SECURITIES AND EXCHANGE COMMISSION

**WASHINGTON, D.C. 20549**

**FORM 20-F**

 

**ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF**

**THE SECURITIES EXCHANGE ACT OF 1934**

 

FOR THE FISCAL YEAR ENDED DECEMBER 31, 2006       

COMMISSION FILE NO. 005-60609

____________________________________________________

**Compugen Ltd.**

(Exact name of registrant asspecified in its charter and translation of registrant's name into English)

___________________________________________________________________

Israel

(Jurisdiction of incorporation ororganization)

**72 Pinchas Rosen Street,Tel Aviv, 69512 Israel**

(Address of principal executiveoffices)

________________________________________________

**Securities registered or to beregistered pursuant to Section 12(b) of the Act:**

Ordinary Shares, par value NewIsraeli Shekels 0.01 per share

 

**Securities registered or to beregistered pursuant to Section 12(g) of the Act:**

 None

 (Title of Class)

**Securities for which there is areporting obligation pursuant to Section 15(d) of the Act:**

None

Indicate the number of outstanding shares of eachof the issuer's classes of capital or common stock as of the close of theperiod covered by the annual report: 

28,162,202 Ordinary Shares 

 

Indicate bycheck mark if theregistrant is a well known seasoned issuer, as defined in Rule 405 of theSecurities Act.

oYes  ý  No

If this reportis an annual or transition report, indicate by check mark if the registrant isnot required to file reports pursuant to Section 13 or 15(d)of the Securities Exchange Act of 1934

o Yes                 x  No

Indicate bycheck mark whether the registrant: (1) has filed all reports required to befiled by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorterperiod that the registrant was required to file such reports), and (2) has beensubject to such filing requirements for the past 90 days: 

x Yes     o  No 

 

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

Large accelerated filer  o                                    Acceleratedfiler  o       Non-accelerated filer  x

**__1__** 

 

Indicate by check mark which financial statementitem the registrant has elected to follow:

Item 17 o Item 18 x

If this is an annual report, indicateby check mark whether the registrant is a shell company (as defined in Rule 12b‐2of the Exchange Act).

o Yes                 x  No

 

 

**__2__** 

 

**TABLE OFCONTENTS**

 

PART I.                                                                                                                                                            5

 

ITEM 1.     IDENTITY OFDIRECTORS, SENIOR MANAGEMENT AND ADVISORS. 5

ITEM 2.     OFFER STATISTICSAND EXPECTED TIMETABLE.. 5

ITEM 3.     KEY INFORMATION.. 5

ITEM 4.      INFORMATIONON THE COMPANY. 18

ITEM 5.     OPERATING ANDFINANCIAL REVIEW AND PROSPECTS. 30

ITEM 6.     DIRECTORS,SENIOR MANAGEMENT AND EMPLOYEES. 42

ITEM 7.     MAJORSHAREHOLDERS AND RELATED PARTY TRANSACTIONS. 50

ITEM 8.     FINANCIALINFORMATION.. 53

ITEM 9.     THE OFFER ANDLISTING.. 54

ITEM 10.    ADDITIONALINFORMATION.. 55

ITEM 11.    QUANTITATIVEAND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.. 70

ITEM 12.    DESCRIPTIONOF SECURITIES OTHER THAN EQUITY SECURITIES. 70

PART II 71

ITEM 13.    DEFAULTS,DIVIDEND ARREARAGES AND DELINQUENCIES. 71

ITEM 14.    MATERIALMODIFICATIONS TO THE RIGHTS OF SECURITY HOLDERS AND USE OF PROCEEDS. 71

ITEM 15.    CONTROLSAND PROCEDURES. 71

ITEM 16.    RESERVED.. 71

ITEM 16A.  AUDITCOMMITTEE FINANCIAL EXPERT. 71

ITEM 16B.  CODEOF ETHICS. 71

ITEM 16C. PRINCIPALACCOUNTANT FEES AND SERVICES. 72

PART III 73

ITEM 17.    FINANCIALSTATEMENTS. 73

ITEM 18.    FINANCIALSTATEMENTS. 73

ITEM 19.    EXHIBITS. 73

**COMPUGEN LTD. AND ITS SUBSIDIARIES**   1

**CONSOLIDATED FINANCIAL STATEMENTS**   1

**AS OF DECEMBER 31, 2006**  1

**REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTINGFIRM**    2

* *

**__3__** 

 

**CAUTIONARY STATEMENT REGARDING**

**FORWARD-LOOKING STATEMENTS**

* *

This annual report on Form 20-F includes"forward-looking" statements within the meaning of Section 21E of theSecurities Exchange Act of 1934. These statements include words such as  "may","expect", "believe", and "intend", and describe opinions about future events.We have based these forward-looking statements on information available to uson the date hereof, and on our current intentions, beliefs, expectations andprojections about future events. We assume no obligation to update any suchforward-looking statements. These forward-looking statements are not guaranteesof future performance and are subject to risks, uncertainties and assumptionsthat could cause our actual results to differ materially from our expectationsor projections. Factors that could cause our actual results to differmaterially from those projected in the forward-looking statements include therisk factors set forth under "Item 3. Key Information. Risk Factors", theinformation about us set forth under "Item 4. Information about the Company",and information related to our financial condition under "Item 5. Operating andFinancial Review and Prospects." 

 

Compugen Ltd. is referred to in this annual reportas "we", "our", "our company" or "us".

 

‐‐‐‐‐‐‐‐‐‐‐‐

 

We have prepared our consolidated financialstatements in United States dollars and in accordance with accounting principlesgenerally accepted in the United States. All references herein to "dollars" or"$" are to United States dollars, and all references to "Shekels" or "NIS" areto New Israeli Shekels.  

‐‐‐‐‐‐‐‐‐‐‐‐

** **

**__4__** 

**PARTI.**

### ITEM 1.                  IDENTITY OF DIRECTORS, SENIORMANAGEMENT AND ADVISORS

 

                Not applicable.

### ITEM 2.                  OFFER STATISTICS AND EXPECTEDTIMETABLE

 

                Not applicable.

### ITEM 3.                  KEY INFORMATION

 

**Selected Financial Data******

*** ***
| ** **

****                                                                                                      | Year ended December 31                                            |
|-----------------------------------------------------------------------------------------------------------------------|-------------------------------------------------------------------|
| ** **

****                                                                                                      |  

2002                                                      |  

2003 |  

2004 |  

2005 |  

2006 |
|                                                                                                                  | ($ in thousands, except share and per share data)                 |
| **Consolidated  Statements of Operations Data**                                                                       |                                                              |   |   |   |   |
|   Revenues                                                                                                  | $          9,262          | $          6,776 | $          2,630 | $             646 | $             215 |
|   Total  operating expenses *                                                                               | 24,306                                                            | 20,992 | 18,207 | 15,524 | 14,208 |
|         Operating loss                                                                  | (15,044)                                                          | (14,216) | (15,577) | (14,878) | (13,020) |
| Financial  income, net                                                                                                | 2,789                                                             | 2,112 | 1,417 | 682 | 884 |
| Net  loss available to ordinary shares                                                                                |  

(12,204)                                                  |  

(11,442) |  

(13,722) |  

(13,978) |  

(13,978) |
| Basic  and diluted net loss per ordinary share                                                                        |  

$          (0.47) |  

$          (0.43) |  

$          (0.50) |  

$          (0.50) |  

$          (0.47) |
| Weighted  average number of ordinary shares used in computing basic and diluted net  loss per share                   |  

 

 

26,103,343                                |  

 

 

26,409,180 |  

 

 

27,473,341 |  

 

 

27,774,535 |  

 

 

27,985,957 |
| **Consolidated  Balance Sheet Data**                                                                                  |                                                              |   |   |   |   |
| Cash  and cash equivalents, short-term deposits, marketable securities and cash  held in favor of consortium partners |  

 

 

 

$48,402                           |  

 

 

 

$16,707 |  

 

 

 

$20,574 |  

 

 

 

$31,821 |  

 

 

 

$25,403 |
| Long-term  deposits and marketable securities                                                                         |  

18,940                                                    |  

43,803 |  

27,854 |  

4,983 |  

1,000 |
| Total  assets                                                                                                         | 77,257                                                            | 67,526 | 55,353 | 42,106 | 30,856 |
| Accumulated  deficit                                                                                                  | (80,592)                                                          | (92,034) | (105,756) | (119,734) | (132,754) |
| Total  shareholders' equity                                                                                           | 68,881                                                            | 59,808 | 49,566 | 36,248 | 25,738 |

* *

(*)       Includesdeferred stock compensation - see Note 11 of our 2006 consolidated financialstatements.

*** ***

For additional financial information, please see"Item 5. Operating and Financial Review and Prospects - Results of Operations".

 

**__5__** 

**Risk Factors**

 

Many factors could affect our financial condition, cash flows andresults of operations. We are subject to various risks resulting from changingeconomic, political, social, industry, business and financial conditions. If we do not successfully address therisks to which we are subject, we could experience a material adverse effect onour business, results of operations and financial condition and our share pricemay decline. We can give no assurance that we will successfully address any ofthese risks. The****principal risks are described below. 

 

***Factors Related to our Financial Results andFinancing Needs***

*** ***

**We may not be as successful as wehope in implementing our evolving business model.**

** **

Since in or about 2004, wehave made significant changes to our business model, which included theelimination of our sale of computational tools products and services. Theelimination of computational tools revenue has negatively affected ourfinancial results.  In 2004, we recognized computational toolsrevenue of approximately $2.6 million. In 2005 and 2006, we recognizedapproximately $646,000 and approximately $205,000 of computational toolsrevenue respectively. Under our current business model, we seek to increaserevenue through developing therapeutic and diagnostic product candidates andlicensing the rights to these product candidates to collaborators and licenseeswho may be able to develop novel drugs and diagnostic products. Productcandidates are molecules that we discover and identify as having a potentialtherapeutic or diagnostic application. Our current business model in somerespects remains untested. We cannot be certain that it will generate aprofitable revenue stream. The inability to derive adequate revenues from ourcurrent business model may significantly impede improvement in our operatingresults and profitability.

 

We**havea history of losses, we expect to incur future losses and we may never achieveor sustain profitability**

 

We incurred net losses of approximately $13.7million in 2004, approximately $14 million in 2005 and approximately $13million in 2006. As of December 31, 2006, we had an accumulated deficit ofapproximately $107.9 million (not including approximately $24.9 million inaccumulated deficit attributable to the conversion of preferred shares upon theclosing of our initial public offering in 2000). We expect to continue to incurnet losses in the future due in part to the costs and expenses associated withour research and development activities. We cannot assure you that we will everachieve profitability. Even if we do achieve profitability, we may not be ableto sustain or increase profitability. 

 

**We may be required to allocate substantial additionalfunds in the future to our discovery and development activities, and we maynever be able to achieve profitability.**

** **

We discover and carry out early stage developmentof therapeutic and diagnostic product candidates. Product candidates aremolecules that we discover and identify as having a potential therapeutic ordiagnostic application. In 2006, we allocated a substantial portion of our cashand other resources to our discovery and development activities and we intendto continue to do so. To date, these activities have generated only negligiblerevenues. These activities may never generate significant revenues and we maynever achieve profitability. 

 

In December 2005, we underwent a re-organization inorder to focus our resources on our research and development and on ourcommercialization goals. Nevertheless, we do not anticipate that we willachieve profitability in the near future. We expect that we will needadditional funds to continue financing our discovery and development andcommercialization activities. If we are unable to obtain the requiredadditional financing, whether internally or from third parties, on commerciallyreasonable terms, we may have to curtail or cease our discovery and developmentactivities, and our business will likely be materially harmed.

 

**__6__** 

**If we are unable to raise additional capital in thefuture, we may need to curtail or cease operations, and if we raise additionalcapital, our existing shareholders are likely to experience dilution of theirshareholdings.**

** **

As of December 31, 2006, we had cash and cashequivalents, short-term deposits and marketable securities of approximately$25.4 million, and long-term deposits and marketable securities of approximately$1.0 million. Based on our current projections, we anticipate that our existingcash and cash equivalents, and short term and long term deposits and marketablesecurities will be sufficient to support our operations for at least the nexttwo years. We expect that we will need to raise additional capital within thenext two years. 

 

However, we cannot assure you that we would be ableto raise sufficient additional capital on favorable terms, if at all. If weraise additional capital by issuing equity securities, we expect that ourshareholders will experience dilution of their shareholdings. If we fail toraise sufficient funds, we will likely have to further curtail or ceaseactivities, which would materially harm our business and financial results. 

 

**If we are unable to continue to successfully apply forresearch and development grants, our financial results may be materiallyharmed.**

 

We receive research and development grants from theOffice of the Chief Scientist of the Israeli Ministry of Industry, Trade andLabor, from the Israel-U.S. Bi-national Industrial Research and DevelopmentFoundation and from the European Community, under the European Union`s 6thFramework Program. Oursubsidiary, Keddem Bioscience, also receives certain grants under Israeligovernment programs and receives funds in support of some of its research anddevelopment programs from the Office of Chief Scientist of the Israel Ministryof Industry, Trade and Labor.Ourentitlement to receive these grants is dependent on, among other things, ourcompliance with the various grants` respective terms and conditions. Inaddition, the total value of grants that the Office of the Chief Scientistmakes available generally, and to each individual grantee, has graduallydecreased in recent years and may reduceor eliminate these benefits in the future. In 2006, the grants we received andthat accrued totaled approximately $1.8 million, compared with approximately$2.3 million in 2005 and approximately $1.4 million in 2004.

 

If we do not comply with the terms and conditions of thegrants or if we do not succeed in obtaining these grants in the future, or ifwe will be able to obtain only a reduced amount of grants, our business andfinancial results may be materially harmed, and we may have to restrict orcease operations. 

 

**If our wholly-owned subsidiary, Keddem Bioscience Ltd.,will not be able to raise capital in the next few months, it may have to ceaseoperations, in which case all of our investments in Keddem Bioscience`sbusiness to date may be lost and our financial results may be harmed.**

 

In 2004, we turned our chemistry division, whichwas engaged in small-molecule drug discovery, into a wholly-owned subsidiary,Keddem Bioscience Ltd. The transaction was effected by us transferring toKeddem Bioscience all of our assets and liabilities that were dedicated to theoperation of our chemistry division. In connection with this transaction, weagreed to loan to Keddem Bioscience $1,572,000. In November 2005, our board ofdirectors also agreed to assign approximately $400,000****toKeddem Bioscience, which amount represented our entitlement to receive from theInvestment Center of the Israeli Ministry of Industry, Trade and Labor onaccount of our investment in the expansion of our computational chemistryfacilities and the building of a chemistry laboratory for drug discovery.Pursuant to our board of directors` decision of June, 2006, Keddem Biosciencereceived the amount of approximately $400,000. 

 

We currently seek to raise third party funding forKeddem Bioscience. Since late 2005, Keddem Bioscience`s external auditorsraised substantial doubts on Keddem Bioscience`s ability to continue as a goingconcern. Keddem has been experiencing operating losses since its incorporationand has accumulated a deficit of $2,917,000 as of December 31, 2006. Keddem's ability to continue, as a going concern in thenext year is dependent on its ability to raise additional funding. IfKeddem Bioscience fails to raise additional capital, it will likely need tocease its operations. If so, our investments in Keddem Bioscience will be lost,and this is likely to harm our financial results. 

 

***Factors Related to our Discovery and DevelopmentActivities and to the Commercialization of our Discoveries***

*** ***

**Our approach to discovering novel therapeutic anddiagnostic product candidates, is itself novel and has not yet been fullyproven or validated. If this approach does not prove to be successful, ourbusiness will be significantly harmed.**

 

Our method of discovering novel product candidates involvesincorporating ideas and methods from mathematics, computer science and physicsinto biology, chemistry and medicine. By using this approach, we have alreadypredicted 

**__7__** 

discoveries *insilico*, which means prediction by computers. We have also initiallyvalidated the suitability of some ofthese discoveries for diagnostic and therapeutic application.However, our approach has not yet been proven or validated beyond that initialvalidation and we cannot predict whether thismethod will yield other discoveries or that such discoveries will be suitablefor development into therapeutic or diagnostic products.

*** ***

If our approachis ultimately proven to be ineffective for discovering therapeutic ordiagnostic candidates, if we fail to make further discoveries, or if our discoveries are not suitable for developmentinto therapeutic or diagnostic products****our business maybe materially harmed. If our potential licensees or collaborators believe thatthis is not a successful approach, or if we are not able to find any biologicalactivity for the therapeutic and diagnosticproduct candidates that we discover, wemay fail to commercialize discoveries that we make, and, as a result, ourbusiness will likely be significantly harmed. 

** **

**There are risks that are inherent in the developmentand commercialization of therapeutic and diagnostic products, and if theserisks materialize, our business and financial results may be materially harmed.**

*** ***

We face a number of risksof failure that are inherent in the process of developing and commercializingtherapeutic and diagnostic products. These risks include, among other risks,the possibility that: 

●*       *our therapeutic product candidates will be found tobe pharmacologically ineffective or toxic or to have other detrimental sideeffects; 

●*       *our diagnostic product candidates will prove to beineffective in distinguishing between healthy and disease samples or inproviding information relating to a patient`s response to a drug; 

●*       *our collaborators will fail to receive applicableregulatory approvals; 

●*       *our collaborators will fail to manufacture theseproducts on a large scale in a cost effective manner; 

●*       *our collaborators will fail to develop and marketproducts based on our discoveries prior to the successful marketing ofcompeting products; 

●*       *the development, marketing or sale of our productcandidates will fail because they may infringe third party intellectualproperty rights; 

●*       *the development, marketing or sale of our productcandidates will fail because of our inability or failure to protect or maintainour own intellectual property rights and/or

●*       *once a product is launched on the market, therewill be little or no demand for it as a result of its exclusion from healthfunds' reimbursement schemes. 

 

If any of these risks materialize our business andfinancial results may be materially harmed.

 

**We have limited experience in, and limited resourcesfor, the discovery and development of therapeutic and diagnostic productcandidates, and if we fail to maintain and/or acquire the appropriateexperience, our business may be materially harmed.**

** **

Our experience in the discovery and development oftherapeutic and diagnostic product candidates is limited. In order tosuccessfully develop and commercialize therapeutic and diagnostic productcandidates, we must improve our internal expertise, capabilities andfacilities. We may not be able to maintain and/or engage any or all of theexperts that we need in order to do so. 

 

If we fail to acquire all of the requiredexperience and expertise in the discovery and development of therapeutic anddiagnostic product candidates, we may be unsuccessful in our discovery anddevelopment activities, and as a result our business may be materially harmed. 

** **

**The biotechnology and pharmaceutical industries arehighly competitive, and we may be unable to compete effectively.**

 

The biotechnology and pharmaceutical industries arehighly competitive. Numerous entities in the United States, Europe andelsewhere compete with our efforts to discover, validate and partner with licensees to****commercialize therapeutic and diagnostic products or product candidates.Our competitors include pharmaceutical, biotechnology and diagnostic companies,academic and research institutions and governmental and other publicly fundedagencies. We face, and expect to continue to face, competition from theseentities to the extent that they develop products that have a function similaror identical to the function of our therapeutic and diagnostic productcandidates. We also face, and expect to continue to face, 

**__8__** 

competition from entities that seek to developtechnologies that enable the discovery of novel therapeutic and diagnosticproduct candidates. 

 

Many of our competitors benefit from greater marketrecognition, and have substantially greater financial, technical, human,research and development, and marketing resources than we do. Since we are asmall company with limited human resources, we are not able to work with alarge number of collaborators in parallel. Our competitors may discover anddevelop product candidates or market and sell products based on theirdiscoveries, in advance of us or of our collaborators or licensees. They mayalso obtain patents and other intellectual property rights before us andthereby prevent us from pursuing the development and commercialization of ourdiscoveries. For information about the specific competitors with whom wecompete, see "Competition" under "Item 4. Information on the Company."

 

If we are unable to compete successfully againstexisting or potential competitors, our financial results and business may bematerially harmed.

** **

**The trend towards consolidation in the pharmaceutical,diagnostic and biotechnology industries may adversely affect us.**

*** ***

There is a trend towards consolidation in thepharmaceutical, diagnostic and biotechnology industries. This consolidationtrend may result in the remaining companies having greater financial resourcesand discovery technological capabilities, thus intensifying competition in theindustries. This trend may also result in fewer potential collaborators orlicensees for our therapeutic and diagnostic product candidates. Also, if aconsolidating company is already doing business with our competitors, we maylose existing licensees or collaborators as a result of such consolidation. 

 

This trend may adversely affect our ability toenter into agreements for the development and commercialization of our productcandidates, and as a result may harm our business.

 

**We depend significantly on collaborators and licenseesfor the development and commercialization of our therapeutic and diagnostic product candidates, and if we are unable to maintain ourexisting agreements and enter into additional agreements with collaborators andlicensees in the future, our business will likely be materially harmed.**

 

Our strategy for the development andcommercialization of therapeutic and diagnostic product candidates depends onthe formation of collaborations or licensing relationships with third partiesthat have complementary capabilities. We depend significantly on ourcollaborators and licensees to carry out and/or finance product development andcommercialization of our therapeutic and diagnostic product candidates.Potential collaborators and licensees include pharmaceutical, biotechnology anddiagnostic companies. 

 

To date, we have granted a small number of licensesfor the development and commercialization of our product candidates. Overapproximately the past two and a half years, we entered into 6 license collaborationagreements for the development and commercialization of a multiple number ofour product candidates. 

 

We cannot assure you that any of these agreementswill result in the successful development or commercialization of any productsbased on our discoveries. Further, we cannot assure you that we will succeed inidentifying suitable collaborators orlicensees orenteringinto any other agreements with collaborators or licensees for the developmentand commercialization of our therapeutic and diagnostic product candidates. Ifwe are unable to identify suitable collaborators orlicensees or enter into new collaborationsor license agreements, our business will likely be materially harmed. 

 

**We may not be able to find additional collaborators orlicensees that will agree to in-license our discoveries at an early stage, andif we do not find these collaborators or licensees, our business will likely bematerially harmed.**

** **

Our strategy for the development andcommercialization of therapeutic and diagnostic product candidates is based onour discovery and early stage validation and in some cases pre-clinicaldevelopment of those product candidates. We consider early stage development ofdiagnostic product candidates to be a stage at which their existence is validated.At this stage we may demonstrate that the product candidate is differentiallyexpressed in different physiological conditions, but in any case with noclinical proof. We consider early stage development of therapeutic productcandidate, to be a stage at which we show biological activity of that candidatein animal models. We ordinarily carry out such early stage validation workourselves, and we ordinarily seek to rely on our collaborators and licensees tocarry out further product development.

**__9__** 

 

 

Pharmaceutical anddiagnostic companies may be reluctant or refuse to in-license our therapeuticand diagnostic product candidates at these early stages of discovery orvalidation or may not agree to do so on terms that we would considercommercially desirable.

 

If we are unable to out-license our discoveries atan early stage, we may need to validate and develop our discoveries ourselvesuntil the candidates attain a more mature stage of development. Suchdevelopment activities may require us to expend substantial additionalfinancial and other resources. If we are unable to raise or spend theseadditional resources, we may have to curtail or cease our discovery anddevelopment activities, and as a result our business will likely be materiallyharmed.

** **

**Our dependence on licensing and collaborationagreements with third parties presents a number of risks, and if one or more ofthese risks materialize, our business may be materially harmed.**

** **

The risks that we face inconnection with our existing collaborations, licenses and other businessalliances as well as those that we may enter into the future include, amongother things, the following:

●*       *we may be unable to comply or fully comply with ourobligations under license or collaboration agreements into which we enter, andas a result, we may not generate royalties from such agreements, and ourability to enter into additional agreements may be harmed; 

●*       *our collaborators may have significant discretionin electing whether to pursue any of the planned activities and the manner inwhich this will be done;  

●*       *we may not be able to control our collaborators` orlicensees` willingness to pursue development of our product candidates, or theamount of resources that our collaborators will devote to the collaboration;

●*       *changes in a collaborator's or a licensee`sbusiness strategy may negatively affect its willingness or ability to completeits obligations under its arrangement with us; 

●*       *we may not be able to obtain our collaboratorsagreement that we own the intellectual property generated under our 

●*       *collaboration; 

●*       *our ownership of rights in any intellectualproperty or products that may result from our collaborations may depend onadditional investment of money that we may not be able nor willing to make;

●*       *prospective collaborators may pursue alternativeproducts or technologies, by internally developing them or by preferring thoseof our competitors; 

●*       *disagreements between us and our collaborators maylead to delays in, or termination of, the collaboration; and our collaboratorsmay fail to develop or commercialize successfully any products based on productcandidates to which they have obtained rights from us.

 

If any of these risks materialize, our business,financial condition and results of operations may be materially harmed. 

** **

***Factors Related to our Discovery Engines and RelatedTechnologies***

*** ***

**The success of our business largely depends on ourability to continue to develop and enhance our discovery engines and relatedtechnologies, and if we fail to continue to develop and enhance them, ourbusiness will likely be materially harmed.**

*** ***

Our discoveryengines are proprietary computational platforms that are designed to identifytherapeutic and diagnostic product candidates in a specific therapeutic anddiagnostic area of interest. By using our discovery engines and relatedtechnologies, we intend to constantly feed our pipeline of discoveries withnovel therapeutic and diagnostic product candidates. Our success as a  discoverycompany largely depends on our ability to continue to develop and enhance ourdiscovery engines and related technologies.

 

Thepharmaceutical and biotechnology industries are characterized by continuoustechnological changes. We may not be able to make the necessary newdevelopments and enhancements to our discovery engines and related technologiesin order to compete successfully within these industries. Further, since we usepublic and freely available bioinformatics and other data to improve andenhance our discovery engines, our use of these data may render our discoveryengines and related technologies less valuable or even obsolete.

**__10__** 

 

If we fail to continue to develop and enhance ourdiscovery engines and related technologies, our business will likely bematerially harmed.

** **

**We rely on access to public and commercial databases tofeed our discovery engines and on the quality of the data available from thosedatabases, and if we are denied access to these databases for any reason or ifthe quality of available information is poor, our operations and business maybe harmed.**

 

In carrying out our discovery and development oftherapeutic and diagnostic product candidates, we rely on our ability to accessand use public and commercially available databases. The quality of ourdiscoveries is in part dependent on the quality of the data in these databases.If we are denied access to these databases, or if we are granted access to suchdatabases on terms, which are not commercially reasonable, or if the quality ofdata available from those databases is poor, our business and our results ofoperation may be harmed. 

*** ***

***Factors Related to our Operations***

** **

**The licensing cycle for our commercial offerings iscomplex and lengthy and as a result, we may expend substantial funds andmanagement resources with no assurance of success**. 

*** ***

We are required to negotiate agreements containingterms unique to each licensee and collaborator and which suit each licensee`sor collaborator`s specific discovery, development and business strategies. Theaccommodation of these requirements mandates a thorough consideration of boththe scientific and business aspects of each transaction. As a result, theprocess of preparing and negotiating our licensing and other agreements iscomplex and may take 12 months or longer. These business development andrelated commercial activities require the input and efforts of our keymanagement personnel. 

 

As a result we believe that we will need tocontinue to expend substantial funds and management effort into these business development activities with no assurance of successfully entering into agreementswith potential collaborators and licensees. 

** **

**We may be unable to hire or retain key personnel orsufficiently qualified employees, in which case our business may be harmed.**

** **

Our business is highly dependent upon the continuedservices of our senior management and key scientific and technical personnel.While members of our senior management and other key personnel have enteredinto employment or consulting agreements and non-competition and non-disclosureagreements, we cannot assure you that these key personnel and others will notleave us or compete with us, which could harm our business activities andoperations. Within our geographic location, it is difficult to find suitableand highly qualified personnel in certain aspects of our industry. 

 

Furthermore, we do not carry key person lifeinsurance on any member of our senior management. 

 

Our business may be harmed if we are unable toretain our key personnel, or to attract, integrate or retain other highlyqualified personnel in the future. 

*** ***

**Revenues that we may generate from commercialization ofour technologies or discoveries may be reduced  because ofobligations to pay back Israeli governmental grants that we receive.**

 

The development of some of our technologies and ofthe discoveries that we make have been and may in the future be partiallyfunded by governmental grants that we receive from the Office of the ChiefScientist of the Israeli Ministry of Industry, Trade and Labor. According toIsraeli law, certain restrictions and obligations may be imposed on us inrelation to the development and commercialization of discoveries that arefinanced by these grants. These obligations and restrictions may be imposed ifwe were to seek to manufacture outside of Israel or transfer our know-howwithin or outside of Israel. 

 

We believe that these obligations and restrictionsdo not apply to us for a number of reasons, including our strategy not totransfer, as opposed to license, the know-how subsisting in our technologiesand discoveries. We also believe that these restrictions do not apply to thesale or to the export of product candidates that we develop by using or basedon our Office of the Chief Scientist-funded technologies or discoveries. Inaddition, due to certain changes to the applicable Israeli law that came intoforce in June 2005, these obligations and restrictions, have been ameliorated. 

**__11__** 

 

Nevertheless, if the Office of the Chief Scientistof the Israel Ministry of Industry, Trade and Labor adopts a view contrary toour own or if restrictive statutory changes are legislated in the future, ourability to commercialize some of our technologies or discoveries may belimited. 

 

**We may be unable to safeguard the integrity, securityand confidentiality of our data or third parties` data, and if we are unable todo so, our business may be harmed.**

 

We rely heavily on the use and manipulation oflarge amounts of data and on the secure and continuous use of our internalcomputers, communication networks and software and hardware systems. We haveimplemented and maintain physical and software security measures to preserveand protect our computers, communication, and hardware and software systems aswell as our data and third parties` data. However, these methods may notprotect us against fire, storm, flood, power loss, earthquakes,telecommunications failures, physical or software break-ins or similar events.In addition, these measures may not be sufficient to prevent unauthorizedaccess, use or publication of such proprietary data. A party who is able tocircumvent our security measures could misappropriate or destroy proprietaryinformation or cause interruptions in our operations. In addition, a party whoobtains unauthorized access to our proprietary data or breaches aconfidentiality agreement with us could publish or transfer large portions orall of our proprietary data. Such publication of proprietary data couldmaterially harm our intellectual property position, thereby seriously harmingour financial condition. These security problems, if significant, could harmour operations and even cause our business to cease.   

*** ***

**We may be subject to claims related to hazardouschemicals and biological materials that we use, and these claims may harm ourbusiness.**

 

Our research and development activities in somecases involve the controlled use of biological and chemical materials, a smallamount of which could be hazardous. We cannot eliminate the risk of accidentalcontamination or discharge of any of these materials. If hazardous biologicalor chemical materials in our possession were to be improperly used, this couldresult in harm to persons or property and we could be subject to both civildamages and criminal penalties. In such event, our liability may exceed ourinsurance coverage.   

*** ***

**The clinical development and marketing of productsbased on our discoveries are subject to governmental regulation and the receiptof regulatory approvals, and if we or our collaborators or licensees fail toreceive such approvals, our business may be materially harmed.**

 

The clinical development and marketing of therapeutic and diagnosticproducts based on our discoveries requires obtaining regulatory approvals tosuch effect. The process of obtaining regulatory approvals for therapeutic ordiagnostic products based on our discoveries in the United States, Israel and inother countries can be lengthy and complex. Changes in legislation and inguidelines and policies made pursuant to such legislation could increase thecomplexity and the length of the process of obtaining such regulatoryapprovals. Even if and once we or our collaborators or licensees obtainregulatory approval for products based on our discoveries, these products maybe subject to continuous regulatory review. Products based on our discoveriesthat are found to be unsuitable for human consumption, for example due to thecausation of unwanted side effects, may result in the withdrawal of suchproducts from the market. 

