**UNITED STATES**

**SECURITIES AND EXCHANGECOMMISSION**

**WASHINGTON, DC 20549**

** **

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** **

**FORM 10-Q**

**(MarkOne)**
| x                                                                                                                       | **Quarterly report pursuant to Section 13 or 15(d) of the Securities  Exchange Act of 1934**  |
|-------------------------------------------------------------------------------------------------------------------------|-----------------------------------------------------------------------------------------------|
|                                                                                                                    |                                                                                          |
| **For the  quarterly period ended June 30, 2006 or**                                                                    |
|                                                                                                                    |                                                                                          |
| o                                                                                                                       | **Transition Report Pursuant to Section 13 or 15(d) of the Securities  Exchange Act of 1934** |
|                                                                                                                    |                                                                                          |
| **For the  transition period from                 to** |

 

**Commission File Number000-31141**

**DISCOVERY PARTNERSINTERNATIONAL, INC.**

(Exact Name of Registrant asSpecified in Its Charter)

| **Delaware**                                                 |   | **33-0655706**                       |
|--------------------------------------------------------------|--------|--------------------------------------|
| (State or Other Jurisdiction of                              |   | (I.R.S. Employer Identification No.) |
| Incorporation or Organization)                               |   |                                 |
|                                                         |   |                                 |
| **9640 Towne Centre Drive**                                  |
| **San Diego, California 92121**                              |
| (Address of Principal Executive Offices, Including Zip Code) |
|                                                         |
| **(858) 455-8600**                                           |
| (Registrant’s Telephone Number, Including Area Code)    |

 

Indicateby check mark whether the registrant (1) has filed all reports required tobe filed by Section 13 or 15(d) of the Securities Exchange Act of1934 during the preceding 12 months (or for such shorter period that theRegistrant was required to file such reports), and (2) has been subject tosuch filing requirements for the past 90 days.

Yes x   No o

Indicateby check mark whether the registrant is a large accelerated filer, anaccelerated filer, or a non-accelerated filer. See definition of “acceleratedfiler and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Checkone):

| Large accelerated filer    o |   | Accelerated  filer  x |   | Non-accelerated  filer  o |
|----------------------------------------|--------|---------------------------------|--------|-------------------------------------|

 

Indicateby check mark where the registrant is a shell company (as defined in Rule 12b-2of the Act).      o Yes  x No

As of August 7, 2006, a total of 26,437,931 shares ofthe Registrant’s Common Stock, $0.001 par value, were issued and outstanding.

 

 

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**DISCOVERY PARTNERS INTERNATIONAL, INC.**

**FORM 10-Q**

** **

**TABLE OF CONTENTS**
| **PART I.  FINANCIAL  INFORMATION** | ** ** | ** **                                                                                                                  |
|-----------------------------------------------|------------|-----------------------------------------------------------------------------------------------------------------------------|
| **Item 1.**                                   | ** ** | **Financial Statements:**                                                                                                   | ** ** | ** ** |
| ** **                                    | ** ** | **Condensed  Consolidated Balance Sheets at June 30, 2006 (unaudited) and December 31,  2005**                              | ** ** | ** ** |
| ** **                                    | ** ** | **Condensed  Consolidated Statements of Operations for the Three and Six Months Ended June  30, 2006 and 2005 (unaudited)** | ** ** | ** ** |
| ** **                                    | ** ** | **Condensed  Consolidated Statements of Cash Flows for the Six Months Ended June 30, 2006  and 2005 (unaudited)**           | ** ** | ** ** |
| ** **                                    | ** ** | **Notes to Condensed  Consolidated Financial Statements**                                                                   | ** ** | ** ** |
| **Item 2.**                                   | ** ** | **Management’s Discussion and Analysis of  Financial Condition and Results of Operations**                             | ** ** | ** ** |
| **Item 3.**                                   | ** ** | **Quantitative and Qualitative Disclosures  About Market Risk**                                                             | ** ** | ** ** |
| **Item 4.**                                   | ** ** | **Controls and Procedures**                                                                                                 | ** ** | ** ** |
| ** **                                    | ** ** | ** **                                                                                                                  | ** ** | ** ** |
| **PART  II.  OTHER INFORMATION**    | ** ** | ** **                                                                                                                  |
| **Item 1.**                                   | ** ** | **Legal Proceedings**                                                                                                       | ** ** | ** ** |
| **Item 1A.**                                  | ** ** | **Risk Factors**                                                                                                            | ** ** | ** ** |
| **Item 2.**                                   | ** ** | **Unregistered  Sales of Equity Securities and Use of Proceeds**                                                            | ** ** | ** ** |
| **Item 3.**                                   | ** ** | **Defaults Upon  Senior Securities**                                                                                        | ** ** | ** ** |
| **Item 4.**                                   | ** ** | **Submission of  Matters to a Vote of Security Holders**                                                                    | ** ** | ** ** |
| **Item 5.**                                   | ** ** | **Other Information**                                                                                                       | ** ** | ** ** |
| **Item 6.**                                   | ** ** | **Exhibits**                                                                                                                | ** ** | ** ** |

 

 

2

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**DISCOVERY PARTNERSINTERNATIONAL, INC.**

**PART I**

**FINANCIAL INFORMATION**

** **

**Item 1. *FinancialStatements***

**Discovery Partners International,Inc.**

**Condensed ConsolidatedBalance Sheets**

 
| ** **                                                                                                                                                                 | ** ** | **June 30,  2006** | ** ** | **December 31,  2005** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|-----------------------------|------------|
| ** **                                                                                                                                                                 | ** ** | **(unaudited)**         | ** ** | ** **                  | ** ** |
| **ASSETS**                                                                                                                                                                 | ** ** | ** **              | ** ** | ** **                  | ** ** |
| Current assets:                                                                                                                                                            |       |                    |       |                        |       |
| Cash and cash equivalents                                                                                                                                                  |       | $                       | 25,652,167 |                        | $          | 24,231,257 |   |
| Short-term investments                                                                                                                                                     |       | 49,782,675              |       | 59,254,873                  |       |
| Prepaid expenses                                                                                                                                                           |       | 166,073                 |       | 627,989                     |       |
| Other current assets                                                                                                                                                       |       | 1,549,509               |       | 422,156                     |       |
| Assets of discontinued operations                                                                                                                                          |       | 10,540,822              |       | 16,618,309                  |       |
| Total current assets                                                                                                                                                       |       | 87,691,246              |       | 101,154,584                 |       |
| Restricted cash                                                                                                                                                            |       | —                  |       | 1,060,753                   |       |
| Other assets, net                                                                                                                                                          |       | —                  |       | 64,344                      |       |
| Total assets                                                                                                                                                               |       | $                       | 87,691,246 |                        | $          | 102,279,681 |   |
| **LIABILITIES AND STOCKHOLDERS’  EQUITY**                                                                                                                             | ** ** | ** **              | ** ** | ** **                  | ** ** |
| Current liabilities:                                                                                                                                                       |       |                    |       |                        |       |
| Accounts payable and accrued expenses                                                                                                                                      |       | $                       | 567,763    |                        | $          | 741,475 |   |
| Accrued compensation                                                                                                                                                       |       | 494,854                 |       | 421,459                     |       |
| Liabilities of discontinued operations                                                                                                                                     |       | 4,042,204               |       | 6,042,458                   |       |
| Total current liabilities                                                                                                                                                  |       | 5,104,821               |       | 7,205,392                   |       |
| Stockholders’ equity:                                                                                                                                                 |       |                    |       |                        |       |
| Preferred stock, $.001 par value, 1,000,000 shares  authorized, no shares issued and outstanding at June 30, 2006 and December  31, 2005                              |       | —                  |       | —                      |       |
| Common stock, $.001 par value, 100,000,000 shares  authorized, 26,453,974 and 26,441,902 issued and outstanding at June 30, 2006  and December 31, 2005, respectively |       | 26,454                  |       | 26,442                      |       |
| Common stock issuable                                                                                                                                                      |       | —                  |       | 1,596,500                   |       |
| Treasury stock, at cost, 306,933 shares at June 30, 2006  and December 31, 2005, respectively                                                                              |       | (1,037,190              | )          | (1,037,190                  | )          |
| Additional paid-in capital                                                                                                                                                 |       | 210,690,204             |       | 209,237,267                 |       |
| Deferred compensation                                                                                                                                                      |       | —                  |       | (919,217                    | )          |
| Accumulated other comprehensive income                                                                                                                                     |       | 253,427                 |       | 63,779                      |       |
| Accumulated deficit                                                                                                                                                        |       | (127,346,470            | )          | (113,893,292                | )          |
| Total stockholders’ equity                                                                                                                                            |       | 82,586,425              |       | 95,074,289                  |       |
| Total liabilities and stockholders’ equity                                                                                                                            |       | $                       | 87,691,246 |                        | $          | 102,279,681 |   |

See accompanying notes

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**Discovery Partners International,Inc.**

**CondensedConsolidated Statements of Operations**

**(Unaudited)**

 
| ** **                                                         | ** ** | **Three Months Ended June 30,** | ** ** | **Six Months Ended June 30,** | ** ** |
|--------------------------------------------------------------------|------------|-----------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                                         | ** ** | **2006**                                            | ** ** | **2005**                                          | ** ** | **2006** | ** ** | **2005** | ** ** |
| Operating expenses:                                                |       |                                                |       |                                              |       |   |   |   |   |
| Selling,  general and administrative                               |       | $                                                   | 4,123,824  |                                              | $          | 2,619,107 |   | $ | 6,999,512 |   | $ | 5,742,430 |   |
| Restructuring                                                      |       | —                                              |       | —                                            |       | 22,193 |   | — |   |
| Loss from continuing operations                                    |       | (4,123,824                                          | )          | (2,619,107                                        | )          | (7,021,705 | ) | (5,742,430 | ) |
| Interest income                                                    |       | 896,404                                             |       | 413,286                                           |       | 1,751,645 |   | 877,992 |   |
| Foreign currency transaction losses, net                           |       | (9,192                                              | )          | (3,340                                            | )          | (10,942 | ) | (4,040 | ) |
| Other income (loss), net                                           |       | —                                              |       | —                                            |       | 4,212 |   | 26 |   |
| Loss from continuing operations before provision for  income taxes |       | (3,236,612                                          | )          | (2,209,161                                        | )          | (5,276,790 | ) | (4,868,452 | ) |
| Income tax refund                                                  |       | —                                              |       | (10,800                                           | )          | — |   | — |   |
| Net loss from continuing operations                                |       | (3,236,612                                          | )          | (2,198,361                                        | )          | (5,276,790 | ) | (4,868,452 | ) |
| Discontinued operations:                                           |       |                                                |       |                                              |       |   |   |   |   |
| Gain on  sale from discontinued operations                         |       | —                                              |       | —                                            |       | 164,970 |   | — |   |
| Gain  (loss) from discontinued operations                          |       | (1,177,214                                          | )          | 830,176                                           |       | (8,341,358 | ) | (1,048,014 | ) |
| Net loss                                                           |       | $                                                   | (4,413,826 | )                                                 | $          | (1,368,185 | ) | $ | (13,453,178 | ) | $ | (5,916,466 | ) |
| Basic and diluted:                                                 |       |                                                |       |                                              |       |   |   |   |   |
| Continuing  operations                                             |       | $                                                   | (0.12      | )                                                 | $          | (0.08 | ) | $ | (0.20 | ) | $ | (0.19 | ) |
| Discontinued  operations                                           |       | (0.05                                               | )          | 0.03                                              |       | (0.31 | ) | (0.04 | ) |
| Net loss  per share                                                |       | $                                                   | (0.17      | )                                                 | $          | (0.05 | ) | $ | (0.51 | ) | $ | (0.23 | ) |
| Weighted average shares outstanding:                               |       |                                                |       |                                              |       |   |   |   |   |
| Basic and diluted                                                  |       | 26,116,048                                          |       | 25,852,604                                        |       | 26,114,127 |   | 25,847,616 |   |

