolism arises from arelative 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 seen in patients with type 2diabetes can lead to many long-term complications such as coronary heartdisease, stroke, blindness, peripheral vascular disease, kidney disease andnerve damage. Diabetes is a leading cause of death in the U.S. Type 2 diabetesafflicts over 170 million people worldwide and over 18 million peoplein the U.S.

*Current Treatments*

The United Kingdom Prospective Diabetes Study, alandmark 20-year clinical study completed in 1996, demonstrated thatstringent control of blood glucose levels reduces the risk of the seriouscomplications associated with type 2 diabetes. As a result of this study, theAmerican Diabetes Association now recommends that levels of hemoglobin A1c bemaintained under 7% in patients with type 2 diabetes. However, other thaninsulin, at the present time no single marketed drug is capable of loweringhemoglobin A1c levels into the targeted range for a sustained period of time inthe majority of patients with type 2 diabetes.

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Drugs from each ofthe three major classes of oral diabetes drugs not only exhibit limitedefficacy, but also are associated with less than desired tolerability andsignificant mechanism-based side effects. These drug classes include:

·       insulinsecretion enhancers, which lower glucose levels by inducing insulin secretionfrom the pancreas. This drug class has been associated with a significant riskof hypoglycemia,

·       insulinsensitizers, which lower glucose levels by enhancing insulin sensitivity. Thisdrug class has been associated with fluid retention, weight gain and a risk ofcongestive heart failure, and

·       hepaticglucose output inhibitors, the primary mechanism of which is to lower glucoselevels by inhibiting liver glucose production. The only drug in this class ismetformin, which, based on a study reported in the medical journal Diabetes,inhibits glucose production by the liver by only approximately 20-25%,even when administered at the maximum allowed dose. Metformin does not directlyblock the gluconeogenesis pathway as data generated to date indicate that CS-917does. Therefore, a more effective hepatic glucose output inhibitor, such as CS-917,which directly inhibits the gluconeogenesis pathway, may provide improvedefficacy compared to metformin. Metformin therapy is associated with an increasedrisk of lactic acidosis in certain patient populations, including patients withkidney dysfunction. In addition, metformin therapy commonly leads to transientgastrointestinal disturbances such as nausea, diarrhea and vomiting, which maycompromise patient compliance.

Certain widely used insulin secretion enhancers andinsulin sensitizers, but not metformin, are also associated with increasedweight gain. Since weight gain is known to impact glucose control, physiciansoften prescribe metformin as a first line therapy to obese patients, whoaccording to a recent study published in the medical journal Diabetes &Endocrinology comprise more than 90% of newly diagnosed patients with type 2diabetes. In the United Kingdom Prospective Diabetes Study, obese patientstreated with maximum doses of metformin or an insulin secretion enhancerultimately showed a steady rise in hemoglobin A1c levels above the targetedrange at three years. Progressively fewer patients were able to maintainbaseline hemoglobin A1c levels at six years and nine years, respectively.

Once treatment with asingle oral drug fails to adequately control glucose levels, patients withdiabetes typically are treated with one or more additional oral drugs. It isestimated that more than 75% of patients with type 2 diabetes will requiremultiple oral drug therapies to attain adequate glucose control and just over30% of patients with type 2 diabetes will ultimately advance to a stage thatrequires daily insulin injections. We believe that because of the limitationsin currently marketed drugs, the diabetes market is receptive to new drugs, andnew therapeutic approaches have the potential to experience rapid clinicalacceptance.

*Markets*

The U.S., Japan, France, Germany, Italy, Spain and theUnited Kingdom comprise the seven major pharmaceutical markets.  Combined sales of oral products used to treattype 2 diabetes in these markets were $12.5 billion in 2006, with the U.S.accounting for $8.4 billion of that total.  By 2020, combined sales oforal products used to treat type 2 diabetes in the seven major pharmaceuticalmarkets are expected to increase to $15.7 billion, and sales in the U.S. areexpected to increase to $9.7 billion.  

If CS-917 is approved by regulatory authorities andits safety and/or efficacy profile is determined by physicians to be betterthan, or equal to, metformin based on data from clinical trials, then CS-917may be used as first line therapy in a broad population of patients with type 2diabetes and will likely be prescribed by physicians based on the differencebetween each respective drug’s safety and/or efficacy profile as well as howindividual patients respond to each drug. In addition to this broad population, CS-917 may also be prescribed tothose patients who are intolerant to, or contraindicated for, metformin use andto those 

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patients who are not onmetformin as well as those who are not achieving their glucose lowering targetswhile taking other oral therapies, or combinations of other oraltherapies.  Market research indicatesthat by 2017 these patient populations together are projected to compriseapproximately 60% of patents with type 2 diabetes.  

If CS-917 is approved by regulatory authorities, andit is ultimately determined in further clinical trials that the use of CS-917cannot be safely combined with metformin, then CS-917 will be targeted to thosepatients who are intolerant to, or contraindicated for, metformin use and tothose patients who are not on metformin as well as those who are not achievingtheir glucose lowering targets while taking other oral therapies, orcombinations of other oral therapies. These patient populations, as indicated above, together are projected torepresent approximately 60% of patients with type 2 diabetes in 2017. 

Based on these data webelieve there is a considerable market opportunity for CS-917 regardless ofwhether CS-917 is determined by physicians to have a superior or equivalent safetyand/or efficacy profile compared to metformin or if it is ultimately determinedin further clinical trials that the use of CS-917 cannot be safely combinedwith metformin.

*CS-917*

Studies show that the elevated blood glucose levelsthat characterize patients with type 2 diabetes are correlated with theoverproduction of glucose by the liver, which arises from an increased rate offlow, or flux, through the gluconeogenesis pathway. We believe that CS-917is the first product candidate to be studied in human clinical trials that isdesigned to directly block the gluconeogenesis pathway by inhibiting FBPase. Webelieve that FBPase represents an important control point within this pathwayand a suitable target for inhibiting the overproduction of glucose found inpatients with type 2 diabetes. Pharmaceutical companies have tried to findinhibitors of FBPase, but have, to our knowledge, thus far failed to discovercompounds of sufficient potency and specificity to be considered as productcandidates. Using our NuMimetic technology, we have identified molecules thateffectively bind to the nucleotide-binding site on FBPase and potentlyand specifically inhibit FBPase activity in animal models.

We believe that CS-917may be effective across a broad patient population because glucoseoverproduction by the liver is common to all patients with type 2 diabetesregardless of disease stage or body mass. Unlike insulin sensitizers andcertain insulin secretion enhancers, CS-917 does not cause weight gain inanimals and is therefore expected to be appropriate for effective treatment ofobese patients with type 2 diabetes. Studies also show that CS-917 iseffective in animal models of lean diabetes and that glucose lowering occursindependent of insulin levels. Taken together, these characteristics may makeCS-917 useful:

·       inpatients with advanced type 2 diabetes, a patient population commonly resistantto therapies dependent on insulin production such as insulin sensitizers andinsulin secretion enhancers,

·       inearly stage diabetes, and

·       inpatients with prediabetes in which CS-917 may be effective in preventingor delaying the onset of diabetes.

We expect that the initialdevelopment and marketing focus for CS-917 will be on patients that areunable to tolerate the current first line therapy, metformin. The currentalternative for these patients, which constitute as much as 15% of the totalpatient population with type 2 diabetes, is treatment with drugs such asinsulin secretion enhancers, insulin sensitizers or more recently,  a new class of diabetes drugs known as incretinmimetics which include dipeptidyl peptidase IV or DPP-IV inhibitors, and BYETTA® (exenatide) injection. However, these drugsare less efficacious than metformin and in the case of insulin secretionenhancers and sensitizers, they cause weight gain. Based on early data webelieve that CS-917 has the potential to be more effective than thesecurrent second line agents and be the first 

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alternativetherapy for this important and underserved patient population. Moreover, asphysicians and patients gain more experience with CS-917, we believe itcould be used as a first line therapy in newly diagnosed type 2 patients, incombination with additional oral therapies other than metformin and as analternative for patients who have failed on other oral therapies prior toswitching to insulin or in combination with insulin in these patients. In fact,many diabetic patients will eventually fail on oral therapies.

*Clinical Trials*

To date, our partner Daiichi Sankyo has completed anumber of Phase 1 clinical trials of CS-917 in healthy volunteers as wellas Phase 1 and Phase 2a clinical trials of CS-917 in patients with type 2diabetes.

Results from two Phase 2a clinical trials, the firstof which was completed in 2003, provide evidence that CS-917 is capableof significantly lowering blood glucose levels in humans. The first Phase 2aclinical trial completed involved treatment of 39 patients with type 2 diabeteswith CS-917 or a placebo once daily for 14 days using a randomized,placebo-controlled, double-blind clinical trial design. The patients were dividedinto groups that received 50, 100, 200 or 400 milligrams of CS-917 or aplacebo. Patients were dosed in the morning following a ten-hour overnight fastand then fasted an additional six hours. The efficacy endpoint of the clinicaltrial was a comparison of cumulative glucose levels over the six-hour fastingperiod following administration on day 14 relative to baseline levels (whichare cumulative glucose levels determined for the same period prior to clinicaltrial initiation) in patients treated with CS-917, as compared to thechange from baseline levels in patients treated with a placebo. CS-917appeared to be safe and well tolerated, and the primary efficacy endpoint ofthe clinical trial, demonstration of a statistically significant reduction inthese cumulative 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-valueof less than or equal to 0.05 is generally considered to signify astatistically significant result, which means a result is unlikely to occur bychance. Furthermore, the reduction in glucose levels seen on day 14 compared tobaseline levels was greater in all groups treated with CS-917 than thatseen in the placebo-treated groups.

In the second Phase 2a clinical trial, completed in2004, 146 patients with type 2 diabetes were treated with CS-917 or aplacebo administered two or three times per day for 28 days using arandomized, placebo-controlled, double-blind clinical trial design. The primaryefficacy endpoint of the clinical trial was the change from baseline in theplasma glucose level measured after an overnight fast, often called the fastingplasma glucose level, on the morning of day 29 following the last dose on theevening of day 28, as compared to the change measured in the patients thatreceived a placebo over the same time period. In each case, the group ofpatients who received CS-917 showed a statistically significant reductionin fasting plasma glucose levels compared to the corresponding dose group thatreceived a placebo, as determined by a p-value of less than 0.05.

In March 2005 we were notified by Daiichi Sankyothat two serious adverse events involving lactic acidosis had occurred in twopatients in a Phase 1 clinical trial evaluating the interaction of CS-917with metformin. The serious adverse events were resolved after medicalintervention. After the adverse events occurred, the three clinical trials thatwere ongoing at the time were stopped while one Phase 1 clinical trial whichdid not combine CS-917 with metformin continued and was completed. Afterextensive analysis Daiichi Sankyo concluded that the lactic acidosis observedin the two patients was likely due to significantly increased blood levels ofmetformin. The reason for the increase in metformin blood levels observed inthese two patients has not been determined to date. At high blood levels,metformin is believed to cause a form of cellular toxicity known asmitochondrial toxicity which can cause lactic acidosis. Subsequently, DaiichiSankyo, in consultation with the FDA, decided that clinical trials of CS-917could safely resume as a mono-therapy or in combination with otheranti-diabetes agents other than metformin.

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In January 2006 Daiichi Sankyo initiated amulti-center, randomized, double-blind, placebo-controlled Phase 2b clinicaltrial designed to evaluate safety and tolerability after three months dosing ofCS-917, as well as its effect on blood levels of hemoglobin A1c. In February 2007we announced that full enrollment of a total of 392 patients at approximately100 sites had been achieved. Patients were evenly distributed among four groupsconsisting of two active dose groups of CS-917, an active comparator andplacebo. If successful, this Phase 2b clinical trial could support selection ofa dose for Phase 3 clinical trials which we believe Daiichi Sankyo couldinitiate in the second half of 2007 or early 2008.

The results of clinicaltrials to date indicate that CS-917 may need to be administered more thanonce daily although this has not been definitively proven.

*Preclinical Studies*

Results from clinical trials of CS-917 areconsistent with the glucose-lowering effect observed in preclinical studies weconducted with Daiichi Sankyo in several animal models of diabetes. Studies inrats showed that daily oral administration of CS-917 lowered bloodglucose when dosed chronically, or over an extended period of time. Moreover,maximum glucose lowering in these studies was better than or equal to theglucose lowering effects of insulin sensitizers and insulin secretion enhancers.Moreover, CS-917 lowered glucose both in the fed state (at meal time) aswell as in the fasted state (between meals). CS-917 also lowered glucosein both obese and lean diabetes animal models. Like metformin, but unlike theinsulin sensitizers and certain insulin secretion enhancers, CS-917induced no weight gain in treated animals relative to untreated animals.

Preclinical studies in diabetes animal models havealso indicated that the combination of maximally effective doses of an insulinsensitizer with an FBPase inhibitor may result in greater efficacy than eitherdrug alone. In addition, preclinical studies may support the use of CS-917in patients with advanced diabetes. 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 to CS-917,indicating glucose-lowering effects in both advanced stage and early stageanimal models of the disease.

In addition, DaiichiSankyo has shown that chronic dosing of CS-917 decreases the insulin doserequired to maintain a target glucose level in a mouse model of diabetes. Basedon these studies and other preclinical data, including glucose-lowering effectsin non-human primates and oral bioavailability data and toxicology results fromstudies in both rats and non-human primates, Daiichi Sankyo moved CS-917into clinical trials in July 2001.

**MB07803: Asecond-generation gluconeogenesis inhibitor for the treatment of type 2diabetes**

MB07803 is an oral productcandidate for the treatment of type 2 diabetes that, like CS-917, wasdiscovered using our NuMimetic technology and is designed to inhibitgluconeogenesis. While MB07803 is structurally different from CS-917 andmay offer certain pharmacological advantages, both product candidates aredesigned to inhibit gluconeogenesis by targeting the same binding site on theFBPase enzyme. MB07803 is targeting the same market as CS-917 and isexpected to have advantages over current therapies that are similar to thoseexpected for CS-917. The preliminary efficacy results demonstrated by CS-917in the Phase 2 clinical trials improve our confidence in the potential forMB07803 as an approach for treating diabetes. We are currently independentlydeveloping this product candidate.

*Markets*

Combined sales of oral products used to treat type 2diabetes in the seven major pharmaceutical markets were $12.5 billion in 2006,with the U.S. accounting for $8.4 billion of that total.  By 2020, 

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combined sales of oralproducts used to treat type 2 diabetes in the seven major pharmaceuticalmarkets are expected to increase to $15.7 billion, and sales in the U.S. areexpected to increase to $9.7 billion.  

If MB07803 is approved by regulatory authorities andits safety and/or efficacy profile is determined by physicians to be better than,or equal to, metformin based on data from clinical trials, then MB07803 may beused as first line therapy in a broad population of patients with type 2diabetes and will likely be prescribed by physicians based on the differencebetween each respective drug’s safety and/or efficacy profile as well as howindividual patients respond to each drug. In addition to this broad population, MB07803 may also be prescribed tothose patients who are intolerant to, or contraindicated for, metformin use andto those patients who are not on metformin as well as those who are notachieving their glucose lowering targets while taking other oral therapies, orcombinations of other oral therapies. Market research indicates that by 2017 these patient populations togetherare projected to comprise approximately 60% of patents with type 2diabetes.  

If MB07803 is approved by regulatory authorities, andit is ultimately determined in further clinical trials that the use of MB07803cannot be safely combined with metformin, then MB07803 will be targeted tothose patients who are intolerant to, or contraindicated for, metformin use andto those patients who are not on metformin as well as those who are notachieving their glucose lowering targets while taking other oral therapies, orcombinations of other oral therapies. These patient populations, as indicated above, together are projected torepresent approximately 60% of patients with type 2 diabetes in 2017. 

Based on these data webelieve there is a considerable market opportunity for MB07803 regardless ofwhether MB07803 is determined by physicians to have a superior or equivalent safetyand/or efficacy profile compared to metformin or if it is ultimately determinedin further clinical trials that the use of MB07803 cannot be safely combinedwith metformin.

*Clinical Trials*

We have completed fourPhase 1 clinical trials in healthy volunteers, the most advanced of which was a14-day, rising multiple dose clinical trial. The results from thesecompleted clinical trials indicated that MB07803 was safe and well toleratedand support the advancement of MB07803 into Phase 2 clinical trials. We expectMB07803 to commence Phase 2 clinical trials in the second quarter of 2007.

**MB07811:**A liver-targeted thyroidreceptor agonist for the management of hyperlipidemia, including elevatedcholesterol and low-density lipoprotein cholesterol, or cholesterol, and TGs

MB07811 is the outgrowthof our efforts to find ways to control the expression of certain genes in theliver that are important for making or using cholesterol as well as genesinvolved in the control of energy expenditure. MB07811 uses our proprietary HepDirect prodrug technology andother structural characteristics to target aTRß agonist to the liver to lower cholesterol and TGs. We are currently independently developingthis product candidate.

*Hyperlipidemia*

Hyperlipidemiais a disease characterized by an elevation of lipids, such as cholesterol ortriglycerides, in the bloodstream. Elevation of cholesterol and/ortriglycerides in the bloodstream can speed up a process called atherosclerosis,or hardening of the arteries through the formation of plaque deposits on theartery walls. As more plaque builds up, the arteries can narrow and stiffen.Eventually, enough plaque may build up to reduce blood flow through thearteries leading to a greater risk of cardiovascular disease and heart attackor stroke.Cardiovascular disease isthe leading cause of death worldwide, and in the U.S. alone claims more livesthan cancer, chronic respiratory diseases, accidents and diabetes combined.

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*Current Treatments*

If MB07811 isultimately determined safe and effective and approved for marketing, it wouldcompete with products marketed by several large pharmaceutical companies thatcurrently comprise a large share of the hyperlipidemia market. Major classes ofhyperlipidemia drugs include, but are not limited to:

·       statins—reduceserum cholesterol levels by inhibiting a key enzyme involved in thebiosynthesis of cholesterol,

·       fibrates—reducethe amount of cholesterol and triglycerides (fatty substances) in blood,

·       nicotinicacid derivatives—lower cholesterol, triglycerides and low density lipoproteinsand increase high density lipoproteins,

·       cholesterolabsorption inhibitors or CAIs—inhibit the absorption of dietary and biliarycholesterol,

·       bileacid sequestrants—bind with cholesterol-containing bile acids in the intestinesand remove them in bowel movements, and

·       statincombination therapies—combine statins with members of the above-mentioned classes.

Lipitor® (atorvastatin; a statin marketed by PfizerInc.) is currently the best selling prescription medicine for the treatment ofhyperlipidemia.Several largepharmaceutical companies are also developing novel therapies that targethyperlipidemia.

While many drug classesare currently available for treating hyperlipidemia either alone or incombination with other drugs, many patients are not achieving optimalcholesterol lowering and are not meeting their cholesterol lowering targetswith current therapies. We believe that because of the limitations of currentlymarketed drugs, the hyperlipidemia market is receptive to new drugs, and newtherapeutic approaches have the potential to experience rapid clinicalacceptance. For example, the results from the Lipid Treatment AssessmentProject or L-TAP, a large, multi-center study, showed that of the 4,888patients with evaluable data, only 38% achieved their cholesterol target goalsas defined by National Cholesterol Education Program guidelines on lipid-loweringdrugs. One reason patients with hyperlipidemia fail to reach their cholesterollowering goals may be inadequate titration, or gradual escalation, of the doseof statins that they are prescribed due to the increased potential of adverseevents at higher doses and because doubling of the statin dose only provides asmall incremental (6%) reduction in cholesterol. For patients with highcholesterol who do not respond well to statins, their options are limited tochanging to another statin and/or using a statin in combination therapy with anon-statin, lipid-lowering agent. If MB07811 is ultimately determined to besafe and effective and approved for marketing, it may be capable of reducingcholesterol in combination with statins to a level that exceeds the cholesterollowering potential of statins alone. In addition, while statins are generallyconsidered to be first line agents for the majority of patients withhyperlipidemia, approximately 5% of patients with hyperlipidemia, orapproximately 5.5 million patients in the U.S., are intolerant to statins. Forthese statin-intolerant patients, MB07811 may be considered as an alternativefirst line therapy.

*Markets*

Combined sales of products used to treathyperlipidemia in the seven major pharmaceutical markets were $24.6 billion in2004, with the U.S. accounting for $17.1 billion of that total.  By 2014combined sales in the seven major pharmaceutical markets are expected toincrease to $25.1 billion and sales in the U.S. are expected to decline to $15.1billion.  The relatively modest growth in sales in the combined sevenmajor markets, and the decline in U.S. sales over this period, are mainly dueto the projected impact of the loss of exclusivity of the major statins,including the market leader Lipitor (atorvastatin), during this period.  However, the number of patients diagnosedwith hyperlipidemia is expected to increase from 301 million worldwide in 2004to 327 million in 2014.  In the U.S., thenumber of patients diagnosed with 

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hyperlipidemia is expectedto increase from 109 million in 2004 to 124 million in 2014.  In addition, MB07811, if approved, willlikely constitute the first in an entirely new class of anti-hyperlipidemicagents which may help patients better reach targeted cholesterol levels eitheras first line therapy or in combination with statins.  Therefore MB07811, if approved, may not besubject to competitive pressure from the introduction of generic statins duringthis period.  

MB07811, if approved byregulatory authorities, will likely be initially targeted to patients who areeither intolerant to statins, or for use in combination with statins for thesignificant portion of patients who fail to meet their targeted cholesterolreduction goals with statins.  Both of these categories representsignificant populations of patients with hyperlipidemia and therefore webelieve there is a considerable market opportunity for MB07811.

*MB07811*

MB07811 uses our HepDirectprodrug technology and other structural characteristics to target a TRß agonistto the liver to reduce cholesterol and TGs. Thyroid hormone receptor agonistsare known to reduce cholesterol in animal models, but typically at dosessimilar to those associated with potential safety concerns, including cardiacand other non-hepatic toxicities. MB07811 is an internally discovered HepDirectprodrug of a novel TRßreceptor agonist that is designed to deliver the agonist to the site wherecholesterol is produced and metabolized, i.e. the liver, while reducing theexposure of the agonist to other tissues. We believe that liver-targeting mayavoid the safety concerns previously seen with non-liver targeted TRß agonists and thus unlock thetherapeutic potential of this approach. Preclinical data suggest thatMB07811 could be as effective at lowering cholesterol as statins and have anadditive effect in reducing cholesterol when used with statins.

*Clinical Trials*

MB07811 has successfullycompleted a rising single dose Phase 1 clinical trial in healthy volunteers. Weexpect to initiate a rising multiple dose Phase 1 clinical trial designed toevaluate the safety and tolerability of MB07811 in healthy volunteers withelevated cholesterol after submitting the results of the first Phase 1 clinicaltrial and additional preclinical studies to the FDA and after obtaining the FDA’sagreement to proceed.

*Preclinical Studies*

We have discovered a series of compounds that exhibithigh liver specificity in animals, and data indicate that these compounds canlower cholesterol in animals without causing the toxicities which have beenassociated with previously discovered compounds in the same class. The mostadvanced compound from this series, MB07811, was recommended for clinicaldevelopment in 2005. Data generated in numerous preclinical models across sixspecies indicate that MB07811 may be able to effectively lower serumcholesterol with an acceptable therapeutic index. Data from tests in a primatemodel indicate that MB07811 may lower serum cholesterol as effectively as themost widely prescribed statin, Lipitor (atorvastatin) (see Chart A below) andis additive with Lipitor (labeled “AT” in Chart B below).

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

 

**Advanced ResearchPrograms—Metabolic Diseases**

We are expanding our product pipeline by using ourproprietary technologies, our knowledge of liver diseases, and our expertise inpathways and proteins residing in the liver that significantly contribute tometabolic diseases. We have additional expertise in processes in the liver thatare important for drug uptake, metabolism and excretion, all of which areimportant for targeting drugs to the liver with high specificity. We have usedthis knowledge 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 computationalmethods useful for predicting drug binding effectiveness and specificity. Thesemethods have aided our design and discovery of novel nucleotide mimetics. Ourgoal is to expand our clinical development pipeline by continuing to developand move additional new drug compounds into clinical development. We believeour advanced research programs have the potential to yield additional clinicaldevelopment candidates.

Our metabolic diseaserelated advanced research programs are:

*A second generation TRß agonist program to identifydrug candidates to reduce cholesterol and TGs for the management ofhyperlipidemia.*

We have an advancedresearch program to identify second-generation TRß agonists to reducecholesterol and TGs for the management of hyperlipidemia. This program mayyield additional development candidates that lower cholesterol and TGs by thesame mechanism as MB07811 but with potential improvements.

*A metabolic disease program to identify drugcandidates to treat type 2 diabetes via a mechanism other than those used inour other type 2 diabetes programs*

We have an advancedresearch program to identify drug candidates to treat type 2 diabetes via amechanism other than those used in our other type 2 diabetes programs.  This program may yield additional developmentcandidates to further expand our product pipeline.

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**Our Pipeline—LiverDiseases**

Thefollowing table summarizes our product candidates for the treatment of liverdiseases that are currently in clinical development and our advanced researchprograms for the treatment of liver diseases, in order from the most advancedin clinical development:

| **Product Candidates/Programs(1)** | ** ** | **Disease/Condition** | ** ** | **Partner**     | ** ** | **Our Commercial Rights** | ** ** | **Status**           |
|------------------------------------|------------|-----------------------|------------|-----------------|------------|---------------------------|------------|----------------------|
| Pradefovir                         |       | Hepatitis B           |       | Schering-Plough |       | Royalties                 |       | Phase 2b completed   |
| MB07133                            |       | Primary Liver  Cancer |       | None            |       | Worldwide                 |       | Phase 1/2  completed |
| Unnamed(2)                         |       | Hepatitis C           |       | Merck           |       | Royalties                 |       | Discovery            |
| Unnamed(3)                         |       | Hepatitis C           |       | Idenix          |       | Royalties                 |       | Discovery            |

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(1)          None of our productcandidates have received regulatory approval in the U.S. or in foreigncountries.

(2)          We are collaboratingwith Merck to apply our HepDirect and other liver-targeting technologies tocertain compounds for the treatment of hepatitis C infection.

(3)          Weare collaborating with Idenix to apply our HepDirect technology to certaincompounds for the treatment of hepatitis C infection.

**Pradefovir: A HepDirectprodrug of adefovir for the treatment of hepatitis B**

Pradefovir is an oralproduct candidate that has successfully completed Phase 2 clinical trials toevaluate its potential to treat hepatitis B, a serious liver infection.Although several marketed drugs target hepatitis B, the disease remains poorlytreated. One currently marketed hepatitis B drug is Hepsera, anon-liver-specific prodrug of the antiviral compound adefovir. A prodrug is adrug to which a chemical modification has been made that renders it inactiveuntil enzymes in the body convert it to its active form. Hepsera offersadvantages 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, while limitingthe amount of adefovir generated outside of the liver, thereby potentiallysignificantly reducing dose-related toxicities. In preclinical 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. Prior to January 2007 pradefovir had beendeveloped in collaboration with Valeant. In April 2006 Valeantannounced plans to out-license pradefovir as part of an overall restructuringof its operations. As a result of this restructuring plan Valeant, with ourconsent, assigned its development and commercial rights to pradefovir in January 2007to Schering Plough, and we entered intoan amended and restated license agreement for pradefovir with Schering-Plough. Basedon the results of the Phase 2b clinical trial and an end of Phase 2 meetingwith the FDA, we believe that pradefovir is ready to commence Phase 3 clinicaltrials. However, the ultimate decision to proceed with Phase 3 clinical trialsis the responsibility of Schering-Plough.

*Hepatitis B*

Hepatitis B is a viral disease that causesinflammation of the liver. Hepatitis B is transmitted by contact with the bloodor other body fluids of an infected person. Hepatitis B infection is oftendifficult to diagnose because, depending upon the severity of the infection,patients may either be asymptomatic or experience only general flu-likesymptoms such as fatigue, nausea or vomiting. Without appropriate 

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treatment, continuedinflammation of the liver leads to progressive scarring, or fibrosis, andeventually may lead to liver cancer, resulting in death.

Hepatitis B is the most common serious liver infectionin the world. Over two billion people worldwide, or approximately one-third ofthe world’s population, have been infected at some time with hepatitis B, andapproximately 400 million of those people are chronic carriers of thevirus. Approximately 1.2 million deaths per year worldwide are hepatitisB-related. The Centers for Disease Control and Prevention reports that, in theU.S., over 1.2 million people are chronically infected with hepatitis Band nearly 80,000 new infections occur every year.

There is also anopportunity for substantial additional growth from potential sales ofanti-viral drugs for hepatitis B in emerging markets including Eastern Europeand Asia. These regions have some of the highest rates of chronic hepatitis Binfection in the world. There are currently over 300 million people withchronic hepatitis B infection in these emerging markets, representing greaterthan 75% of the total chronic infections worldwide.

*Current Treatments*

In the U.S., there are five approved treatments forchronic hepatitis B: Intron A, Epivir-HBV, also referred to as Zeffix(lamivudine), Hepsera, BaracludeTM (entecavir) and TYZEKATM (telbivudine). Eachof these therapies has limitations in the treatment of patients with hepatitisB. For example, Intron A is generally poorly tolerated. Patients takingEpivir-HBV or Zeffix can develop significant resistance to lamivudine, the drug’sactive ingredient. We believe that induction of viral resistance is also asignificant issue for certain hepatitis B product candidates that are currentlyin late stage clinical development. Hepsera, on the other hand, shows limitedpropensity to induce virus mutations that are resistant to drug therapy and hasproven effective against lamivudine-resistant strains of hepatitis B.However, potential kidney toxicities limit the level at which Hepsera can bedosed. To date, for the relatively short time that it has been on the market,Baraclude has not been shown to induce significant viral resistance indrug-naïve patients. However, based on clinical data, lamivudine-resistantpatients respond less effectively to Baraclude therapy and exhibit a higherrate of viral resistance. TYZEKA has not been on the market long enough for aclear profile to emerge. However, based on clinical data it appears to have thepotential for inducing significant viral resistance over time.

Hepsera, lamivudine,Baraclude and TYZEKA all decrease virus levels, as measured by hepatitis B DNAin the blood serum. Nevertheless, further decreases are desirable since thesereductions are not sufficient to cure the infection in the majority ofpatients. In 2003, the *New England Journal ofMedicine* reported that a three-fold higher dose of Hepsera led to amore than ten-fold greater reduction in hepatitis B DNA in the blood serumand consistent trends toward improvement in all measures of liver injury.However, this higher dose caused elevation in markers of kidney toxicity thatprevented further development at that dose. As a result, we believe that theapproved dose of Hepsera (10 mg.) may be suboptimal for the reduction of viruslevels in patients with hepatitis B.

*Markets*

In the seven majorpharmaceutical markets combined sales of oral hepatitis B anti-viral productswere $486 million in 2005, with the U.S. accounting for $197 million of thattotal.  By 2015, combined sales in the seven major pharmaceutical marketsare expected to increase to $1.7 billion and sales in the U.S. are expected toincrease to $415 million.  In addition to the seven major pharmaceuticalmarkets, considerable potential exists in the growing Chinese pharmaceuticalmarket, as there are more patients with hepatitis B in China than all othermarkets combined.  Based on the resultsof clinical trials to date we believe that pradefovir has the potential tobecome a best-in-class product that is used as first-line treatment in themajority of patients.  Pradefovir, ifapproved by regulatory authorities, may also be targeted as a second 

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linetherapy in patients for whom treatment with other approved agents has failed.Therefore, we believe that there is a considerable worldwide market opportunityfor pradefovir.

*Pradefovir*

Pradefovir and Hepsera areboth prodrugs of  9 -[2(Phosphonomethoxy) ethyl] adenine (PMEA), or adefovir. When the prodrug isconverted to adefovir in patients with hepatitis B, it acts in the liver and leadsto decreased viral levels. Pradefovir is a HepDirect prodrug that after oraladministration is absorbed rapidly after which it is taken up by the liver andconverted to the active form, adefovir. Hepsera, on the other hand, isconverted to adefovir throughout the bloodstream. As a result of thisdifference in distribution, higher dosing of pradefovir is possible due to thereduced systemic and renal adefovir levels, providing potentially improvedefficacy relative to Hepsera in the treatment of hepatitis B, based on resultsof a Phase 2 clinical trial, which is further discussed in the clinical trialssection below.

*Clinical Trials*

Prior to assigning its rights to Schering-Plough,Valeant completed two single-dose Phase 1 clinical trials of pradefovir in 47healthy volunteers. Pradefovir was safe and well tolerated at all dose levelsstudied. These clinical trials evaluated the pharmacokinetic profile ofpradefovir, indicating that pradefovir appeared to be converted to its desiredform, adefovir, in humans.

Pradefovir was also studied in two 28-day,randomized, placebo-controlled, double-blind, dose-escalation Phase 1 clinicaltrials designed to evaluate safety and preliminary efficacy in 80 hepatitis Bpatients in the U.S. and Taiwan. The hepatitis B patients in the 28-dayU.S. Phase 1 clinical trial were divided into groups that received 5, 10, 30 or60 milligrams of pradefovir or a placebo administered orally once a day. Thepatients in the 28-day Taiwanese Phase 1 clinical trial were divided intogroups that received 5, 10, 20 or 30 milligrams of pradefovir or a placeboadministered orally once a day. In each of the dose groups evaluated,pradefovir was safe and well tolerated, and patients treated with pradefovirexhibited a statistically significant reduction, as determined by a p-value ofless than 0.05, in hepatitis B virus levels compared to patients treated with aplacebo. The reduction in median hepatitis B virus levels, which was determinedby measuring viral DNA, and the overall distribution of adefovir throughout thebody were consistent with results expected for our HepDirect technology basedon preclinical studies.

Based on these initial results, in July 2004Valeant commenced a 12-month dose-ranging Phase 2 clinical trial ofpradefovir the purpose of which was to select appropriate doses for Phase 3clinical trials. The Phase 2 clinicaltrial conducted by Valeant was an open-label, randomized, multiple doseclinical trial with 242 patients enrolled at 21 sites in the United States,Taiwan, Singapore and South Korea. Approximately half of the patients had beenpreviously treated ineffectively with other drugs. Patients that have beenpreviously treated ineffectively are considered to be more difficult to treat.The Phase 2 clinical trial consisted of five treatment groups: pradefovir—5,10, 20 and 30 mg administered once a day (called QD administration), andHepsera—10 mg (QD), with an overall treatment duration of 48 weeks.

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The data from the Phase 2clinical trial showed that the patient group that received 30 mg (QD)pradefovir achieved a 5.54 log (10) drop in hepatitis B viral (HBV) DNA, ameasure of viral load, from baseline as compared to a 4.19 log (10) dropin the 10 mg (QD) Hepsera (adefovir dipivoxil) group (p<0.001). Pradefovirat doses of 10 and 20 mg (QD) also showed a statistically significant greaterreduction in viral load compared to Hepsera. The following chart illustratesthese results:

**Pradefovir Phase 2—Week 48 Results (all patients)**

**Mean Log(10) HBV DNA Decline From Baseline**

**(Intent-to-TreatAnalysis)**

| ** ** | ** ** | ** ** | ** ** | ** **         | ** ** | **Baseline Mean** | ** ** | **Week 48**      | ** ** | **p-Value**          | ** ** |
|------------|------------|------------|------------|--------------------|------------|------------------------|------------|-----------------------|------------|----------------------|------------|
| ** ** | ** ** | ** ** | ** ** | ** **         | ** ** | **HBV DNA**       | ** ** | **Mean Decline** | ** ** | **Compared to** | ** ** |
| ** ** | ** ** | ** ** | ** ** | **Number of** | ** ** | **(Log (10)**     | ** ** | **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 percentages 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.

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.

In January 2007,Valeant with our consent assigned its development and commercial rights topradefovir to Schering-Plough and we entered into an amended and restatedlicense agreement for pradefovir with Schering-Plough. Based on the results ofthe Phase 2b clinical trial and an end of Phase 2 meeting with the FDA, webelieve that pradefovir is ready to commence Phase 3 clinical trials. However,the ultimate decision to proceed with Phase 3 clinical trials is theresponsibility of Schering-Plough.

*Preclinical Studies*

Together with Valeant, we conducted preclinicalstudies of pradefovir in rats, mice and monkeys. These studies showed thatanimals treated with an oral dose of pradefovir exhibited higher levels ofadefovir and its biologically active form, adefovir diphosphate, in the liverand lower levels of adefovir and adefovir diphosphate in tissues outside of theliver, including the kidney and gastrointestinal tract, relative to animalstreated with a similar dose of Hepsera.

The improvement in liver to kidney distributionresulting from treatment with pradefovir in comparison to Hepsera was alsodemonstrated in a study in rats using whole body autoradiography, a process inwhich a radioactive marker was included with the drugs when administered andthe radioactivity of the rats was later analyzed to determine the distributionof adefovir and related metabolites in their bodies. At various times afterdosing, rats treated with pradefovir exhibited high levels of adefovir andrelated metabolites in the liver relative to the kidney, whereas rats dosedwith a similar amount of Hepsera showed high levels of adefovir and relatedmetabolites in the kidney relative to the liver.

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We believe that pradefovirachieves higher liver levels of adefovir and related metabolites relative toHepsera because pradefovir more readily distributes into the liver where it isspecifically converted to adefovir which is then converted to adefovir diphosphate.Moreover, unlike Hepsera, pradefovir is not readily converted to adefovir inthe blood, intestine and kidney. Since kidney exposure to adefovir isimplicated in kidney toxicity, decreased kidney exposure may result in a saferdrug. This expectation was supported by six and nine-month toxicology studiesin rats and monkeys, which showed pradefovir to have a significantly bettersafety profile than Hepsera, based on findings showing that pradefovir’shighest non-toxic dose was approximately 15 -fold higher than the non-toxicdose for Hepsera in each species.