 

Neither we, nor our licensees or collaborators,have yet applied for or received any regulatory approvals for any therapeuticor diagnostic products based on our discoveries. Such approvals are alsorequired for conducting clinical trials of products based on our discoveries.We rely on our collaborators and licensees to advance regulatory approvalprocesses. However, we cannot be certain that we or our collaborators orlicensees will be able to obtain such approvals for any product or productcandidate that we may develop. 

 

If we or our collaborators or licensees fail toobtain required regulatory approvals, our collaborators or licensees may beprevented from marketing therapeutic or diagnostic products based on ourdiscoveries. This will in turn reduce our chances of receiving payment from ourcollaborators and as a result, our business may be materially harmed. 

*** ***

**__12__** 

***Factors Related to Intellectual Property***

*** ***

**We may not be able to protect our non-patentedproprietary data, technologies or discoveries, and this may materially harm ourbusiness.**

*** ***

We rely heavily on our proprietary know-how andtrade secrets that we develop and that are not protectable or protected bypatents. The protective measures that we employ may not provide adequateprotection for our trade secrets and know-how. Our business collaborators,employees, advisors and consultants may disclose our proprietary know-how ortrade secrets in violation of their obligations to us. We may not be able tomeaningfully protect our rights in our proprietary know-how or trade secretsagainst such unauthorized disclosure and any consequent unauthorizedpublication. 

 

If we are not able to adequately protect ourproprietary know-how and trade secrets, competitors may be able to developtechnologies and resulting discoveries and inventions that are the same orsimilar to our own discoveries and inventions. This could erode our competitiveadvantage****and materially harm our business.

 

**We may not be able to obtain or maintain patentprotection for our inventions that relate to genes and gene-based products, andif we fail to do so, our business will likely be materially harmed.**

*** ***

The success of our business depends, to a largeextent, on our ability to obtain and maintain patents that cover ourtherapeutic and diagnostic product candidates. We have applied for patentscovering our therapeutic and diagnostic product candidates as well as aspectsof some of our technologies. We have a total of eight patents, of which sevenare US patents and one is an Australian patent. We plan to continue to applyfor patents as we deem appropriate, but we cannot assure you that our patentapplications will be accepted, or that they will be accepted to the extent thatwe seek. 

 

The process of obtainingpatents for inventions that cover our genes and gene-based products is uncertainfor a number of reasons, including but not limited to:

 

●*       *the patenting of genes and gene-based inventionsinvolves complex legal issues, many of which have not yet been settled; 

●*       *legislative and judicial changes, or changes in theexamination guidelines of governmental patent offices may negatively affect ourability to obtain genes and gene-based patents;

●*       *in view of the finite number of human genes, weface intense competition from other biotechnology and pharmaceutical companieswho have already sought patent protection relating to gene and gene-baseddiscoveries that we may intend to develop and commercialize; 

●*       *publication of large amounts of genomic data bynon-commercial and commercial entities may hinder our ability to obtainsufficiently broad patent claims for our inventions;

●*       *even if we succeed in obtaining patent protection,such protection may not be sufficient to prevent third parties from using ourpatented inventions; and 

●*       *even if we succeed in obtaining patent protection,our patents could be partially or wholly invalidated, including by ourcompetitors. 

 

If we do not succeed in obtaining patent protectionfor our inventions to the fullest extent for which we seek protection, ourbusiness and financial results will likely be materially harmed.

 

**The existence of third party intellectual propertyrights may prevent us from developing our discoveries or require us to expendfinancial and other resources to be able to continue to do so.**

*** ***

In selecting a therapeutic or diagnostic productcandidate for development, we take into account, among other considerations,the existence of third party intellectual property rights that may hinder ourright to develop and commercialize that product candidate. The human genomicpool is finite. To our knowledge, third parties, including our competitors,have been filing wide patent applications covering an increasing portionof the human genomic pool and the proteins expressed therefrom. 

* *

As a result of theexistence of such third party intellectual property rights, we have been andmay be required further to:

●*       *forgo the research, development andcommercialization of therapeutic and diagnostic products candidates that wediscover, notwithstanding their promising scientific and commercial merits; or 

**__13__** 

●*       *invest substantial management and financialresources to either challenge or in-license such third party intellectualproperty, and we cannot assure you that we will succeed in doing so oncommercially reasonable terms, if at all.

 

We do not always have available to us, in a timelymanner, information of the existence of third party intellectual propertyrights related to our own discoveries. The content of US and other patentapplications remain unavailable to the public for a period of approximately 18months from their filing date. In some instances, the content of US patentapplications remain unavailable to the public until the patents are issued. Asa result, we can never be certain that development projects that we commencewill be free of third party intellectual property rights. If we become aware ofthe existence of third party intellectual property rights only after we havecommenced a particular development project, we may have to forgo such projectafter having invested in it substantial resources.

 

**We may infringe third party rights and may becomeinvolved in litigation, which may materially harm our business.**

 

If a third party accuses us of infringing itsintellectual property rights or if a third party commences litigation againstus for the infringement of patent or other intellectual property rights, we mayincur significant costs in defending such action, whether or not we ultimatelyprevail. Typically, patent litigation in the pharmaceutical and biotechnologyindustry is expensive. Costs that we incur in defending third partyinfringement actions would also include diversion of management`s and technicalpersonnel`s time. In addition, parties making claims against us may be able toobtain injunctive or other equitable relief that could prevent us from furtherdeveloping our discoveries or commercializing our products. In the event of asuccessful claim of infringement against us, we may be required to pay damagesand obtain one or more licenses from the prevailing third party. If we are notable to obtain these licenses at a reasonable cost, if at all, we couldencounter delays in product introductions and loss of substantial resourceswhile we attempt to develop alternative products. Defense of any lawsuit orfailure to obtain any of these licenses could prevent us or our partners fromcommercializing available products and could cause us to incur substantialexpenditures.

 

***Factors Related to our Ordinary Shares***

** **

**Holders of our ordinary shares who are****U.S.****residents may be required to pay additional****U.S.****federal incometaxes.**

*** ***

There is a significant risk that we may beclassified as a passive foreign investment company, or PFIC. Our treatment as aPFIC could result in a reduction in the after-tax return to the U.S. holders ofour ordinary shares and may cause a reduction in the value of our shares. ForU.S. federal income tax purposes, we will be classified as a PFIC for anytaxable year in which either: (i) 75% or more of our gross income is passiveincome or (ii) at least 50% of the average value of our assets for the taxableyear produce or are held for the production of passive income. If we weredetermined to be a PFIC for U.S. federal income tax purposes, highly complexrules would apply to U.S. holders owning our ordinary shares. 

 

U.S. holders should carefully read "Taxation,United States Federal Income Tax Consequences" under "Item 10. AdditionalInformation" for a more complete discussion of the U.S. federal income taxrisks, including the potential application of the PFIC rules, related to acquiring,owning and disposing of our ordinary shares. 

 

We have a limited operatinghistory based on our revised business model, upon which to base an investmentdecision. 

* *

Since ourinception in 1993, our business model has continually evolved. We started ourbusiness of discovering therapeutic and diagnostic candidates in 1998, but only fully focused on thisbusiness since 2004.  Our operations in this business provide alimited basis for you to assess our ability to commercialize our productcandidates and the advisability of investing in our securities.

 

These difficulties may result in our ordinaryshares trading at a discount. 

** **

**Our share price has been volatile andmay be volatile in the future and this could limit investors` ability to sellstock at a profit.**

* *

During thelast two fiscal years, our stock price on the Nasdaq Global Market has tradedat a low of $2.1 to a high of $6.54. The volatile price of our stock may makeit difficult for investors to predict the value of their investment, to sellshares at a profit at any given time, or to plan purchases and sales inadvance.  A variety of factors may affect the market price of ourordinary shares including:

**__14__** 

* *

●*       *delay or failure in initiating, completing oranalyzing pre-clinical or clinical trials or the unsatisfactory design orresults of these trials;

●*       *achievement or rejection of regulatory approvals byour competitors or us;

●*       *announcements of technological innovations or newcommercial products by our competitors;

●*       *developments concerning proprietary rights,including patents;

●*       *developments concerning our collaborations;

●*       *regulatory developments in the United States,  Israel and foreign countries;

●*       *economic or othercrises and other external factors;

●*       *period to periodfluctuations in our revenues and other results of operations; 

●*       *changes in financial estimates by securities analysts; and;

●*       *sales of our ordinary shares

*** ***

We will not be able to control many ofthese factors, and we believe that period-to-period comparisons of ourfinancial results will not necessarily be indicative of our future performance.

 

In addition, the stock market ingeneral, and the market for biotechnology companies in particular, hasexperienced extreme price and volume fluctuations that may have been unrelatedor disproportionate to the operating performance of individual companies. Thesebroad market and industry factors may seriously harm the market price of ourordinary shares, regardless of our operating performance.

*** ***

In addition, the market prices of equity securitiesof companies that have a significant presence in Israel may also be affected bythe changing security situation in the Middle East and particularly in Israel.As a result, these companies may experience difficulties in raising additionalfinancing required to effectively operate and grow their businesses. Suchfailure and the volatility of the securities market in general, and our shareprice in particular, may affect our ability to raise additional financing inthe future. Market and industry fluctuations may adversely affect the tradingprice of our ordinary shares, regardless of our actual operating performance. 

 

**Our share price may decline if our operating resultsfluctuate and/or if we fail to meet the expectations of the investmentcommunity.**

** **

Our quarterly operating results fluctuated. Sincewe seek to generate revenues from collaborators and licensees commercializingtherapeutic and diagnostic products that are based on our discoveries and whichare enabled by the use of the intellectual property, scientific know-how andcomputational biology capabilities, our quarterly operating results mayfluctuate in the future. The fluctuations may result from the extent to whichour collaborators and licensees succeed in commercializing our technology. 

 

Our operating results mayalso fluctuate as a result of, among other things:

●*       *inflation/deflation in Israel or changes inthe conversion rate between New Israeli Shekel and other currencies;

●*       *the outcome and length of conflicts in the Middle East;

●*       *the time within which our collaborators and licensees maydevelop our therapeutic and/or diagnostic product candidates intorevenue-producing products; 

●*       *our ability to secure research and developmentgrants.

** **

These fluctuations may cause our share price tofluctuate significantly. If our operating results fail to meet the expectationsof the investment community, this may cause fluctuations in our share price.These results should not be relied upon as indications of future performance,and comparisons of quarterly results of operations may not be any meaningfulindication of our progress in the long term.

** **

**Provisions of Israeli law may delay, prevent or affecta potential acquisition of all or a significant portion of our shares or assetsand therefore depress the price of our shares.**

** **

Israeli corporate law regulates mergers, requirestender offers for acquisitions of shares above specified thresholds, requiresspecial approvals for transactions involving directors, officers or significantshareholders and regulates other matters that may be relevant to these types oftransactions. The provisions of Israeli law may delay or prevent anacquisition, or make it less desirable to a potential acquirer, even if such anacquisition would be considered beneficial by a 

**__15__** 

majority of our shareholders, and therefore depressthe price of our shares. For information about these limitations, see"Anti-Takeover Provisions under Israeli Law" Under "Item 10. AdditionalInformation." Furthermore, Israeli tax considerations may make potentialtransactions undesirable to us or to some of our shareholders. 

** **

***Risks Relating to Operations in******Israel***

** **

**Conditions in the Middle East and in****Israel****may harm our operations.****

** **

Our principal offices and research and developmentfacilities are located in Israel. Accordingly, political, economic and militaryconditions in Israel may directly affect our operations. Since theestablishment of the State of Israel in 1948, a number of armed conflicts havetaken place between Israel and its Arab neighbors, as well as incidents ofcivil unrest, military conflicts and terrorist actions. During the summer of2006, Israel was engaged in an armed conflict with Hezbollah, a LebaneseIslamist Shiite militia group and political party. This conflict involvedmissile strikes against civilian targets in northern Israel, and negativelyaffected business conditions in Israel. In addition, Israel and companies doingbusiness with Israel have, in the past, been the subject of an economicboycott. Although Israel has entered into various agreements with Egypt, Jordanand the Palestinian Authority, Israel has been and is subject to civil unrestand terrorist activity, with varying levels of severity, since September 2000.The election in early 2006 of representatives of the Hamas movement to a majorityof seats in the Palestinian Legislative Council and the tension among thedifferent Palestinian factions may create additional unrest and uncertainty.Any future armed conflicts or political instability in the region maynegatively affect business conditions and adversely affect our results ofoperations. Parties with whom we do business have sometimes declined to travelto Israel during periods of heightened unrest or tension, forcing us to makealternative arrangements when necessary. In addition, the political andsecurity situation in Israel may result in parties with whom we have agreementsinvolving performance in Israel claiming that they are not obligated to performtheir commitments under those agreements pursuant to force majeure provisions inthe agreements.. To date, we do not believe that the political and securitysituation has had a material adverse impact on our business but we cannot giveyou any assurance that this will continue to be the case. However, if therewere to be emergency conditions, some of our key employees may be called toactive duty for extended periods of time and could adversely affect ouroperations. Any hostilities involving Israel or the interruption or curtailmentof trade between Israel and its present trading partners could also adverselyaffect our operations and could make it more difficult for us to raise capital.

 

Our insurance does not cover losses that may occuras a result of events associated with the security situation in the Middle East.Although the Israeli government currently covers the reinstatement value ofdirect damages that are caused by terrorist attacks or acts of war, we cannotassure you that this government coverage will be maintained. Any losses ordamages incurred by us could have a material adverse effect on our business. Anyarmed conflicts or political instability in the region would likely negativelyaffect business conditions and could harm our results of operations.  

** **

**Our results of operations may be adversely affected byinflation and/or by a devaluation of the Dollar against the New****Israel****Shekel.****

** **

We hold most of our cash, cash equivalents depositsand marketable securities in US dollars but incur a significant portion of ourexpenses, principally salaries and related personnel expenses, in New IsraelShekels. As a result, we are exposed to the risk that the US dollar will bedevalued against the New Israel Shekel. To date, our business has not beenmaterially adversely affected by changes in the Israeli rate of inflation orthe exchange rates of the NIS compared to the US dollar. However, ouroperations could also be adversely affected if we will be unable in the futureto guard against devaluation of the Dollar against the New Israel. 

** **

**We may not continue to be entitled to certain taxbenefits.**

*** ***

We and our subsidiary Keddem Bioscience areentitled to certain tax benefits under Israeli government programs.

 

The tax benefits that we are entitled to receiveare a function of the "Approved Enterprise" status of our existing facilitiesin Israel. For more information, see "Item 5. Operating and Financial Reviewand Prospects; Operating Results; Governmental Economic, Fiscal, Monetary orPolitical Policies that Materially Affected or Could Materially Affect ourOperations". To date we have not received any such tax benefits because we havenot yet generated any taxable income. To maintain our eligibility for these taxbenefits, we must continue to meet certain conditions, including makingspecified investments in fixed assets and financing a percentage of investmentswith share capital. 

 

If we cease to become entitled to these taxbenefits, we may be required to pay increased taxes on the taxable income thatwe may generate in the future from funded technology. 

**__16__** 

** **

 

**It may be difficult to enforce a****US****judgment against us, or our officers and directors or to assert US securitieslaw claims in****Israel****.**

** **

Service of process upon us, since we areincorporated in Israel, and upon our directors and officers and our Israeliauditors, almost all of whom reside outside the United States, may be difficultto obtain within the United States. In addition, because substantially all ofour assets and almost all of our directors and officers are located outside the United States, any judgment obtained in the United States against us or any ofour directors and officers may not be collectible within the United States.

**__17__** 

### ITEM 4.                  INFORMATION ON THECOMPANY

*** ***

**History and Development of theCompany******

Our legal and commercial name is Compugen Ltd. Wewere established as a corporation and have operated under the laws of the Stateof Israel since 1993. Our principal offices are located at 72 Pinchas RosenStreet, Tel Aviv 69512, Israel, and our telephone number is +972-3-765-8585.The principal offices of Compugen USA, Inc. (formerly known as Compugen, Inc.),our wholly-owned US subsidiary, are located at 560 S. Winchester Blvd., Suite  500, San Jose, California 95128, and its telephone number is (408) 236-7336.Our primary Internet address is www.cgen.com. None of the information on ourwebsite is incorporated by reference into this annual report. 

 

Our initialbusiness since 1994 was to develop and commercialize a computerhardware system and software applications to accelerate homology searches ofbiological sequences under the name "Bioccelerator". In 2003, we sold theBioccelerator product line as partof a shift in the focus of our business.  We are now focused on further developing our discoveryengines and using them to discover therapeutic and diagnosticproduct candidates.  

 

Using thecapabilities we previously developed for our computational tools, we starteddeveloping therapeutic and diagnostic product candidates in or about 1997,using the biology laboratory that we initially built to validate our computationally-generatedpredictions.With the use ofour computational platforms, we have been able to discover novel genes andgene-based products, including novel transcripts and proteins. 

 

Weincorporated our wholly-owned US subsidiary, Compugen USA, Inc., in 1997.  Sincethat time, we have conducted most of our business development and commercialoperations from the United States, primarily in New Jersey, California and Maryland. Our businessdevelopment and commercial operations are now carried out primarily from ourTel Aviv offices. 

 

In August 2000, we sold 5,000,000 of our ordinaryshares in an initial public offering of our shares on the Nasdaq Global Marketat $10.00 per share. In September 2000, we sold an additional 750,000 ordinaryshares upon the exercise by our underwriters of their over-allotment option. InJanuary 2002, we listed our shares for trading on the Tel Aviv Stock Exchange(TASE).  

 

In 1999, we established a division focusing onagricultural biotechnology and plant genomics. On January 1, 2002, we transferred this business to what is now a minority held affiliate in which we haveapproximately a 15% shareholding. For more information about this transactionand our holdings in Evogene, see Item 7, "Major Shareholders and Related PartyTransactions; Related Party Transactions; Evogene Ltd."

 

In 1999, we also established a chemistry divisionto carry out a research program in which we integrated the disciplines oforganic chemistry with physics and advanced computational technologies for thedevelopment of a method to substantially increase the predictability andsuccess rates of small molecule drug discovery. On August 1, 2004, we transferred all of the assets and liabilities ofthis division to Keddem Bioscience, a wholly-owned subsidiary. This transfer was part of our continuing efforts to streamline ourfocuson our discovery engines and the discovery and development of novel therapeuticproteins and diagnostic biomarkers. 

 

Since 2002, we have been focusing on the discoveryof novel therapeutic proteins and peptides in addition to the discovery ofdiagnostic biomarkers. Therapeutic peptides and proteins are peptides andproteins that are themselves drugs and are usually administered by injection.Since peptides are typically short proteins, we refer collectively to suchproteins and peptides as "therapeutic proteins". Diagnosticbiomarkers indicate: the presence or absence of a physiological condition, suchas a disease, a person's predisposition to either acquire a disease or torespond to a therapeutic treatment. We discover these therapeutic proteins anddiagnostic biomarkers through the use of the intellectual property, scientificknow-how and computational biology capabilities that we had developed since ourinception. During 2003 and 2004 we expanded our biology laboratory by, amongother things, expanding its floor space and adding new functions and equipment.During that time, we also recruited experts for the purpose of strengtheningour protein expression, production, purification and analysis capabilities. Weseek to commercialize the novel therapeutic protein and diagnostic biomarkercandidates that we discover by entering into contracts with potentialcollaborators and licensees, including leading diagnostic, biotechnology and pharmaceuticalcompanies. We intend for these revenues to be in the form of milestone androyalty payments. 

*** ***

**__18__** 

In December 2005, we underwent a re-organization toconcentrate on the discovery, validation and commercialization of 

our therapeutic and diagnostic biomarker productcandidates and relevant research and discovery activities. As part of this re-organization we reduced the number of our employees byapproximately 25%.

*** ***

During 2006, we achieved proof of concept for anumber of new technologies, all relating to the discovery of therapeutic anddiagnostic product candidates. These include technologies for the detection oflarge-scale genetic variation that are relevant to the detection of diseasepredisposition and drug response predisposition and peptides that bind toGPCRs. GPCRs are membrane protein receptors that are involved in signaltransduction of numerous physiologic processes. 

*** ***

##### Business Overview 

*** ***

We are a biotechnology discovery company focused onthe discovery of therapeutic and diagnostic product candidates. Our predictivemodels and discovery engines enable us to discover numerous potentialtherapeutics and diagnostic biomarkers. This capability results from ourpioneering efforts in the deeper understanding of important biologicalphenomena at the molecular level through the incorporation of ideas and methodsfrom mathematics, computer science, and physics into biology, chemistry andmedicine.  To date, our product discovery efforts and initialdiscovery engines have focused mainly on cancer, cardiovascular andimmune-related diseases. Product development is pursued both in-house andthrough collaborative arrangements. Our primary commercialization pathway forour therapeutic and diagnostic product candidates is to enter into milestoneand revenue sharing out-licensing and joint development agreements with leadingcompanies.

 

We focus on three principal research anddevelopment activities; therapeutics, diagnostic biomarkers and research anddiscovery. These activities are serviced and supported by our financial, legaland business development personnel. 

*** ***

***Therapeutics Activities***

 

Our therapeutics activities comprise the selectionand validation of therapeutic protein and peptide product candidates that wediscover in-house with the use of our predictive discovery engines. Theseactivities include the in vitro and in vivo experimental validation of selectedpotential therapeutic protein candidates. In vitro and in vivo experiments areexperiments outside the living body, performed in an artificial environment andexperiments within a living body respectively. This validation is done bothinternally and by outsourcing to third party laboratories and includes proteinproduction, purification and analysis, and in vitro and in vivo bioassays. 

 

Once we identify therapeutic product candidates *insilico,* which means by computer, we select candidate molecules forvalidation in a biology laboratory. The molecules that we select for validationand further development, are those molecules that we believe are most likely tosucceed, based on a set of criteria that we continually develop and use in ourdiscovery process. 

 

Currently, our most advanced therapeutic productcandidates are based on our first discovery engine that focuses on novel splicevariants of known, clinically-related protein drugs or drug targets. Thisengine is based on our long-term leadership in the area of alternativesplicing. In using this discovery engine, we seek tobenefit from the availability of relevant biological and medical informationthat in part relates to our novel splice variant. The current therapeuticcandidates are of potential use in the treatment of various types of cancer,inflammatory diseases, and cardiovascular indications. 

 

Our therapeutic product candidates also compriseeight GPCR peptide ligands that are of potential use in the treatment ofcardiovascular and inflammatory disorders. We selected these from a largergroup of ligands that we discovered with the use of a proprietary model of thepeptidome, which is an *in silico* predicted database of human peptides.Peptides are formed through the cleavage of precursor proteins, and ourproprietary peptidome is based on predicting cleavage sites in precursorproteins. 

 

Our ability to seek partners for the ongoing developmentand commercialization of our therapeutic protein candidates will depend onthose molecules' potential to become therapeutic proteins and on our ability togenerate experimental data in support of that potential. 

* *

**__19__** 

We believe that in 2006, we have demonstrated ourability to discover targets for therapeutic products candidates that are ofinterest for development and commercialization by leading companies in thetherapeutics field. Our discovery engines together with our relatedtechnologies have already formed the basis for a discovery-based collaborationwith Medarex novel for the discovery and development of monoclonalantibody-based therapeutics for oncology and autoimmune diseases.

 

***Diagnostics Activities***

*** ***

The program consists of biomarker discovery at theDNA, RNA and protein levels for a variety of applications. Our diagnosticactivities comprise of the selection and prioritizations of diagnostic productcandidates that we discover in-house with the use of our predictive discoveryengines. Experimental validation of each selected candidate biomarker iscarried out using a robust quantitative RT-PCR protocol, sequencing methods andantibody and ELISA-based detection assays. To date, we have establisheddiscovery and licensing collaborations in the field of immunoassay diagnosticmarkers and NAT-based drug toxicity biomarkers******and******areseeking additional partnerships to develop and commercialize our discoveries inother areas, particularly nucleic-acid testing for cancer and genetic testingfor disease predisposition, theranostic and pharmacogenomic applications.

 

Our discovery engines and related technologies areused to discover therapeutic product candidates and to discover DNA, RNA andproteins that we believe to be potential diagnostic biomarker productcandidates. We first identify diagnostic product candidates *in silico*andthen select for validation those molecules that we believe are most likely tosucceed, based on a set of criteria that we developed. 

 

There are three principalselection criteria that we apply to select for validation and furtherdevelopment of diagnostic product candidates that we identify *in silico*.These are:

●*       *Novelty and freedom to operate - we selectmolecules that we predict to be novel and have found to not be covered by thirdparty patents or known patent applications. 

●*       *Differentiation between disease and healthyconditions - we select molecules that we predict to be present in differentquantities in diseased and healthy human tissues.

●*       *Biological characteristics - we select moleculesthat have biological features, which make them suitable for diagnosticdetection. For example, in the case of immunoassay-based diagnostic biomarkers,we select molecules that are predicted to be secreted into the blood stream andtherefore possibly detectable in blood. 

 

We believe that in 2005 and 2006, we havedemonstrated our ability to discover biomarker candidates, primarily forvarious cancers and cardiovascular diseases, that are of interest for furtherdevelopment and commercialization by leading companies in the field ofimmunoassay diagnostics. Our diagnostic discovery engines together with ourrelated technologies have already formed the basis for a broad discovery-basedcollaborations with: Diagnostic Product Corporation, a division of SiemensMedical Solutions Diagnostics company; Ortho-Clinical Diagnostics, a Johnson& Johnson company and with Biosite Incorporated, for the development andcommercialization of immunoassay diagnostic products and with TevaPharmaceuticals Industries for the development of NAT-based drug toxicitybiomarkers. For more information about these transactions, see the Sectionentitled "Our Selected Customers and Collaborators" in this Item 4. 

 

We expect that during 2007 and 2008, together withour licensees and partners, we will continue to validate and develop productsbased on the first wave of discoveries from our immunoassay based diagnosticdiscovery engines. We also intend to continue our discovery activities, whichare currently targeted at cancer and cardiovascular diseases, and we havealready commenced to extend our efforts to other disease areas. 

 

Our development activities with respect to nucleicacid diagnostics, which rely on slightly modified versions of our immunoassaydiscovery engines and our development activities with respect to our databaseof genetic variations, are approximately one and two years respectively behindour immunoassay based diagnostic development activities. 

 

***Research and Discovery Activities***

*** ***

Our research and discovery activities comprise ofthe discovery of therapeutic and diagnostic product candidates. Thesediscoveries have all been made *in silico*. We intend for our research anddiscovery activities to continue to generate discoveries of therapeutic anddiagnostic product candidates as well as create additional discovery enginesand other platforms and technologies that will enable us to add to and improveupon our predictive biology capabilities. 

**__20__** 

 

Our ability to discover therapeutic candidates anddiagnostic product candidates is enabled by our computational platforms,discovery engines and related technologies which we continue to develop. Theseplatforms include our therapeutic proteins and peptides discovery engines, ourdiagnostic biomarkers discovery engines and our LEADScomputational biology platform, our first major technology platform, whichamong other functions, analyzes and rearranges genomic and expressed sequencedata.****

 

In 2005 we began an analysis aimed at selecting newprojects for the development of new platforms and technologies that wouldenable us to discover new types of therapeutic and diagnostic productcandidates that we had not discovered to date. It is our current intentionthat, having attained proof of concept in 2006 for a number of new platformsand technologies, their further development and commercialization will be thesubject of collaborations with pharmaceutical and/or biotechnology partners. 

 

One such project is our structural genomicvariations discovery project developed in 2006. This project comprises thegeneration of a what we believe is the largest database available today of nonsingle******nucleotide polymorphism (SNP), which are medium andlarge-scale genetic variations in the human genome. These variations may bestudied in relation to a number of diseases and other physiological conditions,and are expected to facilitate drug response and disease predisposition studieswith a higher degree of success than current SNP-only approaches.

 

Another project involves G-protein coupledreceptors (also known as "GPCR"s), which are membrane proteinreceptors that are involved in signal transduction of numerous physiologicprocesses. There are approximately 370 GPCRs relevant for drug discovery anddevelopment and at least 40% of drugs in the market are thought to act onGPCRs. It is estimated that at least 40 novel endogenous GPCR peptide ligandshave yet to be discovered. Our peptidome is a collection of thousands of novelhuman peptide sequences which are expected to correspond to natural peptides,and is based on predicting novel cleavage sites in precursor proteins. To date,using our proprietary engines for the discovery of novel peptides, we haveidentified eight novel peptides that activate GPCRs. 

 

Other research projects include the identificationof novel indications for known drugs, targets for monoclonal antibodies andprotein intra-molecular interactions in the context of drug discovery.

 

**Our Enabling Technologies**

 

***Discovery Engines***

 

Our discoveryengines are proprietary computational platforms which in part incorporatesophisticated search and analysis algorithms. Our discovery engines aredesigned to enable our researchers to identify proteins, peptides andtranscripts that are suitable for the development of therapeutic and diagnosticproduct candidates. We use our discovery engines and related technologies inour internal therapeutic and diagnostics discovery efforts. By using theseengines and related technologies, we intend to constantly feed our pipeline ofdiscoveries with novel therapeutic and diagnostic product candidates. 

 

Our approach to discovering novel productcandidates can be applied to the discovery and selection of therapeutic proteinand diagnostic product candidates, potential targets for small molecules, antibodiesand other types of gene products with clinical value, such as DNApolymorphisms, which are changes in the DNA nucleotide base pair sequence. 

 

*Therapeutic Protein and Peptide DiscoveryEngines -*Our**therapeutic protein and peptide discovery engines aredesigned to identify proteins or peptides for which there is substantialevidence indicating a therapeutic utility. One such engine has enable us toselect therapeutic protein product candidates based on their predictedbiological properties such as the existence of a signal peptide, which is abiological signal on the protein directing it to be secreted out of the cellinto biological fluid. Another engine enables us to identify hundreds ofpeptides that are likely to activate GPCRs. The input into our therapeuticcandidates discovery engines is analyzed by proprietary software and automatedprocesses. Its output is thereafter manually analyzed by our scientists andconsulting experts to evaluate each molecule`s potential to become atherapeutic product candidate. 

 

*Diagnostic Biomarker Discovery Engines* -Another example of our discovery engines is our series of diagnostic biomarkerdiscovery engines. These engines identify novel DNA segments, transcripts andproteins, that are differentially expressed in specific tissues or pathologicalconditions, and which may therefore serve as biomarkers for diagnosis. Genes,transcripts and proteins that are involved in various diseases may bedifferentially expressed in such conditions. Our approach to identifying suchgenes, transcripts and proteins is to search *in silico*for, among otherthings, patterns of 

**__21__** 

differential expression, and then to attempt toverify these predictions by experimental methods in our biology laboratory. 