 

See accompanying notes

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**Discovery Partners International,Inc.**

**CondensedConsolidated Statements of Cash Flows**

**(Unaudited)**

** **
| ** **                                                                | ** ** | **Six Months Ended June 30,** | ** **  |
|---------------------------------------------------------------------------|------------|---------------------------------------------------|-------------|
| ** **                                                                | ** ** | **2006**                                          | ** **  | **2005** | ** ** |
| **Operating  activities**                                                 |       |                                              |        |   |   |
| Net loss                                                                  |       | $                                                 | (13,453,178 | ) | $ | (5,916,466 | ) |
| Adjustments to reconcile net loss to cash used in  operating activities:  |       |                                              |        |   |   |
| Amortization (accretion) on investments                                   |       | (26,723                                           | )           | 147,374 |   |
| Stock based compensation                                                  |       | 751,235                                           |        | 545,095 |   |
| Restructuring expense                                                     |       | 22,193                                            |        | — |   |
| Gain on sale of discontinued operations                                   |       | (164,970                                          | )           | — |   |
| Realized (gain) loss on investments                                       |       | (4,249                                            | )           | 126,459 |   |
| Change in operating assets and liabilities:                               |       |                                              |        |   |   |
| Other current assets                                                      |       | 514,905                                           |        | 547,448 |   |
| Accounts payable and accrued expenses                                     |       | (168,255                                          | )           | (1,012,616 | ) |
| Restricted cash                                                           |       | —                                            |        | (47,494 | ) |
| Net cash used in  operating activities                                    |       | (12,529,042                                       | )           | (5,610,200 | ) |
| Net cash  provided by operating activities from discontinued operations   |       | 5,519,319                                         |        | 9,242,706 |   |
| **Investing  activities**                                                 |       |                                              |        |   |   |
| Proceeds from  sale of discontinued operations                            |       | 164,970                                           |        | — |   |
| Purchases of  short term investments                                      |       | (10,530,541                                       | )           | (13,665,486 | ) |
| Proceeds from  sales and maturity of short term investments               |       | 20,028,930                                        |        | 29,368,492 |   |
| Net cash  provided by investing activities                                |       | 9,663,359                                         |        | 15,703,006 |   |
| Net cash used in  investing activities from discontinued operations       |       | (1,372,351                                        | )           | (3,746,859 | ) |
| **Financing  activities**                                                 |       |                                              |        |   |   |
| Net proceeds  from issuance of common stock                               |       | 24,431                                            |        | 221,172 |   |
| Principal  payments on capital leases                                     |       | —                                            |        | (70,320 | ) |
| Net cash  provided by financing activities                                |       | 24,431                                            |        | 150,852 |   |
| Effect of  exchange rate changes                                          |       | 115,194                                           |        | 27,380 |   |
| Net increase in  cash and cash equivalents                                |       | 1,420,910                                         |        | 15,766,885 |   |
| Cash and cash  equivalents at beginning of period                         |       | 24,231,257                                        |        | 13,148,242 |   |
| Cash and cash  equivalents at end of period                               |       | $                                                 | 25,652,167  |   | $ | 28,915,127 |   |
| **Supplemental  disclosure of cash flow information**                     |       |                                              |        |   |   |
| Interest paid                                                             |       | $                                                 | 1,398       |   | $ | — |   |
| Income taxes  paid                                                        |       | $                                                 | 10,386      |   | $ | 2,000 |   |
| **Supplemental  schedule of non cash investing and financing activities** |       |                                              |        |   |   |
| Unrealized gain  (loss) on investments                                    |       | $                                                 | (4,783      | ) | $ | (165,257 | ) |
| Common stock  received in payment of notes receivable                     |       | $                                                 | —      |   | $ | 36,750 |   |
| Issuance of  right to acquire stock                                       |       | $                                                 | —      |   | $ | 644,000 |   |
| Repurchase/forfeiture  of restricted stock                                |       | $                                                 | —      |   | $ | 537,388 |   |

See accompanying notes

 

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**DISCOVERY PARTNERS INTERNATIONAL,INC.**

**NOTES TO CONDENSEDCONSOLIDATED FINANCIAL STATEMENTS**

**(Unaudited)**

**JUNE 30, 2006**

**1. Basis of Presentation**

The accompanying unauditedcondensed consolidated financial statements have been prepared in accordancewith accounting principles generally accepted in the United States for interimfinancial information and with the instructions to Form 10-Q and Article 10 ofRegulation S-X. Accordingly, they do not include all of the information anddisclosures required by accounting principles generally accepted in the UnitedStates for complete financial statements. The condensed consolidated balancesheet as of June 30, 2006, condensed consolidated statements of operations forthe three and six months ended June 30, 2006 and 2005, and the condensedconsolidated statements of cash flows for the six months ended June 30, 2006and 2005 are unaudited, but include all adjustments (consisting of normalrecurring adjustments and adjustments related to discontinued operations asdescribed in Note 6), which Discovery Partners International, Inc. (theCompany) considers necessary for a fair presentation of the financial position,results of operations and cash flows for the periods presented.

On June 12, 2006, the Company entered into a Stockand Asset Purchase Agreement with Galapagos NV (“Galapagos”), a Belgiancorporation, and Biofocus Inc., an Ohio corporation and a subsidiary ofGalapagos (“Biofocus”), pursuant to which the Company agreed to sell thecapital stock of its direct subsidiary Discovery Partners International AG (DPIAG) to Galapagos and the capitalstock or equity interests of its direct subsidiaries ChemRx AdvancedTechnologies, Inc. (ChemRx), Xenometrix, Inc. (Xeno) and DiscoveryPartners, L.L.C. (DPI LLC) to Biofocus, and to assign certain assets andliabilities related to the businesses of the acquired subsidiaries to Biofocusfor $5.4 million in cash. The transaction subsequently closed on July 5, 2006.As a result of this transaction, theresults of operations for the three and six months ended June 30, 2006 shownherein are not necessarily indicative of the results that may be expected forthe year ending December 31, 2006. Information included in Note 6 and Note 7herein should be considered when evaluating the Company’s financial results.For more complete financial information, these financial statements, and notesthereto, should be read in conjunction with the audited consolidated financialstatements for the year ended December 31, 2005 included in the Company’s Form10-K filed with the Securities and Exchange Commission and the proxystatement/prospectus, as amended, included in the Company’s RegistrationStatement on Form S-4 filed with the Securities and Exchange Commission onAugust 7, 2006.

The condensed consolidated financial statementsinclude all of the accounts of the Company and its wholly owned subsidiaries: DPIAG, which wholly owns Discovery Partners International GmbH (DPI GmbH): ChemRx;Xeno; DPI LLC; Structural Proteomics, Inc. (substantially inactive);Systems Integration Drug Discovery Company, Inc. (substantially inactive)and Irori Europe, Ltd. (substantially inactive). All intercompany accountsand transactions have been eliminated.

The consolidated financial statements have been recastto reflect the results of operations, financial positions and cash flows of DPIAG, DPI GmbH, ChemRx and DPI LLC (our operating asset group) and our formerinstrumentation product lines as discontinued operations. The amounts includedin the results for discontinued operations consist of revenues, cost of sales,operating expenses, impairmentcharges and restructuring costs associated with the operating asset groupexcluding any allocations for corporate support. The amounts included in theresults for discontinued operations also consist of revenues, cost of sales andoperating expenses associated with the former operations of the instrumentationproduct lines excluding any allocations for facilities and other corporate support.All footnotes included herein, except where indicated, exclude the amountsrelated to the assets and liabilities classified as held for sale at June 30,2006 or sold as part of the instrumentation product lines in the fourth quarterof 2005.

The preparation of financialstatements in conformity with generally accepted accounting principles requiresmanagement to make estimates and assumptions that affect the reported amountsof assets and liabilities, such as assets held for sale and liabilities held forsale, at the date of the financial statements and the reported amounts ofexpenses during the reporting period. Actual results could differ from thoseestimates.

Certain amounts related to stockbased compensation reported in prior periods have been reclassified to conformto current year presentation requirements.

**2. Net Loss Per Share**

Basic and dilutednet loss per share is presented in conformity with Statement of FinancialAccounting Standard No. 128, “*Earningsper Share”*(FAS 128). In accordance with FAS 128, basic netloss per share has been computed by dividing net loss by the weighted averagenumber of shares of common stock outstanding during the period, less sharessubject to repurchase. In lossperiods, common stock equivalents are excluded from the computation of dilutednet loss per 

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share as their effectwould be anti-dilutive. The total number of shares issuable upon exercise ofstock options and rights to acquire restricted stock excluded from thecalculation of diluted earnings per share since they are anti-dilutive was2,008,408 and 2,175,446 for the three and six months ended June 30, 2006,respectively and 3,678,847 and 3,661,725 for the three and six months endedJune 30, 2005, respectively.

**3. Change in Accounting Method forShare-Based Compensation**

In December 2004, the Financial AccountingStandards Board (FASB) revised Statement of Financial Accounting StandardsNo. 123 (FAS 123R), “*Share-BasedPayment*,” which establishes accounting for share-based awardsexchanged for employee services andrequires companies to expense the estimated fair value of these awards over therequisite employee service period. On April 14, 2005, the Securities andExchange Commission adopted a new rule amending the effective dates for FAS123R. In accordance with the new rule, the Company adopted the accountingprovisions of FAS 123R beginning in the first quarter of fiscal 2006.

Under FAS 123R, share-based compensation cost ismeasured at the grant date, based on the estimated fair value of the award, andis recognized as expense over theemployee’s requisite service period. The Company adopted the provisions of FAS123R on January 1, 2006, the first day of the Company’s fiscal year 2006, usinga modified prospective application, which provides for certain changes to themethod for valuing share-based compensation. Under the modified prospectiveapplication, prior periods are not revised for comparative purposes. Thevaluation provisions of FAS 123R apply to new awards and to awards that areoutstanding on the effective date and subsequently modified or cancelled.Estimated compensation expense for awards outstanding at the effective datewill be recognized over the remaining service period using the compensationcost calculated for pro forma disclosure purposes under FASB StatementNo. 123, “*Accounting for Stock-BasedCompensation*” (FAS 123).

Upon the adoption of FAS 123R, the Company has electedto continue to use the Black-Scholes-Merton valuation model in estimating thefair value of equity awards. The Company’s option grants are simplistic innature and generally vest under service provisions. The Company does not allowfor the exercise of options prior to vesting (after January 1, 2003), they arenot transferable nor do they allowfor hedging. There were four options to purchase 60,000 shares of common stockgranted during the three months ended June30, 2006. These options were granted in connection with the automaticoption grant program for the benefit of the board of directors, which is acomponent of the 2000 Stock Incentive Plan.