**MB07133: AHepDirect prodrug of araC for the treatment of primary liver cancer**

MB07133 is a productcandidate that is expected to be administered intravenously and continuouslyover a multiple-day period on an out-patient basis. MB07133 has completed aPhase 1/2 clinical trial designed to evaluate safety and preliminary efficacyin a limited number of patients with primary liver cancer. Few treatmentoptions exist, and no drug has been approved for treatment of primary livercancer. Cytarabine, or araC, is amarketed anti-cancer drug used to treat leukemia. AraC has shown only limitedsuccess in solid tumors such as primary liver cancer because the liver lacks aparticular protein, or kinase, necessary for converting it to an importantintermediate form known as araCMP.  MB07133 uses our HepDirect technology todeliver this intermediate form of araC to the liver where it is then readilyconverted by a different liver kinase into its anti-cancer form, known asaraCTP. This approach bypasses the need for the first kinase which the liverlacks. In addition, araC, when systemically delivered is readily converted toaraCTP in tissues such as the bone marrow where it can cause toxicity. MB07133appears to avoid this potential toxicity because the HepDirect prodrug versionof araCMP is not converted to araCTP in tissues outside the liver. We believethe unique ability of MB07133 to deliver araCMP selectively to the liver whereit can be readily converted into its anti-cancer form will enhance efficacywhile minimizing the toxicities associated with systemic araC therapy. Weare currently independently developing this product candidate.

*Primary LiverCancer*

Primary liver cancer is a malignancy originating in theliver that often kills patients within six months after diagnosis with lessthan 10% of patients surviving for five years or more. Metastatic liver cancer,on the other hand, originates in other organs and then progresses to the liver.In the U.S., the American Cancer Society reports that primary liver cancer isthe ninth leading cause of cancer mortality in men and is the twelfth leadingcause of cancer mortality in women. The American Cancer Society estimates thatapproximately 19,000 new cases of primary liver cancer will be diagnosed in theU.S in 2007. Primary liver cancer is responsible for over 500,000 deaths peryear worldwide.

While the definitive cause of primary liver cancer isunknown, it is well-recognized that patients with chronic liver diseases suchas hepatitis B, hepatitis C, alcoholic cirrhosis and iron overload are at highrisk for developing liver cancer over a 30-year period. In the U.S.,Europe and Japan, hepatitis C is considered to be one of the leading riskfactors associated with primary liver cancer. The incidence of primary livercancer in these countries is expected to increase over the next 10 to15 years due to the large number of people previously infected withhepatitis C whose disease has or will advance to liver cirrhosis. In the U.S.alone, the National Institutes of Health projects a four-fold increase overthis period in patients with chronic hepatitis C.

We believe that given thecurrent and projected primary liver cancer incidence levels, and the cost ofsimilar cancer therapeutics, an approved drug for primary liver cancer couldpresent a substantial worldwide commercial opportunity.

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*Current Treatments*

Treatment methods for patients with primary livercancer are typically determined by the stage of the disease at diagnosis.Patients are generally classified as eligible for surgical tumor resection,inoperable and non-terminal, or terminal. According to the American CancerSociety, on average, over a ten-year period, over 16% of patients have beentreated by surgical tumor resection. Additionally, over 50% of patients areinoperable and non-terminal and 26% of patients are terminal. Patients whoundergo successful tumor resection have a future life expectancy of about fiveyears, whereas all other patients have an average life expectancy of less thanone year. Treatment for inoperable and non-terminal patients is dependent onmany factors. Liver transplantation represents the only method that can curethe disease, but few transplants are possible due to the severe shortage inliver donors and the high cost.

Other alternatives involvenon-surgical therapies that use either radioactive microscopic beads (such asTheraSpheres) or chemotherapy (known as Transcatheter ArterialChemoembolization (TACE))injected through a catheter directly into the liver. Other treatments includeregional tumor destruction and chemotherapy with unapproved agents that haveshown limited efficacy. Nexavar® (sorafenib), a chemotherapy approved for thetreatment of kidney cancer, is being evaluated for the treatment of primaryliver cancer. The drug’s developer, Bayer Healthcare Pharmaceuticals, recentlyannounced that an ongoing Phase 3 clinical trial of Nexavar for the treatmentof primary liver cancer was stopped early because the trial met its primaryendpoint resulting in superior overall survival in those patients receivingNexavar tablets versus those patients receiving placebo. Therefore it is likelythat Nexavar will be approved for the treatment of patients with primary livercancer and it is expected that it will experience significant off-label useprior to its approval. Still, even with the availability of Nexavar we believethe disease will remain poorly treated and that an agent with a differentmechanism of action like MB07133, if approved, could find wide usage.

*Markets*

There are currently no approved drugs for thetreatment of primary liver cancer.  In the seven major pharmaceuticalmarkets approximately 112,000 patients were afflicted with primary liver cancerin 2004.  By 2014, the prevalence rate in the seven major globalpharmaceutical markets is expected to increase to approximately 185,000patients.  The prevalence rate in the U.S. includes approximately 19,000patients expected to be diagnosed in 2007, a number that is expected to grow toapproximately 40,000 patients by 2010.  In addition, China, which is notone the seven major pharmaceutical markets, has an incidence rate of primaryliver cancer of approximately 1.2 million patients as of 2004.  This is greater than rest of the worldcombined.  This incidence rate isexpected to rise to 1.9 million by 2014.

MB07133, if approved byregulatory authorities, potentially could be targeted as a first linechemotherapeutic treatment for patients with inoperable primary livercancer.  Given the current and projected primary liver cancer prevalencerates, and the cost of similar cancer therapies, we believe that MB07133, ifapproved by regulatory authorities, could present a substantial worldwidecommercial opportunity.

*MB07133*

Cytarabine, or araC, is amarketed anti-cancer drug used to treat leukemia. AraC has shown only limitedsuccess in solid tumors such as primary liver cancer because the liver lacks aparticular protein, or kinase, necessary for converting it to an importantintermediate form known as araCMP.  MB07133 uses our HepDirect technology todeliver this intermediate form of araC to the liver where it is then readilyconverted by a different liver kinase into its anti-cancer form, known asaraCTP. This approach bypasses the need for the first kinase which the liverlacks. In addition, araC, when systemically delivered is readily converted toaraCTP in tissues such as the bone marrow where it can cause toxicity. MB07133appears to 

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avoidthis potential toxicity because the HepDirect prodrug version of araCMP is notconverted to araCTP in tissues outside the liver. We believe the unique abilityof MB07133 to deliver araCMP selectively to the liver where it can be readilyconverted into its anti-cancer form will enhance efficacy while minimizing thetoxicities associated with systemic araC therapy.

*Clinical Trials*

In September 2003 weinitiated a Phase 1/2 clinical trial designed to evaluate the safety andpreliminary efficacy of MB07133 in non-terminal patients with inoperable primaryliver cancer tumors in the U.S. and Hong Kong. This clinical trial was an openlabel, dose escalation Phase 1/2 trial in patients with confirmed primary livercancer tumors involving continuous intravenous infusion of MB07133 for sevendays followed by a 21-day recovery period. Patients were eligible toreceive up to a total of six infusions of MB07133 per the clinical trialprotocol with additional infusions possible by request of each patient’sattending physician. This Phase 1/2clinical trial was designed to assess preliminary safety and tolerability, toidentify the maximum tolerated dose and to evaluate indicators of potentialefficacy. The results indicated that MB07133 was well tolerated and nodrug-related adverse events were noted that limited dosing. Apharmacokinetic analysis was conducted, and the results were consistent withMB07133’s expected liver-targeting mechanism. Although this Phase 1/2 clinical trial was not designed to evaluateefficacy, MB07133 showed evidence of anti-tumor activity with some patientsshowing evidence of tumor shrinkage and disease stabilization at three months. Webelieve these results indicate that MB07133 may offer an important newtreatment for patients with this usually fatal type of cancer for which thereare no currently approved drug treatments.  The following computer assistedtomography scan image depicts evidence of tumor shrinkage with an observedoverall decrease in tumor volume of 30% in one patient (patient number 1008) inthe Phase 1/2 clinical trial after that patient had received 8 cycles oftreatment with MB07133 over 8 months:

*Preclinical Studies*

MB07133 has been studied in animals and shown to producea significantly different distribution of araC and araCTP when compared toanimals treated with araC. In one study, rats treated with MB07133 demonstratedsignificantly higher levels of araCTP in the liver and significantly lowerlevels of araC and araCTP in the blood and bone marrow, respectively, than ratstreated with araC.  In another study,MB07133 and araC were continuously infused into rats for two days, after whichthe levels of araCTP in the liver and bone marrow were determined. The MB07133-treatedrats showed high levels of araCTP in the liver, whereas araCTP was not detectedin the livers of animals treated with araC. The opposite was observed in bonemarrow, where araCTP levels were high in the rats treated with araC and notdetected in the MB07133-treated rats. The level of araCTP achieved in theliver with MB07133 in these studies is above the levels of araCTP shown to killhuman primary liver cancer cells in culture.

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The differences in liverand bone marrow araCTP levels produced by MB07133 as compared to araC result insignificant improvement in animal toxicology. Mice treated for five days witharaC produced a dose-dependent decrease in body weight and a dose-dependentloss of bone marrow cells, whereas mice treated for the same period withMB07133 showed no loss in weight or bone marrow cells except at the highestdose, where a partial decrease in bone marrow cells was noted. We believe theseresults show that relative to araC, MB07133 will deliver therapeutically activelevels of araCTP to human primary liver cancer tumors with less toxicity.

**Advanced ResearchPrograms—Liver Diseases**

We are expanding our product pipeline by using ourproprietary technologies, our knowledge of liver diseases, and our expertise inpathways and proteins residing in the liver that significantly contribute tometabolic diseases. We have additional expertise in processes in the liver thatare important for drug uptake, metabolism and excretion, all of which areimportant for targeting drugs to the liver with high specificity. We have usedthis knowledge 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 develop and moveadditional new drug compounds into clinical development. We believe ouradvanced research programs have the potential to yield additional clinicaldevelopment candidates.

Our liver disease relatedadvanced research programs are:

*A viral enzymeinhibitor program for the treatment of hepatitis C*

Hepatitis C is a viral disease that causesinflammation of the liver that may lead to cirrhosis, primary liver cancer andother long-term complications. Roughly 3% of the world population has beeninfected with hepatitis C. In the U.S., nearly 4 million people areinfected with hepatitis C, of which 2.7 million are chronically infected.Since the discovery of the hepatitis C virus in 1989, manyantiviral targets have been identified, and many novel approaches to hepatitisC infection are currently being evaluated. Protease and polymerase enzymes,which are proteins contained within the hepatitis C virus, have been targetedby several successful therapeutic approaches in treating human immunodeficiencyvirus or HIV, and are becoming the focus of the multiple agents enteringclinical development for the treatment of hepatitis C. The polymerase andprotease inhibitors have shown to be excellent targets for selective hepatitisC therapy. Clinical studies with a limited number of hepatitis C protease andpolymerase inhibitors have demonstrated encouraging early results. However, andnot unexpectedly, preclinical and clinical evidence suggests that the hepatitisC virus may become rapidly resistant to protease inhibitors. Consequently, combinationtherapies of drugs targeting both enzymes may be required.

We have entered into anon-exclusive collaboration with Merck to create liver-targeted prodrugsof certain compounds that Merck is supplying to us. These compounds target thepolymerase enzyme structure within the hepatitis C virus residing in the liver.All of our activities under the collaboration were funded by Merck and thetwo-year, funded research phase of this collaboration has been completed. Merckis currently evaluating certain candidate compounds discovered during thecollaboration to determine if one or more will be recommended for clinicaldevelopment. Merck is solely responsible for conducting and funding alldevelopment work for compounds resulting from this collaboration and forcommercializing any resulting products. If a product is successfully developed,Metabasis will receive substantial milestone payments as well as receive aportion of the revenue from sales of the drug in the form of a royalty on netsales.

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*A second viralenzyme inhibitor program for the treatment of hepatitis C*

We have entered into anon-exclusive collaboration with Idenix to create liver-targeted prodrugsof certain compounds that Idenix is supplying to us. All of our activitiesunder the collaboration are being funded by Idenix during the two year, fundedresearch phase of this collaboration. Idenix is solely responsible forconducting and funding all development work for compounds resulting from thiscollaboration and for commercializing any resulting products. If a product issuccessfully developed, Metabasis will receive substantial milestone paymentsas well as receive a portion of the revenue from sales of the drug in the formof a royalty on net sales.

**Our Proprietary Technologies**

We have developedproprietary technologies that we have used to develop our current productcandidates and which we expect to help us expand our product pipeline in thefuture. Our NuMimetic technology encompasses know-how and compound librariesthat are useful in the discovery of molecules that bind effectively andspecifically to nucleotide binding sites on certain key enzymes controllingimportant metabolic pathways. We used this technology to identify CS-917and MB07803 and may continue to use it to help discover product candidates inother areas. Our HepDirect technology is a proprietary technology used totarget drugs to the liver. We applied this technology to develop pradefovir,MB07133 and MB07811 and will continue to use it in programs focused on thediscovery of drugs for liver diseases such as hepatitis C as well as metabolicdiseases.

*NuMimeticTechnology*

The liver plays a central role in many metabolicdiseases. Metabolic pathways in the liver are responsible for much of thebody’s generation of products such as cholesterol, glucose and lipids. Thisproduction is normally dependent on an individual’s nutritional and hormonalstatus. However, in individuals with metabolic diseases, these pathways areimproperly controlled, leading to excessive production of cholesterol, glucoseand lipids.

We are studying enzymes found in the liver thatdirectly or indirectly control the rate of flow through these pathways. Webelieve that many of these enzymes use compounds called nucleotides as a signalfor switching flow on or off. While nucleotides are more typically known as acell’s primary chemical energy form and its building blocks for DNA synthesis,they are now becoming recognized as important regulators of metabolic pathways.

We believe that certain nucleotide-binding enzymesrepresent important drug targets. Nucleotides that bind to these enzymes affectenzyme activity and therefore the rate of flow through certain metabolicpathways. Certain enzymes important to glucose, cholesterol and fat productionand metabolism are known to contain a nucleotide-binding site. It islikely that successful drug compounds targeting these sites will need toexhibit both high binding effectiveness and high enzyme specificity. Over thepast two decades, efforts to find such compounds by screening large compoundlibraries have failed in large part due to the physical characteristics ofthese sites.

We have extensivelystudied the structure of certain nucleotide-binding sites to determinethe structural elements that are important for binding and specificity. Throughthese efforts, we have discovered proprietary compounds that bind to thesesites and simulate the action of the natural nucleotides. We have generatedlarge libraries of these compounds, which are known as nucleotide mimetics. Theselibraries and the know-how generated from our studies constitute our NuMimetictechnology.

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*HepDirect Technology*

Developing drugs to treatdiseases of the liver and metabolic diseases that involve the liver has been amajor challenge for the pharmaceutical industry. Although companies have workedfor decades to develop drugs that treat chronic liver diseases, relatively fewdrugs are commercially available. In addition, currently marketed drugsapproved for chronic liver diseases often 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. In addition, prior approaches todeveloping therapeutics for metabolic diseases were unable to selectivelytarget pathways in the liver that were believed to play important roles inthese diseases. We believe that our liver targeting technologies may be usefulin developing therapeutics that selectively target these pathways in the liverand thus reduce the risk of peripheral toxicity due to exposure to tissuesoutside the liver.

Our HepDirect technologyaddresses these problems by delivering high concentrations of the biologicallyactive forms of target drugs to the liver while simultaneously reducing drugexposure in other tissues. We accomplish this process by making a simplechemical modification that renders the target drug biologically inactive. Werefer to the modified drug as a HepDirect prodrug. The following diagram showshow a HepDirect prodrug works:

Administration ofHepDirect prodrugs results in their distribution throughout the body. HepDirectprodrugs, unlike most other prodrug classes, are generally stable in the bloodand tissues outside the liver. Because of the limited capacity of non-livertissues to metabolize and convert HepDirect prodrugs to their active forms,distribution into these tissues leads to rapid reappearance of the prodrugsinto the blood stream and ultimately diffusion of the prodrugs from the bloodinto the liver. In the liver, HepDirect prodrugs are metabolized by an enzymeexpressed predominantly in the liver (CYP3A4) which converts the prodrug to thebiologically active form of the target drug. Because HepDirect prodrugs aremetabolized primarily in the liver, higher target drug levels are achieved inthe liver while target drug levels outside of the liver are diminished.

Our HepDirect technologyis broadly applicable to a wide variety of drugs. In some cases, the technologymay enable the use of drugs that are otherwise ineffective or poorly effectivein a particular liver disease due to the drug’s failure to achieve therapeuticlevels in the liver or due to the inability to administer doses that achievetherapeutic levels as a consequence of drug-related toxicities outside of theliver.

We have shown that ourHepDirect technology can deliver compounds with anti-viral, anti-cancer, oranti-hyperlipidemic activity, and we are continuing to use this technology todiscover innovative new 

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productsfor treating liver diseases, and to deliver compounds that affect pathways inthe liver responsible for metabolic diseases. For example, we are using thistechnology and other liver-targeting technologies in collaborations with Merckand Idenix in which we are creating prodrugs of certain compounds to target the hepatitis C virus residing inthe liver.

*Other Technologies*

We have developed otherproprietary technologies useful for discovering new candidates for treatingdiseases. These include additional proprietary methods for targeting the liverand structure-based drug design technologies. We continue to develop andrefine our capabilities for identifying important new drugs.

**Our Business Strategy**

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

·       *Advancing the development of our product candidates*.   Wecurrently have five product candidates in clinical development. These productcandidates, in order from the most advanced in clinical trials, are pradefovir,CS-917, MB07803, MB07133 and MB07811 indicated for the treatment ofhepatitis B, type 2 diabetes, primary liver cancer andhyperlipidemia, respectively. Daiichi Sankyo and Schering-Plough are primarilyresponsible for further clinical development of CS-917 and pradefovir,respectively. We participate on a joint development team with Schering-Plough. Ajoint development team with Daiichi Sankyo is in place, though the level of ourparticipation on this team is currently limited. We are currently independentlydeveloping MB07803, MB07133 and MB07811.

·       *Continuing to develop a broad product pipeline*.   Weare aggressively seeking to expand our pipeline of product candidates. Our goalis to expand our clinical development pipeline by continuing to develop andmove additional new drug compounds into clinical development. We have advancedresearch programs to develop second-generation TRß agonists to reducecholesterol and TGs for the management of hyperlipidemia, two programs todevelop treatments for hepatitis C infection that we are working on incollaboration with Merck and Idenix, respectively, an advanced research programdeveloping treatments for type 2 diabetes via a mechanism other than those usedin our other type 2 diabetes programs and several research programs, one ofwhich is focused on developing drugs that activate AMPK for the treatment for hyperlipidemiaand NASH that is being conducted in collaboration with Merck. Using ourinternal drug discovery capabilities and our proprietary NuMimetic andHepDirect technologies, we intend to discover and develop new drug compoundsfor the treatment of metabolic diseases and liver diseases. In addition, at theappropriate time, and as resources allow, we may seek to expand our productpipeline by acquiring products or businesses or in-licensing technologies thatwe believe are a strategic fit with our business and complement our existingproduct candidates and research programs.

·       *Continuing to enhance our expertise in liver pathways and metabolismand related intellectual property rights.  *Our near-termstrategy is to continue to develop proprietary drugs and technologies for thepotential treatment of metabolic diseases, cancer and certain other diseaseslinked to pathways in the liver. We have extensive expertise in liver diseases,as well as pathways and proteins residing in the liver that significantlycontribute to certain metabolic diseases or that are important for drug uptake,metabolism and excretion. We intend to continue to invest in our know-how andcapabilities, including NuMimetic, HepDirect 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.

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·       *Pursuing adiversified development and commercialization strategy for our productcandidates.  *We have implemented a development andcommercialization strategy that combines collaborative partnerships with ourown internal product development and commercialization efforts. The revenuesfrom license fees, milestone payments and research funding associated withthese arrangements, combined with reduced clinical development expenses, willallow us to better manage our resources and focus on building newopportunities. 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 alliancewhereby Daiichi Sankyo is responsible for conducting clinical trials, but wehave retained an option to co-promote CS-917 in North America, while withMB07803, MB07133 and MB07811, we are solely responsible for development ofthese product candidates. Merck is responsible for conducting future clinicaltrials under our AMPK collaboration while we have retained the option toco-promote any resulting products in the United States. MB07803, MB07133 andMB07811 all target markets which are highly sought after by potentialpharmaceutical partners. In addition, due to a number of factors, therecurrently exists a climate of intense competition among large pharmaceuticalcompanies for promising, in-licensable, clinical stage product candidates thattarget these markets. Therefore, we believe that MB07803, MB07133 and MB07811will be highly sought after should we seek to further develop these productcandidates in collaboration with pharmaceutical partners. Further, our goal forfuture collaborations is to establish them after we have demonstrated highvalue for each product candidate, a strategy which we believe will allow us toretain greater control over development and participation in commercialization.

·       *Establishing additional partnerships based onHepDirect or our other proprietary liver-targeting technologies*.   OurHepDirect and other proprietary technologies can help overcome some of thechallenges faced in developing drugs for liver and metabolic diseases. Webelieve these technologies are broadly applicable to a wide variety of drug targets. We maypartner these technologies with other biopharmaceutical companies whoseproducts would benefit from improved liver-targeting. For example, we haveentered into non-exclusive collaborations with Merck and Idenix to discover newtreatments for hepatitis C by applying our HepDirect technology to compoundsthat they have supplied to us. We may enter into additional, similarpartnerships leveraging our HepDirect technology for this, as well as other,disease indications.

·       *Becoming a fully-integrated pharmaceutical company*.   Weplan to become a fully-integrated pharmaceutical company. In time and asresources allow, we will relyless on collaborative arrangements with other pharmaceutical companies and moreon our own internal development, marketing and sales capabilities. We haverelied and continue to rely on our partners for the development of our firsttwo product candidates, CS-917 and pradefovir. In contrast, we havemanaged the early clinical development of MB07803, MB07133 and MB07811entirelyon our own. We are expanding our internal infrastructure and intend to continueto do so over time as the value of our pipeline grows, and as we furtherdevelop products internally.

**Strategic Alliances**

We use, or plan to use,strategic alliances and collaborative partnerships with pharmaceutical orbiotechnology companies to augment our internal drug discovery and developmentcapabilities, and to assist the commercialization of our products globally. Therevenues from license fees, milestone payments and research funding associatedwith our current arrangements, combined with clinical development expensesassumed by our partners, have allowed us to better manage our resources andfocus on building new opportunities. We have generally structured our alliancesand partnerships to license specific 

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products,rather than technology, or to apply our technology to a partner’s product, andwe intend to continue this practice in the future.

*Daiichi Sankyo*

In April 1997, weestablished a multi-year research, development and commercialization collaborationwith Daiichi Sankyo to discover, develop and commercialize FBPase inhibitorsfor the treatment of diabetes. The discovery research portion of thecollaboration was extended in February 2000 and March 2001 and endedin April 2002. Under this agreement, our drug discovery efforts were fullyfunded by Daiichi Sankyo. Daiichi Sankyo has the right to select compoundsdiscovered during the discovery period and is responsible for conducting andfunding the clinical development of any compound selected for development.Daiichi Sankyo will have exclusive, worldwide commercialization rights toproducts developed under the agreement. Daiichi Sankyo selected CS-917 asa clinical candidate in 1999 and initiated Phase 1 clinical trials of CS-917in July 2001. A joint development team composed of members from bothDaiichi Sankyo and Metabasis is in place, though the level of our participationon this team is currently limited. Compounds that Daiichi Sankyo developsduring the five-year period following completion of the drug discovery phase ofthe collaboration, which target type 1 or type 2 diabetes and act by directsuppression of hepatic gluconeogenesis by inhibiting FBPase, are also subjectto the collaboration agreement.

As part of thecollaboration, Daiichi Sankyo paid us license fees and sponsored researchtotaling $20.25 million over the five-year discovery research portion ofthe collaboration and made an investment of $7.25 million in our Series Apreferred stock. To date, Daiichi Sankyo has made three milestone paymentstotaling $6.5 million and is obligated to make additional payments basedon the achievement of future clinical and regulatory milestones. If allclinical and regulatory milestones are achieved, and including the$20.25 million in license fees and sponsored research, the$7.25 million investment in our Series A preferred stock and the$8.5 million option fee referred to below, we may be entitled to paymentswhich total up to $54.5 million. In addition, Daiichi Sankyo will pay us aroyalty on net sales of any product developed under the collaboration agreementfor the longer of (1) ten years from the first commercial sale or (2) theterm of any valid patent right of a product. In keeping with our partneringstrategy, we have the option to co-promote CS-917 or any other productdeveloped under the collaboration in North America on terms and conditions tobe negotiated after we exercise the option. We have the contractual right toexercise our co-promotion option for CS-917 prior to the filing of a NewDrug Application, or NDA, for CS-917.

In October 2002, weentered into an exclusive option agreement with Daiichi Sankyo, under whichDaiichi Sankyo paid us a non-refundable $8.5 million option fee that gaveDaiichi Sankyo the right to negotiate a new agreement for the discovery,development and licensing of second generation gluconeogenesis inhibitors, andan option to license an additional back-up compound discovered during theoption period. In August 2003, Daiichi Sankyo exercised its rights underthe option agreement to designate an additional back-up compound, which DaiichiSankyo will have the option to license only in the event that the developmentof CS-917 and the current back-up compound are discontinued. DaiichiSankyo has the right to terminate development of CS-917 and the currentback-up compound and to substitute the additional back-up compound for CS-917and the current back-up compound under the terms of our collaborationagreement. Also in August 2003, Daiichi Sankyo chose not to exercise itsoption to negotiate a new agreement for the discovery, development andlicensing of second generation gluconeogenesis inhibitors. As a result, webelieve that we retain all rights to compounds discovered under the secondgeneration program and therefore we may develop these compounds on our own orin collaboration with another company. However, it is possible that DaiichiSankyo could challenge our rights to independently develop second generationgluconeogenesis inhibitors, including MB07803, a second-generation productcandidate currently being independently developed by us. Such a challenge coulddelay 

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orprevent the development, partnering and/or commercialization of such productcandidates.  In addition, because MB07803may be directly competitive with CS-917 should they both be developed,the information that Metabasis receives from Daiichi Sankyo regarding CS-917has been reduced.

The term of ourcollaboration agreement, including the license of the additional back-upcompound under our option agreement, will continue until all of Daiichi Sankyo’sroyalty payment obligations have expired, unless the agreement is earlierterminated. The agreement may be terminated by either party only for materialbreach which remains uncured or for bankruptcy of the other party. In addition,on a country-by-country basis, we will be entitled to regain rights to CS-917from Daiichi Sankyo if Daiichi Sankyo does not diligently develop and market CS-917in a particular country.

*Schering-Plough*

In October 2001, weentered into a development and license agreement with Valeant for thedevelopment and commercialization of pradefovir. In January 2007, Valeantwith our consent assigned its rights, interests and obligations under thedevelopment and license agreement to Schering-Plough and further grantedSchering-Plough a license to its intellectual property related to pradefovir. Concurrently,we and Schering-Plough entered into an amended and restated development andlicense agreement for the continued future development and commercialization ofpradefovir. Under the amended and restated development and license agreementand pursuant to Valeant’s assignment, Schering-Plough was granted exclusiveworldwide rights to develop and commercialize pradefovir during the term of theagreement. Valeant paid us a license fee of $2 million and made milestonepayments of $2 million under the original agreement. Schering-Plough paid us anon-refundable license fee of $1.8 million in January 2007 and will beobligated to make future milestone payments to us upon the occurrence ofspecified development, regulatory and commercial milestones as well asroyalties on sales of products resulting from the collaboration. If alldevelopment, regulatory and commercial milestones are achieved, and includingthe $1.8 million non-refundable license fee, we may be entitled topayments which total up to $25 million, plus royalties under the agreementwith Schering-Plough. In addition, Schering-Plough is solely responsible forconducting and funding all development work. We participate on a jointdevelopment team with Schering-Plough.

The term of thedevelopment and license agreement will continue until all of Schering-Plough’sroyalty payment obligations have expired, unless the agreement is earlier terminated.The agreement may be terminated entirely or on a country by country basis byeither party for material breach of the other party which remains uncured. Schering-Ploughhas the sole right to terminate the agreement in its entirety or in certain countriesby providing at least 180 days written notice to us.

*Merck*

In December 2003, weentered into a collaboration agreement with Merck to discover new treatmentsfor hepatitis C. Under this collaboration, we created liver-targetingprodrugs of certain compounds that Merck supplied to us. These compounds targetthe polymerase enzyme structure within 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 through December 2005.At the same time, the scope of the technology that we apply to the Merckcompounds was expanded. As part of this collaboration, Merck paid us an upfrontfee of $500,000 and research support of $1.4 million per year during thetwo year research term. Merck is also obligated to pay preclinical and clinicalmilestone payments if specified development and regulatory events occur androyalties on sales of products resulting from the collaboration. If allpreclinical 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$25.3 million, plus royalties. Merck is currently evaluating certaincandidate compounds discovered during the collaboration to determine if one ormore will be recommended for 

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clinicaldevelopment. Merck is solely responsible for conducting and funding alldevelopment work for compounds resulting from the collaboration and forcommercializing any resulting products.

The term of thecollaboration agreement will continue until all of Merck’s royalty paymentobligations have expired, unless the agreement is earlier terminated. Theagreement may be terminated by either party for material breach or insolvencyof the other party. Merck also has the right to terminate the agreement withoutcause at any time after the end of the research term upon 90 days’ advancewritten notice to us.

In June 2005, weentered into a collaboration agreement with Merck to research, develop andcommercialize novel small molecule therapeutics with the potential to treatseveral metabolic diseases including type 2 diabetes, hyperlipidemia and NASHby activating AMPK. As part of this collaboration, Merck paid an initialnon-refundable license fee of $5.0 million in July 2005 and agreed toprovide research support funding of a minimum of $2.1 million each year duringthe three-year research term. The three-year research term is subject torenewal for one additional year upon the parties’ mutual agreement. Our levelof research activities, and the minimum research support funding, may beincreased during the term upon mutual agreement of both parties. Merck is alsoobligated to pay milestone payments if specified preclinical and clinicaldevelopment and regulatory events occur and to pay royalties on sales of anyproduct resulting from this collaboration. We would also have the option toco-promote any such product in the United States. If all preclinical andclinical milestones are achieved on multiple indications, then including the$5.0 million initial, non-refundable license fee and the minimum $6.3 millionin research support funding, we may be entitled to payments which total up to$74.3 million, plus royalties. Merck is solely responsible for conducting andfunding all development work for compounds resulting from this collaboration.

The term of thecollaboration agreement will continue until all of Merck’s royalty paymentobligations have expired, unless the agreement is earlier terminated. Theagreement may be terminated by either party for material breach or insolvencyof the other party. Merck also has the right to terminate the agreement withoutcause at any time after the end of the twenty-first month following theeffective date upon 90 days’ advance written notice to us.

*Idenix*

In October 2006, weentered into a collaboration agreement with Idenix to apply our HepDirecttechnology to certain Idenix lead compounds with the goal of improving thesafety and efficacy of these compounds for the treatment of hepatitis C. Theresearch term will be for two years and may be extended beyond two years bymutual agreement of the parties.  Inaddition, Idenix will have the option to terminate the research term upon thefirst anniversary of the effective date of the agreement or upon theachievement of certain preclinical and clinical development milestones duringthe research term. As part of this collaboration, Idenix paid us an initial,non-refundable license fee of $2.0 million in November 2006 and agreed toprovide us research funding of up to $1.7 million per year during the researchterm. Idenix will also pay us milestones if specified preclinical and clinicaldevelopment and regulatory events occur and royalties on product sales thatresult from the collaboration. If all milestones are achieved, and includingthe $2.0 million license fee and the up to $1.7 million per year in researchfunding over the term, we may be entitled to payments which total up to $68.8million, plus royalties. Idenix is solely responsible for conducting andfunding all development work for compounds resulting from this collaboration.

The term of thecollaboration agreement will continue until all of Idenix’s royalty payment obligationshave expired, unless the agreement is earlier terminated. The agreement may beterminated by either party for material breach or insolvency of the other party.Idenix also has the right to terminate the agreement without cause after theexpiration or early termination of the research term upon 60 days’ advancewritten notice to us.

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*Sicor*

As part of our June 1999corporate restructuring, we agreed to pay Sicor Inc., now an indirectwholly-owned subsidiary of Teva Pharmaceutical Industries Ltd., a 2%royalty on our direct sales of products that are covered by a claim of anissued, valid and unexpired patent or a patent application, that was inexistence or based on any discoveries or inventions in existence as of ourcorporate restructuring, and 10% of any royalties we receive from licenses ofthese patents, patent applications, discoveries or inventions. We also agreedto pay Sicor a 1% royalty on our direct sales of products that use, contain orare based on our trade secrets, know-how and other proprietary rights inexistence as of our corporate restructuring that are not covered by the 2%royalty, and 5% of any royalties we receive from licenses of these tradesecrets, know-how and other proprietary rights that are not covered by the 10%royalty. Some of our current product candidates and drug compounds from ourresearch programs may be subject to these royalty provisions. The determinationof any potential obligations will be assessed at the time such products arecommercially available.

**Intellectual Property**

Oursuccess will depend in large part on our ability to:

·       obtainand maintain patent and other legal protections for the proprietary technology,inventions and improvements we consider important to our business,

·       prosecuteand defend our patents,

·       preserveour trade secrets, and

·       operatewithout infringing the patentsand proprietary rights of third parties.

We intend to continue toseek appropriate patent protection for our lead compounds, our proprietarytechnologies and their uses by filing patent applications in the U.S. andselected other countries. We intend for these patent applications to cover,where possible, claims for composition of matter, medical uses, processes forpreparation and formulations.

As of February 22,2007 we owned a total of 36 issued U.S. patents, 3 allowed U.S. applicationsand 27 pending U.S. applications. In foreign countries, as of the same date, weowned a total of 148 issued patents and 232 pending applications. As of theabove date, we co-owned 2 pending U.S. applications and 4 foreign grantedapplications. As of the same date, we held rights to a total of 4 in-licensedU.S. patents.

We believe we have astrong intellectual property position, including 16 issued U.S. patents, 3allowed U.S. applications, 25 pending U.S. applications, 107 foreign issuedpatents and 227 foreign pending applications that relate to proprietarytechnologies and compounds used in our current business. Patents and patentapplications, if they issue as patents, in the U.S. that cover our compoundscurrently in clinical development will expire as follows: CS-917,December 2020; MB07803, August 2025; pradefovir, May 2023;MB07133, October 2023; and, MB07811, November 2024. The precedingpatent term expirations do not include possible patent term extensions.

Although we believe ourrights under patents and patent applications provide a competitive advantage,the patent positions of pharmaceutical and biotechnology companies are highlyuncertain and involve complex legal and factual questions. We may not be ableto develop patentable products or processes, and may not be able to obtainpatents from pending applications. Even if patent claims are allowed, theclaims may not issue, or in the event of issuance, may not be sufficient toprotect the technology owned by or licensed to us. Any patents or patent rightsthat we obtain may be circumvented, challenged or invalidated by ourcompetitors.

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We also rely on tradesecrets, proprietary know-how and continuing innovation to develop and maintainour competitive position, especially when we do not believe that patentprotection is appropriate or can be obtained. Our policy is to require each ofour employees, as well as consultants and advisors when appropriate, 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 andbiopharmaceutical industries are characterized by the existence of a largenumber of patents and frequent litigation based on allegations of patentinfringement. As our current and potential product candidates and others basedupon our proprietary technologies progress toward commercialization, thepossibility of an infringement claim against us increases. While we attempt tobe certain that our products and proprietary technologies do not infringe otherparties’ patents and other proprietary rights, competitors or other parties mayassert that we infringe on their proprietary rights.

We have conducted searchesof U.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 applicationsrelated to these patents that are unknown to us and may prevent us frommarketing our product candidates. Other product candidates that we may develop,either internally or in collaboration with others, could be subject to similardelays and uncertainties.

For a more detaileddiscussion of risks and uncertainties concerning intellectual propertyprotection for our product candidates and proprietary technologies, see thesection in “Risk Factors” entitled *“RisksRelated to Our Intellectual Property.”*

**Sales and Marketing**

We do not currently haveinternal sales or marketing capabilities. In order to commercially market ourproduct candidates if we obtain regulatory approval, we must either develop asales and marketing infrastructure or collaborate with third parties with salesand marketing capabilities. We have granted Daiichi Sankyo and Schering-Ploughworldwide marketing and commercialization rights for CS-917 andpradefovir, respectively. However, we have retained a co-promotion option todirectly market CS-917 in North America. In addition, at this point wehave not entered into collaborative partnerships for MB07803, MB07133 andMB07811 and are currently independently developing these product candidates.  We may either independently market, orcollaborate with third parties to further develop and market some or all ofthese product candidates in the future. We currently retain all rights tocompounds from our research programs, with the exception of hepatitis C andmetabolic disease product candidates that are covered by our hepatitis C andAMPK collaborations with Merck and hepatitis C product candidates that arecovered by our collaboration with Idenix.

We intend to makedecisions regarding independent marketing of the product candidates for whichwe retain commercialization rights based on the data derived from ourdevelopment and research programs in the future. If we proceed with independentmarketing of any product candidates, we anticipate building a sales forcedesigned to call on specialists that would be expected to prescribe asignificant portion of the market share of the product candidate.

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**Competition**

The biotechnology andbiopharmaceutical industries are characterized by rapidly advancingtechnologies, intense competition and a strong emphasis on proprietaryproducts. We face competition from many different sources, including commercialpharmaceutical and biotechnology enterprises, academic institutions, governmentagencies and private and public research institutions. Due to the high demandfor treatments for liver and metabolic diseases, research is intense and newtreatments are being sought out and developed by our competitors.