 

Our diagnostic biomarker discovery engines consistof disease-driven biomarker engines and **application-drivenbiomarker engines. The**disease-driven biomarker enginesidentify DNA segments, transcripts and proteins that are expressed differentlyin disease situations, compared to the expression levels of such transcriptsand proteins in normal physiological conditions. The diseases that theseengines target are various cancers, autoimmune diseases and heart-relateddiseases. **The**application-drivenbiomarker engines identify transcripts and proteins that are characterized byselected features or their suitability for certain diagnostic applications. Thenature of these biomarkers is that they are secreted forms of known biomarkersthat can be found in serum, biomarkers that are membrane-bound which aresuitable for in vivo imaging applications and biomarkers that can be used atthe nucleic acid level, primarily in the field of cancer.

 

***Our Approach to Research and Discovery***

*** ***

By incorporating ideas and methods frommathematics, computer science and physics into biology, chemistry and medicine,we attempt to discover novel potential therapeutic and diagnostic productcandidates. Over approximately the past decade, we have been developingtechnologies, including our discovery engines, which enable researchers toidentify genes, transcripts, and proteins that can form the basis for thedevelopment of therapeutic and diagnostic products of interest. Ourmultidisciplinary discovery process combines sophisticated mathematicalmodeling with experimental "wet" biological validation in an iterative processthat is designed to investigate biological phenomena and discover potentiallyvaluable drug targets, therapeutic proteins and diagnostic biomarkers. Webelieve that our approach to drug and diagnostic discovery makes it possiblefor us to further discover novel therapeutic and diagnostic product candidates.

 

Our discovery cycle relies on an iterative processof predictive modeling followed by hypothesis-driven experimentation, yieldingdiscoveries, which in turn, facilitate the improvement of the predictivemodels, thereby increasing the probability of making additional discoveries inthe future. This process nurtures the continuing improvement and enhancement ofour discovery engines and related technologies. 

 

We believe that the mathematical modeling ofsignificant biological phenomena will lead us to better research capabilitiesand to more efficient and effective discovery of potential therapeutic anddiagnostic product candidates. 

 

We believe that the understanding of one biologicalphenomenon that is derived from an understanding of other biological phenomenais made possible as life sciences transform and mature from largelyobservational to more predictive. We believe that a deeper understanding ofbiological phenomena is useful for drug discovery. Our belief is supported bydiscoveries of novel genes and gene-based therapeutic and diagnostic productcandidates that we have already made and that have resulted from our modelingof biological phenomena. Below are five examples of biological phenomena thatwe have modeled:

 

●*       **Alternative Splicing*- alternative splicingis a biological phenomenon whereby a single gene may give multiple differenttranscripts that could be translated into more than one protein. Since 1997, byapplying our proprietary LEADS computational biology platform to the analysisof publicly available genomic information, we discovered that the phenomenon ofalternative splicing occurs in at least 50% of human genes. Previously, scientistsbelieved that alternative splicing occurred in only a very small number ofgenes. By having identified the wide-spread nature of the alternative splicingphenomenon and having developed the computational technologies to identify it,we are able to discover unknown proteins that are encoded by known genes. 

* *

●*       **Antisense* - antisense is a biologicalphenomenon of the existence of two genes that are located on opposite strandsof DNA and, therefore, have complementary nucleic acid sequences. In 2002, byapplying our proprietary LEADS computational biology platform to the analysisof publicly available genomic information, we discovered that the phenomenon ofnaturally occurring antisense in the human genome was significantly more commonthan previously believed. We identified hundreds of antisense pairs of genesand published our findings in the April 2003 issue of Nature Biotechnology,Volume 21, No. 4. 

* *

●*       **RNA Editing* - RNA editing is a biologicalphenomenon in which small nucleotide changes occur in RNA after itstranscription from DNA. Although it has been known that RNA editing is anessential factor for mammalian development and although recent evidence hassuggested that it may be a fairly common phenomenon, very few RNA editing siteshad been actually discovered and it was generally believed to be impossible tosystematically discover such sites with current experimental and computationalprocedures and tools. We developed and proved 

**__22__** 

●*       *systematic identification of adenosine to inosine(A to I) RNA editing sites in the human transcriptome, and increased the numberof known A to I RNA editing sites from approximately 100 to 12,723. Ourdiscovery was published in the August 2004 issue of Nature Biotechnology,Volume 22, No. 8. 

* *

●*       **Processed Pseudogenes* - processedpseudogenes are naturally occurring copies of genes that were created throughreverse transcription of mature spliced messenger RNAs, ormRNAs and then reinserted into the genomeat a new location. These genomic sequences are generally considered "junk DNA".However, through analysis of thousands of such human pseudogenes with ourpredictive methodology, we were able to predict the existence of hundreds ofnovel transcript variants, a selected subset of which were then experimentallyvalidated in our biology laboratories. Our discovery was published in theJanuary 2006 edition of the Proceedings of the National Academy of Sciences (USA).  

* *

●*       **Cleavage sites* - Peptides are cleaved fromlarger precursor proteins. We have developed technology that predicts novelcleavage sites in known proteins, and as a consequence, predicts novelpeptides. This technology enables us to search for therapeutically interestingnovel peptides, such as peptides that are ligands to G-protein coupledreceptors (GPCRs).

** **

**Our Products and Commercial Offerings**

*** ***

Our therapeutic and diagnostic product candidates,that we offer for out-licensing, exclusively comprise our own discoveries. Webelieve that our unique approach to drug discovery makes it possible for us toidentify novel therapeutic and diagnostic product candidates. 

 

Our most commercially advanced product area isimmunoassay diagnostics. We have signed agreements with three leadingdiagnostic companies, each of which have the right to develop and commercializeour diagnostic product candidates and in each of which our candidates are indifferent stages of development. 

 

Other commercial offerings for which we havealready signed agreements for development and commercialization areantibody-targets and biomarkers for the detection of drug toxicity inpreclinical stages of the drug development process.

 

For more information about these transactions, see"Our Selected Customers and Collaborators." 

 

We also seek toout-license and form joint development collaborations around drug candidatesfrom our therapeutics program as they emerge with positive results. Forcandidates that will not be directly out-licensed, we expect to work togetherwith collaborators during pre-clinical and early clinical stages, providing anexclusive license to the collaborator for further clinical development andcommercialization. Current candidates for which collaborators are sought are:

●*                  *our therapeutic protein candidates comprising atruncated form of the c-Met receptor, a variant of the MCP1 protein and twopeptide hormones deriving from the precursor of two natriuretic peptidehormones (atrial natriuretic peptide (ANP) and Urodilatin) - relevant tocertain cancers, inflammatory diseases and cardiovascular diseases and renalindications respectively; and 

●*                  *eight peptides that were shown to activate GPCRsknown as MAS1 and MAS-related GPCRs, MRGX1 and MRGX2, as well as FPRL1 and twoof the Relaxin family receptors, RXFP1 and RXFP2. 

 

For our therapeutic product candidates, we expectto continue seeking collaborators for development and commercialization as wegenerate more experimental data in support of those candidates' potential tobecoming viable therapeutic product candidates. 

 

We intend to generate revenue from commercializingour pipelines of therapeutic protein and diagnostic biomarker productcandidates through commercial relationships with potential collaborators andlicensees, including leading biotechnology, diagnostic and pharmaceuticalcompanies. We intend to receive payments upon the successful completion ofpredetermined development stages, and royalties from the sale of therapeuticand diagnostic products based on our discoveries. 

* *

We offer our prospective collaborators a license todevelop and commercialize our therapeutic and diagnostic product candidates. Bycollaborating with us, our prospective collaborators, primarily pharmaceutical,diagnostic and biotechnology companies, would be able to gain access to the advantagesoffered by use of our proprietary discovery engines and multidisciplinary teamof experts. These collaborations are intended to yield novel putative genes andgene-based products, 

**__23__** 

including transcripts and proteins, to enable ourcollaborators and licensees to develop and commercialize therapeutic anddiagnostic products based on our discoveries. 

* *

##### Our Selected Customersand Collaborators

*** ***

We have to date already entered into agreementsunder which we out-licensed novel therapeutic and diagnostic productcandidates. We intend to continue to focus on licensing-out our noveltherapeutic and diagnostic product candidates, to pharmaceutical, biotechnologyand diagnostics companies. In exchangefor the commercializing our products, we seek to receive from these companiespayment****upon the successfulcompletion of certain predetermined developmental stages and milestones, androyalties from the sales of the drugs and/or diagnostics applications. Underall of the agreements that we have entered to date, we are not subject to anyobligation to actually attain developmental, commercialization or othermilestones.

* *

In March 2007 we announced our entry into anagreement with Biosite Incorporated (Biosite) for the development andcommercialization of immunoassay diagnostic products. Entering into thisagreement was an expansion of our immunoassay diagnostic collaboration withBiosite, which we entered into in June 2005. Our second agreement with Biositeexpanded the number of potential diagnostic biomarkers that we made availableto Biosite for selection. Furthermore, our existing collaboration was expandedto cover additional diagnostic fields such as cardiovascular and oncology. Aswith the initial agreement, we are entitled to receive milestone payments androyalties from the sale of any products emerging from the collaboration.

* *

In January 2007, we announced our entry into acollaborative agreement with Medarex, Inc. to develop novel monoclonalantibody-based therapeutics for oncology and autoimmune diseases. Under theterms of the agreement, we will share with Medarex discovery, development andcommercialization responsibilities on antibody-based therapeutics resultingfrom the collaboration, and share revenues generated from the sale of suchtherapeutic products. Under the collaboration, we expect to utilize ourproprietary antibody-target discovery engine to identify novel drug targets.Medarex plans to develop fully human antibodies against these targets using itsproprietary system for developing human antibodies. The collaboration alsoprovides that we may independently pursue diagnostic applications involvingcertain antibodies and targets. 

 

In January 2007, we also announced our entry intoan agreement with Teva Pharmaceutical Industries to collaborate on a projectfor the discovery of biomarkers for the detection of drug toxicity inpreclinical stages of the drug development process. The initial focus of thecollaboration will be on biomarkers for the early detection of potentialnephrotoxicity (being toxicity to kidney cells). We may jointly choose toexpand the scope of the collaboration to include biomarkers for the detectionof hepatotoxicity (being toxicity to liver cells) and/or cardiotoxicity (beingtoxicity to heart cells) in response to drug treatment. We have granted Teva alicense to use the discovered markers for research and development activitieswhile retaining commercialization rights for licensing to other companies, aswell as rights for internal use. Under the collaboration, we expect to utilizeour proprietary computational tools, discovery engines and nucleic acid testingtechnologies for the purpose of predicting and validating toxicity biomarkers.Our integrated analysis will incorporate data derived from biological samplescollected by Teva in a preclinical study designed specifically for thisproject, as well as our proprietary expression and clinical data.

 

We currently coordinate a consortium funded by the European 6th Framework aspart of a three year collaborative project, which commenced on January 1 2006. The grants the Company will receive from this project do not bear anyrepayment royalties. We enjoy the generic knowledge accumulated in thecollaborative project and, as a coordinator of this project, receive theconsortium funds from the European Commission and distribute those funds to theconsortium members based on an agreement among the consortium members. 

 

In June 2005, we announced our entry into acollaboration with Ortho-Clinical Diagnostics, Inc, a Johnson & Johnsoncompany, or OCD , for the development and commercialization of immunoassaybased diagnostic products that are based on the output of our diagnosticdiscovery engines. The terms of this agreement allow OCD to select up to ninediagnostic biomarkers which we will then collaborate on the initial clinicalvalidation of the selected biomarkers. Under the agreement, successfullyvalidated biomarkers will be developed into products and commercialized by OCD.In exchange, we will receive milestone payments and license fees for eachcommercialized biomarker, in addition to revenue-based royalties. We appliedtogether with OCD for a grant from the Israel-U.S. Bi-national IndustrialResearch and Development Foundation for contribution to our research anddevelopment expenditures under our joint collaborative project. For moreinformation about this grant, see "Item 5.****Operating and FinancialReview and Prospects; Research and Development, Patents and Licenses."

**__24__** 

 

 

In June 2005, we also announced our entry into acollaboration with Biosite, for the development and commercialization ofimmunoassay based diagnostic products based on the output of our diagnosticdiscovery engines. Under the terms of this agreement, we granted to Biosite anexclusive license in the diagnostic field to use certain of our targets forimmunoassay based diagnostic applications. In return for this grant, we areentitled to receive milestone payments and royalties from the sales of eachdiagnostic product emerging from the collaboration. 

 

In August 2004, we entered into a broad pipelinediscovery-based collaboration with Diagnostic Product Corporation, a divisionof Siemens Medical Solutions Diagnostics, (DPC), for the development andcommercialization of certain diagnostic products based on the output of ourdiagnostic discovery engines. The terms of this agreement allow DPC to developand commercialize immunoassay and nucleic-acid based diagnostic products thatare based on candidate biomarkers that we already discovered, as well asadditional candidates that may arise out of the collaboration. We are entitledto receive milestone payments and royalties from the sales of each diagnosticproduct emerging from the collaboration. In February 2006, we entered into anexpansion agreement with DPC under which we agreed to collaborate in relationto up to an additional five diagnostic product candidates. The terms of theexpansion agreement entitle DPC to acquire a license to candidates thatCompugen validates using serum samples to be supplied by DPC, in considerationfor an option and milestone payments that are in excess of the analogouspayments under the original agreement. 

 

**Our Strategy******

*** ***

We seek to generate revenues from our collaboratorsand licensees with whom we contract tofurther develop andcommercialize therapeutic and diagnostic products that are based on ourdiscoveries. We intend to share in the revenues generated. In the case oflicensing arrangements, we intend to share by way of receiving payments uponthe successful completion of certain predetermined development stages,milestones, and royalties from the sales of the drugs or diagnostics products,which will be based on our discoveries. In the case of collaborations whichinclude joint commercialization of products, we intend to receive a directshare of the revenues.

* *

We also seekto generate revenues from our collaborators harnessing our research anddiscovery capabilities, including our discovery engines, for the purpose oftheir specific research and development programs.Incases where we provide our research and discovery capabilities for the purposeof our partners' specific programs, we intend to receive annual research feesas well as milestone payments upon the successful completion of certainpredetermined development stages, as well as royalties from the sales of thetherapeutic and diagnostics products, based on our discoveries.

 

We believe that we can commercializediscoveries that result from our in-house discovery programs or that resultfrom collaboration discovery projects aimed at a given area of interest to ourcollaborators and/or their profile of requirements.

 

To date, we havecommenced implementing this strategy by entering into a collaboration andlicense agreement with each of Diagnostic Products Corporation, Ortho-ClinicalDiagnostics, Biosite, and Teva, for the development and commercialization ofnovel diagnostic products and with Medarex for the development andcommercialization of novel therapeutic products.

 

**Subsidiaries**

*** ***

***Keddem Bioscience Ltd.***

*** ***

In 1999, we formed a chemistry division thatfocused on substantially increasing the predictability and success rates ofsmall molecule drug discovery. On August 1, 2004, we turned this division intoa wholly-owned subsidiary, Keddem Bioscience. For more information on KeddemBioscience, see Item 7. "Major Shareholders and Related Party Transactions;Related Party Transactions. Keddem Bioscience Ltd.". 

 

Keddem Bioscience is a drug discovery company thataims to improve the success rate for the discovery of new drug products bydeveloping and applying a technology platform that consistently enables thedesign of small molecules which can potentially modulate a given proteintarget. 

 

Identifying a lead chemical for a potential targetis a long, arduous and expensive undertaking, considered by many to be theprincipal bottleneck in small molecule drug discovery. Common methods forfinding such small molecules, typically involving high-throughput screening ofdrug like compounds, have low success rates and often fail to find anycandidate compound for a given target.

**__25__** 

 

 

KeddemBioscience`s method does not rely on protein structure information orhigh-throughput screening of very large compound libraries. Instead,KeddemBioscience`s approach is based on the proposed creation of a comprehensive, yetrelatively small set of approximately 70,000 carefully designed molecules and aset of algorithms. Keddem Bioscience intends******to synthesize thisset of molecules and then use it in a screening process, in which the activityof drug targets will be tested against the screening library molecules. KeddemBioscience`s ability to implement its intention to synthesize a set ofapproximately 70,000 molecules will depend on the availability to it of all thenecessary resources, including funding. The design of Keddem Bioscience`s setof molecules is aimed at obtaining information that, when analyzed by itsproprietary algorithms, will provide accurate and comprehensivethree-dimensional information about a drug target`s active site. Keddem Biosciencebelieves that this information can then be used to design a variety of potentinhibitors satisfying desired drug-like properties. Keddem Bioscience`sapproach is unique in that it is designed to generate information relating to aprotein`s active sites, sufficient to enable the design of small molecules drugcandidates.  

 

Keddem Bioscience has been experiencing operatinglosses since its incorporation and has accumulated a deficit of approximately$2,917,000 at December 31, 2006. Keddem Bioscience's ability to continue, as a going concern in the next year is dependent onits ability to raise additional funding until the stage at which its operationsmay become profitable. 

** **

***Evogene Ltd.***

*** ***

In 1999, we formed a division focusing onagricultural biotechnology and plant genomics. On January 1, 2002, we converted  this division into a majority-owned subsidiary, Evogene Ltd. 

 

In February, 2006, Evogene entered into an equityinvestment agreement with certain investors for $7,000,000, of whichapproximately $2,000,000 was originally received as a bridge loan in January2005. We did not participate in the investment in Evogene under this financinground. Under the equity investment agreement, the investors agreed to convertall outstanding loans into equity. Following the entering into that equityinvestment agreement, irrevocable proxies that we previously granted to certaininvestors in Evogene with respect to approximately 50% of our holding inEvogene, empowering them to vote in a manner determined in their discretion,ceased to be of force and effect. As a result, as of February 28, 2007, we had the power to vote 15.01% of Evogene's share capital. For more information onour holdings in Evogene, see Item 7. "Major Shareholders and Related PartyTransactions; Related Party Transactions; Evogene Ltd." 

 

Evogene is a crop genetics company, focused on thedevelopment of improved traits in commercially important plants through genediscovery, genome remodeling and advanced classical breeding techniques.Evogene's current product development efforts are focused on enhanced fiber incotton, abiotic stress tolerance and nitrogen use efficiency in various crops,and a unique plant platform for the production of therapeutic proteins. Formore information, see below "Organizational Structure" in this Item 4 and Item7. "Major Shareholders and Related Party Transactions; Related PartyTransactions; Evogene Ltd."

 

**Sales, Marketing and Business Development**

*** ***

Since our incorporation in 1993, we devoted most of our capital and humanresources to research and development of our technologies, discoveries,products and services. Since 2003 we moved away from commercializing oursoftware tools and software products and began concentrating our efforts on ourin-house discovery activities and commercializing those discoveries. Inconnection with this shift in strategy, we reduced the number of our marketing,sales and business development staff from 19 employees in 2002 to fiveemployees by the end of 2006.  

** **

The approximate geographical breakdown of ourrevenues for the year ended December 31, 2006 was 7% in North America and 93%in Europe. The approximate geographical breakdown of our revenues for the yearended December 31, 2005 was 65% in North America, 34% in Europe and less than onepercent in other countries. The approximate geographical breakdown of ourrevenues for the year ended December 31, 2004 was 40% in North America, 48% inEurope, 10% in the Far East and 2% in other countries. 

 

In the United States, we had business developmentpresence in Rockville, Maryland and until March 2007 in San Jose, California.  

*** ***

**RawMaterials**

*** ***

We use a large range of raw materials in our research. For our researchand discovery activities, we use bioinformatics 

**__26__** 

databases such as databases of ESTs, which are short nucleotidesequences that code for the expression of partial mRNA, databases on DNAsequences gene expression databases, including from microarrays, databaseswhich link proteins to diseases, protein interaction pathway databases and databasesthat match drugs with their respective targets. We also use a large range ofbiological reagents such as cell growth media, enzymes, antibodies andchromatographic resins for our therapeutics validation activities and a rangeof biological reagents such as human tissue samples, cell lines and certainenzymes for our diagnostic validation activities. These raw materials areeither freely available or easily available to us or to our customers atreasonable prices. 

* *

We rely on the quality and integrity of the raw materials that we use.We have encountered circumstances in which tissue samples that we acquired werefound to be of poor quality. Such circumstances may delay and even interferewith our discovery and development efforts. 

 

**Intellectual Property Rights****  **

*** ***

Our intellectual property assets are our principalassets. These assets include the intellectual property rights subsisting in ourproprietary know-how and trade secrets, the copyrights subsisting in oursoftware and related documentation and in our patents and patent applications.We seek to vigorously protect our rights and interests in our intellectualproperty. We expect that our commercial success will depend on, among otherthings, our ability to obtain commercially valuable patents especially for ourtherapeutic and diagnostic product candidates, maintain the confidentiality ofour proprietary know-how and trade secrets and otherwise protect ourintellectual property.

 

We seek patent protection for inventions thatrelate to our therapeutic and diagnostic potential product candidates as wellas certain components of our technology platforms. We currently have eightregistered patents of which 7are registered in the United States and 1 isregistered in Australia. We also have 97 pending patent applications, whichinclude 34 patent applications that have been filed in the United States and 8eight applications that have been filed under the Patent Cooperation Treaty forwhich we have not yet designated the countries of filing. We intend to continueto apply for patent protection for our therapeutic and diagnostic inventions,including for related inventions such as antibodies and peptides. 

 

We also seek protection for our proprietaryknow-how and trade secrets that are not protectable or protected by patents, byway of safeguarding them against unauthorized disclosure. This is done throughthe extensive use of confidentiality agreements and assignment agreements withour employees, consultants and third parties as well as by technological means.We use license agreements both to access third party technologies and to grantlicenses to third parties to exploit our intellectual property rights. 

** **

**Competition**

*** ***

The biotechnology and pharmaceutical industries arehighly competitive. Numerous entities in the United States and elsewherecompete with our efforts to make discoveries and commercialize them. Ourcompetitors include pharmaceutical, biotechnology and diagnostic companies,academic and research institutions and governmental and other publicly fundedagencies. 

 

We face, and expect to continue to face,competition from entities that discover and develop products that have afunction similar or identical to the function of our therapeutic and diagnosticproduct candidates. In respect of our diagnostic product candidates, wepotentially face competition from any company to the extent that it discoversor develops diagnostic products, and especially, if its products are aimed atdiagnosing cancers and cardiovascular diseases as well as toxicity biomarkers.  Thesecompanies include companies such as Roche, Abbott and Bayer as well as CorixaCorporation, diaDexus, Inc., and Celera Diagnostics. In respect of ourtherapeutic product candidates, our potential competitors comprise companiesthat develop or commercialize therapeutic protein or peptides such as Amgen,Inc., Wyeth Pharmaceuticals, Inc., Genentech, Inc., Xencor, Inc. andZymogenetics, Inc.

 

Our discovery program depends, in large part, onour discovery engines and other technologies and our proprietary data to makeinventions and establish intellectual property rights in genes and gene-basedproducts, including mRNAs, proteins and peptides. There are a number of othermeans by which such inventions and intellectual property can be generated. Webelieve that our computational technologies, and specifically our discoveryengines, provide us with a competitive advantage in the field of predictinggene based products, and occasionally gain some information on their biologicalimportance. We believe that this advantage is made possible by theincorporation of ideas and methods from mathematics and computer science intobiology, and by the modeling of significant biological phenomena and theresultant better research capabilities that we developed. Nevertheless, we maylose this advantage if our existing or future competitors make scientific andtechnological progress. In addition, we may discover and pursue the developmentof therapeutic or diagnostic 

**__27__** 

product candidates that could conflict with ourcollaborators` discovery and development plans, including licensees orcollaborators to whom we granted in the past a license to use our computationalplatforms. The prospect of such a conflict arising is particularly pertinent inrelation to those collaborators and licensees that received from us a licenseto use our LEADS computational platform to analyze raw data which is the sameor similar to the raw data that we may analyze through LEADS.  

 

**Government Regulation**

** **

***Environmental Regulation***

 

Some of our research and development activitiesinvolve the controlled use of biological and chemical materials, a small amountof which could be considered to be hazardous. We also have the facilities forsafe use and handling of radioactive materials, although these facilities arecurrently not in use. We are subject to Israeli laws and regulations governingthe use, storage, handling and disposal of all these materials and resultingwaste products. We store relatively small amounts of biological and chemical materials.To our knowledge, we substantially comply with these laws and regulations.However, the risk of accidental contamination or injury from these materialscannot be entirely eliminated. In the event of an accident, we could be heldliable for any resulting damages, and any liability could exceed our resources.

 

***Regulation of Use ofHuman Tissue***

* *

We need to access and usevarious human or other organisms` tissue samples for the purpose of developmentand or validation of some of our products. Our access and use of these samplesis subject to government regulation, in the US, Israel and elsewhere and maybecome subject to further regulation. US and other governmental agencies mayalso impose restrictions on the use of data derived from human or other tissuesamples. To our knowledge, we substantially comply with these regulatoryrequirements. 

 

***Regulation of Products Developed with theSupport of Research and Development Grants***

*** ***

For a discussion of regulations governing productsdeveloped with research and development grants from the Government of Israel,see "Item 5. Operating and Financial Review and Prospects; Research andDevelopment, Patents and Licenses; Israeli Government Research and DevelopmentPrograms."

** **

**Organizational Structure**

 

We are the parent of two wholly-owned subsidiaries,Compugen USA, Inc., which is a Delaware corporation with its principal place ofbusiness in California, and Keddem Bioscience Ltd., which is an Israeli companywith its principal place of business in Ashqelon, Israel. 

*** ***

As of February 28, 2007, we also held and had the power to voteapproximately15.01% of the outstanding share capital of Evogene Ltd.. For more informationon Evogene, see Item 7. "Major Shareholders and Related Party Transactions;Related Party Transactions; Evogene Ltd." Evogene is not consolidated into ourconsolidated financial statements for the year 2006. For an explanation of ourreason for not consolidating Evogene into our financial statement, see Item 5."Operating And Financial Review And Prospects;" "Critical Accounting Policies;""Investment in Evogene Ltd." Evogene was formed under the laws of the State ofIsrael and has its principal place of business in Rehovot, Israel. 

*** ***

##### Property, Plant andEquipment

** **

We lease an aggregate of approximately 28,200square feet of office and biology laboratory facilities in Tel Aviv, Israel.The leases in Tel Aviv expire in December 2009. Since February 28, 2006, we sublease approximately 3,800 square feet of thisspace to another entity.*  *

 

Keddem Bioscience leases approximately 7,750 squarefeet of office and biology laboratory facilities in Ashqelon, Israel. The leasein Ashqelon expires on August 31, 2011, and Keddem Bioscience is entitled toterminate it effective on every anniversary of the lease.

 

In addition, Compugen USA leases approximately 406square feet of office space in San Jose, California which expires on May 30, 2007. Compugen USA had also leased approximately 145 square feet in Rockville, Marylandwhich lease expired in January 2006. 

**__28__** 

** **

 

We believe that the facilities that we currentlylease are sufficient for approximately the next 12 months. 

 

There are no encumbrances on our rights in theseleased properties or on any of the equipment that we own. 

 

To our knowledge, there are no environmental issuesthat affect our use of the properties that we lease. 

ITEM 4A.              UNRESOLVEDSTAFF COMMENTS

 

Not Applicable

**__29__** 

### ITEM 5.                  OPERATING AND FINANCIALREVIEW AND PROSPECTS

*** ***

The following discussion of our critical accountingpolicies and our financial condition and operating results should be read inconjunction with our consolidated financial statements and related notes,prepared in accordance with US GAAP for the years ended December 31, 2006, 2005and 2004 respectively, and with any other selected financial data includedelsewhere in this annual report.

*** ***

##### Background

*** ***

We are a biotechnology discovery company focused onthe discovery oftherapeuticand diagnostic product candidates. Our powerful predictive models and discoveryengines enable us to discover numerous potential therapeutics and diagnosticbiomarkers. This capability results from our decade-long pioneering efforts inthe deeper understanding of important biological phenomena at the molecularlevel through the incorporation of ideas and methods from mathematics, computerscience, and physics into biology, chemistry and medicine.  To date, product discovery efforts andourinitial discovery efforts have focused mainly on cancer, cardiovascular andimmune-related diseases. Product development is pursued both in-house andthrough collaborative arrangements. Our primary commercialization pathway forour therapeutic and diagnostic product candidates is to enter into milestoneand revenue sharing out-licensing and joint development agreements with leadingcompanies.

 

Approximately3 years ago, we shifted our business focus to our current business model. Our primary focus was to use our intellectual property,scientific know-how and computational biology capabilities to develop, marketand sell to third parties life science software products and services. We usethose assets and capabilities in our current business.  

 

We carry out three principal activities with afocus on the discovery, validation and commercialization of our therapeutic anddiagnostic biomarker product candidates. These three activities consist of atherapeutics, diagnostic biomarkers, and research and discovery activities. 

 

We develop technological platforms, discoveryengines and other related technologies that better enable us to discover andanalyze genes and gene-based products, including transcripts and proteins.These technologies include our discovery engines, such as our therapeuticprotein discovery engine and our diagnostic biomarkers discovery engines.  

 

Our discovery engines are proprietary technologiesthat are designed to enable our researchers to identify proteins andtranscripts that are suitable for the development of therapeutic and/ordiagnostic product candidates. Our discovery engines extend the capabilities ofour LEADS platform by incorporating sophisticated search and analysisalgorithms to select the most promising therapeutic proteins and diagnosticbiomarkers in a specific category or area of interest, from the many proteinsidentified by our technologies. The LEADS computational biology platform is our firstmajor technology platform, which among other functions, analyzes and rearrangesgenomic and expressed sequence data.

 

By using thesediscovery engines and related technologies, we have discovered novel moleculesthat may be suitable for developing therapeutic and diagnostic productcandidates. Based on our belief in the capabilities of our discovery enginesand related technologies, it is our intention to continue our efforts in theidentification of additional therapeutic and diagnostic biomarkers productcandidates. We have an early stage in-house project for the discovery and earlystage development of selected potential therapeutic and diagnostic productcandidates . Going forward, we plan to continually develop and enhance ourinternal capabilities of discovering therapeutic and diagnostics productcandidates. We intend to continue to pursue licensing arrangements andcollaboration agreements with leading biotechnology, diagnostic andpharmaceutical companies, for the development and commercialization of productcandidates that we discover through the use of our discovery engines andrelated technologies. 

**__30__** 

 

 

OPERATINGRESULTS

*** ***

#####  Overview

 

***We have incurredlosses and our revenues are likely to decrease in the next few years***. 

* *

Since our inception, we haveincurred significant losses and, as of December 31, 2006, we had an accumulateddeficit of $107.9 million (not including approximately $24.9 million inaccumulated deficit attributable to the conversion of preferred shares upon theclosing of our initial public offering). We expect to continue to incur netlosses in the forseeable future. 

 

Prior to 2004, our primarybusiness was to develop and sell hardwareand software platforms, tools and databases, in which we incorporated certainaspects of our understandings and/or discoveries and made them available to ourcustomers. For example, in 2004, our revenues were primarily attributable tothe commercialization of our LEADS platform, Genecarta and OligoLibraries. Weno longer pursue the commercialization of these products.  