On November 10, 2005, the FASB issued FASB StaffPosition (FAS 123(R)-3), “*TransitionElection Related to Accounting for Tax Effects of Share-Based Payment Awards*.”The Company has elected to adopt the alternative transition method provided inthis FASB Staff Position for calculating the tax effects of share-basedcompensation pursuant to FAS 123R. The alternative transition method includes a simplified method to establish thebeginning balance of the additional paid-in capital pool (APIC pool) related tothe tax effects of employee share-based compensation, which is available toabsorb tax deficiencies recognized subsequent to the adoption of FAS 123R. TheCompany is in the process of determining whether to adopt the alternative transitionmethod provided in FAS 123R-3 for calculating the tax effects of share-basedcompensation pursuant to FAS 123R.

Total estimatedshare-based compensation expense, related to all of our share-based awards,recognized under FAS 123R for the quarter ended June 30, 2006 was comprised of the following:
| ** **                                                   | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|--------------------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                                   | ** ** | **June 30, 2006**      | ** ** | **June 30, 2006**    | ** ** |
| Cost of sales                                                |       | $                                | 5,995      |                           | $          | 13,606 |   |
| Selling, general  and administrative                         |       | 565,024                          |       | 737,285                        |       |
| Share-based  compensation expense before taxes               |       | 571,019                          |       | 750,891                        |       |
| Related income  tax benefits                                 |       | —                           |       | —                         |       |
| Share-based  compensation expense                            |       | $                                | 571,019    |                           | $          | 750,891 |   |
|                                                         |       |                             |       |                           |       |
| Net share-based  compensation expense per basic common share |       | $                                | (0.02      | )                              | $          | (0.03 | ) |

 

Share-based compensation expense recognized under FAS123R for the three and six months ended June 30, 2006 included $39,832 and$76,447, respectively, from stock options and $531,187 and $674,444,respectively, related to restricted stock awards. The Company maintains a netoperating loss carryforward as of June 30, 2006, therefore, no excess taxbenefits for the tax deductions related to share-based awards were recognizedin the condensed consolidated statement of operations. Additionally, noincremental tax benefits were recognized from stock options exercised in thequarter ended June 30, 2006, which would have resulted in a reclassification toreduce net cash provided by operating activities with an offsetting increase innet cash provided by financing activities. Share-based compensation expense,related to stock options, was not recognized during the three and six monthsended June 30, 2005. As of June 30, 2006, $275,562 of total 

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unrecognizedcompensation costs related to non-vested awards is expected to be recognized ona straight-line basis over a modified requisite service period ending September15, 2006, as determined in April 2006 based on strategic events furtherdescribed below in Note 6.

On March 30, 2006, the Board of Directors of theCompany approved various retention agreements that, among other things, providefor the acceleration of vesting of 100% of unvested restricted stock in theevent of a change in control, or if a change of control has not occurred bysuch date, December 31, 2006. This resulted in a modification to the originalterms of the vesting provisions in the restricted stock agreements, however, nochange in the number of shares awarded. In accordance with FAS 123R, wereassessed any incremental valuation change in the modified award and concludedthere was none (the fair value of the award on March 30, 2006 is less than thefair value at date of original grant). The Company also assessed the change inthe vesting provisions anddetermined that while the original service based vesting provisions of theawards were probable to be achieved, the added performance based vestingprovisions are more likely to occur in advance of the service provisions basedon the announcement of the Company’s entering into the Agreement and Plan ofMerger and Reorganization dated April 11, 2006 (the “Merger Agreement”) by andamong the Company, Darwin Corp. and Infinity Pharmaceuticals, Inc. and thetransaction related thereto (the “Merger”), as further described in Note 6. Inconnection with the Merger, the Company disposed of all of its currentoperating assets under a separate stock and asset purchase agreement withGalapagos NV and Biofocus which closed on July 5, 2006. The Company anticipatesthe Merger will close on or about September 15, 2006, subject to stockholderapproval. Management believes that the closing of the Merger, which wouldresult in the acceleration of vesting of the outstanding equity based awardssubject to vesting provisions, is probable. As a result, the unrecognizedcompensation cost at April 11, 2006 will be recognized prospectively over therevised requisite service period ending September 15, 2006 for all outstandingequity awards. There is no cumulative effect adjustment as the modificationwould not change the grant date fair values or the quantity of awards to berecognized.

*Pro Forma Information under FAS 123 for Periods Prior toFiscal 2006*.

Through fiscal 2005, the Company accounted forshare-based awards to employees using the intrinsic value method in accordancewith APB 25 and related interpretations and provided the required pro formadisclosures of FAS 123. Under the intrinsic value method, no share-basedcompensation expense had been recognized in the Company’s consolidatedstatement of operations for share-basedawards to employees, other than compensation related to restricted stockawards, because the exercise price of the Company’s stock options granted toemployees equaled the fair market value of the underlying stock at the date ofgrant.

The following table summarizes the pro forma effect onthe Company’s net loss and per share data if the Company had applied the fairvalue recognition provisions of FAS 123 to share-based employee compensationfor the three and six months ended June 30, 2005. In the pro forma information required under FAS 123 for theperiods prior to fiscal 2006, the Company accounted for forfeitures using anestimated forfeiture rate based on historical trends.
| ** **                                                                                                                                                             | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                                                                                                                                             | ** ** | **June 30, 2005**      | ** ** | **June 30, 2005**    | ** ** |
| Net loss, as  reported                                                                                                                                                 |       | $                                | (1,368,185 | )                              | $          | (5,916,466 | ) |
| Deduct: Total  share-based employee compensation expense determined under fair value based  method for stock options and shares under the employee stock purchase plan |       | (297,590                         | )          | (1,746,724                     | )          |
| Pro forma net loss                                                                                                                                                     |       | $                                | (1,665,775 | )                              | $          | (7,663,190 | ) |
| Net loss per  share                                                                                                                                                    |       |                             |       |                           |       |
| Basic and diluted — as reported                                                                                                                                   |       | $                                | (0.05      | )                              | $          | (0.23 | ) |
| Basic and  diluted — pro forma                                                                                                                                    |       | $                                | (0.06      | )                              | $          | (0.30 | ) |

 

**4. Employee Benefit Plans**

**Stock Options**

In November 1995, the Company adopted the 1995Stock Option/Stock Issuance Plan, under which 2,350,000 shares of common stockwere reserved for issuance of stock and stock options granted by the Company.In July 2000, the Company adopted the 2000 Stock Incentive Plan (the “Plan”) as the successor plan to the1995 Stock Option/Stock Issuance Plan. Under the Plan 3,300,000 shares ofcommon stock were reserved, including shares rolled over from the 1995 Plan.The Plan provides for the grant of incentive and non-statutory options. Theexercise price of options must equal at least the fair value on the date ofgrant. The options generally vest over a four-year period. Options grantedprior to January 1, 2003 are exercisable immediately, subject to theCompany’s right of repurchase. Options granted after January 1, 2003 areexercisable as the options vest. All options expire no later than ten yearsafter the date of grant.

8

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A summaryof the Company’s stock option activity and related information is as follows:
| ** **                         | ** ** | **Three Months Ended June 30,** | ** ** | **Six Months Ended June 30,** | ** ** |
|------------------------------------|------------|-----------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                         | ** ** | **2006**                                            | ** ** | **2006**                                          | ** ** |
| ** **                         | ** ** | **Options**                                         | ** ** | **Weighted-  Average  Exercise  Price**           | ** ** | **Options** | ** ** | **Weighted-  Average  Exercise  Price** | ** ** |
| Outstanding at beginning of period |       | 2,166,235                                           |       | $                                                 | 5.40       |   | 2,837,075 |   | $ | 5.45 |   |
| Granted                            |       | 60,000                                              |       | 2.50                                              |       | 60,000 |   | 2.50 |   |
| Exercised                          |       | —                                              |       | —                                            |       | (1,000 | ) | 1.50 |   |
| Forfeited                          |       | (359,415                                            | )          | 6.12                                              |       | (1,029,255 | ) | 5.45 |   |
| Outstanding at end of period       |       | 1,866,820                                           |       | $                                                 | 5.35       |   | 1,866,820 |   | $ | 5.35 |   |
| Exercisable                        |       | 1,713,665                                           |       | $                                                 | 5.52       |   | 1,713,665 |   | $ | 5.52 |   |

 

Following is a furtherbreakdown of the options outstanding as of June 30, 2006:

 
| **Range of Exercise Prices** | ** ** | **Options  Outstanding** | ** ** | **Weighted  Average  Remaining Life  in Years** | ** ** | **Weighted  Average  Exercise Price** | ** ** | **Options  Exercisable** | ** ** | **Weighted  Average  Exercise Price  of Options  Exercisable** | ** ** |
|---------------------------------------------|------------|--------------------------|------------|-----------------------------------------------------------|------------|--------------------------------------------|------------|--------------------------|------------|--------------------------------------------------------------------------|------------|
| $0.20 — 2.50                           |       | 106,000                  |       | 7.0                                                       |       | $                                          | 2.35       |                     | 46,000     |                                                                     | $          | 2.15 |   |
| $2.51 — 5.00                           |       | 812,466                  |       | 6.2                                                       |       | $                                          | 3.56       |                     | 740,728    |                                                                     | $          | 3.57 |   |
| $5.01 — 12.00                          |       | 895,669                  |       | 5.7                                                       |       | $                                          | 6.52       |                     | 874,252    |                                                                     | $          | 6.53 |   |
| $12.01 — 24.00                         |       | 52,685                   |       | 4.2                                                       |       | $                                          | 19.16      |                     | 52,685     |                                                                     | $          | 19.16 |   |
|                                        |       | 1,866,820                |       |                                                      |       |                                       |       | 1,713,665                |       |                                                                     |       |

 

Exercise prices for options outstanding as of June 30,2006 ranged from $0.20 to $24.00 per share. The weighted-average remaining contractual life of those options isapproximately 5.97 years. The weighted-average fair value of the options andawards granted during the three and six months ended June 30, 2005 was $3.17and $3.43 per share, respectively. The intrinsic value of the options granted,outstanding and exercised during the three and six months ended June 30, 2006are immaterial.

**Employee Stock Purchase Plan**

In June 2000, the Board of Directors andstockholders adopted the Employee Stock Purchase Plan (the “Purchase Plan”).The Purchase Plan permits eligible employees to purchase common stock at adiscount, but only through payroll deductions, during defined offering periods. The price at which stock is purchasedunder the Purchase Plan is equal to 85% of the fair market value of the commonstock on the first or last day of the offering period, whichever is lower. Inaddition, the Purchase Plan provides for annual increases of shares availablefor issuance under the Purchase Plan beginning with fiscal 2001. Employeeparticipation in the Purchase Plan commenced August 1, 2002. Pursuant tothe Purchase Plan, the participating employees purchased 11,079 shares of theCompany’s common stock during the six months ended June 30, 2006. There were nopurchases made during the three months ended June 30, 2006.

**Restricted Stock Awards**

The Company awarded 142,500 shares of restricted stockand rights to acquire 700,000 shares of restricted stock in August 2003,July 2004 and April 2005, collectively, pursuant to the Company’s 2000Stock Incentive Plan to certain of the Company’s key employees. The restricted stock and rights to acquire restrictedstock, awarded in 2003, vest in annual installments over a four-year period.The restricted stock and rights to acquire restricted stock awarded in 2004 and2005, will vest at the end of five years from the grant date except thatvesting can be accelerated if certain performance conditions are met. On March30, 2006, restricted stock awards for a total of 45,000 shares were granted tocertain of the Company’s key employees pursuant to the Company’s 2000 StockIncentive Plan. The stock awards will vest in annual installments over afour-year period. The fair value of these awards totaled $109,350, the value ofthe Company’s stock on the date of grant. Share-based compensation related tothese awards will be recognized over the requisite service period on astraight-line basis.

