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**UNITED STATESSECURITIES AND EXCHANGE COMMISSION****WASHINGTON, D.C. 20549**

**FORM10-Q**

 

| ý                                            | **QUARTERLY REPORT PURSUANT TO SECTION  13 OR 15(d)**  |
|---------------------------------------------------|--------------------------------------------------------|
|                                              | **OF THE SECURITIES EXCHANGE ACT OF  1934**            |
|                                              |                                                   |
| **For  the quarterly period ended June 30, 2001** |
|                                              |                                                   |
| **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 Number 000-31147**              |
|                                                   |                                                        |  |

**DELTAGEN,INC.****(Exact name of Registrant as specified in its charter)**

| **Delaware**                              | **94-3260659**      |
|-------------------------------------------|---------------------|
| (State or other jurisdiction of           | (I.R.S. Employer    |
| incorporation or organization)            | Identification No.) |
|                                      |                |
| **1003  Hamilton Avenue, Menlo Park, CA** | **94025**           |
| (Address of principal executive offices)  | (Zip code)          |

**(650) 752-0200**(Registrant'stelephone number, including area code)

Indicate by checkmark whether the registrant (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the registrant was required to filesuch reports), and (2) has been subject to such filing requirements for thepast 90 days.

| YES | ý | NO | o |
|-----|--------|----|---|

Indicate the number of shares outstandingof each of the issuer’s classes of common stock, as of the latest practicabledate:

| Common Stock $0.001 par  value |   | 30,849,365                    |
|--------------------------------|--------|-------------------------------|
| Class                          |   | Outstanding at July  31, 2001 |

 

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**DELTAGEN,INC.**

**FORM10-Q**

**QUARTERLYREPORT**

**TABLEOF CONTENTS**

|                            |                                                                                   |   |
|---------------------------------|----------------------------------------------------------------------------------------|--------|
| PART I - FINANCIAL  INFORMATION |                                                                                   |
|                            |                                                                                   |   |
| Item 1.                         | Financial Statements                                                                   |   |
|                            |                                                                                   |   |
|                            | Consolidated Balance Sheets  (unaudited)                                               |   |
|                            | Consolidated  Statements of Operations (unaudited)                                     |   |
|                            | Consolidated  Statements of Cash Flows (unaudited)                                     |   |
|                            | Notes  to Consolidated Financial Statements (unaudited)                                |   |
|                            |                                                                                   |   |
| Item  2.                        | Management's  Discussion and Analysis of Financial Condition and Results of Operations |   |
|                            |                                                                                   |   |
| Item 3.                         | Quantitative and Qualitative  Disclosures about Market Risk                            |   |
|                            |                                                                                   |   |
| PART II - OTHER  INFORMATION    |                                                                                   |
|                            |                                                                                   |   |
| Item 1.                         | Legal Proceedings                                                                      |   |
|                            |                                                                                   |   |
| Item 2.                         | Changes in  Securities and Use of Proceeds                                             |   |
|                            |                                                                                   |   |
| Item 3.                         | Defaults Upon  Senior Debt                                                             |   |
|                            |                                                                                   |   |
| Item  4.                        | Submission  of Matters to a Vote of Security Holders                                   |   |
|                            |                                                                                   |   |
| Item 5.                         | Other Information                                                                      |   |
|                            |                                                                                   |   |
| Item 6.                         | Exhibits and  Reports on Form 8-K                                                      |   |
|                            |                                                                                   |   |
| Signatures                      |                                                                                   |
|                                 |                                                                                        |        |  |  |

**Part I.****Financial Information****Item 1.**             **Financial Statements**

**DELTAGEN,INC.CONSOLIDATED BALANCE SHEETS(Unaudited)(in thousands, except share data)**

|                                             | **June  30, 2001**                                                                                         |       | **December  31,**** ****2000** |       |
|--------------------------------------------------|-----------------------------------------------------------------------------------------------------------------|------------|-------------------------------------|------------|
|                                             | ****                                                                                                            | ** ** | ****                                | ** ** |
| **Assets**                                       |                                                                                                            |       |                                |       |
| Current assets:                                  |                                                                                                            |       |                                |       |
|                                             | Cash and cash  equivalents                                                                                      | $          | 82,646                              |       | $ | 93,352 |   |
|                                             | Short term investments                                                                                          | 19,843     |                                | 24,981     |   |
|                                             | Accounts receivable,  net                                                                                       | 3,261      |                                | 1,682      |   |
|                                             | Prepaid expenses and  other current assets                                                                      | 1,647      |                                | 945        |   |
|                                             | Note receivable                                                                                                 | 450        |                                | -          |   |
|                                             |                                                                                                            |            |                                |            |   |
|                                             | Total current assets                                                                                            | 107,847    |                                | 120,960    |   |
|                                             |                                                                                                            |       |                                |       |
| Property and  equipment, net                     | 9,248                                                                                                           |       | 8,635                               |       |
| Other assets                                     | 653                                                                                                             |       | 464                                 |       |
| Notes receivable                                 | 260                                                                                                             |       | -                                   |       |
|                                             |                                                                                                                 |       |                                     |       |
|                                             | Total assets                                                                                                    | $          | 118,008                             |       | $ | 130,059 |   |
|                                             |                                                                                                            |            |                                |            |   |
|                                             |                                                                                                            |       |                                |       |
| **Liabilities and Stockholders'  Equity**        |                                                                                                            | ** ** |                                | ** ** |
| Current liabilities:                             |                                                                                                            |       |                                |       |
|                                             | Accounts payable                                                                                                | $          | 2,926                               |       | $ | 1,140 |   |
|                                             | Accrued expenses                                                                                                | 4,658      |                                | 3,669      |   |
|                                             | Current portion of  capital lease obligations                                                                   | 8          |                                | 25         |   |
|                                             | Current portion of  loans payable                                                                               | 2,243      |                                | 1,599      |   |
|                                             | Current portion of  deferred revenue                                                                            | 6,824      |                                | 6,820      |   |
|                                             |                                                                                                            |            |                                |            |   |
|                                             | Total current  liabilities                                                                                      | 16,659     |                                | 13,253     |   |
|                                             |                                                                                                            |       |                                |       |
| Capital lease  obligations, less current portion | 13                                                                                                              |       | 15                                  |       |
| Loans payable, less  current portion             | 4,194                                                                                                           |       | 3,248                               |       |
| Other long-term  accrued liabilities             | 990                                                                                                             |       | -                                   |       |
| Deferred revenue, less  current portion          | 2,367                                                                                                           |       | 2,679                               |       |
|                                             |                                                                                                                 |       |                                     |       |
|                                             | Total liabilities                                                                                               | 24,223     |                                | 19,195     |   |
|                                             |                                                                                                            |            |                                |            |   |
|                                             |                                                                                                            |       |                                |       |
| Commitments and  Contingencies  (Note 4)    |                                                                                                            |       |                                |       |
|                                             |                                                                                                            |       |                                |       |
| Stockholders' equity:                            |                                                                                                            |       |                                |       |
| Common stock, $0.001  par value:                 |                                                                                                            |       |                                |       |
|                                             | Authorized: 75,000,000 shares                                                                                   |       |                                |       |   |
|                                             | Issued and  outstanding: 29,751,449 and 29,867,968 shares at June 30, 2001 and December  31, 2000, respectively | 30         |                                | 30         |   |
| Additional paid-in  capital                      | 169,271                                                                                                         |       | 171,064                             |       |
| Unearned stock-based  compensation               | (5,105                                                                                                          | )          | (8,750                              | )          |
| Notes receivable from  stockholders              | (805                                                                                                            | )          | (805                                | )          |
| Accumulated deficit                              | (69,606                                                                                                         | )          | (50,675                             | )          |
|                                             |                                                                                                                 |       |                                     |       |
|                                             | Total stockholders'  equity                                                                                     | 93,785     |                                | 110,864    |   |
|                                             |                                                                                                                 |       |                                     |       |
|                                             |                                                                                                            |       |                                |       |
|                                             | Total liabilities and  stockholders' equity                                                                     | $          | 118,008                             |       | $ | 130,059 |   |
|                                             |                                                                                                                 |       |                                     |       |
|                                                  |                                                                                                                 |            |                                     |            |  |  |  |  |  |

The accompanying notes are an integral part of theseconsolidated financial statements.****DELTAGEN,INC.CONSOLIDATED STATEMENTS OFOPERATIONS(unaudited)(in thousands, except per share data)**
 **Three  Months Ended** **June 30,** **Six  Months Ended  June 30,**  **2001** **2000** **2001** **2000**      Contract revenue$2,735 $268 $5,186 $554      Costs and expenses:         Research and  development10,407 6,840 18,608 12,467  Selling, general and  administrative5,289 2,417 8,182 4,462        Total costs and  expenses15,696 9,257 26,790 16,929                 Loss from operations(12,961)(8,989)(21,604)(16,375)          Interest income1,245 218 2,972 398  Interest expense(143)(93)(299)(182)      Net loss(11,859)(8,864)(18,931)(16,159)         Deemed dividend related  to beneficial conversion feature of preferred stock- - - (22,360)              Net loss attributable  to common stockholders$(11,859)$(8,864)$(18,931)$(38,519)     Net loss per share  attributable to common stockholders, basic and diluted$(0.41)$(5.27)$(0.66)$(19.13)     Weighted average  shares used in computing net loss per share, basic and diluted28,835 1,681 28,697 2,014      
Theaccompanying notes are an integral part of these consolidated financialstatements.
**DELTAGEN,INC.CONSOLIDATED STATEMENTS OF CASH FLOWS(unaudited)(in thousands)**
 **Six  Months Ended  June 30,**  ****  **2001** **2000**  **** **** Cash flows from  operating activities:     Net loss$(18,931)$(16,159) Adjustments to reconcile net loss to net cash used in  operating activities:     Depreciation and  amortization1,114 612  Amortization of  warrants issued in connection with loans12 18  Amortization of  unearned stock-based compensation expense1,969 6,044  Amortization of  discount on short-term investments(439)-  Changes in operating assets and liabilities:     Accounts receivable(1,579)240  Prepaid expenses and  other current assets(702)(162) Other assets(189)(1,006) Accounts payable1,617 (346) Accrued expenses1,979 866  Deferred revenue(308)(205)     Net cash used in  operating activities(15,457)(10,098)          Cash flows from  investing activities:     Purchase of short-term  investments(34,423)-  Maturities of  short-term investments40,000 -  Acquisition of  property and equipment(1,508)(2,220) Leasehold improvements(50)(711) Issuance of notes  receivable(710)-      Net cash provided by  (used in) investing activities3,309 (2,931)    Cash flows from  financing activities:     Principal payments  under capital lease obligations(19)(16) Repayment of loans  payable(875)(337) Proceeds from the  issuance of notes payable2,453 2,931  Proceeds from the  issuance of preferred stock, net of issuance costs- 22,360  Proceeds from the  issuance of common stock, net of issuance costs and stock repurchased(117)582      Net cash provided by  financing activities1,442 25,520     Net increase  (decrease) in cash and cash equivalents(10,706)12,491      Cash and cash  equivalents, beginning of period93,352 848         Cash and cash  equivalents, end of period$82,646 $13,339         Supplemental  disclosures of cash flow information:     Cash paid during the  period for interest$299 $182 Supplemental  disclosures of non-cash investing and financing activities:     Property and equipment  acquired with accounts payable$169 $-  Unearned stock-based  compensation$- $11,646  Reversal of unearned  stock-based compensation$1,676 $-  Issuance of notes  receivable in exchange for common stock$- $805 
Theaccompanying notes are an integral part of these consolidated financialstatements.
**DELTAGEN, INC.**

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS****(unaudited)June 30, 2001**

**1.  Business of theCompany**

             Deltagen, Inc.(the "Company"), is a leading provider of genomics-based information,products and programs that are used to discover drug targets and drugcandidates and to accelerate pharmaceutical and biotechnology drug and productdevelopment. The Company researches, develops and uses technologies that buildupon technology platforms to discover the function, role, usefulness anddisease relevance of mammalian genes and secreted proteins in drug discoveryand development. The technology enables the Company to select and target genesbelieved to be relevant to disease and delete, or "knock out," thesegenes in mice. The Company then uses an extensive, integrated analysis programto assess the function and potential pharmaceutical relevance of these genesand the proteins these genes encode. The Company believes that the technologyallows the Company to knock out genes in mice and to make discoveries on themammalian function, role, usefulness and disease relevance of genes andsecreted proteins in drug discovery faster and on a larger scale than has beenpreviously possible.