 

We have already and now intend to continue tocommercialize our therapeutic and diagnostic product candidates. We identify these candidates by applying our intellectualproperty, scientific know-how and computational biology capabilities, includingour discovery engines. To date, our discoveries have formed the basis of ourcollaborations with Diagnostic Products Corporation, a division of SiemensMedical Solutions Diagnostics, Ortho-Clinical Diagnostics, a Johnson &Johnson company, Biosite Incorporated, Medarex Inc., and Teva PharmaceuticalIndustries. We continue to evaluate various opportunities for additionalcollaborations. We intend to continue to focus on the licensing out of our noveltherapeutic and diagnostic product candidates. We intend that suchlicensing-out arrangements will be with pharmaceutical, biotechnology anddiagnostics companies, which will develop and commercialize therapeutic ordiagnostic products based on our discoveries and that we will receive milestonepayments upon the successful completion of predetermined developmental stagesand royalties from the sales of the therapeutic or diagnostics products 

 

We believe thatthe greatest long term and sustainable financial potential for us lies in ourability to continually evolve and further develop our powerful predictivemodels and discovery engines, which  enable us to discover andcommercialize numerous potential therapeutics and diagnostic biomarkers and thecommercialization of specific therapeutic and diagnostic biomarker productcandidates. 

*** ***

Since we shifted our focus away fromcommercializing our computationally-based products to the discovery of therapeutic and diagnostic productcandidates, our revenues have decreased. Our revenues decreased byapproximately 67% in 2006 compared to our 2005 and****byapproximately 75% in 2005, compared to 2004 and by approximately 61% in 2004compared to 2003. 

 

***Our net research and development expenses areexpected to account for more than 50% of our total operating expenses.***

 

Our net research and development expenses areexpected to be our major operating expense in 2007, accounting for more than50% of our total 2007 operating expenses. Our research and development expenseshave always comprised a significant portion of our expenses. In 2004 and 2005,we increased the resources allocated to research and development in order toadvanceour internal therapeutic and diagnostic biomarkers pipeline. In 2006, as aresult of our December 2005 re-organization, our operating expenses andresearch and development expenses decreased. These expenses continued to be,and we expect will continue to be, our largest operating expense. 

 

Previously, we presented governmental and othergrants as a component of our revenues and grants, based on the single stepincome statement presentation approach. These amounts have been reclassifiedfor all periods presented and are now shown as a deduction from research anddevelopment expenses. 

*** ***

***We base our budget and operating expenses onour cash flow.***

*** ***

We base our budget and operating expenses on ourcash flow. For a detailed description of our cash and cash equivalentsposition, see "Liquidity and Capital Resources" in this Item 5. 

 

**__31__** 

##### Compensation expenses attributed to optiongrants.

 

We recorded compensation expenses of approximately$755,000 in 2004, and approximately $378,000 in 2005,and approximately $1.9 million in 2006 in connection with the grant of shareoptions. These expenses are mostly attributable to options that we granted toour employees and directors and to those of our consultants to whom we grantedstock options at the higher of the fair market value known on the date of grantor the average of our share price during the thirty trading days preceding thedate of grant. These amounts are amortized over the vesting periods of theindividual share options. Based on options granted through December 31 2006 and on our ordinary share price on that date, we estimate that our futureamortization of compensation expenses will be approximately $1.5 million in2007 and approximately $1.3 million in 2008. Since January 2006, new accountingstandard SFAS 123R applies. Standard SFAS 123R determines the accountingtreatment for share-based compensation to employees. The above futureamortization of compensation expense estimates for 2007 and 2008 reflect theapplication of this standard. These estimates are subject to the amount ofgranted options at any given point in time. Our current policy is to grant optionsat the higher of the fair market value known on the date of grant or theaverage of our share price during the thirty trading days preceding the date ofgrant.  

 

##### Impact of Inflationand a Devaluation of the Dollar against theNew Israel Shekel

 

We hold most of our cash, cash equivalents depositsand marketable securities in US dollars but incur a significant portion of ourexpenses, principally salaries and related personnel expenses, in New IsraelShekels. As a result, we are exposed to the risk that the US dollar will bedevalued against the New Israel Shekels. To date, our business has not beenmaterially adversely affected by changes in the Israeli rate of inflation orthe exchange rates of the NIS compared to the US dollar. 

* *

##### Critical AccountingPolicies 

 

The preparation of our consolidated financialstatements and other financial information appearing in this annual reportrequires our management to make estimates and judgments that affect thereported amounts of assets, liabilities, revenues and expenses, and relateddisclosure of contingent assets and liabilities. We evaluate on an on-goingbasis these estimates, mainly related to revenues,  contingencies,and investment in affiliates. 

 

We base our estimates on our experience and onvarious assumptions that we believe are reasonable under the circumstances. Theresults of our estimates form the basis for our management`s judgments aboutthe carrying values of assets and liabilities that are not readily apparentfrom other sources. Actual results may differ from these estimates underdifferent assumptions or conditions.

 

***Revenue Recognition***

*** ***

During 2004, 2005 and 2006******wegenerated most of our revenues from license fees related to thecommercialization of our software products. We also generated revenues from thesale of services, including from the provision of maintenance, support,customization, training and installation services, and also from the sale ofproducts (such as our OligoLibraries products). 

 

We recognizesoftware license revenues in accordance with Statement of Position("SOP") 97-2, "Software Revenue Recognition" ("SOP 97-2"),as amended and SOP 98-9, "Modification of SOP 97-2, Software RevenueRecognition with Respect to Certain Transactions" ("SOP 98-9"). SOP 97-2generally requires revenues earned on software arrangements involving multipleelements to be allocated to each element based on the relative fair value ofthe elements. SOP 98-9 requires that revenues be recognized under the"Residual Method" when vendor specific objective evidence (VSOE) offair value exists for all undelivered elements and no VSOE exists for thedelivered elements and all revenue recognition criteria of SOP 97-2, asamended, are satisfied. Revenues from license fees are recognized whenpersuasive evidence of an agreement exists, delivery of the product hasoccurred, no significant obligations with regard to implementation remain, thefee is fixed or determinable, and collectability is probable. 

 

Maintenanceand support revenues included in these arrangements are deferred and recognizedon a straight-line basis over the term of the maintenance and supportagreement. The VSOE of fair value of the undelivered elements (maintenance,support and professional services) is determined based on the price charged forthe undelivered element when sold separately or based on renewal rate.

 

We licenseproducts on either a perpetual or on a term basis. License revenues arisingfrom the sale of perpetual licenses and term licenses for a period longer thanone year are recognized in the accounting period during which the sale tookplace. 

**__32__** 

Licenserevenue arising from a term license for a period of one year or less isrecognized over the contractual term of the license.

 

Revenues fromsoftware license fees that involve customization of the our software tocustomer specific specifications, development services, integration andinstallation are recognized in accordance with SOP 81-1 "Accounting forPerformance of Construction-Type and Certain Production-Type Contracts"("SOP 81-1"), using contract accounting on a percentage of completion method,over the period from signing of the license through to customer acceptance inaccordance with the "Input Method". The amount of revenue recognizedis based on the total license fees under the license agreement and thepercentage to completion achieved. The percentage to completion is measured bymonitoring progress using records of actual time incurred to date in theproject compared to the total estimated project requirement, which correspondsto the costs related to earned revenues. Estimates of total projectrequirements are based on prior experience of customization, delivery andacceptance of the same or similar technology and are reviewed and updatedregularly by management. After delivery, if uncertainty exists about customeracceptance of the software, license revenue is not recognized until acceptance.Provisions for estimated losses on uncompleted contracts are made in the periodin which such losses are first determined, in the amount of the estimated losson the entire contract. 

 

We believethat the use of the percentage of completion method is appropriate as we havethe ability to make reasonably dependable estimates of the extent of progresstowards completion, contract revenues and contract costs. In addition,contracts executed include provisions that clearly specify the enforceablerights regarding services to be provided and received by the parties to thecontracts, the consideration to be exchanged and the manner and terms ofsettlement. In all cases, we expect to perform its contractual obligations andits licensees are expected to satisfy their obligations under the contract. 

 

During 2004,revenues from sales of products (OligoLibraries) were recognized in accordancewith Staff Accounting Bulletin ("SAB") No. 104 "RevenueRecognition in Financial Statements", and EITF No. 99-19 "Reportinggross revenues as a principal vs. net as an agent", when delivery hasoccurred, persuasive evidence of an agreement exists, the vendor's fee is fixedor determinable, no further obligation exists and collectability is probable.

 

Deferred revenues include amounts received fromcustomers for which revenue has not been recognized.

 

***Contingencies***

 

We periodically estimate the impact of variousconditions, situations and/or circumstances involving uncertain outcomes to ourfinancial condition and operating results. These events are called"contingencies", and the accounting treatment for such events is prescribed bythe Statement of Financial Accounting Standards No. 5, "Accounting forContingencies" ("SFAS No. 5"). SFAS No. 5 defines a contingency as "an existingcondition, situation, or set of circumstances involving uncertainty as topossible gain or loss to an enterprise that will ultimately be resolved whenone or more future events occur or fail to occur". Legal proceedings are a formof such contingencies.

 

We are not currently involved in any legalproceedings and are not required to assess the likelihood of any specificadverse judgments or outcomes of such proceedings or of any potential ranges ofprobable losses. A determination of the amount of any accruals, if required,for these contingencies would be made after careful analysis. For moreinformation in relation to legal proceedings, see "Item 8.****FinancialInformation; Consolidated Statements and Other Financial Information; LegalProceedings." It is possible, however, that future results of operations forany particular quarter or annual period could be materially affected by changesin our assumptions or as a result of the effectiveness of our strategiesrelated to these legal proceedings.

 

***Investment in Evogene Ltd.***

 

The investment in Evogene is accounted for inaccordance with APB 18, "The Equity Method of Accounting for Investmentsin Common Stock". Through February 2006, time when Evogene completed amajor finance round we accounted for the investment under the equity method.The finance round resulted in our holdings being diluted to below 20% ofEvogene's outstanding stock. As such, from the date of the financing round, wecan not exercise significant influence over operating and financial policies ofEvogene and the carrying amount of the investment is currently accounted forunder the Cost method. Under the Cost method, we do not adjust the carryingamount of the investment to recognize our share of the earnings or losses ofEvogene.

* *

**__33__** 

#####  Results of Operations

 

***Selected FinancialData***

 

The following discussion andanalysis is based on and should be read in connection with our auditedconsolidated financial statements, including the related notes, contained in"Item 18 - Financial Statements" and the other financial information appearingelsewhere in this annual report. 

*** ***
| ** **

****                                                                                    | Year ended December 31                                            |
|-----------------------------------------------------------------------------------------------------|-------------------------------------------------------------------|
| ** **

****                                                                                    |  

2002                                                      |  

2003 |  

2004 |  

2005 |  

2006 |
|                                                                                                | (US$ in thousands, except share and per share data)               |
| **Consolidated  Statements of Operations Data**                                                     |                                                                   |  |  |  |   |
|                                                                                                |                                                                   |  |  |  |   |
|   Revenues                                                                                | $        9,262                      | $        6,776 | $        2,630 | $        646 | $        215 |
|                                                                                                |                           |   |   |   |   |
|   Cost  of revenues                                                                       |  

2,819                                                     |  

2,275 |  

1,100 | 148 | 6 |
| Research  and   development expenses                                                      |  

14,170                                                    |  

13,306 |  

12,318 | 12,725 | 11,561 |
| Less -  governmental and other grants                                                               |  

(1,835)                                                   |  

(2,050) |  

(1,397) | (2,254) | (1,751) |
| Research  and   development expenses, net                                                 |  

 

12,335                                            |  

 

11,256 |  

 

10,921 | 10,471 | 9,810 |
| Selling  and marketing expenses                                                                     |  

5,538                                                     |  

3,811 |  

2,446 | 1,772 | 1,719 |
| General  and administrative expenses                                                                |  

3,614                                                     |  

3,650 |  

3,740 | 3,133 | 2,673 |
| Total  operating expenses *                                                                         |  

24,306                                                    |  

20,992 |  

18,207 |  

15,524 |  

14,208 |
|         Operating loss                                                | (15,044)                                                          | (14,216) | (15,577) | (14,878) | (13,993) |
| Financial  and other income, net                                                                    |  

2,840                                                     |  

2,774 |  

1,855 |  

900 |  

973 |
| Net  loss                                                                                           | $      (12,204)                               | $      (11,442) | $      (13,722) | $      (13,978) | $      (13,020) |
|                                                                                                |                                                              |   |   |   |   |
| Basic  and diluted net loss per ordinary share                                                      |  

$          (0.47) |  

$          (0.43) |  

$          (0.50) |  

$          (0.50) |  

$          (0.47) |
| Weighted  average number of ordinary shares used in computing basic and diluted net  loss per share |  

 

 

 

26,103,343                        |  

 

 

 

26,409,180 |  

 

 

 

27,473,341 |  

 

 

 

27,774,535 |  

 

 

 

27,985,957 |

 

**__34__** 

 
|                                                                                                                 | As of December 31, |
|----------------------------------------------------------------------------------------------------------------------|--------------------|
| ** **                                                                                                           | 2002               | 2003 | 2004 | 2005 | 2006 |
|                                                                                                                 | (US$ in thousands) |
| **Consolidated Balance Sheet Data:**                                                                                 |                    |  |  |  | * * |
| Cash and cash equivalents, short-term deposits,  marketable securities and cash held in favor of consortium partners | $48,402            | $16,707 | $20,574 | $31,821 | $25,403 |
| Long-term deposits and marketable securities                                                                         | 18,940             | 43,803 | 27,854 | 4,983 | 1,000 |
| Trade receivables                                                                                                    | 4,601              | 1,456 | 1,545 | 676 | 856 |
| Inventory                                                                                                            | 111                | - | - | - | - |
| Total assets                                                                                                         | 77,257             | 67,526 | 55,353 | 42,106 | 30,856 |
| Accumulated deficit                                                                                                  | (80,592)           | (92,034) | (105,756) | (119,734) | (132,754) |
| Total shareholders' equity                                                                                           |  

68,881     |  

59,808 |  

49,566 |  

36,248 |  

25,738 |

* *

(*)    Includesdeferred stock compensation - see Note  11 of our 2006 consolidatedfinancial statements.

*** ***

*** ***

***Years Ended******December 31, 2006******and 2005***

*** ***

*Revenues.* We have been shifting our business model away from thesale of our software products in order to concentrate on identifyingtherapeutic and diagnostic candidates.  As a result, revenuesdecreased by 67% to approximately $215,000 in 2006 from approximately $646,000in 2005. The decrease in revenues was anticipated andprimarilydue to decreased sales of LEADS and related products. The decrease in the salesof these products is attributable to the shift away from commercializing ourcomputational products. We have ceasedcommercializing these products. Revenues from Novartisrepresented 93% of our revenues in 2006. Our agreement with Novartis expired in2006.

* *

*Cost of Revenues.*Cost of revenues decreasedby 96% to approximately $6,000 for 2006 from approximately $148,000 for 2005.This decrease was primarily due to our cessation of commercializing our legacy products andthe fact that we have not yet generated any revenues from product candidates.

 

*Researchand Development Expenses, Net.*Research and development expenses, netdecreased by 6%, to approximately $9.8 million for 2006 from approximately$10.5 million for 2005. The decrease in our research and development expenses,net, was primarily due to both a reduction in the number of our personnel andrelated expenses which followed the re-organization that we underwent inDecember 2005, and a decrease in governmental and other research anddevelopment grants that we received. Had we not adopted SFAS 123(R), whichresulted in an increase of approximately $1.4 million of deferred stockcompensation in 2006 compared to 2005, the decrease in research and developmentexpenses would have been higher. 

** **

*Selling and Marketing Expenses*. Selling andmarketing expenses decreased by 3% to approximately $1.7 million for 2006 fromapproximately $1.8 million for 2005. This decrease was due to a reduction inthe number of our personnel and related expenses. Had we not adopted SFAS123(R), which resulted in an increase of approximately $269,000 of deferredstock compensation in 2006 compared to 2005, the decrease in selling andmarketing expenses would have been higher. Selling and marketing expenses, as apercentage of revenues, increased from 274% in 2005 to 800% in 2006. 

* *

*General and Administrative Expenses.*Generaland administrative expenses decreased by 15% to approximately $2.7 million for2006 from approximately $3.1 million for 2005. This decrease was primarily dueto a reduction in the number of our personnel and related expenses as a resultof the re-organization that we underwent in December 2005. 

* *

*Financial Income, Net.*Financial income,net, increased by 30% to approximately $884,000 for 2006 from approximately$682,000 million for 2005. This increase was attributable mainly to higherinterest rates we received on deposits and marketable securities.

**__35__** 

*** ***

***Years Ended******December 31, 2005******and 2004***

*** ***

*Revenues.* Revenues decreased by 75% toapproximately $646,000 in 2005 from approximately $2.6 million in 2004. Thedecrease in revenues was primarily due to decreased sales of LEADS andOligolibraries. Revenues from Novartis and Abbott represented 98% of ourrevenues in 2005. Our agreement with Abbott expired in 2005.  

 

*Cost of Revenues.*Cost of revenues decreasedby 87% to approximately $148,000 for 2005 from approximately $1.1 million for2004. This decrease was primarily due to decreased costs related to the sale ofour OligoLibraries and LEADS products. 

 

*Research and Development Expenses, Net.*Researchand development expenses, net decreased by 4%, to approximately $10.5 millionfor 2005 from approximately $10.9 million for 2004. The decrease in ourresearch and development expenses, net, was primarily due to an increase ingovernmental and other research and development grants that we received. 

 

*Selling and Marketing Expenses*. Selling andmarketing expenses decreased by 28% to approximately $1.8 million for 2005 fromapproximately $2.4 million for 2004. This decrease was due to our decision todecrease our marketing and sales efforts for our computational products andrelated services. 

* *

*General and Administrative Expenses.*Generaland administrative expenses decreased by 16% to approximately $3.1 million for2005 from approximately $3.7 million for 2004. This decrease was primarily dueto the closing of our offices in New Jersey. General and administrativeexpenses, as a percentage of revenues, increased from 142% for 2004 to 485% in2005. 

* *

*Financial Income, Net.*Financial income,net, decreased by 52% to approximately $682,000 for 2005 from approximately$1.4 million for 2004. This decrease was attributable to manner in which weearned interest on three structured notes, at par value totaling $14 million.Whether or not these structured notes bear interest depends upon the rate forsix-months LIBOR. For each day on which the six-month dollar LIBOR is below anagreed annual fixed rate, the investments bear coupon interest at the rate of3.15%, 3.625% and 4.1% per annum******respectively. For each day onwhich the six-month dollar LIBOR is above an agreed annual fixed rate, theinvestments, do not bear interest at all. The decrease was also attributable tolower levels of cash and cash related accounts. 

*** ***

***Years Ended******December 31, 2004******and 2003***

* *

*Revenues.* Revenues decreased by 61% toapproximately $2.6 million in 2004 from approximately $6.8 million in 2003. Thedecrease in revenues was primarily due to decreased sales of LEADS, Genecarta,and Oligolibraries.. Revenues from Novartis and Sigma-Genosys represented 61%of our revenues in 2004. Our agreement with Sigma-Genosys terminated in 2004. 

 

*Cost of Revenues.*Cost of revenues decreasedby 52% to approximately $1.1 million for 2004 from approximately $2.3 millionfor 2003. This decrease was primarily due to decreased costs related to thesale of LEADS, Genecarta and OligoLibraries. 

 

*Research and Development Expenses, net.*Researchand development expenses, net decreased by 3% to approximately $10.9 millionfor 2004 from approximately $11.3 million for 2003. The decrease in researchand development expenses, net was primarily due to decrease in cost of salariesdue to a reduction of employees, and decrease of depreciation expenses. 

* *

*Selling and Marketing Expenses*. Selling andmarketing expenses decreased by 36% to approximately $2.5 million for 2004 fromapproximately $3.8 million for 2003. This decrease was due to our decision todecrease our marketing and sales efforts for some of our existing hardware andsoftware products and related services. Selling and marketing expenses, as apercentage of revenues increased from 56% in 2003 to 93% in 2004.

* *

*General and Administrative Expenses.*Generaland administrative expenses increased by 2% to approximately $3.7 million for2004 from approximately $3.65**million for 2003. This increase wasprimarily due to an increase in our CEO`s salary, and to the costs associatedwith the closing of our offices in New Jersey. 

* *

*Financial Income, Net.*Financial income,net, decreased by 33% to approximately $1.4 million for 2004 from approximately$2.1 million for 2003. This decrease was attributable to lower levels of cashand cash related accounts, and lower interest rates we received on short andlong-term marketable securities. 

**__36__** 

 

* *

Governmental Policies that Materially Affected orCould Materially Affect Our Operations 

*** ***

Until January 2007, Israelicompanies were generally subject to income tax at the corporate tax rate of31%, and since January 2007, this was reduced to 29%, and is expected to befurther reduced to 27% in 2008 to 26% in 2009 and to 25% in 2010 andthereafter. However, several investment programs at our facility in Tel Avivhave been granted Approved Enterprise status under which we are eligible for areduced rate of corporate tax under the Law for the Encouragement of CapitalInvestments, 1959. Subject to compliance with applicable requirements, theportion of our profits that may be derived from the approved enterpriseprograms will be tax-exempt for a period of two years commencing in the firstyear in which we generate taxable income from the applicable ApprovedEnterprise. The portion of our profits that may be derived from our approvedenterprise programs will be subject, for an additional period of five or eightyears, to reduced corporate tax rates of between 10% and 25%. The tax ratewithin the range of 10% and 25% that may actually become payable is a functionof the percentage of non-Israeli investors holding our ordinary shares.These reducedcorporate tax rates will cease to apply uponthe expiry of the earlier of twelve years from the time at which we attain aprescribed level of investment in our approved enterprise (known as"commencement of production") or 14 years from the date on which we receivedapproval for an Approved Enterprise. The period of tax benefits withrespect to our approved enterprise programs has not yet commenced, because wehave not yet generated any taxable income. These benefits should result inincome recognized by us being tax exempt or taxed at a lower rate for aspecified period of time after we begin to report taxable income and exhaustany net operating loss carry-forwards. However, these benefits may not beapplied to reduce the US federal tax rate for any income that our US subsidiarymay generate. There can be no assurance that such tax benefits will continue inthe future at their current levels, if at all.

 

As of December 31, 2006, we had not generated anytaxable income. As of December 31, 2006, our net operating loss carry-forwardsfor Israeli tax purposes amounted to approximately $83.5 million. Under Israelilaw, these net-operating losses may be carried forward indefinitely and offsetagainst certain future taxable income. 

 

At December 31, 2006, the net operating losscarry-forwards of our US subsidiary for US tax purposes amounted toapproximately $15 million. These losses are available to offset any future UStaxable income of our US subsidiary and will expire between the years 2012 and2024. 

*** ***

Use of our US net operating losses may be subjectto substantial annual limitation due to the "change in ownership"provisions of the Internal Revenue Code of 1986 and similar state provisions.The annual limitation may result in the expiration of net operating lossesbefore utilization. 

 

For a description of Israel government policiesthat affect our research and development expenses, and the financing of ourresearch and development, see "Research and Development, Patents and Licenses;Research and Development Grants" in this Item 5 below.

 

 

LIQUIDITY AND CAPITAL RESOURCES

** **

In 2006, as in 2005 and, 2004, our sources of cashcame from 

 

●*                  *Our IPO which took place in August 2000

●*                  *Revenues generated from sales

●*                  *Governmental and other sources of grants

●*                  *The exercise of employee stock options

●*                  *Financing income. 

We used these fundsprimarily to finance our business operations. 

**__37__** 

***Equity Financing***

 

From our inception until the initial publicoffering of our ordinary shares in August 2000, we obtained financing primarilythrough private placements of equity securities, and, to a lesser extent,governmental and other grants and loans. Financing activities from privateplacements of preferred and ordinary shares, net of issuance costs, providedcash of approximately $14.8 million in 1998, approximately $19,000 in  1999and approximately $35.5 million in 2000.

 

In August 2000, we sold 5,000,000 of our ordinaryshares in the initial public offering of our shares on the Nasdaq GlobalMarket, and in September 2000, we sold an additional 750,000 ordinary sharesupon the exercise by our underwriters of their over-allotment option. Ouraggregate proceeds from these sales were $57.5 million ($51.1 million net ofissuance expenses). All outstanding preferred shares were converted intoordinary shares upon the closing of the initial public offering. 

 

***Net Cash Used in Operating Activities***

 

Net cash usedin operating activities was approximately $12.2 million in 2004, approximately$11.1 million in 2005 and approximately $9.9 million in 2006. These amountswere used to fund our net losses for these periods, adjusted for non-cashexpenses and changes in operating assets and liabilities. The sources of thecash that we used in our activities through 2006 was the cash we had in thebank, revenues,  governmental and other grants that we received, thereceipts from the exercise of employee stock options, and financing income. Weexpect that our sources of cash for 2007 will be similar. Our subsidiaries arenot restricted from transferring funds to Compugen, although we do not expectany cash to flow in from them.  

 

***Net Cash Provided By Investing Activities***

 

Net cash used in investing activities consists ofproceeds from redemption of marketable securities, net of purchases of propertyand equipment, plus investment grants relating to fixed assets. Net cashgenerated by investing activities was approximately $5.9 million in 2004,approximately $15.1 million in 2005 and approximately $7.0 million in 2006. Thedecrease in net cash provided by investing activities in 2006 was mainlyattributable to  the investing activities in bank deposit andmarketable securities. 

 

***Net Cash Provided by Financing Activitie****s*

 

Our net cash provided by financing activities wasapproximately $2.7 in 2004, approximately $178,000 in 2005 and approximately$665,000 in 2006. The principal sources of cash provided by financingactivities in 2006 were  proceeds that we received from the issuanceof ordinary shares as result of the exercise of stock options by employees. 

*** ***

***Net Liquidity***

*** ***

Liquidity refers to theliquid financial assets we have available to fund our business operations andpay for near term future obligations. These liquid financial assets consist ofcash and cash equivalents as well as short-term and long-term deposits andmarketable securities. As of December 31, 2006, we had cash and cashequivalents, , and short-term deposits and marketable securities ofapproximately $25.4 million, and long-term deposits and marketable deposits ofapproximately $1 million. We believe that our existing cash and cashequivalents, short-term and long-term deposits and short-term and long-termmarketable securities will be sufficient to fund our operations for at leastthe next two years. However, we expect that we will need additional financingin the future to fund our activities. 

** **

As of December 31, 2006, Keddem Bioscience had cashand cash equivalents and short-term deposits of approximately $301,000.Webelieve that Keddem Bioscience`s existing cash and cash equivalents will besufficient to fund its operations for less than one year. In both 2005 and2006, Keddem Bioscience`s external auditors raised substantial doubts on KeddemBioscience`s ability to continue as a going concern.

**__38__** 

** **

** **

 

RESEARCH ANDDEVELOPMENT, PATENTS AND LICENSES 

*** ***

We invest heavily inresearch and development. Research and development expenses, net, were ourmajor operating expenses, representing more than 50% of the total operatingexpenses for each of , 2004, 2005 and 2006. Our research and developmentexpenses, net, were approximately $9.8 million in 2006, compared withapproximately $10.5 million in 2005 and approximately $10.9 million in 2004. Asof December 31, 2006,  58 of our employees were engaged in researchand development on a full-time basis. This represents approximately 72% of ourentire work force. 

 

Consistent with our shift in focus away fromselling our computational and software products, we now focus our research anddevelopment efforts on the development of our discovery engines and relatedtechnologies, and of our therapeutic proteins and diagnostic biomarker productcandidates. We expect that in 2007 our research and development expenses netwill continue to be our major operating expense, representing more than 50% ofour total operating expenses. 

 

We believe that our future success will depend, inlarge, on our ability to continue to expand our inventory of promisingpotential therapeutic proteins and diagnostic biomarkers, which we intend todiscover through the use of our discovery engines and related technologies andvalidate in our and third parties` respective molecular biology laboratories.

* *

***Research and Development Grants***

*** ***

We participate in programs offered by the Office ofthe Chief Scientist under the Industry and Trade Ministry of Israel ("OCS")that supports research and development activities, by the Israel-U.S.Bi-national Industrial Research and Development Foundation ("BIRD") and by theEuropean Community, under the European Union`s 6th FrameworkProgram. We received grants and other forms of consideration from the OCS ofapproximately $1.4 million in 2004 and from the OCS and BIRD of approximately$2.3 million in 2005 and grants and other forms of consideration from the OCS,BIRD and European Union of approximately $1.8 million in 2006. We have appliedfor additional grants from the Office of the Chief Scientist for research,technological development and demonstration activities in 2007. 

 

*The Office of the Chief Scientist*

* *

We received grants from the OCS for severalprojects. Under the terms of these grants, we will be required to pay royaltiesranging between 3% to 5% of the net sales of products developed from theOCS-funded projects, beginning with the commencement of sales of such productsand ending when 100% of the dollar value of the grant is repaid (100% plusLIBOR interest applicable to grants received on or after January 1, 1999). Theroyalty rate varies depending on the amount of years that lapse between receiptof the grant and its repayment by us. As of December 31, 2006, our contingent accrued obligation for royalties, based on royalty-bearing government grants,net of royalties already paid, totaled approximately $4 million payable out offuture net sales of products that were developed under OCS -funded projects. 

 

Israeli law requires that the manufacture ofproducts developed with government grants will be carried out in Israel, unlessthe OCS provides its approval to the contrary. Following legislative changes toIsraeli legislation in 2005, this approval, if provided, is generallyconditioned on an increase in the total amount to be repaid to the OCS, to upto 300% of the amount of funds granted. The specific increase within thisceiling would depend on the extent of the manufacturing to be conducted outsideof Israel. Alternatively, the restriction on manufacturing outside of Israelshall not apply to the extent that plans to manufacture were disclosed whenfiling the application for funding (and provided the application was approvedbased on the information disclosed in the application). We believe that thisrestriction does not apply to the commercialization through licensing ofproduct candidates that we develop by using or based on our OCS-fundedtechnologies or discoveries. In such circumstances, the OCS will take intoaccount the proposal that OCS-funded projects will have an overseasmanufacturing component. Under applicable Israeli law, Israeli governmentconsent is required to transfer to Israeli third parties technologies developedunder projects, which the government funded. Transfer of OCS-fundedtechnologies outside of Israel is prohibited, unless conducted in accordancewith the restrictions set forth under Israeli law. Israeli law furtherspecifies that both the transfer of know-how as well as the transfer ofintellectual property rights in such know-how are subject to the samerestrictions. These restrictions do not apply to exports from Israel or thesale of products developed with these technologies. 

 

In addition to the OCS programs described above, weparticipated in a number of research consortia in which Israeli researchinstitutions and high technology companies are members. These consortia aredevoted to the development of generic technologies in the fields ofbiotechnology, agricultural biotechnology and pharmaceuticals. The OCS MAGNET 

**__39__** 

program sponsors these consortia. Under the termsof the MAGNET program, the OCS contributes 66% of the consortium`s researchbudget that the OCS approves and the consortium industry members contribute theremaining 34%. No royalties are payable to the OCS with respect to thisfunding. Expenses in excess of the approved budget are borne by the consortiummembers. 

 

In general, any member of a consortium thatdevelops technology in the framework of a consortium retains the intellectualproperty rights to this technology and all other consortium members have theright to use and implement this technology without having to pay royalties tothe developing consortium member, provided that the technology will not betransferred under any circumstances to any entity outside of the consortium.The terms of the program prohibit both the manufacture of products usingtechnology developed in the context of the program outside of Israel and thetransfer of technology developed under the program to any Israeli third party,without the prior written consent of the OCS.