The Company recorded stock-based compensation expense,for continuing operations, relating to restricted stock awards of $531,187 and$313,946 for the three months ended June 30, 2006 and 2005, respectively and$674,444 and $598,346 for the six months ended June 30, 2006 and 2005,respectively.

9

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** **

**Stockholder Rights Agreement**

On February 13, 2003, the Company’s Board ofDirectors adopted a Rights Agreement (the “Agreement”). The Agreement providesfor a dividend distribution of one preferred share purchase right for eachoutstanding share of the Company’s common stock held of record at the close ofbusiness on February 24, 2003. The rights are not currently exercisable.Under certain conditions involving an acquisition or proposed acquisition byany person or group holding 15 percent or more of the Company’soutstanding common stock, the rights permit the holders to purchase from theCompany one unit consisting of one-thousandth of a share of the Company’sSeries A junior participating preferred stock at a price of $19.00 perunit, subject to adjustment. Under certain conditions, the rights may beredeemed by the Company’s Board of Directors in whole, but not in part, at aprice of $0.01 per right.

On April 11, 2006, the Board of Directors of theCompany approved an amendment to the Agreement dated as of February 13, 2003.The amendment provides that the provisions of the Agreement shall not apply tothe execution, delivery or performance of the Merger Agreement, the voting agreements in connection therewith or anydefinitive agreement entered into in connection therewith, or the consummationof the transactions contemplated thereby. The rights will continue to tradewith the Company’s common stock, unless and until they are separated upon theoccurrence of certain future events.

**Common Shares Reserved For Future Issuance**

At June 30, 2006common shares reserved for future issuance consist of the following:

| Stock and stock options       |   | 3,943,605 |   |
|-------------------------------|--------|-----------|--------|
| Employee stock  purchase plan |   | 2,316,828 |   |
|                          |   | 6,260,433 |   |

 

**4. Comprehensive Loss**

SFAS No. 130, *Reporting Comprehensive Income,*requires the Company toreport, in addition to net income or loss, comprehensive income or loss and itscomponents. A summary follows:
| ** **                               | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                               | ** ** | **June 30, 2006**      | ** ** | **June 30, 2005**    | ** ** | **June 30, 2006** | ** ** | **June 30, 2005** | ** ** |
| Comprehensive loss:                      |       |                             |       |                           |       |   |   |   |   |
| Foreign currency translation  adjustment |       | $                                | 154,313    |                           | $          | (402,435 | ) | $ | 193,402 |   | $ | (708,582 | ) |
| Unrealized gain on investments           |       | (664                             | )          | 232,838                        |       | (3,752 | ) | 165,257 |   |
| Net loss                                 |       | (4,413,826                       | )          | (1,368,185                     | )          | (13,453,178 | ) | (5,916,466 | ) |
| Comprehensive  loss                      |       | $                                | (4,260,177 | )                              | $          | (1,537,782 | ) | $ | (13,263,528 | ) | $ | (6,459,791 | ) |

 

**5. Restructuring Accrual**

In November 2005, the Company announced the conclusionof discussions with Pfizer around a new collaboration for services in thedesign and development of compounds exclusively for Pfizer. With the absence ofa new contract with Pfizer, the Company initiated the process of reducing itschemistry operational capacity in a restructuring of its South San Franciscofacility. Under the restructuring plan, 50 employees were involuntarilyterminated, including scientific, operational and administrative staff.Restructuring charges totaled approximately $134,000 and $1.7 million for thethree and six months ended June 30, 2006 (where the majority of such costs areincluded in discontinued operations) and a total of $2.6 million sinceinitiation of this restructuring plan. The Company required all employees torender service for a minimum of 60 days to receive termination benefits. As aresult, the fair value of the obligation was determined on the date ofcommunication to the employee and is recognized over the service period. Indetermining costs to consolidate excess facilities, the Company estimates thefair value of the obligation at the cease-use date based on the remaining leaserentals, reduced by estimated future sublease rentals that could be reasonablyobtained for the property, even if the Company is unsuccessful in entering intoa sublease. Liabilities related to the consolidation of excess facilities arerecorded when the premises have been vacated. Moving, relocation and othercosts related to consolidation of facilities are expensed as incurred and areincluded in operating expenses. The remaining lease obligation related to thisrestructuring event was sold in connection with the Stock and Asset PurchaseAgreement entered into with Galapagos NV and Biofocus on June 12, 2006.

10

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In April 2003, theCompany announced that it would consolidate its domestic chemistry facilitiesinto two locations: in South San Francisco for primary screening library designand synthesis programs and in San Diego for lead optimization and medicinalchemistry projects. Restructuring charges, related to this consolidation plan,totaled $1,985,354, of which $129,672 was charged during the six months endedJune 30, 2005 (which is included in discontinued operations). All finalpayments were made under this restructuring plan in fiscal 2005.

Restructuring chargeswere comprised of the following:

 
| ** **                                                             | ** ** | **Three Months Ended June 30,** | ** ** | **Six Months Ended June 30,** | ** ** |
|------------------------------------------------------------------------|------------|-----------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                                             | ** ** | **2006**                                            | ** ** | **2005**                                          | ** ** | **2006** | ** ** | **2005** | ** ** |
| Severance and  Retention Bonuses for Involuntary Employee Terminations |       | $                                                   | 71,175     |                                              | $          | — |   | $ | 605,496 |   | $ | — |   |
| Costs to Exit  Certain Contractual and Lease Obligations               |       | 62,387                                              |       | —                                            |       | 1,101,042 |   | 129,672 |   |
| Total Restructuring  Expense                                           |       | $                                                   | 133,562    |                                              | $          | — |   | $ | 1,706,538 |   | $ | 129,672 |   |

 

The following table summarizes the activity andbalances of the restructuring reserve:
| ** **                         | ** ** | **Severance**            | ** ** | ** **            | ** ** | ** ** | ** ** |
|------------------------------------|------------|--------------------------|------------|-----------------------|------------|------------|------------|
| ** **                         | ** ** | **and Retention**   | ** ** | **Costs to**     | ** ** | ** ** | ** ** |
| ** **                         | ** ** | **Bonuses**              | ** ** | **Exit Certain** | ** ** | ** ** | ** ** |
| ** **                         | ** ** | **for Involuntary** | ** ** | **Contractual**       | ** ** | ** ** | ** ** |
| ** **                         | ** ** | **Employee**             | ** ** | **and Lease**    | ** ** | ** ** | ** ** |
| ** **                         | ** ** | **Terminations**         | ** ** | **Obligations**       | ** ** | **Total**  | ** ** |
| Balance at  December 31, 2004 |       | $                        | —     |                  | $          | 293,929    |       | $ | 293,929 |   |
| Reserve Established                |       | 927,890                  |       | 112,368               |       | 1,040,258  |       |
| Utilization of reserve:            |       |                     |       |                  |       |       |       |
| Payments                           |       | —                   |       | (406,297              | )          | (406,297   | )          |
| Balance at  December 31, 2005 |       | 927,890                  |       | —                |       | 927,890    |       |
| Reserve Established                |       | 605,496                  |       | 1,101,042             |       | 1,706,538  |       |
| Utilization of reserve:            |       |                     |       |                  |       |       |       |
| Payments                           |       | (1,533,386               | )          | (300,329              | )          | (1,833,715 | )          |
| Balance at June 30,  2006          |       | $                        | —     |                  | $          | 800,713    |       | $ | 800,713 |   |

 

The restructuring accrual is reflected on the condensedconsolidated balance sheet at June 30, 2006 as a liability held for sale.Amounts recorded in the six months ended June 30, 2006 related to leaseobligations are based on estimates of potential sublease income that may bereasonably obtained and are subject to change for actual sublease income as itoccurs.

**6. Discontinued Operations**

On April 11, 2006, the Company entered into anAgreement and Plan of Merger and Reorganization (the “Merger Agreement”) withInfinity Pharmaceuticals, Inc. (“Infinity”), a privately ownedbiopharmaceutical company, and Darwin Corp., a new wholly owned subsidiary ofthe Company. The Merger Agreement provides that, upon the terms and subject tothe conditions set forth in theMerger Agreement, Infinity will merge with and into Darwin Corp., with Infinityas the surviving corporation, becominga wholly owned subsidiary of the Company. As a result of the Merger, each outstanding share of Infinity capitalstock will be converted into the right to receive shares of the Company’s commonstock. Under the terms of the Merger Agreement, the Company will issue, andInfinity securityholders will be entitled to receive, in a tax-free exchange,shares of the Company’s common stock such that Infinity securityholders willown approximately 69.1% of the combined company on a pro forma basis and theCompany’s stockholders will own approximately 30.9%. The Merger Agreementprovides that the conversion ratios for Infinity’s capital stock are subject toupward and downward adjustment based on the Company’s net cash balance, ascalculated pursuant to the Merger Agreement, at the closing of the Merger.  Following execution of the Merger Agreement,and as explicitly allowed under the Merger Agreement, the Company began activelyseeking to divest its various operating assets, including key personnel and keyservice agreements, as the Company and Infinity intended that all of thecombined company’s business immediately following the Merger would be thebusiness of Infinity. In addition, the Company actively sought to sell itsoperating assets because the sale of all of the operating assets would improvethe net cash balance as the basis to determine the conversion ratios forInfinity’s stock. The Company determined that all criteria under SFAS 144,Accounting for the Impairment or Disposal of Long-lived Assets, that qualifiesan asset group as held for sale had been met upon the approval by the Company’sboard of directors of the Merger Agreement.

11

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On June 12, 2006, the Company entered into aStock and Asset Purchase Agreement with Galapagos NV (“Galapagos”), a Belgiancorporation, and Biofocus Inc., a Ohio corporation and a subsidiary ofGalapagos (“Biofocus”), pursuant to which the Company agreed to sell thecapital stock of its direct subsidiary Discovery Partners International AG toGalapagos and the capital stock orequity interests of its direct subsidiaries ChemRx AdvancedTechnologies, Inc., Xenometrix, Inc. and Discovery Partners, L.L.C.to Biofocus, and to assign certain assets and liabilities related to thebusinesses of the acquired subsidiaries to Biofocus for $5.4 million in cash.The transaction subsequently closed on July 5, 2006.

On October 7, 2005, the Company entered into anAsset Purchase Agreement with IRORI Discovery, Inc., now known as NexusBiosystems (“Nexus”), pursuant to which the Company agreed to sell certainassets and liabilities to Nexus, including the IRORI® chemical synthesisproducts, the Crystal Farm® automated protein crystallization products, and theUniversal StoreTM compound storage systems products for a purchase price of$1,901,580, inclusive of a purchase price adjustment.  Nexus is aCalifornia company whose Chief Executive Officer, John Lillig, was previouslythe Chief Technology Officer, Vice President and General Manager, DiscoverySystems for the Company. The sale of net assets pursuant to the AssetPurchase Agreement was completed on October 12, 2005.  The sale pricefor the assets was effectively based on the total book value of the net assetsand the cash cost of operations for the assets sold through the closing date.As of June30, 2006, the Company had received $1,901,580 in proceeds from Nexus forpayment of the net assets. The Company recognized a gain on sale of the netassets of $164,970 for the six months ended June 30, 2006 and an aggregate gain on sale of$558,869.