**2.  Basis ofPresentation**

             Theaccompanying interim consolidated balance sheet as of June 30, 2001, theconsolidated statements of operations for the three and six month periods endedJune 30, 2001 and 2000 and the consolidated statements of cash flows for thesix month period ended June 30, 2001 and 2000 are unaudited and have beenprepared in accordance with generally accepted accounting principles forinterim financial information, the instructions to Form 10-Q and Article 10 ofRegulation S-X.  Accordingly, they donot contain all of the information and footnotes required by generally acceptedaccounting principles for complete financial statements.  The unaudited interim financial statementshave been prepared on the same basis as the annual financial statements and, inthe opinion of management, reflect all adjustments, which include only normalrecurring adjustments, necessary to present fairly the Company's financialposition and its results of operations and its cash flows for the three and sixmonth periods ended June 30, 2001 and 2000. Certain financial statement items have been reclassified to conform tothe current years presentation.  Thesereclassifications had no impact on previously reported net loss.  The results for the three and six monthperiods ended June 30, 2001 are not necessarily indicative of the results to beexpected for the year ending December 31, 2001.

             Theseinterim financial statements should be read in conjunction with the annualaudited financial statements included in the Company’s Annual Report on Form10-K (File No. 000-31147) filed with the Securities and Exchange Commission(the “SEC”) on April 2, 2001.

**3.  Net Loss Per Share**

             Basicearnings per share is calculated based on the weighted-average number of commonshares outstanding during the period. Diluted earnings per share would giveeffect to the dilutive effect of common stock equivalents consisting of stockoptions and warrants.  Dilutivesecurities of 4,333,639 and 1,305,439 have been excluded from the dilutedearnings per share calculations for the periods ended June 30, 2001 and 2000,respectively, as they have an antidilutive effect due to the Company's netlosses.

             Areconciliation of shares used in the calculations is as follows:
 **Three  Months Ended June 30,** **Six  Months Ended June 30,**  **** **** **(in  thousands, except per share data)****2001** **2000** **2001** **2000**  **** **** **** ****          Basic and diluted:         Net loss$(11,859)$(8,864)$(18,931)$(16,159) Deemed dividend  related to beneficial conversion feature of preferred stock- - - (22,360)       Net loss attributable  to common stockholders$(11,859)$(8,864)$(18,931)$(38,519)       Weighted average  shares of common stock outstanding29,750 3,668 29,808 3,049  Less:  Weighted average shares subject to  repurchase(915)(1,987)(1,111)(1,035)       Weighted average  shares used in basic and diluted net loss per share28,835 1,681 28,697 2,014        Net loss per share  attributable to common stockholders$(0.41)$(5.27)$(0.66)$(19.13)      
** **

**4.  Commitments andContingencies**

             OnMay 24, 2000, Lexicon Genetics Incorporated filed a lawsuit against theCompany in the United States District Court for the District of Delaware. Thecomplaint in the lawsuit alleges that the Company's methods of making knockoutmice infringe United States Patent No. 5,789,215 (the '215 patent), under whichLexicon claims to be an exclusive licensee. The complaint seeks a judgment thatthe Company infringed this patent, a permanent injunction against furtherinfringement of the patent and an award of damages in an unspecified amountthat, under certain circumstances, may be trebled. On June 13, 2000, theCompany responded to Lexicon's complaint by filing an answer and seeking adeclaratory judgment in its favor. On October 31, 2000, an Order wasentered by the Court amending the complaint and adding GenPharm International,the patentee of the '215 patent, as a plaintiff. On November 14, 2000, Deltagenfiled an answer as well as federal antitrust counterclaims under the ShermanAntitrust Act against Lexicon and GenPharm, alleging that Lexicon asserted afraudulently procured patent (the '215 patent) against Deltagen in an attemptto illegally monopolize the market for production and sale of knockout mice, aviolation of Section 2 of the Sherman Act. The counterclaim asserts thatLexicon knew that the '215 patent was obtained by fraud and that the patent wasinvalid when it brought suit against Deltagen. The antitrust counterclaim alsocharges Lexicon and GenPharm with conspiracy to monopolize the market forknockout mice, in violation of Section 2 of the Sherman Act, as well as withconcerted conduct in restraint of trade, in violation of Section 1 of the ShermanAct. The counterclaim seeks damages, including lost profits, devaluation of theinitial public offering and legal fees, as well as a trebling of damagespursuant to Section 4 of the Clayton Act. In addition, the answer seeks adeclaratory judgment that Deltagen does not infringe the claims of the '215patent and that the patent is invalid. The answer also asserts that the patentwas obtained by knowing and willful fraud on the United States Patent andTrademark Office, rendering the patent unenforceable.  A claim construction hearing is scheduled for October 4,2001.  The Company intends to defend theaction vigorously. The outcome of the hearing and the litigation cannot be predicted.The Company believes that if Lexicon were to prevail in this lawsuit, theimpact would not significantly affect the operations of the Company. TheCompany believes that the methods covered by the '215 patent represent amodification of prior methods of generating knockout mice. Although the Companybelieves this modification was previously described by others prior toGenPharm's filing of its patent application, the Company has intentionallyavoided the use of this modification.

             Inaddition, on October 13, 2000, Lexicon and the University of Utah ResearchFoundation filed a lawsuit against the Company in the United States DistrictCourt for the Northern District of California. The complaint in this lawsuitalleges that the Company is infringing United States Patents Nos. 5,631,153;5,464,764; 5,627,059 and 5,487,992 (the Capecchi patents), under which Lexiconclaims to be an exclusive licensee. All of these patents relate to the use of apositive-negative selection vector in gene targeting. The complaint seeks ajudgment that the Company infringed these patents, a preliminary and permanentinjunction against further infringement of the patents and an award of damagesin an unspecified amount that, under certain circumstances, may be trebled. OnNovember 8, 2000, the Company filed an answer denying infringement, and acounterclaim seeking a declaratory judgment that the patents are invalid. Thecounterclaim seeks an award of damages including attorney fees.

             TheCompany believes that the methods employed by the Company do not infringe thesepatents and that the patents are invalid. The Company believes that theCapecchi patents cover certain modifications to existing methods of generatingknockout mice, such modifications that the Company does not practice. Thesemodifications are therefore but one method available for use in generatingknockout mice. Numerous equally effective design-arounds exist, as well asmethods that predate the Capecchi patents that are in the public domain andthus outside the scope of the patent. Thus, if Lexicon prevails in any suchlawsuit, the Company would only be prevented from using certain of its methodsbut would not be prevented from using all of its current methods. However, anadverse determination as to those certain methods could significantly affectthe development and marketing of its existing function database and DeltaSelectprograms and could cause the Company to incur significant financial liabilitiesthat could materially affect its business and operating results.

             Aclaim construction hearing is set for December 6, 2001, the outcome of whichcannot be predicted with certainty.  Thelitigation is in the early stages and its outcome cannot be predicted. We maybe involved in additional litigation, investigations or proceedings in thefuture. Any litigation, investigation or proceeding, with or without merit,could be costly and time-consuming and could divert our management's attentionand resources which in turn could harm our business and financial results.

**Operating Leases**

             InJune 2001, the Company agreed to lease a facility in Alameda, California underan operating lease which expires in February 2006. Under the term of the lease,the Company is responsible for 100% of the operating expenses, tenants share ofcommon area, tenants share of utilities and 100% of tax expenses. In conjunctionwith the lease agreement, a standby letter of credit of $211,200 will be issuedin August  2001 with a financialinstitution, in favor of the landlord, as collateral for the fulfillment of thecontract obligations. The letter of credit will be secured by a cash deposit ofthe same amount and will be automatically renewed on an annual basis, unlessnotice of cancellation is provided by 30 days in advance.

             Futureminimum lease payments related to this lease at June 30, 2001 are as follows(in thousands): 
Six months ending  December 31, 2001$422 Year Ending December  31,  2002865 2003890 2004915 2005941 Later years158   Total$4,191   
**5.**          **Research and Development Collaborations and LicenseAgreements**

             On May 7, 2001, the Company entered into itsfirst GeneClass DeltaBase subscription agreement with Vertex PharmaceuticalsIncorporated. Under the GeneClass DeltaBase agreement, Vertex has the right toaccess GeneClass DeltaBase information on gene function and validated gene targetsbased upon knockout mouse studies. The GeneClass DeltaBase agreement alsogrants Vertex non-exclusive, worldwide licenses to knockout mice, materials andintellectual property rights under GeneClass DeltaBase. The Company may receiveup to an aggregate of $2.9 million in subscription licensing fees over thethree-year term of the agreement. In addition, the Company may receiveadditional licensing fees for access to its intellectual property andadditional payments on certain milestones achieved and royalties on productsdeveloped by Vertex, if any, using DeltaBase information, materials and relatedintellectual property.

**6.**          **Loans Payable**

             DuringJune 2001, the Company entered into a loan with a financial institution in theamount of $2,453,000. This loan bears interest at 12.49% and is required to berepaid in 48 monthly installments beginning in July 2001.  A corresponding amount of machinery,equipment and other property is pledged as collateral for this loan.

 

**7.          Notes Receivable**

             InApril 2001, the Company received promissory notes from certain officers for$150,000 and $110,000, respectively. The promissory notes are collateralized by 58,824 and 43,137 shares ofcommon stock, bear annual interest at 4.94% and are payable in April 2006 orearlier upon employee termination.

             InMay 2001, the Company entered into a loan and security agreement with Arcaris,Inc. (“Arcaris”) whereby the Company received a promissory note from Arcarisfor $450,000.  The note bears interestat 9% per annum with interest and principal payable in July 2001 or earlierupon a change of control of Arcaris. Under the terms of the security agreement, certain of Arcaris’ assetsand intellectual property are collateral for the note.  In connection with the loan and security agreement,the Company received two warrants, each exercisable to purchase 1,250,000shares of Arcaris common stock at $0.01 per share. The warrants wereexercisable in July and August 2001 and expired upon the closing of theacquisition of Arcaris.

**8.**          **Recent Accounting Pronouncements**

In July 2001, the Financial Accountingand Standards Board (“FASB”) issued Statements of Financial AccountingStandards No. 141 (“SFAS 141”), “Business Combinations,” and No. 142 (“SFAS142”), “Goodwill and Other Intangible Assets.” SFAS 141 requires that all business combinations initiated after June30, 2001 be accounted for under a single method—the purchase method.  Use of the pooling-of-interests method is nolonger permitted.  SFAS 142 requiresthat goodwill no longer be amortized to earnings, but instead be reviewed forimpairment upon initial adoption of the Statement and on an annual basis goingforward.  The amortization of goodwillwill cease upon adoption of SFAS 142. The provisions of SFAS 142 will be effective for fiscal years beginningafter December 15, 2001.  The Companybelieves that SFAS 142 will not have a material effect on the financialposition or results of operation of the Company.

**9.**          **Subsequent Events**

**Acquisition of Arcaris, Inc.**

             InJuly 2001, the Company entered into a definitive merger agreement under whichthe Company acquired Arcaris, a privately-held company with a proprietarytechnology portfolio consisting of genetic, proteomic and cell-biologicalsystems for direct identification and validation of novel drug targets and thecreation of small molecule screens, in a tax-free reorganization. The newwholly-owned subsidiary will be operated out of Arcaris' facilities in SaltLake City, Utah, under the name Deltagen Proteomics, Inc.

             Underthe terms of the definitive merger agreement, the Company acquired all of theoutstanding shares of Arcaris and assumed Arcaris employee stock options. Inthe transaction, the Company issued approximately 767,000 new shares of theCompany’s common stock, paid $450,000 in cash plus transaction fees andexpenses, and reserved approximately 77,000 shares of the Company’s commonstock for Arcaris employee stock options assumed in connection with thetransaction. An additional 516,000 newly issued shares of the Company’s commonstock will be issued to Arcaris' shareholders upon the achievement of certainkey milestones.

**Operating Leases**

             InJuly 2001, the Company leased facilities in Redwood City, California underoperating leases which expire in July 2010. Under the terms of the leases, the Company is responsible for 100% ofthe operating expenses, tenants share of common area, tenants share ofutilities and tax expenses. In conjunction with the lease agreements, twostandby letters of credit totaling $2,201,481 were issued in July 2001 with afinancial institution, in favor of the landlords, as collateral for thefulfillment of the contract obligations. The letters of credit are secured bycash deposits of the same amount and will be automatically renewed on an annualbasis, unless notice of cancellation is provided by 30 days in advance.