*  *

*Bi-national Industrial Research and DevelopmentFoundation (BIRD)*

*** ***

In 2005 we, together with OCD became jointlyentitled to receive from BIRD a grant for our joint collaborative project withOCD, according to a budget that was approved by BIRD. The BIRD Foundation'smission is to stimulate, promote and support industrial research and developmentof mutual benefit to the US and to Israel. The BIRD Foundation offers researchand development grants of up to one million dollars for a collaboration. 

 

We entered into a tripartite cooperation andproject funding agreement with OCD and BIRD based on BIRD`s standard terms andconditions. The term of the funded collaborative project is 4 years. BIRD`sstandard terms and conditions require its grantees to repay 100% of the grantmonies, provided that repayment is made within the first year following expiryof the term of the project. For every year of delay in these repayments, theamounts to be repaid incrementally increase up to an amount of 150% in thefifth year following expiry of the term of the project. All amounts to berepaid to BIRD are subject to us generating revenue from commercializing thefunded project and linked to the U.S. consumer price index.

 

The Governments of Israel and of the United Statesare each entitled to a non-exclusive, royalty-free license to make and use anyproducts generated from the funded project. Otherwise, neither we not OCD aresubject to any restrictions relating to the ownership or commercialization ofthe intellectual property and products generated from the funded collaborativeproject.

 

As of December 31, 2006, our contingent accruedobligation for royalties, based on royalty-bearing BIRD grant, totaledapproximately $460,000 payable out of future net sales of products that weredeveloped under BIRD funded project.

 

*The European Union`s 6th FrameworkProgram*

 

In 2005 we joined two research consortia under theEuropean Union's 6th Framework Program, which is a program based onthe Treaty establishing the European Union, with the aim of promoting researchand technology among the European Community members. 

 

We are the appointed coordinator of one of theseresearch consortia, which means that we are the consortium`s primary contactwith the European Community for the purpose of managing the consortium`sprogress. This includes a responsibility to distribute the research grantmonies to the consortium members and to provide to the European Communityreports describing the consortium`s progress of the funded research. 

 

The terms of the grant from the European Communitydo not require us to repay the grant monies that we receive, unless we or anyof our consortium members default in our obligations such as carrying out theresearch that we undertook to perform, or in reporting the progress of theresearch. 

 

TRENDINFORMATION 

** **

***Trend towards consolidation***

*** ***

There is a trend towards consolidation in thepharmaceutical diagnostic and biotechnology industries, which may negativelyaffect our ability to enter into agreements. This trend often involves largercompanies acquiring smaller companies, and this may result in the largercompanies having greater financial resources and technological capabilities.This trend towards consolidation in the pharmaceutical diagnostic andbiotechnology industries may also result in there being fewer customers for ourproducts and services. Also, if one of the consolidating companies already usesthe technologies or services of our competitors, we may lose existing customersas a result of such consolidation. 

**__40__** 

 

** **

***Trend towards making genomic data and relatedsoftware publicly available***

*** ***

Large amounts of genomic bioinformatic data areincreasingly becoming available to the general public.. Following thepublication of the first draft of the human genome, there has been an increasein public efforts to develop analysis tools for understanding genomic,functional genomic and proteomic data. These efforts have already resulted andmay further result in the future in the development of products, which arecompetitive to ours and that are available free of charge. Such developmentscould require us to lower our prices, could cause some of our products to beless commercially viable or to be obsolete, or could assist third parties todiscover genes or proteins that are of interest to us.

 

***The pharmaceutical industry is generallyready to consider in-licensing potential therapeutic products which are at theearly stage of their development***

 

Pharmaceutical and biotechnological companies are generally ready toconsider in-licensing product candidates at a stage of development which issignificantly earlier than Phase II clinical trials and even at pre-clinicalstages. As a result, we are able to seek to enter into agreements relating tothe further development and commercialization of our early stage productcandidates.

* *

However, there may be a trend towards pharmaceutical andbiotechnological companies being willing to in-license only product candidatesthat are at a stage of development beyond the stage of development that wecurrently seek to attain for our product candidates, as has been the case inthe past. In such circumstances, we may be required to invest a substantialamount of money and other resources in each product candidate, withoutassurance that its product candidates will be commercialized and the number ofproduct candidates in which we will be able to invest our research anddevelopment resources will be limited. 

 

If, consistent with our strategy forcommercialization of our diagnostic and therapeutic product candidates, we aresuccessful in commercializing our product candidates at an early stage ofdevelopment, the consideration that we expect to receive would be relativelylow. The consideration that we would expect to receive in consideration forcommercializing our products candidates increases commensurately with the stageof development that we attain for our product candidates**.**

** **

OFF-BALANCE SHEET ARRANGEMENTS

 

We are not a party to any materialoff-balance-sheet arrangements. 

** **

TABULAR DISCLOSURE OF CONTRACTUAL OBLIGATIONS

*** ***

The table below summarizes our contractualobligations as of December 31, 2006, and should be read together with theaccompanying comments that follow. 

** **
|                                                        | Payments due by period

(US$ in thousands) |
|-------------------------------------------------------------|--------------------------------------------|
|                                                        | Total                                      | Less than 1 year | 1-3 years | 3-5 years |
| Operating Lease Obligations                                 | $1,634                                     | $564 | $1,070 | $0 |
| Accrued Severance Pay Reflected  on our Balance Sheet       | 1,483                                      | 0 | 0 | 1,483 |
| Other Long-Term Liabilities  Reflected on our Balance Sheet | 60                                         | 0 | 40 | 20 |
| Total                                                       | 3,177                                      | 564 | 1,110 | 1,503 |

 

The above table does not include royalties that wemay be required to pay to the OCS or BIRD. For more information, see "Researchand Development, Patents and Licenses" in this Item 5. We are unable toreasonably estimate the time and the amounts that we will eventually berequired to pay to the OCS and BIRD, if at all, since these amounts and timesdepend on our ability to sell products based on the OCS and BIRD -fundedtechnologies and the timing of any such sales. 

 

**__41__** 

The above table also does not include contingentcontractual obligations or commitments that may crystallize in the future, suchas contractual undertakings to pay royalties subject to certain conditionsoccurring. 

### ITEM 6.                  DIRECTORS, SENIOR MANAGEMENTAND EMPLOYEES

** **

##### Directors and SeniorManagement

** **

The following sets forth information with respectto our directors and executive officers as of March 1, 2007***.***

** **
| Name                     | Age | Positions                                                      |
|--------------------------|-----|----------------------------------------------------------------|
| Martin S. Gerstel        | 65  | Chairman of the Board of Directors                             |
| Alex Kotzer              | 60  | President, Chief Executive Officer, President and  Director    |
| Orna Berry, Ph.D         | 57  | Director                                                       |
| David Schlachet          | 61  | Director                                                       |
| Ruben Krupik1            | 55  | Director                                                       |
| Nurit Benjamini          | 40  | Chief Financial Officer                                        |
| Eli Zangvil, MD          | 43  | Vice President, Business Development                           |
| Anat Cohen Dayag, Ph.D   | 40  | Vice President, Diagnostic Biomarkers and Therapeutic  Targets |
| Yossi Cohen**,**M.D**.** | 35  | Vice President, Research and Development                       |

* *

1              Ruben Krupikresigned from our board of directors effective as of April 15, 2006 

**Martin S. Gerstel** has served as our chairmansince August 1997. Prior to 1994, Mr. Gerstel was co-chairman and CEO of ALZACorporation , which he helped found in 1968. Mr.Gerstel is also the Chairman of Evogene Ltd. and Keddem Bioscience Ltd.,co-founder and co-chairman of Itamar Medical, and serves as a director ofYissum Ltd., Yeda Ltd. and the Foundation for the US Foundation for theNational Medals of Science and Technology. He is a member of the Board ofGovernors and the Executive Committee of the Weizmann Institute of Science andthe Board of Governors of The Hebrew University of Jerusalem, and is an advisorto the Burrill Life Science Funds and the board of the Israel-US Bi-nationalIndustrial Research and Development (BIRD) Foundation. Mr. Gerstel holds a B.S.from Yale University and an MBA from Stanford University.

 

**Alex Kotzer******joined Compugen inSeptember 2005 as President and Chief Executive Officer and a director. Mr. Kotzerbrings with him over thirty years of senior managerial experience in variousindustries. Prior to joining Compugen, he served for twelve years at Serono(virt-x: SEO and NYSE: SRA), a global biotechnology leader, headquartered in Switzerland.During his tenure at Serono, Mr. Kotzer held several senior positions, mostrecently as Vice President of Biotechnology Manufacturing. Previously, Mr.Kotzer was President and Chief Executive Officer of InterPharm, Serono'sIsraeli affiliate. Before joining Serono, he held a variety of managerialpositions in the food and chemical industries. Mr. Kotzer received his B.Sc. inChemical Engineering from the Technion, Israel Institute of Technology, of Haifa, Israel.

** **

**Orna Berry****, Ph.D**joined our board ofdirectors as an outside director in June 2001. She is a Venture Partner atGemini Israel Funds, and the Chairperson  of the IVA, Israel VentureAssociation, Prime Sense, Inc. and Adamind Ltd. From 1997 through 2000, she wasthe Chief Scientist of the Ministry of Industry, Trade and Labor of theGovernment of Israel. Dr. Berry was the co-founder of ORNET Data CommunicationTechnologies Ltd. She served as the Chief Scientist of Fibronics International Inc****and as a seniorresearch engineer in several companies, including IBM and UNISYS**.  **Dr. Berry received her Ph.D. in computer science from the University of Southern California and her M.A. and B.A. degrees in statistics and mathematics fromTel Aviv and Haifa Universities in Israel, respectively. Dr. Berry serves as anoutside director on our board of directors for a fixed term, which expires inJune 2007.

**David Schlachet******joined our board ofdirectors as an outside director in June 2001. Since 2005 he serves as the CEOof Syneron Medical Ltd. (Nasdaq: Elos).He also serves on the Boards of Directors of the following companies: TayaInvestment Company Ltd., United Studios Ltd., Pharmos Ltd., Edgar Developmentand Investment Ltd., and LanOptics 

**__42__** 

Nasdaq:LNOP. From 2000 and until 2004, he was a managingpartner of BioCom Management and Investment (2002) Ltd, which serves as themanaging company of BioCom venture capital fund, focused on life sciences. From1997 to January 2000, he was Chairman of the Board of Directors of EliteIndustries Ltd. From 1996 to January 2000, Mr. Schlachet served as VicePresident of the Strauss Group of companies. Mr. Schlachet holds a B.Sc. inchemical engineering from the Technion, Israel Institute of Technology and anMBA from the Tel Aviv University, Israel. Mr. Schlachet serves as an outsidedirector on our board of directors for a fixed term, which expires in June2007.

** **

**Ruben Krupik**joined our board of directorsin 2003 and ceased being a director of our company effective as of April 15, 2007. Mr. Krupik serves as the President and CEO of Arte Venture Group Ltd.,which provides a framework of business development, investments and managementfor various large investment entities in Israel. Mr. Krupik serves as the CEOof Clal Biotechnology Industries. Concurrently, Ruben serves as the generalmanager of Biomedical Investments, the active chairman of a number of Israelihigh-tech companies, such as GamidaCell, D-Pharm, CureTech and Mediwound. From1991 to 2000 Mr. Krupik held a number of positions, including the President andCEO of RDC (Rafael Development Corporation Ltd.). Prior to that, Mr. Krupikheld a number of senior management positions at Tadiran Communications Group.Mr. Krupik holds an LL.B. in law from the Tel Aviv University and a BA inEconomics and Political Science from the Hebrew University, Israel.

** **

**Nurit Benjamini******joined us in 2000bringing over ten years of experience in the Israeli and international economicfield. Prior to joining us, Ms. Benjamini served as CFO of Phone-Or Ltd.Between 1993 and 1998, Ms. Benjamini was CFO at Aladdin Knowledge Systems Ltd.(NASDAQ: ALDN). Ms. Benjamini holds a B.A. in Economics and Business and an MBAin Finance, both from Bar Ilan University, Israel.

** **

**Anat Cohen-Dayag****, Ph.D**. joinedCompugen in 2002 as Director of Diagnostics, a position she held until 2005 atwhich time she became Vice President Diagnostic Biomarkers and assumed hercurrent position, Vice President Biomarkers and Therapeutic Targets, in January2007. Prior to joining Compugen, she was head of research and development andmember of the Executive Management at Mindsense Biosystems Ltd. Prior toMindsense Biosystems, Dr. Cohen-Dayag served as a scientist at the R&Ddepartment of Orgenic. Dr. Cohen-Dayag holds a B.Sc. in Biology from theBen-Gurion University, Israel, and an M.S. in Chemical Immunology and a Ph.D.in Cellular Biology, both from the Weizmann Institute of Science, Israel.

** **

**Yossi Cohen****, M.D.**joined Compugen in2001, holding several senior research and development positions until 2005 atwhich time he was appointed as Compugen's Vice President, Research andDiscovery, and until he assumed his current position, Vice President Researchand Development, in January 2007. Dr. Cohen's diverse prior experience includesserving as a physician in the Israel Defense Forces and holding varioussoftware development positions in the Israeli hi-tech industry. Dr. Cohen has aB.S. in Electrical and Electronics Engineering from the Tel-Aviv University, Israel,and an M.S. in Neurobiology and an M.D., both from the Hebrew University,Israel.

 

**Eli****Zangvil****, M**.**D**.joined Compugen in November 2006 as Vice President Business Development. Hepreviously served as Chief Operating Officer of UltraShape headquartered in Tel-Aviv., Israel, and prior to that was Head of Medical Services of the Israeli DefenceForce's Central Command where he held the rank of Colonel. Dr. Zangvil holds anM.D. from the Hebrew University of Jerusalem and specializes in internalmedicine, and a Master's Degree in Health Administration from the Tel-AvivUniversity, Israel. 

 

##### Compensation

*** ***

The aggregate compensation paid by us and by ourwholly-owned subsidiaries to all persons who served as directors or seniormanagement for the year 2006 (11 persons) was approximately $1.5 million. Thisamount includes approximately $269,000 set aside or accrued to provide pension,severance, retirement or similar benefits.

 

During 2006, we granted a total of 1,390,000 options to purchase ordinary shares to our directors andsenior management, as a group. These options are exercisable at a range ofbetween $3 and $4.13****per share, and generally expire ten years aftertheir respective dates of grant. As of December 31, 2006, there were a total of3,763,428 outstanding options to purchase ordinary shares that were granted toour directors and senior management, and 278,065 outstanding options that weregranted to the members of our scientific advisory board.  

 

All members of our board of directors who are notour employees or consultants are reimbursed for their expenses for each meetingattended and are eligible to receive share options under our share optionplans. The aggregate amount paid to all of our non-employee directors for theyear ended December 31, 2006 was approximately $ 42,000. These fees areadjusted semi-annually to reflect changes prescribed by regulations under theIsrael Companies Law, 5759-199 (the 

**__43__** 

"Companies Law"), for payment to outsidedirectors. Members of our scientific advisory board receive cash compensationand, have been granted and may be granted further stock options for theirservices.  

** **

***Approvals Required for Compensation to ourDirectors***

 

In accordance with therequirements of Israeli Law, we determine our directors` compensation in thefollowing manner:

 

●*       *first, a proposal for compensation is submitted toour audit committee, which then reviews the proposal;

●*       *second, provided that the audit committee approvesthe proposed compensation, the proposal is then submitted to our board ofdirectors for review, except that a director who is the beneficiary of theproposed compensation does not participate in any discussion or voting withrespect to such proposal; 

●*       *finally, if our board of directors approves theproposal, it must then submit its recommendation to our shareholders, which isusually done during our shareholders` general meeting; and

●*       *the approval of a majority of our shareholders isrequired to implement any such compensation proposal.

 

##### Board Practices

#####  

##### *Election of Directors andTerms of Office*

 

Our board of directors consisted of five members asat December 31, 2006, including our chairman and chief executive officer. Otherthan our two outside directors, our directors are elected by an ordinaryresolution at the annual general meeting of our shareholders. Effective from April 15, 2007, Ruben Krupic ceased being a director on our board of directors.

 

Unless they resign before the end of their term orare removed in accordance with our Articles of Association, all our directors,other than our outside directors, will serve as directors until our next annualgeneral meeting of shareholders.  

 

Dr. Orna Berry and Mr. David Schlachet serve asoutside directors pursuant to the provisions of the Companies Law for a secondthree-year term ending in June 2007. 

 

None of our directors or officers have any familyrelationship with any other director or officer.

 

None of our directors are entitled to receive anyseverance or similar benefits upon termination of his or her service, except forMr. Alex Kotzer, who is entitled pursuant to the terms of his employmentagreement, to receive severance in the amount of a multiple of six times hisgross monthly salary, as may be updated from time to time if the companyterminates his employment without justifiable cause. Mr. Alex Kotzer`sentitlement to this severance payment is in addition to any severance paymentto which he would be entitled to receive under relevant law in suchcircumstances. 

 

Our Articles of Association permit us to maintaindirectors' and officers' liability insurance and to indemnify our directors andofficers for actions performed on behalf of the company, subject to specifiedlimitations.  

 

***Outside and Independent Directors***

 

The Companies Law requiresIsraeli companies with shares that have been offered to the public either in oroutside of Israel to appoint at least two outside directors. No person may beappointed as an outside director if that person or that person's relative,partner, employer or any entity under the person's control, has or had, on orwithin the two years preceding the date of that person's appointment to serveas an outside director, had any affiliation with the company or any entitycontrolling, controlled by or under common control with the company. The termaffiliation includes:

●*       *an employment relationship; 

●*       *a business or professional relationship maintainedon a regular basis;

●*       *control; and 

●*       *service as an office holder. 

 

No person may serve as an outside director if thatperson's position or business activities create, or may create, a conflict ofinterest with that person's responsibilities as an outside director or mayotherwise interfere with his/her ability to serve as an outside director. If,at the time outside directors are to be appointed, all current members of theboard of directors are of 

**__44__** 

the same gender, then at least one outside director mustbe of the other gender.

 

The Companies Law was recently amended to requirethat at least one outside director must have financial and accounting expertiseand the other outside directors must possess certain professionalqualifications that are promulgated by regulations to the Companies Law. Theseregulations provide that outside directors must possess a high level ofunderstanding in business matters, to the extent that they are able to read andunderstand financial statements in depth and to comment on the manner in whichfinancial data is presented. Each company's board of directors must determineeach outside director's qualifications based on his or her education,experience and skills regarding financial matters and knowledge of financialstatements in accordance with the Companies Law and Israeli securities laws.

 

Outside directors are to beelected by a majority vote at a shareholders' meeting, provided that either:

●*       *the majority of shares voted at the meeting,including at least one-third of the shares held by non-controlling shareholdersvoted at the meeting, vote in favor of election of the director; abstainingvotes shall not be counted in this vote, or

●*       *the total number of shares held by non-controllingshareholders voted against the election of the director does not exceed onepercent of the aggregate voting rights in the company.

 

The initial term of an outside director is threeyears and may be extended for an additional three years term. After suchadditional three year term, their term of service can be renewed for additionalperiods of up to three years, pursuant to a recent amendment to the CompaniesLaw, and provided that the audit committee and the board of directors confirmsthat, in light of the outside director`s expertise and special contribution tothe work of the board of directors and its committees, the reelection for suchadditional period(s) is beneficial to the company.

 

Outside directors may be removed only by the samepercentage of shareholders as is required for their election, or by a court,and then only if the outside directors cease to meet the statutoryqualifications for their appointment or if they violate their duty of loyaltyto the company. Each committee of a company's board of directors must includeat least one outside director.

 

An outside director is entitled to compensation as provided inregulations adopted under the Companies Law and is otherwise prohibited fromreceiving any other compensation, directly or indirectly, in connection withservice provided as an outside director.

 

Dr. Orna Berry and Mr. David Schlachet currentlyserve as our outside directors under Israeli law and as our independentdirectors under Nasdaq requirements. They both serve on our audit committee.

 

In addition to the requirements of the CompaniesLaw as described above, since our shares are listed on the Nasdaq GlobalMarket, a majority of our directors must be independent (as defined by theNasdaq Global Marketplace Rules), and our audit committee must be comprised ofat least three members, all of whom must be independent (subject to limitedexceptions). We currently actively seeking a replacement for Ruben Krupic toserve on our board of directors and audit committee. 

 

***Audit Committee***

 

We have an audit committee consisting of threeindependent directors, all of whom are financially literate and one of whom hasaccounting or related financial management expertise. The members of the AuditCommittee are, Mr. David Schlachet,****who****serves as the chairman ofour Audit Committee, Dr. Orna Berry and Mr. Ruben Krupic. All of the members ofour audit committee qualify as independent directors under the current NasdaqGlobal Market requirements. The Audit Committee has adopted a charter. 

* *

The responsibilities of the audit committee includeidentifying irregularities in the management of the company's business andapproving related party transactions as required by law. An audit committee mustconsist of at least three directors, including all of its outside directors.The chairman of the board of directors, any director employed by or otherwiseproviding services to the company, and a controlling shareholder or anyrelative of a controlling shareholder, may not be a member of the auditcommittee. An audit committee may not approve an action or a transaction with acontrolling shareholder, or with an office holder, unless at the time ofapproval two outside directors are serving as members of the audit committeeand at least one of the outside directors was present at the meeting in whichan approval was granted. 

**__45__** 

 

***Other Committees***

** **

We have a NominatingCommittee which consists of our independent directors of our Board ofDirectors.

** **

We do not have acompensation committee. This practice is compliant with Israeli law. 

** **

***Approval of Compensation to Our Officers***

 

The Companies Law prescribes that compensation toofficers must be approved by a company`s board of directors. In accordance withArticle 52(d) of our Articles of Association, our board of directors authorizedand empowered our Chief Executive Officer to appoint office holders anddetermine their terms of employment, without our board of director`s approval.Compensation to our officers who serve as members of our board of directorsrequire the approval of our audit committee, the board of directors andshareholders, as specified above.

 

***Internal Auditor***

** **

Under the Companies Law, the board of directorsmust appoint an internal auditor, nominated by the audit committee. The role ofthe internal auditor is to examine, among other matters, whether the company'sactions comply with the law and orderly business procedure. Under the CompaniesLaw, the internal auditor may be an employee of the company but not an officeholder, or an affiliate, or a relative of an office holder or affiliate, and heor she may not be the company's independent accountant or its representative.We comply with the requirement of the Companies Law relating to internal auditors.Our internal auditors examine whether our various activities comply with thelaw and orderly business procedure. 

 

Our internal auditors, Ezra Yehudah Management ServicesLtd., are not employees, affiliates or office holders of the company. They wereappointed in 1999. 

 

***Scientific Advisory Board***

*** ***

Our scientific advisory board convenes once ortwice annually, and we consult with its individual members when we determinethat there is a need to do so. At the advisory board meetings, we review ourprimary ongoing and planned projects and development plans, and the advisoryboard recommends which projects and product candidates to pursue and in whatpriority. Our scientific advisory board currently includes: 

 
| Name                       | Affiliation                                                                                                                                                                                         |
|----------------------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                       |                                                                                                                                                                                                |
| Nabil Hannah, Ph.D.        | Former Executive Vice President, Research, Biogen Idec  Inc. Member, National Academy of Sciences, USA                                                                                              |
| C. Ronald Kahn, M.D.       | President and Director, Joslin Diabetes Center,  Mary K. Iacocca Professor, Harvard Medical School                                                                                                  |
| Joseph Schlessinger, Ph.D. | William  H. Prusoff Professor and Chairman of the Department of Pharmacology of the Yale University School of  Medicine;

Member, National Academy of Sciences, USA                                 |
| Arthur Weiss, M.D., Ph.D.  | Ephraim P. Engleman Distinguished Professor of  Rheumatology; Investigator, Howard Hughes Medical Institute, University   of California, San Francisco;

Member,  National Academy of Sciences, USA |

*** ***

**__46__** 

##### Employees

*** ***

The following table sets out the number of our employees engaged inspecified activities, by geographic location both for the end of the fiscalyears 2004 and 2005 and as of February 28, 2007.****

* *
| ** **                                                                                                               | February 28, 2007       | December 31, 2005       | December 31, 2004       |
|--------------------------------------------------------------------------------------------------------------------------|-------------------------|-------------------------|-------------------------|
| Research &  Development 

  Israel

  USA                                              |  

 

58

0   |  

 

92

0   |  

 

90

2   |
| Administration,  Accounting and Operations

  Israel

  USA                                          |  

 

17

0   |  

 

23

0   |  

 

24

1   |
| Sales,  Marketing, Business Development and Support 

  Israel

  USA

  United    Kingdom |  

 

1

4

0 |  

 

0

5

1 |  

 

1

4

1 |
| Total                                                                                                                    | 80                      | 121                     | 123                     |

 

 

We and our Israeli employees are subject, by anextension order of the Israeli Ministry of Welfare, to a few provisions ofcollective bargaining agreements between the Histadrut, the General Federationof Labor Unions in Israel and the Coordination Bureau of EconomicOrganizations, including the Industrialists Associations. These provisionsprincipally concern cost of living increases, recreation pay, travel expenses,vacation pay and other conditions of employment. We provide our employees withbenefits and working conditions equal to or above the required minimum. Ouremployees are not represented by a labor union. We have written employmentcontracts with each of our employees, and we believe that our relations withour employees are good. 

 

##### Share Ownership

 

***Share Ownership byDirectors and Senior Management***

 

All of the persons listedabove under the caption "Directors and Senior Management" own ordinary sharesand/or options to purchase ordinary shares. Except as set forth in the tablebelow, none of the directors or executive officers owns shares and/or optionsamounting to 1% or more of the outstanding ordinary shares. The following tablesets forth certain information as of February 28, 2007, regarding thebeneficial ownership by our directors and executive officers. All numbersquoted in the table are inclusive of options to purchase shares that areexercisable within 60 days after , February 28 2007. 

 
| **Beneficial Owner**                                | **Amount Owned** | **Percent of Class** |
|-----------------------------------------------------|------------------|----------------------|
| Martin S. Gerstel (1)                               | 1,952,568        | 6.9%                 |
| All directors and senior  management as a group (2) | 2,557,958        | 9.1%                 |

*** ***

(1)       Includes 550,000 shares held by Shomar Corporation, anaffiliate of Mr. Martin S. Gerstel, 1,152,568 shares held by Merrill Lynch IRA for Martin Gerstel,of which Martin Gerstel is the beneficiary, and options to purchase 250,000shares that are exercisable within 60 days of February 28, 2007. 

 

 (2)      Includes the shares that are beneficially owned byMartin S. Gerstel as noted on the first row of the above table.

 

***Share Option Plans***

*** ***

We maintain three share option plans for our andour subsidiaries' employees, directors and consultants. In addition to thediscussion below, see Note 11 of our 2006 Consolidated Financial Statements.

**__47__** 

 

*** ***

Our board of directors administers our share optionplans and has the authority to designate all terms of the options granted underour plans including the grantees, exercise prices, grant dates, vestingschedules and expiration dates, which may be no more than ten years after thegrant date. Options may not be granted with an exercise price of less than thefair market value of our ordinary shares on the date of grant, unless otherwisedetermined by our board of directors.

*** ***

*Compugen Ltd. Employee Share Option Plan (1996)*

 

We have granted options to purchase up to 559,750ordinary shares to our employees and consultants under the Compugen Ltd.Employee Share Option Plan (1996). As of February 28, 2007, options to purchase 6,000 ordinary shares, granted at a weighted average exercise price ofapproximately $2.04 per share, remained outstanding under the plan. Theseoptions expire ten years after the date of grant or four weeks after terminationof a grantee`s employment or other relationship with us, without cause. If weterminate the grantee for cause, the options expire immediately. We do notintend to grant additional options under this plan.

 

*Compugen Share Option Plan (1998)*

* *

Under the Compugen Share Option Plan (1998), wehave granted options to purchase up to 2,329,250 ordinary shares to our and oursubsidiaries` employees, directors and consultants. As of February 28, 2007, options to purchase 396,386 ordinary shares were outstanding under the plan at aweighted average exercise price of approximately $ 2.54 per share. Options topurchase 1,431,398  ordinary shares under the plan have previouslybeen exercised at an exercise price of approximately $ 1.54, and options topurchase  672,216  ordinary shares remain available forfuture grant. If a grantee leaves his or her employment or other relationshipwith us, the term of his or her unexercised vested options expire 90 dayslater. 

 

*Compugen Share Option Plan (2000)*

*** ***

Under the Compugen ShareOption Plan (2000), we may grant options for up to an aggregate of  9,051,103ordinary shares to our and our subsidiaries' employees, directors andconsultants. This total number automatically increases on January 1 of everyyear by the lesser of 1,500,000 shares or 4% of the total number of ourthen-outstanding shares, or such lower amount as shall be determined by theboard of directors. If a grantee leaves his or her employment or otherrelationship with us, or if his or her relationship with us is terminatedwithout cause, the term of his or her unexercised options will expire 90 dayslater. As of February 28, 2007, options to purchase 6,139,481 ordinary shareswere outstanding under the plan at a weighted average exercise price ofapproximately $3.72 per share. Options to purchase  789,330 ordinaryshares under the plan have previously been exercised at an exercise price ofapproximately $ 3.56, and options to purchase  2,122,202 ordinaryshares remain available for future grant. 

 

In 2003, the terms of this plan were modified tocomply with changes in the Israeli tax law relating to the taxation ofincentive options to Israeli resident employees. Pursuant to the Tax Reform(see "Item 10. Additional Information;Taxation; Israeli Tax Considerations; Tax Reform") and in order to comply withthe revised provisions of Section 102 of the Income Tax Ordinance (AmendmentNo. 132), 5762-2002 (the Ordinance), on February 4, 2003, our board ofdirectors adopted an addendum to our share option plan which applies to optionsgranted as of January 1, 2003 to grantees who are residents of Israel. Thisaddendum does not affect grantees that are not residents of Israel. 

 

On February 4, 2003, our board of directors furtherresolved to elect the "Capital Gains Track" (as defined in Section 102(b)(2) ofthe Ordinance) for the grant of options to Israeli grantees. Generally, underthe Capital Gains Track, the tax liability to a Grantee resulting from thegrant and exercise of options will be postponed until the time that shares thatare acquired upon the exercise of options will be sold or released from trust,subject to fulfillment of the requirements of Section 102 of the Ordinance.Entitlement to the benefits under the Capital Gains Track is contingent uponthe grantee of options holding them and the shares issued upon their exercisefor a period of at least 24 months from the time of grant. Under the CapitalGains Track, a fixed rate of 25% apply to gains that are realized from the saleof shares issued upon exercise of options (i.e., for sales proceeds in excessof the exercise price of the options, assuming that the exercise price is equalto the fair market value of the shares on the date of the award), and providedthat the sale occurs after the required holding period. 

* *

If a grantee sells shares or releases them fromtrust prior to expiration of the required holding period, the grantee will besubject to income tax on his gains at a rate which is his or her marginalincome tax rate (currently up to 49%), as well as payment of associated healthtax and national insurance payments. Additionally, in such circumstances,withholding 

**__48__** 

requirements will apply and be carried out by theemploying company in accordance with applicable laws, regulations and rules. 