We are aware of manycompetitive products currently marketed or under development that are used totreat some of the diseases we have targeted. If CS-917 and/or MB07803 areultimately determined safe and effective and approved for marketing, they mayface significant competition from various formulations of metformin andproducts containing metformin. Metformin is a drug that inhibits liver glucoseproduction like CS-917 and MB07803, but does so through an unknownmechanism other than inhibition of gluconeogenesis. Because it does not causeweight gain, metformin is often prescribed as a first-line therapy to obesetype 2 diabetes patients, who are reported to comprise more than 90% of newlydiagnosed type 2 subjects. In addition, inexpensive generic forms of metforminare available.

Othercurrently marketed drugs that may compete with CS-917 and/or MB07803include, but are not limited to the following classes:

·       sulfonylureas—increasethe secretion of insulin by the pancreas, thereby lowering the level of thesugar glucose in the blood,

·       insulins—mimicinsulin,  the naturally occurring hormonemade by the pancreas to control blood glucose levels,

·       peroxisomeproliferator-activated receptor agonists, or PPARs—improve insulin sensitivityby activating certain genes involved in fat synthesis and carbohydrate metabolism,

·       incretinmimetics—lower glucose levels by increasing the levels of certain naturallyoccurring hormones from the pancreas, including glucagon-like peptide-1or GLP-1, a peptide that facilitates the response of the pancreas andliver to fluctuations in glucose levels by its action on pancreatic beta andalpha cells. Compounds in this class include dipeptidyl peptidase IV or DPP-IVinhibitors, and BYETTA ® (exenatide) injection. DPP-IV is an enzyme inthe bloodstream that cleaves and inactivates GLP-1. Inhibition of DPP-IVthus increases the half-life of endogenous GLP-1 by preventing cleavageand inactivation of GLP-1. BYETTA is an injectable medication thatexhibits many of the same glucose regulating actions of GLP-1. Theoverall effect of these compounds is to enhance glucose-dependent insulinsecretion and suppress inappropriate glucagon secretion,

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

·       glinides—stimulatethe pancreas’ beta-cells to produce insulin, and

·       combinationtherapies—combine metformin with members of several of the above-mentionedclasses, particularly sulfonylureas and PPARs.

In addition, manycompanies are developing novel therapies that target diabetes.

Currentlyapproved treatments for hepatitis B in the U.S. that may compete withpradefovir are included in the following classes:

·       interferons—mimicinterferon, the naturally occurring infection-fighting immune substanceproduced by the body,

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·       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.

A competitor to pradefovirmay be Hepsera (adefovir dipivoxil), which is a nucleotide analogue marketed inthe U.S. by Gilead Sciences, Inc. Pradefovir and Hepsera are prodrugs ofthe same active drug, and therefore may directly compete. In addition, marketedproducts approved to treat HIV infections are being evaluated for theireffectiveness in treating hepatitis B infections.

There are no currentlyapproved drugs for primary liver cancer. However, a few companies aredeveloping novel therapies specifically for primary liver cancer. Nexavar(sorafenib), a chemotherapy approved for the treatment of kidney cancer, isbeing evaluated for the treatment of primary liver cancer. The drug’sdeveloper, Bayer Healthcare Pharmaceuticals, recently announced that an ongoingPhase 3 clinical trial of Nexavar for the treatment of primary liver cancer wasstopped early because the trial met its primary endpoint resulting in superioroverall survival in those patients receiving Nexavar tablets versus thosepatients receiving placebo. Therefore it is likely that Nexavar will beapproved for the treatment of patients with primary liver cancer and it is expectedthat it will experience significant off-label use prior to its approval. Still,even with the availability of Nexavar we believe the disease will remain poorlytreated and that an agent with a different mechanism of action like MB07133, ifapproved, could find wide usage.

In addition, companies aredeveloping therapies for other solid tumors which may be efficacious intreating primary liver cancer. These companies may develop and introduceproducts competitive with MB07133.

IfMB07811 is ultimately determined safe and effective and approved for marketing,it would compete with products marketed by several large pharmaceuticalcompanies that currently comprise a very large share of the hyperlipidemiamarket. The major classes of hyperlipidemia drugs include, but are not limitedto:

·       statins—reduceserum cholesterol levels by inhibiting a key enzyme involved in thebiosynthesis of cholesterol,

·       fibrates—reducethe amount of cholesterol and triglycerides (fatty substances) in blood,

·       nicotinicacid derivatives—lower cholesterol and triglycerides, decrease low densitylipoproteins and increase high density lipoproteins,

·       CAIs—inhibitthe absorption of dietary and biliary cholesterol,

·       bileacid sequestrants—bind with cholesterol-containing bile acids in the intestinesand remove them in bowel movements, and

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

These large pharmaceuticalcompanies are also developing novel therapies that target hyperlipidemia. Thesecompanies may develop and introduce products competitive with or superior toMB07811. Lipitor (atorvastatin; a statin marketed by Pfizer) is currently thebest selling prescription medicine. In addition, generic statins (cholesterol-reducers)have recently been approved in the major pharmaceutical markets and would alsocompete with MB07811.

In addition, many othercompanies are developing products for the treatment of the diseases we aretargeting and if successful, these products could compete with our products. Ifwe receive approval to market and sell any of our product candidates, we maycompete with these companies and their products as well as others in varyingstages of development.

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**Manufacturing**

Daiichi Sankyo andSchering-Plough are responsible for all clinical and commercial manufacturingof CS-917 and pradefovir, respectively. We rely on several suppliers toproduce sufficient quantities of MB07803, MB07133 and MB07811 for use inclinical trials. We currently intend to continue this practice for any futureclinical trials and the possible large-scale commercialization ofMB07803, MB07133 and MB07811 and for any other potential products that weindependently develop and commercialize. All of our current product candidatesare small molecule drugs. These drugs are historically simpler and lessexpensive to manufacture than biologic drugs. We believe our focus on smallmolecule drugs gives us a manufacturing advantage over companies that developand manufacture biologic drugs.

**Government Regulation and Product Approval**

*Our Product Candidates*

Our metabolic diseaseproduct candidates, CS-917, MB07803 and MB07811; our liver diseaseproduct candidates, pradefovir and MB07133; and any other product candidatesthat we or our collaborators develop will require regulatory approval duringclinical development and before they can be commercialized. Daiichi Sankyo andSchering-Plough are responsible for clinical development and regulatoryapproval of CS-917 and pradefovir, respectively. We actively participateon a joint development team with Schering-Plough. While a joint developmentteam with Daiichi Sankyo is in place, our participation on this team iscurrently limited. Although our collaborations with Merck and Idenix have notyet yielded product candidates, should they be successful, we will be dependenton Merck and/or Idenix, as applicable, for clinical development and regulatoryapproval of any resulting product candidates. We are solely responsible forclinical development and regulatory approval of MB07803, MB07133 and MB07811.

*Product Regulation*

Governmental authoritiesin the U.S. and foreign countries regulate, among other things, the preclinicaland clinical testing, manufacturing, labeling, storage, record-keeping,advertising, promotion, export, marketing and distribution of drug products. Inthe U.S., pharmaceutical products are regulated by the FDA under the FederalFood, Drug, and Cosmetic Act, its implementing regulations and other federallaws and regulations. Both before and after the FDA approves a product, themanufacturer and the holder of the product approval are subject tocomprehensive regulatory oversight. Violations of regulatory requirements atany stage, including the preclinical and clinical testing process, the NDAapproval process, or the post-FDA-approval marketing of the product, may resultin various adverse consequences. These adverse consequences may include aclinical hold on an ongoing study, the FDA’s delay in approving or refusal toapprove a product, suspension of manufacturing or withdrawal of an approvedproduct from the market, seizure or recall of a product or the imposition ofcriminal or civil penalties against the manufacturer or the holder of theproduct approval. In addition, later discovery of previously unknown problemsmay result in restrictions on a product, its manufacturer, or the NDA holder,or market restrictions through labeling changes or product withdrawal. Also,new government requirements may be established that could delay or preventregulatory approval of our products under development.

Thesteps required before a new drug may be approved for marketing in the U.S.generally include:

·       conductingappropriate preclinical laboratory tests and preclinical studies in animals incompliance 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,

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·       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 preclinical 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.

Preclinicalstudies generally include animal studies to evaluate the product’s mechanism ofaction, safety and efficacy. Compounds must be produced according to applicableCGMP requirements, and preclinical safety tests must be conducted in compliancewith FDA’s GLP and similar international regulations. The results of thepreclinical tests, together with manufacturing information and analytical data,are generally submitted to the FDA as part of an IND, which must becomeeffective before human clinical trials may be commenced. The IND automaticallybecomes effective 30 days after receipt by the FDA, unless the FDA beforethat time requests an extension or raises concerns about the conduct of theclinical trials described in the application. The sponsor of the applicationand the FDA must resolve any outstanding concerns before clinical trials canproceed. 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:

·       theobjectives of the study,

·       theparameters to be used to monitor safety, and

·       theefficacy criteria to be evaluated.

Each protocol must besubmitted to the FDA as part of the IND. Further, each clinical study must bereviewed and approved by an IRB at each institution at which the study will becommenced, prior to the recruitment of subjects. The IRB will consider, amongother things, ethical factors, the safety of human subjects and the possibleliability of the institution.

Clinical trials typicallyare conducted in three sequential phases, but the phases may overlap. In Phase 1,the initial introduction of the drug into human subjects, the drug is tested inhealthy volunteers or, on occasion, in patients, for safety and, asappropriate, for absorption, metabolism, distribution, excretion,pharmacodynamics, pharmacokinetics and other preliminary measures of efficacy.Phase 2 usually involves initial studies designed to identify doses of the drugthat result in suitable efficacy, safety and tolerance in patients with thetargeted disease. A clinical trial designed to generate efficacy data but thatis not expected to satisfy FDA criteria for NDA approval is sometimes referredto as a Phase 2b study. Phase 3 clinical trials, commonly referred to aspivotal studies, are undertaken to provide proof of clinical efficacy and toprovide sufficient evidence of safety to justify FDA approval, typically withinan expanded and diverse patient population at multiple, geographicallydispersed clinical study sites. Some clinical trials that  combine elements of two Phases may bereferred to as a Phase 1/2 or a Phase 2/3 clinical trial. Phase 1, Phase 2 orPhase 3 testing may not show sufficient safety or efficacy within any specifictime period, if at all, with respect to any products being tested. Furthermore,the sponsor, the FDA or the IRB may suspend clinical trials at any time onvarious grounds, including a finding that the healthy volunteers or patientsare being exposed to an unacceptable health risk.

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The results of thepreclinical studies and clinical trials, together with detailed information onthe manufacture and composition of the product, are submitted to the FDA aspart of an NDA requesting approval for the marketing of the product. The costof preparing and submitting an NDA is substantial.

The FDA has 60 days fromits receipt of an NDA to determine whether the application will be accepted forfiling based on the agency’s threshold determination that the NDA issufficiently complete to permit substantive review. Once the submission isaccepted for filing, the FDA begins an in-depth review of the NDA. Underfederal law, the FDA has agreed to certain performance goals in the review ofNDAs. The goal for review of most such applications for non-priority drugproducts is ten months and for priority drug products is six months. The reviewprocess is often significantly extended by FDA requests for additionalinformation or clarification regarding information already provided in thesubmission. The FDA may also refer applications for novel drug products or drugproducts which present difficult questions of safety or efficacy to an advisorycommittee, typically a panel that includes clinicians and other experts, for review,evaluation and a recommendation as to whether the application should beapproved. The FDA is not bound by the recommendation of an advisory committee.

If FDA evaluations of theNDA and the manufacturing facilities are favorable, the FDA may issue anapproval letter, or, in some cases, an approvable letter followed by anapproval letter. An approvable letter generally contains a statement ofspecific conditions that must be met in order to secure final approval of theNDA. If and when those conditions have been met to the FDA’s satisfaction, theFDA will typically issue an approval letter. An approval letter authorizescommercial marketing of the drug with specific prescribing information forspecific indications. As a condition of NDA approval, the FDA may require postapproval testing and surveillance to monitor the drug’s safety or efficacy andmay impose other conditions, including labeling restrictions which canmaterially impact the potential market and profitability of the drug. Oncegranted, product approvals may be withdrawn if compliance with regulatorystandards is not maintained or problems are identified following initialmarketing.

Once the NDA is approved,a product will be subject to certain post-approval requirements, includingrequirements for adverse event reporting and submission of periodic reports.Additionally, the FDA also strictly regulates the promotional claims that maybe made about prescription drug products. In particular, the FDA requiressubstantiation of any claims of superiority of one product over anotherincluding, in many cases, requirements that such claims be proven by adequateand well controlled head-to-head clinical trials. To the extent that marketacceptance of our products may depend on their superiority over existingtherapies, any restriction on our ability to advertise or otherwise promoteclaims of superiority, or requirements to conduct additional expensive clinicaltrials to provide proof of such claims, could negatively affect the sales ofour products and/or our costs.

If the FDA’s evaluation ofthe NDA submission or manufacturing facilities is not favorable, the FDA mayrefuse to approve the NDA or issue a not approvable letter.

The not approvable letteroutlines the deficiencies in the submission and often requires additionaltesting or information in order for the FDA to reconsider the application. Evenwith submission of this additional information, the FDA ultimately may decidethat the application does not satisfy the regulatory criteria for approval.With limited exceptions, FDA may withhold approval of an NDA regardless ofprior advice it may have provided or commitments it may have made to thesponsor.

FDA approval of anyapplication may entail many delays or never be granted. Moreover, if regulatoryapproval of a product is granted, the approval may include limitations on theuses or patient populations for which the product may be marketed. Further,product approvals may be withdrawn if compliance with regulatory standards isnot maintained or if safety or manufacturing problems occur following initialmarketing. Finally, if there are any modifications to the drug, includingchanges in indications, labeling or manufacturing processes or facilities, weor our collaborators may be required to submit and obtain FDA 

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approvalof a new NDA or NDA supplement, which may require the development of additionaldata or the conduct of additional preclinical studies and clinical trials.

Among the conditions forapproval is the requirement that the prospective manufacturer’s qualitycontrol, recordkeeping and manufacturing procedures conform to CGMPrequirements enforced by the FDA through its facilities inspection program. Inaddition, product manufacturing facilities in California are subject tolicensing requirements of the California Department of Health Services. Theserequirements must be followed at all times in the manufacture of the approvedproduct, and manufacturing facilities are subject to inspection by the FDA andthe California Department of Health, or other applicable governmentalauthorities, at any time. In complying with these requirements, manufacturersmust continue to expend time, money and effort in the area of production andquality control to be certain of full compliance. The applicable requirementsare complex, can be subject to differing interpretations and are subject tochange without clear advance notice or guidance from the FDA. Any failure tocomply with these requirements may subject manufacturers to, among otherthings, notices or letters detailing alleged deviations and demandingcorrective actions, actions seeking fines and civil penalties, suspension ordelay in product approvals, product seizure or recall, suspension ofmanufacturing, or withdrawal of product approval.

Once an NDA is approved,the product covered thereby becomes a “listed drug” which can, in turn, becited by potential competitors in support of approval of an abbreviated NDA, orANDA. An ANDA provides for marketing of a drug product that has the same activeingredients in the same strengths and dosage form as the listed drug and hasbeen shown through bioequivalence testing to be therapeutically equivalent tothe listed drug. There is no requirement, other than the requirement forbioequivalence testing, for an ANDA applicant to conduct or submit results ofpreclinical or clinical tests to prove the safety or effectiveness of its drugproduct. Drugs approved in this way are commonly referred to as “genericequivalents” to the listed drug, are listed as such by the FDA, and can oftenbe substituted by pharmacists under prescriptions written for the originallisted drug.

There are limitations onthe timing of FDA’s ability to approve an ANDA for a generic equivalent of alisted drug. In the event that the sponsor of the listed drug has properlyinformed FDA 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 applicantcertifies that it believes one or more listed patents are invalid or notinfringed, it is required to provide notice of its filing to the NDA sponsorand the patent holder. If the patent holder then initiates a suit for patentinfringement against the abbreviated NDA sponsor within 45 days of receipt ofthe notice, FDA cannot grant effective approval of the ANDA until either 30months has passed or there has been a court decision holding that the patentsin question are invalid or not infringed. A holding that a valid andenforceable listed patent is infringed will preclude approval of the ANDA untilthe expiration of that patent. If the ANDA applicant certifies that it does notintend to market its generic product before some or all listed patents on thelisted drug expire, then FDA cannot grant effective approval of the ANDA untilthose patents expire. Under Federal law, the term of a patent covering a newchemical entity can be extended by up to five years, for an effective patentlife of up to 14 years after approval, based on restoration of part of thepatent life lost during clinical testing and FDA review.

Federal law also providesfor periods of non-patent exclusivity that also limit the timing of potentialapproval of an ANDA for a generic equivalent to a listed drug. These include aperiod of three years of non-patent exclusivity following approval of a listeddrug that contains previously approved active ingredients but is approved in anew dosage, dosage form, route of administration or combination, or for a newuse, the approval of which was required to be supported by new clinical trialsconducted by or for the sponsor, during which such three year period FDA cannotgrant effective approval of an ANDA based on that listed drug. Federal law alsoprovides a period of five years following approval of a drug containing nopreviously approved active ingredients, during which an ANDA for a genericequivalent cannot be 

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submittedunless the submission accompanies a challenge to a listed patent, in which casethe submission may be made four years following the original product approval.

The first ANDA applicantsubmitting a substantially complete application certifying that listed patentsfor a particular product are invalid or not infringed may qualify for a periodof 180 days after a court decision of invalidity or non-infringement or afterit begins marketing its product, whichever occurs first, during whichsubsequently submitted ANDAs cannot be granted effective approval. Similarnon-patent exclusivity restrictions and patent certification requirements applyto so-called 505(b)(2) NDA applications which rely, in part or in whole,on data generated by or for parties other than the applicant to support an NDAapproval.

FDA also imposes a numberof complex requirements and restrictions on entities that advertise and promoteprescription drugs, which include, among others, standards for and regulationsof print and in-person promotion, product sampling, direct-to-consumeradvertising, off-label promotion, industry sponsored scientific and educationalactivities, and promotional activities involving the Internet. The FDA has verybroad enforcement authority under the Federal Food, Drug and Cosmetic Act, andfailure to abide by FDA requirements can result in penalties and otherenforcement actions, including the issuance of warning letters or other lettersobjecting to violations and directing that deviations from FDA standards becorrected, total or partial suspension of production, and state and federal civiland criminal investigations and prosecutions.

Federal regulations andFDA policies prohibit a sponsor or investigator, or any person acting on behalfof a sponsor or investigator, from representing in a promotional context thatan investigational new drug is safe or effective for the purposes for which itis under investigation. Prior to approval of a product candidate, any assertionthat one of our product candidates is safe or effective for any purpose or thatit is superior to any currently approved product could result in regulatoryaction by FDA and could delay approval of the product candidate.

A variety of Federal andstate laws apply to the sale, marketing and promotion of pharmaceuticals thatare paid for, directly or indirectly, by Federal or state health care programs,such as Medicare and Medicaid. The restrictions imposed by these laws are inaddition to those imposed by the FDA and corresponding state agencies. Some ofthese laws significantly restrict or prohibit certain types of sales, marketingand promotional activities by pharmaceutical manufacturers. Violation of theselaws can result in significant criminal, civil, and administrative penalties,including imprisonment of individuals, fines and penalties and exclusion ordebarment from Federal and state health care and other programs. Many privatehealth insurance companies also prohibit payment to entities that have beensanctioned, excluded, or debarred by Federal agencies. We are also subject tovarious laws and regulations regarding laboratory practices, the experimentaluse of animals, and the use and disposal of hazardous or potentially hazardoussubstances in connection with our research. In each of these areas, as above,the FDA and other agencies have broad regulatory and enforcement powers,including the ability to impose fines and civil penalties, suspend or delayissuance of approvals, seize or recall products, and withdraw approvals, anyone or more of which could have a material adverse effect upon us.

*Other Regulations*

We are also subject toregulation by the Occupational Health and Safety Administration and state andfederal environmental protection agencies, and to regulation under the ToxicSubstances Control Act. We may in the future be subject to additional federal,state or local regulations. The Occupational Health and Safety Administrationor these environmental protection agencies may promulgate regulations that mayaffect our research and development programs. We cannot predict whether anyagency will adopt any regulation which could limit or impede our operations.

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**Environmental and Safety Matters**

We use hazardouschemicals, biological agents and various radioactive isotopes and compounds inour research and development activities. Accordingly, we are subject toregulations under federal, state and local laws regarding employee safety,environmental protection and hazardous substance control, and to other presentand possible future federal, state and local regulations. We may also incursignificant costs complying with environmental laws and regulations adopted in thefuture.

Also, although we believeour current safety procedures for handling and disposing of hazardous materialscomply with federal, state and local laws and regulations, we cannot entirelyeliminate the risk of accidental injury or contamination from the use, storage,handling or disposal of these materials. In the event of contamination orinjury, we could be held liable for damages or penalized with fines in anamount exceeding our resources, and our clinical trials or regulatory approvalscould be suspended.

**Employees**

As of March 1, 2007,we employed 127 full-time employees, consisting of 95 employees in research,development and regulatory affairs and 32 in management, administration,finance, receiving and facilities. As of the same date, 41 of our employees hada Ph.D. or M.D. degree. None of our employees is subject to a collectivebargaining agreement. We consider our relationship with our employees to begood.

**Scientific Advisory Board**

We have established ascientific advisory board consisting of medical professors and industry expertswith knowledge of our target markets. Our scientific advisors generally meetonce a year as a group to assist us in formulating our research, developmentand clinical strategies. Some individual scientific advisors consult with andmeet informally with us on a more frequent basis. We have entered intoconsulting agreements with all of our scientific advisors, but they are not ouremployees and may have commitments to, or consulting or advisory contractswith, other entities that may limit their availability to us. In addition, ourscientific advisors may have arrangements with other companies to assist thosecompanies in developing products or technologies that may compete with ours.

**Corporate Information**

We were incorporated inDelaware in April 1997 as a wholly owned subsidiary of Gensia Sicor Inc.,now Sicor Inc., which became an indirect wholly owned subsidiary of TevaPharmaceutical Industries Limited in January 2004. In December 1997,Sicor assigned to us specified assets and liabilities relating to its thenexisting business of discovering and developing proprietary pharmaceuticalproducts. Although we established a new business plan, pursued newopportunities and discovered new products and technologies following ourinception, many of the assets we obtained in the transfer served as afoundation upon which we built our technologies and know how. In June, 1999 wecompleted a corporate restructuring and management stock purchase in which webecame an independent company. We have a wholly owned subsidiary, Aramed, Inc.,which was transferred to us by Sicor and does not conduct an active business.

**Available Information**

We make available free ofcharge on or through our Internet website our annual report on Form 10-K,quarterly reports on Form 10-Q, current reports on Form 8-K,and amendments to those reports, as soon as practicable after we electronicallyfile these materials with, or furnish them to, the Securities and ExchangeCommission. The address of our website is http:/ /www.mbasis.com. Theinformation contained in, or that can be accessed through, our website is notpart of this annual report on Form 10-K.

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**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 ourother filings with the Securities and Exchange Commission, before you decide tobuy or 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.*

**RisksRelated to our Business**

***We are dependent onthe success of one or more of our current product candidates and we cannot becertain that any of them will receive regulatory approval or be commercialized.***

We have expendedsignificant time, money and effort in the development of our metabolic diseaseproduct candidates, CS-917, MB07803 and MB07811, and our liver diseaseproduct candidates, pradefovir and MB07133. Clinical trials conducted to datein patients treated with CS-917 and pradefovir have provided evidence ofefficacy as measured by various parameters that we believe to be clinically andstatistically significant. However, no pivotal, adequate and well-controlledclinical trials designed to provide clinical and statistically significantproof of efficacy, or to provide sufficient evidence of safety to justifyapproval, have been completed with any of our products. All of our productcandidates will require additional development, clinical trials and regulatoryclearances before they can be commercialized. Positive results from preclinicalstudies and early clinical trials do not necessarily mean later clinical trialswill succeed. Our product development efforts may not lead to commercial drugs,either because our product candidates fail to be safe and effective in clinicaltrials or because we have inadequate financial or other resources to pursue ourproduct candidates through the clinical trial and approval processes. If any ofour product candidates fail to demonstrate safety or efficacy at any time orduring any phase of development, we would experience potentially significantdelays in, or be required to abandon, development of the product candidate.

We do not anticipate thatany of our current product candidates will be eligible to receive regulatoryapproval and begin commercialization for a number of years, if at all. Even ifwe were ultimately to receive regulatory approval for these product candidates,we and/or our partners, as applicable, may be unable to commercialize themsuccessfully for a variety of reasons. These include, for example, theavailability of alternative treatments, lack of cost effectiveness, the cost ofmanufacturing the product on a commercial scale and the effect of competitionwith other drugs. The success of our product candidates may also be limited bythe prevalence and severity of any adverse side effects. If we fail tocommercialize one or more of our current product candidates, we may be unableto generate sufficient revenues to attain or maintain profitability, and ourreputation in our industry and the investment community 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.***

Toreceive regulatory approval for the commercialization of our metabolic disease productcandidates CS-917, MB07803 and MB07811, our liver disease productcandidates pradefovir and MB07133, or any other product candidates that we maydevelop, adequate and well-controlled clinical trials must be conducted todemonstrate safety and efficacy in humans to the satisfaction of the FDA, inthe U.S. and other regulatory agencies elsewhere in the world. In order tosupport marketing approval, these agencies typically require successful resultsin one or more Phase 3 clinical trials, which our current product candidateshave not yet reached and may never reach. Clinical testing is expensive, cantake many years and has an uncertain outcome. Failure can occur at any stage ofthe testing. We may experience numerous 

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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:

·       clinicaltrials may produce negative or inconclusive results,

·       patientrecruitment and enrollment in clinical trials may be slower than we anticipate,

·       costsof clinical trials may be greater than we anticipate,

·       ourproduct candidates may cause undesirable side effects that delay or precluderegulatory approval or limit their commercial use or market acceptance ifapproved,

·       collaboratorswho are responsible for clinical trials of our product candidates may notdevote sufficient resources to these clinical trials or conduct them in atimely manner, or

·       wemay face delays in obtaining regulatory approvals to commence a clinical trial.

Success in preclinicaltesting and early clinical trials does not mean that later clinical trials willbe successful because product candidates in later-stage clinical trials mayfail to demonstrate sufficient safety and efficacy despite having progressedthrough initial clinical testing. Our clinical experience with our productcandidates is limited, and to date our product candidates have been tested inless than the number of patients that will likely need to be studied to gainregulatory approval. The data collected from clinical trials with largerpatient populations may not demonstrate sufficient safety and efficacy tosupport regulatory approval of these product candidates.

The targeted endpoints forclinical trials of CS-917 have been, and will continue to be, primarilyestablished by Daiichi Sankyo. The targeted endpoints for clinical trials ofpradefovir have been primarily established by Valeant and, in the future, willbe primarily established by Schering-Plough. We are solely responsible forestablishing the targeted endpoints for clinical trials of MB07803, MB07133 andMB07811. These targeted endpoints may be inadequate to demonstrate the safetyand efficacy levels required for regulatory approvals. Even if we believe datacollected from clinical trials of our product candidates are promising, suchdata may not be sufficient to support marketing approval by the FDA or otherregulatory agencies abroad. Further, preclinical and clinical data can beinterpreted in different ways, and the FDA or other foreign regulatory agenciesmay interpret such data in different ways than us or our collaborators. Ourfailure to adequately demonstrate the safety and efficacy of our productcandidates would prevent our receipt of regulatory approval, and ultimately thecommercialization of these product candidates.

***Our productcandidates may cause undesirable side effects that could delay or prevent theirregulatory approval or commercialization or have other significant adverse implicationson our business.***

Prior to receivingregulatory approval, undesirable side effects caused by our product candidatescould interrupt, delay or halt clinical trials and could result in the denialof regulatory approval by the FDA or other regulatory authorities for any orall targeted indications, and in turn prevent us from commercializing ourproduct candidates and generating revenues from their sale.

For example, theinhibition of gluconeogenesis can cause elevated levels of lactic acid, orlactate, which, if high and sustained under certain conditions, could lead tolactic acidosis, a serious and potentially fatal condition. Certain preclinicalanimal studies have shown that CS-917 raises lactate levels two- tothree-fold in some but not all animal models. Elevated lactate levels have alsobeen observed in certain human clinical trials of CS-917. For example, ina 28-day Phase 2 clinical trial of CS-917, isolated instances oflactate elevation significantly above the normal range were seen in some patientsin both CS-917 and placebo treated groups over the course of the28 days. No patient exhibited sustained lactate levels significantly abovethe normal range over a period of consecutive days during the clinical trial.However, one patient who received 200 milligrams of CS-917 twice a daywas withdrawn from the clinical trial by the 

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investigatoron day 15 due to concerns over consistently elevated lactate levels measuredthe previous day. Other incidences of elevated lactate levels have beenobserved and will likely occur in the future.

Our product candidatescould also exhibit adverse interactions with other drugs. For instance, in March 2005we were notified by Daiichi Sankyo that two serious adverse events involvinglactic acidosis had occurred in two patients in a Phase 1 clinical trialevaluating the interaction of CS-917 with metformin. The serious adverseevents were resolved after medical intervention. After the adverse eventsoccurred, the three clinical trials that were ongoing at the time were stoppedwhile one Phase 1 clinical trial which did not combine CS-917 withmetformin continued and was completed. After extensive analysis Daiichi Sankyoconcluded that the lactic acidosis observed in the two patients was likely dueto significantly increased blood levels of metformin. The reason for theincrease in metformin blood levels observed in these two patients has not beendetermined. At high blood levels, metformin is believed to cause a form ofcellular toxicity known as mitochondrial toxicity which can cause lacticacidosis. Subsequently, Daiichi Sankyo decided that clinical trials of CS-917could safely resume.

Daiichi Sankyo hasconducted and will likely conduct additional studies combining CS-917with other diabetes drugs to assess both the safety and eventually thepotential for enhanced efficacy with the combination. However, further use ofCS-917 in combination with metformin will be avoided unless additionaldata suggests that the elevation of metformin blood levels as seen in the twopatients can be avoided through patient exclusion or through the administrationof CS-917 at lower doses or through other means. Should CS-917eventually be approved and the use of CS-917 in combination withmetformin remains an issue, the FDA may require additional measures be takenduring 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.

In February 2006, weinitiated Phase 1 clinical trials of our second-generation product candidatefor type 2 diabetes, MB07803, which works by the same mechanism as CS-917and thus may be subject to some or all of the same risks described previouslyfor CS-917.

It is also possible thatCS-917 and MB07803 may cause other side effects. In certain preclinicalstudies, as expected based on the mechanism of these compounds, fasted animalstreated with CS-917 showed pronounced hypoglycemia, a condition involvingabnormally low blood glucose levels that can lead to coma or death.Hypoglycemia has been observed in one patient participating in a clinical trialthat involved multi-day administration of the highest dose of CS-917tested to date in patients (400 milligrams twice a day). This dose is abovewhat is expected to be used in Phase 3 clinical trials if warranted. However,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 preclinical 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. Elevatedtriglyceride levels have not been observed in human clinical trials to date.Other side effects observed during early clinical trials of CS-917included nausea and vomiting.

We apply our HepDirecttechnology to make liver-specific prodrugs of certain compounds. A prodrug is adrug to which a chemical modification has been made that renders it inactiveuntil enzymes in the body convert it to its active form. When converted by thebody to their active forms, HepDirect prodrugs produce a byproduct that iswithin a class of compounds that have the potential of causing toxicity,genetic mutations and cancer. We are unaware of any byproduct-relatedtoxicities demonstrated to date in clinical trials of any of pradefovir,MB07133 or MB07811. However, we cannot be certain that this byproduct will notcause adverse effects in current or future clinical trials of these productcandidates or other HepDirect prodrugs we may develop. In addition, because ourcurrent product candidates are in early stages of 

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developmentand have been tested in relatively small populations, additional side effectsmay be observed as their development progresses.

MB07811 is a HepDirectprodrug of a potent TRßagonist discovered by us. Thyroid hormone and thyroid hormone mimetics areknown to exhibit a wide array of physiological actions involvinga variety of organs that can be assessed in preclinicalanimal studies.  Both beneficial and undesirableeffects can be inferred from studies of humans with hyperthyroidism(elevated thyroid hormone). The development of liver-selective thyroid receptormodulators for the treatment of hyperlipidemia is a novel approachseeking to exploit the beneficial hepatic effects while avoidingtoxicities related to systemic exposure of thyromimetic agents.  Successfuldevelopment of MB07811 will require finding a dose range inhumans that provides adequate benefit and an acceptablesafety profile.

Inaddition, undesirable side effects seen in the clinical trials of our productcandidates may have other significant adverse implications on our business, forexample:

·       wemay be unable to obtain additional financing on acceptable terms, if at all,

·       ourstock price could decline,

·       ourcollaborators may ultimately terminate development of our partnered products,may further decide not to develop backup product candidates and may terminateour agreements,

·       ifthese agreements were terminated we may determine not to further develop theaffected product candidates due to resource constraints and may not be able toestablish additional collaborations for their further development on acceptableterms, if at all,

·       ifwe were to later continue the clinical trials of these product candidates andreceive regulatory approval, earlier findings may significantly limit theirmarketability and thus significantly lower our potential future revenues fromtheir sale,

·       wemay be subject to product liability or stockholder litigation, and

·       wemay be unable to attract and retain key employees.

Inaddition, if any of our product candidates receive marketing approval and we orothers later identify undesirable side effects caused by the product:

·       regulatoryauthorities may withdraw their approval of the product, or we may decide tocease marketing and sale of the product voluntarily,

·       wemay be required to change the way the product is administered, conductadditional clinical trials, change the labeling of the product, or change theproduct’s manufacturing facilities, and

·       ourreputation may suffer.

Any of these events couldprevent us from achieving or maintaining market acceptance of the affectedproduct or could substantially increase the costs and expenses ofcommercializing the product, which in turn could delay or prevent us fromgenerating significant revenues from the sale of the product.

***We are currentlydependent on our collaborations with Daiichi Sankyo and Schering-Plough fordevelopment of CS-917 and pradefovir, respectively, and events involvingthese collaborations, our collaborations with Merck and Idenix, or any futurecollaborations could prevent us from developing and commercializing our productcandidates and achieving or sustaining profitability.***

We have entered intocollaborations with Daiichi Sankyo and Schering-Plough for the development andcommercialization of CS-917 and pradefovir, respectively. Daiichi Sankyoand Schering-Plough have 

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agreedto finance the clinical trials for CS-917 and pradefovir, respectively,and, if they are approved, manufacture and market them. Accordingly, we arecurrently dependent on Daiichi Sankyo and Schering-Plough to gain FDA and otherforeign regulatory agency approval of, and to commercialize, CS-917 andpradefovir. We have also entered into two collaborations with Merck and acollaboration with Idenix. The first collaboration with Merck seeks to developand commercialize new products for the treatment of hepatitis C infection andthe second seeks to develop and commercialize new products to treat severalmetabolic diseases including type 2 diabetes, hyperlipidemia and NASH. Ourcollaboration with Idenix seeks to develop and commercialize new products forthe treatment of hepatitis C infection. Although our collaborations with Merckand Idenix have not yet yielded any product candidates, should they ultimatelybe successful, we will be dependent on Merck and/or Idenix, as applicable, forfurther development and commercialization of any resulting product candidates.In addition, since we do not currently possess the resources necessary toindependently develop and commercialize all of the potential products that maybe based upon our technologies, including MB07803, MB07133 and MB07811, we mayneed to enter into additional collaborative agreements to assist in the developmentand commercialization of some or all of these product candidates. However, ourdiscussions with potential collaborators may not lead to the establishment ofnew collaborations on acceptable terms, if at all, or it may take longer thanexpected to establish new collaborations, leading to development andcommercialization delays.

We have limited controlover the amount and timing of resources that Daiichi Sankyo, Schering-Plough,Merck, Idenix or any future collaborators devote to our programs or potentialproducts. These collaborators may breach or terminate their agreements with usor otherwise fail to conduct their collaborative activities successfully and ina timely manner. Further, our collaborators may not develop products that ariseout of our collaborative arrangements or devote sufficient resources to thedevelopment, manufacture, marketing or sale of these products. In the eventthat one of our collaborations is terminated, and we believe that the continueddevelopment or commercialization of a product candidate or drug compoundcovered by the collaboration is warranted, we may seek to obtain rights todevelop and commercialize the product candidate or drug compound, if we did notalready have those rights. We would then determine whether to continue thedevelopment or commercialization of the product candidate or drug compoundindependently or together with a new collaborator. However, in the event thatwe do not have sufficient resources to independently develop or commercializethe product candidate or drug compound, and we cannot establish a newcollaboration on acceptable terms, we would be forced to discontinue itsdevelopment or commercialization.

Our agreement with DaiichiSankyo contains certain rights and restrictions regarding our access to and useof confidential data and information generated by Daiichi Sankyo. We haveinitiated clinical trials of MB07803, a second-generation gluconeogenesisinhibitor 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 alreadybeen reduced and we expect that further reductions in information flow willoccur. This situation may limit our ability to (i) provide informationregarding clinical 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. In addition, the past and/or any future transfer to us of confidentialinformation and data related to CS-917 may increase the risk of claimsbased on our access to this information and data. It is possible that DaiichiSankyo could challenge our rights to independently develop second generationgluconeogenesis inhibitors, including MB07803, which may delay or prevent thedevelopment, partnering and/or commercialization of such product candidates.