             Futureminimum lease payments related to these leases are as follows (in thousands): 
Six months ending  December 31, 2001$929 Year Ending December  31,  20026,091 20036,887 20047,120 20057,307 Later years35,404   Total$63,738   
 

**Item 2. **            **Management's Discussion and Analysis of FinancialConditions and Results of Operations**

INFORMATIONREGARDING FORWARD-LOOKING STATEMENTS

             Thisreport contains forward-looking statements. The forward-looking statements are contained principally in this sectionentitled "Management's Discussion and Analysis of Financial Condition andResults of Operations."  Thesestatements involve known and unknown risks, uncertainties and other factorswhich may cause our actual results, performance or achievements to bematerially different from any future results, performances or achievementsexpressed or implied by the forward-looking statements.  Forward-looking statements include, but arenot limited to, statements about:

•            limitations in the drug discoveryprocess;

•            the capabilities, development andmarketing of our products and services;

•            the benefits of knockout miceprograms and, in particular, our technology and methods;

•            the requirements of pharmaceuticaland biotechnology companies;

•            our future revenues andprofitability;

•            our estimates regarding our capitalrequirements and needs for additional financing;

•            plans for future products andservices and for enhancements of existing products and services;

•            our patent applications, licensedtechnology and proposed patents;

•            the litigation between us, GenPharmInternational Incorporated, the University of Utah Research Foundation andLexicon Genetics Incorporated;

•            our ability to attract customers andestablish licensing and other agreements; and

•            sources of revenues and anticipatedrevenues, including contributions from customers, license agreements andother  collaborative efforts for thedevelopment and commercialization of products, and the continued viability andduration of those agreements and efforts.

             Thisreport contains statistical data regarding the biotechnology and pharmaceuticalindustries that we obtained from private and public industry publications.  These publications generally indicate thatthey have obtained their information from sources believed to be reliable, butdo not guarantee the accuracy and completeness of their information.  Although we believe that the publicationsare reliable, we have not independently verified their data.

             Insome cases, you can identify forward-looking statements by terms such as"may," "will," "should," "could,""would," "expects," "plans,""anticipates," "believes," "estimates,""projects," "predicts," "potential" and similarexpressions intended to identify forward-looking statements.  These statements reflect our current viewswith respect to future events and are based on assumptions and subject to risksand uncertainties.  Given theseuncertainties, you should not place undue reliance on these forward-lookingstatements.  We discuss many of theserisks in this report in greater detail under the heading "RiskFactors."  Also, these forward-lookingstatements represent our estimates and assumptions only as of the date of thisreport.

             Youshould read this report and the documents that we reference in this reportcompletely and with the understanding that our actual future results may bematerially different from what we expect. We qualify all of our forward-lookingstatements by these cautionary statements.

             YOUSHOULD READ THE FOLLOWING DISCUSSION AND ANALYSIS IN CONJUNCTION WITH OURFINANCIAL STATEMENTS AND THE ACCOMPANYING NOTES TO THE FINANCIAL STATEMENTS.

 

**Overview**

             Deltagenwas formed in 1997 and is a leading provider of genomics-based information,products and programs that are used to discover drug targets and drugcandidates and to accelerate pharmaceutical and biotechnology drug and productdevelopment. We research, develop and use technologies that build upon our technologyplatforms to discover the function, role, usefulness and disease relevance ofmammalian genes and secreted proteins in drug discovery and development. Ourtechnology enables us to select and target genes we believe to be relevant todisease and delete, or "knock out," these genes in mice. We then usean extensive, integrated analysis program to assess the function and potentialpharmaceutical relevance of these genes and the proteins these genes encode. Webelieve that our technology allows us to knock out genes in mice and to makediscoveries on the mammalian function, role, usefulness and disease relevanceof genes and secreted proteins in drug discovery faster and on a larger scalethan has been previously possible.

             Weare implementing a strategy to integrate our;

•            Data and information generated fromour knockout animal models

•            Mammalian gene function and secretedprotein discoveries

•            Commercialization of theintellectual property we generate on the use of mammalian genes and secretedproteins in drug development through alliances and collaborations with othersand our own internal products and programs

•            Generation of information, productsand services for pharmaceutical and biotechnology drug discovery efforts

•            Development and expansion of our ownproducts and programs in collaboration with other companies and through our owninternal programs

             Wehave established collaborations and relationships with major pharmaceutical andbiotechnology companies worldwide to accelerate the discovery of and tocommercialize therapeutic and diagnostic products to improve human and animalhealth. These companies include Eli Lilly and Company, GlaxoSmithKline plc,Merck & Co., Inc., Pfizer Inc., Schering-Plough ResearchInstitute and Vertex Pharmaceuticals Incorporated.

             Webelieve that our ability to determine gene function, to develop products and toidentify potential drug candidates results from leveraging our powerfultechnology platforms. Our genomics technologies, processes and informationsystems are fully integrated with one another and rapidly generate informationon the function of and relationships between genes and the proteins these genesencode and the usefulness of genes as new drug targets and proteins as new drugcandidates.

             Wehave used these systems to establish our products and programs that include our

•            Large-scale program to generatemammalian gene knockout animals and to discover gene function

•            DeltaBase(TM) portfolioof gene knockout animal models and mammalian gene function data analysis andmanagement database

•            DeltaXpress(TM)microarray-based mammalian gene knockout expression data program

•            Mammalian gene knockout secretedprotein discovery programs, including our Delta-GT(TM) secreted genetrap program

•            Internal early-stage biopharmaceuticalproduct development programs, including our CD123 antigen program in-licensedas a potential treatment for acute myelogenous leukemia (AML)

             Todate, we have generated revenue from our DeltaBase and DeltaSelect(TM)programs.

             DeltaBaseis our database that provides information, based on knockout mouse studies, ongene function and validated gene targets for drug discovery. We createdDeltaBase to be marketed to the pharmaceutical and biotechnology industries tohelp define the role that genes play in biological processes and disease. Atour current rate of production, we expect to provide gene function and targetvalidation information through DeltaBase on approximately 250 differentmammalian genes per year. We select genes for DeltaBase based upon what webelieve to be their potential to become useful drug targets. We generateinformation on these genes by comprehensively analyzing knockout mice generatedthrough our proprietary gene knockout methods. Each knockout mouse undergoes astandardized, detailed and extensive analysis in order to determine thefunction and role that a particular gene plays in the mouse and that gene'ssuitability as a drug target. We currently intend that DeltaBase will deliver atotal of approximately five million individual in vivo function data points peryear. In addition to accessing target validation data, DeltaBase subscriberswill have access to the knockout mice used to generate this data.
             TheDeltaSelect program was our initial product. Customers received targetvalidation information for selected genes on a fee-for-service basis. Thisprogram was provided to validate our proprietary technology and promoteinterest in the DeltaBase product that became available in 2000. DeltaSelectwill now be utilized to develop new technologies and programs in collaborationwith pharmaceutical companies.

             We have DeltaBase agreements withboth GlaxoSmithKline plc and Pfizer Inc. Each of these agreements provides forpayments aggregating $15 million over three years. In addition, we may receiveadditional fees for access to our intellectual property.  On May 7, 2001, the Company entered into itsfirst GeneClass DeltaBase subscription agreement with Vertex PharmaceuticalsIncorporated. Under the GeneClass DeltaBase agreement, Vertex has the right toaccess GeneClass DeltaBase information on gene function and validated genetargets based upon knockout mouse studies. The GeneClass DeltaBase agreementalso grants Vertex non-exclusive, worldwide licenses to knockout mice, materialsand intellectual property rights under GeneClass DeltaBase. The Company mayreceive up to an aggregate of $2.9 million in subscription licensing fees overthe three-year term of the agreement. In addition, the Company may receiveadditional licensing fees for access to its intellectual property andadditional payments on certain milestones achieved and royalties on productsdeveloped by Vertex, if any, using DeltaBase information, materials and relatedintellectual property.

 In the first six months of 2000, we derived all of our revenue from thedevelopment and analysis of knockout mice under our DeltaSelect program. Weanticipate that a significant portion of our future revenues will be derivedfrom periodic licensing fees under agreements with DeltaBase subscribers.
 **For the Three Months** **For the Six Months** **Revenue:****Ended June 30,** **Ended June 30,** (in thousands)**2001** **2000** **2001** **2000**  **** **** **** **** DeltaSelect$547 $268 $866 $554 DeltaBase2,188 - 4,320 -      Total$2,735 $268 $5,186 $554      
             Underour revenue recognition policy, revenues are recognized when persuasiveevidence of an arrangement exists, delivery has occurred or services have beenrendered and meet all customer-specified criteria, the price is fixed anddeterminable and collectibility is reasonably assured. Revenue derived fromDeltaBase agreements is recognized on a straight-line basis over the term inwhich services are to be provided. Research and development collaboration agreementsspecify milestones to be met and the payments associated with meeting eachmilestone. Revenue derived from these contracts is recognized upon completionof the milestone. The amount of revenue recognized upon completion of eachmilestone is such that the earned revenue, as a percentage of total anticipatedrevenue, approximates the costs incurred in achieving the related milestone, asa percentage of the total anticipated costs. Where the contract does notspecify milestones and payment is upon completion of the contract, revenue isrecognized based on the percentage-of-completion method of accounting. Anypayments received in advance of the completion of a milestone or servicesperformed are recorded as deferred revenue.

             Wehad net losses of $18.9 million and $16.2 million for the six months ended June30, 2001 and 2000, respectively. The net loss attributable to commonstockholders for the six months ended June 30, 2000, was $38.5 million, after adeemed dividend of $22.4 million relating to a beneficial conversionfeature on our Series C redeemable convertible preferred stock. Our losseshave resulted primarily from costs incurred in connection with research anddevelopment activities, from selling, general and administrative costsassociated with our operations and non-cash charges for amortization ofunearned stock-based compensation costs. This amortization was $2.0 million and$6.0 million for the six months ended June 30, 2001 and 2000, respectively.Research and development expenses consist primarily of salaries and relatedpersonnel costs, material costs, legal expenses resulting from intellectualproperty filings and other expenses related to the development of ourDeltaBase, DeltaSelect and secreted protein programs. We expense our research anddevelopment costs as they are incurred. Selling, general and administrativeexpenses consist primarily of salaries and related expenses for executive,finance and other administrative personnel, professional and other corporateexpenses including business development, marketing, litigation costs andgeneral legal activities. In connection with the development and expansion ofour gene function and gene expression databases and our secreted proteinprogram, we expect to incur increasing research and development and selling,general and administrative costs. As a result, we will need to generatesignificantly higher revenues to achieve profitability. We expect to reportsubstantial net losses through the next several years.
             Weaccount for stock-based employee compensation arrangements in accordance withprovisions of Accounting Principles Board Opinion No. 25 (APB No. 25),"Accounting for Stock Issued to Employees"; Financial AccountingStandards Board Interpretation No. 44 (FIN No. 44), "Accounting for CertainTransactions Involving Stock Compensation—An Interpretation of APB No.25"; and Financial Accounting Standards Board Interpretation No. 28 (FINNo. 28), "Accounting for Stock appreciation Rights and Other VariableStock Option or Award Plans," and comply with the disclosure provisions ofStatement of Financial Accounting Standards No. 123 (SFAS No. 123),"Accounting for Stock-Based Compensation."

             UnderAPB No. 25, compensation expense is based on the difference, if any, on thedate of the grant, between the fair value of our stock and the exercise price.SFAS No. 123 defines a "fair value" based method of accounting for anemployee stock option or similar equity investment.

             Weaccount for equity instruments issued to non-employees in accordance with theprovisions of SFAS No. 123 and Emerging Issues Task Force Issue No. 96-18 (EITFNo. 96-18), "Accounting for Equity Instruments That Are Issued to OtherThan Employees for Acquiring, or in Conjunction with Selling, Goods orServices."

             Werecorded approximately $11.6 million of unearned stock-based compensationduring the six months ended June 30, 2000. These amounts are being amortized as charges to operations over therespective vesting period of the individual stock options, generally fouryears.

             We may incur additional stock-basedcompensation expense in the future as a result of both options or othersecurities granted at below fair market value and fluctuations in the marketvalue of our stock that have a direct impact on the value of options and warrantsheld by non-employees.