The Company’s condensed consolidated financialstatements and related notes contained herein have been recast to reflect thefinancial position, results of operations and cash flows of the operatingsubsidiaries and instrumentation product lines as discontinued operations. The Company did not accountfor its instrumentation product lines as a separate legal entity. Therefore,the following selected financial data for the Company’s discontinued operationsis presented for informational purposes only and does not necessarily reflectwhat the net sales or earnings would have been had the businesses operated as astand-alone entity. The financial information for the Company’s discontinuedoperations excludes allocations of certain of the Company’s assets, liabilitiesand expenses to the discontinued operations, such as corporate administrationsupport. These amounts have been excluded from discontinued operations on thebasis that these assets, liabilities and expenses were not transferred in thesale of these product lines and are considered by management to reflect mostfairly or reasonably the incremental results of operations that were sold orclassified as held for sale.

The followingtables set forth, for the periods indicated, selected financial data of theCompany’s discontinued operations:

**SelectedFinancial Data for Discontinued Operations**
| ** **                                   | ** ** | **June 30,  2006** | ** ** | **December 31,  2005** | ** ** |
|----------------------------------------------|------------|-------------------------|------------|-----------------------------|------------|
| **Assets of discontinued  operations:**      | ** ** | ** **              | ** ** | ** **                  | ** ** |
| Accounts receivable, net                     |       | $                       | 2,658,050  |                        | $          | 5,673,509 |   |
| Inventories, net                             |       | 820,068                 |       | 578,842                     |       |
| Prepaid expenses                             |       | 838,332                 |       | 1,106,041                   |       |
| Other current assets                         |       | 339,100                 |       | 539,559                     |       |
| Property and equipment, net                  |       | 5,136,692               |       | 7,950,765                   |       |
| Patent and license rights, net               |       | 684,062                 |       | 717,707                     |       |
| Other assets, net                            |       | 64,518                  |       | 51,886                      |       |
| Total  assets held for sale                  |       | $                       | 10,540,822 |                        | $          | 16,618,309 |   |
| ** **                                   | ** ** | ** **              | ** ** | ** **                  | ** ** |
| **Liabilities of discontinued  operations:** | ** ** | ** **              | ** ** | ** **                  | ** ** |
| Accounts payable and accrued expenses        |       | $                       | 1,096,893  |                        | $          | 1,351,620 |   |
| Accrued compensation                         |       | 538,857                 |       | 876,966                     |       |
| Accrued restructuring                        |       | 800,713                 |       | 927,890                     |       |
| Deferred revenue                             |       | 1,139,976               |       | 2,357,915                   |       |
| Deferred rent                                |       | 365,822                 |       | 420,067                     |       |
| Other liabilities                            |       | 99,943                  |       | 108,000                     |       |
| Total  liabilities held for sale             |       | $                       | 4,042,204  |                        | $          | 6,042,458 |   |

 

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** **
| ** **                           | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|--------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                           | ** ** | **June 30, 2006**      | ** ** | **June 30, 2005**    | ** ** | **June 30, 2006** | ** ** | **June 30, 2005** | ** ** |
| Revenues                             |       | $                                | 3,884,527  |                           | $          | 11,361,652 |   | $ | 8,223,322 |   | $ | 18,429,124 |   |
| Cost of sales                        |       | 3,211,201                        |       | 7,661,685                      |       | 8,222,885 |   | 13,074,431 |   |
| Gross margin                         |       | 673,326                          |       | 3,699,967                      |       | 437 |   | 5,354,693 |   |
| Operating expenses:                  |       |                             |       |                           |       |   |   |   |   |
| Research and development             |       | 1,062,030                        |       | 1,604,601                      |       | 2,042,431 |   | 2,856,191 |   |
| Selling, general and  administrative |       | 609,013                          |       | 1,293,581                      |       | 1,340,308 |   | 2,526,335 |   |
| Restructuring                        |       | 133,560                          |       | —                         |       | 1,684,345 |   | 129,672 |   |
| Impairment of intangibles            |       | —                           |       | —                         |       | 3,225,282 |   | 1,000,000 |   |
| Total operating expenses             |       | 1,804,603                        |       | 2,898,182                      |       | 8,292,366 |   | 6,512,198 |   |
|                                 |       |                             |       |                           |       |   |   |   |   |
| Income  (loss) from operations       |       | $                                | (1,177,214 | )                              | $          | 830,176 |   | $ | (8,341,358 | ) | $ | (1,048,014 | ) |

 

During the three months ended March 31, 2006, theCompany recorded a non-cash impairment charge of $3.2 million, representinglong-lived assets, consisting primarily of property, plant and equipment, ofcertain operating units. The inherent risk in maintaining ongoing operationswith the Company’s employees and customer base and the reduced probability ofentering into drug discovery collaborations while concurrently pursuing variousstrategic transactions (including the proposed Merger with Infinity Pharmaceuticals, Inc.) required theevaluation of impairment of the Company’s long-lived assets. The Companyconsidered all available evidence and developed estimates of the future cashgenerating capacity and the future expenditures associated with the variousoperating asset groups. The results indicated that more than one operatingasset group were expected to generate negative cash flows and would not recovertheir carrying value. Therefore, the fair value of these long-lived assets wasdeemed to be zero.

**7. Subsequent Events**

On July 5, 2006, under the Stock and Asset PurchaseAgreement, Galapagos through Biofocus acquired all of the outstanding equityinterests or capital stock of Discovery Partners International AG, ChemRxAdvanced Technologies, Inc., Xenometrix, Inc., and Discovery PartnersInternational, L.L.C., each of which are the Company’s subsidiaries. Biofocusalso acquired certain specified assets that are held at the Company’s parentlevel, such as certain items of the Company’s intellectual property and theCompany’s information technology infrastructure, financial/accountinginfrastructure, office furniture and other associated equipment, as well ascertain contracts that are held at the Company’s parent level and will beassigned to Biofocus, such as the Company’s leases for its South San Franciscoand San Diego business units, its patent license agreement with Abbott Labs,Incorporated and its agreement with The National Institutes of Mental Health.Consideration provided for the stock and assets totaled $5.4 million in cash,with adjustments based on specified working capital balances and DiscoveryPartners International AG’s cash balances as of June 30, 2006, and assumptionof all related liabilities. The assets and liabilities of the Company that werenot sold in the stock and asset purchase transaction with Galapagos andBiofocus consist primarily of cash, cash equivalents, short-term investments,interest receivables, restricted cash and other working capital items relatedto the Company’s corporate administrative function, the Company’s listing on theNASDAQ Global Market and the Merger Agreement with Infinity. In addition, theCompany’s employees became employees of Galapagos and Biofocus, except for 16general and administrative personnel.

**PART I**

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

THISFORM 10-Q CONTAINS CERTAIN STATEMENTS THAT ARE NOT STRICTLY HISTORICAL AND ARE “FORWARD-LOOKING”STATEMENTS WITHIN THE MEANING OF THE PRIVATE SECURITIES LITIGATION REFORM ACTOF 1995 AND INVOLVE A HIGH DEGREE OF RISK AND UNCERTAINTY. SUCH STATEMENTSINCLUDE BUT ARE NOT LIMITED TO STATEMENTS REGARDING OUR FUTURE CASH FLOWS, STATEMENTS ABOUT OUREXPECTATIONS RELATED TO THE PROPOSED MERGERTRANSACTION WITH INFINITY, THE EXCHANGE RATIOS TO BE USED IN CONNECTION WITHTHAT MERGER, OUR NET CASH AT THE CLOSING OF THE PROPOSED MERGER, THE PROPOSEDMERGER’S TIMING, THE POTENTIAL VALUE CREATED BY THE PROPOSED MERGER FOR OUR ANDINFINITY’S STOCKHOLDERS, ESTIMATES OF THE FAIR VALUE OF OUR OPERATING ASSETS,OUR RESTRUCTURING ACCRUALS AND ASSUMPTIONS USED IN DETERMINING OUR STOCK BASEDCOMPENSATION AMOUNTS. FACTORS THAT MAY CAUSE ACTUAL RESULTS TO DIFFER MATERIALLY INCLUDE THE RISK THAT WE AND INFINITY MAY NOT BEABLE TO COMPLETE THE PROPOSED MERGER, THE RISK THAT OUR NET CASH AT CLOSINGWILL BE LOWER THAN 

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CURRENTLY ANTICIPATED, ANDRISKS AND OTHER UNCERTAINTIES MORE FULLY DESCRIBED IN OUR ANNUAL REPORT ON FORM10-K FOR THE YEAR ENDED DECEMBER 31, 2005 AS FILED WITH THE SECURITIES ANDEXCHANGE COMMISSION AND OUR OTHER REPORTS FILED WITH THE SECURITIES ANDEXCHANGE COMMISSION, INCLUDING THIS FORM 10-Q AND THE PROXYSTATEMENT/PROSPECTUS, AS AMENDED, INCLUDED IN OUR REGISTRATION STATEMENT ONFORM S-4 FILED WITH THE SECURITIES AND EXCHANGE COMMISSION ON AUGUST 7, 2006.

**Web Site Access to SEC Filings**

We maintain an Internet website atwww.discoverypartners.com. We make available free of charge on our Internetwebsite our annual reports on Form 10-K, quarterly reports on Form 10-Q,current reports on Form 8-K, and amendments to those reports filed or furnishedpursuant to Section 13(a) or 15(d) of the Exchange Act as soon as reasonablypracticable after we electronically file such material with, or furnish it to,the SEC.

**Overview**

We were founded in 1995 as IRORI. InOctober 1998, we changed our name to Discovery PartnersInternational, Inc. and in July 2000 we completed our initial publicoffering and simultaneously reincorporated in the state of Delaware.

# Recent Events

On April 11, 2006, we entered into an Agreement andPlan of Merger and Reorganization (the “Merger Agreement”) with InfinityPharmaceuticals, Inc. (“Infinity”), a privately owned biopharmaceuticalcompany, and Darwin Corp., a new wholly-owned subsidiary of ours. The MergerAgreement provides that, upon the terms and subject to the conditions set forthin the Merger Agreement, Infinity will merge with and into Darwin Corp., withInfinity as the surviving corporation, becoming a wholly-owned subsidiary of ours. As a result of theMerger, each outstanding share of Infinity capital stock will be convertedinto the right to receive shares of our common stock. Under the terms of theMerger Agreement, we will issue, and Infinity securityholders will be entitledto receive, in a tax-free exchange, shares of our common stock such thatInfinity securityholders will own approximately 69.1% of the combined companyon a pro forma basis and our securityholders will own approximately 30.9%. TheMerger Agreement provides that the conversion ratios for Infinity’s capitalstock are subject to upward and downward adjustment based on our net cashbalance at the closing of the Merger.  If our net cash balance at theclosing of the Merger is below $70 million, the Merger Agreement provides foradjusting the conversion ratios to increase the number of shares of ourcommon stock issued to former Infinity securityholders. As a result, Infinity’ssecurity holders may receive additional shares of our common stock as mergerconsideration, and consequently our securityholders may be further diluted as aresult of the Merger.  If our net cash balance at theclosing of the Merger is above $75 million, the Merger Agreement provides foradjusting the conversion ratios to decrease the number of shares of ourcommon stock issued to former Infinity securityholders.  These percentages are calculated based onother assumptions as well, and, to the extent these assumptions prove to beinaccurate, Infinity’s securityholders may receive a larger or smallerpercentage of the combined company’s pro forma fully diluted capitalization.  If our net cash balance at the closing of theMerger is below $60 million, Infinity may elect to not consummate the Merger.In such event, neither party would owe the other a termination fee.

The Merger is subject to customary closing conditions,including approval by our stockholders of the issuance of our common stock inthe Merger. We anticipate the Merger will be completed in the third quarter of2006. The Merger Agreement contains certain terminationrights for both us and Infinity, and further provides that, upon termination ofthe Merger Agreement under specified circumstances, either party may berequired to pay the other party a termination fee of $6.0 million.