We andour present and future collaborators may fail to develop or effectivelycommercialize products or drug compounds covered by our present and futurecollaborations if:

·       wedo not achieve our objectives under our collaboration agreements,

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·       weare unable to obtain patent protection for the product candidates or proprietarytechnologies we discover in our collaborations,

·       weare unable to manage multiple simultaneous product discovery and developmentcollaborations,

·       ourpotential collaborators are less willing to expend their resources on ourprograms due to their focus on other programs or as a result of general marketconditions,

·       ourcollaborators become competitors of ours or enter into agreements with ourcompetitors,

·       weor our collaborators encounter regulatory hurdles that preventcommercialization of our product candidates,

·       wedevelop products and processes or enter into additional collaborations thatconflict with the business objectives of our other collaborators,

·       consolidationin our target markets limits the number of potential collaborators, or

·       weare unable to negotiate additional collaboration agreements under termssatisfactory to us.

Ifwe are unable to develop or commercialize our products as a result of theoccurrence of any of these events, we may not be able to generate sufficientrevenues to achieve or maintain profitability.

***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 ourhepatitis C collaboration with Merck has been to discover product candidatesfor the treatment of this disease by applying our technology to certaincompounds provided by Merck. The funded research phase of this collaborationhas ended. Merck has evaluated and may continue to evaluate the drug compoundsdiscovered under the research phase of the collaboration to determine if one ormore will be recommended for clinical development. If Merck so designates aproduct candidate and then subsequently terminates this collaboration before adefined stage of development of that product candidate, which it may do withoutcause at any time upon 90 days’ advance written notice to us, we will nothave any right to develop or commercialize that product candidate. In addition,if this collaboration with Merck terminates and Merck successfully developsproducts based on these proprietary compounds without applying our technology,we will not be entitled to milestone payments or royalties with respect tothose products.

Our agreement with Merckto develop and commercialize new products to treat several metabolic diseasesincluding type 2 diabetes, hyperlipidemia and NASH 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. Similarly, our agreement with Idenix to develop andcommercialize new products to treat hepatitis C infection may include thedevelopment of compounds owned or controlled by Idenix. Accordingly, if Idenixterminates this collaboration it may prove difficult for us to continuedevelopment of such compounds.

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***Conflicts may arise between us and any of ourcollaborators that could delay or prevent the development or commercializationof our product candidates.***

Conflicts may arisebetween our collaborators and us, such as conflicts concerning theinterpretation of clinical data, the achievement of milestones or the ownershipof intellectual property developed during the collaboration. If any conflictsarise with Daiichi Sankyo, Schering-Plough, Merck, Idenix 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:

·       unwillingnesson the part of a collaborator to pay us research funding, milestone payments orroyalties we believe are due to us under our collaboration agreement,

·       uncertaintyregarding ownership of intellectual property rights arising from ourcollaborative activities, which could prevent us from entering into additionalcollaborations or independently pursuing the development and/orcommercialization of product candidates, or disagreements with ourcollaborators regarding the protection of intellectual property rights,

·       unwillingnesson the part of a collaborator to keep us informed regarding the progress of itsdevelopment and commercialization activities or to permit public disclosure ofthe results of those activities, or

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

***Our efforts to discover product candidates beyond ourcurrent product candidates may not succeed, and any product candidates werecommend for clinical development may not actually begin clinical trials.***

We intend to use ourproprietary technologies and our knowledge and expertise to develop andcommercialize novel drugs to address some of the world’s most widespread andcostly chronic diseases. Our goal is to expand our clinical developmentpipeline by continuing to develop and move additional new drug compounds intoclinical development. However, the process of researching and discovering drugcompounds is expensive, time-consuming and unpredictable. Data from our currentresearch programs may not support the clinical development of our leadcompounds or other compounds from these programs, and we may not identify any additionaldrug compounds suitable for recommendation for clinical development. Moreover,any drug compounds we recommend for clinical development may not demonstrate,through preclinical testing, indications of safety and potential efficacy, thatsuch drug compounds warrant advancement into clinical trials. Such findingswould potentially impede our ability to maintain or expand our clinicaldevelopment pipeline. Our ability to identify new drug compounds and advancethem into clinical development also depends upon our ability to fund ourresearch and development operations, and we cannot be certain that additionalfunding will be available on acceptable terms, or at all.

***Delays in the commencement or completion of clinicaltrials could result in increased costs to us and delay our ability to generatesignificant revenues.***

Delays in thecommencement or completion of clinical trials could significantly impact ourproduct development costs. We do not know whether planned clinical trials willbegin on time or be completed on schedule, if at all. The commencement ofclinical trials can be delayed for a variety of reasons, including delaysrelated to:

·       obtainingregulatory approval to commence a clinical trial,

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·       reachingagreement on acceptable terms with prospective contract research organizationsand clinical trial sites,

·       manufacturingsufficient quantities of a product candidate or other materials necessary toconduct the clinical trial,

·       obtaininginstitutional review board approval to conduct a clinical trial at aprospective site,

·       recruitingand enrolling patients to participate in a clinical trial, and

·       thefailure of our collaborators to adequately resource our product candidates dueto their focus on other programs or as a result of general market conditions.

In addition, once aclinical trial has begun, it may be suspended or terminated by us, ourcollaborators, the FDA or other regulatory authorities due to a number offactors, including:

·       failureto conduct the clinical trial in accordance with regulatory requirements orclinical protocols,

·       inspectionof the clinical trial operations or clinical trial site by the FDA or otherregulatory authorities resulting in the imposition of a clinical hold,

·       unforeseensafety issues, or

·       lackof adequate funding to continue the clinical trial.

If we experiencesignificant delays in the commencement or completion of clinical testing, ourproduct development costs may increase, we may lose any competitive advantageassociated with early market entry and our ability to generate significantrevenues may be delayed. In addition, many of the factors that cause, or leadto, a delay in the commencement or completion of clinical trials may alsoultimately lead to the denial of regulatory approval of a product candidate.

***We rely on third parties to conduct our clinicaltrials. If these third parties do not successfully meet their obligations underour agreements, we may not be able to obtain regulatory approval for orcommercialize our product candidates.***

Daiichi Sankyo andSchering-Plough are currently responsible for conducting clinical trials of CS-917and pradefovir, respectively. Although our collaborations with Merck and Idenixhave not yet yielded product candidates, should they be successful, we will bedependent on Merck and/or Idenix, as applicable, to conduct clinical trials ofany resulting product candidates. We intend to rely on other third parties,such as contract research organizations, medical institutions, clinicalinvestigators and contract laboratories, to conduct our clinical trials ofMB07803, MB07133, MB07811 and any other product candidates that we may developfor which a collaborator is not responsible for clinical development. IfDaiichi Sankyo, Schering-Plough, Merck, Idenix 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 product candidates, research programs andcollaborative efforts depend on our proprietary technologies, adverse events affectingour proprietary technologies may delay or prevent the commercialization of ourproduct candidates.***

We used ourNuMimetic technology to identify CS-917 and MB07803. We used ourHepDirect technology to discover pradefovir, MB07133, MB07811 and have appliedit in certain other programs as well. We intend to use these and futureproprietary technologies to expand our product pipeline in the future. We alsomay leverage our HepDirect and other liver-targeting technology throughstrategic alliances and collaborations with other companies, such as ourhepatitis C collaborations with Merck and 

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Idenixin which we are applying our technology to certain Merck and Idenix compounds.Our proprietary technologies are subject to many of the same risks as our productcandidates, including risks related to:

·       obtainingand maintaining patent and trade secret protection for these technologies,

·       avoidinginfringement of the proprietary rights of third parties,

·       thedevelopment of competing technologies by others, and

·       inHepDirect’s case, the safety and effectiveness of this technology in humans.

Because certain of ourproduct candidates and research programs are dependent on our proprietarytechnologies, adverse events affecting our proprietary technologies may in turndelay or prevent the development or commercialization of our productcandidates, which could impede our ability to generate revenues and achieve ormaintain profitability.

***Our product candidates are subject to extensiveregulation, which can be costly and time consuming, cause unanticipated delaysor prevent the receipt of the required approvals to commercialize our productcandidates.***

The clinical development, manufacturing, labeling,storage, record-keeping, advertising, promotion, export, marketing anddistribution of our product candidates are subject to extensive regulation bythe FDA and other regulatory agencies in the U.S. and by comparablegovernmental authorities in foreign markets. In the U.S., neither we, nor ourcollaborators, are permitted to market our product candidates until we or ourcollaborators receive approval of an NDA from the FDA or receive similarapprovals abroad. The process of obtaining these approvals is expensive, oftentakes many years, and can vary substantially based upon the type, complexityand novelty of the product candidates involved. Approval policies orregulations may change. In addition, as a company, we have not previously filedNDAs with the FDA or filed similar applications with other foreign regulatoryagencies. This lack of experience may impede our ability to obtain FDA or otherforeign regulatory agency approval in a timely manner, if at all, for ourproduct candidates for which development and commercialization is ourresponsibility.

Despite the timeand expense invested, regulatory approval is never guaranteed. The FDA or otherforeign regulatory agencies can delay, limit or deny approval of a productcandidate for many reasons, including:

·       aproduct candidate may not be safe and effective,

·       FDAor other foreign regulatory agency officials may not find the data frompreclinical testing and clinical trials sufficient,

·       theFDA or other foreign regulatory agency may not approve of our third-partymanufacturers’ processes or facilities, or

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

Any delay in obtaining, orinability to obtain, these approvals would prevent us from commercializing ourproduct candidates.

***Even if any of our product candidates receiveregulatory approval, our product candidates may still face future developmentand regulatory difficulties.***

If any of ourproduct candidates receive regulatory approval, the FDA or other foreignregulatory agencies may still impose significant restrictions on the indicateduses or marketing of the product candidates or impose ongoing requirements forpotentially costly post-approval studies. In addition, regulatory agenciessubject a product, its manufacturer and the manufacturer’s facilities tocontinual 

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reviewand periodic inspections. If a regulatory agency discovers previously unknownproblems with a product, including adverse events of unanticipated severity orfrequency, or problems with the facility where the product is manufactured, aregulatory agency may impose restrictions on that product, our collaborators orus, including requiring withdrawal of the product from the market. Our productcandidates will also be subject to ongoing FDA and other foreign regulatoryagency requirements for the labeling, packaging, storage, advertising,promotion, record-keeping and submission of safety and other post-marketinformation on the drug. If our product candidates fail to comply withapplicable regulatory requirements, a regulatory agency may:

·       issuewarning letters or other notices of possible violations,

·       imposecivil or criminal penalties or seek disgorgement of revenue or profits,

·       suspendregulatory approval,

·       suspendany ongoing clinical trials,

·       refuseto approve pending applications or supplements to approved applications filedby us or our collaborators,

·       imposerestrictions on operations, including costly new manufacturing requirements, or

·       seizeor detain products or require a product recall.

In order to market any products outside of the U.S.,we and our collaborators must establish and comply with numerous and varyingregulatory requirements of other countries regarding safety and efficacy.Approval procedures vary among countries and can involve additional producttesting and additional administrative review periods. The time required toobtain approval in other countries might differ from that required to obtainFDA approval. The regulatory approval process in other countries may includeall of the risks regarding FDA approval in the U.S. Regulatory approval in onecountry does not ensure regulatory approval in another, but a failure or delayin obtaining regulatory approval in one country may negatively impact theregulatory process in others. Failure to obtain regulatory approval in other countriesor any delay or setback in obtaining such approval could have the same adverseimpact regarding 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 ourcollaborators fail to comply with applicable foreign regulatory requirements,we and our collaborators may be subject to fines, suspension or withdrawal ofregulatory approvals, product recalls, seizure of products, operatingrestrictions and criminal prosecution.

***If our competitors have products that are approvedfaster, marketed more effectively or demonstrated to be more effective thanours, our commercial opportunity will be reduced or eliminated.***

The biotechnology and biopharmaceutical industries arecharacterized by rapidly advancing technologies, intense competition and astrong emphasis on proprietary products. We face competition from manydifferent sources, including commercial pharmaceutical and biotechnologyenterprises, academic institutions, government agencies and private and publicresearch institutions. Due to the high demand for treatments for liver andmetabolic diseases, research is intense and new treatments are being sought outand developed by our competitors.

We are aware of manycompetitive products currently marketed or under development that are used totreat some of the diseases we have targeted. If CS-917 and/or MB07803 areultimately determined safe and effective and approved for marketing, theseproducts may compete for market share with established 

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therapiesfrom a number of competitors, including large pharmaceutical companies. Suchmarketed products include, but are not limited to the following classes:

·       metformin—amember of the biguanide drug class, related to guanidine and currently is themost widely prescribed first line therapy for type 2 diabetes,

·       sulfonylureas—increasethe secretion of insulin by the pancreas, thereby lowering the level of thesugar glucose in the blood,

·       insulins—mimicinsulin, the naturally occurring hormone made by the pancreas to control bloodglucose levels,

·       PPARs—improveinsulin sensitivity by activating certain genes involved in fat synthesis andcarbohydrate metabolism,

·       incretinmimetics—lower glucose levels by increasing the levels of certain naturallyoccurring hormones from the pancreas, including glucagon-like peptide-1or GLP-1, a peptide that facilitates the response of the pancreas andliver to fluctuations in glucose levels by its action on pancreatic beta andalpha cells. Compounds in this class include dipeptidyl peptidase IV or DPP-IVinhibitors, and BYETTA ® (exenatide) injection. DPP-IV is an enzyme inthe bloodstream that cleaves and inactivates GLP-1. Inhibition of DPP-IVthus increases the half-life of endogenous GLP-1 by preventing cleavageand inactivation of GLP-1. BYETTA is an injectable medication thatexhibits many of the same glucose regulating actions of GLP-1. Theoverall effect of these compounds is to enhance glucose-dependent insulinsecretion and suppress inappropriate glucagon secretion,

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

·       glinides—stimulatethe pancreas’ beta-cells to produce insulin, and

·       combinationtherapies—combines metformin with members of several of the above-mentionedclasses, particularly sulfonylureas and PPARs.

Metformin is a drug that inhibits liver glucoseproduction like CS-917 and MB07803 but does so through an unknownmechanism. Because it does not cause weight gain, metformin is often prescribedas a first line therapy to obese patients with type 2 diabetes, who arereported to comprise more than 90% of patients newly diagnosed with type 2diabetes. Generic forms of metformin have recently become available.Accordingly, unless CS-917 and MB07803 demonstrate significant benefitswhen compared to metformin or demonstrate that they can be used in the patientpopulation who do not tolerate and/or adequately respond to metformintreatment, the price required to effectively compete with the generic form ofmetformin may be so low that it becomes uneconomical to market CS-917 orMB07803. Moreover, if the combination of CS-917 with metformin iscontraindicated for safety reasons the market potential of CS-917 couldbe reduced and/or selling expenses could be increased. Should CS-917eventually be approved and combination with metformin remains an issue, the FDAmay require additional measures be taken during marketing, such as prominentwarning labels known as “black-box” warnings, physician education programsand/or other steps to restrict concomitant use of CS-917 and metformin.

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

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Ifpradefovir is ultimately determined safe and effective and approved formarketing, it may compete for market share with established therapies from anumber of competitors, including large pharmaceutical companies. Such marketedproducts include, but are not limited to the following classes:

·       interferons—mimicinterferon, the naturally occurring infection-fighting immune substance produced by the body,

·       nucleosideanalogues—chemically engineered nucleoside compounds that are converted insidecells into other compounds that are structurally similar to the building blocksof DNA and RNA that interfere with the replication of HBV, and

·       nucleotideanalogues—chemically engineered nucleotide compounds that are converted insidecells into other compounds that are structurally similar to the building blocksof DNA and RNA that interfere with the replication of HBV.

A competitor to pradefovirmay be Hepsera (adefovir dipivoxil), which is a nucleotide analogue currentlymarketed in the U.S. and Europe by Gilead Sciences, Inc. Pradefovir andHepsera are prodrugs of the same active drug, and therefore may directlycompete. In order to effectively compete with Hepsera, pradefovir may have tobe significantly more beneficial or less expensive than Hepsera. In addition,marketed products approved to treat HIV infections are being evaluated fortheir effectiveness in treating hepatitis B infections.

There are no currentlyapproved drugs for primary liver cancer. However, some companies are developingnovel therapies specifically for primary liver cancer. Nexavar (sorafenib), achemotherapy approved for the treatment of kidney cancer, is being evaluatedfor the treatment of primary liver cancer. The drug’s developer, Bayer,recently announced that an ongoing Phase 3 clinical trial of Nexavar for thetreatment of primary liver cancer was stopped early because the trial met itsprimary endpoint resulting in superior overall survival in those patientsreceiving Nexavar tablets versus those patients receiving placebo. Therefore itis likely that Nexavar will be approved for the treatment of patients withprimary liver cancer and it is expected that it will experience significantoff-label use prior to its approval.

In addition, companies aredeveloping therapies for other solid tumors which may be efficacious intreating primary liver cancer. These companies may develop and introduceproducts competitive with or superior to MB07133.

IfMB07811 is ultimately determined safe and effective and approved for marketing,it would compete with products marketed by several large pharmaceuticalcompanies that currently comprise a large share of the hyperlipidemia market.Major classes of hyperlipidemia drugs include, but are not limited to:

·       statins—reduceserum cholesterol levels by inhibiting a key enzyme involved in thebiosynthesis of cholesterol,

·       fibrates—reducethe amount of cholesterol and triglycerides (fatty substances) in blood,

·       nicotinicacid derivatives—lower cholesterol, triglycerides and low density lipoproteinsand increase high density lipoproteins,

·       CAIs—inhibitthe absorption of dietary and biliary cholesterol,

·       bileacid sequestrants—bind with cholesterol-containing bile acids in the intestinesand remove them in bowel movements, and

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

Several largepharmaceutical companies are also developing novel therapies that targethyperlipidemia. These companies may develop and introduce products competitivewith or superior to 

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MB07811.Lipitor (atorvastatin; a statin marketed by Pfizer) is currently the bestselling prescription medicine. In addition, generic statins(cholesterol-reducers) have recently been approved in the major pharmaceuticalmarkets and would also compete with MB07811.

In addition, many othercompanies are developing products for the treatment of the diseases we aretargeting and if successful, these products could compete with our products. Ifwe receive approval to market and sell any of our product candidates, we maycompete with these companies and their products as well as others in varyingstages of development.

Many of our competitorshave significantly greater financial resources and expertise in research anddevelopment, manufacturing, preclinical testing, clinical trials, regulatoryapprovals and marketing approved products than we do. Smaller or early-stagecompanies may also prove to be significant competitors, particularly throughcollaborative arrangements with large and established companies. Ourcompetitors may succeed in developing technologies and therapies that are moreeffective, better tolerated or less costly than any which we are developing, orthat would render our product candidates obsolete and noncompetitive. Ourcompetitors may succeed in obtaining approvals from the FDA and foreignregulatory authorities for their products sooner than we do for ours. We willalso face competition from these third parties in recruiting and retainingqualified scientific and management personnel, establishing clinical trialsites 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 andcommercialize our products depends in part on our ability to manufacture, orarrange for collaborators or other third parties to manufacture, our productsat a competitive cost, in accordance with regulatory requirements and insufficient quantities for clinical trials and eventual commercialization.Daiichi Sankyo and Schering-Plough are currently responsible for all clinicaland commercial manufacturing of CS-917 and pradefovir, respectively. Wehave relied on a number of suppliers to manufacture sufficient quantities ofMB07803, MB07133 and MB07811 for use in our current clinical trials. Althoughour suppliers have manufactured other companies’ products on a commercialscale, we have not yet determined if they are capable of manufacturing ourproducts on a commercial scale. 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 thatin any future clinical trials of MB07803, MB07133 and MB07811, we will rely onour current suppliers to manufacture these compounds. However, we do not havelong-term supply agreements with these third parties, and we may not be able toenter into new supply agreements with them in a timely manner or on acceptableterms, if at all. These third parties may also be subject to capacityconstraints that would cause them to limit the amount of these compounds thatwe can purchase. While we believe alternative sources to manufacture thesecompounds are readily available, in the event we have to seek such alternative sourceswe will incur costs associated with identifying and qualifying one or morealternate suppliers. In addition, any resulting interruption or delay weexperience in the supply of MB07803, MB07133 or MB07811 may impede the clinicaltrials of these compounds.

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In addition, we, ourcollaborators or other third-party manufacturers of our products must complywith current good manufacturing practices, or CGMP, requirements enforced bythe FDA and other foreign regulatory agencies through their facilities inspectionprograms. 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, atany time. We, our collaborators or other third-party manufacturers of ourproducts may be unable to comply with these CGMP requirements and with otherFDA, state and foreign regulatory requirements. We have little control overthird-party manufacturers’ compliance with these regulations and standards. Afailure to comply with these requirements may result in fines and civilpenalties, suspension of production, suspension or delay in product approval,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 andmarketing organization, and we have no experience as a company in the sales,marketing and distribution of pharmaceutical products. Daiichi Sankyo andSchering-Plough are currently responsible for worldwide marketing andcommercialization for CS-917 and pradefovir, respectively, although wehave an option to co-promote CS-917 in North America with Daiichi Sankyo.Although our hepatitis C and metabolic disease collaborations with Merck havenot yet yielded product candidates, should they be successful, Merck will beresponsible for worldwide marketing and commercialization of any resultingproduct candidates (subject to, in the case of our metabolic diseasecollaboration, our option to co-promote the product in the U.S. with certainfinancial assistance from Merck). Similarly, should our hepatitis Ccollaboration with Idenix be successful, Idenix will be responsible forworldwide marketing and commercialization of any resulting product candidates. Inorder to co-promote any of these products, or to commercialize MB07803,MB07133, MB07811 or any future product candidates, we must develop our sales,marketing and distribution capabilities, or make arrangements with a thirdparty to perform these services. Even though we may receive financialassistance from Merck if we exercise our U.S. co-promotion option under themetabolic disease collaboration, developing a sales force for any resultingproduct or any product resulting from any of our other product candidates isexpensive and time consuming and could delay any product launch. We may beunable to establish and manage an effective sales force in a timely orcost-effective manner, if at all, and any sales force we do establish may notbe capable of generating sufficient demand for our product candidates. To theextent that we enter into arrangements with collaborators or other thirdparties to perform sales and marketing services, our product revenues arelikely to be lower than if we directly marketed and sold our productcandidates. If we are unable to establish adequate sales and marketingcapabilities, independently or with others, we may not be able to generatesignificant 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.***

Evenif our product candidates obtain regulatory approval, our products, if any, maynot gain market acceptance among physicians, patients, healthcare payors andthe medical community. The degree of market acceptance of any of our approvedproduct candidates will depend on a number of factors, including:

·       ourability to provide acceptable evidence of safety and efficacy,

·       relativeconvenience and ease of administration,

·       theprevalence and severity of any adverse side effects,

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·       restrictionson use in combination with other products,

·       availabilityof alternative treatments,

·       pricingand cost effectiveness,

·       effectivenessof our or our partners’ sales and marketing strategy, and

·       ourability to obtain sufficient third-party coverage or reimbursement.

If approved, CS-917may have to be administered several times daily. Additionally, it may result invariable drug levels in different patient populations, which could complicateits use and limit its marketability. Since CS-917 is eliminated from thebody through the kidney, it may be of limited use in type 2 diabetes patientswith kidney dysfunction. In addition, CS-917 and HepDirect prodrugs suchas pradefovir, MB07133 and MB07811 may also exhibit interactions with othermarketed drugs that could limit their combination with those drugs. Seriousadverse events observed in early 2005 in a Phase 1 clinical trial of CS-917in combination with metformin have raised questions about the safety of thepotential 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, ifrequired, will likely adversely impact the sales of CS-917 and may incuradditional selling expenses thereby reducing profits. While MB07803 has notdemonstrated the same metformin interaction risk in clinical trials to date, itmay exhibit the same metformin interaction risk and thus may be subject to thesame market potential limitations as CS-917. In addition, primarilybecause the number of treatable patients in the U.S. with primary liver canceris relatively small, we expect to market MB07133, if approved, at a relativelyhigh price in the U.S. in order to generate sufficient revenues to recoup ourcosts and provide a return on our investment. This could limit or prevent usfrom achieving the market acceptance of MB07133 in the U.S. The number oftreatable patients outside of the U.S. is much larger than the number oftreatable patients in the U.S. However, because third party reimbursement inmany of these countries is uncertain, we may be unable to recoup our costs orgenerate sufficient returns on our investment in these countries. If any of ourproduct candidates is approved but does not achieve an adequate level ofacceptance by physicians, healthcare payors and patients, we may not generatesufficient revenue from this product candidate and we may not become or remainprofitable.

***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.***

Thecontinuing efforts of the government, insurance companies, managed careorganizations and other payers of health care costs to contain or reduce costsof health care may adversely affect:

·       ourability to set a price we believe is fair for our products,

·       ourability to generate revenues and achieve or maintain profitability,

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

·       theavailability of capital.

In certain foreignmarkets, the pricing of prescription drugs is subject to government control. Inthe U.S., given recent federal and state government initiatives directed atlowering the total cost of health care, Congress and state legislatures willlikely continue to focus on health care reform, the cost of prescription drugsand the reform of the Medicare and Medicaid systems. For example, the MedicarePrescription Drug, Improvement and Modernization Act of 2003 provides aMedicare prescription drug benefit that began in 2006 and mandates otherreforms. While we cannot predict the full outcome of the 

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implementationof this legislation, it is possible that the new Medicare prescription drugbenefit, which will be managed by private health insurers and other managedcare organizations, will result in decreased reimbursement for prescriptiondrugs, which may further exacerbate industry-wide pressure to reduceprescription drug prices. This could harm our ability to market our productsand generate revenues. It is also possible that other similar proposals will beadopted.

Our ability tocommercialize our product candidates successfully will depend in part on theextent to which governmental authorities, private health insurers and otherorganizations establish appropriate coverage and reimbursement levels for thecost of our products and related treatments. Third-party payors including stategovernments are increasingly challenging the prices charged for medicalproducts and services. Also, the trend toward managed health care in the U.S.,which could significantly influence the purchase of health care services andproducts, as well as legislative proposals to reform health care or reducegovernment insurance programs, may result in lower prices for our productcandidates or exclusion of our product candidates from coverage andreimbursement programs. The cost containment measures that health care payorsand providers are instituting and the effect of any health care reform couldsignificantly reduce our revenues from the sale of any approved product.

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

Since we became anindependent company in 1999, we have increased the number of our full-timeemployees from 50 to 127 as of March 1, 2007. We may need to continue toexpand our managerial, operational, financial and other resources in order tomanage and fund our operations and clinical trials, continue our research anddevelopment and collaborative activities, and commercialize our productcandidates. It is possible that our management and scientific personnel,systems and facilities currently in place may not be adequate to support thisfuture growth. Our need to effectively manage our operations, growth andvarious projects requires that we continue to improve our operational,financial and management controls, reporting systems and procedures and toattract and retain sufficient numbers of talented employees. We may be unableto successfully implement these tasks on a larger scale and, accordingly, maynot achieve our research, development and commercialization goals.

***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 ourcontinued ability to attract, retain and motivate highly qualified managementand scientific personnel. The loss of the services of certain principal membersof our management or scientific staff could delay or prevent thecommercialization of our product candidates. We employ these individuals on an “at-will”basis and their employment can be terminated by us or them at any time, for anyreason and with or without notice, subject to the terms of their stockrestriction agreements and severance agreements.

Competition for qualifiedpersonnel in the biotechnology field is intense. We will need to hireadditional personnel as we establish and/or expand our sales, manufacturing,research and development activities in the future. We may not be able toattract and retain quality personnel on acceptable terms given the competitionfor such personnel among biotechnology, pharmaceutical and other companies.

We have established ascientific advisory board, the members of which assist us in formulating ourresearch, development and clinical strategies. These scientific advisors arenot our employees and may have commitments to, or consulting or advisorycontracts with, other entities that may limit their availability to us. Inaddition, our scientific advisors may have arrangements with other companies toassist those companies in developing products or technologies that may competewith ours.

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***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.***

Animportant part of our business strategy is to continue to develop a broadpipeline of product candidates. In addition to our internal drug developmentefforts, we may seek to expand our product pipeline, at the appropriate timeand as resources allow, by acquiring products or businesses or in-licensingtechnologies that we believe are a strategic fit with our business andcomplement our existing product candidates and research programs. Futureacquisitions, however, may entail numerous operational and financial risksincluding:

·       exposureto unknown liabilities,

·       disruptionof our business and diversion of our management’s time and attention todeveloping acquired products or technologies,

·       incurrenceof substantial debt or dilutive issuances of securities to pay foracquisitions,

·       higherthan expected acquisition and integration costs,

·       increasedamortization expenses,

·       difficultyand cost in combining the operations and personnel of any acquired businesseswith our operations and personnel,

·       impairmentof relationships with key suppliers or customers of any acquired businesses dueto changes in management and ownership, and

·       inabilityto retain key employees of any acquired businesses.

We have limited experiencein identifying acquisition targets, successfully completing potentialacquisitions and integrating any acquired products, businesses or technologiesinto our current infrastructure. Moreover, we may devote resources to potentialacquisitions that are never completed or fail to realize the anticipatedbenefits of any acquisition.

**RisksRelated to our Finances and Capital Requirements**

***We have a historyof net losses, which we expect to continue for the foreseeable future, and weare unable to predict the extent of future losses or when we will becomeprofitable, if ever.***

We have incurred netlosses from our inception. As of December 31, 2006, we had an accumulateddeficit of approximately $108.2 million. We expect to increase our operatingexpenses over the next several years as we continue and expand our research anddevelopment activities, including conducting clinical trials for our productcandidates and further developing our product pipeline, acquiring orin-licensing products, technologies or businesses, and funding other workingcapital and general corporate purposes. As a result, we expect to continue to incursignificant and increasing operating losses for the foreseeable future. Becauseof the numerous risks and uncertainties associated with our product developmentefforts, we are unable to predict the extent of any future losses or when wewill become profitable, if ever.

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

Ourability to become and remain profitable depends upon our ability to generatecontinuing 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:

·       successfulcompletion of ongoing clinical trials for our product candidates,

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·       achievementof regulatory approval for our product candidates,

·       successfulcompletion of our current and future strategic collaborations, and

·       successfulsales, manufacturing, distribution and marketing of our products.

We do not anticipate thatwe will generate significant continuing revenues for several years. If we areunable to eventually generate significant continuing revenues, we will notbecome or remain profitable, and we may be unable 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.***

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. Because we do not anticipate that we willgenerate significant continuing revenues for several years, if at all, we willneed to raise substantial additional capital to finance our operations in thefuture. Our additional funding requirements will depend on, and could increasesignificantly as a result of, many factors, including:

·       therate of progress and cost of our clinical trials and other research anddevelopment activities,

·       thescope, prioritization and number of clinical development and research programswe pursue,

·       thecosts of expanding our operations,

·       theterms and timing of any collaborative, licensing and other arrangements that wemay establish,

·       thecosts of filing, prosecuting, defending and enforcing any patent claims andother intellectual property rights,

·       thecosts and timing of regulatory approvals,

·       thecosts of establishing or contracting for sales and marketing capabilities,

·       theeffect of competing technological and market developments, and

·       theextent to which we acquire or in-license new products, technologies orbusinesses.

Until we can generatesignificant continuing revenues, if ever, we expect to satisfy our future cashneeds through public or private equity offerings, debt financings, grants or corporatecollaboration and licensing arrangements, as well as through interest incomeearned on cash balances.

We cannot be certain thatadditional funding will be available on acceptable terms, or at all. Ifadequate funds are not available, we may be required to delay, reduce the scopeof or eliminate one or more of our research and development programs or ourcommercialization efforts and we may be unable to continue as a going concern.

***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 may raise additionalfunds through public or private equity offerings, our committed equityfinancing facility, or CEFF, with Kingsbridge Capital Limited, debt financings,grants or corporate collaboration and licensing arrangements. For example, wehave an effective shelf registration statement on file with the Securities andExchange Commission which allows us to issue shares of our common stock andwarrants to purchase our common stock for an aggregate initial offering priceof up to $75 million. To date, we have sold approximately $40 million of ourcommon stock under this registration statement. We have also filed aregistration statement with the Securities and Exchange Commission covering theresale 

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ofshares issuable under the CEFF though to date, no shares have been issued underthis registration statement. We may sell additional securities from time totime in one or more offerings in amounts, at prices and on terms that we willdetermine at the time of the offering. To the extent that we raise additionalcapital by issuing equity securities, pursuant to our effective shelfregistration statement or otherwise, our existing stockholders’ ownership willbe diluted.

Any debt financing weenter into may involve covenants that restrict our operations. Theserestrictive covenants may include limitations on additional borrowing, specificrestrictions on the use of our assets as well as prohibitions on our ability tocreate liens, pay dividends, redeem our stock or make investments. In addition,if we raise additional funds through collaboration and licensing arrangements,it may be necessary to relinquish potentially valuable rights to our potentialproducts or proprietary technologies, or grant licenses on terms that are notfavorable to us.

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

Weexpect our operating results to be subject to quarterly fluctuations. Therevenues we generate, if any, and our operating results will be affected bynumerous factors, including:

·       thedevelopment status of our product candidates, including results of our clinicaltrials,

·       ourrecommendation of additional drug compounds for clinical development,

·       ouraddition or termination of research programs or funding support,

·       variationsin the level of expenses related to our product candidates or researchprograms,

·       ourexecution of collaborative, licensing or other arrangements, and the timing ofpayments we may make or receive under these arrangements, and

·       changesin the use assumptions or the use of different valuation methods in theapplication of SFAS No. 123R in future periods.

Quarterly fluctuations inour operating results may, in turn, cause the price of our stock to fluctuatesubstantially. We believe that quarterly comparisons of our financial resultsare not necessarily meaningful and should not be relied upon as an indicationof our future performance.

***Our committedequity financing facility with Kingsbridge may not be available to us if weelect to make a draw down, may require us to make additional “blackout” orother payments to Kingsbridge and may result in dilution to our stockholders.***

In November 2006, weentered into the CEFF with Kingsbridge. The CEFF entitles us to sell andobligates Kingsbridge to purchase, from time to time over a period of 36months, shares of our common stock for cash consideration up to an aggregate of$50.0 million, subject to specified conditions and restrictions.Kingsbridge will not be obligated to purchase shares under the CEFF unlessspecified conditions are met, which include a minimum price for our commonstock; the accuracy of representations and warranties made to Kingsbridge;compliance with laws; and the effectiveness of a registration statementregistering for resale the shares of common stock to be issued in connectionwith the CEFF. In addition, among other termination rights, Kingsbridge is permittedto terminate the CEFF by providing written notice to us within 10 business daysafter it obtains actual knowledge that an event has occurred resulting in amaterial and adverse effect on our business, operations, properties orfinancial condition (subject to specified exceptions, including conditions orevents that are reasonably expected to occur in the ordinary course of ourbusiness). If we are unable to access funds through the CEFF, or if Kingsbridgeterminates the CEFF, we may be unable to access capital on favorable terms, orat all.

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We are entitled, incertain circumstances, to deliver a “blackout” notice to Kingsbridge to suspendthe use of this prospectus and prohibit Kingsbridge from selling shares underthis prospectus for a certain period of time. If we deliver a blackout notice inthe 15 trading days following the settlement of a draw down, or if theregistration statement of which this prospectus is a part is not effective incircumstances not permitted by our registration rights agreement withKingsbridge, then we must make a payment to Kingsbridge, or issue Kingsbridgeadditional shares in lieu of this payment, calculated on the basis of aspecified number of shares held by Kingsbridge immediately prior to theblackout period and the change in the market price of our common stock duringthe period in which the use of the registration statement is suspended. If thetrading price of our common stock declines during a suspension of the resaleregistration statement, the blackout or other payment could be significant.

Should we sell shares toKingsbridge under the CEFF, or issue shares in lieu of a blackout payment, itwill have a dilutive effect on the holdings of our current stockholders and mayresult in downward pressure on the price of our common stock. If we draw downamounts under the CEFF, we will issue shares to Kingsbridge at a discount of upto 10% from the volume weighted average price of our common stock. If we drawdown amounts under the CEFF when our stock price is decreasing, we will need toissue more shares to raise the same amount than if our stock price was higher.Issuances in the face of a declining stock price will have an even greaterdilutive effect than if our stock price were stable or increasing and mayfurther decrease our stock price.

**RisksRelated 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 successdepends on obtaining and maintaining patent protection and/or trade secretprotection of our product candidates, proprietary technologies and their uses,as well as successfully defending any patents that issue against third-partychallenges. We may only be able to protect our product candidates, proprietarytechnologies and their uses from unauthorized use by third parties to theextent that valid and enforceable patents or trade secrets cover them.

The filing, prosecutionand defense of patents at pharmaceutical and biotechnology companies can behighly uncertain and involve complex legal and factual questions for whichimportant legal principles remain unresolved. No consistent policy regardingthe breadth of claims allowed in biotechnology patents has emerged to date inthe U.S. The biotechnology patent situation outside the U.S. is even moreuncertain. We may be particularly affected by this because we expect thatpradefovir and MB07133, if approved, will be marketed in foreign countries withhigh incidences of HBV and primary liver cancer, respectively. Decisions oractions regarding patent filing and/or changes in either the patent laws or ininterpretations of patent laws in the U.S. and other countries may diminish thevalue of our intellectual property.

Decisions or actionsregarding patent filing are complex and we may not be successful in protectingour products from competition. Patent positions for products are highlyuncertain and involve complex legal and factual questions which may ultimatelybe decided to the detriment of our products’ competitive positions’ in the U.S.and these other countries. We may not be able to develop patentable products orprocesses in the U.S. and these other countries, and may not be able to obtainpatents from pending applications. Even if patent claims are allowed in the U.S.and these other countries, 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 in the U.S. and othercountries may be circumvented, challenged or invalidated by our competitors. Inaddition, we are dependent on outside patent firms for advice and actionregarding our efforts to secure patents. Should these firms fail to takeappropriate action to secure or enforce our patents in a timely manner, orshould they provide us with incorrect or inappropriate advice it could bedetrimental to our patent positions.