**Results of Operations**

             Total contract revenue increased by$2.5 million to $2.7 million for the three months ended June 30, 2001 from$268,000 for the comparable period in 2000. DeltaBase revenue was $2.2 million for the three months ended June 30,2001.  DeltaSelect revenues increase by$279,000 to $547,000 for the three months ended June 30, 2001 from $268,000 forthe comparable period in 2000.  Totalcontract revenues for the six months ended June 30, 2001 and 2000 were $5.2million and $554,000, respectively. DeltaBase revenue was $4.3 million for the six months ended June 30,2001.  DeltaSelect revenues increased by$312,000 to $866,000 for the six months ended June 30, 2001 from $554,000 forthe comparable period in 2000.  In thefirst six months of 2000, all of our revenue came from DeltaSelect contractswith Merck & Co., Inc., Pfizer Inc., Schering-Plough ResearchInstitute and Tularik Inc.

             Researchand development expenses were $10.4 million for the three months ended June 30,2001 and  $6.8 million for thecomparable period in 2000. Research and development expenses for the six monthsended June 30, 2001 and 2000 were $18.6 million and $12.5 million,respectively.  Excluding amortization ofunearned stock-based compensation expenses, research and development expensesincreased by $4.8 million to $9.8 million for the three months ended June 30,2001 from $5.0 million in the comparable period of 2000.  This increase was primarily attributable tocontinued growth of research and development activities, including$2.0 million related to increased personnel, $1.3 million related to theestimated loss on subleased research and development facilities,  $656,000 related to increased laboratorysupply costs to support development of our gene function database and ourDeltaSelect and secreted protein programs and $878,000 in higher depreciationand amortization and facilities expenses.

             Selling,general and administrative expenses were $5.3 million for the three monthsended June 30, 2001 and $2.4 million for the comparable period of 2000.Selling, general and administrative expenses for the six months ended June 30,2001 and 2000 were $8.2 million and $4.5 million, respectively.  Excluding amortization of unearnedstock-based compensation costs, selling, general and administrative expensesincreased by $3.8 million to $4.8 million for the three months ended June 30,2001 from $1.0 million in the comparable period of 2000.  This increase included $1.2 million relatedto staffing and infrastructure costs, $515,000 related to marketing andadvertising costs and $2.0 million related to legal and professional fees.
             Wehad net interest income of $1.1 million and $125,000 for the three months endedJune 30, 2001 and 2000, respectively. Interest income for the six months ended June 30, 2001 and 2000 were$2.7 million and $216,000, respectively. This increase resulted from increased cash and investment balances as aresult of the completion of our initial public offering during 2000.

**Liquidity and Capital Resources**

             AtJune 30, 2001, we had $102.5 million in cash and cash equivalents andshort-term investments, compared with $118.3 million at December 31, 2000. Weused $15.5 million for operating activities during the first six months of2001.  This consisted primarily of thenet loss for the period of $18.9 million offset in part by non-cash charges of$1.1 million related to depreciation and amortization expenses, and  $2.0 million related to the amortization ofunearned stock-based compensation.   Wereceived $3.3 million from investing activities during the first six months of2001.  This consisted of $40.0 millionfrom the maturities of short-term investments offset in part by the purchase ofshort-term investments of $34.4 million and $1.7 million used for capitalexpenditures.  We received $1.4 millionfrom financing activities during the first six months of 2001.  This consisted primarily of $2.5 million innet loan proceeds partially offset by $894,000 of loan repayments and $117,000related to the repurchase of stock from terminated employees.

We expect to devote substantial capitalresources for facilities and equipment to support expansion of our research anddevelopment efforts, to expand our sales and marketing organization and forother general corporate activities. We believe that our current cash andshort-term investment balances, together with revenues we believe will bederived from subscriptions to our gene function database and collaborativeresearch agreements, will be sufficient to fund our operations through at least2003. During or after this period, if cash generated by operations isinsufficient to satisfy our liquidity requirements or we make acquisitions orother investments, we may need to sell additional equity or debt securities orobtain additional credit arrangements. Additional financing may not beavailable on terms acceptable to us or at all. The sale of additional equity orconvertible debt securities may result in additional dilution to ourstockholders. Any debt financing may have restrictive covenants that adverselyaffect our operating plans and flexibility.

             Deltagenhas not paid any cash dividends on its common stock in the past. We currentlyintend to retain any earnings for use in the business and do not anticipatepaying any cash dividends on our common stock in the foreseeable future.

             Priorto February, 2001 we operated solely in the United States.  Beginning February 15, 2001, our Europeansubsidiary, Deltagen Europe S.A. began operations.  The expenses of these European operations have not been materialand all sales of Deltagen products to date have been made in U.S. dollars.  Accordingly, we have not had any materialexposure to foreign currency rate fluctuations.

**Recent Accounting Pronouncements**

In July 2001, the Financial Accountingand Standards Board (“FASB”) issued Statements of Financial AccountingStandards No. 141 (“SFAS 141”), “Business Combinations,” and No. 142 (“SFAS142”), “Goodwill and Other Intangible Assets.” SFAS 141 requires that all business combinations initiated after June30, 2001 be accounted for under a single method—the purchase method.  Use of the pooling-of-interests method is nolonger permitted.  SFAS 142 requiresthat goodwill no longer be amortized to earnings, but instead be reviewed forimpairment upon initial adoption of the Statement and on an annual basis goingforward.  The amortization of goodwillwill cease upon adoption of SFAS 142. The provisions of SFAS 142 will be effective for fiscal years beginningafter December 15, 2001.  The Companybelieves that SFAS 142 will not have a material effect on the financialposition or results of operation of the Company.

**RISK FACTORS**

**We expect to continue to incur substantial losses and we maynever achieve profitability, which in turn may harm our future operatingperformance and may cause the market price of our stock to decline.**

             Wehave had net losses every year since our inception in 1997 and, as of June 30,2001, had an accumulated deficit of $69.6 million. We had net losses of$18.9 million and $16.1 million in for the six months ended June 30,2001 and 2000, respectively. The net loss for the six months ended June 30,2000 is before a $22.4 million deemed dividend related to the beneficialconversion of our preferred stock. Because we anticipate significantexpenditures for our research and development programs and for the development,implementation and support of our gene function database, we expect to reportsubstantial net losses through at least the next several years. We may neverachieve profitability. If we do not become profitable within the time frameexpected by securities analysts or investors, the market price of our stockwill likely decline. If we do achieve profitability, we may not sustain or increaseprofitability in the future.

             Weexpect that our expenditures will continue to increase, due in part to:
 •continued  investment in the research and development of our new and existing products  and our technology, including increased investment for the development,  implementation and support of our gene function database, our standard and  conditional knockout programs and our secreted protein programs; and    •our  increasing investment in management and other employees, sales and marketing  programs, customer service and operational and financial controls.
**We are a newly public company with an unproven businessstrategy, and our limited history of operations makes evaluation of ourbusiness and prospects difficult.**

             Wehave had a limited operating history and are at an early stage of development.Our strategy of offering a gene function database and using knockout mice toenable our customers to pursue promising candidates for drug target developmentis unproven. Additionally, our pricing models for offering our products andservices are unproven. We currently have three subscribers for our genefunction database. We have generated only limited revenues amounting toapproximately $2.1 million, $1.2 million and $381,000 for the fiscalyears ended 2000, 1999 and 1998, respectively. For the six months ended June30, 2001 and 2000 we recognized revenues of $5.2 million and $554,000,respectively.  Our success will dependupon, among other things, our ability to enter into licensing and otheragreements on favorable terms, our ability to determine and generateinformation on those genes which have potential use as drug targets and thecommercialization of products using our data. Moreover, we had no experienceselling our data, and we had never provided a gene database before. Our salesforce may not succeed in marketing our database product, and our employees maynot succeed in implementing and operating our database in a manner that issatisfactory to our subscribers. Furthermore, the plans for our secretedprotein and conditional knockout programs are unproven, and we cannot be surethat we will ever be able to develop these programs or that any program that wedevelop will be commercially successful. As a result of these factors, it isdifficult to evaluate our prospects, and our future success is more uncertainthan if we had a longer or more proven history of operations.

**We currently have only five customers and will not succeedunless we can attract many more customers.**

             Wehave only three customers for our DeltaSelect program. One of these customersis also a subscriber to our gene function database. We expect to enter intoonly a limited number of future DeltaSelect agreements. To succeed we mustattract customers for our database and other programs. Our existing and futureagreements may not be renewed and may be terminated without penalty in theevent either party fails to fulfill its obligations under one of theseagreements. Failure to renew or the cancellation of these agreements by one ofour customers could result in a significant loss of revenues. In 2000,GlaxoSmithKline and Schering-Plough accounted for 56% and 18%, respectively, ofour revenues. Our current customers are GlaxoSmithKline, Pfizer, Merck,Schering-Plough and Vertex Pharmaceuticals.
             Overthe past several years, companies in the pharmaceutical industry have undergonesignificant consolidation. If two or more of our present or future customersmerge, we may not be able to receive the same fees under agreements with thecombined entities that we were able to receive under agreements with thesecustomers prior to their merger. Moreover, if one of our customers merges withan entity that is not a customer, the new combined entity may prematurelyterminate our agreement. Any of these developments could harm our business orfinancial condition.

**Because we have only recently begun to offer our databaseproduct, which we expect to be our principal source of revenue in the next fewyears, our future prospects are uncertain.**

             Webelieve the majority of our revenues will be derived from fees under agreementswith our database users. We may also derive revenues from royalties receivedfrom these users. We have entered into agreements with three subscribers to ourdatabase, however, we cannot be sure of the terms under which we may enter intofuture agreements, such as fees payable to us or the term of the agreements, ifany. Our agreement with GlaxoSmithKline expires three years after our firstdelivery of data and provides for termination for any reason within the firstsix months after the one-year anniversary of the effective date upon thepayment of a specified termination fee.

             Ifour database is not acceptable to our prospective customers, it may notgenerate revenues and our business and financial condition will be materiallyharmed.

             Wemay not be able to comply with minimum performance levels or restrictiveprovisions or other obligations that may be contained in any agreements, suchas minimum data delivery requirements. In addition, we may experienceunforeseen technical complications in the processes we use to generatefunctional data for our gene database and functional genomics resources. Thesecomplications could materially delay or limit the use of our gene functiondatabase, substantially increase the anticipated cost of generating data orprevent us from implementing our processes at appropriate quality and scalelevels, thereby causing our business to suffer.

**No drugs have been developed and commercialized usinggenomics-based research and therefore the future of our products and programsis uncertain.**

             Noneof the limited number of drugs developed to date using genomics-based researchhave reached the commercial market. We cannot assure you that genomics-baseddrug development efforts will ultimately be successful. We have not proven ourability either to identify drug targets with commercial potential orcommercialize drug targets that we do identify. We cannot assure you that aparticular gene function in a mouse will have any correlation to a patient'sresponse to a particular drug. It is difficult to successfully select thosegenes with the most potential for commercial development. Furthermore, we donot know that any products based on genes that are the subject of our research canbe successfully developed or commercialized. If commercial opportunities arenot realized from genomic-based research, our existing customers could stopusing our products or we could have difficulty attracting or retainingcustomers and, in any event, we would not realize any product royalties.

**Our customers will control the development andcommercialization of products based on genes that we identify, which may meanthat our research efforts will never result in any royalty or milestonepayments or third party product sales.**

             Ouragreements with our customers may provide us with rights to obtain royaltiesfrom the commercial development of compounds or therapeutic approaches derivedfrom access to our database, technology or intellectual property. However, wemay not be able to obtain these rights under future agreements. Our ability toobtain these rights depends in part on the advantages and novelty of ourtechnologies, the validity of our intellectual property, the usefulness of ourdata and our negotiating position relative to each potential customer.

             Wewill have limited or no control over the resources that any customer may devoteto the development of compounds or therapeutic approaches derived from ouraccess to our database. These customers may breach or terminate theiragreements with us, and they are not obligated to conduct any productdiscovery, development or commercialization activities at all. Further, ourcustomers may decide not to develop products arising out of our customeragreements or may not devote sufficient resources to the development, approval,manufacture, marketing or sale of these products. If any of these eventsoccurs, our customers may not develop or commercialize any products based onour gene function research, technologies or intellectual property, we would notreceive royalties on product sales and our results of operations would suffer.Furthermore, our customers may resist sharing revenue derived from thesuccessful commercialization of a drug through royalty or milestone payments orothers may have competing claims to all or a portion of such revenues.