Following execution of the Merger Agreement, and aspermitted under the Merger Agreement, we solicited bids from potentialpurchasers for our operating assets, which we were seeking to sell or otherwisedispose of in one or more strategic transactions. In connection with thatprocess, we ultimately determined to enter into exclusive negotiations withGalapagos NV, a Belgian corporation, based on Galapagos’ willingness to acquireall of our material operating assets and assume all of the related liabilities,its interest in consummating its purchase of our operating assets quickly, itsexisting cash resources, and its proposed purchase price. On July 5, 2006, wecompleted the sale of all of the stock of our operating subsidiaries and all ofour material operating assets, including our material intellectual property,information technology infrastructure, financial/accounting infrastructure,office furniture and other associated equipment, for $5.4 million in cash,subject to a purchase price adjustment, to Galapagos and Biofocus Inc., awholly owned subsidiary of Galapagos. Our remaining assets following the saleconsist primarily of our cash, cash equivalents, short-term investments,interest receivables, restricted cash and other working capital items relatedto our corporate administrative function, our listing on the NASDAQ GlobalMarket and the Merger Agreement with Infinity. In addition, the majority of ouremployees became employees of Galapagos and Biofocus, except for 16 general andadministrative personnel.

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As a result of the sale transaction with Galapagos, all of our business immediatelyfollowing the Merger will be the business conducted by Infinity immediatelyprior to the Merger. Accordingly, because of the pending Merger with Infinityand the closing of the sale transaction with Galapagos, described above, we believeour historical operating results are not indicative of future results.  We cannot assure you that we will close thepending Merger with Infinity on favorable terms, in a timely manner or at all.

We determined that all criteria under SFAS 144,Accounting for the Impairment or Disposal of Long-lived Assets, that qualifiesan asset group as held for sale had been met upon the approval by our board ofdirectors of the Merger Agreement, whereby the Merger Agreement explicitly allows for the sale of all of our operatingassets. As a result, our consolidated financial statements and related notescontained herein have been recast to reflect the financial position, results ofoperations and cash flows of all of the operating subsidiaries and assets heldat the operating locations as discontinued operations.

**Critical Accounting Policies**

This discussion and analysis of our financialcondition and results of operations is based upon our financial statements,which have been prepared in accordance with accounting principles generallyaccepted in the United States. The preparation of these financial statementsrequires us to make estimates and judgments that affect the reported amounts ofassets, liabilities, and expenses. On an ongoing basis, we evaluate our estimates.We base our estimates on historical experience and on various other assumptionsthat we believe to be reasonable under the circumstances, the results of whichform the basis for making judgments about the carrying values of assets andliabilities that are not readily apparent from other sources. Actual resultsmay differ from these estimates, and the estimates themselves might bedifferent if we used different assumptions.

We believe the following critical accounting policiesinvolve significant judgments and estimates that are used in the preparation ofour financial statements.

**Accounting for long-lived assets tobe disposed of. **Inaccounting for long-lived assets to be disposed of, we assess if all of thecriteria qualifying the long-lived assets or disposal group as held for salehas been met. The long-lived assets or disposal group is then classified asheld for sale in the period such criteria has been met. Depreciation andamortization related to the long-lived assets or disposal group is ceased atthe time they are classified as held for sale. In April 2006, we entered intothe Merger Agreement, and as explicitly permitted under the Merger Agreementapproved by our Board of Directors, we solicited bids from potential purchasersfor our operating assets, which we were seeking to sell or otherwise dispose ofin one or more strategic transactions. As a result, the long-lived assets andrelated liabilities of the disposal groups were reclassified as held for saleand are reflected as discontinued operations within the statement ofoperations.

**Valuation of investments inmarketable securities**. In accounting for investments in marketable securities,we classify our investments as Available-for-Sale and record such assets atestimated fair value in the consolidated balance sheets, with unrealized gains and losses, if any, reported in stockholders’ equity (othercomprehensive income). We invest our excess cash balances in marketable debtsecurities, primarily government securities, corporate bonds and notes andasset-backed securities, with strong credit ratings. We limit the amount ofinvestment exposure to institutions, maturity and investment type. The realizedgains and losses of securities sold are determined based on the specificidentification method.

We will record an impairment charge if the securitiescontinue to be impaired beyond twelve months or other factors indicate there ispermanent impairment. We regularly monitor and evaluate the realizable value ofour marketable securities. When assessing marketable securities forother-than-temporary declines in value, we consider such factors as, amongother things, how significant the decline in value is as a percentage of theoriginal cost, how long the market value of the investment has been less than itsoriginal cost and the market in general.

**Results of Continuing OperationsFor The Three Months Ended June 30, 2006 and 2005**

*Selling, general and administrative expenses.  *Inthe second quarter of 2006, selling,general and administrative expenses consisted primarily of salaries andbenefits for executive and administrative personnel, facilities costs, stockcompensation charges, costs related to strategic activitiessuch as legal, accounting, other advisory services and the costs of retentionbenefits. In the second quarter of 2005, selling, general and administrativeexpenses consisted primarily of salaries and benefits for executive,administrative, business development and marketing personnel, advertising andpromotional expenses, facilities costs, professional services, depreciation andstock compensation charges. Selling, general and administrative expensesincreased 57% or $1,505,000 to $4.1 million for the three months endedJune 30, 2006 compared to $2.6 million for the three months ended June 30, 2005.Selling, general and administrative expenses increased primarily due 

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to costs associated with strategicactivities such as legal, investment banking and other advisory fees that didnot occur in the same period in 2005 as well as the impact of accelerated stockcompensation charges as a result of the various strategic transactions. Suchcosts more than offset the impact of lower staffing levels and decreasedbusiness development efforts.

*Interest income.  *Interest income increased 117% to $896,000 for the threemonths ended June 30, 2006 compared to $413,000 for the three months ended inJune 30v, 2005. The increase in interest income is due primarily to higheryields and a decrease in realized losses in thesecond quarter of 2006 compared to 2005.

**Results of Continuing OperationsFor The Six Months Ended June 30, 2006 and 2005**

*Selling, general and administrative expenses*. In the first half of 2006,selling, general and administrative expenses consisted primarily of salariesand benefits for executive, business development and administrative personnel,facilities costs, stock compensation charges, costsrelated to strategic activities such as legal, accounting, other advisoryservices and the costs of retention benefits. In the first half of 2005, selling,general and administrative expenses consisted primarily of salaries andbenefits for executive, administrative, business development and marketingpersonnel, advertising and promotional expenses, facilities costs, professionalservices, depreciation and stock compensation charges. Selling, general andadministrative expenses increased 22%, or $1.3 million, from $5.7 million forthe six months ended June 30, 2005 to $7.0 million for the six months endedJune 30, 2006 due primarily to costs associated with strategic activities suchas legal, investment banking and other advisory fees that did not occur in thesame period in 2005 as well as the impact of accelerated stock compensationcharges as a result of the various strategic transactions. Such costs more thanoffset the savings in 2006 related to lack of severance payments made to ourformer Chief Operating Officer under the separation agreement we entered intoin January 2005, lower staffing levels and lack of depreciation.

*Restructuring expenses*.   In November 2005, we implemented a restructuringplan to reduce our combinatorial chemistry and library synthesis operationalcapacity in our South San Francisco facility in connection with the expirationof our chemistry service collaboration with Pfizer. In the first half of 2006,we incurred $22,000 in termination benefits related to corporate administrativepersonnel that supported these operations. Our restructuring efforts, relativeto this plan, were completed in the first half of 2006.

*Interest income*. Interest income, net, increased 100%, or $874,000, from$878,000 for the six months ended June 30, 2005 to $1.8 million for the sixmonths ended June 30, 2006. The increase in interest income is due primarily tohigher yields and a decrease in realized losses in 2006 compared to 2005.

**DiscontinuedOperations**

In April2006, we entered into a Merger Agreement, and as explicitly permitted under theMerger Agreement approved by our Board of Directors, we solicited bids frompotential purchasers for our operating assets, which we were seeking to sell orotherwise dispose of in one or more strategic transactions. The execution ofthe plan to sale the operating assets concluded on July 5, 2006 with the saleof all of the operating assets to Galapagos and its subsidiary Biofocus.

In October 2005, we sold the assets related to theIRORI® chemical synthesis, Crystal Farm® automated protein crystallization, andUniversal StoreTM compound storage system product lines for $1.9 million. Werecognized an additional $165,000 of gain on the sale of these assets duringthe six months ended June 30, 2006, as a result of proceeds received for anaggregate gain on sale of these assets of $559,000.

Ourconsolidated financial statements and related notes contained herein have beenrecast to reflect the financial position, results of operations and cash flowsof all of the operating subsidiaries and assets held at the operating locationsas discontinued operations. The following selected financial data for ourdiscontinued operations is presented for informational purposes and excludesallocations of general and administrative expenses related to those operationsthat were not transferred in the sale of those assets. These amounts areconsidered by management to reflect most fairly or reasonably the incrementalfinancial results related to those operations.

 

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**SelectedFinancial Data for Discontinued Operations**
| ** **                           | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|--------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                           | ** ** | **June 30, 2006**      | ** ** | **June 30, 2005**    | ** ** | **June 30, 2006** | ** ** | **June 30, 2005** | ** ** |
| Revenues                             |       | $                                | 3,884,527  |                           | $          | 11,361,652 |   | $ | 8,223,322 |   | $ | 18,429,124 |   |
| Cost  of sales                       |       | 3,211,201                        |       | 7,661,685                      |       | 8,222,885 |   | 13,074,431 |   |
| Gross  margin                        |       | 673,326                          |       | 3,699,967                      |       | 437 |   | 5,354,693 |   |
| Operating  expenses:                 |       |                             |       |                           |       |   |   |   |   |
| Research  and development            |       | 1,062,030                        |       | 1,604,601                      |       | 2,042,431 |   | 2,856,191 |   |
| Selling,  general and administrative |       | 609,013                          |       | 1,293,581                      |       | 1,340,308 |   | 2,526,335 |   |
| Restructuring                        |       | 133,560                          |       | —                         |       | 1,684,345 |   | 129,672 |   |
| Impairment  of intangibles           |       | —                           |       | —                         |       | 3,225,282 |   | 1,000,000 |   |
| Total  operating expenses            |       | 1,804,603                        |       | 2,898,182                      |       | 8,292,366 |   | 6,512,198 |   |
|                                 |       |                             |       |                           |       |   |   |   |   |
| Income (loss) from operations        |       | $                                | (1,177,214 | )                              | $          | 830,176 |   | $ | (8,341,358 | ) | $ | (1,048,014 |   |

 

**Liquidityand Capital Resources**

Sinceour inception, we have funded our operations with $39.0 million of privateequity financings and $94.7 million of net proceeds from our initialpublic offering in July 2000.

In May2004 our secondary public offering was declared effective by the SEC. A totalof 8,305,300 shares of common stock at a price of $5.00 per share were madeavailable to the public. Axys Pharmaceuticals, Inc., then a stockholder ofDiscovery Partners International, Inc., registered 7,222,000 shares for resale,with the remaining 1,083,300 shares registered for sale by the Company to theunderwriters to cover over-allotments. We received proceeds from the offeringof the shares registered for sale by the Company, of $5.1 million net ofunderwriters’ discounts.

AtJune 30, 2006, cash and cash equivalents and short-term investments totaledapproximately $75.4 million, compared to $83.5 million atDecember 31, 2005.