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Accordingly, we cannotpredict the breadth of claims that may be allowed or enforced in our patents orin third-party patents in the U.S. and other countries.

Thedegree of future protection for our proprietary rights is uncertain becauselegal means afford only limited protection and may not adequately protect ourrights or permit us to gain or keep our competitive advantage. For example:

·       wemight not have been the first to make the inventions covered by each of ourpending patent applications and issued patents,

·       wemight not have been the first to file patent applications for these inventions,

·       othersmay independently develop similar or alternative technologies or duplicate anyof our technologies,

·       itis possible that none of our pending patent applications will result in issuedpatents,

·       ourissued patents may not provide a basis for commercially viable products, maynot provide us with any competitive advantages, or may be challenged by thirdparties,

·       ourissued patents may not be valid or enforceable,

·       wemay not develop additional proprietary technologies that are patentable, or

·       thepatents of others may have an adverse effect on our business.

Proprietary trade secretsand unpatented know-how are also very important to our business. Although wehave taken steps to protect our trade secrets and unpatented know-how,including entering into proprietary information and inventions agreements withour employees and consultants and entering into confidentiality agreements withother third parties to whom we disclose our proprietary information, thirdparties may still obtain this information without our knowledge and consent.Enforcing a claim that a third party illegally obtained and is using our tradesecrets or unpatented know-how is expensive and time consuming, and the outcomeis unpredictable. In addition, courts outside the U.S. may be less willing toprotect this information. Moreover, our competitors may independently developequivalent 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 successdepends upon our ability and the ability of our collaborators to develop,manufacture, market and sell our product candidates and use our proprietarytechnologies without infringing the proprietary rights of third parties.Numerous U.S. and foreign issued patents and pending patent applications, whichare owned by third parties, exist in the fields in which we and ourcollaborators are developing products. Because patent applications can takemany years to issue, there may be currently pending applications, unknown tous, 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 tofuture litigation by the companies holding these patents or other third partiesbased on claims that our product candidates and/or proprietary technologiesinfringe their intellectual property rights. If one of these patents was foundto cover our product candidates, proprietary technologies or their uses, we orour collaborators could be required to pay damages and could be unable tocommercialize our product candidates or use our proprietary technologies unlesswe or they obtained a license to the patent. In addition, while we are notcurrently subject to pending litigation nor are we aware of any threatenedlitigation, third parties may contact us or our collaborators in the ordinarycourse of 

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businessto bring certain patents to our attention. We and our collaborators evaluateall such communications on a case-by-case basis to assess whether such patentscover our product candidates or proprietary technologies and if so, whether toseek a license from such third parties. A license may not be available to us orour collaborators on acceptable terms, if at all.

Thereis a substantial amount of litigation involving patent and other intellectualproperty rights in the biotechnology and biopharmaceutical industriesgenerally. If a third party claims that we or our collaborators infringe on itstechnology, we may face a number 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,

·       ifa license 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 searchesof U.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 in collaborationwith others, could be subject to similar delays and uncertainties.

***Existing patentsand patent applications covering adefovir or prodrugs of adefovir in the U.S.and foreign countries may prevent the commercialization of pradefovir in thefuture.***

Our product candidatepradefovir is a prodrug of adefovir. A third party, Gilead, has rights toanother product called Hepsera that is a non-liver specific prodrug of adefovir.We are aware of third party patents and patent applications in the U.S. and inEuropean and other foreign countries with claims to prodrugs of adefovir. Thesepatents are scheduled to expire in September 2011 overseas and in 2014 inthe U.S. Although we do not believe that any valid claim covers pradefovir, wecannot guarantee this. If it is determined that patent claims are valid andcover pradefovir, we may not be able to commercialize pradefovir in suchcountries, including those in Europe. Further, we are aware that a patent termextension of one of these prodrug patents has been granted in multiple Europeancountries based on the regulatory approval of Hepsera thereby extendingprotection of Hepsera in those countries to September 2016. Additionalthird party patents covering Hepsera or adefovir may exist, and may expirelater than our expected date of regulatory approval in the country where thepatent is in force.

**RisksRelated to Other Legal Matters**

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

We use hazardousmaterials, including chemicals, biological agents and radioactive isotopes andcompounds that could be dangerous to human health and safety or theenvironment. As appropriate, we 

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storethese materials and wastes resulting from their use at our facility pendingtheir ultimate use or disposal. We currently contract with a third party todispose of these materials and wastes. We are subject to a variety of federal,state and local laws and regulations governing the use, generation,manufacture, storage, handling and disposal of these materials and wastes. Wemay also incur significant costs complying with environmental laws andregulations adopted in the future.

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

We face an inherent riskof product liability exposure related to the testing of our product candidatesin human clinical trials, and will face an even greater risk if we sell ourproduct candidates commercially. For example, in March 2005 two cases oflactic acidosis were observed in a clinical trial combining CS-917 withmetformin. As a result, unless further data changes the situation, thecombination of CS-917 and metformin is contraindicated and theinadvertent combination of the drugs could put patients at risk for lacticacidosis. Therefore, even if CS-917 receives regulatory approval the FDAmay require that additional measures be taken during marketing, such asprominent warning labels known as “black-box” warnings, physician educationprograms and/or other steps to restrict concomitant use of metformin and CS-917.However, none of these programs can be assured of eliminating the possibilityof the inadvertent use of CS-917 with metformin and the consequent riskof lactic acidosis. Therefore, these programs may not effectively protect usfrom a liability claim.

Anindividual may bring a liability claim against us if one of our productcandidates causes, or merely appears to have caused, an injury. If we cannotsuccessfully defend ourselves against the product liability claim, we willincur substantial liabilities. Regardless of merit or eventual outcome,liability claims may result in:

·       decreaseddemand for our product candidates,

·       injuryto our reputation,

·       withdrawalof clinical trial participants,

·       costsof related litigation,

·       substantialmonetary awards to patients or other claimants,

·       lossof revenues, and

·       theinability to commercialize our product candidates.

We have product liabilityinsurance that covers our clinical trials, up to an annual aggregate limit of$10 million. We intend to expand our insurance coverage to include thesale of commercial products if marketing approval is obtained for any of ourproduct candidates. However, insurance coverage is increasingly expensive. Wemay not be able to maintain insurance coverage at a reasonable cost and we maynot be able to obtain insurance coverage that will be adequate to satisfy anyliability that may arise.

***If we usebiological and hazardous materials in a manner that causes injury, we may beliable for damages.***

Our research anddevelopment and manufacturing activities involve the use of biological andhazardous materials. Although we believe our safety procedures for handling anddisposing of these materials comply with federal, state and local laws andregulations, we cannot entirely eliminate the risk of accidental injury orcontamination from the use, storage, handling or disposal of these materials.If one of our employees was accidentally injured from the use, storage,handling or disposal of these materials, the medical costs related to his orher treatment would be covered by our workers’ compensation insurance policy.While our property and casualty and general liability insurance policiesspecifically exclude coverage for damages and fines arising from biological orhazardous waste exposure or contamination, we 

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do carryseparate pollution legal liability coverage that is intended to cover thirdparty claims for bodily injury, property damage and remediation costs. However,in the event of contamination or injury, we could be held liable for damages orpenalized with fines in an amount exceeding our insurance and/or resources.

**RisksRelated to the Securities Markets and Investment in our Common Stock**

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

Themarket price for our common stock has been and is likely to continue to bevolatile. In addition, the market price of our common stock may fluctuatesignificantly in response to a number of factors, most of which we cannotcontrol, including:

·       changesin the regulatory status of our product candidates, including the status andresults of our clinical trials,

·       eventsaffecting Daiichi Sankyo, Schering-Plough, Merck, Idenix or any futurecollaborators,

·       announcementsof new products or technologies, commercial relationships or other events by usor our competitors,

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

·       fluctuationsin stock market prices and trading volumes of similar companies,

·       variationsin our quarterly operating results,

·       changesin securities analysts’ estimates of our financial performance,

·       changesin accounting principles,

·       issuancesof new equity securities by us, pursuant to our effective shelf registrationstatement or otherwise,

·       salesof large blocks of our common stock, including sales by our executive officers,directors and significant stockholders,

·       additionsor departures of key personnel, and

·       discussion of us or ourstock 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 amendedand restated certificate of incorporation and bylaws may delay or prevent anacquisition of us or a change in our management. These provisions include aclassified board of directors, a prohibition on actions by written consent ofour stockholders, and the ability of our board of directors to issue preferredstock without stockholder approval. In addition, because we are incorporated inDelaware, we are governed by the provisions of Section 203 of the DelawareGeneral Corporation Law, which prohibits stockholders owning in excess of 15%of our outstanding voting stock from merging or combining with us. Although webelieve these provisions collectively provide for an opportunity to receivehigher bids by requiring potential acquirers to negotiate with our board ofdirectors, they would apply even if the offer may be considered beneficial bysome stockholders. In addition, these provisions may frustrate or prevent anyattempts by our stockholders to replace or remove our current management bymaking it more difficult for stockholders to replace members of our board ofdirectors, which is responsible for appointing the members of our management.

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

Changes in the laws andregulations affecting public companies, including the provisions of theSarbanes-Oxley Act of 2002 and rules adopted or proposed by the Securitiesand Exchange Commission and by the Nasdaq Stock Market, have resulted inincreased costs to us which are likely to continue and may further increase aswe continue to evaluate the implications of these laws and regulations andrespond to their requirements. 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 confidenceand share value may be adversely impacted if our independent auditors areunable to provide us with the attestation of the adequacy of our internalcontrols over financial reporting, as required by Section 404 of theSarbanes-Oxley Act of 2002.***

Beginning with this annualreport on Form 10-K we are required pursuant to Section 404 ofthe Sarbanes-Oxley Act of 2002 to include in our annual reports on Form 10-Kan assessment by our management of the effectiveness of our internal controlsover financial reporting. In addition, our independent auditors must attest toand report on our management’s assessment. How companies are implementing theserequirements including internal control reforms, if any, and how independentauditors are applying these requirements and testing internal controls, remainsubject to some uncertainty. In addition, any control system, regardless of howwell designed, operated and evaluated, can provide only reasonable, notabsolute, assurance that its objectives will be met. If, during any year, ourindependent auditors are not satisfied with our internal controls overfinancial reporting or the level at which these controls are documented,designed, operated, tested or assessed, or if our independent auditorsinterpret the applicable requirements, rules or regulations differentlythan we do, then they may decline to attest to management’s assessment or mayissue a report that is qualified. This could result in an adverse reaction inthe financial marketplace due to a loss of investor confidence in thereliability of our financial statements, which could negatively impact themarket 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 our outstanding common stock,beneficially owned approximately 68% of our common stock as of December 31,2006. As a result, these stockholders, acting together, are able to control allmatters requiring approval by our stockholders, including the election ofdirectors and the approval of mergers or other business combinationtransactions. The interests of this group of stockholders may not alwayscoincide with our interests or the interests of other stockholders, and theymay act in a manner that advances their best interests and not necessarilythose of other stockholders.

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

A large portion of ourshares are held by a small number of persons and investment funds. In addition,these persons and funds hold warrants to purchase 4,057,176 shares of commonstock that, if exercised, will result in these additional shares becomingavailable for sale. Moreover, several of our stockholders and warrant holdershave rights, subject to some conditions, to require us to file registrationstatements covering the unregistered shares they currently hold or may acquireupon exercise of warrants, 

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or toinclude these shares in registration statements that we may file for ourselvesor other stockholders. Under the CEFF, Kingsbridge is committed to purchase upto $50 million of our common stock over a 36 month period. Sales by thesecurrent and potential future stockholders or warrant holders of a substantialnumber of shares could significantly reduce the market price of our commonstock.

**Item1B.**               Unresolved StaffComments

Not applicable.

**Item2.**                        Properties

We lease approximately82,000 square feet of space in La Jolla, California. We perform all of ourresearch, development, management, administrative and other activities in thisfacility. The initial term of the lease expires in 2015. We have options toextend the lease for two renewal periods of five years each.

We believe that ourfacilities are adequate for our current needs.

**Item3.**                        LegalProceedings

We are currently not aparty to any material legal proceedings.

**Item4.**                        Submissionof Matters to a Vote of Security Holders

Not applicable.

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**PART II**

**Item5.**                        Market forRegistrant’s Common Equity, Related Stockholder Matters and Issuer Purchases ofEquity Securities

**Market Information**

Ourcommon stock has been traded on the Nasdaq Stock Market since June 16,2004 under the symbol MBRX. Prior to such time, there was no public market forour common stock. The following table sets forth the high and low sales pricesfor our common stock as reported on the Nasdaq Stock Market for the periodsindicated.

| ** **                             | ** ** | **High**   | ** ** | **Low**    | ** ** |
|----------------------------------------|------------|------------|------------|------------|------------|
| **Year Ended December 31,  2006** |       |       |       |       |       |
| Fourth Quarter                         |       | $          | 8.39       |       | $          | 5.15 |   |
| Third Quarter                          |       | $          | 8.29       |       | $          | 5.05 |   |
| Second Quarter                         |       | $          | 9.30       |       | $          | 7.45 |   |
| First Quarter                          |       | $          | 9.79       |       | $          | 7.66 |   |
| ** **                             | ** ** | **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 |   |

 

As of March 5, 2007,there were 121 holders of record of our common stock.

**Dividend Policy**

We have never declared orpaid cash dividends on our capital stock. We currently intend to retain all availablefunds and any future earnings for use in the operation and expansion of ourbusiness and do not anticipate paying any cash dividends in the foreseeablefuture.

**Equity Compensation Plan Information**

Thefollowing table provides certain information as of December 31, 2006, withrespect to all of our equity compensation plans in effect on that date.

| ** **                                                 | ** ** | **Number of securities  to be issued upon  exercise of  outstanding options,  warrants and rights  (a)** | ** ** | **Weighted-average  exercise price of  outstanding  options, warrants  and rights  (b)** | ** ** | **Number of securities  remaining available for  issuance under equity  compensation plans  (excluding securities  reflected in column (a))  (c)** | ** ** |
|------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| Equity  compensation plans approved by stockholders(1)     |       |                                                                                                                                                  | 6,695,459  |                                                                                                         |       |                                                                                                                                                                                                      | $          | 4.70 |   |   |   | 1,840,474 |   |   |
| Equity  compensation plans not approved by stockholders(2) |       |                                                                                                                                                  | —     |                                                                                                         |       |                                                                                                                                                                                                      | —     |   |   |   | — |   |   |
| Total                                                      |       |                                                                                                                                                  | 6,687,459  |                                                                                                         |       |                                                                                                                                                                                                      | $          | 4.70 |   |   |   | 1,840,474 |   |   |

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(1)          Includes our Amended and Restated 2001 Equity Incentive Plan, our 2004Non-Employee Directors’ Stock Option Plan and our 2004 Employee Stock PurchasePlan. 688,512 shares under column (c) are attributable to our 2004Employee Stock Purchase Plan.

(2)          As of December 31, 2006, we did not have any equity compensationplans that were not approved by our stockholders.

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**Performance Graph**

*The material in this section is not “soliciting material,” is notdeemed “filed” with the Securities and Exchange Commission, and is not to beincorporated by reference into any filing of Metabasis under the Securities Actof 1933, as amended, or the Securities Exchange Act of 1934, as amended.*

The following graph compares the cumulative 30-month total returnto stockholders on our common stock relative to the cumulative total returns ofthe Nasdaq Composite index and the Nasdaq Biotechnology index. The graphassumes all dividends have been reinvested (to date, we have not declared anydividends). The stock price performance included in the graph is notnecessarily indicative of future stock price performance.

**COMPARISON OF30-MONTH CUMULATIVE TOTAL RETURN*Among Metabasis Therapeutics, Inc., the Nasdaq Composite Indexand the Nasdaq Biotechnology Index**

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*                    $100 investedon 6/16/04 in stock or on 5/31/04 in index, including reinvestment of dividends.Fiscal year ending December 31.

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**Item 6.**                        SelectedFinancial 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 annual report on Form 10-K.

| ** **                                                   | ** ** | **Years Ended December 31,**                           | ** ** |
|--------------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|
| ** **                                                   | ** ** | **2006**                                                              | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
| ** **                                                   | ** ** | **(In thousands, except per share amounts)** | ** ** |
| **Statements of Operations Data:**                           |       |                                                                  |       |   |   |   |   |   |   |   |   |
| Revenue                                                      |       | $                                                                     | 4,386      |   | $ | 3,771 |   | $ | 6,837 |   | $ | 9,124 |   | $ | 2,278 |   |
| Total operating  expenses                                    |       | 41,195                                                                |       | 28,438 |   | 22,112 |   | 18,507 |   | 15,163 |   |
| Loss from  operations                                        |       | (36,809                                                               | )          | (24,667 | ) | (15,275 | ) | (9,383 | ) | (12,885 | ) |
| Other income  (expense), net                                 |       | 3,541                                                                 |       | 1,087 |   | 303 |   | (46 | ) | 88 |   |
| Net loss(1)                                                  |       | (33,268                                                               | )          | (23,580 | ) | (14,972 | ) | (9,429 | ) | (12,797 | ) |
| Preferred stock  deemed dividend(2)                          |       | —                                                                |       | — |   | — |   | (24,900 | ) | — |   |
| Net loss  applicable to common stockholders                  |       | $                                                                     | (33,268    | ) | $ | (23,580 | ) | $ | (14,972 | ) | $ | (34,329 | ) | $ | (12,797 | ) |
| Basic and diluted net  loss per share(1)                     |       |                                                                  |       |   |   |   |   |   |   |   |   |
| Historical                                                   |       | $                                                                     | (1.15      | ) | $ | (1.20 | ) | $ | (1.49 | ) | $ | (23.84 | ) | $ | (10.12 | ) |
| Proforma                                                     |       |                                                                  |       |   |   | $ | (0.98 | ) | $ | (3.74 | ) |   |   |
| Shares used to compute  basic and diluted net loss per share |       |                                                                  |       |   |   |   |   |   |   |   |   |
| Historical                                                   |       | 29,019                                                                |       | 19,706 |   | 10,034 |   | 1,440 |   | 1,265 |   |
| Proforma                                                     |       |                                                                  |       |   |   | 15,254 |   | 9,187 |   |   |   |

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(1)          Please see Note 1to our financial statements for an explanation of the method used to calculatethe historical and pro forma net loss per share and the number of shares usedin the computation of the per share amounts.

(2)          OurSeries E preferred stock financing, which closed in October 2003,involved the sale of our Series E preferred stock at a price per sharebelow the initial public offering price of our common stock contemplated in our2004 initial public filing. Accordingly, pursuant to Emerging Issues TaskForce, or EITF, 98-5, *Accounting forConvertible Securities with Beneficial Conversion Features*, in 2003we recorded a deemed dividend on our Series E preferred stock of$24.9 million, which was the difference between the gross proceeds fromour Series E preferred stock financing and the underlying value of theconversion shares (adjusted for a conversion price adjustment feature andlimited to the proceeds allocated to the convertible instrument). The$24.9 million deemed dividend was entirely recognized as an adjustment tonet loss applicable to common stockholders since our Series E preferredstock was convertible, at any time, at the option of the holder. In accordancewith EITF 00-27, *Application ofIssue No. 98-5 to Certain Convertible Instruments*, wecalculated the deemed dividend of $24.9 million using the most favorableconversion price of $3.12 per conversion share.

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| ** **                                                | ** ** | **As of December 31,** | ** ** |
|-----------------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                                | ** ** | **2006**                              | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | ** ** |
| ** **                                                | ** ** | **(In thousands)**               | ** ** |
| **Balance Sheet Data:**                                   |       |                                  |       |   |   |   |   |   |   |   |   |   |
| Cash, cash  equivalents and securities available-for-sale |       | $                                     | 77,923     |   | $ | 66,893 |   | $ | 43,855 |   | $ | 25,257 |   | $ | 19,562 |   |   |
| Working capital                                           |       | 69,388                                |       | 60,146 |   | 40,906 |   | 22,342 |   | 13,693 |   |   |
| Total assets                                              |       | 85,855                                |       | 73,878 |   | 47,860 |   | 29,110 |   | 21,733 |   |   |
| Long-term  obligations (including current portion)        |       | 5,760                                 |       | 3,168 |   | 2,226 |   | 1,820 |   | 2,854 |   |   |
| Accumulated  deficit                                      |       | (108,213                              | )          | (74,945 | ) | (51,365 | ) | (36,393 | ) | (26,964 | ) |   |
| Total stockholders’  equity                          |       | 68,138                                |       | 59,582 |   | 41,864 |   | 23,437 |   | 8,756 |   |   |
|                                                           |            |                                       |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

**Item 7.**                        Management’sDiscussion and Analysis of Financial Condition and Results of Operations

*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.This discussion 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**

We are a biopharmaceutical company focused on thediscovery, development and commercialization of novel drugs by applying ourproprietary technology, scientific expertise and unique capabilities fortargeting the liver and liver pathways. These diseases include metabolicdiseases such as diabetes, obesity, and hyperlipidemia, among others, and liverdiseases such as hepatitis and primary liver cancer. We have established abroad and growing product pipeline of product candidates and advanced researchprograms targeting large markets with significant unmet medical needs. We havediscovered all of our product candidates internally using our proprietarytechnologies.

Wecurrently have five product candidates in clinical trials. These five productcandidates, by category, and in order from the most advanced in clinical trialswithin each category, are as follows:

**Product Pipeline—MetabolicDiseases**

| **Product  Candidates/Programs(1)** | ** ** | **Disease/Condition** | ** ** | **Partner**    | ** ** | **Our Commercial Rights**                    | ** ** | **Status** |
|-------------------------------------|------------|-----------------------|------------|----------------|------------|----------------------------------------------|------------|------------|
| CS-917                              |       | Diabetes              |       | Daiichi Sankyo |       | Royalties, North America Co-promotion Option |       | Phase 2b   |
| MB07803                             |       | Diabetes              |       | None           |       | Worldwide                                    |       | Phase 1    |
| MB07811                             |       | Hyperlipidemia        |       | None           |       | Worldwide                                    |       | Phase 1    |

 

**Product Pipeline—Liver Diseases**

| **Product  Candidates/Programs(1)** | ** ** | **Disease/Condition** | ** ** | **Partner**     | ** ** | **Our Commercial Rights** | ** ** | **Status**          |
|-------------------------------------|------------|-----------------------|------------|-----------------|------------|---------------------------|------------|---------------------|
| Pradefovir                          |       | Hepatitis B           |       | Schering-Plough |       | Royalties                 |       | Phase 2b completed  |
| MB07133                             |       | Primary Liver Cancer  |       | None            |       | Worldwide                 |       | Phase 1/2 completed |

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(1)          None of our productcandidates have received regulatory approval in the U.S. or in foreigncountries.

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We have incurredannual net losses since inception. As of December 31, 2006, ouraccumulated deficit was approximately $108.2 million. We expect to incursubstantial and increasing losses for the next several years as we:

·       continueto develop current and future clinical development candidates,

·       commercializeour product candidates, if any, that receive regulatory approval,

·       continueand expand our research and development programs, and

·       acquireor in-license products, technologies or businesses that are complementary toour own.

We have a limited history of operations and, to date,we have not generated any product revenues. In addition to our initial publicoffering in June 2004, our private placement of common stock and warrantsin October 2005 and our registered direct offering of common stock in March 2006,we have financed our operations and internal growth through private placementsof preferred stock as well as direct payments of sponsored research funding,license fees, milestone payments, equity investments from our collaborativepartners and, to a lesser extent, the sale of common stock through ourstockholder approved equity incentive plans. We have received additionalfunding through equipment financing arrangements and Small Business InnovationResearch, or SBIR, grants.

Our agreements with collaborators may include jointmarketing or promotion arrangements of our products. For example, we haveretained co-promotion rights for CS-917 in North America with DaiichiSankyo. 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 Schering-Plough. We do not have collaborative partnerships forMB07803, MB07133 or MB07811 and are currently independently developing theseproduct candidates. We retain worldwide commercialization rights to all of thecompounds generated from our current research programs, with the exception ofproduct candidates covered by our collaborations with Merck and Idenix. 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.

We will rely on our partners or third-partymanufacturers to produce sufficient quantities of these products forpreclinical and clinical studies and large-scale commercialization upon theirapproval.

Our business is subject tosignificant risks, including the risks inherent in our ongoing clinical trialsand the regulatory review and approval process, the results of our research anddevelopment efforts, reliance on third parties for the development andcommercialization of our product candidates, competition from other productsand uncertainties associated with obtaining and enforcing patent rights.

**Research andDevelopment**

Our research and development expenses consistprimarily of cash and stock-based compensation and other expenses for researchand development personnel, costs associated with preclinical development andclinical trials of our product candidates, facility costs, supplies andmaterials, costs for consultants and related contract research anddepreciation. We charge all research and development expenses to operations asthey are incurred.

Our research and development activities are primarilyfocused on the clinical development of MB07803, MB07133 and MB07811. Inaddition, research and development activities include work on a variety of compoundsin our other discovery research programs. We are responsible for all costsincurred for these product and clinical candidates and in our discoveryresearch programs with the exception of the AMPK and hepatitis C programspartnered with Merck and our hepatitis C program partnered with Idenix. Underthe terms of our collaboration agreements with Merck, we had receivedapproximately 

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$6.5 million insponsored research funding through December 31, 2006. Daiichi Sankyo andSchering-Plough are responsible for the costs of clinical development of CS-917and pradefovir, respectively.

At this time, due to the risks inherent in theclinical trial process and given the early stage of development of our productcandidates and lead compounds from our research programs, we are unable toestimate with any certainty the costs we will incur in the continueddevelopment of our product candidates for commercialization. Other than costsfor outsourced services associated with our clinical programs, we generally donot track our research and development expenses by project; rather, we tracksuch expenses by the type of cost incurred. Due to these same factors, we areunable to determine the anticipated completion dates for our current researchand development projects. However, we expect our research and development coststo be substantial and to increase as we continue the development of our currentproduct candidates, as well as continue and expand our research programs.

Generally, Phase 1 clinical trials can be expected tolast from 6 to 18 months, Phase 2 clinical trials can be expected to lastfrom 12 to 24 months and Phase 3 clinical trials can be expected to lastfrom 18 to 36 months. However, clinical development timelines vary widely,as do the total costs of clinical trials and the likelihood of success.Although we are currently focused primarily on advancing MB07803, MB07133 andMB07811 through clinical development, we anticipate that we will makedeterminations as to which research and development projects to pursue and howmuch funding to direct to each project on an ongoing basis in response to thescientific and clinical success of each product candidate, our ongoingassessment of its market potential and considering our available financialresources.

The lengthy process ofseeking regulatory approvals for our product candidates, and the compliancewith applicable regulations, require the expenditure of substantial resources.Any failure by us to obtain, or any delay in obtaining regulatory approvalscould cause our research and development expenditures to increase and, in turn,have a material unfavorable effect on our results of operations. We cannot becertain when or if any net cash inflow due to sales of any of our currentproduct candidates will commence.

**General andAdministrative**

General and administrative expenses consist primarilyof salaries, stock-based compensation and other related costs for personnel inexecutive, finance, accounting, business development, investor relations,information systems, legal and human resource functions. Other costs includefacility costs not otherwise included in research and development expenses,depreciation and professional fees for legal and accounting services.

We anticipate continuedincreases in general and administrative expenses to support our expandingresearch and development activities and for investor relations and otheractivities associated with operating as a publicly-traded company. Theseincreases will also likely include the hiring of additional personnel.

**Other Income, Net**

Other income, net includesinterest earned on our cash, cash equivalents and securitiesavailable-for-sale, net of interest expense.

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**Critical AccountingPolicies**

Our discussion and analysis of our financial conditionand results of operations are based on our financial statements, which havebeen prepared in accordance with U.S. generally accepted accounting principles,or GAAP. The preparation of these financial statements requires us to makeestimates and judgments that affect the reported amounts of assets,liabilities, revenues and expenses and related disclosure of contingent assetsand liabilities. We review our estimates on an on-going basis. We base ourestimates on historical experience and on various other assumptions that webelieve to be reasonable under the circumstances, the results of which form thebasis for making judgments about the carrying values of assets and liabilities.Actual results may differ from these estimates under different assumptions orconditions. We believe the following accounting policies to be critical to thejudgments and estimates used in the preparation of our financial statements.

*Revenue Recognition.**  *Our revenue recognition policiesare in accordance with Securities and Exchange Commission Staff AccountingBulletin, or SAB, No. 104,*  Revenue Recognition* and EmergingIssues Task Force, or EITF, Issue 00-21,*Revenue Arrangements with Multiple Deliverables*. Our agreementsgenerally contain multiple elements, including downstream milestones androyalties. All fees are nonrefundable. Revenue from milestones is recognizedwhen earned, provided that:

1)              the milestone eventis substantive and its achievability was not reasonably assured at theinception of the agreement, and

2)              collaboratorfunding, if any, of our performance obligations after the milestone achievementwill continue at a level comparable to before the milestone achievement.

If both of these criteria are not met, the milestonepayment is recognized over the remaining minimum period of our performanceobligations under the agreement. Upfront, nonrefundable fees under ourcollaborations are recognized over the period the related services are provided.Nonrefundable upfront fees not associated with our future performance arerecognized when received. Amounts received for sponsored research funding arerecognized as revenues as the services are performed. Amounts received forsponsored research funding for a specific number of full-time researchers arerecognized as revenue as the services are provided, as long as the amountsreceived are not refundable regardless of the results of the research project.

*ClinicalTrial 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 the completionof clinical trial milestones. Expenses related to clinical trials generally areaccrued based on contracted amounts applied to the actual level of patientenrollment and activity according to the protocol. Other incidental costsrelated to patient enrollment are accrued when known. If contracted amounts aremodified based upon changes in the clinical trial protocol or scope of work tobe performed, we modify our accruals accordingly on a prospective basis.

*Stock-BasedCompensation.*   We grant equity based awards underthree stockholder-approved share-based compensation plans. We may grant optionsand restricted stock awards to employees, directors and consultants under ourAmended and Restated 2001 Equity Incentive Plan. We also grant awards tonon-employee directors under our 2004 Non-Employee Directors’ Stock Option Plan.All of our employees are eligible to participate in our 2004 Employee StockPurchase Plan which provides a means for employees to purchase common stock ata discount through payroll deductions. The benefits provided under all of theseplans are subject to the provisions of revised Statement of FinancialAccounting Standards, or SFAS, No. 123, *Share-BasedPayment*, which we adopted effective January 1, 2006. We electedto use the modified 

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prospective application inadopting SFAS No. 123R and therefore have not restated results forprior periods. The valuation provisions of SFAS No. 123R apply to newawards and to awards that are outstanding on the adoption date and subsequentlymodified or cancelled. Our results of operations for fiscal 2006 were impactedby the recognition of non-cash expense related to the fair value of ourshare-based compensation awards. Share-based compensation expense recognized asa result of adoption of SFAS No. 123R for the year ended December 31,2006 was $1.9 million. As of December 31, 2006, we had approximately$7.6 million of unrecognized compensation expense which we expect to recognizeover a weighted average period of 1.8 years.

We estimate the fair value of stock options grantedusing the Black-Scholes Merton, or Black-Scholes option valuation model. Thisfair value is then amortized over the requisite service periods of the awards.The Black-Scholes option valuation model requires the input of subjectiveassumptions, including the option’s expected life and price volatility of theunderlying stock. Expected volatility is based on the weighted averagevolatility of our stock factoring in daily share price observations and thehistorical price volatility of certain peers within our industry sector. Incomputing expected volatility, the length of the historical period used isequal to the length of the expected term of the option and the share purchaseright. The expected life of employee stock options represents the average ofthe contractual term of the options and the weighted average vesting period, aspermitted under the simplified method, under Staff Accounting Bulletin No. 107.

As stock-basedcompensation expense is based on awards ultimately expected to vest, it hasbeen reduced for estimated forfeitures. SFAS No. 123R**requires forfeitures to be estimated atthe time of grant and revised, if necessary, in subsequent periods if actualforfeitures differ from those estimates. Forfeitures were estimated based onhistorical experience. We may elect to use different assumptions under theBlack-Scholes option valuation model in the future, which could materiallyaffect our net loss and net loss per share. In our pro forma informationrequired under SFAS No. 123, *Accounting for Stock-BasedCompensation*, for the periods prior to fiscal 2006, we accounted forforfeitures as they occurred. We had a deferred stock compensation balance of$3.3 million at December 31, 2005 for options previously issued with anexercise price less than the fair market value of the shares on the date ofgrant which was eliminated against additional paid-in-capital as a result ofadoption of SFAS No. 123R.

**Recently IssuedAccounting Pronouncements**

In February 2006, the Financial AccountingStandards Board, or FASB, issued SFAS No. 155, *HybridInstruments*. The statement amends SFAS No. 133, *Accounting for Derivative Instruments and Hedging Activities,*and SFAS No. 140, *Accounting for Transfersand Servicing of Financial Assets and Extinguishments of Liabilities*.The statement also resolves issues addressed in Statement 133 ImplementationIssue No. D1, *Application of Statement133 to Beneficial Interests in Securitized Financial Assets*. Thestatement: permits fair value remeasurement for any hybrid financial instrumentthat contains an embedded derivative that otherwise would require bifurcation;clarifies which interest-only strips and principal-only strips are not subjectto the requirements of SFAS No. 133; establishes a requirement to evaluateinterests in securitized financial assets to identify interests that arefreestanding derivatives or that are hybrid financial instruments that containan embedded derivative requiring bifurcation; clarifies that concentrations of creditrisk in the form of subordination are not embedded derivatives; and amends SFASNo. 140 to eliminate the prohibition on a qualifying special purposeentity from holding a derivative financial instrument that pertains to abeneficial interest other than another derivative financial instrument. We donot believe the adoption of this standard will have an impact on our results ofoperations or financial position.

In July 2006, the FASB issued Interpretation No.,or FIN, 48, *Accounting for Uncertainty in Income Taxes*.This interpretation requires that we recognize in our financial statements, theimpact of a tax position, if that position is more likely than not of beingsustained on audit, based on the technical merits 

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of the position. Theprovisions of FIN 48 are effective for fiscal years beginning after December 15,2006, with the cumulative effect of the change in accounting principle recordedas an adjustment to retained earnings. We are currently evaluating the impactof FIN 48 on our financial statements, but we do not believe compliance withthis guidance will have a significant impact on our results of operations orfinancial position.

In September 2006, the Securities and ExchangeCommission released SAB No. 108, *Considering the Effects ofPrior Year Misstatements when Quantifying Misstatements in Current YearFinancial Statements*. SAB No. 108 provides interpretiveguidance on the Securities and Exchange Commission’s views regarding theprocess of quantifying materiality of financial statement misstatements.SAB No.108 is effective for fiscal years ending after November 15,2006 (beginning with our 2006 fiscal year). The adoption of this statement didnot have a material impact on our results of operations or financial position.

In September 2006, theFASB issued SFAS No. 157, *Fair Value Measurements*.This standard defines fair value, establishes a framework for measuring fairvalue in generally accepted accounting principles and expands disclosures aboutfair value measurements. This statement is effective for financial statementsissued for fiscal years beginning after November 15, 2007 (beginning withour 2008 fiscal year), although earlier application is encouraged. We have notbegun evaluating the impact of adopting SFAS No. 157 on our results of operationor financial position, however, we intend to evaluate the impact of adoption ofthis standard during fiscal 2007.

**Results ofOperations**

Please refer to Note 1 toour financial statements for discussion of the reclassification of previouslyreported financial statements within research and development and general andadministrative costs.

*Comparison of theYears Ended December 31, 2006 and 2005*

*Revenues.**  *Revenues were $4.4 million for theyear ended December 31, 2006, compared with $3.8 million for the yearended December 31, 2005. The $600,000 increase was mainly due to increasedlicense fee and sponsored research revenues of approximately $1.8 million fromour AMPK collaboration with Merck, which began in the second half of 2005.This increase was partially offset by a decrease of $1.4 million in sponsoredresearch revenues from our hepatitis C collaboration with Merck, the researchportion of which was completed in 2005. We expect an increase in sponsoredresearch revenues in 2007 compared to 2006 as we begin efforts under thesponsored research portion of our agreement with Idenix and continue effortsunder our AMPK collaboration with Merck. In addition, we expect an increase inlicense fee revenue in 2007 as a result of the up-front license fee we receivedfrom Schering-Plough and our hepatitis C collaboration with Idenix.

*Researchand Development Expenses.**  *Research and development expenses were $30.3 millionfor the year ended December 31, 2006, compared with $21.3 million forthe year ended December 31, 2005. The $9.0 million increase wasmainly due to increased spending of $3.2 million in payroll and relatedbenefits as a result of a higher average number of employees in 2006, a $2.9million increase in clinical development expense for MB07803, MB07133 andMB07811, a $2.1 million increase in occupancy costs related to our newfacility, increased travel, supplies and insurance expense and an increase of$800,000 in stock-based compensation expense. We expect continued increases inresearch and development costs as we continue to advance MB07803, MB07133 andMB07811 through clinical development.

*General and AdministrativeExpenses.**  *Generaland administrative expenses were $10.9 million for the year ended December 31,2006, compared with $7.2 million for the year ended December 31,2005. The $3.7 million increase primarily relates to an increase of $1.3million in professional services related to legal costs associated with patentand corporate related matters and consulting services, increased stock-basedcompensation expense of $1.2 million as a result of the implementation of SFAS No. 123R,higher payroll 

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and relatedbenefits costs of $800,000 as a result of a higher average number of employeesin 2006 and increased travel, occupancy and public company costs of $400,000.We anticipate continued increases in general and administrative expenses forinvestor relations and other activities associated with operating as apublicly-traded company.

*Net Interest Income.*   Netinterest income was $3.5 million for the year ended December 31, 2006,compared to net interest income of $1.1 million for the year ended December 31,2005. The $2.4 million increase was due to increased interest income as aresult of higher average cash balances for the twelve months ended December 31,2006 as compared to the same period in 2005 as well as increased yields oninvestments.  Our average cash balanceswere higher in 2006 as compared to 2005 due to the net proceeds from our October 2005and March 2006 stock offerings.