**There are a finite number of gene families upon whichpharmaceutical and biotechnology companies focus their research, which limitsour potential revenue and growth.**

             Ourcurrent and potential subscribers and customers traditionally focus theirresearch and development efforts on a finite number of gene families that theyview as reliable drug targets. Once we provide functional information on thesegene families, our ability to attract and retain subscribers to our databasewill depend, in part, on the willingness of our subscribers to expand theirresearch and development activities to other gene families. If our customers donot do this, we may lose existing subscribers or fail to attract newsubscribers for our database services, and as a result, our business andfinancial condition may be harmed. In addition, we have made and will continueto make significant investments in our database and knockout programs which wemay not recoup if we cannot find additional target opportunities.

**We may fail to meet market expectations because offluctuations in our quarterly operating results, which could cause our stockprice to decline.**

             Thefollowing are among the factors that could cause our operating results tofluctuate significantly from period to period:

•            changes in the demand for andpricing of our products and services;

•            the nature, pricing and timing ofother products and services provided by us or our competitors;

•            changes in the research anddevelopment budgets of our customers;

•            acquisition, licensing and othercosts related to the expansion of our operations;

•            the timing of milestones, licensingand other payments under the terms of our customer agreements and agreementspursuant to which others license technology to us;

•            expenses related to, and the resultsof, patent filings and other proceedings relating to intellectual propertyrights; and

•            our unpredictable revenue sources asdescribed below.

             Weanticipate significant fixed expenses due in part to our need to continue toinvest in product development and potential extensive support for our genefunction database subscribers. We may be unable to adjust our expenditures ifrevenues in a particular period fail to meet our expectations, which would harmour operating results for that period.

             Asa result of these fluctuations, we believe that period-to-period comparisons ofour financial results will not necessarily be meaningful, and you should notrely on these comparisons as an indication of our future performance.

**Ourrevenues will be unpredictable and this may harm our financial condition.**

             Theamount and timing of revenues that we may have from our business will beunpredictable because:

•            the timing of our DeltaSelectprogram agreements, gene function database subscriber agreements andinstallations are determined by our customers and subscribers;

•            whether any products arecommercialized and generate royalty payments depends on the efforts, timing andwillingness of our customers;

•            we do not expect to receive anymilestone or royalty payment under licenses and other arrangements for asubstantial period of time, if ever;

•            to date, we have entered into onlythree customer agreements for our gene function database and may not enter intoany additional agreements;

•            the time required to complete customorders for our database programs can vary significantly; and

•            our sales cycle is lengthy, asdescribed below.
             Asa result, our revenue may significantly vary from quarter to quarter, and ourquarterly results may be below market expectations. If this happens, the priceof our common stock may decline.

**We expect that our sales cycle will be lengthy, which willcause our revenues to be unpredictable and our business to be difficult tomanage.**

             Ourability to identify and obtain subscribers for our gene function databaseproduct and other services depends upon whether customers believe that ourproducts and services can help accelerate drug discovery efforts. Our salescycle will be lengthy because of the need to educate potential customers andsell the benefits of our products and services to a variety of constituencieswithin potential subscriber companies. These companies are large organizationswith many different layers and types of decision-makers. In addition, eachdatabase subscription and development program or services agreement willinvolve the negotiation of unique terms and issues which will take asignificant amount of time. We may expend substantial funds and managementeffort with no assurance that a subscription program or services agreement willresult. Actual or proposed mergers or acquisitions of our prospective customersmay also affect the timing and progress of our sales efforts. Any of these developmentscould harm our business or financial condition.

**We may have conflicts or be in competition with ourcustomers, which will hurt our business prospects.**

             Wemay pursue opportunities in fields, such as secreted proteins, that couldconflict with those of our customers. Moreover, disagreements could arise withour customers or their partners over rights to our intellectual property or ourrights to share in any of the future revenues of compounds or therapeuticapproaches developed by our customers. These kinds of disagreements couldresult in costly and time-consuming litigation and could have a negative impacton our relationship with existing customers. Any conflict with our customerscould reduce our ability to attract additional customers or enter into futurecustomer agreements. Some of our customers could also become competitors in thefuture. Our customers could develop competing products, preclude us fromentering into agreements with their competitors or terminate their agreementswith us prematurely.

**We experience intense competition from other entities engagedin the study of genes, and this competition could adversely affect ourbusiness.**

             Thehuman and mouse genomes contain a finite number of genes. The human genome hasbeen mapped and identified. Our competitors have identified and will continueto identify the sequence of numerous genes in order to obtain proprietarypositions with respect to those genes. In addition, our competitors may seek toidentify and determine the biological function of numerous genes in order toobtain intellectual property rights with respect to specific uses of thesegenes, and they may accomplish this before we do. We believe that the firstcompany to determine the functions of commercially relevant genes or thecommercially relevant portions of the genome will have a competitive advantage.

             Anumber of companies, institutions and government-financed entities are engagedin gene sequencing, gene discovery, gene expression analysis, gene functiondetermination and other gene-related service businesses. Many of thesecompanies, institutions and entities have greater financial and human resourcesthan we do and have been conducting research longer than we have. Inparticular, a significant portion of this research is being conducted byprivate companies and under the international Human Genome Project, amulti-billion dollar program funded, in part, by the U.S. government, whichcompleted and released its initial rough draft of the human genome in June ofthis year. Furthermore, other entities have and will continue to discover andestablish a patent position in genes or gene sequences that we wish to study.Significant competition also arises from entities using standard targetidentification approaches, traditional knockout mouse technology and otherfunctional genomics technologies. These competitors may have intellectualproperty rights in functional or other data which are superior to our rights.These competitors may also develop products earlier than we do, obtainregulatory approvals faster than we can and invent products and techniques thatare more effective than ours. Furthermore, other methods for conductingfunctional genomics research may ultimately prove more advanced, in some or allrespects, to the use of knockout mice. In addition, technologies more advancedthan or superior to our gene trap technology and gene function identificationtechnology may be developed, thereby rendering our gene trap and gene functionidentification technologies obsolete. As we expand our range of products andservices, such as our secreted protein program, we will compete with additionalcompanies, some of which may be our customers at that time or our potentialcustomers.
             Someof our competitors have developed commercially available databases containinggene sequence, gene expression, gene function, genetic variation or otherfunctional genomics information and are marketing or plan to market their datato pharmaceutical and biotechnology companies. Additional competitors mayattempt to establish databases containing this information in the future. Weexpect that competition in our industry will continue to intensify. We alsobelieve that some pharmaceutical and biotechnology companies are discussing thepossibility of working together to discover the functions of genes and sharegene function-related data among themselves. The formation of this type ofconsortium could reduce the prospective customer base for our genefunction-related business. Moreover, the pharmaceutical industry has undergonesignificant mergers and this trend is expected to continue. This concentrationof the industry could further limit our potential customer base and thereforeharm our business.

**If we fail to properly manage our growth, our business couldbe adversely affected.**

             Weexpect to continue to experience significant growth in the number of ouremployees and the scope of our operations, including an increase in the scaleof our mouse knockout program. As of June 30, 2001, we had approximately 268full-time employees. We expect our number of employees to continue to increasefor the foreseeable future. In addition, we have substantially increased thescale of our knockout mouse production in the last year and expect to continuedoing so for the foreseeable future. Our overall growth and need to developmany different areas of our company have placed, and may continue to place, astrain on our management and operations. If we are unable to manage our growtheffectively, our losses could increase. The management of our growth willdepend, among other things, upon our ability to broaden our management team andattract, hire, train and retain skilled employees. Our success will also dependon the ability of our officers and key employees to continue to implement andimprove our operational and other systems. We will also be required to expendfunds, which may be substantial, to improve our operational, financial andmanagement controls, reporting systems and procedures.

             Inaddition, we will have to invest in additional customer support resources. Ourcurrent and potential database subscribers typically have worldwide operationsand may require support at multiple U.S. and foreign sites and in multiplelanguages. To provide this support, we may need to open offices in addition toour Menlo Park and San Carlos, California facilities, which will result inadditional burdens on our systems and resources and require additional capitalexpenditures.

**Ourmerger with Arcaris might not produce the expected benefits.**

             Weoperate in the field of genomics-based information, products and programsmarket.  It may turn out that there areno advantages or “synergies” to adding Arcaris’s research capabilities to ourproduct line and technology platform. Moreover, there is no assurance that Arcaris’s operations can besuccessfully integrated into our operations or that any of the benefitsexpected from such integration will be realized.  Although Arcaris will remain as a separate operating subsidiaryof Deltagen (renamed Deltagen Proteomics, Inc.), we intend to explore theintegration of certain aspects of the operations of Arcaris with ouroperations.  Furthermore, there can beno assurance that the operations, management and personnel of the two companieswill be compatible or that we or Arcaris will not experience the loss of keypersonnel.  The Arcaris acquisitionscould result in the incurrence of debt and contingent liabilities andamortization expenses related to goodwill and other intangible assets, whichcould adversely affect our results of operations and financial condition.

**We may engage in future acquisitions, which could adverselyaffect your investment in us as we may never realize any benefits from suchacquisitions, which also could be expensive and time consuming.**

             Weintend to acquire and license additional products and programs, if we determinethat these products or programs complement our existing technology or augmentour existing information technology platforms. We are continuously engaged inreview of opportunities and discussions with third parties; there is noguarantee that any of these discussions will result in consummatedtransactions. If we do undertake any transactions of this sort, the process ofintegrating an acquired business, technology, service or product may result inoperating difficulties and expenditures and may absorb significant managementattention that would otherwise be available for ongoing development of ourbusiness. Moreover, we may never realize the anticipated benefits of anyacquisition. Future acquisitions could result in potentially dilutive issuancesof equity securities, the incurrence of debt and contingent liabilities andamortization expenses related to goodwill and other intangible assets, whichcould adversely affect our results of operations and financial condition.

**We may need to raise additional capital that may not beavailable, which could adversely affect our operations.**

             Ourproducts and services may not produce revenues that, together with our existingcash and other resources, are adequate to meet our cash needs. We plan to fundour operations from our existing cash balances, but we may in the future seekto raise additional funds from the sale of stock or from debt financing. Ourcash requirements depend on numerous factors, including:

 

•            our ability to attract and retaincustomers for our gene function database and other products and services;

•            expenses in connection with thedevelopment and expansion of our gene function database, our secreted proteinprogram or other products and services;

•            expenditures in connection withlicense agreements and acquisitions of and investments in complementarytechnologies and businesses;

•            the need to increase research anddevelopment spending to keep up with competing technologies and marketdevelopments; and

•            expenditures as we expand our sales,marketing and customer service organizations and improve our management,operational and financial systems.

             Ifwe need additional funding, we may be unable to obtain it on favorable terms,or at all. If adequate funds are not available, we may have to curtailoperations significantly or obtain funds by entering into arrangementsrequiring us to relinquish rights to certain technologies, products or markets.In addition, if we raise funds by selling stock or convertible securities, ourexisting stockholders could suffer dilution.

**We depend on key employees in a competitive market forskilled personnel, and without additional employees, we cannot grow or achieveprofitability.**

             Weare highly dependent on the principal members of our management, operations andscientific staff, including William Matthews, Ph.D., our President andChief Executive Officer, and Mark W. Moore, Ph.D., our Chief ScientificOfficer. The loss of either of their services would harm our business.

             Ourfuture success also will depend in part on the continued service of our keyscientific, software, consultant and management personnel and our ability toidentify, hire and retain additional personnel, including customer service,marketing and sales staff. We experience intense competition for qualifiedpersonnel. We may be unable to attract and retain personnel necessary for thedevelopment of our business. Moreover, our business is located in the SanFrancisco Bay Area of California, where demand for personnel with the skills weseek is extremely high and is likely to remain high. Because of thiscompetition, our compensation costs may increase significantly.

**We currently have no patents, and if we are unable to protectour proprietary information, our business will be adversely affected.**

             Ourbusiness and competitive position depends upon our ability to protect andexploit our proprietary techniques, methods, compositions, inventions, databaseinformation and software technology. However, our strategy of obtaining suchproprietary rights around as many genes as possible is unproven. Unauthorizedparties may attempt to obtain and use information that we regard asproprietary. Although we intend for our gene function database subscriptionagreements to require our potential subscribers to control access to ourdatabase and information, policing unauthorized use of our database informationand software may be difficult.