 

Neither we nor the grantee will be liable to paysocial benefits payments in connection with the granting or exercise of optionsthat are exercised under the Capital Gains Track mechanism, or upon the sale ofthe shares underlying such options or upon the release of such shares from thetrust, provided that such sale or release occurs after the required holdingperiod. However, if such sale or release occurs before expiry of the requiredholding period, for which our consent is required, both we and the grantee willbear each of our respective liability to pay social benefits payments. 

 

We will not be entitled to a tax deduction forIsraeli income tax purposes with respect to options granted under the CapitalGains Track.

 

*Directors` Options*

* *

Prior to our initial publicoffering, we adopted a plan to grant options to our directors, effective as ofthe closing of our initial public offering. Pursuant to such plan, effective asof the closing of our initial public offering, we granted options to purchase20,000 ordinary shares at an exercise price of $10.00 per share to each of ourdirectors (serving on our board of directors on the date of the closing of ourinitial public offering) who were not our employees or consultants. Of theseoptions, options to purchase 1,250 ordinary shares vest at the end of everythree-month period following the date of grant. Pursuant to this plan, we alsogranted and will continue to grant to each new non-employee director options topurchase 20,000 ordinary shares at the time he or she becomes a director. Ofthese options, options to purchase 5,000 ordinary shares vest on the firstanniversary of the grant date, and options to purchase 1,250 ordinary sharesvest at the end of every three-month period afterwards. In addition, pursuant tothe plan, we grant each director options to purchase an additional 5,000ordinary shares on each anniversary of the initial date of grant of options tosuch director. Of these options, options to purchase 1,250 ordinary shares vestat the end of every three-month period during the fourth year after the date ofgrant. All of the options described above have been and will be granted under,and subject to, the terms of our share option plans in effect on the date ofthe grant of the option. 

 

On September 3, 2002, our shareholders approved thefollowing grants to our members of our board of directors: (i) each auditcommittee member shall be entitled to an annual grant of options to purchase2,000 ordinary shares, (ii) each executive committee member shall be entitledto an annual grant of options to purchase 2,000 ordinary shares, and (iii) inaddition to the previous grants, the chairman of the audit committee and theexecutive committee respectively, shall each be granted additional options topurchase 2,000 ordinary shares, each year. All of these options shall vest overa four-year period. These options shall be granted at the exercise price equalto the fair market value of our shares, at the time of grant. 

**__49__** 

### ITEM 7.                  MAJOR SHAREHOLDERS ANDRELATED PARTY TRANSACTIONS

##### Major Shareholders

** **

The following table sets forth certain informationregarding beneficial ownership of our ordinary shares as of February 28 2007 by each person who is known by us to own beneficially more than 5% of ouroutstanding ordinary shares. The voting rights of our major shareholders do notdiffer from the voting rights of other holders of our ordinary shares. 

** **
| ** **

Beneficial Owner               | **Number of  Ordinary Shares Beneficially Owned** | **Percent of  Ownership** |
|--------------------------------------------|---------------------------------------------------|---------------------------|
| Martin Gerstel (1)                         | 1,702,568                                         | 6.04%                     |
| Clal Industries & Investments Ltd. (2) | 3,056,274                                         | 10.85%                    |
| AXA Assurances I.A.R.D. Mutuelle (3)       | 4,650,957                                         | 16.51%                    |

*** ***

(1)       Includes550,000 shares held by Shomar Corporation, an affiliate of Mr. Martin S.Gerstel, 1,152,568 shares held by Merrill Lynch IRA for Martin Gerstel,of which Martin Gerstel is the beneficiary..

(2)       Includes 10,526 shares held byClal Industries & Investments Ltd. and 3,045,748 shares held by ClalBiotechnology Industries Ltd. Clal Industries & Investments Ltd.`s addressis 3 Azrieli Center, Tel Aviv 67023, Israel. This disclosure is based oninformation disclosed by Clal Industries & Investments Ltd. on Form 13D,filed with the SEC on May 19, 2003. 

 

(3)       This disclosure is based oninformation disclosed by AXA Assurances I.A.R.D. Mutuelle on Form 13G, fieldwith the SEC on December 31, 2006.

 

As of February 28, 2007, there were a total of 97holders of record of our ordinary shares, of which 62 were registered withaddresses in the United States. Such United States holders were, as of such date,the holders of record of approximately 89% of the outstanding ordinary shares.  ****

** **

##### Related PartyTransactions 

 

It is our policy to enter into transactions withrelated parties on terms that, on the whole, are no less favorable than thosethat would be available from unaffiliated parties. Based on our experience inthe business in which we operate and the terms of our transactions withunaffiliated third parties, we believe that all of the transactions describedbelow met our policy standards at the time they occurred. 

 

***Evogene Ltd.***

 

In October 1999, we formed a division focusing onagricultural biotechnology and plant genomics. On January 1, 2002, we turned the business of this division into a majority-owned subsidiary, Evogene. As part ofthis transaction, we extended to Evogene a loan in the amount of $900,000. 

 

On January 6, 2003, a group of investors, led byMartin Gerstel, the Chairman of our board of directors, extended to Evogene aloan, convertible into equity, in the amount of $2,000,000. Following theclosing of the convertible loan transaction, we granted these investors anirrevocable proxy empowering them to vote 820,000 of our shares in Evogene(which constituted 50% of our shareholding of Evogene at the time). One of theinvestors` conditions for advancing funds to Evogene, was that we forgive ourloan to Evogene in the amount of $900,000, which we agreed to do in theinterests of Evogene`s continued existence. In February 2004, Evogene and theinvestors entered into an amended and restated convertible loan agreement,under which the amount of the convertible loan was increased by additional$ 1,551,000. In January 2005, Evogene and investors entered into aconvertible bridge loan agreement and an amendment to that agreement, under whichthe amount of the convertible loan was $2,000,000. We did not participate inany of these investments in Evogene.

 

As of December 31, 2006, we held approximately14.76% of Evogene`s issued and outstanding share capital and as of February 28, 2007, following the grant to us of 40,000 pursuant to a Software LicenseAgreement with Evogene dated August 2006, we own 15.01% of Evogene`s issued andoutstanding share capital. For more information, seeNote 1b of our 

**__50__** 

2006 Consolidated Financial Statements and "Item 5.Operating and Financial Review and Prospects; Critical Accounting Policies;Investment in Evogene." 

 

As of December 31, 2006, Martin Gerstel, ourchairman of the board, held approximately 4.76 % of Evogene`s issued andoutstanding share capital (approximately  4.62% of Evogene`s sharecapital, on a fully-diluted basis), and the power to vote approximately  4.76%of Evogene`s share capital. Since December 19, 2004, Martin Gerstel has servedas the chairman of Evogene`s board of directors. 

 

On August 1, 2004, we entered into an ExtensionAgreement to a Computational Tools License Agreement, with Evogene. Theoriginal license was granted to Evogene upon Evogene`s incorporation on January 1, 2002. Under the extension agreement, the license was extended for twoadditional years, until December 31, 2007, in consideration of the issuance tous of 350,000 ordinary shares of Evogene. During these two years we areobligated to provide to Evogene limited support services at no additionalcharge. 

 

On September 6, 2004, we entered into a MaterialTransfer Agreement with Evogene, under which we agreed to provide to Evogenethe sequence information to certain of our proteins, as well as small amountsof purified antibodies that bind to these proteins, for the purpose ofassisting Evogene to develop a method for producing mammalian proteins intrichome plant cells.

 

We are granting bookkeeping services to Evogene,for which we are fully reimbursed on arms length basis. During the years endedDecember 31, 2006, 2005 and 2004 services reimbursed by Evogene amounted to$ 8, $ 6 and $ 6, respectively.

 

In August 2006, we entered into a Software LicenseAgreement with Evogene, under which we agreed to grant Evogene a license tocertain software. In consideration for the grant of the license, Evogene agreedto issue to us 40,000 ordinary shares before December 31, 2006 and an additional 20,000 ordinary shares within one month of Evogene entering into its firstsignificant agreement. To date, we have been issued 60,000 ordinary sharesunder the software license agreement.

 

*** ***

***Keddem Bioscience Ltd.***

*** ***

On August 1, 2004, we turned our chemistry divisioninto a wholly-owned subsidiary, Keddem Bioscience Ltd. The transaction waseffected by way of a transfer to Keddem Bioscience of all of our assets andliabilities that were dedicated to the operation of our chemistry division, inconsideration of the issuance to us of 2,999,900 ordinary shares NIS 0.01 parvalue of Keddem Bioscience. On July 29, 2004 we entered into a Convertible LoanAgreement with Keddem Bioscience, under which we agreed to loan to KeddemBioscience up to $1,572,000. The outstanding principal loan amount bearsinterest at an annual rate (each year considered separately) which is thegreater of (i) 5%; and (ii) the 12 month LIBOR as determined on the firstbusiness day after the corresponding anniversary, compounded annually. The loanis convertible into Keddem Bioscience`s shares at our discretion, until theearlier of: (x) the repayment date or (y) the merger, acquisition, IPO orsimilar event of Keddem Bioscience. If not converted, the loan is to be repaidby Keddem Bioscience upon the earlier of (i) June 30, 2011, and (ii) Keddem Bioscience defaulting under the loan agreement`s terms. 

 

On June 16, 2005, our board of directors resolvedto advance to Keddem an amount of $100,000 for a period of one year, bearinginterest at an annual rate of 5%. On November 1, 2005, our board of directorsalso resolved to assign to Keddem our entitlement to receive from theInvestment Center of the Israel Ministry of Industry, Trade and Labor (the"Investment Center"), an amount of approximately $400,000 - on account of ourinvestment in the expansion of, what was at the time, our Ashqeloncomputational chemistry facilities and the building of a laboratory there fordrug development. In accordance with the terms of the loan, in January 2006,Keddem repaid to us the full amount of the $100,000 loan following its receiptof approximately $400,000 from the Investment Center.   

 

On June 28, 2006, the Company agreed to advance toKeddem additional convertible loan in the amount of $400,000 with the sameterms as agreed for the convertible long term loan advanced on July 29, 2004. The loan payable in two equal installments, the first of which was advancedto the Keddem on July 5, 2006 and the other was advanced on October 16, 2006.******

*** ***

We provide administrative services (includingbook-keeping) to Keddem, for which we are fully reimbursed. During the yearsended December 31, 2006, 2005 and 2004 services reimbursed by Keddem amountedto $ 37, $ 48 and $ 26, respectively.

** **

**__51__** 

***Consulting Agreement with Shomar Corporation,a company controlled by Martin Gerstel, our Chairman of the Board of Directors***

* *

In October 1998, we entered into a consultingagreement with Shomar Corporation, a company controlled by Martin S. Gerstel,our Chairman of the board of directors. The agreement renews automatically eachyear unless terminated by either party. Under the agreement, as amended, Mr.Gerstel provides consulting services to us and is required to devote at least50% of his business time to us. As compensation for his services under thisagreement, we paid Shomar Corporation an annual consulting fee of $150,000,plus reimbursement of Mr. Gerstel's reasonable out-of-pocket expenses. Thisagreement includes non-disclosure and non-competition obligations in our favor.

 

On July 30, 2003, we granted to Martin Gersteloptions to purchase 150,000 of our ordinary shares at an exercise price of$2.38 per share, under the terms of our 2000 Option Plan. This grant was madein consideration of Shomar Corporation`s waiver of the annual consulting feesof $150,000 for each of the years 2003 through 2006 and was ratified by ourshareholders in our annual shareholders` meeting convened on July 30 2003. 

 

On July 30, 2003, we granted to Martin Gersteloptions to purchase 100,000 of our ordinary shares, at the exercise price of$2.38 per share, under the terms of our 2000 Option Plan. This grant was madein consideration for his services as Chairman of our board of directors and wasratified by our shareholders in our annual shareholders` meeting convened on July 30, 2003. 

 

Except for this aforesaid remuneration, thereimbursement of Mr. Gerstel`s reasonable expenses incurred in connection withthe performance of services, in accordance with our consulting agreement withShomar, and for remuneration that all of our non-employee directors receive,which is the maximum amount payable to external directors in accordance withthe Companies Law, Mr. Gerstel does not receive any other direct or indirectcompensation for his services to us. 

**__52__** 

### ITEM 8.                  FINANCIAL INFORMATION

 

##### ConsolidatedStatements and Other Financial Information

** **

Our consolidated financial statements are includedon pages F-1 through F-34 of this annual report.  

 

***Legal Proceedings***

*** ***

Currently, we are not a party to any materialpending legal proceedings. There are no legal proceedings pending or, to our knowledge, threatened against us or oursubsidiaries and we are not involved in any legal proceedings that ourmanagement believes, individually or in the aggregate, would have a materialadverse effect on our business, financial conditions or operating results. 

*** ***

***Dividend Distributions***

*** ***

We have never paid any cash dividends on our ordinaryshares, and we do not intend to pay cash dividends on our ordinary shares inthe foreseeable future. Our current policy is to retain earnings for use in ourbusiness.

 

In the event that we decide to pay a cash dividendfrom income that is tax exempt under our approved enterprise status, we wouldbe liable for corporate tax on the amount distributed at the rate of up to 25%,which would be in addition to the tax payable by the divided payee. See Note 14of our 2006 Consolidated Financial Statements and "Item 10. Taxation." Cashdividends may be paid by an Israeli company only out of retained earnings ascalculated under Israeli law. We currently have no retained earnings and do notexpect to have any retained earnings in the foreseeable future.

 

***Significant Changes***

 

No significant changes have occurred since the dateof the consolidated financial statements included in this annual report. 

**__53__** 

### ITEM 9.                  THE OFFER AND LISTING 

 

*Markets and Share Price History*

 

The principal trading market for our ordinary sharesis the Nasdaq Global Market, where our shares have been listed and traded underthe symbol "CGEN" since our initial public offering in August, 2000. Our shareshave also been traded on the Tel Aviv Stock Market under the Hebrew  symbolwhich is equivalent to "CGEN" since January 7, 2002. The following table sets forth, for the periods indicated, the high and low reported salesprices of the ordinary shares on the Nasdaq Global Market and on the Tel AvivStock Exchange: 

*** ***
| ** **                                                    | Nasdaq | *TASE  |
|---------------------------------------------------------------|--------|--------|
| **Last Six Calendar Months**                                  | High   | Low    | High | Low |
| February 2007                                                 | $3.050 | $2.450 | $3.048 | $2.517 |
| January 2007                                                  | $3.400 | $2.410 | $3.529 | $2.424 |
| December 2006                                                 | $3.310 | $2.100 | $2.950 | $2.412 |
| November 2006                                                 | $3.200 | $2.800 | $3.203 | $2.780 |
| October 2006                                                  | $3.380 | $2.610 | $3.499 | $2.769 |
| September 2006                                                | $2.990 | $2.440 | $2.909 | $2.383 |
| **Financial Quarters During the Past Two Full  Fiscal Years** |   |   |   |   |
| Fourth Quarter of 2006                                        | $3.380 | $2.100 | $3.499 | $2.412 |
| Third Quarter 2006                                            | $3.050 | $2.420 | $3.018 | $2.383 |
| Second Quarter 2006                                           | $4.200 | $2.630 | $4.126 | $2.790 |
| First Quarter 2006                                            | $5.220 | $3.200 | $5.304 | $3.457 |
| Fourth Quarter of 2005                                        | $4.350 | $2.460 | $4.064 | $2.578 |
| Third Quarter 2005                                            | $4.100 | $2.820 | $3.903 | $2.974 |
| Second Quarter 2005                                           | $4.380 | $2.740 | $4.276 | $2.665 |
| First Quarter 2005                                            | $6.540 | $3.800 | $6.557 | $3.844 |
| **Last Five Full Financial Years**                            |   |   |   |   |
| 2006                                                          | $5.220 | $2.100 | $5.304 | $2.383 |
| 2005                                                          | $6.540 | $2.460 | $6.557 | $2.578 |
| 2004                                                          | $8.090 | $3.180 | $8.130 | $3.042 |
| 2003                                                          | $6.300 | 1.500$ | $6.086 | $1.505 |
| 2002                                                          | $5.240 | $0.910 | $6.335 | $0.894 |

* *

*the currency bywhich our stock is traded on the Tel Aviv Stock Exchange is the New IsraelShekels. The above dollar amounts represent a conversion from New IsraelShekels to Dollar amounts in accordance with the Dollar - New Israel Shekelconversion rate as of the relevant date of trade.

**__54__** 

### ITEM10.                ADDITIONAL INFORMATION

*** ***

#####  Memorandum and Articles of Association

** **

***Objects and Purposes of the Company***

** **

We are registered under the Companies Law, 1999 asa public company under the name Compugen Ltd. and public company number51-177-963-9. The objective stated in our Articles of Association is to engagein any lawful activity. 

** **

***Powers of the Directors***

** **

Pursuant to the Companies Law and our Articles ofAssociation, a director is not permitted to vote on a proposal, arrangement orcontract in which he or she has a personal interest. Also, the directors maynot vote compensation to themselves or any members of their body without theapproval of our audit committee and our shareholders at a general meeting. Therequirements for approval of certain transactions are set forth below in "Item10. Additional Information; Memorandum and Articles of Association; Approval ofCertain Transactions". The powers of our directors to enter into borrowingarrangements on our behalf are limited to the same extent as any othertransaction by us. 

** **

***Approval of Certain Transactions***

 

The Companies Law codifies the fiduciary dutiesthat office holders, including directors and executive officers, owe to acompany. An office holder, as defined in the Companies Law, is a director,general manager, chief business manager, deputy general manager, vice generalmanager, executive vice president, vice president, other manager directlysubordinate to the managing director or any other person assuming theresponsibilities of any of the foregoing positions without regard to suchperson's title. An office holder's fiduciary duties consist of a duty of careand a duty of loyalty. The duty of loyalty includes avoiding any conflict ofinterest between the office holder's position in the company and his personalaffairs, avoiding any competition with the company, avoiding exploitation ofany business opportunity of the company in order to reap personal gain forhimself or others, and revealing to the company any information or documentsrelating to the company's affairs which the office holder has received due tohis position as an office holder. Each person listed in the table under"Directors and Senior Management", which is displayed under "Item 6.Directors, Senior Management and Employees; Directors and Senior Management",is one of our office holders. Under the Companies Law, all arrangements as tocompensation of office holders who are not directors, require approval of theboard of directors, or a committee thereof or of persons to whom such power isdelegated. Arrangements regarding the compensation of directors also requireaudit committee and shareholder approval, with the exception of compensation tooutside directors in the amounts specified in the regulations promulgated underthe Companies Law, all as described in "Item 6. Directors and SeniorManagement; Compensation."

 

The Companies Law requires that an office holderpromptly discloses any personal interest that he or she may have and allrelated material information known to him or her, in connection with anyexisting or proposed transaction by the company. The disclosure must be made toour board of directors or shareholders prior to the meeting at which thetransaction is to be discussed. In addition, if the transaction is anextraordinary transaction, as defined under the Companies Law, the officeholder must also disclose any personal interest held by the office holder'sspouse, siblings, parents, grandparents, descendants, spouse's descendants andthe spouses of any of the foregoing, or by any corporation in which the officeholder is a five percent (5%) or greater shareholder, or holder of 5% or moreof the voting power, director or general manager or in which he or she has theright to appoint at least one director or the general manager. An extraordinarytransaction is defined as a transaction not in the ordinary course of business,not on market terms, or that is likely to have a material impact on thecompany's profitability, assets or liabilities.

 

In the case of a transaction which is not an extraordinarytransaction, after the office holder complies with the above disclosurerequirement, only board of directors` approval is required unless the Articlesof Association of the company provide otherwise. A transaction must not beadverse to the company's interest. If the transaction is an extraordinarytransaction, then, in addition to any approval required by the Articles ofAssociation, the transaction must also be approved by the audit committee andby the board of directors, and under specified circumstances, by a meeting ofthe shareholders. An office holder who has a personal interest in a matter thatis considered at a meeting of the board of directors or the audit committee maynot be present at this meeting or vote on this matter.

 

**__55__** 

The Companies Law applies the same disclosurerequirements to a controlling shareholder of a public company, which is definedas a shareholder who has the ability to direct the activities of a company,other than in circumstances where this power derives solely from theshareholder`s position on the board of directors or any other position with thecompany, and includes a shareholder that holds 25% or more of the voting rightsif no other shareholder owns more than 50% of the voting rights in the company.Extraordinary transactions with a controlling shareholder or in which acontrolling shareholder has a personal interest, and the terms of compensationof a controlling shareholder who is an office holder, require the approval ofthe audit committee, the board of directors and the shareholders of thecompany.

 

The shareholders` approval must either include atleast one-third of the disinterested shareholders who are present, in person orby proxy, at the meeting, or, alternatively, the total shareholdings of thedisinterested shareholders who vote against the transaction must not representmore than one percent (1%) of the voting rights in the company.

 

In addition, a private placement of securities thatwill increase the relative holdings of a shareholder that holds five percent(5%) or more of the company`s outstanding share capital, assuming the exerciseby such person of all of the convertible securities into shares held by thatperson, or that will cause any person to become a holder of more than fivepercent (5%) of the company`s outstanding share capital, requires approval bythe board of directors and the shareholders of the company. However, subject tocertain exceptions, shareholder approval will not be required if the aggregatenumber of shares issued pursuant to such private placement, assuming theexercise of all of the convertible securities into shares being sold in such aprivate placement, comprises less than twenty percent (20%) of the votingrights in a company prior to the consummation of the private placement.

 

Under the Companies Law, ashareholder has a duty to act in good faith towards the company and othershareholders and refrain from abusing his power in the company.  Shareholders`voting powers includes their power to vote in the general meetings ofshareholders on the following matters:

●*       *any amendment to the Articles of Association; 

●*       *an increase of the company's authorized sharecapital; 

●*       *a merger; and 

●*       *approval of interested party transactions.

 

In addition, any controlling shareholder, anyshareholder who knows it can determine the outcome of a shareholders vote andany shareholder who, under our Articles of Association, can appoint or preventthe appointment of an office holder, is under a duty to act with fairnesstowards the company. The Companies Law does not describe the substance of thisduty. The Companies Law requires that specified types of transactions, actionsand arrangements be approved as provided for in a company`s articles ofassociation and in some circumstances by the audit committee, by the board ofdirectors and by the shareholders. In general, the vote required by the auditcommittee and the board of directors for approval of these matters, in eachcase, is a majority of the disinterested directors participating in a duly convenedmeeting. 

 

For information concerningthe direct and indirect personal interests of some of our office holders andprincipal shareholders in transactions with us, see "Item 7. MajorShareholders; Related Party Transactions" above.

** **

***Rights Attached to OrdinaryShares***

** **

Our authorized share capitalconsists of 50,000,000 ordinary shares, par value NIS 0.01 per share. Holdersof ordinary shares have one vote per share, and are entitled to participateequally in the payment of dividends and share distributions and, in the eventof our liquidation, in the distribution of assets after satisfaction ofliabilities to creditors. No preferred shares are currently authorized. Alloutstanding ordinary shares are validly issued and fully paid.

** **

***Transfer of Shares***

** **

Fully paid ordinary shares are issued in registeredform and may be freely transferred under our Articles of Association unless thetransfer is restricted or prohibited by another instrument. 

** **

**__56__** 

***Dividend and Liquidation Rights***

** **

We may declare a dividend to be paid to theshareholders of our ordinary shares according to their rights and interests inour profits. In the event of our liquidation, after satisfaction of liabilitiesto creditors, our assets will be distributed to the shareholders of ourordinary shares in proportion to the nominal value of their shareholdings. Thisright may be affected by the grant of preferential dividend or distributionrights to the shareholders of a class of shares with preferential rights thatmay be authorized in the future. Pursuant to Israel's securities laws, acompany registering its shares for trade on the Tel Aviv Stock Exchange (TASE)may not have more than one class of shares for a period of one year followingregistration, after which it is permitted to issue preference shares. Under theCompanies Law, the declaration of a dividend does not require the approval ofthe shareholders of the company, unless the company's Articles of Associationrequire otherwise. Our Articles of Association provide that the board of directorsmay declare and distribute dividends without the approval of the shareholders.

 

To date, we have not declared or distributed anydividend.

** **

***Annual and Extraordinary General Meetings***

*** ***

We must hold our annual general meeting ofshareholders each year no later than 15 months from the last annual meeting, ata time and place determined by the board of directors, upon at least 21 days`prior notice to our shareholders. A special meeting may be convened by requestof two directors or by written request of one or more shareholders holding atleast 5% of our issued share capital and 1% of the voting rights or one or moreshareholders holding at least 5% of the voting rights. Shareholders requestinga special meeting must submit their proposed resolution with their request.Within 21 days of receipt of the request, the board of directors must convene aspecial meeting and send out notices setting forth the date, time and place ofthe meeting. Such notice must be given at least 21 days but not more than 35days prior to the special meeting.

*** ***

The quorum required for a meeting of shareholdersconsists of at least two shareholders present in person or by proxy who hold orrepresent between them at least 33.3% of the issued share capital. A meetingadjourned for lack of a quorum generally is adjourned to the same day in thefollowing week at the same time and place or any time and place as thedirectors designate in a notice to the shareholders. At the reconvened meeting,the required quorum consists of any two members present in person or by proxy.  

 

***Voting Rights***

 

Our ordinary shares do not have cumulative votingrights in the election of directors. As a result, the holders of ordinaryshares that represent more than 50% of the voting power represented at ashareholders meeting have the power to elect all of our directors, except theoutside directors whose election requires a special majority as described underthe section entitled "Item 6. Directors, Senior Management and Employees;Board Practices; Outside and Independent Directors."

* *

Holders of ordinary shareshave one vote for each ordinary share held on all matters submitted to a voteof shareholders. Shareholders may vote in person or by proxy. These votingrights may be affected by the grant of any special voting rights to the holdersof a class of shares with preferential rights that may be authorized in thefuture. 

 

Under the Companies Law, unless otherwise providedin the Articles of Association or by applicable law, all resolutions of theshareholders require a simple majority and all shareholders' meetings requireprior notice of at least 21 days. Our Articles of Association provide that alldecisions may be made by a simple majority. See "Item 10. AdditionalInformation; Memorandum and Articles of Association; Approval of CertainTransactions" above for certain duties of shareholders towards the company.

 

***Limitations on the Rights to Own Securities***

** **

The ownership or voting of ordinary shares bynon-residents of Israel is not restricted in any way by our articles ofassociation or the laws of the State of Israel, except that nationals ofcountries which are, or have been, in a state of war with Israel may not berecognized as owners of our shares.

 

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***Anti-TakeoverProvisions under Israeli Law***

** **

The Companies Law provides that an acquisition ofshares in a public company must be made by means of a tender offer if, as aresult of such acquisition, the purchaser would become shareholder with over25% of the voting rights in the company. This rule does not apply if there isalready another shareholder of the company with 25% or more of the votingrights. Similarly, the Companies Law provides that an acquisition of shares ina public company must be made by means of a tender offer if, as a result of theacquisition, the purchaser`s shareholdings would entitle the purchaser to over45% of the voting rights in the company, unless there is a shareholder with 50%or more of the voting rights in the company. These rules do not apply if theacquisition is made by way of a merger. 

 

Finally, in general, Israeli tax law treatsspecified acquisitions less favorably than does US tax law. However, Israelitax law provides for tax deferral in specified acquisitions, includingtransactions where the consideration for the sale of shares is the receipt ofshares of the acquiring company. 

 

#####  Material Contracts 

 

In March 2007 we announced our entry into anagreement with Biosite Incorporated (Biosite) for the development andcommercialization of immunoassay diagnostic products. Entering into thisagreement was an expansion of our immunoassay diagnostic collaboration withBiosite, which we entered into in June 2005. Our second agreement with Biositeexpanded the number of potential diagnostic biomarkers that we made availableto Biosite for selection. Furthermore, our existing collaboration was expandedto cover additional diagnostic fields such as cardiovascular and oncology. Aswith the initial agreement, we are entitled to receive milestone payments androyalties from the sale of any products emerging from the collaboration.

 

In January 2007, we announced the entry into acollaborative agreement with Medarex, Inc. ("Medarex") to developnovel monoclonal antibody-based therapeutics for oncology and autoimmunediseases. Under the terms of the agreement, we will share with Medarexdiscovery, development and commercialization responsibilities on antibody-basedtherapeutics resulting from the collaboration, and share revenues generatedfrom the sale of such therapeutic products. Under the collaboration, we expectto utilize our proprietary antibody-target discovery engine to identify noveldrug targets. Medarex plans to develop fully human antibodies against thesetargets using its proprietary system for developing human antibodies. Thecollaboration also provides that we may independently pursue diagnosticapplications involving certain antibodies and targets. 

 

In January 2007, we also announced the entry intoan agreement with Teva Pharmaceutical Industries ("Teva") tocollaborate on a project for the discovery of biomarkers for the detection ofdrug toxicity in preclinical stages of the drug development process. Theinitial focus of the collaboration will be on biomarkers for the earlydetection of potential nephrotoxicity (being toxicity to kidney cells). We mayjointly choose to expand the scope of the collaboration to include biomarkersfor the detection of hepatotoxicity (being toxicity to liver cells) and/orcardiotoxicity (being toxicity to heart cells) in response to drug treatment.We have granted Teva a license to use the discovered markers for research anddevelopment activities while retaining commercialization rights for licensingto other companies, as well as rights for internal use. Under thecollaboration, we expect to utilize our proprietary computational tools,discovery engines and nucleic acid testing technologies for the purpose ofpredicting and validating toxicity biomarkers. Our integrated analysis willincorporate data derived from biological samples collected by Teva in a preclinicalstudy designed specifically for this project, as well as our proprietaryexpression and clinical data.

 

In June 2005, we announced the entry into acollaboration with Ortho-Clinical Diagnostics, a Johnson & Johnson company,("OCD"), for the development and commercialization of immunoassay baseddiagnostic products that are based on the output of our diagnostic discoveryengines. The terms of this agreement allow OCD to select up to nine diagnosticbiomarkers and then we will collaborate on the initial clinical validation ofthe selected biomarkers. Under the agreement, successfully validated biomarkerswill be developed into products and commercialized by OCD, and we will receivemilestone payments and license fees for each commercialized biomarker, inaddition to revenue-based royalties. We received together with OCD a grant fromthe Israel-U.S. Bi-national Industrial Research and Development Foundation forcontribution to our research and development expenditures under our jointcollaborative project. 

 

In June 2005, we also announced the entry into acollaboration with Biosite Incorporated, for the development andcommercialization of immunoassay based diagnostic products based on the outputof our diagnostic discovery engines. Under the terms of this agreement, wegranted to Biosite an exclusive license in the diagnostic field to use certainof our targets for immunoassay based diagnostic applications. In return forthis grant, we are entitled to receive milestone payments and royalties from thesales of each diagnostic product emerging from the collaboration. We alsoretained the 

**__58__** 

exclusive right to pursue further development of thesetargets in the therapeutic field, and for which Biosite will be entitled toreceive from us milestone payments and royalties arising from any successfultherapeutic application.

 

In August 2004, we entered into a broad pipelinediscovery-based collaboration with Diagnostic Product Corporation, a divisionof Siemens Medical Solutions Diagnostics, ("DPC"), for the developmentand commercialization of diagnostic products based on the output of ourdiagnostic discovery engines, with an anticipated focus on cancer andcardiovascular disease. The terms of this agreement allow DPC to develop andcommercialize immunoassay and nucleic-acid based diagnostic products that arebased on candidate biomarkers that we already discovered, as well as additionalcandidates that may arise out of the collaboration. 