*Comparison of the Years Ended December 31, 2005and 2004*

*Revenues.**  *Revenues were $3.8 million for theyear ended December 31, 2005, compared with $6.8 million for the yearended December 31, 2004. The $3.0 million decrease was mainly due toa decline in milestone revenue of approximately $4.5 million which wasattributable primarily to a $3.5 million payment earned in the prior yearperiod under our collaboration agreement with Daiichi Sankyo. This decrease waspartially offset by revenues from our AMPK collaboration agreement entered intowith Merck in June 2005 which included sponsored research revenue of$1.1 million and license fee revenue of $0.4 million.

*Research and DevelopmentExpenses.**  *Researchand development expenses were $21.3 million for the year ended December 31,2005, compared with $17.2 million for the year ended December 31,2004. The $4.1 million increase was mainly due to increased spending of$1.1 million in preclinical development expenses for MB07803, increasedresearch and development services expense of $1.1 million, an increase of $1.0million in payroll and related benefits as a result of a higher average numberof employees in 2005, increased occupancy costs related to our new facility of$0.5 million and increased travel, supplies and insurance expense of $0.4million.

*General and AdministrativeExpenses.**  *Generaland administrative expenses were $7.2 million for the year ended December 31,2005, compared with $4.9 million for the year ended December 31,2004. The $2.3 million increase was primarily a result of an increase inpayroll and related benefits costs of $0.8 million as a result of a higheraverage number of employees in 2005, increased travel and occupancy, publiccompany costs of $0.9 million and increased professional services expense of$0.6 million.

*Net Interest Income.**  *Net interest income was $1.1million for the year ended December 31, 2005, compared to net interestincome of $0.3 million for the year ended December 31, 2004. The $0.8million net increase was mainly due to higher levels of invested cash in 2005resulting from the proceeds of our October 2005 common stock offering, aswell as higher investment yields.

**Liquidity and Capital Resources**

Since our inception, wehave funded our operations primarily with $55.8 million in private equityfinancings and $107.5 million in net proceeds from our initial public offeringin June 2004, a private placement of common stock and warrants in October 2005and a registered direct offering of common stock in March 2006.

In November 2006, weentered into a Committed EquityFinancing Facility. or CEFF, with an institutional investor. Under theterms of the CEFF the investor is committed to providing us up to $50 millionin funding over a three-year term through the purchase of newly-issued sharesof our common stock. We may access capital under the CEFF in tranches of up tothe lesser of $10 million or from between 0.75% to 1.5% of our marketcapitalization at the time of the draw down of such tranche, subject to certainconditions. The investor will purchase shares of our common stock pursuant tothe CEFF at 

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discountsranging from 6% to 10%, depending on the average market price of our commonstock during an eight-day pricing period, provided that the minimum acceptablepurchase price for any shares to be issued to the investor during the eight-daypricing period is determined by the higher of $2.25 or 90% of our share pricethe day before the commencement of each draw down. Pursuant to the agreement wefiled a registration statement with the Securities and Exchange Commission forthe resale of the shares of common stock issuable in connection with the CEFFand the shares of common stock underlying the warrant discussed below whichbecame effective on December 22, 2006.

In connection with the CEFF, we issued a warrant tothe investor to purchase up to 260,000 shares of our common stock at anexercise price of $9.26, which represents a 30% premium over the average of theclosing prices of our common stock during the five days preceding the signingof the agreement. The warrant will become exercisable after the six-monthanniversary of the effective date of the agreement and will remain exercisable,subject to certain exceptions, until five years after the effective date of theagreement.

In October 2006, we entered into a collaborationagreement with Idenix to apply our HepDirect technology to certain Idenix leadcompounds with the goal of improving the safety and efficacy of these compoundsfor the treatment of hepatitis C. The research term will be for two years andmay be extended beyond two years by mutual agreement of the parties.  In addition, Idenix will have the option toterminate the research term upon the first anniversary of the effective date ofthe agreement or upon the achievement of certain preclinical and clinicaldevelopment milestones during the research term. As part of this collaboration,Idenix paid us an initial, non-refundable license fee of $2.0 million in thefourth quarter of 2006 and agreed to provide us research funding of up to $1.7million per year during the research term. Idenix will also pay us milestonesif specified preclinical and clinical development and regulatory events occurand royalties on product sales that result from the collaboration. If allmilestones are achieved, and including the $2.0 million license fee and up to $1.7million per year in research funding over the term, we may be entitled topayments which total up to $68.8 million, plus royalties. Idenix is solelyresponsible for conducting and funding all development work for compoundsresulting from this collaboration.

In March 2006, we raised approximately $40.0million in gross proceeds in a registered direct offering involving the sale ofapproximately 4.9 million shares of common stock at a price of $8.10 per share.Placement agency fees and other offering expenses were approximately $2.7million.

In October 2005,we raised gross proceeds of approximately $41.3 million in a private placementof common stock and the concurrent issuance of warrants for the purchase ofcommon stock. Placement agent fees and other offering expenses wereapproximately $2.3 million. Under the terms of the financing, we sold 7.0million shares of common stock at $5.86 per share, the closing bid price forour common stock immediately preceding the entering into of the bindingagreement 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 additionalpurchase price equal to $0.125 per each share issuable upon exercise of thewarrants.

In June 2005, we entered into a collaborationagreement with Merck to research, develop and commercialize novel smallmolecule therapeutics with the potential to treat several metabolic diseasesincluding type 2 diabetes, hyperlipidemia and NASH by activating AMPK. As partof this collaboration, Merck paid an initial non-refundable license fee of $5.0million in July 2005 and will provide sponsored research funding of aminimum of $2.1 million each year during the three-year research term.

In June 2004, we completed an initial publicoffering of our common stock in which we sold approximately 5.0 millionshares of common stock for proceeds of $30.6 million, net of underwritingdiscounts and commissions and offering expenses. In July 2004, theunderwriters exercised their over-allotment option, resulting in the sale of anadditional 75,000 shares of common stock, which resulted in proceeds of$0.5 million, net of underwriting discounts and commissions.

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Additionally, we have received cumulative SBIR grantfunding of approximately $1.6 million through December 31, 2006. Wedo not expect additional funding under SBIR grants in fiscal 2007 as we havediscontinued further work under this program.

As of December 31, 2006, we had$77.9 million in cash and cash equivalents and securitiesavailable-for-sale as compared to $66.9 million as of December 31,2005, an increase of $11.0 million. The increase is primarily a result ofnet proceeds of $37.3 million raised from our registered direct offering inMarch 2006 and a $2.0 million non-refundable license payment under ourcollaboration with Idenix which was offset by net cash used in operations of$27.3 million and net cash used in investing activities of $33.8 millionfor the year ended December 31, 2006 resulting from net purchases ofinvestments of $30.6 million and $3.2 million of equipment purchases.

As of December 31, 2006, we have financed throughleases and loans the purchase of equipment and leasehold improvements totalingapproximately $10.1 million, of which $5.8 million was outstanding atthat date. The loans are collateralized with the purchased equipment, bearinterest at rates ranging from approximately 8.0% to 12.85%, and are due inmonthly installments through October 2015. We currently anticipateinvesting approximately $3.5 million to $4.5 million in cash in 2007for leasehold improvements and capital equipment necessary to support ourclinical development efforts, research programs and to support all otheroperations. We expect to continue to finance our capital expenditures throughthe use of debt.

In November 2006, we entered into a CEFF with aninstitutional investor. Under the terms of the agreement the investor iscommitted to providing us up to $50 million in funding over a three-year termthrough the purchase of newly-issued shares of our common stock as describedabove. As of December 31, 2006, we have not exercised our option to sellshares under this agreement. In the event we determine that the need for anequity financing is necessary to pursue specific strategic initiatives, and wedetermine that an equity offering under this agreement provides for morefavorable terms and results than what may be available through other financingvehicles at the time, and we determine that the market will favorably supportthe additional equity available, we may utilize our option to sell shares ofcommon stock under this agreement.

We believe that our existing cash, cash equivalentsand short-term investments will be sufficient to meet our projected operatingrequirements through at least the next twelve months. We expect to continue toincrease our use of cash resources in fiscal 2007 for the further advancementof our current product candidates. This includes, but is not limited to,expenditures for additional personnel to further our preclinical, clinical andregulatory efforts, increased consulting services and increases in facilitiesand general and administrative support costs. Excluding potential cash inflowsfrom financing activities or additional collaborations and net of anticipatedcash inflows from existing collaborations, we currently anticipate utilizingapproximately $43.0 million to $48.0 million in cash during 2007 to support thefurther development of our current product candidates, research programs and insupport of all other operations. Based on our expected 2007 cash utilization,we expect to raise additional cash to fund our cash needs beyond the nexttwelve months through the sale of our common stock,including by the exercise ofour option under the CEFF, and/or by entering into additional collaborations in2007.

Until we can generate significant cash from ouroperations, we expect to continue to fund our operations with existing cash resourcesthat were primarily generated from the proceeds of additional offerings of ourequity securities, cash payments under our strategic collaborations, our CEFFand debt financing arrangements. In addition, we may finance future cash needsthrough the sale of other equity securities, entering into additional strategiccollaboration agreements and debt financing. However, we may not be successfulin obtaining additional collaboration agreements, or in receiving milestone orroyalty payments under current or future agreements. In addition, we cannot besure that our existing cash, cash equivalents and securities available-for-salewill be adequate or that additional financing will be available 

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when needed or that, ifavailable, financing will be obtained on terms favorable to us or ourstockholders. 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.

To the extent that we raise additional capital byissuing equity securities, our existing stockholders’ ownership will be diluted.Any debt financing we enter into may involve covenants that restrict ouroperations. 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 relinquishrights to our potential products or proprietary technologies, or grant licenseson terms that are not favorable to us.

Thefollowing summarizes our long-term contractual obligations as of December 31,2006 (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             |       | $                          | 26,206     |   |   | $ | 1,760 |   |   | $ | 5,086 |   | $ | 6,265 |   | $ | 13,094 |   |
| Equipment  financing         |       | 5,669                      |       |   | 1,762 |   |   | 3,064 |   | 699 |   | 144 |   |
| Purchase  commitments        |       | 1,277                      |       |   | 1,277 |   |   | — |   | — |   | — |   |
| Capital leases               |       | 91                         |       |   | 20 |   |   | 46 |   | 25 |   | — |   |
| Total                        |       | $                          | 33,243     |   |   | $ | 4,819 |   |   | $ | 8,196 |   | $ | 6,990 |   | $ | 13,238 |   |
|                              |            |                            |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

We also enter into agreements with clinical sites andcontract research organizations for the conduct of our clinical trials. We willmake payments to these sites and organizations based upon the number ofpatients enrolled and the length of their participation in the clinical trials.In addition, under certain agreements, we may be subject to penalties in theevent we prematurely discontinue performance under these agreements. At thistime, due to the variability associated with these agreements, we are unable toestimate with certainty the future costs we will incur.

We have entered into employment agreements with ourexecutive officers and certain other key employees that, under certaincircumstances, provide for the continuation of salary and certain otherbenefits if terminated under specified circumstances. These agreements generally expire upon termination for cause or when theCompany has met its obligations under these agreements. As of December 31,2006, no events have occurred resulting in the obligation of any such payments.

Our future capitaluses and requirements depend on numerous forward-looking factors. These factorsmay include but are not limited to the following:

·       therate of progress and cost of our clinical trials and other research anddevelopment activities,

·       thescope, prioritization and number of clinical development and research programswe pursue,

·       thecosts of expanding our operations,

·       theterms and timing of any collaborative, licensing and other arrangements that wemay establish,

·       thecosts of filing, prosecuting, defending and enforcing any patent claims andother intellectual property rights,

·       thecosts and timing of regulatory approvals,

·       thecosts of establishing or contracting for manufacturing, sales and marketingcapabilities,

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·       theeffect of competing technological and market developments, and

·       the extent to which weacquire or in-license new products, technologies or businesses.

**Environmental Risk**

Our research anddevelopment activities involve the use of biological and hazardous materials.We incurred approximately $435,000, $409,000 and $132,000 for the years ended December 31,2006, 2005 and 2004, respectively, of costs associated with managing hazardoussubstances and pollution in ongoing operations.

**Off-Balance SheetArrangements**

As of December 31,2006, we did not have any relationships with unconsolidated entities orfinancial partnerships, such as entities often referred to as structuredfinance or special purpose entities, which would have been established for thepurpose of facilitating off-balance sheet arrangements or other contractuallynarrow or limited purposes. In addition, we do not engage in trading activitiesinvolving non-exchange traded contracts. As such, we are not materially exposedto any financing, liquidity, market or credit risk that could arise if we hadengaged in these relationships.

**Related PartyTransactions**

For a description of ourrelated party transactions, see Item 13 of Part III of this annual reporton Form 10-K, “Certain Relationships and Related Transactions, andDirector Independance.”

**Item 7A.**                Quantitativeand Qualitative Disclosures About Market Risk

Our exposure to market risk for changes in interestrates relates primarily to the increase or decrease in the amount of interestincome we can earn on our investment portfolio. Our risk associated withfluctuating interest income is limited to our investments in interest ratesensitive financial instruments. Under our current policies, we do not useinterest rate derivative instruments to manage this exposure to interest ratechanges. We seek to ensure the safety and preservation of our investedprincipal by limiting default risk, market risk, and reinvestment risk. Wemitigate default risk by investing in short-term investment grade securities. A100 basis point increase or decrease in interest rates would increase ordecrease our current investment balance by approximately $140,000 annually.While changes in our interest rates may affect the fair value of our investmentportfolio, any gains or losses are not recognized in our statement ofoperations until the investment is sold or if a reduction in fair value isdetermined to be a permanent impairment.

We do not have any foreign currency or otherderivative financial instruments.

Our long-term capitallease obligations bears interest at fixed rates and therefore we do not havesignificant market risk exposure with respect to these obligations.

**Item 8.**                        FinancialStatements and Supplementary Data

The information requiredto be disclosed herein is incorporated by reference to Item 15 of Part IIIof this annual report on Form 10-K.

**Item 9.**                        Changesin and Disagreements with Accountants on Accounting and Financial Disclosures

Not applicable.

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**Item 9A.**                Controlsand Procedures

We maintain disclosurecontrols and procedures that are designed to ensure that information requiredto be disclosed in our Exchange Act reports is recorded, processed, summarized andreported within the time periods specified in the Securities and ExchangeCommission’s rules and forms, and that such information is accumulated andcommunicated to our management, including our chief executive officer and chieffinancial officer, as appropriate, to allow timely decisions regarding requireddisclosure. In designing and evaluating the disclosure controls and procedures,management recognized that any controls and procedures, no matter how welldesigned and operated, can provide only reasonable and not absolute assuranceof achieving the desired control objectives. In reaching a reasonable level ofassurance, management necessarily was required to apply its judgment inevaluating the cost-benefit relationship of possible controls and procedures.In addition, the design of any system of controls also is based in part uponcertain assumptions about the likelihood of future events, and there can be noassurance that any design will succeed in achieving its stated goals under allpotential future conditions; over time, a control may become inadequate becauseof changes in conditions, or the degree of compliance with policies orprocedures may deteriorate. Because of the inherent limitations in acost-effective control system, misstatements due to error or fraud may occurand not be detected.

**ConclusionRegarding the Effectiveness of Disclosure Controls and Procedures**

As of the end of theperiod covered by this annual report on Form 10-K, we carried out anevaluation, under the supervision and with the participation of our management,including our chief executive officer and chief financial officer, of theeffectiveness of the design and operation of our disclosure controls andprocedures, as defined in Rules 13a-15(e) and 15d-15(e) underthe Securities Exchange Act of 1934, as amended. Based on this evaluation, ourchief executive officer and chief financial officer concluded that ourdisclosure controls and procedures were effective as of December 31, 2006,at the reasonable assurance level.

**Changes in InternalControl Over Financial Reporting**

An evaluation was alsoperformed under the supervision and with the participation of our management,including our chief executive officer and chief financial officer, of anychange in our internal control over financial reporting that occurred duringour last fiscal quarter and that has materially affected, or is reasonablylikely to materially affect, our internal control over financial reporting.There was no change in our internal control over financial reporting during ourlatest fiscal quarter that has materially affected, or is reasonably likely tomaterially affect, our internal control over financial reporting.

**Management’s Reporton Internal Control Over Financial Reporting**

Our management is responsible for establishing andmaintaining adequate internal control over financial reporting, as such term isdefined in Rule 13a-15(f) of the Securities and Exchange Act of1934, as amended. Under the supervision and with the participation of ourmanagement, including our chief executive officer and chief financial officer,we conducted an evaluation of the effectiveness of our internal control overfinancial reporting as of December 31, 2006 based on the framework in*Internal Control—Integrated Framework*issued by the Committee of Sponsoring Organizations of the Treadway Commission(COSO). Based on our evaluation under the framework in*Internal Control—Integrated Framework*,our management concluded that our internal control over financial reporting waseffective as of December 31, 2006.

Our management’s assessment of the effectiveness ofour internal control over financial reporting as of December 31, 2006 hasbeen audited by Ernst & Young LLP, an independent registered publicaccounting firm, as stated in their report which is included herein.

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**Reportof Independent Registered Public Accounting Firmon Internal Control Over Financial Reporting**

The Board of Directors andStockholdersMetabasis Therapeutics, Inc.

We have audited management’sassessment, included in the accompanying “Management’s Report on InternalControl Over Financial Reporting,” that Metabasis Therapeutics, Inc.maintained effective internal control over financial reporting as of December 31,2006, based on criteria established in Internal Control-Integrated Frameworkissued by the Committee of Sponsoring Organizations of the Treadway Commission(the COSO criteria). Metabasis Therapeutics’ management is responsible formaintaining effective internal control over financial reporting and for itsassessment of the effectiveness of internal control over financial reporting.Our responsibility is to express an opinion on management’s assessment and anopinion on the effectiveness of the company’s internal control over financialreporting based on our audit.

We conducted our audit inaccordance with the standards of the Public Company Accounting Oversight Board(United States). Those standards require that we plan and perform the audit toobtain reasonable assurance about whether effective internal control overfinancial reporting was maintained in all material respects. Our audit includedobtaining an understanding of internal control over financial reporting,evaluating management’s assessment, testing and evaluating the design andoperating effectiveness of internal control, and performing such otherprocedures as we considered necessary in the circumstances. We believe that ouraudit provides a reasonable basis for our opinion.

A company’s internalcontrol over financial reporting is a process designed to provide reasonableassurance regarding the reliability of financial reporting and the preparationof financial statements for external purposes in accordance with generallyaccepted accounting principles. A company’s internal control over financialreporting includes those policies and procedures that (1) pertain to themaintenance of records that, in reasonable detail, accurately and fairlyreflect the transactions and dispositions of the assets of the company; (2) providereasonable assurance that transactions are recorded as necessary to permitpreparation of financial statements in accordance with generally acceptedaccounting principles, and that receipts and expenditures of the company arebeing made only in accordance with authorizations of management and directorsof the company; and (3) provide reasonable assurance regarding preventionor timely detection of unauthorized acquisition, use, or disposition of thecompany’s assets that could have a material effect on the financial statements.

Because of its inherentlimitations, internal control over financial reporting may not prevent ordetect misstatements. Also, projections of any evaluation of effectiveness tofuture periods are subject to the risk that controls may become inadequatebecause of changes in conditions, or that the degree of compliance with thepolicies or procedures may deteriorate.

In our opinion, management’sassessment that Metabasis Therapeutics, Inc. maintained effective internalcontrol over financial reporting as of December 31, 2006, is fairlystated, in all material respects, based on the COSO criteria. Also, in ouropinion, Metabasis Therapeutics, Inc. maintained, in all materialrespects, effective internal control over financial reporting as of December 31,2006, based on the COSO criteria**.**

Wealso have audited, in accordance with the standards of the Public CompanyAccounting Oversight Board (United States), the balance sheets as of December 31,2006 and 2005, and the related statements of operations, stockholders’ equityand cash flows for each of the three years in the period ended December 31,2006 of Metabasis Therapeutics, Inc. and our report dated March 5,2007 expressed an unqualified opinion thereon.

/s/ ERNST & YOUNG LLP

San Diego, CaliforniaMarch 5, 2007

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**Item 9B.**               OtherInformation

OnMarch 7, 2007, the compensation committee of our board of directorsapproved increases in base salary and the grant of additional stock options forcertain of our executive officers. The following table sets forth the 2007 basesalary and the number of shares of common stock underlying the stock optiongrants for these executive officers:

| **Name**                           | ** ** | **2007 Base Salary** | ** ** | **Stock Options** | ** ** |
|------------------------------------|------------|--------------------------------|------------|------------------------|------------|
| Paul K. Laikind,  Ph.D.            |       |                           | $          | 379,000                |       |   |   | 100,000 |   |   |
| Mark D. Erion,  Ph.D.              |       |                           | $          | 325,000                |       |   |   | 75,000 |   |   |
| John W. Beck,  C.P.A.              |       |                           | $          | 258,000                |       |   |   | 60,000 |   |   |
| Edgardo Baracchini,  Ph.D., M.B.A. |       |                           | $          | 263,000                |       |   |   | 60,000 |   |   |

 

The stock options described above (i) weregranted pursuant to our Amended and Restated 2001 Equity Incentive Plan,(ii) terminate ten years after March 7, 2007, the date of grant, orearlier in the event the optionholder’s service to us is terminated and(iii) have an exercise price per share of $7.60, or the closing price ofour common stock as reported on the Nasdaq Stock Market on the date of grant. Subjectto the optionholder’s continued service to us, 25% of the shares of commonstock subject to such stock options vest on the first anniversary of the dateof grant, and the remaining shares vest monthly over the following three years.

Inaddition, the compensation committee reviewed the achievement of the corporateand individual goals set for 2006 and based on that review, the compensationcommittee approved 2006 incentive cash bonuses to certain of our executiveofficers as follows:

| **Name**                           | ** ** | **2006 Bonus** | ** ** |
|------------------------------------|------------|---------------------|------------|
| Paul K. Laikind,  Ph.D.            |       |                | $          | 108,187 |   |   |
| Mark D. Erion,  Ph.D.              |       |                | $          | 78,947 |   |   |
| John W. Beck,  C.P.A.              |       |                | $          | 62,790 |   |   |
| Edgardo Baracchini,  Ph.D., M.B.A. |       |                | $          | 66,099 |   |   |

 

Alsoon March 7, 2007, the compensation committee approved our EmployeeIncentive Compensation Plan for 2007, which is attached hereto asExhibit 10.34 and incorporated herein by reference, and established 2007target bonuses, as a percentage of base salary, for certain of our executiveofficers as follows:

| **Name**                           | ** ** | ** ** | ** ** | **2007 Target Bonus %** | ** ** |
|------------------------------------|------------|------------|------------|----------------------------------------|------------|
| Paul K. Laikind,  Ph.D.            |       |       | 50         | %                                      |       |
| Mark D. Erion,  Ph.D.              |       |       | 35         | %                                      |       |
| John W. Beck,  C.P.A.              |       |       | 35         | %                                      |       |
| Edgardo Baracchini,  Ph.D., M.B.A. |       |       | 35         | %                                      |       |

 

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**PART III**

**Item 10.**                 Directors,Executive Officers and Corporate Governance

The information required by this item will be setforth in the sections entitled “Election of Directors,”  “Executive Officers” and “Section 16(a) BeneficialOwnership Reporting Compliance” in our definitive proxy statement to be filedwith the Securities and Exchange Commission in connection with the AnnualMeeting of our Stockholders, or the Proxy Statement, which is expected to befiled not later than 120 days after the end of our fiscal year ended December 31,2006, and is incorporated in this report by reference.

We have adopted a code of ethics for directors,officers (including our principal executive officer and principal financial andaccounting officer) and employees, known as the Code of Business Conduct andEthics. The Code of Business Conduct and Ethics is available on our website at http://www.mbasis.com.If we make any substantive amendments to the Code of Business Conduct andEthics or grant any waiver from a provision of the Code of Business Conduct andEthics to any executive officer or director, we will promptly disclose thenature of the amendment or waiver on our website, as well as via any othermeans as required by Nasdaq listing standards or applicable law. Stockholdersmay request a free copy of the Code of Business Conduct and Ethics from:

Metabasis Therapeutics, Inc.Attention: Investor Relations11119 North Torrey Pines RoadLa Jolla, CA 92037(858) 587-2770Bienfait@mbasis.com

**Item 11.**                 ExecutiveCompensation

The information requiredby this item will be set forth in the sections entitled “Compensation ofExecutive Officers,” “Compensation Committee Report” and “CompensationCommittee Interlocks and Insider Participation” in the Proxy Statement and isincorporated in this report by reference.

**Item 12.**                 SecurityOwnership of Certain Beneficial Owners and Management and Related StockholderMatters

The information requiredby this item will be set forth in the sections entitled “Security Ownership ofCertain Beneficial Owners and Management” and “Equity Compensation PlanInformation” in the Proxy Statement and is incorporated in this report byreference.

**Item 13.**                 CertainRelationships and Related Transactions, and Director Independence

The information requiredby this item will be set forth in the sections entitled “Election of Directors”and “Certain Relationships and Related Transactions” in the Proxy Statement andis incorporated in this report by reference.

**Item 14.**                 PrincipalAccountant Fees and Services

The information required by this item will be setforth in the section entitled “Ratification of Selection of IndependentRegistered Public Accounting Firm” in the Proxy Statement and is incorporatedin this report by reference.

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**PART IV**

**Item 15.**                 Exhibitsand Financial Statement Schedules

(a)   Thefollowing documents are filed as part of this report:

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

·       Reportof Independent Registered Public Accounting Firm

·       Balancesheets as of December 31, 2006 and 2005

·       Statementsof operations for the years ended December 31, 2006, 2005 and 2004

·       Statementsof stockholders’ equity for the years ended December 31, 2006, 2005 and2004

·       Statementsof cash flows for the years ended December 31, 2006, 2005 and 2004

·       Notesto financial statements

2)               List of financialstatement schedules. All financial statement schedules are omitted because theyare not applicable or the required information is shown in the financialstatements or notes thereto.

3)               List of exhibitsrequired 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.                                                                        |

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| 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.                                                                                      |
| 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.                                                                                                                                                   |
| 4.14(12)       |   | Common Stock Purchase  Agreement dated November 2, 2006 between the Company and Kingsbridge  Capital Limited.                                                                                                            |
| 4.15(13)       |   | Registration Rights  Agreement dated November 2, 2006 between the Company and Kingsbridge  Capital Limited.                                                                                                              |
| 4.16(14)       |   | Warrant dated  November 2, 2006 issued by the Company to Kingsbridge Capital Limited.                                                                                                                                    |
| 10.1(1)†  |   | Form of Indemnity  Agreement.                                                                                                                                                                                            |
| 10.2†     |   | Amended and Restated  2001 Equity Incentive Plan and Form of Stock Option Agreement  thereunder.                                                                                                                         |
| 10.3†     |   | 2004 Non-Employee  Directors’ Stock Option Plan and Form of Stock Option Agreement  thereunder.                                                                                                                     |
| 10.4†     |   | 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(7)† |   | Amended and Restated  Severance Agreement dated July 19, 2006 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. |

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| 10.18(1)*       |   | Exclusive Option  Agreement dated October 21, 2002 between the Company and Daiichi Sankyo  Company, Ltd.                                                                           |
|-----------------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.19^          |   | Amended and Restated  Development and License Agreement dated December 13, 2006 between the  Company and Schering-Plough Corporation.                                              |
| 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(8)^       |   | 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(8)^       |   | Amendment dated  November 2, 2005 to Exclusive License and Research Collaboration  Agreement dated December 23, 2003 between the Company and  Merck & Co., Inc. |
| 10.31(9)^       |   | Amendment dated  May 1, 2006 to Exclusive License and Research Collaboration Agreement  dated December 23, 2003 between the Company and Merck &  Co., Inc.      |
| 10.31(10)       |   | Amendment dated  May 16, 2006 to Lease Agreement dated December 21, 2004 between the  Company and CarrAmerica Realty, L.P.                                                    |
| 10.31(11)† |   | Offer Letter dated  September 12, 2006 by and between the Company and David F. Hale.                                                                                          |
| 10.32^          |   | Exclusive License and  Research Collaboration Agreement dated October 24, 2006 by and between  the Company and Idenix Pharmaceuticals, Inc.                                   |
| 10.33(2)        |   | Assignment and  Assumption Agreement dated December 13, 2006 by and among the Company,  Valeant Research & Development and Schering Corporation.                          |
| 10.34†     |   | Metabasis Employee  Incentive Compensation Plan.                                                                                                                                        |
| 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.                                                                               |
| 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.                                                 |

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                  † Indicates management contract orcompensatory plan.

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                 * Confidential treatment has been granted withrespect to certain portions of this exhibit. Omitted portions have been filedseparately with the Securities and Exchange Commission.

           ^ Confidential treatment has been requested withrespect to certain portions of this exhibit. Omitted portions have been filedseparately with the Securities and Exchange Commission.

       (1) Incorporated by reference to the exhibit of thesame number to the Company’s Registration Statement on Form S-1 (No. 333-112437),originally filed on February 3, 2004.

       (2) Incorporated by reference to Exhibit 10.35to the Valeant Pharmaceuticals International Annual Report on Form 10-Kfor the fiscal year ended December 31, 2006.

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

       (4) Incorporated by reference to Exhibit 10.27to the Company’s Quarterly Report on Form 10-Q for the quarterly periodended March 31, 2005.

       (5) Incorporated by reference to Exhibit 10.28to the Company’s Quarterly Report on Form 10-Q for the quarterly periodended June 30, 2005.

       (6) Incorporated by reference to the exhibit of thesame number to the Company’s Current Report on Form 8-K filed on October 5,2005.

       (7) Incorporated by reference to Exhibit 10.1to the Company’s Current Report on Form 8-K filed on July 25, 2006.

       (8) Incorporated by reference to the exhibit of thesame number to the Company’s Annual Report on Form 10-K for the fiscalyear ended December 31, 2005.

       (9) Incorporated by reference to Exhibit 10.1to the Company’s Quarterly Report on Form 10-Q for the quarterly periodended June 30, 2006.

(10) Incorporated by reference to Exhibit 10.2to the Company’s Quarterly Report on Form 10-Q for the quarterly periodended June 30, 2006.

(11) Incorporated by reference to Exhibit 10.1to the Company’s Current Report on Form 8-K filed on September 12,2006.

(12) Incorporated by reference to Exhibit 10.1to the Company’s Current Report on Form 8-K filed on November 2,2006.

(13) Incorporated by reference to Exhibit 4.2to the Company’s Current Report on Form 8-K filed on November 2,2006.

(14) Incorporated by reference to Exhibit 4.1to the Company’s Current Report on Form 8-K filed on November 2,2006.

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**SIGNATURES**

Pursuantto the requirements of Section 13 or 15(d) of the Securities andExchange Act of 1934, the registrant has duly caused this report to be signedon its behalf by the undersigned, thereunto duly authorized.
|                             | METABASIS THERAPEUTICS, INC. |
|-----------------------------|-----------------------------------|
| Dated: March 12,  2007 | By:                               | /s/ PAUL K. LAIKIND |
|                        | * *                          | Paul K. Laikind, Ph.D. |
|                        | * *                          | *Chief Executive Officer and President* |

 

Pursuantto the requirements of the Securities Exchange Act of 1934, this report hasbeen signed below by the following persons on behalf of the registrant and inthe capacities and on the dates indicated.
| Signature                  | ** ** | **Title**                                                                           | ** ** | **Date**             |
|----------------------------|------------|-------------------------------------------------------------------------------------|------------|----------------------|
| /s/ PAUL K.  LAIKIND       |       | Chief Executive Officer,                                                            |       | March 12,  2007 |
| Paul K. Laikind,  Ph.D.    |       | President, Secretary and Director  (Principal Executive Officer)                    |       |                 |
| /s/  JOHN W. BECK          |       | Senior Vice President of  Finance,                                                  |       | March 12,  2007 |
| John W. Beck,  C.P.A.      |       | Chief Financial Officer and Treasurer  (Principal Financial and Accounting Officer) |       |                 |
| /s/  MARK D. ERION         |       | Executive Vice President  of Research and                                           |       | March 12,  2007 |
| Mark D. Erion,  Ph.D.      |       | Development, Chief Scientific Officer and Director                                  |       |                 |
| /s/  DAVID F. HALE         |       | Chairman of the Board of  Directors                                                 |       | March 12,  2007 |
| David F. Hale              |       |                                                                                |       |                 |
| /s/  DANIEL D. BURGESS     |       | Director                                                                            |       | March 12,  2007 |
| Daniel D.  Burgess, M.B.A. |       |                                                                                |       |                 |
| /s/  LUKE B. EVNIN         |       | Director                                                                            |       | March 12,  2007 |
| Luke B. Evnin,  Ph.D.      |       |                                                                                |       |                 |
| /s/  ARNOLD L. ORONSKY     |       | Director                                                                            |       | March 12,  2007 |
| Arnold L.  Oronsky, Ph.D.  |       |                                                                                |       |                 |
| /s/  WILLIAM R. ROHN       |       | Director                                                                            |       | March 12,  2007 |
| William R. Rohn            |       |                                                                                |       |                 |
| /s/  HEINZ GSCHWEND        |       | Director                                                                            |       | March 12,  2007 |
| Heinz Gschwend,  Ph.D.     |       |                                                                                |       |                 |

 

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**METABASISTHERAPEUTICS, INC.INDEX TO FINANCIAL STATEMENTS**

| Report of Independent  Registered Public Accounting Firm                                           |   | F-2 |   |
|----------------------------------------------------------------------------------------------------|--------|-----|--------|
| Balance Sheets as of December 31, 2006 and 2005                                               |   | F-3 |   |
| Statements of Operations for the years ended  December 31, 2006, 2005 and 2004                |   | F-4 |   |
| Statements of Stockholders’ Equity for the years ended  December 31, 2006, 2005 and 2004 |   | F-5 |   |
| Statements  of Cash Flows for the years ended December 31, 2006, 2005 and 2004                |   | F-6 |   |
| Notes  to Financial Statements                                                                     |   | F-7 |   |

 

F-1

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**REPORT OFINDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**

The Board of Directors and StockholdersMetabasis Therapeutics, Inc.

We have audited the accompanying balance sheets ofMetabasis Therapeutics, Inc. as of December 31, 2006 and 2005, andthe related statements of operations, stockholders’ equity, and cash flows foreach of the three years in the period ended December 31, 2006. Thesefinancial statements are the responsibility of the Company’s management. Ourresponsibility is to express an opinion on these financial statements based onour audits.

We conducted our audits in accordance with thestandards of the Public Company Accounting Oversight Board (United States).Those standards require that we plan and perform the audit to obtain reasonableassurance about whether the financial statements are free of materialmisstatement. An audit includes examining, on a test basis, evidence supportingthe amounts and disclosures in the financial statements. An audit also includesassessing the accounting principles used and significant estimates made bymanagement, as well as evaluating the overall financial statement presentation.We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the financial statements referred toabove present fairly, in all material respects, the financial position ofMetabasis Therapeutics, Inc. at December 31, 2006 and 2005, and theresults of its operations and its cash flows for each of the three years in theperiod ended December 31, 2006, in conformity with U.S. generally acceptedaccounting principles.

As discussed in Note 1 to the financial statements,Metabasis Therapeutics, Inc. changed its method of accounting forshare-based payments in accordance with Statement of Financial AccountingStandards No. 123 (revised 2004) on January 1, 2006.

We have also audited, inaccordance with the standards of the Public Company Accounting Oversight Board(United States), the effectiveness of Metabasis Therapeutics Inc.’s internalcontrol over financial reporting as of December 31, 2006, based on thecriteria established in Internal Control-Integrated Framework issued by theCommittee of Sponsoring Organizations of the Treadway Commission and our reportdated March 5, 2007, expressed an unqualified opinion on management’sassessment  and an unqualified opinion onthe effectiveness of internal control over financial reporting.