             Wecurrently have no issued patents or registered copyrights. Patents have beenissued to other entities based on claims relating to knockout mice. Inaddition, many applications have been filed seeking to protect partial humangene sequences, many of which are based primarily on gene sequence informationalone. Some of these applications have issued as patents. Some of these mayclaim sequences which we have used or may use in the future to generateknockout mice in our gene knockout program. In addition, other applicationshave been filed which seek to protect methods of using genes and geneexpression products, some of which attempt to assign biological function to theDNA sequences based on laboratory experiments, computer predictions,mathematical algorithms and other methods. The issuance of these applicationsas patents will depend, in part, upon whether practical utility can besufficiently established for the claimed sequences and whether sufficientcorrelation exists between the experimental results predictions, algorithms andother methods and actual functional utility. The patent application processbefore the United States Patent and Trademark Office and other similar agenciesin other countries is confidential in nature. As each application is evaluatedindependently and confidentially, we cannot predict whether applications havebeen filed or which, if any, will ultimately issue as patents. However, it isprobable that patents will be issued to our competitors claiming knockout mice,partial human gene sequences and methods of using genes and gene expressionproducts.
             Numerousapplications have been filed by other entities claiming gene sequences. Manypatents have already issued and we expect more will issue in the future. Inaddition, others may discover uses for genes or proteins other than usescovered in any patents issued to us, and these other uses may be separatelypatentable. We may not be able to obtain issued patents on our patentapplications because our patent applications may not meet the requirements ofthe patent office. The holder of a patent covering a particular use of a geneor a protein, isolated gene sequence or deduced amino acid sequence couldexclude us from using that gene, protein or sequence. In addition, a number ofentities make gene information, techniques and methods publicly available,which may affect our ability to obtain patents.

             Othercompanies or institutions have filed and may file patent applications thatattempt to patent electronic databases that may be similar to our DeltaBasedatabase.  If such patents were toissue, the holders may claim that DeltaBase infringes such patents.   We may dispute this claim in aproceeding.  Any such proceeding wouldbe costly, and we may not prevail.  Inthis event, the prevailing party may require us or our collaborators to stopusing DeltaBase or to negotiate a license arrangement to continue to useDeltaBase.  We may not be able to obtaina license from the prevailing party on acceptable terms, or at all.

             Some ofour patent applications may claim compositions, methods or uses that may alsobe claimed in patent applications filed by others. In some or all of theseapplications, a determination of priority of inventorship may need to bedecided in an interference proceeding before the U.S. Patent and TrademarkOffice. Regardless of determined outcome, this process is time-consuming andexpensive.

             Issuedpatents may not provide commercially-meaningful protection against competitors.Other companies or institutions may challenge our or our customers' patents orindependently develop similar products that could result in an interferenceproceeding in the U.S. Patent and Trademark Office or a legal action. In theevent any researcher or institution infringes upon our or our customers' patentrights, enforcing these rights may be difficult and can be time-consuming.Others may be able to design around these patents or develop unique productsproviding effects similar to our products.

             Ourability to use our patent rights to limit competition in the creation and useof knockout mice, as well as our ability to obtain patent rights, may be morelimited in certain markets outside of the United States because the protectionsavailable in other jurisdictions may not be as extensive as those availabledomestically.

             Wepursue a policy of having our employees, consultants and advisors executeproprietary information and invention agreements when they begin working forus. However, these agreements may not be enforceable or may not providemeaningful protection for our trade secrets or other proprietary information inthe event of unauthorized use or disclosure. We also cannot prevent others fromindependently developing technology or software that might be covered bycopyrights issued to us, and trade secret laws do not prevent independentdevelopment.

**We may be subject to litigation and infringement claims whichmay be costly and divert management's attention.**

             Thetechnology we use in our business may subject us to claims that we infringe onthe patents or proprietary rights of others. The risk of this occurring willtend to increase as the genomics, biotechnology and software industries expand,more patents are issued and other companies attempt to discover gene functionthrough mouse gene knockouts and engage in other genomics-related businesses.Furthermore, many of our competitors and other companies performing research ongenes have already applied for patents covering some of the genes upon which weperform research, and many patents have already been issued which cover thesegenes, as well as genes we may wish to use in the future.

             In1998, Lexicon Genetics Incorporated, one of our competitors, informed us thatit was a coexclusive licensee under a patent covering certain isogenic DNAtechnology that may be used to modify the genome of a target cell. OnMay 24, 2000, Lexicon Genetics Incorporated filed a lawsuit against us inthe United States District Court for the District of Delaware. The complaint inthe lawsuit alleges that our methods of making knockout mice infringe United StatesPatent No. 5,789,215, under which Lexicon claims to be an exclusivelicensee. The complaint seeks a judgment that we infringed this patent, apermanent injunction against further infringement of the patent and an award ofdamages in an unspecified amount that, under certain circumstances, may betrebled. On June 13, 2000, we responded to Lexicon's complaint by filingan answer and seeking a declaratory judgment in our favor. On October 31,2000, an Order was entered by the Court amending the complaint and addingGenPharm International, the patentee of the '215 patent, as a plaintiff. OnNovember 14, 2000, we filed an answer as well as federal antitrustcounterclaims under the Sherman Antitrust Act against Lexicon and GenPharm,alleging that Lexicon asserted a fraudulently procured patent (the '215 patent)against us in an attempt to illegally monopolize the market for production andsale of knockout mice, a violation of Section 2 of the Sherman Act. Thecounterclaim asserts that Lexicon knew that the '215 patent was obtained byfraud and that the patent was invalid when it brought suit against us. Theantitrust counterclaim also charges Lexicon and GenPharm with conspiracy tomonopolize the market for knockout mice, in violation of Section 2 of theSherman Act, as well as with concerted conduct in restraint of trade, inviolation of Section 1 of the Sherman Act. The counterclaim seeks damagesincluding lost profits, devaluation of the initial public offering and legalfees, as well as a trebling of damages pursuant to Section 4 of theClayton Act. In addition, the answer seeks a declaratory judgment that we donot infringe the claims of the '215 patent and that the patent is invalid. Theanswer also asserts that the patent was obtained by knowing and willful fraudon the U.S. Patent and Trademark Office rendering the patent unenforceable. Weintend to defend the action vigorously.
             Aclaim construction hearing is scheduled for October 4, 2001.  The outcome of the hearing or the litigationcannot be predicted. We believe that if Lexicon were to prevail in thislawsuit, the impact would not significantly affect our operations. We believethat the methods covered by the '215 patent represent a modification of priormethods of generating knockout mice. Although we believe this modification waspreviously described by others prior to GenPharm's filing of its patentapplication, we have intentionally avoided the use of this modification.

             Inaddition, on October 13, 2000, Lexicon and the University of Utah ResearchFoundation filed a lawsuit against us in the United States District Court forthe Northern District of California. The complaint in this lawsuit alleges thatwe are infringing United States Patents Nos. 5,631,153, 5,464,764, 5,627,059and 5,487,992 (the Capecchi patents), under which Lexicon claims to be anexclusive licensee. All of these patents relate to the use of apositive-negative selection vector in gene targeting. The complaint seeks ajudgment that we infringed these patents, a preliminary and permanentinjunction against further infringement of the patents and an award of damagesin an unspecified amount that, under certain circumstances, may be trebled. OnNovember 8, 2000, we filed an answer denying infringement, and acounterclaim seeking a declaratory judgment that the patents are invalid. Thecounterclaim seeks an award of damages including attorney fees.

             Webelieve that the methods employed by us do not infringe these patents and thatthe patents are invalid. We believe that the Capecchi patents cover certainmodifications to existing methods of generating knockout mice, suchmodifications that we do not practice. These modifications are therefore butone method available for use in generating knockout mice. Numerous equallyeffective design-arounds exist, as well as methods that predate the Capecchipatents that are in the public domain and thus outside the scope of the patent.Thus, if Lexicon prevails in any such lawsuit, we would only be prevented fromusing certain of our methods but would not be prevented from using all of ourcurrent methods. However, an adverse determination as to those certain methodscould significantly affect the development and marketing of our existingfunction database and DeltaSelect programs and could cause us to incursignificant financial liabilities that could materially affect our business andoperating results.

             Aclaim construction hearing is scheduled for December 6, 2001, the outcome ofwhich cannot be predicted with certainty. The litigation is in the early stages and its outcome cannot bepredicted.

             Wemay be involved in future lawsuits alleging patent infringement or otherintellectual property rights violations. In addition, litigation may benecessary to:

•            assert claims of infringement;

•            enforce our patents, if any;

•            protect our trade secrets orknow-how; and

•            determine the enforceability, scopeand validity of the proprietary rights of others.

             Wemay be unsuccessful in defending or pursuing these lawsuits. Regardless of theoutcome, litigation, including our litigation with Lexicon, can be very costly,can divert management's efforts and could materially affect our business andoperating results. An adverse determination may subject us to significantliabilities or restrict or prohibit us from selling our products.

             Becausewe do not have any issued patents, and because knockout mouse and gene-relatedpatents even if obtained may not be enforceable, our intellectual property maynot have any material value, which would diminish our business prospects.

             Oneof our strategies is to obtain proprietary rights around as many gene knockoutsas possible. Although we have filed patent applications covering the knockoutmice we produce, we do not currently have any issued patents. We rely on acombination of copyright and trademark law, trade secrets, non-disclosureagreements and contractual provisions in our agreements with our customers toestablish and maintain intellectual property rights. While the U.S. Patent andTrademark Office in the past has issued patents to others covering function ofgenes, knockout mice, types of cells, gene sequences and methods of testingcells, we do not know whether or how courts may enforce those patents, if thatbecomes necessary. If a court finds these types of inventions to beunpatentable, or interprets them narrowly, the benefits of our strategy may notmaterialize and our business and financial condition could be harmed.

**Our rights to the use of technologies licensed to us by thirdparties are not within our control, and without these technologies, ourproducts and programs may not be successful and our business prospects could beharmed.**

             Werely, in part, on licenses to use certain technologies which are material toour business, including a secreted protein gene trap which we licenseexclusively from the University of Edinburgh. We do not own the patents thatunderlie these licenses. Our rights to use these technologies and employ theinventions claimed in the licensed patents are subject to our licensors abidingby the terms of those licenses and not terminating them. In most cases, we donot control the prosecution or filing of the patents to which we hold licenses.Instead we rely upon our licensors to prevent infringement of those patents.Some of the licenses under which we have rights, such as the license from theUniversity of Edinburgh, provide us with exclusive rights in specified fields,but we cannot assure you that the scope of our rights under these and otherlicenses will not be subject to dispute by our licensors or third parties.

**Ouractivities involve hazardous material and may subject us to environmentalliability, which would seriously harm our financial condition.**

             Our research and developmentactivities involve the controlled use of hazardous and radioactive materialsand generate biological waste. We are subject to federal, state and local lawsand regulations governing the storage, handling and disposal of these materialsand waste products. Although we believe that our safety procedures for handlingand disposing of these materials and wastes comply with legally prescribedstandards, the risk of accidental contamination or injury from these materialscannot be completely eliminated. We may be sued for any injury or contaminationthat results from our use or the use by third parties of these materials, andour liability may exceed our insurance coverage and our total assets. Futureenvironmental regulations could require us to incur significant costs.

**Compliance with governmental regulations regarding animalwelfare and genetically modified organisms could increase our operating costsor adversely affect our customers' ability to obtain governmental approval ofgene based products, which would adversely affect the commercialization of ourtechnology.**

             TheAnimal Welfare Act, or AWA, is the federal law that currently covers animals inlaboratories. It applies to institutions or facilities using any regulated liveanimals for research, testing, teaching or experimentation, includingdiagnostic laboratories and private companies in the pharmaceutical andbiotechnology industries. The AWA currently does not cover rats, mice or birds.However, the United States Department of Agriculture, which enforces the AWA,has been sued on this matter and recently agreed, as part of the settlement ofthis lawsuit, to begin the process of changing the regulations issued under theAWA to include rats, mice and birds within its coverage. Congress subsequentlyprohibited, for the next fiscal year ending September 30, 2001, theexpenditure of any money for the purpose of changing the regulations withrespect to including rats, mice and birds.

             Currently,the AWA imposes a wide variety of specific regulations which govern the humanehandling, care, treatment and transportation of certain animals by producersand users of research animals, most notably personnel, facilities, sanitation,cage size, feeding, watering and shipping conditions. We cannot assure you thatthe USDA will not in the future include rats, mice and birds in its regulationsand that we will not become subject to registration, inspections and reportingrequirements. Compliance with the AWA could be expensive, and current or futureregulations could impair our research and production efforts.