 

#####  Exchange Controls 

*** ***

Under Israeli Law, Israeli non-residents who purchaseordinary shares with certain non-Israeli currencies (including dollars) mayfreely repatriate in such non-Israeli currencies all amounts received inIsraeli currency in respect of the ordinary shares, whether as a dividend, as aliquidating distribution, or as proceeds from any sale in Israel of theordinary shares, provided in each case that any applicable Israeli income taxis paid or withheld on such amounts. The conversion into the non-Israelicurrency must be made at the rate of exchange prevailing at the time ofconversion. Under Israeli law, both residents and non-residents of Israel mayfreely hold, vote and trade ordinary shares.

#####  

##### Taxation

 

The following discussion of Israeli and United  States tax consequences material to our shareholders is not intended andshould not be construed as legal or professional tax advice and does notexhaust all possible tax considerations. To the extent that the discussion isbased on new tax legislation, which has not been subject to judicial oradministrative interpretation, the views expressed in the discussion might notbe accepted by the tax authorities in question.  

 

**We urge shareholders and prospective purchasersof our ordinary shares to consult their own tax advisors as to the US, Israeli,or other tax consequences of the purchase, ownership and disposition ofordinary shares, including, in particular, the effect of any foreign, state orlocal taxes.**

* *

*Israeli Taxation and InvestmentPrograms*

 

Thefollowing is a summary of the principal tax laws applicable to companies in Israel,including special reference to their effect on us, and Israeli governmentprograms benefiting us. This section also contains a discussion of the materialIsraeli tax consequences to you if you acquire Ordinary Shares of our company.This summary does not discuss all the acts of Israeli tax law that may berelevant to you in light of your personal investment circumstances or if youare subject to special treatment under Israeli law. To the extent that thediscussion is based on new tax legislation which has not been subject tojudicial or administrative interpretation, we cannot assure you that the viewsexpressed in this discussion will be accepted by the tax authorities. Thediscussion should not be understood as legal or professional tax advice and isnot exhaustive of all possible tax considerations. 

* *

*General Corporate Tax Structure*

* *

Generally, Israelicompanies are subject to "Corporate Tax" on their taxable income. On July 25,2005, the Knesset (Israeli Parliament) approved the Law of the Amendment of theIncome Tax Ordinance (No. 147), 2005, which prescribes, among others, a gradualdecrease in the corporate tax rate in Israel to the following tax rates: in2006 - 31%, in 2007 - 29%, in 2008 - 27%, in 2009 - 26% and in 2010 and thereafter- 25%.  However, the effective tax rate payable by a company whichderives income from an approved enterprise (as further discussed below) may beconsiderably less.  

* *

***Tax Benefits under theLaw for the Encouragement of Industry (Taxes), 1969*

*** ***

The Lawfor the Encouragement of Industry (Taxes), 1969, generally referred to as theIndustry Encouragement Law, provides several tax benefits for industrialcompanies. An industrial company is defined as a company resident in Israel, atleast 90% of the income of which in a given tax year exclusive of income fromspecified government loans, capital gains, interest and dividends, is derivedfrom an industrial enterprise owned by it. An industrial enterprise is definedas an enterprise whose major activity in a given tax year is industrialproduction activity.

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* *

 

Under the Industry Encouragement Law, industrialcompanies are entitled to a number of corporate tax benefits, including:

●*       *deduction of purchase of know-how and patents and/or right to use a patentover an eight-year period ;

●*       *the right to elect, under specified conditions, tofile a consolidated tax return with additional related Israeli industrialcompanies and an industrial holding company;

●*       *accelerateddepreciation rates on equipment and buildings.

●*       *Expensesrelated to a public offering on TA stock exchange and as of 1.1.2003 on recognizedstock markets outside of Israel,are deductible in equal amounts over three years.

* *

Under some taxlaws and regulations, an industrial enterprise may be eligible for specialdepreciation rates for machinery, equipment and buildings. These rates differbased on various factors, including the date the operations begin and thenumber of work shifts. An industrial company owning an approved enterprise maychoose between these special depreciation rates and the depreciation ratesavailable to the approved enterprise.

 

Eligibility for benefits under theIndustry Encouragement Law is not subject to receipt of prior approval from anygovernmental authority.

 

We believe thatwe currently qualify as an industrial company within the definition of theIndustry Encouragement Law. We cannot assure you that the Israeli taxauthorities will agree that we qualify, or, if we qualify, that we willcontinue to qualify as an industrial company or that the benefits describedabove will be available to us in the future.

 

*TaxBenefits Under the Law for the Encouragement of Capital Investments, 1959*

**** ****

*Tax benefits prior the 2005  amendment*

* *

The Law for theEncouragement of Capital Investments, 1959, as amended (effective as of April1, 2005) (the "Investments Law"), provides that a proposed capital investmentin eligible facilities may, upon application to the Investment Center of theMinistry of Industry and Commerce of the State of Israel, be designated as anapproved enterprise. The Investment Center bases its decision as to whether ornot to approve an application, among other things, on the criteria set forth inthe Investments Law and regulations, the then prevailing policy of the InvestmentCenter, and the specific objectives and financial criteria of the applicant.Each certificate of approval for an approved enterprise relates to a specificinvestment program delineated both by its financial scope, including itscapital sources, and by its physical characteristics, e.g*.*, theequipment to be purchased and utilized pursuant to the program.

* *

The Investments Lawprovides that an approved enterprise is eligible for tax benefits on taxableincome derived from its approved enterprise programs. The tax benefits under the Investments Lawalso apply to income generated by a company from the grant of a usage rightwith respect to know-how developed by the approved enterprise, income generatedfrom royalties, and income derived from a service which is auxiliary to suchusage right or royalties, provided that such income is generated within theapproved enterprise`s ordinary course of business. If a company has more than one approval or only a portion of its capitalinvestments are approved, its effective tax rate is the result of a weightedaverage of the applicable rates. The tax benefits under the Investments Law arenot, generally, available with respect to income derived from productsmanufactured outside of Israel. In addition, the tax benefits available to an approvedenterprise are contingent upon the fulfillment of conditions stipulated in theInvestments Law and regulations and the criteria set forth in the specificcertificate of approval, as described above. In the event that a company doesnot meet these conditions, it would be required to refund the amount of taxbenefits, plus a consumer price index linkage adjustment and interest.

* *

The Investments Lawalso provides that an approved enterprise is entitled to accelerateddepreciation on its property and equipment that are included in an approvedenterprise program in the first five years of using the equipment.

 

Taxable income of a company derivedfrom an approved enterprise is subject to corporate tax at the maximum rate of25%, rather than the regular corporate tax rate, for the benefit period. Thisperiod is ordinarily seven years commencing with the year in which the approvedenterprise first generates taxable income, and is limited to 12 years fromcommencement of production or 14 years from the date of approval, whichever isearlier. The year`s limitation doesnot apply to the exemption period. 

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A company may electto receive an alternative package of benefits. Under the alternative package ofbenefits, a company`s undistributed income derived from the approved enterprisewill be exempt from corporate tax for a period of between two and ten yearsfrom the first year the company derives taxable income under the program,depending on the geographic location of the approved enterprise within Israel,and such company will be eligible for a reduced tax rate for the remainder ofthe benefits period**.**A company that has elected the alternative packageof benefits, such as us, that subsequently pays a dividend out of incomederived from the approved enterprise during the tax exemption period will besubject to corporate tax in respect of the amount distributed, including anytaxes thereon, at the rate which would have been applicable had it not electedthe alternative package of benefits, generally 10%-25%, depending on thepercentage of the company`s ordinary shares held by foreign shareholders. Thedividend recipient is subject to withholding tax at the rate of 15% applicableto dividends from approved enterprises, if the dividend is distributed duringthe tax exemption period or within twelve years thereafter. The company mustwithhold this tax at source.

* *

A company that has an approved enterpriseprogram is eligible for further tax benefits if it qualifies as a foreigninvestors` company. A foreign investors` company is a company which more than25% of its share capital and combined share and loan capital is owned bynon-Israeli residents. A company that qualifies as a foreign investors` companyand has an approved enterprise program is eligible for tax benefits for aten-year benefit period. As specified above, depending on the geographiclocation of the approved enterprise within Israel, incomederived from the approved enterprise program may be exempt from tax on itsundistributed income for a period of between two to ten years, and will besubject to a reduced tax rate for theremainder of the benefits period. The tax rate for the remainder of the benefits period will be 25%, unless thelevel of foreign investment exceeds 49%, in which case the tax rate will be 20%if the foreign investment is more than 49% and less than 74%; 15% if more than74% and less than 90%; and 10% if 90% or more.  

* *

Subject toapplicable provisions concerning income under the alternative package ofbenefits, dividends paid by a company are considered to be attributable toincome received from the entire company and the company`s effective tax rate isthe result of a weighted average of the various applicable tax rates, excludingany tax-exempt income. Under the Investments Law, a company that has electedthe alternative package of benefits is not obliged to distribute retainedprofits, and may generally decide from which year`s profits to declaredividends. We currently intend to reinvest any income derived from our approvedenterprise program and not to distribute such income as a dividend. As of December 31, 2005, the company didnot generate income under the provision of the new law.

* *

Currently we have two approvedenterprises programs under the capital investment law, which entitle us to sometax benefits. The tax benefits period for these programs has not yet begun.Income derived from these alternative benefit programs is exempt from tax for aperiod of ten years, starting in the first year in which we generate taxable incomefrom the approved enterprise, subject to certain conditions.****Asmentioned above the year`s limitation does not apply to the exemption period. 

* *

*Tax benefits under the 2005 Amendment*

*** ***

The amendment includes revisions to the criteria forinvestments qualified to receive tax benefits as an Approved Enterprise. Theamendment applies to new investment programs and investment programs commencingafter 2004, and does not apply to investment programs approved prior to December 31, 2004. However, a company that was granted benefits according to section 51 ofthe Investment Law would not be allowed to commence production for a period of3 years from the company`s previous year of commencement of benefits under theinvestment law (prior the amendment).

 

 A companywishing to receive the tax benefits afforded to a Benefited Enterprise isrequired to select the tax year from which the period of benefits under theInvestment Law are to commence by notifying the Israeli Tax Authority within 12months of the end of that year. 

 

(Our company will continue to enjoy its current tax benefits inaccordance with the provisions of the Investment Law prior to its revision, butif our company is granted any new benefits in the future they will be subjectto the provisions of the amended Investment Law. Therefore, the followingdiscussion is a summary of the Investment Law prior to its amendment as well asthe relevant changes contained in the new legislation(.

 

The amendmentsimplifies the approval process: according the amendment, only ApprovedEnterprises receiving cash grants require the approval of the Investment Center.The Investment Center will be entitled, to approve such programs only until30.12.2007

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 The Amendmentdoes not apply to benefits included in any certificate of approval that wasgranted before the Amendment came into effect, which will remain subject to theprovisions of the Investment Law as they were on the date of such approval. 

 

Tax benefits are available under the Amendment to production facilities(or other eligible facilities), which are generally required to derive morethan 25% of their business income from export (referred to as a "BenefitedEnterprise"). In order to receive the tax benefits, the Amendment states thatthe company must make an investment in the Benefited Enterprise exceeding acertain percentage or a minimum amount specified in the Law. Such investmentmay be made over a period of no more than three years ending at the end of theyear in which the company requested to have the tax benefits apply to theBenefited Enterprise (the "Year of Election"). Where the companyrequests to have the tax benefits apply to an expansion of existing facilities,then only the expansion will be considered a Benefited Enterprise and the company`seffective tax rate will be the result of a weighted combination of theapplicable rates. In this case, the minimum investment required in order toqualify as a Benefited Enterprise is required to exceed a certain percentage ora minimum amount of the company`s production assets before the expansion.

* *

The durationof tax benefits is subject to a limitation of the earlier of 7 to 10 years fromthe Commencement Year, or 12 years from the first day of the Year of Election.The tax benefits granted to a Benefited Enterprise are determined, asapplicable to its geographic location within Israel, according to one of thefollowing new tax routes, which may be applicable to us: 

●*       *Similar to thecurrently available alternative route, exemption from corporate tax on undistributedincome for a period of two to ten years, depending on the geographic locationof the Benefited Enterprise within Israel, and a reduced corporate tax rate of10% to 25% for the remainder of the benefits period, depending on the level offoreign investment in each year.  Benefits may be granted for a termof seven to ten years, depending on the level of foreign investment in thecompany.  If the company pays a dividend out of income derived fromthe Benefited Enterprise during the tax exemption period, such income will besubject to corporate tax at the applicable rate (10%-25%) in respect of the grossamount of the dividend that we may distribute. The company is required towithhold tax at the source at a rate of 15% from any dividends distributed fromincome derived from the Benefited Enterprise; and

●*       *A special tax route,which enables companies owning facilities in certain geographical locations in Israel to paycorporate tax at the rate of 11.5% on income of the Benefited Enterprise. Thebenefits period is ten years. Upon payment of dividends, the company isrequired to withhold tax at source at a rate of 15% for Israeli residents andat a rate of 4% for foreign residents.

Generally, a company that is Abundant in ForeignInvestment (as defined in the Investments Law) is entitled to an extension ofthe benefits period by an additional five years, depending on the rate of itsincome that is derived in foreign currency.

* *

The Amendment changes the definition of "foreigninvestment" in the Investments Law so that the definition now requires aminimal investment of NIS 5 million by foreign investors. Furthermore, suchdefinition now also includes the purchase of shares of a company from anothershareholder, provided that the company`s outstanding and paid-up share capitalexceeds NIS 5 million. Such changes to the aforementioned definition will takeeffect retroactively from 2003.

* *

The Amendment will apply to approved enterpriseprograms in which the year of election under the Investments Law is 2004 orlater, unless such programs received approval from the Investment Center on orprior to December 31, 2004, in which case the Amendment provides that terms andbenefits included in any certificate of approval already granted will remainsubject to the provisions of the law as they were on the date of such approval.

*  *

**__62__** 

*Special Provisions Relating toMeasurement of Taxable Income*

Ourcompany is taxed under theIncome Tax Law (Inflationary Adjustments), 1985, generally referred to as theInflationary Adjustments Law. The Inflationary Adjustments Law is highlycomplex and represents an attempt to overcome the problems presented to atraditional tax system by an economy undergoing rapid inflation. Its features,which are material to us, are summarized as follows:

* *

●*       *Wherea company`s equity, as calculated under the Inflationary Adjustments Law,exceeds the depreciated cost of its fixed assets (as defined in theInflationary Adjustments Law), a deduction from taxable income is permittedequal to the excess multiplied by the applicable annual rate of inflation. Themaximum deduction permitted in any single tax year is 70% of taxable income,with the unused portion permitted to be carried forward, linked to the Israeliconsumer price index. The unused portion that was carried forward may bedeductible in full in the following year.

●*       *Wherea company`s depreciated cost of fixed assets exceeds its equity, then theexcess multiplied by the applicable annual rate of inflation is added totaxable income. (hereinafter: "Inflation supplement"). Note, the inflationsupplement will only be added to the corporate income but not to other incomessuch as capital gains.

●*       *Subjectto specified limitations, depreciation deductions on fixed assets and lossescarried forward are adjusted for inflation based on the change in the consumerprice index.

* *

The Minister of Finance may, with the approval of the KnessetFinance Committee, determine by decree, during a certain fiscal year (or untilFebruary 28th of the following year) in which the rate of increase of theIsraeli consumer price index would not exceed or did not exceed, as applicable,3.0%, that some or all of the provisions of the Inflationary Adjustments Lawshall not apply with respect to such fiscal year, or that the rate of increaseof the Israeli consumer price index relating to such fiscal year shall bedeemed to be 0%, and to make the adjustments required to be made as a result ofsuch determination

**** ****

*TaxBenefits of Research and Development*

 

Israeli taxlaw permits, under some conditions, a tax deduction in the year incurred forexpenditures, including capital expenditures, in scientific research anddevelopment projects, if the expenditures are approved by the relevantgovernment ministry and if the research and development is for the promotion ofthe enterprise and is carried out by, or on behalf of, a company seeking thededuction. 

* *

The OCS hasapproved some of our research and development programs and we have been able todeduct, for tax purposes, a portion of our research and development expensesnet of the grants received. Other research and development expenses that arenot approved may be deducted for tax purposes in 3 equal installments during a3-year period. 

 

Capital Gains Tax on Sales of OurOrdinary Shares

* *

Israeli law generally imposes acapital gains tax on the sale of any capital assets by residents of Israel, asdefined for Israeli tax purposes, and on the sale of assets located in Israel,including shares in Israeli companies, by both residents and non-residents ofIsrael, unless a specific exemption is available or unless a tax treaty betweenIsrael and the shareholder`s country of residence provides otherwise. The lawdistinguishes between real gain and inflationary surplus. The inflationarysurplus is a portion of the total capital gain which is equivalent to theincrease of the relevant asset`s purchase price which is attributable to theincrease in the Israeli consumer price index or, in certain circumstances, aforeign currency exchange rate, between the date of purchase and the date ofsale. The real gain is the excess of the total capital gain over theinflationary surplus.  

* *

Generally, until the 2006 tax year, capitalgains tax was imposed on Israeli resident individuals ata rate of 15% on real gains derived on or after January 1, 2003, from the saleof shares in, among others, Israeli companies publicly traded on Nasdaq or on arecognized stock exchange or regulated market in a country that has a treatyfor the prevention of double taxation with Israel. This tax rate was contingentupon the shareholder not claiming a deduction for financing expenses inconnection with such shares (in which case the gain was generally betaxed at a rate of 25%), and did not apply to:(i) the sale of shares to a relative (as defined in the Israeli Income TaxOrdinance); (ii) the sale of shares by dealers in securities; (iii) the sale ofshares by shareholders that report in accordance with the InflationaryAdjustments Law (that were taxed at 

**__63__** 

corporate tax rates for corporations and at marginal taxrates for individuals); or (iv) the sale ofshares by shareholders who acquired their shares prior to an initial publicoffering (that may be subject to a different tax arrangement). 

* *

As of January 1, 2006, the tax rateapplicable to capital gains derived from the sale of shares, whether listed ona stock market or not, is 20% for Israeli individuals, unless such shareholderclaims a deduction for financing expenses in connection with such shares, inwhich case the gain will generally be taxed at a rate of 25%. Additionally, ifsuch shareholder is considered a "material shareholder" at any time during the12-month period preceding such sale, i.e., such shareholder holds directly orindirectly, including with others, at least 10% of any means of control in thecompany, the tax rate shall be 25%. Israeli companies are subject to theCorporate Tax rate on capital gains derived from the sale of shares, unlesssuch companies were not subject to the Adjustments Law (or certain regulations)at the time of publication of the aforementioned amendment to the Tax Ordinancethat came into effect on January 1, 2006, in which case the applicable tax rateis 25%. However, the foregoing tax rates do not apply to: (i) dealers insecurities; and (ii) shareholders who acquired their shares prior to an initialpublic offering (that may be subject to a different tax arrangement).

* *

The tax basis ofshares acquired prior to January 1, 2003 will be determined in accordance with theaverage closing share price in the three trading days preceding January 1, 2003. However, a requestmay be made to the tax authorities to consider the actual adjusted cost of theshares as the tax basis if it is higher than such average price. 

* *

Non-Israeliresidents are exempt from Israeli capital gains tax on any gains derived fromthe sale of shares of Israeli companies publicly traded on a recognized stockexchange or regulated market outside of Israel, provided however that suchcapital gains are not derived from a permanent establishment in Israel, suchshareholders are not subject to the Adjustments Law, and such shareholders didnot acquire their shares prior to an initial public offering. However,non-Israeli corporations will not be entitled to such exemption if an Israeliresident (i) has a controlling interest of 25% or more in such non-Israelicorporation, or (ii) is the beneficiary or is entitled to 25% or more of therevenues or profits of such non-Israeli corporation, whether directly orindirectly.

*    *

In some instanceswhere our shareholders may be liable to Israeli tax on the sale of theirordinary shares, the payment of the consideration may be subject to thewithholding of Israeli tax at the source. 

* *

Pursuant to theConvention Between the government of the United States of America and thegovernment of Israel with Respect to Taxes on Income, as amended (the"U.S.-Israel Tax Treaty"), the sale, exchange or disposition of ordinary sharesby a person who (i) holds the ordinary shares as a capital asset, (ii)qualifies as a resident of the United States within the meaning of theU.S.-Israel Tax Treaty and (iii) is entitled to claim the benefits afforded tosuch person by the U.S.-Israel Tax Treaty, generally, will not be subject tothe Israeli capital gains tax. Such exemption will not apply if (i) such TreatyU.S. Resident holds, directly or indirectly, shares representing 10% or more ofour voting power during any part of the 12-month period preceding such sale,exchange or disposition, subject to certain conditions, or (ii) the capitalgains from such sale, exchange or disposition can be allocated to a permanentestablishment in Israel. In such case, the sale, exchange or disposition ofordinary shares would be subject to Israeli tax, to the extent applicable;however, under the U.S.-Israel Tax Treaty, such Treaty U.S. Resident would bepermitted to claim a credit for such taxes against the U.S. federal income taximposed with respect to such sale, exchange or disposition, subject to thelimitations in U.S. laws applicable to foreign tax credits. The U.S.-Israel TaxTreaty does not relate to U.S. state or local taxes.

**** ****

Taxationof Non-Resident Holders of Shares

 

Non-residents of Israel are subject toincome tax on income accrued or derived from sources in Israel. Such sources of incomeinclude passive income such as dividends, royalties and interest, as well asnon-passive income from services rendered in Israel. On distributionsof dividends other than bonus shares, or stock dividends, income tax iswithheld at the source at the following rates: (i) for dividends distributedprior to January 1, 2006 - 25%; (ii) for dividends distributed on or afterJanuary 1, 2006 - 20%, or 25% for a shareholder that is considered a "materialshareholder" at any time during the 12-month period preceding suchdistribution, unless a different rate is provided in a treaty between Israeland the shareholder`s country of residence. Under the U.S.-Israel Tax Treaty,the maximum tax on dividends paid to a holder of ordinary shares who is aTreaty U.S. Resident is 25%. However, under the Investments Law, dividendsgenerated by an Approved Enterprise (or Benefited Enterprise) are taxed at therate of 15%. Furthermore, dividends not generated by an Approved Enterprise (orBenefited Enterprise) paid to a U.S. corporation holding at least 10% of ourissued voting powerduring the part of the tax year which precedes the date of payment of thedividend and during the whole of its prior tax year,are generally taxed at a rate of 12.5%.

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* *

* *

For information with respect to the applicability ofIsraeli capital gains taxes on the sale of ordinary shares by United Statesresidents, see above " - Capital Gains Tax on Sales of Our Ordinary Shares."

*** ***

**United  States****Federal Income Tax Considerations**

 

Subject to the limitationsdescribed below, the following discussion summarizes certain U.S. federalincome tax consequences of the purchase, ownership and disposition of ourordinary shares to a U.S. holder that owns our ordinary shares as a capitalasset (generally, for investment).  A U.S. holder is a holder of ourordinary shares that is:

●*       *an individual citizen or resident of the United  States;

●*       *a corporation (or other entity taxable as acorporation for U.S. federal income tax purposes) created or organizedin the United States or under the laws of the United States, any politicalsubdivision thereof or the District of Columbia;

●*       *an estate, the income of which is subject to U.S.federal income tax regardless of its source; or

●*       *a trust if (i) a court within the United States is able to exercise primary supervision over its administration and oneor more U.S. persons have the authority to control all of its substantialdecisions or (ii) that has in effect a valid election under applicable U.S.Treasury Regulations to be treated as a U.S. person.

If a partnership (or anyother entity treated as a partnership for U.S. federal income tax purposes)holds our ordinary shares, the tax treatment of the partnership and a partnerin such partnership will generally depend on the status of the partner and theactivities of the partnership.  Such a partner or partnership shouldconsult its tax advisor as to its tax consequences.

Certain aspects of U.S.federal income taxes relevant to a holder of our ordinary shares that is not a U.S.holder (a "Non-U.S. holder") are also discussed below.

This discussion is based oncurrent provisions of the Internal Revenue Code of 1986, as amended (the"Code"), current and proposed Treasury Regulations, and administrative andjudicial decisions as of the date of this annual report, all of which aresubject to change, possibly on a retroactive basis. This discussion does notaddress all aspects of U.S. federal income taxation that may be relevant to anyparticular U.S. holder in light of the holder`s individual circumstances. Inparticular, this discussion does not address the potential application of thealternative minimum tax or the U.S. federal income tax consequences to U.S.holders that are subject to special treatment, including U.S. holders that:

●*       *are broker-dealers or insurance companies;

●*       *have elected mark-to-market accounting;

●*       *are tax-exempt organizations or retirement plans;

●*       *are grantor trusts;

●*       *are certain former citizens or long-term residentsof the United States;

●*       *are financial institutions or financial servicesentities;

●*       *hold ordinary shares as part of a straddle, hedgeor conversion transaction with other investments;

●*       *acquired their ordinary shares upon the exercise ofemployee stock options or otherwise as compensation;

●*       *are real estate investment trusts or regulatedinvestment companies;

●*       *own directly, indirectly or by attribution at least10% of our voting power; or

●*       *have a functional currency that is not the U.S.dollar.

This discussion is not a comprehensive descriptionof all of the tax considerations that may be relevant to each person`s decisionto purchase our ordinary shares. For example, this discussion does not addressany aspect of state, local or non-U.S. tax laws or the possible application of United  States federal gift or estate taxes.

 

**__65__** 

**Each holder of our ordinary shares is advised toconsult his or her own tax advisor with respect to the specific taxconsequences to him or her of purchasing, owning or disposing of our ordinaryshares, including the applicability and effect of federal, state, local andforeign income and other tax laws to his or her particular circumstances.**

 

Taxation of Distributions Paid onOrdinary Shares

Subject to the discussionbelow under "Tax Consequences if We are a Passive Foreign Investment Company,"a U.S. holder will be required to include in gross income as dividend incomethe amount of any distribution paid on our ordinary shares, including anynon-U.S. taxes withheld from the amount paid, on the date the distribution isreceived to the extent the distribution is paid out of our current oraccumulated earnings and profits, as determined for U.S. federal income taxpurposes. Distributions in excess of earnings and profits will be appliedagainst and will reduce the U.S. holder`s tax basis in its ordinary shares and,to the extent in excess of that basis, will be treated as gain from the sale orexchange of ordinary shares. The dividend portion of such distributiongenerally will not qualify for the dividends received deduction otherwiseavailable to corporations.

Dividends that are receivedby U.S. holders that are individuals, estates or trusts will be taxed at therate applicable to long-term capital gains (currently a maximum rate of 15% fortaxable years beginning on or before December 31, 2010), provided that such dividendsmeet the requirements of "qualified dividend income." Dividends that fail tomeet such requirements, and dividends received by corporate U.S. holders, aretaxed at ordinary income rates.  No dividend received by a U.S.holder will be a qualified dividend if (1) the U.S. holder held the ordinaryshare with respect to which the dividend was paid for less than 61 days duringthe 121-day period beginning on the date that is 60 days before the ex-dividenddate with respect to such dividend, excluding for this purpose, under the rulesof Code Section 246(c), any period during which the U.S. holder has an optionto sell, is under a contractual obligation to sell, has made and not closed ashort sale of, is the grantor of a deep-in-the-money or otherwise nonqualifiedoption to buy, or has otherwise diminished its risk of loss by holding otherpositions with respect to, such ordinary share (or substantially identicalsecurities) or (2) the U.S. holder is under an obligation (pursuant to a shortsale or otherwise) to make related payments with respect to positions inproperty substantially similar or related to the ordinary share with respect towhich the dividend is paid.  If we were to be a "passive foreigninvestment company" (as such term is defined in the Code) for any year,dividends paid on our ordinary shares in such year or in the following yearwould not be qualified dividends.  In addition, a non-corporate U.S.holder will be able to take a qualified dividend into account in determiningits deductible investment interest (which is generally limited to its netinvestment income) only if it elects to do so; in such case the dividend willbe taxed at ordinary income rates.

Distributions of current oraccumulated earnings and profits paid in foreign currency to a U.S. holder(including any non-U.S. taxes withheld from the distributions) will beincludible in the income of a U.S. holder in a dollar amount calculated byreference to the exchange rate on the date of the distribution. A U.S. holderthat receives a foreign currency distribution and converts the foreign currencyinto dollars after the date of distribution will have foreign exchange gain orloss based on any appreciation or depreciation in the value of the foreigncurrency against the dollar, which will generally be U.S. source ordinaryincome or loss.

U.S. holders will have theoption of claiming the amount of any non-U.S. income taxes withheld at sourceeither as a deduction from gross income or as a dollar-for-dollar creditagainst their U.S. federal income tax liability. Individuals who do not claimitemized deductions, but instead utilize the standard deduction, may not claima deduction for the amount of the non-U.S. income taxes withheld, but theamount may be claimed as a credit against the individual`s U.S. federal incometax liability. The amount of non-U.S. income taxes that may be claimed as acredit in any year is subject to complex limitations and restrictions, whichmust be determined on an individual basis by each shareholder. These limitationsinclude rules which limit foreign tax credits allowable for specific classes ofincome to the U.S. federal income taxes otherwise payable on each such class ofincome. The total amount of allowable foreign tax credits in any year cannotexceed the pre-credit U.S. tax liability for the year attributable to non-U.S.source taxable income. Distributions of current or accumulated earnings andprofits will generally be non-U.S. source passive income for U.S. foreign taxcredit purposes; however, special rules will apply if we are a "UnitedStates-owned foreign corporation."  In that case, distributions ofcurrent or accumulated earnings and profits will be treated as U.S. source andnon-U.S. source income in proportion to our earnings and profits in the year ofthe distribution allocable to U.S. and non-U.S. sources. We will be treated asa United States-owned foreign corporation as long as stock representing 50% ormore of the voting power or value of our ordinary shares is owned, directly orindirectly, by United States persons.  Non-U.S. taxes allocable tothe portion of our distributions treated as from U.S. sources under these rulesmay not be creditable against a U.S. holder`s U.S. federal income tax liabilityon such portion.

**__66__** 

A U.S. holder will be denieda foreign tax credit for non-U.S. income taxes withheld from a dividendreceived on the ordinary shares if (1) the U.S. holder has not held theordinary shares for at least 16 days of the 31-day period beginning on the datewhich is 15 days before the ex-dividend date with respect to such dividend or(2) to the extent the U.S. holder is under an obligation to make relatedpayments with respect to positions in substantially similar or relatedproperty.  Any days during which a U.S. holder has substantiallydiminished its risk of loss on the ordinary shares are not counted towardmeeting the required 16-day holding period. 