/s/ ERNST & YOUNG LLP

San Diego, California

March 5, 2007

F-2

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**METABASISTHERAPEUTICS, INC.BALANCE SHEETS(in thousands, except par value data)**

| ** **                                                                                                                                                                                                                            | ** ** | **December 31,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                                                                            | ** ** | **2006**              | ** ** | **2005** | ** ** |
| **Assets**                                                                                                                                                                                                                            | ** ** | ** **            | ** ** | ** ** | ** ** |
| Current assets:                                                                                                                                                                                                                       |       |                  |       |   |   |
| Cash and cash equivalents                                                                                                                                                                                                             |       | $                     | 12,052     |   | $ | 32,597 |   |
| Securities available-for-sale                                                                                                                                                                                                         |       | 65,871                |       | 34,296 |   |
| Trade accounts receivable                                                                                                                                                                                                             |       | 187                   |       | 199 |   |
| Prepaids and other current assets                                                                                                                                                                                                     |       | 1,303                 |       | 1,970 |   |
| Total current assets                                                                                                                                                                                                                  |       | 79,413                |       | 69,062 |   |
| Property and equipment, net                                                                                                                                                                                                           |       | 6,263                 |       | 4,664 |   |
| Other assets                                                                                                                                                                                                                          |       | 179                   |       | 152 |   |
| Total assets                                                                                                                                                                                                                          |       | $                     | 85,855     |   | $ | 73,878 |   |
| **Liabilities  and stockholders’ equity**                                                                                                                                                                                        | ** ** | ** **            | ** ** | ** ** | ** ** |
| Current liabilities:                                                                                                                                                                                                                  |       |                  |       |   |   |
| Accounts payable                                                                                                                                                                                                                      |       | $                     | 1,053      |   | $ | 1,745 |   |
| Accrued liabilities                                                                                                                                                                                                                   |       | 3,999                 |       | 3,937 |   |
| Deferred revenue, current portion                                                                                                                                                                                                     |       | 3,192                 |       | 2,192 |   |
| Current portion of long-term debt                                                                                                                                                                                                     |       | 1,761                 |       | 1,024 |   |
| Current portion of capital lease obligations                                                                                                                                                                                          |       | 20                    |       | 18 |   |
| Total current liabilities                                                                                                                                                                                                             |       | 10,025                |       | 8,916 |   |
| Deferred revenue, net of current portion                                                                                                                                                                                              |       | 1,630                 |       | 2,463 |   |
| Deferred rent                                                                                                                                                                                                                         |       | 1,566                 |       | 330 |   |
| Long-term debt                                                                                                                                                                                                                        |       | 3,908                 |       | 2,067 |   |
| Capital lease  obligations, net of current portion                                                                                                                                                                                    |       | 71                    |       | 59 |   |
| Other long-term  liabilities                                                                                                                                                                                                          |       | 517                   |       | 461 |   |
| Total liabilities                                                                                                                                                                                                                     |       | 17,717                |       | 14,296 |   |
| Stockholders’  equity:                                                                                                                                                                                                           |       |                  |       |   |   |
| Preferred stock, $0.001 par value; 5,000 shares  authorized at December 31, 2006 and December 31, 2005, no shares  issued or outstanding                                                                                    |       | —                |       | — |   |
| Common stock, $0.001 par value; 100,000 shares  authorized at December 31, 2006 and December 31, 2005; 30,493 and  25,313 shares issued and outstanding at December 31, 2006 and December 31,  2005, respectively |       | 30                    |       | 25 |   |
| Additional paid-in capital                                                                                                                                                                                                            |       | 176,298               |       | 137,822 |   |
| Deferred compensation                                                                                                                                                                                                                 |       | —                |       | (3,266 | ) |
| Accumulated deficit                                                                                                                                                                                                                   |       | (108,213              | )          | (74,945 | ) |
| Accumulated other comprehensive loss                                                                                                                                                                                                  |       | 23                    |       | (54 | ) |
| Total stockholders’ equity                                                                                                                                                                                                       |       | 68,138                |       | 59,582 |   |
| Total liabilities and stockholders’ equity                                                                                                                                                                                       |       | $                     | 85,855     |   | $ | 73,878 |   |

 

See accompanying notes.

F-3

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**METABASISTHERAPEUTICS, INC.STATEMENTS OF OPERATIONS(in thousands, except per share data)**

| ** **                                                                                                            | ** ** | **Years Ended December 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                                                            | ** ** | **2006**                                    | ** ** | **2005** | ** ** | **2004** | ** ** |
| Revenues:                                                                                                             |       |                                        |       |   |   |   |   |
| Sponsored research                                                                                                    |       | $                                           | 2,210      |   | $ | 2,493 |   | $ | 1,375 |   |
| License fees                                                                                                          |       | 1,984                                       |       | 871 |   | 458 |   |
| Other revenue                                                                                                         |       | 192                                         |       | 407 |   | 504 |   |
| Milestones                                                                                                            |       | —                                      |       | — |   | 4,500 |   |
| Total revenues                                                                                                        |       | 4,386                                       |       | 3,771 |   | 6,837 |   |
| Operating  expenses:                                                                                                  |       |                                        |       |   |   |   |   |
| Research and development                                                                                              |       | 30,305                                      |       | 21,252 |   | 17,226 |   |
| General and administrative                                                                                            |       | 10,890                                      |       | 7,186 |   | 4,886 |   |
| Total operating  expenses                                                                                             |       | 41,195                                      |       | 28,438 |   | 22,112 |   |
| Loss from operations                                                                                                  |       | (36,809                                     | )          | (24,667 | ) | (15,275 | ) |
| Other income (expense):                                                                                               |       |                                        |       |   |   |   |   |
| Interest income                                                                                                       |       | 3,932                                       |       | 1,297 |   | 531 |   |
| Interest expense                                                                                                      |       | (391                                        | )          | (210 | ) | (228 | ) |
| Total other  income                                                                                                   |       | 3,541                                       |       | 1,087 |   | 303 |   |
| Net loss                                                                                                              |       | $                                           | (33,268    | ) | $ | (23,580 | ) | $ | (14,972 | ) |
| Basic and diluted net loss per share                                                                                  |       | $                                           | (1.15      | ) | $ | (1.20 | ) | $ | (1.49 | ) |
| Shares used to  compute basic and diluted net loss per share                                                          |       | 29,019                                      |       | 19,706 |   | 10,034 |   |
| Proforma net loss per common share assuming  conversion of preferred stock, basic and diluted                         |       |                                        |       |   |   | $ | (0.98 | ) |
| Shares used to compute proforma net loss per common  share asssuming conversion of preferred stock, basic and diluted |       |                                        |       |   |   | 15,254 |   |

 

 

See accompanying notes.

F-4

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**METABASISTHERAPEUTICS, INC.STATEMENTS OF STOCKHOLDERS’ EQUITY(in thousands)**

| ** **                                                                               | ** ** | ** **               | ** ** | ** **            | ** ** | ** **     | ** ** | ** **   | ** ** | ** **      | ** ** | **Accumulated**   | ** ** | ** **             | ** ** |
|------------------------------------------------------------------------------------------|------------|--------------------------|------------|-----------------------|------------|----------------|------------|--------------|------------|-----------------|------------|-------------------|------------|------------------------|------------|
| ** **                                                                               | ** ** | **Convertible**          | ** ** | ** **            | ** ** | **Additional** | ** ** | ** **   | ** ** | ** **      | ** ** | **Other**         | ** ** | **Total**              | ** ** |
| ** **                                                                               | ** ** | **Preferred Stock** | ** ** | **Common Stock** | ** ** | **Paid-In**    | ** ** | **Deferred** | ** ** | **Accumulated** | ** ** | **Comprehensive** | ** ** | **Stockholders’** | ** ** |
| ** **                                                                               | ** ** | **Shares**               | ** ** | **Amount**            | ** ** | **Shares**     | ** ** | **Amount**   | ** ** | **Capital**     | ** ** | **Compensation**  | ** ** | **Deficit**            | ** ** | **Income (Loss)** | ** ** | **Equity** | ** ** |
| 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, 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 of 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 |   |
| Net loss                                                                                 |       | —                   |       |                  | —     |           | —     |         |       | —          |       | —            |       |                   | —     |   |   | (33,268 | ) |   | — |   |   | (33,268 | ) |
| Unrealized gain on short-term investments                                                |       | —                   |       |                  | —     |           | —     |         |       | —          |       | —            |       |                   | —     |   |   | — |   |   | 77 |   |   | 77 |   |
| Net comprehensive loss                                                                   |       | —                   |       |                  | —     |           | —     |         |       | —          |       | —            |       |                   | —     |   |   | — |   |   | — |   |   | (33,191 | ) |
| Issuance of common stock in registered direct offering, net of  offering costs of $2,696 |       | —                   |       |                  | —     |           | 4,938      |         |       | 5               |       | 37,299            |       |                   | —     |   |   | — |   |   | — |   |   | 37,304 |   |
| Issuance of common stock for option exercises                                            |       | —                   |       |                  | —     |           | 44         |         |       | —          |       | 95                |       |                   | —     |   |   | — |   |   | — |   |   | 95 |   |
| Issuance of common stock pursuant to the Employee Stock Purchase Plan                    |       | —                   |       |                  | —     |           | 198        |         |       | —          |       | 603               |       |                   | —     |   |   | — |   |   | — |   |   | 603 |   |
| Reclass of deferred compensation                                                         |       | —                   |       |                  | —     |           | —     |         |       | —          |       | (3,266            | )          |                   | 3,266      |   |   |   |   |   |   |   |   | — |   |
| Stock-based compensation                                                                 |       | —                   |       |                  | —     |           | —     |         |       | —          |       | 3,745             |       |                   | —     |   |   | — |   |   | — |   |   | 3,745 |   |
| Balance at December 31, 2006                                                        |       | —                   |       |                  | $          | —         |       | 30,493       |       |            | $          | 30                |       | $                      | 176,298    |   |   | $ | — |   |   | $ | (108,213 | ) |   | $ | 23 |   |   | $ | 68,138 |   |

 

See accompanying notes.

F-5

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**METABASIS THERAPEUTICS, INC.STATEMENTS OF CASH FLOWS(in thousands)**

| ** **                                                                               | ** ** | **Years Ended December 31,** | ** **  |
|------------------------------------------------------------------------------------------|------------|---------------------------------------------|-------------|
| ** **                                                                               | ** ** | **2006**                                    | ** **  | **2005** | ** ** | **2004** | ** ** |
| **Operating activities**                                                                 |       |                                        |        |   |   |   |   |
| Net loss                                                                                 |       | $                                           | (33,268     | ) | $ | (23,580 | ) | $ | (14,972 | ) |
| Adjustments to reconcile net loss to net cash used in  operating activities:             |       |                                        |        |   |   |   |   |
| Stock-based compensation                                                                 |       | 3,745                                       |        | 1,938 |   | 1,811 |   |
| Depreciation and  amortization                                                           |       | 1,602                                       |        | 910 |   | 699 |   |
| Deferred rent                                                                            |       | 1,236                                       |        | 263 |   | (55 | ) |
| Loss on disposal of  assets                                                              |       | 29                                          |        | — |   | — |   |
| Amortization of discount  on equipment loan                                              |       | —                                      |        | 5 |   | 15 |   |
| Realized gain on  investments                                                            |       | (1                                          | )           | (2 | ) | — |   |
| Amortization of discount  and premium on securities available-for-sale                   |       | (924                                        | )           | 528 |   | 561 |   |
| Change in operating assets and liabilities:                                              |       |                                        |        |   |   |   |   |
| Trade accounts receivable                                                                |       | 12                                          |        | (403 | ) | 432 |   |
| Other current assets                                                                     |       | 667                                         |        | (115 | ) | (660 | ) |
| Other assets                                                                             |       | (27                                         | )           | (152 | ) | 199 |   |
| Deferred revenue                                                                         |       | 167                                         |        | 4,655 |   | (458 | ) |
| Accounts payable                                                                         |       | (692                                        | )           | 881 |   | 97 |   |
| Accrued liabilities and  other long-term liabilities                                     |       | 118                                         |        | 1,559 |   | 333 |   |
| Net cash flows used in  operating activities                                             |       | (27,336                                     | )           | (13,513 | ) | (11,998 | ) |
| **Investing activities**                                                                 |       |                                        |        |   |   |   |   |
| Purchases of securities  available-for-sale                                              |       | (134,752                                    | )           | (36,785 | ) | (40,327 | ) |
| Sales/maturities of  securities available-for-sale                                       |       | 104,179                                     |        | 34,897 |   | 21,024 |   |
| Purchases of property and  equipment                                                     |       | (3,230                                      | )           | (3,220 | ) | (1,326 | ) |
| Net cash flows used in  investing activities                                             |       | (33,803                                     | )           | (5,108 | ) | (20,629 | ) |
| **Financing activities**                                                                 |       |                                        |        |   |   |   |   |
| Issuance of common stock,  net                                                           |       | 38,002                                      |        | 39,380 |   | 32,140 |   |
| Principal payments on  debt and capital lease obligations                                |       | (1,486                                      | )           | (870 | ) | (788 | ) |
| Repurchase unvested  common stock                                                        |       | —                                      |        | (20 | ) | — |   |
| Proceeds received from  debt and capital lease obligations                               |       | 4,078                                       |        | 1,807 |   | 1,179 |   |
| Net cash flows provided  by financing activities                                         |       | 40,594                                      |        | 40,297 |   | 32,531 |   |
| (Decrease) increase in  cash and cash equivalents                                        |       | (20,545                                     | )           | 21,676 |   | (96 | ) |
| Cash and cash equivalents  at beginning of year                                          |       | 32,597                                      |        | 10,921 |   | 11,017 |   |
| Cash and cash equivalents  at end of period                                              |       | $                                           | 12,052      |   | $ | 32,597 |   | $ | 10,921 |   |
| **Supplemental disclosure of cash flow  information:**                                   |       |                                        |        |   |   |   |   |
| Interest paid                                                                            |       | $                                           | 405         |   | $ | 205 |   | $ | 214 |   |
| **Supplemental schedule of noncash investing and  financing activities:**                |       |                                        |        |   |   |   |   |
| Reclass of deferred  compensation                                                        |       | $                                      | 3,266  |   | $  | —     —  |   | $  | —           |   |
| Fair value of warrant  issued in connection with the Committed Equity Financing Facility |       | $                                           | 1,098       |   | $ | — |   | $ | — |   |
| Unrealized gain (loss) on  short-term investments                                        |       | $                                           | 77          |   | $ | — |   | $ | (48 | ) |
| Conversion of convertible preferred stock to common  stock upon initial public offering  |       | $                                      | —      |   | $  | — |   | $  | 64 |   |

 

See accompanying notes.

F-6

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**METABASISTHERAPEUTICS, INC.NOTES TO FINANCIAL STATEMENTS**

**1. Organization andSummary of Significant Accounting Policies**

***Organization and Basis of Presentation***

Metabasis Therapeutics, Inc. (“Metabasis” or the “Company”)is a biopharmaceutical company focused on the discovery, development andcommercialization of novel drugs to address some of the world’s most widespreadand costly chronic diseases. The Company was incorporated in Delaware in April 1997as a wholly owned subsidiary of Gensia Sicor Inc., now Sicor Inc., which becamean indirect wholly owned subsidiary of Teva Pharmaceutical Industries Limitedin January 2004. In December 1997, Sicor assigned the Companyspecified assets and liabilities relating to its then existing business ofdiscovering and developing proprietary pharmaceutical products. In June 1999the Company completed a corporate restructuring and management stock purchasein which the Company became an independent company.

Certain prior year amountshave been reclassified to be consistent with current year presentation. In thefourth quarter of 2006, the Company began reporting all legal costs associatedwith patent related activities as general and administrative costs. All generaland administrative and research and development costs referred to within this Form 10-Khave been reclassified to give effect of the reclassification of these costs.The cumulative adjustment for the reclassification of these costs for the nine monthsended September 30, 2006 totaled $1.5 million, and $1.4 million and $587,000, forthe twelve months ended December 31, 2005 and 2004, respectively. There is noimpact on retained earnings, total operating expenses, net cash used foroperating activities, net loss or earnings per share as a result of theclassification of these costs. In addition, the Company recorded otherimmaterial reclassifications within its prior year balance sheet to conform tocurrent year presentation. None of these additional reclassifications had animpact to total assets, total liabilities or net cash used in operating orinvesting activities for the period presented herein.

***Use of Estimates***

The preparation offinancial statements in conformity with U.S. generally accepted accounting principlesrequires management to make estimates and assumptions that affect the reportedamounts of assets and liabilities and disclosures of contingent assets andliabilities at the date of the financial statements. Estimates also affect thereported amounts of revenues and expenses during the reporting period. Actualresults could differ from those estimates.

***Cash and Cash Equivalents***

Cash and cash equivalentsconsist of cash and highly liquid instruments with original maturities of threemonths or less when purchased.

***Securities Available-For-Sale***

Short-term investments are classified asavailable-for-sale and are carried at fair value, with unrealized gains andlosses reported in stockholders’ equity. The amortized cost of debt securitiesin this category is adjusted for amortization of premiums and accretion ofdiscounts to maturity. Such amortization is included in interest income.Realized gains and losses and declines in value judged to beother-than-temporary, if any, on available-for-sale securities are included inother income. The cost of securities sold 

F-7

----

is based on thespecific-identification method. Interest and dividends on securities classifiedas available-for-sale are included in interest income.

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

| ** **                  | ** ** | **December 31, 2006** | ** ** |
|-----------------------------|------------|---------------------------------|------------|
| ** **                  | ** ** | **Amortized  Cost**             | ** ** | **Gross  Unrealized  Gains** | ** ** | **Gross  Unrealized  Losses** | ** ** | **Estimated  Fair  Value** | ** ** |
| Corporate debt  securities  |       |                            | $          | 55,074 |   |   |   | $ | 22 |   |   |   | $ | (1 | ) |   |   | $ | 55,095 |   |   |
| Mortgage-backed  securities |       |                            | 10,774     |   |   |   | 2 |   |   |   | — |   |   |   | 10,776 |   |   |
| Total                       |       |                            | $          | 65,848 |   |   |   | $ | 24 |   |   |   | $ | (1 | ) |   |   | $ | 65,871 |   |   |

 

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

 

Gross realized gains and losses on available-for-salesecurities were immaterial during the years ended December 31, 2006, 2005and 2004. All realized gains and losses are reclassified out of othercomprehensive income (loss) in the period recognized. Proceeds from the sale ofshort-term investments totaled $104.2 million, $35.4 million and $21.6 millionfor the years ended December 31, 2006, 2005 and 2004, respectively. Allavailable-for-sale securities at December 31, 2006 have a contractualmaturity of one year or less.

Investmentsconsidered to be temporarily impaired at December 31, 2006 are as follows:

| ** **                           | ** ** | ** **                      | ** ** | **Less than 12 months  of temporary impairment** | ** ** |
|--------------------------------------|------------|---------------------------------|------------|---------------------------------------------------------------------------|------------|
| ** **                           | ** ** | **Number of  Investments** | ** ** | **Fair Value**                                                       | ** ** | **Unrealized  Losses** | ** ** | ** ** |
| Corporate debt  securities           |       |                            | 2          |                                                                      |       |   | $ | 5,247 |   |   |   | $ | (1 | ) |   |   |
| Total temporary impaired  securities |       |                            | 2          |                                                                      |       |   | $ | 5,247 |   |   |   | $ | (1 | ) |   |   |

 

There are no investments held at December 31,2006, which are considered to be temporarily impaired beyond 12 months. TheCompany regularly monitors and evaluates the realizable value of its marketablesecurities. When assessing marketable securities for other-than-temporarydeclines in value, the Company considers such factors as, among other things,how significant the decline in value is as a percentage of the original cost,how long the market value of the investment has been less than its originalcost and the market in general.

The Company believes thatthe decline in value of its marketable securities is temporary and related tothe change in market interest rates since purchase. The decline is not relatedto any company or industry specific event, and all portfolio investments areinvestment grade quality. The Company anticipates full recovery of amortizedcost with respect to these securities at maturity or sooner in the event of achange in the market interest rate environment.

***Fair Value of Financial Instruments***

The carrying amount ofcash and cash equivalents, securities available-for-sale, accounts receivable,accounts payable, accrued liabilities and deferred revenue are considered to berepresentative of their respective fair values because of the short-term natureof those instruments. Based on the borrowing rates 

F-8

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currentlyavailable to the Company for loans with similar terms, management believes thefair value of the long-term obligations approximate their carrying value.

***Concentration of Credit Risks and Major Partners***

Financial instruments that potentially subject the Companyto a significant concentration of credit risk consist primarily of cash andcash equivalents and securities available-for-sale. The Company invests itsexcess cash 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.

One collaborative partnerindividually accounted for 86% and 90% of total revenues during the years endedDecember 31, 2006, and 2005, respectively and a different collaborativepartner individually accounted for 51% of total revenues during the year ended December 31,2004 (see Note 5).

***Property and Equipment***

Property and equipment is carried at cost lessaccumulated depreciation. Depreciation is computed on the straight-line methodand depending 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.

Propertyand equipment consisted of the following (in thousands):

| ** **                                       | ** ** | **December 31,** | ** ** |
|--------------------------------------------------|------------|-----------------------|------------|
| ** **                                       | ** ** | **2006**              | ** ** | **2005** | ** ** |
| Laboratory  equipment                            |       | $                     | 9,849      |   | $ | 7,561 |   |
| Computers and  electronics                       |       | 3,117                 |       | 2,322 |   |
| Office furniture  and fixtures                   |       | 1,197                 |       | 987 |   |
| Leasehold  improvements                          |       | 1,120                 |       | 943 |   |
| Construction in  progress                        |       | 150                   |       | 456 |   |
|                                             |       | 15,433                |       | 12,269 |   |
| Less: accumulated  depreciation and amortization |       | (9,170                | )          | (7,605 | ) |
|                                             |       | $                     | 6,263      |   | $ | 4,664 |   |

 

Depreciation andamortization expenses, which include assets held under capital leases, were$1.6 million, $910,000 and $699,000 for the years ended December 31, 2006,2005 and 2004, respectively. Assets held under capital leases and equipmentloans totaled approximately $5.8 million and $3.2 million at December 31,2006 and 2005, respectively. The related accumulated amortization wasapproximately $4.0 million and $2.4 million at December 31, 2006and 2005, respectively. Maintenance and repairs are charged to operations asincurred.

***Impairment of Long-Lived Assets***

The Company assessespotential impairment to its long-lived and intangible assets in accordance withSFAS No. 144, *Accounting for theImpairment or Disposal of Long-Lived Assets,* when there is evidencethat events or changes in circumstances indicate that the carrying amount of anasset may not be recovered. There have been no indicators of impairment throughDecember 31, 2006.

F-9

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***Revenue Recognition***

The Company’s revenue recognition policies are inaccordance with the SAB No. 104, *RevenueRecognition,* and Emerging Issues Task Force (“EITF”) Issue No. 00-21,*Revenue Arrangements with MultipleDeliverables*. The Company’s revenues are primarily related tocollaborations with pharmaceutical companies. The Company’s agreementsgenerally contain multiple elements, including sponsored research funding,future milestone payments and royalties. All fees are nonrefundable.

Upfront, nonrefundable fees under the Company’s collaborationsand advance payments for sponsored research, which are in excess of amountsearned are classified as deferred revenue and are recognized as income over theperiod of performance obligation. 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 arerecognized as revenues as the services are performed. These agreements are on abest-efforts basis and do not require scientific achievement as a performanceobligation and provide for payment to be made when costs are incurred or theservices are performed.

Revenue from milestones isrecognized when earned, provided that (i) the milestone event issubstantive and its achievability was not reasonably assured at the inceptionof the agreement, and (ii) collaborator funding (if any) of the Company’sperformance obligations after the milestone achievement will continue at alevel comparable to before the milestone achievement. If both of these criteriaare not met, the milestone payment is recognized as revenue over the remainingminimum period of the Company’s performance obligations under the agreement.

***Research and Development***

All costs of research anddevelopment, including those incurred in relation to the Company’scollaborative agreements, are expensed in the period incurred. Research anddevelopment costs primarily consist of salaries and related expenses forpersonnel, stock-based compensation expense, outside service providers,facilities costs, fees paid to consultants, professional services, travelcosts, dues and subscriptions, depreciation and materials used in clinicaltrials and research and development. The Company reviews and accrues clinicaltrials expenses based on work performed, which relies on estimates of totalcosts incurred based on completion of patient studies and other events. TheCompany follows this method since reasonably dependable estimates of the costsapplicable to various stages of a research agreement or clinical trial can bemade. Accrued clinical development costs are subject to revisions as trialsprogress to completion. Revisions are charged to expense in the period in whichthe facts that give rise to the revision become known.

***Stock-Based Compensation***

In December 2004, the Financial AccountingStandards Board (“FASB”) issued SFAS No. 123R, *Share-BasedPayment*. SFAS No. 123R requires all share-based payments toemployees or non-employee directors as compensation for service on the Board ofDirectors, to be recognized as compensation expense in the financial statementsbased on the fair values of such payments.

The Company maintains three shareholder-approvedshare-based compensation plans that are subject to the requirements of SFAS No. 123R.The Amended and Restated 2001 Equity Incentive Plan (“Equity Incentive Plan”)provides for the grant of stock options and restricted stock to officers,directors and employees of, and consultants and advisors to, the Company. The2004 Non-Employee Directors’ Stock Option Plan (“Directors’ Stock Option Plan”)provides for the grant of non-statutory stock options to non-employee directors.The 2004 Employee Stock Purchase Plan (“Employee Stock Purchase Plan”) provides

F-10

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a means by which employeesmay purchase common stock at a discount through payroll deductions and isintended to qualify as an employee stock purchase plan within the meaning of Section 423of the Internal Revenue Code.

Grants under the Equity Incentive Plan and theDirectors’ Stock Option Plan are primarily in the form of options that allow agrantee to purchase a fixed number of shares of the Company’s common stock at afixed exercise price equal to the market price of the shares at the date of thegrant. Grants under the Equity Incentive Plan are “incentive stock optiongrants” or “non-qualified stock option grants” if they are granted to employeesand “non-qualified stock option grants” if granted to non-employees. Grantsunder the Directors’ Stock Option Plan are “non-qualified stock option grants.”  Options under both the Equity Incentive Planand the Directors’ Stock Option Plan may vest on a single date or in tranchesover a period of time, but normally they do not vest unless the grantee isstill employed by or a director of the Company on the vesting date. Optionsunder the Equity Incentive Plan generally vest over a four year period: 1/4th on the first year anniversary of the date ofgrant and in equal monthly installments over the remaining three years andexpire ten years from the date of grant. Options under the Directors’ StockOption Plan generally vest from one to two years, and expire ten years from thedate of grant. The Company made no modifications to outstanding options withrespect to vesting periods or exercise prices prior to adopting SFAS No. 123R.Rights to purchase shares under the Employee Stock Purchase Plan allowparticipating employees to purchase stock at a discount during offering periodsof 6, 12, 18 or 24 months with purchases occurring every six months.

In March 2005, the Securities and ExchangeCommission issued SAB No. 107*, Share-Based Payments,*which provides guidance on the implementation of SFAS No. 123R. TheCompany applied the principles of SAB No. 107 in conjunction with itsadoption of SFAS No. 123R.

The Company adopted SFAS No. 123R effective January 1,2006, using the modified-prospective transition method. Under this transitionmethod, compensation expense under both the Equity Incentive Plan and theDirectors’ Stock Option Plan will be recognized based on the grant date fairvalue estimated in accordance with the provisions of SFAS No. 123R for allnew grants effective January 1, 2006, and for options granted prior to butnot vested as of December 31, 2005, compensation will be recognized basedon the grant date fair value as estimated in accordance with SFAS No. 123.Compensation expense will be recognized over the requisite service period whichis typically the period over which the stock-based compensation awards vest. Compensationexpense under the Employee Stock Purchase Plan will be recognized based on thefair value on the date that the purchase rights were granted in accordance withthe provisions of SFAS No. 123R for all new grants effective January 1,2006, and for share purchase rights granted prior to but not vested as of December 31,2005, and will be recognized over the remaining period of each grant’srespective offering period.

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Prior periods were notrestated to reflect the impact of adopting the new standard and therefore donot include compensation expense related to qualified stock option grants forthose periods. In accordance with SFAS No. 123R, the Company recognizedshare-based compensation expense for all three plans as follows (in thousands):

| ** **                              | ** ** | **Twelve months ended  December 31, 2006** | ** ** | ** ** |
|-----------------------------------------|------------|----------------------------------------------------------------|------------|------------|
| Stock-based compensation  expense:      |       |                                                           |       |       |   |   |
| Research and development                |       |                                                           | $          | 1,936      |   |   |   |
| General and  administrative             |       |                                                           | 1,809      |       |   |   |
| Total stock-based  compensation expense |       |                                                           | $          | 3,745      |   |   |   |
| Net effect on net loss                  |       |                                                           | $          | 3,745      |   |   |   |
| Effect on loss per  share:              |       |                                                           |       |       |   |   |
| Basic and diluted                       |       |                                                           | $          | 0.13       |   |   |   |

 

As a result of adopting SFAS No. 123R on January 1,2006, the Company’s net loss for the twelve months ended December 31, 2006is approximately $1.9 million greater than if the Company had continued toaccount for share-based compensation under Accounting Principles Board (“APB”)Opinion No. 25, *Accounting for StockIssued to Employees*. Basic and diluted net loss per share for thetwelve months ended December 31, 2006 is $0.07 greater, than if the Companyhad continued to account for share-based compensation under APB Opinion No. 25.

Compensationexpense for all options granted under the Equity Incentive Plan and theDirectors’ Stock Option Plan during the twelve-month period ended December 31,2006 was recognized on a straight-line basis over the vesting period of eachgrant, net of estimated forfeitures. The Company’s estimated forfeiture ratesare based on its historical experience. The estimated fair value of the optionsand share purchase rights granted during 2006 and in prior years was calculatedusing a Black-Scholes Merton option-pricing model (“Black-Scholes model”). Thefollowing summarizes the assumptions used in the Black-Scholes model as appliedin 2006:

| ** **                                    | ** ** | **Equity Incentive Plan and  Directors’ Stock Option Plan** | ** ** | **Employee Stock Purchase  Plan** | ** ** |
|-----------------------------------------------|------------|------------------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| Risk-free  interest rate(1)                   |       |                                                                                           | 4.7        | %                                           |       |   | 4.7 | % |   |
| Volatility(2)                                 |       |                                                                                           | 69.0       | %                                           |       |   | 67.5 | % |   |
| Dividend yield(3)                             |       |                                                                                           | 0.0        | %                                           |       |   | 0.0 | % |   |
| Expected Life(4)                              |       |                                                                                           | 6 years    |                                        |       |   | 1.3 years |   |   |
| Weighted average fair  value at date of grant |       |                                                                                           | $          | 4.84                                        |       |   |   | $ | 2.11 |   |   |
|                                               |            |                                                                                                |            |                                             |            |  |  |  |  |  |  |

----

(1)          The risk-free interestrate is based on U.S. Treasury debt securities with maturities close to theexpected term of the option and the share purchase right.

(2)          Expected volatility isbased on the weighted average volatility of the Company’s stock factoring indaily share price observations and the historical price volatility of certainpeers within the Company’s industry sector. In computing expected volatility,the length of the historical period used is equal to the length of the expectedterm of the option and the share purchase right.

(3)          No cash dividends havebeen declared on the Company’s common stock since the Company’s inception, andthe Company currently does not anticipate paying cash dividends over theexpected term of the option and the share purchase right.

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(4)          The expected life ofemployee stock options represents the average of the contractual term of theoptions and the weighted average vesting period, as permitted under thesimplified method, under SAB No. 107.

Forfeitures are estimated at the time of grant andrevised, if necessary, in subsequent periods if actual forfeitures differ fromthose estimates. Forfeitures were estimated to be $68,831 for the optionsgranted during the twelve months ended December 31, 2006, based onhistorical experience. In the Company’s pro forma information required underSFAS No. 123, *Accounting for Stock-BasedCompensation*, for the periods prior to fiscal 2006, the Companyaccounted for forfeitures as they occurred.

The Employee Stock Purchase Plan permits for themodification of the original rate of contribution an employee elects uponenrollment. The Company accounts for each increase from the original rate ofcontribution, during an offering period, as a modification of the originalaward and recognizes the incremental change in compensation expense as a resultof the change in fair value from the modification. The incremental effect tostock compensation as a result of modifications to these awards during thetwelve months ended December 31, 2006, was immaterial.

F-13

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Thefollowing is a summary of stock option activity under the Equity Incentive Planand the Directors’ Stock Option Plan as of December 31, 2005, and changesduring the twelve months ended December 31, 2006 (in thousands, except pershare data): 

| ** **                             | ** ** | **Number  of  Options** | ** ** | **Weighted  average  exercise price** | ** ** |
|----------------------------------------|------------|-------------------------|------------|--------------------------------------------|------------|
| 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 |   |   |
| Granted                                |       |                    | 1,338      |                                       |       |   | $ | 8.05 |   |   |
| Exercised                              |       |                    | (44        | )                                          |       |   | $ | 2.17 |   |   |
| Canceled                               |       |                    | (61        | )                                          |       |   | $ | 6.40 |   |   |
| Outstanding at  December 31, 2006 |       |                    | 2,638      |                                       |       |   | $ | 5.58 |   |   |
| Exercisable at  December 31, 2006 |       |                    | 1,025      |                                       |       |   | $ | 3.01 |   |   |

 

The intrinsic value of options exercised during thetwelve months ended December 31, 2006 was $254,000. The aggregateintrinsic value of stock options exercisable and outstanding as of December 31,2006 was $3.1 million and $14.7 million, respectively. The weighted averagecontractual life for options outstanding as of December 31, 2006 was 8.2years. The weighted average contractual life for options exercisable as of December 31,2006 was 6.9 years. The weighted average fair value of options vested duringfiscal 2006 was $5.39.

Thefollowing is a summary of activity for non-vested stock options under theEquity Incentive Plan and the Directors’ Stock Option Plan as of December 31,2005, and changes during the twelve months ended December 31, 2006 (inthousands, except per share data): 

| ** **                           | ** ** | **Number  of  Options** | ** ** | **Weighted  Average Fair  Value  Price Per  Share** | ** ** |
|--------------------------------------|------------|-------------------------|------------|---------------------------------------------------------------|------------|
| Nonvested at  December 31, 2005 |       |                    | 737        |                                                          |       |   | $ | 5.68 |   |   |
| Granted                              |       |                    | 1,338      |                                                          |       |   | $ | 4.84 |   |   |
| Vested                               |       |                    | (394       | )                                                             |       |   | $ | 5.58 |   |   |
| Forfeited                            |       |                    | (61        | )                                                             |       |   | $ | 3.36 |   |   |
| Nonvested at  December 31, 2006 |       |                    | 1,620      |                                                          |       |   | $ | 5.07 |   |   |

 

As of December 31, 2006, the Company hadapproximately $7.6 million of unrecognized compensation expense of which $7.4million related to stock options under the Equity Incentive Plan and theDirectors’ Stock Option Plan and $172,000 related to share purchase rightsunder the Employee Stock Purchase Plan. The expense is expected to berecognized over a weighted average period of approximately 1.8 years. Theresulting effect on net loss and net loss per share is not likely to berepresentative of the effects in future periods due to additional grants,subsequent periods of vesting and changes in volatility and expected life.

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Prior to January 1, 2006, the Company accountedfor its stock-based compensation plans under APB Opinion No. 25*.* In accordance with APB Opinion No. 25,the Company recognized no compensation expense for incentive stock optiongrants where the exercise price was equal to the market price on the date ofgrant. For options issued with an exercise price less than the fair marketvalue of the shares at the date of grant, the Company recognized the differencebetween the exercise price and fair market value as compensation expense inaccordance with APB Opinion No. 25. Compensation expense was recognizedand amortized on a straight-line basis over the vesting period of the relatedoptions, generally four years. The Company had a deferred stock compensationbalance of $3.3 million at December 31, 2005 for options previously issuedwith an exercise price less than the fair market value of the shares on thedate of grant. Upon adoption of SFAS No. 123R, deferred stock compensationwas eliminated against additional paid-in-capital.

Priorto January 1, 2006, the Company provided pro forma disclosure amounts inaccordance with SFAS No. 123, as amended by SFAS No. 148, *Accounting for Stock-Based Compensation—Transitionand Disclosure*. In the Company’s pro forma information requiredunder SFAS No. 123 for periods prior to the fiscal year ended 2006, theCompany accounted for forfeitures as they occurred. The fair value of theseoptions was estimated at the date of grant using the Black-Scholes model withthe following weighted average assumptions used for option grants:

| ** **                      | ** ** | **Years Ended  December 31,** | ** ** |
|---------------------------------|------------|-----------------------------------------|------------|
| ** **                      | ** ** | **2005**                                | ** ** | **2004** | ** ** |
| Risk-free  interest rate        |       | 4.4                                     | %          | 3.6 | % |
| Dividend yield                  |       | 0.0                                     | %          | 0.0 | % |
| Volatility factor               |       | 70.0                                    | %          | 70.0 | % |
| Weighted average life in  years |       | 6.3                                     |       | 5.0 |   |

 

Thefollowing table illustrates the effect on net loss and net loss per share ifthe Company had applied the fair value recognition provisions of SFAS No. 123to stock-based employee compensation in the prior fiscal year 2005 and 2004 (inthousands, except per share data):

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

 

The Company accounts forstock options granted to non-employees for acquiring, or in conjunction withselling, goods and services in accordance with SFAS No. 123 and EITF No. 96-18,*Accounting For Equity Instruments That AreIssued To Other Than Employees For Acquiring, Or In Conjunction With Selling,Goods Or Services*, and accordingly recognizes as expense theestimated fair value of such options as calculated using the Black-Scholesmodel. The fair value is remeasured during the service period and is amortizedover the vesting period of each option or the recipient’s contractualarrangement, if shorter. Expense recognized for acquiring, or in conjunctionwith selling, goods or services for the twelve months ended December 31,2006, 2005 and 2004 were not material.

F-15

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***Comprehensive Loss***

SFAS No. 130, *Reporting Comprehensive Income*, requiresthat all components of comprehensive loss, including net loss, be reported inthe financial statements in the period in which they are recognized.Comprehensive loss is defined as the change in equity during a period fromtransactions and other events and circumstances from non-owner sources. TheCompany’s other comprehensive loss for December 31, 2006, 2005 and 2004consisted of unrealized gains and losses on available-for-sale securities andis reported in stockholders’ equity.