             Sincewe develop animals containing changes in their genetic make-up, we may becomesubject to a variety of laws, guidelines, regulations and treaties specificallydirected at genetically modified organisms, or GMOs. The area of environmentalreleases of GMOs is rapidly evolving and is currently subject to intenseregulatory scrutiny, particularly internationally. If we become subject tothese laws we could incur substantial compliance costs. For example, theBiosafety Protocol, or the BSP, a recently adopted treaty, is expected to covercertain shipments from the U.S. to countries abroad that have signed the BSP.The BSP is also expected to cover the importation of living modified organisms,a category that could include our animals. If our animals are not contained asdescribed in the BSP, our animals could be subject to the potentially extensiveimport requirements of countries that are signatories to the BSP.

**If we, or our collaborators, do not comply with governmentregulations, we may not be able to develop or sell our technologies andproducts.**

**Regulation of New Drugs or Biological Drugs for Human Use**

             Weare planning to engage in the future in the development and commercializationof therapeutic products that will be subject to United States Federal, stateand local, and foreign regulation, principally in the United States under theFood, Drug & Cosmetic Act as amended, the Public Health Service Act asamended, and other laws. Governmental authorities in the United States and inother countries, including the Food and Drug Administration (FDA) extensivelyregulate the testing, manufacturing, labeling, advertising, promotion,recordkeeping, safety, efficacy, storing, exporting and marketing, among otherthings, of human therapeutic products.

             Inthe United States, our potential therapeutic products likely will be regulatedas human drugs (including biological drugs). The FDA will require us to fileand obtain approval of a Biologics License Application (BLA) (for biologicaldrugs) or a New Drug Application (NDA) (for other drugs) before we cancommercialize any such products. BLAs cover both the facility in which theproducts are manufactured and the products themselves. Generally, biologicaldrug regulation is more rigorous than other drug regulation, particularly becausebiologics are subject to lot-to-lot release requirements whereas other drugsare not.

             Thesteps required before approval of a new human drug (including a biologicaldrug) for marketing in the United States generally include:

•            preclinical laboratory tests andanimal tests;

•            the submission to the FDA of anInvestigational New Drug, or IND, application for human clinical testing, whichmust become effective before human clinical trials may lawfully commence;

•            adequate and well-controlled humanclinical trials to establish the safety and efficacy of the product;

•            the submission to the FDA of a BLAor NDA;

•            FDA review of the BLA or NDA; and

•            satisfactory completion of an FDAinspection of the manufacturing facilities at which the product is made toassess compliance with current Good Manufacturing Practices which includeselaborate testing, control, documentation and other quality assuranceprocedures.

             Thetesting and approval process requires substantial time, effort and financialresources. After approval is obtained, a supplemental approval is generallyrequired for each proposed new indication and for many different types ofmanufacturing changes. The supplement often contains data similar to thatsubmitted in the original BLA or NDA.

             Preclinicalstudies include laboratory evaluation of the product chemistry, formulation,and stability, as well as animal studies to assess the safety and potentialefficacy of the product. Preclinical safety tests must be conducted bylaboratories that comply with FDA regulations regarding Good LaboratoryPractices. The results of the preclinical studies, together with manufacturinginformation and analytical data are submitted to the FDA as part of the IND andare reviewed by the FDA before the commencement of clinical trials. The INDautomatically will become effective in 30 days unless the FDA, before thattime, raises concerns or questions and imposes a "clinical hold". Insuch case, the IND sponsor must resolve with the FDA any outstanding concerns beforethe trial can proceed. Once trials have commenced, the FDA may stop the trialsby imposing a clinical hold because of concerns about, for example, the safetyof the product being tested or the adequacy of the trial design.

             Clinicaltrials involve the administration of investigational products to healthyvolunteers or patients under the supervision of a qualified principalinvestigator consistent with an informed consent. An independent InstitutionalReview Board, or IRB, must review and approve each clinical trial at eachinstitution at which the study will be conducted. The IRB will consider, amongother things, ethical factors, the safety of human subjects and the possibleliability of the institution.

             Clinicaltrials typically are conducted in three sequential phases, but the phases mayoverlap. In Phase I, the initial introduction of the drug into human subjects,the drug is usually tested for safety or adverse effects, dosage tolerance,absorption, metabolism, distribution, excretion and pharmacodynamics. Phase IIclinical trials usually involve studies in a limited patient population toevaluate the efficacy of the drug for specific, targeted indications, todetermine dosage tolerance and optimal dosage and to identify possible adverseeffects and safety risks. Phase III clinical trials generally further evaluateclinical efficacy and test further for safety within an expanded patientpopulation and at multiple clinical sites. The goal of these studies is toobtain definitive statistical and clinical evidence of the efficacy and safetyof the drug and dosage regimens. Phase IV clinical trials are conducted afterapproval to gain additional experience from the treatment of patients in theintended therapeutic indication. If the FDA approves a product, additional clinicaltrials may be necessary. A company may be able to use the data from theseclinical trials to meet all or part of any Phase IV clinical trial requirement.These clinical trials are often referred to as Phase III/IV post-approvalclinical trials.
             Insome cases, drug reviews may proceed under the accelerated approvalregulations, "fast track" statutory provisions, or the expeditedreview regulations. The accelerated approval provisions apply to products usedin the treatment of serious or life-threatening illnesses that appear toprovide meaningful therapeutic benefits over existing treatments. The expeditedreview regulations apply to products for life-threatening andseverely-debilitating illnesses, especially where no satisfactory alternativetherapy exists. These regulations permit approval of such products at the endof phase 2, or before clinical research is completed based on the drug's effecton a clinical endpoint or surrogate endpoint. FDA retains considerablediscretion to determine eligibility for expedited and accelerated review andapproval mechanisms.

             Theresults of the preclinical studies and clinical trials, together with detailedinformation on the manufacture and composition of the product, are submitted tothe FDA in the NDA or BLA requesting approval to market the product. Beforeapproving an NDA or BLA, the FDA will inspect the facilities at which theproduct is manufactured and will not approve the product unless themanufacturing facility is in compliance with current Good ManufacturingPractices. The FDA may delay approval of an NDA or BLA if applicable regulatorycriteria are not satisfied, require additional testing or information, and/orrequire postmarketing testing and surveillance to monitor safety, purity orpotency of a product. It may also limit the indicated uses for which anapproval is given. There can be no assurance that FDA will approve any futureNDAs or BLAs or that manufacturing facilities will pass FDA preapprovalinspections.

**Pervasive and Continuing Human Drug Regulation**

             Anyfuture drug approvals that are granted remain subject to continual FDA review,and newly discovered or developed safety or efficacy data may result inwithdrawal of products from marketing. Moreover, if and when such approval isobtained, the manufacture and marketing of future drugs will remain subject toextensive regulatory requirements administered by the FDA and other regulatorybodies, including compliance with current Good Manufacturing Practices, adverseevent reporting requirements and the FDA's general prohibitions againstpromoting products for unapproved or "off-label" uses. Companies aresubject to inspection and market surveillance by the FDA for compliance withthese regulatory requirements. Domestic manufacturing facilities are subject tobiennial inspections by the FDA and must comply with the FDA's GoodManufacturing Practices regulations. In complying with these regulations,manufacturers must spend funds, time and effort in the areas of production,record keeping, personnel and quality control to ensure full technicalcompliance. The FDA stringently applies regulatory standards for manufacturing.Failure to comply with the requirements can, among other things, result inwarning letters, product seizures, recalls, fines, injunctions, suspensions orwithdrawals of regulatory approvals, operating restrictions and criminalprosecutions. Any such enforcement action could have a material adverse effecton Deltagen. Unanticipated changes in existing regulatory requirements or the adoptionof new requirements could also have a material adverse effect on Deltagen.

**Foreign Regulation**

             Companiesare be subject to a variety of regulations governing clinical trials and salesof their products outside the United States. Companies must obtain approval oftheir products by the comparable non-U.S. regulatory authorities prior to thecommencement of product marketing in the country whether or not the company hasobtained FDA approval. The approval process varies from country to country andthe time needed to secure approval may be longer or shorter than that requiredfor FDA approval. The European Union requires approval of a MarketingAuthorization Application by the European Medicines Evaluation Agency. Theseapplications require the completion of extensive preclinical and clinicalstudies and manufacturing and controls information.

**Other Regulation**

             Weare also subject to a variety of other federal and state laws and regulationsin the U.S. and in other countries pertaining to our facilities, the shipment,exportation and importation of various articles and health and safety matters.For example, the Department of Transportation and various internationalguidelines and regulations govern the transport of different types ofmaterials. The Bureau of Export Administration of the Department of Commerceexercises export controls over technology such as our gene database. TheDepartment of Health and Human Services and USDA both regulate various types ofarticles that present the possibility of spreading communicable and otherdiseases, including the regulation of vectors, such as animals and articlesthat present risks of other harm to plants, human beings and other animals. TheEnvironmental Protection Agency has responsibility for facility emissions andother environmental matters, including the regulation of new chemicalsubstances, which could include gene sequences.

**Ethical and social issues may limit or discourage the use ofknockout mice or other genetic processes which could reduce our revenues andadversely affect our business.**

             Governmentalauthorities could, for social or other purposes, limit the use of geneticprocesses or prohibit the practice of our gene trap and knockout mousetechnologies. Public attitudes may be influenced by claims that geneticallyengineered products are unsafe for consumption or pose a danger to theenvironment. The subject of genetically modified organisms, like knockout mice,has received negative publicity and aroused public debate. In addition, animalrights activists could protest or make threats against our facilities, whichmay result in property damage. Ethical and other concerns about our methods,particularly our use of knockout mice, could adversely affect our marketacceptance.

**All our research is conducted at two facilities, and anatural disaster at these facilities is possible and could result in aprolonged interruption of our business.**

             Weconduct all our scientific and management activities at two facilities inCalifornia. Both locations are in seismically active areas. We have takenprecautions to safeguard our mouse colony including through insurance, storageof animals off-site at a back-up facility in Massachusetts, the freezing ofsperm and the storing of embryonic stem cells, or ES cells, to allow for theregeneration of mice. However, a natural disaster, such as an earthquake, fire,flood or outbreak of infectious disease, could cause substantial delays. Thiscould interrupt mouse breeding, cause us to incur additional expenses andadversely affect our reputation with customers.

**Security risks in electronic commerce or unfavorable internetregulations may deter future use of our products and services.**

             Wemay provide access to our gene function database on the Internet. A fundamentalrequirement to conduct our business over the Internet is the securetransmission of confidential information over public networks. Advances incomputer capabilities, new discoveries in the field of cryptography or otherdevelopments may result in a compromise or breach of the security measures weuse to protect the content in our gene function database. Anyone who is able tocircumvent our security measures could misappropriate our proprietaryinformation or confidential customer information or cause interruptions in ouroperations. We may be required to incur significant costs to protect againstsecurity breaches or to alleviate problems caused by breaches, and theseefforts may not be successful. Further, a well-publicized compromise ofsecurity could deter people from using the Internet to conduct transactionsthat involve transmitting confidential information. For example, recent attacksby computer hackers on major e-commerce web sites have heightened concernsregarding the security and reliability of the Internet.

             Becauseof the growth in electronic commerce, the U.S. Congress has held hearings onwhether to further regulate providers of services and transactions in theelectronic commerce market, and federal and state authorities could enact laws,rules and regulations affecting our business and operations. If enacted, theselaws, rules and regulations could make our business and operations more costlyand burdensome as well as less efficient.

**We rely on third-party data sources, and without thesesources, our products and programs would be incomplete and less appealing tocustomers, seriously harming our business prospects.**

             Wemay rely on scientific and other data supplied by third parties, and all of ourgene sequence data comes from public genomics data. This data could bedefective, be improperly generated or contain errors or other defects, whichcould corrupt our gene function database and our other programs and services.In addition, we cannot guarantee that our sources acquired this data incompliance with legal requirements. In the event of any such defect, corruptionor finding of nonconformance, our business prospects could be adverselyaffected.