OperatingActivities.   We rely on cash on hand, and proceeds received on the sale ofthe operating assets subsequent to June 30, 2006, totaling $5.9 million, toprovide working capital for current operations and to meet the net cashrequirement under the Merger Agreement with Infinity. Cash flows used inoperating activities from continuing operations totaled $12.5 million forthe first half of 2006 compared to $5.6 million in the first half of 2005. Thedecrease in operating cash flows in 2006 compared to 2005 was primarily due toour net operating loss.

Webelieve we have sufficient cash resources to fund existing operations for thenext twelve months should the pending Merger with Infinity not successfullyclose.

InvestingActivities.   Cash provided by investing activities from continuingoperations totaled $9.7 million in the first half of 2006 compared to $15.7million in the first half of 2005. The decrease in cash provided by investingactivities in 2006 compared to 2005 is due primarily to an increase in theinvestment of highly liquid securities considered cash equivalents where theyare reflected in our cash balance versus short-term investments during thefirst half of 2006.

Wecurrently do not anticipate using any cash resources for any long-terminvestments.

FinancingActivities.   Cash provided by financing activities totaled $24,000 and$151,000 in the first half of 2006 and 2005, respectively. This change isprimarily due to lower proceeds from the exercise of stock options. We do notexpect to incur debt in 2006.

As aresult of the completion of the sale of all of our operating subsidiaries andoperating assets on July 5, 2006, our remaining cash requirements consistprimarily of fees associated with the Merger including fees payable tofinancial advisors, consulting fees, legal and accounting support, key employeeretention, severance and change of control benefits and ongoing compensationobligations for the 16 general and administrative personnel that remain with usas of the date the sale transaction was completed. We currently anticipateutilizing approximately $6.0 million to $8.0 million, in transaction relatedcosts, to complete the Merger.

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On October 4, 2001, ourBoard of Directors approved a Stock Repurchase Plan, authorizing us torepurchase up to 2,000,000 shares of common stock at no more than $3.50 pershare. In 2003, we purchased 115,000 shares under this Plan for $289,000 and in2001, we purchased 35,000 shares for $119,250. We did not purchase any sharesin 2004, 2005 or in the first half of 2006 pursuant to this Plan. Under theMerger Agreement, we are restricted from purchasing additional shares underthis plan.

**ContractualObligations**

We have entered intovarious agreements that obligate us to make future payments. The table belowsets forth the contractual cash obligations that exist as of June 30, 2006 thatare not reflected on the balance sheet at June 30, 2006:
| ** **                         | ** ** | **Payments Due by Period** | ** ** |
|------------------------------------|------------|-------------------------------------------|------------|
| **Contractual Obligations**   | ** ** | **Total**                                 | ** ** | **Less than  1 Year** | ** ** | **1-3 Years** | ** ** | **4-5 Years** | ** ** | **More than  5 Years** | ** ** |
| Minimum license fees(A)(D)         |       | $                                         | 75,000     |   | $ | 15,000 |   | $ | 20,000 |   | $ | 20,000 |   | $ | 20,000 |   |
| Firm purchase orders(D)            |       | 1,255,964                                 |       | 1,254,989 |   | 975 |   | — |   | — |   |
| Operating leases(D)                |       | 9,675,269                                 |       | 2,986,183 |   | 4,468,256 |   | 1,248,630 |   | 972,200 |   |
| Employee commitments(B)            |       | 3,027,979                                 |       | 3,027,979 |   | — |   | — |   | — |   |
| Other contractual commitments(C)   |       | 3,142,864                                 |       | 3,142,864 |   | — |   | — |   | — |   |
| Total contractual cash obligations |       | $                                         | 17,177,076 |   | $ | 10,427,015 |   | $ | 4,489,231 |   | $ | 1,268,630 |   | $ | 992,200 |   |

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(A)         Theterms of the license agreements generally range from the remaining life of thepatent up to 25 years.

(B)           OnMarch 30, 2006 the Compensation Committee of our Board of Directorsapproved a severance and retention bonus plan for our key employees, includingcertain key executive officers’ to remain with us throughout the process ofimplementing strategic initiatives, which include the sale of our assetsand the proposed Merger. In general, payments under these arrangements arecontingent on various events.

(C)           Amountsconsist primarily of a contingent obligation to a professional services firm inconnection with the successful closing of the pending merger.

(D)          Theseliabilities have been transferred to Galapagos subsequent to June 30, 2006.

We donot have any off-balance sheet arrangements.

**RISKS AND UNCERTAINTIES**

Inaddition to the other information contained in the Form 10-Q you shouldcarefully consider the material risks described below and under the caption “RiskFactors” in the proxy statement/prospectus, as amended, included in ourRegistration Statement on Form S-4 filed with the Securities and ExchangeCommission on August 7, 2006, particularly the sections entitled “Risks Relatedto the Merger”, “Risks Related to Infinity”, and “Risks Related to the CombinedCompany”. As discussed above, we have entered into a Merger Agreement withDarwin Corp. and Infinity pursuant to which Infinity will merger with and intoDarwin Crop., with Infinity as the surviving corporation, becoming awholly-owned subsidiary of ours.

**We may not be ableto complete the Merger and may elect to pursue another strategic transactionlike the Merger or liquidate our remaining assets.**

Wecannot assure you that we will close the pending Merger with Infinity in a timely manneror at all. On July 5, 2006, we completed the sale of all of the stock of ouroperating subsidiaries and all of our material operating assets, including ourmaterial intellectual property, information technology infrastructure,financial/accounting infrastructure, office furniture and other associatedequipment to Galapagos and Biofocus. Our remaining assets following the saleconsist primarily of cash, cash equivalents and short-term investments, ourlisting on the NASDAQ Global Market and the Merger Agreement with Infinity.Following the completion of the sale transaction with Galapagos and Biofocus,16 of our general and administrative personnel remain employed by us. If we donot close the pending Merger with Infinity, our board of directors may elect toattempt to complete another strategic transaction like the Merger ortake the steps necessary to liquidate all of our remaining assets.

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**We recently adopted a severance and retention bonusplan that may require material payments to key employees in connection withtheir continued service with us during 2006 or otherwise in connection with the**Merger.

Thecompensation committee of our board of directors recently approved a severanceand retention bonus plan for key employees, including certain key executiveofficers. That plan, together with existing change in control agreements, wouldbe triggered by the closing of the pending Merger with Infinity or the employees’continuation of employment with us or our successor following a change incontrol, through December 31, 2006 and the achievement of certainmilestones on or before such date. If all eligible employees were awardedpayments under the plan and under existing change of control and otheragreements as a result of the closing of the Merger followed by termination of suchemployee, the value of total awards would aggregate approximately $4.1 million,with approximately $3.0 million in cash payments and 463,250 shares of ourcommon stock from the acceleration of vesting. These payments due to change incontrol or severance arrangements arising in connection with the Merger orotherwise owed to employees in connection with the Merger will reduce our net cash at theclosing of the Merger.

**Our stock price willlikely be volatile, and you may lose all or a substantial part of yourinvestment.**

The trading price of ourcommon stock has been and will likely continue to be volatile and could besubject to fluctuations in price in response to various factors, many of whichare beyond its control, including:

 

·                                        announcementsrelated to developments involving the Merger with Infinity and to Infinity’sbusiness, including developments relating to Infinity’s product candidates andtheir clinical and/or preclinical results;

·                                        actualor anticipated variations in quarterly operating results;

·                                        changesin financial estimates by, or the beginning or cessation of research coverageby, securities analysts;

·                                        theannouncements by us of financial results that do not meet or exceed the resultsanticipated by the public markets;

·                                        conditionsor trends in the pharmaceutical and biopharmaceutical industries that investorsbelieve may affect the combined company;

·                                        announcementsby us or Infinity’s competitors of significant acquisitions, divestitures orother strategic transactions, collaborations, joint ventures or capitalcommitments;

·                                        additionsor departures of key personnel;

·                                        economicand political factors; and

·                                        salesof our common stock, including sales by any of our stockholders whobeneficially own more than 5% of our common stock and who could potentiallysell large amounts of our common stock at any one time.

From January 1,2004 to June 30, 2006, the high and low prices for our common stock, asreported on the NASDAQ Global Market, were $6.50 and $2.24, respectively.

In addition, priceand volume fluctuations in the stock market in general, and the NASDAQ GlobalMarket and the market for technology companies in particular, have often beenunrelated or disproportionate to the operating performance of those companies.Further, the market prices of securities of life sciences companies have beenparticularly volatile. Conditions or trends in the pharmaceutical andbiopharmaceutical industries generally may cause further volatility in thetrading price of our common stock, because the market may anticipate that thoseconditions or trends may affect the combined company after the Merger.These broad market and industry factors may harm the market price of our commonstock, regardless of our operating performance. In the past, plaintiffs haveoften instituted securities class action litigation following instances ofvolatility in the market price of a company’s securities. A securities classaction suit against us could result in potential liabilities, substantial costsand the diversion of management’s attention and resources, regardless ofwhether we win or lose.

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**Wemay be subject to liability regarding hazardous materials.**

Our formerproducts and services as well as our former research and development processesinvolved the controlled use of hazardous materials. For example, we often useddangerous acids, bases, oxidants, radio isotopic and flammable materials. Wehave been subject to federal, state and local laws and regulations governingthe use, manufacture, storage, handling and disposal of such materials andcertain waste products. We cannot completely eliminate the risk of accidentalcontamination or injury from these materials. In the event of such an accident,we could be held liable for any damages that result, and any such liabilitycould exceed our resources. In addition, we may have to incur significant coststo comply with environmental laws and regulations related to the handling ordisposal of such materials or waste products in the future, which would requireus to spend substantial amounts of money. We do not maintain insurance for theuse of hazardous materials and chemicals that would mitigate these potentialliabilities.

**Becauseit is unlikely that we will pay dividends, our stockholders will only be ableto benefit from holding our stock if the stock price appreciates.**

We have never paidcash dividends on our capital stock and do not anticipate paying any cashdividends in the foreseeable future. As a result, holders of our common stockwill only be able to benefit from holding such stock if the stock priceappreciates.

**Anti-takeoverprovisions in our stockholder rights plan and in our charter and bylaws couldmake a third-party acquisition difficult.**

In 2003, weadopted a stockholder rights plan, also referred to as a poison pill. Also, ourcertificate of incorporation and bylaws contain provisions that could make itmore difficult for a third party to acquire us, even if doing so would bebeneficial to our stockholders. These provisions could limit the price thatinvestors might be willing to pay in the future for shares of our common stock.

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

*Short-term investments.*Our interest income is sensitive to changes inthe general level of U.S. interest rates, particularly since a significantportion of our investments are in short-term marketable securities, U.S.government securities and corporate bonds. Due to the nature and maturity ofour short-term investments, we have concluded that there is no material marketrisk exposure to our principal. The average maturity of our investmentportfolio is six months. A 1% change in interest rates would have an effect ofapproximately $262,000 on the value of our portfolio.

*Foreign currency ratefluctuations.*The functional currency for our DiscoveryPartners International LLC (DPI LLC) group is the US dollar and of ourDiscovery Partners International AG (DPI AG) group, including DiscoveryPartners International GmbH, is the Swiss franc. DPI AG accounts are translatedfrom their local currency to the U.S. dollar using the current exchange rate ineffect at the balance sheet date for the balance sheet accounts, and using theaverage exchange rate during the period for revenues and expense accounts. Theeffects of translation for our DPI AG group are recorded as a separatecomponent of stockholders’ equity (accumulated other comprehensive income(loss)). The cumulative balance held in other comprehensive income would berealized as a component of the gain or loss on the disposition of theseoperations, which could be material given the cumulative change in exchange ratesover time. DPI AG conducts its business with customers in local currencies.Exchange gains and losses arising from these transactions are recorded usingthe actual exchange differences on the date the transaction is settled.