***Net Loss Per Share***

TheCompany calculated net loss per share in accordance with SFAS No. 128, *Earnings Per Share*. Basic earnings pershare (“EPS”) is calculated by dividing the net loss by the weighted averagenumber of common shares outstanding for the period, without consideration forcommon stock equivalents. Diluted EPS is computed by dividing the net loss bythe weighted average number of common share equivalents outstanding for theperiod determined using the treasury-stock method. For purposes of thiscalculation, common stock subject to repurchase by the Company, options, andwarrants are considered to be common stock equivalents and are only included inthe calculation of diluted earnings per share when their effect is dilutive. The total number of shares issuable uponexercise of stock options and warrants excluded from the calculation of dilutedearnings per share since they are anti-dilutive were 5,142,606, 2,622,617 and1,679,518 in 2006, 2005 and 2004, respectively.

| ** **                                                                                         | ** ** | **Years Ended December 31,**                           | ** ** |
|----------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|
| ** **                                                                                         | ** ** | **2006**                                                              | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                                                                         | ** ** | **(in thousands, except per share amounts)** | ** ** |
| **Actual:**                                                                                        |       |                                                                  |       |   |   |   |   |
| *Numerator:*                                                                                       |       |                                                                  |       |   |   |   |   |
| Net loss                                                                                           |       | $                                                                     | (33,268    | ) | $ | (23,580 | ) | $ | (14,972 | ) |
| *Denominator:*                                                                                     |       |                                                                  |       |   |   |   |   |
| Weighted average common shares                                                                     |       | 29,152                                                                |       | 19,981 |   | 10,452 |   |
| Weighted average unvested common shares subject to  repurchase                                     |       | (133                                                                  | )          | (275 | ) | (418 | ) |
| Denominator for basic and diluted net loss per share                                               |       | 29,019                                                                |       | 19,706 |   | 10,034 |   |
| Basic and diluted  net loss per share                                                              |       | $                                                                     | (1.15      | ) | $ | (1.20 | ) | $ | (1.49 | ) |
| **Pro forma:**                                                                                     |       |                                                                  |       |   |   |   |   |
| *Numerator:*                                                                                       |       |                                                                  |       |   |   |   |   |
| Proforma net loss                                                                                  |       | $                                                                     | (33,268    | ) | $ | (23,580 | ) | $ | (14,972 | ) |
| *Denominator:*                                                                                     |       |                                                                  |       |   |   |   |   |
| Shares used above                                                                                  |       | 29,019                                                                |       | 19,706 |   | 10,034 |   |
| Pro forma adjustments to reflect assumed weighted  average effect of conversion of preferred stock |       | —                                                                |       | — |   | 5,220 |   |
| Pro forma shares used to compute basic net loss per  share                                         |       | 29,019                                                                |       | 19,706 |   | 15,254 |   |
| Basic and diluted net  loss per share                                                              |       | $                                                                     | (1.15      | ) | $ | (1.20 | ) | $ | (0.98 | ) |

 

***Warrants***

The Company issueswarrants to purchase the Company’s shares of common stock in connection withfinancing arrangements. Generally, the warrants are provided as additionalconsideration to an investor for the purchase of the Company’s common stockthrough a structured offering. The terms of the warrants may vary, however,generally include an exercise price equal to a specific premium over the valueof the common stock at the time of the financing. They are generally requiredto be settled in cash, however, 

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underrare and certain circumstances, such as in a default of funding by theinvestor, may require the Company to repurchase common stock obtained throughthe exercise of the warrant. The Company accounts for these financialinstruments in accordance with SFAS No. 150, *Accounting for Certain Financial Instruments with Characteristics ofboth Liabilities and Equity,* and EITF Issue No. 00-19, *Accounting for Derivative Financial InstrumentsIndexed to and Potentially Settled in a Company’s Own Stock*. Wherethe instrument qualifies as a freestanding financial instrument and does notrepresent an obligation or where the monetary value of the instrument changesin the same direction as the shares of common stock, the Company will assessthe terms of the instrument against the criteria within EITF Issue No. 00-19to determine the appropriate classification as equity or a liability. As of December 31,2006, all warrants issued are classified as equity.

***Recent Accounting Pronouncements***

In February 2006, the FASB issued SFASNo. 155, Hybrid Instruments. The statement amends SFAS No. 133, *Accounting for Derivative Instruments and Hedging Activities*,and SFAS No. 140, *Accounting for Transfersand Servicing of Financial Assets and Extinguishments of Liabilities*.The statement also resolves issues addressed in Statement 133 ImplementationIssue No. D1, *Application of Statement133 to Beneficial Interests in Securitized Financial Assets*. Thestatement: permits fair value remeasurement for any hybrid financial instrumentthat contains an embedded derivative that otherwise would require bifurcation;clarifies which interest-only strips and principal-only strips are not subjectto the requirements of SFAS No. 133; establishes a requirement to evaluateinterests in securitized financial assets to identify interests that are freestandingderivatives or that are hybrid financial instruments that contain an embeddedderivative requiring bifurcation; clarifies that concentrations of credit riskin the form of subordination are not embedded derivatives, and; amendsStatement 140 to eliminate the prohibition on a qualifying special purposeentity from holding a derivative financial instrument that pertains to abeneficial interest other than another derivative financial instrument. TheCompany believes the adoption of this standard will not have an impact on itsresults of operations or financial position.

In July 2006, the FASB issued Interpretation, orFIN, No. 48, *Accounting for Uncertainty in Income Taxes*.This interpretation requires that we recognize in our financial statements, theimpact of a tax position, if that position is more likely than not of beingsustained on audit, based on the technical merits of the position. Theprovisions of FIN 48 are effective for fiscal years beginning afterDecember 15, 2006, with the cumulative effect of the change in accountingprinciple recorded as an adjustment to opening retained earnings. The Companyis currently evaluating the impact of the adoption of FIN 48 on itsfinancial statements.

In September 2006, the Securities and ExchangeCommission released SAB No. 108, *Considering the Effects ofPrior Year Misstatements when Quantifying Misstatements in Current YearFinancial Statements*. SAB 108 provides interpretive guidance onthe Securities and Exchange Commission’s views regarding the process ofquantifying materiality of financial statement misstatements. SAB 108 iseffective for fiscal years ending after November 15, 2006 (beginning withour 2006 fiscal year). The adoption of this guidance did not have a materialimpact on the Company’s results of operations or financial position.

In September 2006,the FASB issued FAS 157, *Fair Value Measurements*.This standard defines fair value, establishes a framework for measuring fairvalue in generally accepted accounting principles, and expands disclosuresabout fair value measurements. This statement is effective for financialstatements issued for fiscal years beginning after November 15, 2007(beginning with our 2008 fiscal year), although earlier application isencouraged. The Company has not yet evaluated the impact of adopting SFAS 157on its financial statements, however, the Company expects to assess the impactof adoption of this standard will have on its results of operations andfinancial position.

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**2. AccruedLiabilities**

Accruedliabilities consisted of the following (in thousands):

| ** **                     | ** ** | **December 31,** | ** ** |
|--------------------------------|------------|-----------------------|------------|
| ** **                     | ** ** | **2006**              | ** ** | **2005** | ** ** |
| Accrued  development expenses  |       | $                     | 1,464      |   | $ | 1,008 |   |
| Accrued bonuses                |       | 1,169                 |       | 700 |   |
| Other accrued  liabilities     |       | 621                   |       | 864 |   |
| Accrued employee  benefits     |       | 542                   |       | 752 |   |
| Accrued legal and  patent fees |       | 203                   |       | 613 |   |
|                           |       | $                     | 3,999      |   | $ | 3,937 |   |

 

**3. Commitmentsand Contingencies**

***Lease Commitments***

The Company leases itsoffice and research facilities and certain laboratory and electronic equipmentunder operating and capital lease agreements, which expire at varying datesthrough 2015. In December 2004, the Company entered into an operatinglease agreement pursuant to which the Company leased approximately 82,000square feet of real estate space in La Jolla, California consisting oflaboratory and office space. The lease commenced in October 2005 and hasan initial term of 10 years unless extended or sooner terminated. TheCompany has options to extend the lease for two renewal periods of five yearseach. The Company’s aggregate lease payments through 2015 will be$26.2 million. The facility lease provides for various forms of rentabatement during the first 48 months of the lease and annual rent increases of3.0%. The difference between the straight-line expense over the term of thelease and actual amounts paid are recorded as deferred rent. Prior to October 2005,the Company leased its office and research facilities under a differentoperating lease.

Rent expense wasapproximately $2.8 million, $1.4 million and $1.3 million for each of theyears ended December 31, 2006, 2005 and 2004, respectively.

***Debt***

In 2001, the Companyentered into a $650,000 equipment loan agreement with a financing company,which was subsequently amended two times to increase the amount available underthe agreement to $2.1 million. The Company utilized approximately$1.7 million before the amended agreement expired on December 31,2002. The proceeds from the loan were used to purchase laboratory, computer andelectronic equipment, tenant improvements and furniture which also served ascollateral to the loan. Each borrowing was payable over 48 months with aninterest rate fixed at the funding date of each borrowing ranging from 9.58% to12.05%. The weighted average interest rate during 2006 was 10%. The outstandingbalance of this loan is $0 and $178,000 at December 31, 2006 and 2005,respectively.

In conjunction with theinitial equipment loan and first amendment, warrants to purchase up to 53,938shares of Series C Convertible Preferred Stock (“Series C Preferred”)at $1.25 per share were issued, of which 45,000 shares are exercisable at anytime through June 16, 2007. The remaining warrant to purchase 8,938 sharesof Series C Preferred is exercisable at any time through December 31,2007. The cash exercise of these warrants would result in the issuance of 8,877shares of the Company’s common stock.

In conjunction with thesecond amendment to the initial equipment loan, the Company issued warrants topurchase 30,666 shares of Series D Convertible Preferred Stock (“Series DPreferred”). The warrants have an exercise price of $1.50 per share and areexercisable at any time through June 16, 2007. The cash exercise of thesewarrants would result in the issuance of 5,290 shares of the Company’s commonstock.

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The warrants issued by theCompany in connection with the equipment loan and related amendments wereaccounted for under APB 14, *Accounting forConvertible Debt and Debt Issued with Stock Purchase Warrants* andEITF Issue No. 96-18, which requires the warrants to be recorded at theirfair value. The fair value of the warrants was accounted for under SFAS No. 123using the Black Scholes model. The warrants were valued at $59,000 using thefollowing assumptions: risk-free interest rates of 4.59% to 4.97%,respectively; dividend yield of 0%; expected volatility of 70%; and a term of1.7 to 5 years. The fair market value was recorded as a discount on theequipment loan and is being amortized to interest expense over the term of theequipment loan. The unamortized discount was $1,000 and $9,000 at December 31,2005 and 2004, respectively. There are no amounts outstanding under thisagreement at December 31, 2006.

In August 2003, theCompany entered into a $1.4 million equipment loan agreement with adifferent financing company. This agreement was subsequently amended two timesto increase the amount available to $7.6 million. The proceeds are used tofinance lab equipment, computer and electronic equipment and furniture, whichserve as collateral under the loan. As of December 31, 2006, the Companyhas utilized the total amount available under the equipment loan agreement.Each borrowing is payable over 48 months with the interest rate  fixed at the funding date of each borrowingranging from 8.62% to 10.96%. The weighted average interest rate in 2006 was 9%.No warrants were issued in connection with this equipment loan agreement. Theoutstanding balance of this loan is $5.4 million and $2.6 million at December 31,2006 and 2005, respectively.

In connection with thefacility lease which commenced in October 2005, the Company agreed to a$300,000 loan for tenant improvements. The term of the loan corresponds to theinitial 10 year term of the lease. The interest rate is 8.0% per annum. Theoutstanding balance of this loan is $276,000 and $297,000 at December 31,2006 and 2005, respectively.

***Licensing andPurchase Commitments***

Paymentschedules for commitment and contractual obligations at December 31, 2006,are as follows (in thousands):

| ** **                                    | ** ** | **Capital  Leases** | ** ** | **Equipment  Financing** | ** ** | **Operating  Leases** | ** ** |
|-----------------------------------------------|------------|---------------------|------------|--------------------------|------------|-----------------------|------------|
| 2007                                          |       |                | $          | 29                       |       |                  |       | $ | 2,244 |   |   |   | $ | 1,760 |   |   |
| 2008                                          |       |                | 29         |                     |       |                  | 1,911      |   |   |   | 2,306 |   |   |
| 2009                                          |       |                | 28         |                     |       |                  | 1,638      |   |   |   | 2,781 |   |   |
| 2010                                          |       |                | 22         |                     |       |                  | 711        |   |   |   | 3,088 |   |   |
| 2011                                          |       |                | 5          |                     |       |                  | 44         |   |   |   | 3,178 |   |   |
| Thereafter                                    |       |                | —     |                     |       |                  | 167        |   |   |   | 13,093 |   |   |
| Total minimum  payments                       |       |                | 113        |                     |       |                  | 6,715      |   |   |   | $ | 26,206 |   |   |
| Less amount  representing interest            |       |                | (22        | )                        |       |                  | (1,046     | ) |   |   |   |   |   |
| Present value of  net minimum payments        |       |                | 91         |                     |       |                  | 5,669      |   |   |   |   |   |   |
| Less current  portion                         |       |                | (20        | )                        |       |                  | (1,761     | ) |   |   |   |   |   |
| Long-term debt and  capital lease obligations |       |                | $          | 71                       |       |                  |       | $ | 3,908 |   |   |   |   |   |   |

 

The Company also has openpurchase orders from time to time for the purchase of capital expenditures,consulting services, subscriptions and materials. Obligations under these openpurchase orders totaled $1.3 million at December 31, 2006. These purchasecommitments expire at varying dates through December 31, 2007.

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***Executive Severance Agreements***

The Company has entered into employment agreements withour executive officers and certain other key employees that, under certaincircumstances, provide for the continuation of salary and certain otherbenefits if terminated under specified circumstances.

Theseagreements generally expire upon termination for cause or when the Company hasmet its obligations under these agreements. As of December 31, 2006, noevents have occurred resulting in the obligation of any such payments.

***Clinical Development Agreements***

The Company has enteredinto agreements with various vendors for the preclinical and clinicaldevelopment of its product candidates, which are generally cancelable at theoption of the Company at any time. Under the terms of these agreements, thevendors provide a variety of services including conducting preclinicaldevelopment research, manufacturing clinical compounds, enrolling patients,recruiting patients, monitoring studies, data analysis and regulatory filingassistance. Payments under these agreements typically include fees for servicesand reimbursement of expenses. In addition, under certain agreements, we aresubject to penalties in the event we prematurely discontinue performance underthese agreements.

**4. Collaborative Researchand Development Agreements**

*Idenix*

In October 2006, theCompany entered into a non-exclusive collaboration agreement with Idenix, Inc.(“Idenix”) to apply its HepDirect technology to certain Idenix lead compoundswith the goal of improving the safety and efficacy of these compounds for thetreatment of hepatitis C. The research term will be for two years and may beextended beyond two years by mutual agreement of the parties.  In addition, Idenix will have the option toterminate the research term upon the first anniversary of the effective date ofthe agreement or upon the achievement of certain preclinical and clinicaldevelopment milestones during the research term. As part of this collaboration,Idenix paid the Company an initial, non-refundable license fee of $2.0 millionin the fourth quarter of 2006 and agreed to provide sponsored research fundingof up to $1.7 million per year during the research term. Idenix will also paythe Company milestones if specified preclinical and clinical development andregulatory events occur and royalties on product sales that result from thecollaboration. If all milestones are achieved, and including the $2.0 millionlicense fee and the up to $1.7 million per year in sponsored research fundingover the term, the Company may be entitled to payments which total up to $68.8million, plus royalties. Idenix is solely responsible for conducting andfunding all development work for compounds resulting from this collaboration.

*Valeant*

In October 2001, theCompany entered into a development and license agreement with ValeantPharmaceuticals International (“Valeant”) for the development andcommercialization of pradefovir for the treatment of hepatitis type B. Underthe agreement, Valeant was granted exclusive worldwide rights to develop andcommercialize pradefovir. As of December 31, 2006, the Company hadachieved developmental milestones triggering a total of $2.0 million inpayments from Valeant. The first milestone was earned in April 2003 andthe second milestone was earned in July 2004.

*Schering-Plough*

In January 2007, Valeant assigned its rights,interests and obligations under the development and license agreement toSchering-Plough and further granted Schering-Plough a license to itsintellectual 

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property related topradefovir. Concurrently, the Company and Schering-Plough entered into anamended and restated development and license agreement for the continued futuredevelopment and commercialization of pradefovir. Under the amended and restateddevelopment and license agreement and pursuant to Valeant’s assignment,Schering-Plough was granted exclusive worldwide rights to develop andcommercialize pradefovir during the term of the agreement. The Company receiveda non-refundable license fee of $1.8 million in January 2007 fromSchering-Plough and will receive future milestone payments upon the occurrenceof specified development, regulatory and commercial milestones as well asroyalties on sales of products resulting from the collaboration. If alldevelopment, regulatory and commercial milestones are achieved, and includingthe $1.8 million non-refundable license fee, the Company will be entitledto payments totaling up to $25 million, plus royalties under the agreementwith Schering-Plough. In addition, Schering-Plough is solely responsible forconducting and funding all development work.

The term of thedevelopment and license agreement will continue until all of Schering-Plough’sroyalty payment obligations have expired, unless the agreement is earlierterminated. The agreement may be terminated entirely or on a country by countrybasis by either party for material breach of the other party which remainsuncured. Schering-Plough has the sole right to terminate the agreement in itsentirety or in certain countries by providing at least 180 days written noticeto the Company.

*Daiichi Sankyo*

The Company has a research, development andcommercialization agreement with Daiichi Sankyo Company, Ltd., (“Daiichi Sankyo”)to develop novel FBPase inhibitors for the treatment of diabetes. The research period ended in April 2002.Daiichi Sankyo is responsible for funding the clinical development of 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, 2006, theCompany has achieved three developmental milestones triggering a total of $6.5million in payments, including $3.5million received in 2004 and none in 2005 and 2006 from Daiichi Sankyo. In 2003, Daiichi Sankyo chose not to exercisean option with the Company to negotiate a new agreement for next generationcompounds to treat diabetes. Because the Company concluded that it thereforehad no future performance obligation remaining it recognized $7.6 millionrelated to a previously unamortized option fee. If all clinical andregulatory milestones are achieved, and including the $36.0 million in licensefees, sponsored research payments and an equity investment received to dateunder the agreement, the Company may be entitled to payments which total up to$54.5 million.

Assuming a compound issuccessfully developed and commercialized, the Company would receive royaltieson net sales. Daiichi Sankyo will have exclusive, worldwide commercializationrights to those products selected for development and subsequently licensed.The Company would also have co-promotion rights in North America to anycommercialized product, on terms to be negotiated.

*Merck*

In December 2003, the Company entered into anon-exclusive collaboration agreement with Merck to discover new treatments forhepatitis C. Under this collaboration, the Company is creating liver-targetingprodrugs of certain compounds that Merck has supplied to us. These compoundstarget the hepatitis C virus residing in the liver. The research term of thecollaboration was initially for one year and in January 2005, was extendedfor an additional year through December 2005. At the same time, the scopeof the technology that the Company applies to the Merck compounds was expanded.As part of this collaboration, Merck paid an upfront fee of $500,000 which wasrecognized as revenue over the initial one-year term of the agreement and paidresearch support totaling $2.7 million during 2004 and 2005. Revenuerecognized under the agreement was $1.4 million and $1.8 million for the yearsended December 31, 2005 and 2004, respectively. Merck is also obligated topay preclinical and clinical milestone payments if 

F-21

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specified development andregulatory events occur and royalties on sales of products resulting from thecollaboration. If all preclinical and clinical milestones are achieved, andincluding the $500,000 upfront fee, the $2.7 million in research supportand an additional exclusive option, the Company may be entitled to paymentswhich total up to $25.3 million million,plus royalties. Merck is solely responsible for conducting and funding alldevelopment work for compounds resulting from the collaboration and forcommercializing any resulting products.

In June 2005, theCompany entered into a second collaboration agreement with Merck toresearch, develop and commercialize novel small molecule therapeutics with thepotential to treat several metabolic diseases including type 2 diabetes,hyperlipidemia and NASH by activating an enzyme in the liver called AMP-activatedProtein Kinase. As part of this collaboration, Merck paid an initialnon-refundable license fee of $5.0 million in July 2005 and will provideresearch support funding of a minimum of $2.1 million each year during thethree year research term. The three year research term is subject to renewalfor one additional year by mutual agreement of the Company and Merck. TheCompany’s level of research activities, and the minimum research supportfunding, may be increased during the term upon mutual agreement of bothparties. Merck is also obligated to pay milestone payments if specifiedpreclinical and clinical development and regulatory events occur and payroyalties on sales of any product resulting from this collaboration. As ofDecember 31, 2006, the Company has not achieved any developmentalmilestones and thus, no payments have been received for milestones from Merck.The Company would also have the option to co-promote any such product in theUnited States. If all preclinical and clinical milestones are achieved onmultiple indications, and including the $5.0 million initial, non-refundablelicense fee and the minimum $6.3 million in research support funding, theCompany 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. Under theagreement, the Company recognized revenue of $3.8 million and $1.9 million forthe years ended December 31, 2006 and 2005, respectively. Deferred revenueof $3.0 million is reflected on the balance sheet as of December 31, 2006,relating to this agreement.

**5. Committed Equity Financing Facility (CEFF)**

InNovember 2006, the Company entered into a CEFF with an institutionalinvestor. Under the terms of the agreement the investor is committed toproviding the Company up to $50 million in funding, or up to a maximum of6,046,071of shares of common stock, over a three-year term through the purchaseof newly-issued shares of the Company’s common stock. The Company may accesscapital under the CEFF in tranches of up to the lesser of $10 million or frombetween 0.75% to 1.5% of the Company’s market capitalization at the time of thedraw down of such tranche, subject to certain conditions.  The investor will purchase shares of theCompany’s common stock pursuant to the CEFF at discounts ranging from 6% to10%, depending on the average market price of the common stock during theeight-day pricing period, provided that the minimum acceptable purchase pricefor any shares to be issued to the investor during the eight-day pricing periodis determined by the higher of $2.25 or 90% of the Company’s share price theday before the commencement of each draw down. In accordance with SFASNo. 133 Implementation Issue A6, the Company determined the option tosell shares of the Company’s common stock does not qualify as a derivative asthe notional amount, the sales price of the stock, is variable and thereforeundeterminable. In addition, this arrangement does not require a minimum numberof shares to be sold and is restricted to a maximum number of shares to be sold.

Inconnection with the CEFF, the Company issued a warrant to the investor topurchase up to 260,000 shares of common stock at an exercise price of $9.26which represents a 30% premium over the average of the closing prices of theCompany’s common stock during the 5 days preceding the signing of theagreement. The warrant will become exercisable after the six-month anniversaryof the effective date of the agreement and will remain exercisable, subject tocertain exceptions, until November 2, 2011. In accordance with EITF IssueNo. 00-19, the warrant met all criteria within the guidance providing forthe 

F-22

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classification of this financial instrument as equity.The fair value of this warrant, totaling $1.1 million, was determined using theBlack-Scholes model using the following assumptions: risk-free interest ratesof 4.84%; dividend yield of 0%; expected volatility of 74%; and a term of5.5 years. The net effect of recording the fair value to equity is zero atDecember 31, 2006.

The Company filed a registration statement with theSecurities and Exchange Commission for the resale of the shares of common stockissuable in connection with the CEFF and the shares of common stock underlyingthe warrant in accordance with a registration rights agreement entered intoconcurrently with the above agreements. The registration rights agreementmaintains penalty and “make-whole” provisions in the event the registrationstatement does not become effective within an allotted time frame and where theinvestor may be restricted, due to “black out periods”, from trading shares ofthe Company’s common stock purchased pursuant to the CEFF or by the exercise ofthe warrant. In accordance with SFAS 133, *Accounting for DerivativeInstruments and Hedging Activities*, and EITF Issue No. 00-19-2,*Accounting for Registration Payment Arrangements,*the Company accounts for these provisions under SFAS No.5, *Accounting for Contingencies* and will record the fair valueof the liability in the event such a penalty is measurable and probable. As ofDecember 31, 2006, an effective registration statement was filed with theSecurities and Exchange Commission and the Company had not utilized thisfinancial instrument. 

**6. Stockholders’ Equity**

***CommonStock***

InMarch 2006, the Company raised approximately $40.0 million in grossproceeds in a registered direct offering involving the sale of approximately4.9 million shares of common stock at a price of $8.10 per share. Placementagency fees and other offering expenses were approximately $2.7 million. Theseshares were offered pursuant to an effective registration statement that theCompany had previously filed with the Securities and Exchange Commission.

In October 2005, the Company raised grossproceeds of approximately $41.3 million in a private placement of common stockand 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.

In June 2004, the Company completed an initialpublic offering of its common stock in which it sold approximately5.0 million shares of common stock for proceeds of $30.6 million, netof underwriting discounts and commissions and offering expenses. In July 2004,the underwriters exercised their over-allotment option resulting in the sale ofan additional 75,000 shares which resulted in proceeds of $0.5 million,net of underwriting discounts and commissions.

***Warrants***

Inconjunction 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 of the warrants which can be exercised untilSeptember 30, 2010.

Inconjunction with the 2000 Series C Preferred offering, the Company soldwarrants to the Series C investors to purchase 4.5 million shares ofSeries C Preferred at a purchase price of $0.01 per warrant resulting inproceeds of approximately $45,000. The stock purchase warrants have an exerciseprice of $1.00 per share and shall terminate December 31, 2007. The cashexercise of these warrants would result in the issuance of 735,670 shares ofthe Company’s common stock

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In conjunction with the 2001 Series D Preferredoffering, the Company sold warrants to the Series D investors to purchase3.5 million shares of Series D Preferred at a purchase price of $0.01per warrant resulting in proceeds of approximately $35,000. The stock purchasewarrants have an exercise price of $1.50 per share and can be exercised untilthe earlier of October 18, 2008, or after the Company’s common stocktrades on a securities exchange or the Nasdaq Stock Market and the averageclosing price of such common stock over any consecutive 20-trading day periodequals or exceeds $27.34 (adjusted to reflect subsequent stock dividends, stocksplits or recapitalizations). The cash exercise of these warrants would resultin the issuance of 597,339 shares of the Company’s common stock.

Additional warrants were issued in connection with theissuance of equipment loans (see Note 3) and in connection with theCompany’s CEFF (see Note 5).

None of the above issuedwarrants had been exercised through December 31, 2006.

***Equity Incentive Plan***

On June 21, 2004, theCompany authorized 2,213,995 shares of its common stock for issuance uponexercise of options or restricted stock granted under the Equity IncentivePlan. Approximately 915,000 and 619,000 shares were added to the EquityIncentive Plan on January 1, 2006 and 2005, respectively, pursuant to an “evergreen”provision contained in the Equity Incentive Plan. The Equity Incentive Planprovides for the grant of stock options and restricted stock to officers,directors, and employees of, and consultants and advisors to, the Company.Options under the Equity Incentive Plan may be designated as incentive stockoptions or non-statutory stock options, generally vest over four years andexpire ten years from the date of grant. In addition, incentive stock optionsmay not be granted at prices less than 100% of the fair value on the date ofgrant. The number of vested options available for exercise as of December 31,2006 and 2005 were approximately 834,000 and 580,000, respectively.

***Directors’ Stock Option Plan***

On June 21, 2004, the Company authorized 300,000shares of its common stock for issuance upon exercise of options or restrictedstock granted under the Directors’ Stock Option Plan. On January 1, 2006and 2005, 100,000 shares were added to the plan pursuant to an “evergreen”provision contained in the Directors’ Stock Option Plan. The Directors’ StockOption Plan provides for the grant of stock options and restricted stock todirectors of the Company. Options under the Directors’ Stock Option Plan aredesignated as non-statutory stock options, generally vest from one to twoyears, and expire ten years from the date of grant. In addition, optionsgranted under the Directors’ Stock Option Plan may not be granted at prices lessthan 100% of the fair value on the date of grant. The number of vested optionsavailable for exercise as of December 31, 2006 and 2005 were approximately188,000 and 109,000, respectively.

The weighted-average remaining contractual life of theoptions outstanding under both plans at December 31, 2006 wasapproximately 8.2 years. The estimated weighted average fair value of stockoptions granted during 2006, 2005 and 2004 was $4.84, $2.38 and $6.32,respectively.

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Thefollowing is a further breakdown of the options outstanding as of December 31,2006 (in thousands, except per share 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** | ** ** |
| $0.30 to $2.00                           |       |       | 705        |                         |       |                                                | 6.4        |   |   |   | $ | 1.40 |   |   |   | 597 |   |   |   | $ | 1.39 |   |   |
| $2.01 to $4.00                           |       |       | 227        |                         |       |                                                | 7.5        |   |   |   | $ | 2.82 |   |   |   | 156 |   |   |   | $ | 2.80 |   |   |
| $4.01 to $6.00                           |       |       | 299        |                         |       |                                                | 8.7        |   |   |   | $ | 5.66 |   |   |   | 74 |   |   |   | $ | 5.56 |   |   |
| $6.01 to $8.00                           |       |       | 551        |                         |       |                                                | 8.9        |   |   |   | $ | 7.34 |   |   |   | 163 |   |   |   | $ | 6.80 |   |   |
| $8.01 to $9.22                           |       |       | 856        |                         |       |                                                | 9.3        |   |   |   | $ | 8.59 |   |   |   | 35 |   |   |   | $ | 8.51 |   |   |
| Total                                    |       |       | 2,638      |                         |       |                                                | 8.2        |   |   |   | $ | 5.58 |   |   |   | 1,025 |   |   |   | $ | 3.01 |   |   |
|                                          |            |            |            |                              |            |                                                     |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

There were approximately9,000 and 24,000 shares of common stock outstanding at December 31, 2006and 2005, respectively, pursuant to option exercises that were subject torepurchase by the Company.

***Employee Stock Purchase Plan***

On June 21,2004, the Company authorized 500,000 shares of its common stock for issuanceunder the Employee Stock Purchase Plan. Approximately 305,000 and 206,000shares were added to the plan on January 1, 2006 and 2005, respectively,pursuant to an “evergreen” provision contained in the Employee Stock PurchasePlan. The Employee Stock Purchase Plan provides for all eligible employees topurchase shares of common stock at 85% of the lower of the fair market value onthe first day of each two year offering period or any purchase date during suchoffering period (generally held every six months during such period). Employeesmay authorize the Company to withhold up to 15% of their total compensationduring each six-month purchase period, subject to certain limitations to payfor the Employee Stock Purchase Plan shares. The following shares were issuedunder the Employee Stock Purchase Plan during the year ending December 31:

| ** ** | ** ** | **Number of  Shares  Purchased** | ** ** | **Weighted  Average  Price** | ** ** | **Total  Proceeds** | ** ** |
|------------|------------|---------------------------------------|------------|------------------------------|------------|---------------------|------------|
| 2006       |       |                                  | 198,158    |                         |       |                | $          | 3.04 |   |   | $ | 602,961 |   |
| 2005       |       |                                  | 104,551    |                         |       |                | $          | 2.67 |   |   | 279,369 |   |
| 2004       |       |                                  | 29,656     |                         |       |                | $          | 5.98 |   |   | 177,453 |   |
|       |       |                                  | 332,365    |                         |       |                |       |   |   | $ | 1,059,783 |   |

 

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***Shares Reserved For Future Issuance***

Thefollowing shares of common stock were reserved for future issuance at December 31,2006 (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  |   |
| Warrants to  purchase shares in conjunction with the CEFF                |   | 260    |   |
| Common stock options:                                                    |   |   |   |
| Granted and outstanding                                                  |   | 2,638  |   |
| Reserved for future issuance                                             |   | 1,152  |   |
| Employee stock  purchase plan                                            |   | 689    |   |
|                                                                     |   | 8,537  |   |

 

**7. Income Taxes**

Significantcomponents of the Company’s deferred tax assets as of December 31, 2006and 2005 are shown below (in thousands). A valuation allowance of $46.6 millionand $32.9 million has been established at December 31, 2006 and 2005,respectively, to offset the net deferred tax assets as realization isuncertain.

| ** **                                   | ** ** | **December 31,** | ** ** |
|----------------------------------------------|------------|-----------------------|------------|
| ** **                                   | ** ** | **2006**              | ** ** | **2005** | ** ** |
| Deferred tax  assets:                        |       |                  |       |   |   |
| Net operating loss carryforwards             |       | $                     | 37,406     |   | $ | 27,874 |   |
| Research and development credits             |       | 5,890                 |       | 4,601 |   |
| Deferred revenue                             |       | 1,964                 |       | — |   |
| Other, net                                   |       | 1,403                 |       | 557 |   |
| Total deferred  tax assets                   |       | 46,663                |       | 33,032 |   |
| Deferred tax  liabilities:                   |       |                  |       |   |   |
| Deferred compensation                        |       | (28                   | )          | (97 | ) |
| Valuation  allowance for deferred tax assets |       | (46,635               | )          | (32,935 | ) |
| Net deferred assets                          |       | $                     | —     |   | $ | — |   |

 

At December 31, 2006, the Company had federal andCalifornia net operating loss carryforwards of $91.9 million and$91.6 million, respectively, which will begin to expire in 2019 and 2009,respectively, unless previously utilized. The Company also had federal andstate research and development tax credit carryforwards of approximately $3.7million and $3.2 million respectively. The federal research and developmenttax credit carryforwards will begin expiring in 2019 unless previously utilizedand the state credits do not expire.

Pursuant to Internal Revenue Code Sections 382and 383, use of the Company’s net operating loss and credit carryforwards maybe limited in the event cumulative changes in ownership of more than 50% haveoccurred.

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Theprovision for income taxes on earnings subject to income taxes differs from thestatutory Federal rate at December 31, 2006, 2005 and 2004, due to thefollowing (in thousands):

| ** **                                         | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|----------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Federal income  taxes at 35%                       |       | $        | (11,644    | )        | $          | (8,253   | )          | $ | (5,240 | ) |
| State income tax,  net of Federal benefit          |       | (1,751   | )          | (1,268   | )          | (766     | )          |
| Tax effect on  non-deductible expenses and credits |       | (305     | )          | (556     | )          | (364     | )          |
| Increase in  valuation allowance                   |       | 13,700   |       | 10,077   |       | 6,370    |       |
|                                               |       | $        | —     |     | $          | —   |       | $ | — |   |

 

**8. Employee Benefit Plan**

The Company established adefined contribution employee retirement plan (the “401(k) Plan”)effective January 1, 1999, conforming to Section 401(k) of theInternal Revenue Code (“IRC”). All full-time employees (as defined in the 401(k) Plan)may elect to have a portion of their salary deducted and contributed to the 401(k) Planup to the maximum allowable limitations of the IRC, which may be matched by theCompany in an amount determined by the Board of Directors. Matchingcontributions have not been approved or made since the inception of the 401(k) Plan.Plan administration costs totaled $6,850, $6,500 and $6,500 for the years endedDecember 31, 2006, 2005 and 2004, respectively.

**9. Related PartyTransactions**

In June 1999, theCompany entered into an agreement with Sicor called the Master Agreement underwhich, among other things, the Company agreed to pay Sicor a 2% royalty onsales of products that are covered by a claim of an issued, valid and unexpiredpatent or a patent application, that was in existence or based on anydiscoveries or inventions in existence as of the Company’s restructuring, and10% on any royalties the Company receives from licenses of these patents,patent applications, discoveries or inventions. The Company also agreed to paySicor a 1% royalty on sales of products that use, contain or are based on theCompany’s trade secrets, know-how and other proprietary rights in existence asof the Company’s restructuring that are not covered by the 2% royalty, and 5%of any royalties the Company receives from licenses of these trade secrets,know-how and other proprietary rights that are not covered by the 10% royalty.Some of the Company’s current product candidates and drug compounds from ourresearch programs may be subject to these royalty provisions. The determinationof any potential obligations will be assessed at the time such products arecommercially available.

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**10. Summary of QuarterlyFinancial Data (Unaudited)**

Thefollowing is a summary of the quarterly results of operations for the yearsended December 31, 2006 and 2005 (in thousands, except for net loss pershare data):
|                                                                                          | ** ** | **Quarters Ended** | ** ** | ** **          | ** ** |
|------------------------------------------------------------------------------------------|------------|-------------------------|------------|---------------------|------------|
| ** **                                                                               | ** ** | **First  Quarter**      | ** ** | **Second  Quarter** | ** ** | **Third  Quarter** | ** ** | **Fourth  Quarter** | ** ** | **Year Ended  Dec 31(1)** | ** ** |
| **2006**                                                                                 |       |                    |       |                |       |   |   |   |   |   |   |   |   |
| Revenue                                                                                  |       | $                       | 973        |                | $          | 942 |   | $ | 1,055 |   | $ | 1,416 |   |   | $ | 4,386 |   |   |
| Research and  development(2)                                                             |       | 6,791                   |       | 6,820               |       | 7,715 |   | 8,979 |   |   | 30,305 |   |   |
| General and  administrative(2)                                                           |       | 2,248                   |       | 2,725               |       | 2,779 |   | 3,138 |   |   | 10,890 |   |   |
| Total operating  expenses                                                                |       | 9,039                   |       | 9,545               |       | 10,494 |   | 12,117 |   |   | 41,195 |   |   |
| Net loss  attributable to common stockholders                                            |       | (7,466                  | )          | (7,645              | )          | (8,410 | ) | (9,747 | ) |   | (33,268 | ) |   |
| Basic and diluted net  loss per share:                                                   |       | (0.30                   | )          | (0.25               | )          | (0.28 | ) | (0.32 | ) |   | (1.15 | ) |   |
| **2005**                                                                                 |       |                    |       |                |       |   |   |   |   |   |   |   |   |
| Revenue                                                                                  |       | $                       | 397        |                | $          | 617 |   | $ | 1,395 |   | $ | 1,362 |   |   | $ | 3,771 |   |   |
| Research and  development(3)                                                             |       | 5,115                   |       | 4,869               |       | 4,989 |   | 6,279 |   |   | 21,252 |   |   |
| General and  administrative(3)                                                           |       | 1,722                   |       | 1,680               |       | 1,721 |   | 2,063 |   |   | 7,186 |   |   |
| Total operating  expenses                                                                |       | 6,837                   |       | 6,549               |       | 6,710 |   | 8,342 |   |   | 28,438 |   |   |
| Net loss income  attributable 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 | ) |   |

 

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

(2)          Approximately $0.4,$0.6, and $0.5 related to patent and patent related activities werereclassified from research and development to general and administrative forthe first, second, and third quarter of 2006, respectively.

(3)          Approximately $0.3,$0.4, $0.4, and $0.3 related to patent and patent related activities werereclassified from research and development to general and administrative forthe first, second, third and fourth quarters of 2005, respectively.

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