**Our common stock may experience extreme price and volumefluctuations, which could lead to costly litigation for us and make aninvestment in us less appealing.**

             Themarket price of our common stock may fluctuate substantially due to a varietyof factors, including:

•            announcements of technologicalinnovations or new products by us or our competitors;

•            developments or disputes concerningpatents or proprietary rights, including announcements with respect to ourlitigation with Lexicon or of infringement, interference or other litigationagainst us or our licensors;

•            the timing and development of ourproducts and services;

•            media reports and publications aboutgenetics and gene-based products;

•            changes in pharmaceutical andbiotechnology companies' research and development expenditures;

•            announcements concerning ourcompetitors, or the biotechnology or pharmaceutical industry in general;

•            changes in government regulation ofgenetic research or gene-based products, and the pharmaceutical or medicalindustry in general;

•            general and industry-specificeconomic conditions;

•            actual or anticipated fluctuationsin our operating results;

•            changes in financial estimates orrecommendations by securities analysts;

•            changes in accounting principles;and

•            the loss of any of our keyscientific or management personnel.

             Inaddition, the stock market has experienced extreme price and volumefluctuations. The market prices of the securities of biotechnology companies,particularly companies like ours without consistent product revenues andearnings, have been highly volatile and may continue to be highly volatile inthe future. This volatility has often been unrelated to the operatingperformance of particular companies. For example, the stock prices of manybiotechnology companies, even those that would benefit from publicly availablegene sequence information, declined on news of the announcement by formerPresident Clinton and British Prime Minister Blair that, as their respectivegovernments had each advocated before, gene sequence information should befreely available in the public domain. In the past, securities class actionlitigation has often been brought against companies that experience volatilityin the market price of their securities. Moreover, market prices for stocks ofbiotechnology-related and technology companies, particularly following aninitial public offering, frequently reach levels that bear no relationship tothe operating performance of such companies. These market prices generally arenot sustainable and are subject to wide variations. Whether or not meritorious,litigation brought against us could result in substantial costs, divertmanagement's attention and resources and harm our financial condition andresults of operations.

**The future sale of common stock could negatively affect ourstock price.**

             Wehad 29,751,449 shares of common stock outstanding at June 30, 2001.

             Ifour common stockholders sell substantial amounts of common stock in the publicmarket, or the market perceives that such sales may occur, the market price ofour common stock could fall. The holders of approximately 18,180,856 shares ofour common stock will have rights, subject to some conditions, to require us tofile registration statements covering their shares or to include their sharesin registration statements that we may file for ourselves or otherstockholders. Furthermore, if we were to include in a company-initiatedregistration statement shares held by those holders pursuant to the exercise oftheir registration rights, those sales could impair our ability to raise neededcapital by depressing the price at which we could sell our common stock.

**Our principal stockholders, executive officers and directorsown a significant percentage of our stock, and as a result, the trading pricefor our shares may be depressed and these stockholders can take actions thatmay be adverse to your interests.**

             Asof June 30, 2001, our executive officers and directors and entities affiliatedwith them beneficially own, in the aggregate, approximately 54% of our commonstock which includes, as applicable, shares issuable upon the exercise of all optionsand warrants exercisable within 60 days of June 30, 2001. This significantconcentration of share ownership may adversely affect the trading price for ourcommon stock because investors often perceive disadvantages in owning stock incompanies with controlling shareholders. These stockholders, acting together,will have the ability to exert substantial influence over all matters requiringapproval by our stockholders, including the election and removal of directorsand any proposed merger, consolidation or sale of all or substantially all ofour assets. In addition, they could dictate the management of our business andaffairs. This concentration of ownership could have the effect of delaying,deferring or preventing a change in control, or impeding a merger orconsolidation, takeover or other business combination that could be favorableto you.

**Our incorporation documents and Delaware law may inhibit atakeover that stockholders consider favorable and could also limit the marketprice of your stock.**

             Ourrestated certificate of incorporation and bylaws contain provisions that coulddelay or prevent a change in control of our company. Some of these provisions:

•            authorize the issuance of preferredstock which can be created and issued by the board of directors without priorstockholder approval, commonly referred to as "blank check" preferredstock, with rights senior to those of common stock;

•            provide for a classified board ofdirectors; and

•            prohibit stockholder action bywritten consent.

             Inaddition, we are governed by the provisions of Section 203 of DelawareGeneral Corporate Law. These provisions may prohibit large stockholders, inparticular those owning 15% or more of our outstanding voting stock, frommerging or combining with us. These and other provisions in our amended andrestated certificate of incorporation and bylaws and under Delaware law couldreduce the price that investors might be willing to pay for shares of ourcommon stock in the future and result in the market price being lower than itwould be without these provisions.

**Item 3. **            **Quantitativeand Qualitative Disclosures About Market Risk**

             We investour excess cash primarily in obligations of governmental agencies andmarketable debt securities of financial institutions and corporations withstrong credit ratings.  Theseinstruments have maturities of twenty-four months or less when acquired.  We do not utilize derivative financialinstruments, derivative commodity instruments or other market risk sensitiveinstruments, positions or transactions in any material fashion.  Accordingly, we believe that, while theinstruments we hold are subject to changes in the financial standing of theissuer of such securities, we are not subject to any material risks arisingfrom changes in interest rates, foreign currency exchange rates, commodityprices, equity prices or other market changes that affect market risk sensitiveinstruments.  Therefore no quantitativetabular disclosure is included in this report.

**PARTII.  OTHER INFORMATION****Item 1. – Legal Proceedings**

             OnMay 24, 2000, Lexicon Genetics Incorporated filed a lawsuit against us inthe United States District Court for the District of Delaware. The complaint inthe lawsuit alleges that our methods of making knockout mice infringe United StatesPatent No. 5,789,215, under which Lexicon claims to be an exclusivelicensee. The complaint seeks a judgment that we infringed this patent, apermanent injunction against further infringement of the patent and an award ofdamages in an unspecified amount that, under certain circumstances, may betrebled. On June 13, 2000, we responded to Lexicon's complaint by filingan answer and seeking a declaratory judgment in our favor. On October 31,2000, an Order was entered by the Court amending the complaint and addingGenPharm International, the patentee of the '215 patent, as a plaintiff. OnNovember 14, 2000, we filed an answer as well as federal antitrustcounterclaims under the Sherman Antitrust Act against Lexicon and GenPharm,alleging that Lexicon asserted a fraudulently procured patent (the '215 patent)against us in an attempt to illegally monopolize the market for production andsale of knockout mice, a violation of Section 2 of the Sherman Act. Thecounterclaim asserts that Lexicon knew that the '215 patent was obtained byfraud and that the patent was invalid when it brought suit against us. Theantitrust counterclaim also charges Lexicon and GenPharm with conspiracy tomonopolize the market for knockout mice, in violation of Section 2 of theSherman Act, as well as with concerted conduct in restraint of trade, inviolation of Section 1 of the Sherman Act. The counterclaim seeks damagesincluding lost profits, devaluation of the initial public offering and legalfees, as well as a trebling of damages pursuant to Section 4 of theClayton Act. In addition, the answer seeks a declaratory judgment that we donot infringe the claims of the '215 patent and that the patent is invalid. Theanswer also asserts that the patent was obtained by knowing and willful fraudon the U.S. Patent and Trademark Office rendering the patent unenforceable. Weintend to defend the action vigorously.

             Aclaim construction hearing is set for October 4, 2001.  Neither the outcome of the hearing nor ofthe litigation can be predicted. We believe that if Lexicon were to prevail inthis lawsuit, the impact would not significantly affect our operations. Webelieve that the methods covered by the '215 patent represent a modification ofprior methods of generating knockout mice. Although we believe thismodification was previously described by others prior to GenPharm's filing ofits patent application, we have intentionally avoided the use of thismodification.

             Inaddition, on October 13, 2000, Lexicon and the University of Utah ResearchFoundation filed a lawsuit against us in the United States District Court forthe Northern District of California. The complaint in this lawsuit alleges thatwe are infringing United States Patents Nos. 5,631,153, 5,464,764, 5,627,059and 5,487,992 (the Capecchi patents), under which Lexicon claims to be anexclusive licensee. All of these patents relate to the use of apositive-negative selection vector in gene targeting. The complaint seeks ajudgment that we infringed these patents, a preliminary and permanentinjunction against further infringement of the patents and an award of damagesin an unspecified amount that, under certain circumstances, may be trebled. OnNovember 8, 2000, we filed an answer denying infringement, and acounterclaim seeking a declaratory judgment that the patents are invalid. Thecounterclaim seeks an award of damages including attorney fees.

             Webelieve that the methods employed by us do not infringe these patents and thatthe patents are invalid. We believe that the Capecchi patents cover certainmodifications to existing methods of generating knockout mice, suchmodifications that we do not practice. These modifications are therefore butone method available for use in generating knockout mice. Numerous equallyeffective design-arounds exist, as well as methods that predate the Capecchipatents that are in the public domain and thus outside the scope of the patent.Thus, if Lexicon prevails in any such lawsuit, we would only be prevented fromusing certain of our methods but would not be prevented from using all of ourcurrent methods. However, an adverse determination as to those certain methodscould significantly affect the development and marketing of our existingfunction database and DeltaSelect programs and could cause us to incursignificant financial liabilities that could materially affect our business andoperating results.

             Aclaim construction hearing is set for December 6, 2001, the outcome of whichcannot be predicted with any certainty. The litigation is in the early stages and its outcome cannot bepredicted.

             Wemay be involved in additional litigation, investigations or proceedings in thefuture. Any litigation, investigation or proceeding, with or without merit,could be costly and time-consuming and could divert our management's attentionand resources which in turn could harm our business and financial results.

**Item 2. – Changes in Securities**

a)          Not applicable.

b)          Not applicable.

c)          Not applicable

d)          On August 2, 2000, our RegistrationStatement on Form S-1 (File No. 333-34668), the IPO Registration Statement, wasdeclared effective by the Securities and Exchange Commission.  The IPO Registration Statement registered atotal of 7,000,000 shares of common stock all of which were issued and sold byus.  The offering commenced on August 3,2000 and was closed on August 8, 2000. The shares sold by us were sold at an aggregate offering price of $105million, netting proceeds of approximately $95.9 million to us after underwritingfees of approximately $7.4 million and other offering expenses of approximately$1.7 million.  On August 30, 2000 the underwriters' of our offering exercised theirover–allotment for the purchase of approximately 1,025,000 shares.  The shares sold by us were sold at anaggregate offering price of $15.4 million, netting proceeds of approximately$14.3 million to us after underwriting fees of approximately $1.1 million andother offering expenses.

Sincethe effective date of the IPO Registration Statement, the net offering proceedsof $110.2 million have been invested in bank deposits, money market funds,corporate debt securities and obligations of government agencies.
Repayment of  indebtedness$463,000 Purchase and  installation of equipment and build out of facilities1,435,000 Working capital5,813,000 Bank Deposits and  temporary investments$102,489,000 
Noneof the net offering proceeds have been paid to any director, officer, or 10% orgreater stockholder of the Company or an affiliate of these persons.

**Item 3. – Defaults Upon Senior Securities**

             Notapplicable.

**Item 4. – Submission of Mattersto a Vote of Security Holders**

TheCompany’s Annual Meeting of Stockholders was held on April 26, 2001.  F. Noel Perry and Nicholas J. Simon III wereelected to three-year terms ending with the 2004 Annual Meeting.  The voting was as follows:
 **For****Against****Abstain** ************F.  Noel Perry26,599,3184,650--Nicholas  J. Simon III26,599,1184,850--
**Item 5.– Other Information**

             Notapplicable.

**Item 6. – Exhibits and Reports on Form 8-K**

a)          Exhibits
 10.30Lease  Agreement for 740 Bay Road, Redwood City, California 10.31.1Sublease  Agreement for 700 Bay Road, Redwood City, California 10.31.2Consent  to Sublease Agreement for 700 Bay Road, Redwood City, California+10.32Agreement  and Plan of Merger and Reorganization with Arcaris, Inc. dated July 24, 2001
 

b)          Reports on Form 8-K
 No  reports on Form 8-K were filed during the quarter ended June 30, 2001.   +Confidential  treatment has been requested with respect to a portion of this agreement.
 

**DELTAGEN, INC.**

**SIGNATURES**

Pursuant to the requirements of theSecurities Exchange Act of 1934, the registrant has duly caused this report tobe signed on its behalf by the undersigned thereunto duly authorized.
  DELTAGEN,  INC.      Date:      August 9, 2001 /s/  William Mattews, Ph.D.   William  Matthews, Ph.D.  President  and Chief Executive Officer   Date:     August 9, 2001 /s/  Richard H. Hawkins   Richard  H. Hawkins  Chief  Financial Officer
 **