*Inflation.*We do not believe that inflation has had amaterial impact on our business or operating results during the periodspresented.

**Item 4. Controls and Procedures**

We have carried out an evaluation, under thesupervision and the participation of our management, including our principalexecutive officer and principal financial officer, of the effectiveness of thedesign and operation of our disclosure controls and procedures (as defined inRule 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, asamended (the “Exchange Act”), as of the end of the fiscal quarter covered bythis report. Based upon that evaluation, our principal executive officer andprincipal financial officer concluded that our disclosure controls andprocedures are effective in providing reasonable assurance that (a) theinformation required to be disclosed by us in the reports that we file orsubmit under the Exchange Act is recorded, processed, summarized and reportedwithin the time periods specified in the SEC’s rules and forms, and(b) such information is accumulated and communicated to our management,including our principal executive officer and principal financial officer, asappropriate to allow timely decisions regarding required disclosure. Indesigning and evaluating our disclosure controls and procedures, our managementrecognized that any controls and procedures, no matter 

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howwell designed and operated, can provide only reasonable assurance of achievingthe desired control objectives, and our management necessarily was required toapply its judgment in evaluating the cost-benefit relationship of possiblecontrols and procedures.

Therewere no changes in our internal control over financial reporting that occurredin the second quarter of 2006 that materially affected our internal control overfinancial reporting.

** **

**PART II**

**OTHER INFORMATION**

** **

**Item 1. Legal Proceedings**

None.

**Item 1A. Risk Factors**

The risk factors identified above under Part I, “Item 2.Management’s Discussion and Analysis of Financial Condition and Results ofOperations — Risks and Uncertainties”, are incorporated by reference into thisitem. Substantive revisions to these risk factors from the risk factorsincluded in our Annual Report on Form 10-K for the year ended December 31, 2005include the addition of the introductory paragraph to these risk factors and tothe risk factors entitled *“We may not be able tocomplete the merger and may elect to pursue another strategic transaction likethe merger or liquidate our remaining assets”, We recently adopted a severanceand retention bonus plan that may require material payments to key employees inconnection with their continued service with us during 2006 or otherwise inconnection with the merger”, and revisions to the risk factor entitled “Ourstock price will likely be volatile”, and deletion of the risk factorsentitled, “We may engage in strategic transactions, which could adverselyaffect our business”, “Our strategy of placing a high degree of emphasis onintegrated drug discovery collaborations is untested, involves higher risk andcomplexity, requires significant upfront funding, and will likely result incontinued operating losses for the foreseeable future”,”Our collaborations andservices involve significant scientific risk of fulfillment”,” We derive asignificant percentage of our revenues from a single customer. If this customerrelationship terminated, we would incur a larger net loss from operations”,” Ifour revenues decline, we will not be able to correspondingly reduce ouroperating expenses”,” The drug discovery industry is highly competitive andsubject to technological changes, and we may not have the resources necessaryto compete successfully”,” Our financial performance will depend on theprospects of the pharmaceutical and biopharmaceutical industries and the extentto which these industries engage outside parties to perform one or more aspectsof their drug discovery process”,” The concentration of the pharmaceuticalindustry and the current trend toward increasing consolidation could hurt ourbusiness prospects”, “We may fail to expand customer relationships through theintegration of services”,” Our services and technologies may never helpdiscover drugs that receive Food and Drug Administration approval, which maymake it difficult for us to gain new business”,” Our financial performance willdepend on improved market conditions in the segments of the drug discovery anddevelopment process in which we participate”,” Many of our collaboration andservices offerings have lengthy sales cycles, which could cause our operatingresults to fluctuate significantly from quarter to quarter”, “The intellectualproperty rights on which we rely to protect the technology underlying ourtechniques may not be adequate, which could enable third parties to use ourtechnology or very similar technology and could reduce our ability to competein the market”,” The drug discovery industry has a history of intellectualproperty litigation and we may be involved in intellectual property lawsuits,which may be lengthy and expensive”,” Our customers may restrict our use ofscientific information, which could prevent us from using this information foradditional revenue”,” Our ability to maintain the current infrastructure willdepend on our attracting and retaining key executives, experienced scientistsand business development personnel”,” We may incur write-downs or write-offs inconnection with potential future acquisitions, and exit costs, losses andliabilities in connection with potential future business divestitures orshutdowns”,” Our operations could be interrupted by damage to our facilities”,”We are subject to foreign currency risk related to conducting business inmultiple currencies”,  “We have acquiredseveral businesses and face risks associated with integrating these businessesand potential future drug discovery technology-driven acquisitions”.*

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

The registration statement (File No. 333-36638)for our initial public offering was declared effective by the SEC onJuly 27, 2000. We received net proceeds from the offering of approximately$94.7 million. Through June 30, 2006, we had used approximately$18.5 million of the net proceeds for acquisitions of companies,$6.0 million for prepaid μARCS royalties, $16.8 million for capitalexpenditures and $4.3 million for costs associated with restructuring.

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** **

**Item 3. Defaults Upon SeniorSecurities**

None.

**Item 4. Submission of Matters toa Vote of Security Holders**

We held our annual meeting of stockholders on May 11, 2006.  As of March 24, 2006, the record date of ourmeeting, 26,436,931 shares of our common stock were outstanding and entitled tovote.

The following matters were voted upon at the meeting:

1.                                       The stockholders elected two Directors to holdoffice for a term expiring upon the 2009 Annual Meeting of Stockholders:

| Name of Director Elected | ** ** | **Shares Voting in Favor** | ** ** | **Shares Withheld** | ** ** |
|-----------------------------------------|------------|-------------------------------------------|------------|--------------------------|------------|
| Dr. Harry F. Hixson, Jr.                |       | 19,429,712                                |       | 2,699,087                |       |
| Dr.  Michael C. Venuti.                 |       | 21,507,940                                |       | 620,859                  |       |

 

The following individuals are continuing directors with terms expiringupon the 2007 Annual Meeting of Stockholders: Herm Rosenman and Sir Colin T. Dollery, FmedSci. The followingindividual is a continuing director with a term expiring upon the 2008 AnnualMeeting of Stockholders:  Alan J. Lewis,Ph.D.

2.                                       The stockholders ratified the appointment ofErnst & Young LLP as our independent auditors for the fiscal year endingDecember 31, 2006:

|            | ** ** | **Votes**  | ** ** |
|------------|------------|------------|------------|
| For        |       | 21,776,734 |       |
| Against    |       | 138,896    |       |
| Abstaining |       | 207,037    |       |

 

**Item 5. Other Information**

None.

**Item 6. Exhibits**
| Exhibit  Number | ** ** | **Exhibit Description**                                                                                                                                                                                                                                                                                                                                                          |
|-----------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| ** **      | ** ** | ** **                                                                                                                                                                                                                                                                                                                                                                       |
| 2.1             |       | Agreement and Plan of Merger and Reorganization  among Discovery Partners International, Inc., Darwin Corp. and Infinity  Pharmaceuticals, Inc. dated April 11, 2006. (1)                                                                                                                                                                                                        |
| 2.2             |       | Stock and Asset Purchase Agreement among Galapagos  NV, Biofocus Inc. and Discovery Partners International, Inc. dated  June 12, 2006, and amended as of July 5, 2006. (2)                                                                                                                                                                                             |
| 3.1             |       | Certificate of Incorporation  of the Company. (3)                                                                                                                                                                                                                                                                                                                                |
| 3.2             |       | Bylaws of the Company. (3)                                                                                                                                                                                                                                                                                                                                                       |
| 4.1             |       | Specimen common stock  certificate. (4)                                                                                                                                                                                                                                                                                                                                          |
| 4.2             |       | Rights Agreement between the Company and American  Stock Transfer & Trust Company, which includes the form of Certificate of  Designation for the Series A junior participating preferred stock as Exhibit  A, the form of Rights Certificate as Exhibit B and the Summary of Rights to  Purchase Series A Preferred Stock as Exhibit C, dated as of February 13,  2003. (5) |
| 4.3             |       | First Amendment to the Rights Agreement between  Discovery Partners International, Inc. and American Stock Transfer &  Trust Company dated April 11, 2006. (1)                                                                                                                                                                                                               |
| 10.1            |       | Form of Retention Bonus Agreement. (6)                                                                                                                                                                                                                                                                                                                                           |
| 10.2            |       | Amendment No. 1 to 2000 Stock Incentive Plan. (7)                                                                                                                                                                                                                                                                                                                                |

22

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| 31.1 |   | Certification of the Chief Executive Officer  pursuant to Rule 13a-14(a) or Rule 15d-14(a) of the  Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the  Sarbanes-Oxley Act of 2002. |
|------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 31.2 |   | Certification of the Chief Financial Officer  pursuant to Rule 13a-14(a) or Rule 15d-14(a) of the  Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the  Sarbanes-Oxley Act of 2002. |
| 32.1 |   | Certification of the Chief Executive Officer  pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002.                                                                       |
| 32.2 |   | Certification of the Chief Financial Officer  pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002.                                                                       |

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(1)             Incorporated by Referenceto the Company’s Report on Form 8-K filed with the Securities and Exchange Commission on April 12, 2006

(2)             Incorporated byReference to the Company’s Report on Form 8-K filed with the Securities and Exchange Commission on July11, 2006

(3)             Incorporated by Reference to the Company’sRegistration Statement No. 333-36638 on Form S-1 filed with the Securities andExchange Commission on June 23, 2000

(4)             Incorporated by Reference to the Company’sRegistration Statement No. 333-36638 on Form S-1 filed with the Securities andExchange Commission on July 26, 2000

(5)             Incorporated by Reference to the Company’s Reporton Form 8-K filed with the Securities and Exchange Commission on February 24,2003

(6)             Incorporatedby Reference to the Company’s Amendment No. 1 to Registration Statement No.333-134438 on Form S-4 filed with the Securities and Exchange Commission onJuly 11, 2006

(7)             Incorporatedby Reference to *Annex H* to thejoint proxy statement/prospectus forming a part of the Company’s Amendment No.1 to Registration Statement No. 333-134438 on Form S-4 filed with theSecurities and Exchange Commission on July 11, 2006

 

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** **

**SIGNATURES**

** **

Pursuant to the requirements ofthe Securities Exchange Act of 1934, the registrant has duly caused this reportto be signed on its behalf by the undersigned thereunto duly authorized.

 
|                      | DISCOVERY PARTNERS  INTERNATIONAL, INC. |
|----------------------|-----------------------------------------|
|                 |                                    |   |
| Date: August 8, 2006 | By:                                     | /s/    Michael  C. Venuti |
|                 |                                    | Michael C. Venuti, Ph.D |
|                 |                                    | Acting  Chief Executive Officer and Director |
|                 |                                    | (Duly Authorized Officer) |
|                 |                                    |   |
| Date: August 8, 2006 | By:                                     | /s/    Craig  Kussman |
|                 |                                    | Craig Kussman |
|                 |                                    | Chief Financial Officer, |
|                 |                                    | Senior Vice President Finance |
|                 |                                    | and Administration and  Secretary |
|                 |                                    | (Principal Financial and  Accounting Officer) |

 

 

24

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