Taxation of the Disposition ofOrdinary Shares

Subject to the discussionbelow under "Tax Consequences if We are a Passive Foreign Investment Company,"upon the sale, exchange or other disposition of our ordinary shares, a U.S.holder will recognize capital gain or loss in an amount equal to the differencebetween the U.S. holder`s basis in the ordinary shares, which is usually the costto the U.S. holder of the ordinary shares, and the amount realized on thedisposition. A disposition of ordinary shares will be considered to occur onthe trade date, regardless of the U.S. holder`s method of accounting. Capitalgain from the sale, exchange or other disposition of ordinary shares held morethan one year will be long-term capital gain and may, in the case ofnon-corporate U.S. holders, be subject to a reduced rate of taxation (long-termcapital gains are currently taxable at a maximum rate of 15% for taxable yearsbeginning on or before December 31, 2010).  Gain or loss recognizedby a U.S. holder on a sale, exchange or other disposition of ordinary shareswill generally be treated as U.S. source income for U.S. foreign tax creditpurposes. The deductibility of a capital loss recognized on the sale, exchangeor other disposition of ordinary shares is subject to limitations.

A U.S. holder that uses thecash method of accounting calculates the dollar value of the proceeds receivedon the sale as of the date that the sale settles.  However, a U.S.holder that uses the accrual method of accounting is required to calculate thevalue of the proceeds of the sale as of the trade date and may thereforerealize foreign currency gain or loss. A U.S. holder may avoid realizingforeign currency gain or loss if he or she has elected to use the settlementdate to determine its proceeds of sale for purposes of calculating the foreigncurrency gain or loss. In addition, a U.S. holder that receives foreign currencyupon disposition of ordinary shares and converts the foreign currency intodollars after the settlement date or trade date (whichever date the U.S. holderis required to use to calculate the value of the proceeds of sale) will haveforeign exchange gain or loss based on any appreciation or depreciation in thevalue of the foreign currency against the dollar, which will generally be U.S.source ordinary income or loss.

Tax Consequences if We are a PassiveForeign Investment Company

For U.S. federal income taxpurposes, we will be classified as a passive foreign investment company, orPFIC, for any taxable year in which either, after applying certain look-thrurules, (i) 75% or more of our gross income is passive income or (ii) at least50% of the average value of our total assets for the taxable year produces orare held for the production of passive income. For this purpose, cash isconsidered to be an asset which produces passive income.  Passiveincome includes dividends, interest, royalties, rents, annuities and the excessof gains over losses from the disposition of certain assets which producepassive income.

Based on our income, assets,activities and market capitalization, we do not believe that we were a PFIC forthe taxable year ended December 31, 2006.  However, there can be noassurances that the United States Internal Revenue Service ("IRS") will notchallenge this conclusion.  There is a risk that we were a PFIC forthe taxable years 2001, 2002 and 2003 as a result of our substantial cash positionand the performance of our ordinary shares during those taxable years.  Ifwe were a PFIC during, U.S. holders who acquired or held our ordinary sharesduring those taxable years will he subject to the PFIC rules described belowregardless of whether we were a PFIC for 2006.  However, if we werenot a PFIC for 2006, U.S. holders who acquired our ordinary shares in 2006 willnot be subject to the PFIC rules unless we are classified as a PFIC in futureyears.  The tests for determining PFIC status are applied annuallyand it is difficult to make accurate predictions of our future income, assetsand market capitalization, which are relevant to this determination.

If we are a PFIC, a U.S. holder of our ordinaryshares could be subject to increased tax liability upon the sale or otherdisposition (including gifts) of its ordinary shares or upon the receipt ofamounts treated as "excess distributions," which could result in a reduction inthe after-tax return to such U.S. holder. In general, an excess distribution isthe amount of distributions received during a taxable year that exceed 125% ofthe average amount of distributions received by A U.S. holder in respect of theordinary shares during the preceding three taxable years, or if shorter, duringthe U.S. holder`s holding period prior to the taxable year of the distribution.Under these rules, the excess distribution and any gain on the disposition ofordinary shares would be allocated ratably over the U.S. holder`s holdingperiod for the ordinary shares. The amount allocated to the current taxableyear and any taxable year prior to the first taxable year in which we were aPFIC would be taxed as ordinary income. The amount allocated to each of theother taxable years would be subject to tax at the highest marginal rate ineffect for the applicable class of taxpayer for that taxable year, and aninterest charge for the deemed deferral benefit would be imposed on theresulting tax allocated to such other taxable years. The tax liability with 

**__67__** 

respect to the amount allocated to taxable years prior tothe year of the disposition or distribution cannot be offset by net operatinglosses. In addition, holders of stock in a PFIC may not receive a "step-up" inbasis on shares acquired from a decedent.

 

As an alternative to the tax treatment describedabove, a U.S. holder could elect to treat us as a "qualified electing fund"("QEF"), in which case the U.S. holder would be required to include in income,for each taxable year that we are a PFIC, its pro rata share of our ordinaryearnings as ordinary income and its pro rata share of our net capital gains aslong-term capital gain, subject to a separate election to defer payment oftaxes which deferral is subject to an interest charge.  Any incomeinclusion will be required whether or not such U.S. holder owns our ordinaryshares for an entire taxable year or at the end of our taxable year. The amountso includable will be determined without regard to our prior year losses or theamount of cash distributions, if any, received from us.  Specialrules apply if a U.S. holder makes a QEF election after the first year in itsholding period in which we are a PFIC.  We will supply U.S. holdersthat make a request in writing with the information needed to report income andgain under a QEF election if we are a PFIC.  A U.S. holder`s basis inits ordinary shares will increase by any amount included in income and decreaseby any amounts not included in income when distributed because such amountswere previously taxed under the QEF rules. So long as a U.S. holder`s QEFelection is in effect with respect to the entire holding period for itsordinary shares, any gain or loss realized by such holder on the disposition ofits ordinary shares held as a capital asset ordinarily would be capital gain orloss. Such capital gain or loss ordinarily would be long-term if such U.S.holder had held such ordinary shares for more than one year at the time of thedisposition. For non-corporate U.S. holders, long-term capital gain isgenerally subject to a maximum federal income tax rate of 15% for taxable yearsbeginning on or before December 31, 2010. The QEF election is made on ashareholder-by-shareholder basis, applies to all ordinary shares held orsubsequently acquired by an electing U.S. holder and can be revoked only withthe consent of the IRS.

 

As an alternative to making aQEF election, a U.S. holder of PFIC stock which is "marketable stock" (e.g.,"regularly traded" on the Nasdaq National Market) may in certain circumstancesavoid certain of the tax consequences generally applicable to holders of stockin a PFIC by electing to mark the stock to market as of the beginning of suchU.S. holder`s holding period for the ordinary shares. As a result of such anelection, in any taxable year that we are a PFIC, a U.S. holder would generallybe required to report gain or loss to the extent of the difference between thefair market value of the ordinary shares at the end of the taxable year andsuch U.S. holder`s tax basis in its ordinary shares at that time. Any gainunder this computation, and any gain on an actual disposition of the ordinaryshares, would be treated as ordinary income. Any loss under this computation,and any loss on an actual disposition of the ordinary shares, generally wouldbe treated as ordinary loss to the extent of the cumulative net-mark-to-marketgain previously included. Any remaining loss from marking ordinary shares tomarket will not be allowed, and any remaining loss from an actual dispositionof ordinary shares generally would be capital loss. A U.S. holder`s tax basisin its ordinary shares is adjusted annually for any gain or loss recognizedunder the mark-to-market election. There can be no assurances that there willbe sufficient trading volume with respect to the ordinary shares for theordinary shares to be considered "regularly traded" or that our ordinary shareswill continue to trade on the Nasdaq National Market.  Accordingly,there are no assurances that the ordinary shares will be marketable stock forthese purposes. As with a QEF election, a mark-to-market election is made on ashareholder-by-shareholder basis, applies to all ordinary shares held orsubsequently acquired by an electing U.S. holder and can only he revoked withconsent of the IRS (except to the extent the ordinary shares no longerconstitute "marketable stock").

**The****U.S.****federal income tax consequences to a****U.S.****holder if we were to be a PFIC are complex.  A****U.S.****holder should consult with his or her own advisor with regard to thoseconsequences, as well as with regard to whether he or she should make either ofthe elections described above.**

*** ***

Tax Consequences for Non-U.S.Holders of Ordinary Shares

Except as described in"Information Reporting and Back-up Withholding" below, a Non-U.S. holder of ordinaryshares will not be subject to U.S. federal income or withholding tax on thepayment of dividends on, and the proceeds from the disposition of, our ordinaryshares, unless:

●*       *the item is effectively connected with the conductby the Non-U.S. holder of a trade or business in the United States and in thecase of a resident of a country which has a treaty with the United States, theitem is attributable to a permanent establishment, or in the case of anindividual, the item is attributable to a fixed place of business in the UnitedStates; or

●*       *the Non-U.S. holder is an individual who holds theordinary shares as a capital asset and is present in the United Statesfor 183 days or more in the taxable year of the disposition and certain otherconditions are met.

**__68__** 

 

Information Reporting and Back-upWithholding

U.S. holders generally are subject to informationreporting requirements with respect to dividends paid in the United States on,or proceeds from the disposition of, our ordinary shares. In addition, a U.S.holder may be subject, under certain circumstances, to backup withholding at arate of up to 28% with respect to dividends paid on, or proceeds from thedisposition of, our ordinary shares unless the U.S. holder provides proof of anapplicable exemption or correct taxpayer identification number and otherwisecomplies with applicable requirements of the backup withholding rules. A U.S.holder of our ordinary shares who provides an incorrect taxpayer identificationnumber may be subject to penalties imposed by the IRS. Amounts withheld underthe backup withholding rules are not an additional tax and may be refunded orcredited against the U.S. holder`s federal income tax liability, provided therequired information is furnished to the IRS.

 

Non-U.S. holders generallyare not subject to information reporting or back-up withholding with respect todividends paid on, or proceeds from the disposition of, our ordinary shares,provided that the Non-U.S. holder provides taxpayer identification number,certifies to its foreign status, or establishes another exemption to theinformation reporting or back-up withholding requirements.

** **

#####  Documents on Display

** **

We are required to file reports and otherinformation with the SEC under the Securities Exchange Act of 1934 and theregulations thereunder applicable to foreign private issuers. You may inspectand copy reports and other information filed by us with the SEC at the SEC`spublic reference facilities described below.  Although as a foreignprivate issuer we are not required to file periodic information as frequentlyor as promptly as United States companies, we generally announce publicly ourquarterly and year-end results promptly and file periodic information with theSEC under cover of Form 6-K. As a foreign private issuer, we are also exemptfrom the rules under the Exchange Act prescribing the furnishing and content ofproxy statements and our officers, directors and principal shareholders areexempt from the reporting and other provisions in Section 16 of the ExchangeAct.

 

You may review a copy of our filings with the SEC,including any exhibits and schedules, at the SEC`s public reference facilitiesin 100F Street N.W., Washington, D.C. 20549 and at offices of the IsraelSecurities Authority at 22 Kanfei Nesharim St., Jerusalem, Israel. You may alsoobtain copies of such materials from the Public Reference Section of the SEC, 100  F Street, N.W., Washington, D.C. 20549, at prescribed rates. You may call theSEC at 1-800-SEC-0330 for further information on the public reference rooms. Asa foreign private issuer we were only required to file through the SEC`s EDGARsystem as of November 2002. Our periodic filings are therefore available on theSEC`s Website www.sec.gov from that date. You may read and copy any reports,statements or other information that we file with the SEC, through the SEC`sEDGAR system available on the SEC`s website and at the SEC facilities listedabove. These SEC filings are also available to the public on the IsraelSecurities Authority`s website at www.isa.gov.il and from commercial documentretrieval services.  

 

Any statement in this annual report about any ofour contracts or other documents is not necessarily complete. If the contractor document is filed as an exhibit to this annual report, the contract ordocument is deemed to modify the description contained in this annual report.We urge you to review the exhibits themselves for a complete description of thecontract or document.

**__69__** 

### ITEM11.                QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

 

 We are exposed to a variety of risks, includingchanges in interest rates and foreign currency exchange risk and inflation. On December 31, 2005 and December 31, 2004, $14 million of our available cash was invested inmarket risk sensitive instruments. On December 31, 2006, $5 million of ouravailable cash was invested in market risk sensitive instruments Theseinstruments are three structured notes that we acquired from three separate andunaffiliated issuers. These bear an interest rate, which is dependent upon thesix-months LIBOR rate. During the 12 months ended December 31, 2006 two out of the three structured notes, totaling $9 million matured.

 

We may, in the future, undertake hedging or othersimilar transactions or invest in other market risk sensitive instruments, ifour management will determine that it is necessary to offset these risks.

 

**Interest Rate Risk**

 

As of December 31, 2006, we had $26.4 million incash, cash equivalents, deposits and marketable securities. We invest our cashsurplus in bank deposits and marketable securities. Since these investmentstypically carry fixed interest rate, excluding our structure note, and sinceour policy and practice is to hold these investments to maturity, financialincome over the holding period is not sensitive to changes in interest rates.

 

##### Foreign CurrencyExchange Risk and Inflation 

** **

Since the majority of our cash, cash equivalents,deposits and marketable securities are held in US dollars, we believe thatinflation and fluctuations in the NIS/US dollar exchange rate have no materialeffect on our revenues. 

 

We incur a significant portion of our expenses,principally salaries and related personnel expenses, in New Israel Shekels, or NIS.As a result, we are exposed to the risk that the US dollar will be devaluedagainst the New Israel Shekels. To date, our business has not been materiallyadversely affected by changes in the Israeli rate of inflation or the exchange ratesof the NIS compared to the US dollar. 

### * *

### ITEM12.                DESCRIPTION OF SECURITIES OTHER THAN EQUITY SECURITIES

 

Not applicable.

**__70__** 

 

# PARTII

 

### ITEM 13.                DEFAULTS, DIVIDEND ARREARAGESAND DELINQUENCIES

 

None. 

 

### ITEM 14.                MATERIAL MODIFICATIONS TO THERIGHTS OF SECURITY HOLDERS AND USE OF PROCEEDS

 

##### Material Modificationsto the Rights of Security Holders

 

None. 

 

##### Use of Proceeds 

** **

None. 

** **

### ITEM 15.                CONTROLS AND PROCEDURES

 

Our disclosure controls and procedures are designedto provide reasonable assurance that information required to be disclosed inthis report is recorded, processed, summarized and reported on a timely basis.Under the supervision of our Chief Executive Officer and Chief FinancialOfficer, we conducted an evaluation of our disclosure controls and procedures,as such term is defined under Rule 13a-15(e) and 15d-15(e) promulgated underthe Securities Exchange Act of 1934. Based on this evaluation, our ChiefExecutive Officer and Chief Financial Officer concluded that our disclosurecontrols and procedures were effective as of the end of the period covered bythis annual report. Our Chief Executive Officer and Chief Financial Officerhave also concluded that there were no significant changes in our internalcontrols or in other factors that could significantly affect the internalcontrols subsequent to that date of evaluation, including any correctiveactions with regard to significant deficiencies and material weaknesses.

 

### ITEM 16.                RESERVED

** **

### ITEM 16A.            AUDIT COMMITTEE FINANCIAL EXPERT

 

Our board of directors has determined that Mr. David Schlachet, who chairs our audit committee, is our "audit committee financialexpert". Mr. Schlachet is "independent" as defined by Nasdaq.

### ITEM 16B.             CODE OF ETHICS

 

Our board of directors adopted a code of ethicsthat applies to our chief executive officer, chief financial officer, directorof finance, controller, and other persons performing similar functions. 

 

The code of ethics is posted on our website,addressed www.cgen.com.

**__71__** 

 

### ITEM16C.             PRINCIPAL ACCOUNTANT FEES AND SERVICES

 

The following table presentsthe fees paid to our external auditors for professional services rendered inthe years ended December 31, 2006 and 2005: 

 
|               | 2006        | 2005        |
|--------------------|-------------|-------------|
| Audit Fees         | $55,000     | $55,000     |
| Audit Related Fees |        | -           |
| Tax Fees           | $10,000     | $10,000     |
| All Other Fees     | $10,000     | $2,120      |
| **Total**          | **$75,000** | **$67,120** |

 

"Audit Fees" are fees for professional servicesrendered in connection with the audit of our consolidated annual financialstatements and review of our unaudited interim financial statements;

 

"Audit Related Fees" are fees for professionalservices rendered in connection with the audit and other assignments, relatingto internal accounting functions and procedures;

 

"Tax Fees" are fees for services rendered inconnection with tax compliance, tax planning and tax advice; and

 

"All Other Fees" are fees for consulting servicesrendered to us.

 

ITEM 16D.             EXEMPTIONS FROM THE LISTINGSTANDARDS FOR AUDIT COMMITTEES

None.

 

ITEM 16E.             PURCHASES OF EQUITY SECURITIES BYTHE ISSUER AND AFFILIATED PURCHASERS

 

None.

**__72__** 

# PARTIII

*** ***

### ITEM 17.                FINANCIAL STATEMENTS

 

We have elected to furnish financial statements andrelated information specified in Item 18.

 

### ITEM 18.                FINANCIAL STATEMENTS

 

See pages F-1 to F-34.

 

### ITEM 19.                EXHIBITS 

** **

##### Index to Exhibits

 
| **Exhibit Number** | **Description**                                                                                                                                  |
|--------------------|--------------------------------------------------------------------------------------------------------------------------------------------------|
|               |                                                                                                                                             |
| *1.1               | Form of Articles of Association of Issuer                                                                                                        |
| 10.1               | Consent of Kost Forer Gabbay & Kasierer, a  member of Ernst & Young Global, dated April 16, 2007.                                        |
| 10.2               | Consent of Kesselman & Kesselman, member of PriceWaterhouseCoopers,  independent auditors of Keddem Bioscience, dated April 16, 2007.        |
| 10.3               | Audit Report by Kesselman & Kesselman, member  of PriceWaterhouseCoopers, independent auditors of Keddem Bioscience, dated January 24, 2007. |
| 12.1               | Certification by Chief Executive Officer pursuant  to section 302 of the Sarbanes-Oxley Act of 2002.                                             |
| 12.2               | Certification by Chief Financial Officer pursuant  to section 302 of the Sarbanes-Oxley Act of 2002.                                             |
| 12.3               | Certification by Chief Executive Officer pursuant  to section 906 of the Sarbanes-Oxley Act of 2002.                                             |
| 12.4               | Certification by Chief Financial Officer pursuant  to section 906 of the Sarbanes-Oxley Act of 2002.                                             |

* *

*  Filed as exhibit toour registration statement on Form F-1, registration number 333-12316, asamended, filed with the Securities and Exchange Commission, and is herebyincorporated by reference.

**__73__** 

SIGNATURES

 

Pursuant to the requirements of Section 12 of theSecurities Exchange Act of 1934, the registrant hereby certifies that it meetsall the requirements for filing on Form 20-F and has duly caused this annualreport to be signed on its behalf by the undersigned, thereunto dulyauthorized, in the city of Tel Aviv, State of Israel, on this 16 day of April,2007.

 

 

** **

** **

**COMPUGEN LTD.**

 

 

 

Signature:      \s\ Mr. Alex Kotzer

Name:             Alex Kotzer

Title:               President, Chief ExecutiveOfficer and Director

Date:               April 16,2007

 

**__74__** 

Exhibit12.1

**CERTIFICATION****PURSUANT TO SECTION 302**

**OF THE SARBANES-OXLEY ACT OF 2002**

 

I, Mr. Alex Kotzer, certify that:

1.             Ihave reviewed this annual report on Form 20-F of Compugen Ltd.; 

2.             Basedon my knowledge, this report does not contain any untrue statement of amaterial fact or omit to state a material fact necessary to make the statementsmade, in light of the circumstances under which such statements were made, notmisleading with respect to the period covered by this report; 

3.             Basedon my knowledge, the financial statements, and other financial informationincluded in this report, fairly present in all material respects the financialcondition, results of operations and cash flows of the company as of, and for,the periods presented in this report; 

4.             Thecompany's other certifying officer and I are responsible for establishing andmaintaining disclosure controls and procedures (as defined in Exchange ActRules 13a-15(e) and 15d-15(e)) and internal control over financial reporting(as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the company andhave: 

a.             designed such disclosure controls andprocedures, or caused such disclosure controls and procedures to be designedunder our supervision, to ensure that material information relating to thecompany, including its consolidated subsidiaries, is made known to us by otherswithin those entities, particularly during the period in which this report isbeing prepared; 

b.             designed such internal control overfinancial reporting, or caused such internal control over financial reportingto be designed under our supervision, to provide reasonable assurance regardingthe reliability of financial reporting and the preparation of financialstatements for external purposes in accordance with generally acceptedaccounting principles;

c.             evaluated the effectiveness of thecompany's disclosure controls and procedures and presented in this report ourconclusions about the effectiveness of the disclosure controls and procedures,as of the end of the period covered by this report based on such evaluation ;and 

d.             disclosed in this report any change inthe company's internal control over financial reporting that occurred duringthe period covered by the annual report that has materially affected, or isreasonably likely to materially affect, the company's internal control over financial reporting; and 

5.             Thecompany's other certifying officer and I have disclosed, based on our mostrecent evaluation of internal control over financial reporting, to thecompany's auditors and the audit committee of the company's board of directors(or persons performing the equivalent functions): 

a.             all significant deficiencies andmaterial weaknesses in the design or operation of internal control overfinancial reporting which are reasonably likely to adversely affect thecompany's ability to record, process, summarize and report financialinformation; and 

b.             any fraud, whether or not material,that involves management or other employees who have a significant role in thecompany's internal control over financial reporting.

 

\s\ Alex Kotzer

 

Title: President, Chief Executive Officer and Director

Date: April 16,2007

**__75__** 

Exhibit 12.2

**CERTIFICATION PURSUANT TO SECTION 302**

**OF THE SARBANES-OXLEY ACT OF 2002**

 

I, Nurit Benjamini, certify that:

1.             Ihave reviewed this annual report on Form 20-F of Compugen Ltd.; 

2.             Basedon my knowledge, this report does not contain any untrue statement of amaterial fact or omit to state a material fact necessary to make the statementsmade, in light of the circumstances under which such statements were made, notmisleading with respect to the period covered by this report; 

3.             Basedon my knowledge, the financial statements, and other financial informationincluded in this report, fairly present in all material respects the financialcondition, results of operations and cash flows of the company as of, and for,the periods presented in this report; 

4.             Thecompany's other certifying officer and I are responsible for establishing andmaintaining disclosure controls and procedures (as defined in Exchange ActRules 13a-15(e) and 15d-15(e)) and internal control over financial reporting(as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the company andhave: 

a.             designed such disclosure controls andprocedures, or caused such disclosure controls and procedures to be designedunder our supervision, to ensure that material information relating to thecompany, including its consolidated subsidiaries, is made known to us by otherswithin those entities, particularly during the period in which this report isbeing prepared; 

b.             designed such internal control overfinancial reporting, or caused such internal control over financial reportingto be designed under our supervision, to provide reasonable assurance regardingthe reliability of financial reporting and the preparation of financialstatements for external purposes in accordance with generally acceptedaccounting principles;

c.             evaluated the effectiveness of thecompany's disclosure controls and procedures and presented in this report ourconclusions about the effectiveness of the disclosure controls and procedures,as of the end of the period covered by this report based on such evaluation ;and 

d.             disclosed in this report any change inthe company's internal control over financial reporting that occurred duringthe period covered by the annual report that has materially affected, or isreasonably likely to materially affect, the company's internal control over financial reporting; and 

5.             Thecompany's other certifying officer and I have disclosed, based on our mostrecent evaluation of internal control over financial reporting, to thecompany's auditors and the audit committee of the company's board of directors(or persons performing the equivalent functions): 

a.             all significant deficiencies and material weaknesses inthe design or operation of internal control over financial reporting which arereasonably likely to adversely affect the company's ability to record, process,summarize and report financial information; and 

b.             any fraud, whether or not material, that involvesmanagement or other employees who have a significant role in the company'sinternal control over financial reporting.

** **

\s\ Nurit Benjamini

 

Title:       Chief Financial Officer 

Date:       April 16, 2007

**__76__** 

 

Exhibit 12.3

**CERTIFICATION PURSUANT TO SECTION 906**

**OF THE SARBANES-OXLEY ACT OF 2002**

 

In connectionwith the annual report of Compugen Ltd. (the "Company") on Form 20-F for theperiods ending December 31, 2006 as filed with the Securities and ExchangeCommission on the date hereof (the "Report"), I the undersigned, being thePresident and Chief Executive Officer of the Company, certify, pursuant to 18 U.S.C.Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of2002, that to my knowledge:****

1.             TheReport fully complies with the requirements of sections 13(a) or 15(d) of theSecurities Exchange Act of 1934; and

2.             Theinformation contained in the Report fairly presents, in all material respects,the financial condition and results of operations of the Company.

 

 

\s\ Alex Kotzer

 

Title:       President, ChiefExecutive Officer and Director

Date:       April 16, 2007

 

The foregoingcertification is being furnished solely to accompany the Report pursuant to 18U.S.C. No. 1350, and is not being filed for purposes of Section 18 of theSecurities Exchange Act of 1934, as amended, and is not to be incorporated byreference into any filing of the Company, whether made before or after the datehereof, regardless of any general incorporation language in such filing.

 

**__77__** 

 

Exhibit 12.4

**CERTIFICATION PURSUANT TO SECTION 906**

**OF THE SARBANES-OXLEY ACT OF 2002**

 

In connectionwith the annual report of Compugen Ltd. (the "Company") on Form 20-F for theperiods ending December 31, 2006 as filed with the Securities and ExchangeCommission on the date hereof (the "Report"), I the undersigned, being theChief Financial Officer of the Company, certify, pursuant to 18 U.S.C. Section1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002,that to my knowledge:****

1.             TheReport fully complies with the requirements of sections 13(a) or 15(d) of theSecurities Exchange Act of 1934; and

2.             Theinformation contained in the Report fairly presents, in all material respects,the financial condition and results of operations of the Company.

 

 

** **

\s\ Nurit Benjamini

 

Title:       Chief FinancialOfficer 

Date:       April 16, 2007

 

 

The foregoingcertification is being furnished solely to accompany the Report pursuant to 18U.S.C. No. 1350, and is not being filed for purposes of Section 18 of theSecurities Exchange Act of 1934, as amended, and is not to be incorporated byreference into any filing of the Company, whether made before or after the datehereof, regardless of any general incorporation language in such filing.

 

 

**__78__** 

 

**COMPUGEN LTD. AND ITS SUBSIDIARIES**

 

 

**CONSOLIDATED FINANCIAL STATEMENTS**

** **

** **

**AS OF****DECEMBER 31, 2006**

 

 

**U.S. DOLLARS INTHOUSANDS**

 

 

 

 

**INDEX**

 

 
| ** **                                                   | **Page**   |
|--------------------------------------------------------------|------------|
| ** **                                                   | ** ** |
| **Report of  Independent Registered Public Accounting Firm** | **2**      |
| ** **                                                   | ** ** |
| **Consolidated  Balance Sheets**                             | **3**      |
| ** **                                                   | ** ** |
| **Consolidated  Statements of Operations**                   | **4**      |
| ** **                                                   | ** ** |
| **Statements  of Changes in Shareholders' Equity**           | **5**      |
| ** **                                                   | ** ** |
| **Consolidated  Statements of Cash Flows**                   | **6**      |
| ** **                                                   | ** ** |
| **Notes to  Consolidated Financial Statements**              | **7 - 31** |

 

 

 

 

- - - - - - - - - - -- -

 

**F-1** 

 

 

**REPORT OF INDEPENDENTREGISTERED PUBLIC ACCOUNTING FIRM**

* *

**To the Board of Directors and Shareholders of**

*** ***

**COMPUGEN LTD.**

 

We have audited the accompanying consolidated balancesheets of Compugen Ltd. ("the Company") and its subsidiaries as of December 31, 2006 and2005, and the related consolidated statements of operations, changes inshareholders' equity and cash flows for each of the three years in the periodended December 31, 2006. These financial statements are the responsibility ofthe Company's management. Our responsibility is to express an opinion on thesefinancial statements based on our audits. We did not audit the financialstatements of Keddem BioScience Ltd., a wholly-owned subsidiary, for the yearsended December 31, 2006, 2005 and 2004 which statements reflect total assetsconstituting 2%, 3% and 4% and no revenues, in 2006, 2005 and 2004,respectively, of the related consolidated totals. Those statements were auditedby other auditors whose unqualified report which has been furnished to usincluded an explanatory paragraph on circumstances which raise substantialdoubts on Keddem BioScience Ltd.'s ability to continue as a going concern. Ouropinion, insofar as it relates to the amounts included for Keddem BioScienceLtd. is based solely on the report of the other auditors.

 

We conducted our audits inaccordance with the standards of the Public Company Accounting Oversight Board(United States). Those standards require that we plan and perform the audit toobtain reasonable assurance about whether the financial statements are free ofmaterial misstatement. We were not engaged to perform an audit of the Company'sinternal control over financial reporting. Our audits included consideration ofinternal control over financial reporting as a basis for designing auditprocedures that are appropriate in the circumstances, but not for the purposeof expressing an opinion on the effectiveness of the Company's internal controlover financial reporting. Accordingly, we express no such opinion. An auditalso includes examining, on a test basis, evidence supporting the amounts anddisclosures in the financial statements, assessing the accounting principlesused and significant estimates made by management, and evaluating the overallfinancial statement presentation. We believe that our audits and the report ofthe other auditors provide a reasonable basis for our opinion.

 

In our opinion, based on ouraudits and the report of the other auditors, the consolidated financialstatements referred to above present fairly, in all material respects, theconsolidated financial position of the Company and its subsidiaries as ofDecember 31, 2006 and 2005, and the consolidated results of their operationsand their cash flows for each of the three years in the period ended December31, 2006, in conformity with U.S. generally accepted accounting principles.

* *

As discussed in Note 2l to the consolidated financialstatements, in 2006 the company adopted Statement of Financial AccountingStandards Board No. 123 (R), "Share-Based Payment".

 

 
| Tel-Aviv, Israel | KOST FORER GABBAY & KASIERER     |
|------------------|--------------------------------------|
| February 5, 2007 | A Member of Ernst & Young Global |

**F-2** 

**CONSOLIDATED BALANCE SHEETS**

**U.S. dollars in thousands(except share and per share data)**

** **
| * *                                                                                                                                                                                                  |         |         |   | December 31, |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------------|--------------|--------|--------------|
| * *                                                                                                                                                                                                  |         | Note         |   | 2006         |   | 2005 |
| ASSETS                                                                                                                                                                                                    |         | * *     |   | * *     |   | * * |
| CURRENT ASSETS:                                                                                                                                                                                           |         | * *     |   |         |   |   |
| Cash and cash equivalents                                                                                                                                                                                 | * *     | 5            |   | $6,251       |   | $8,492 |
| Cash held in favor of other consortium partners                                                                                                                                                           | * *     | 4            |   | -            |   | 834 |
| Short-term deposits and marketable securities                                                                                                                                                             | * *     | 6            |   | 19,152       |   | 22,495 |
| Trade receivables                                                                                                                                                                                         | * *     | * *     |   | 10           |   | - |
| *    Other  accounts receivable and prepaid expenses*                                                                                                                                 | * *     | 7            |   | 846          |   | 676 |
| * *                                                                                                                                                                                                  | * *     | * *     |   | * *     |   | * * |
| Total  current assets                                                                                                                                                                                     | * *     | * *     |   | 26,259       |   | 32,497 |
| * *                                                                                                                                                                                                  | * *     | * *     |   | * *     |   | * * |
| LONG-TERM INVESTMENTS:                                                                                                                                                                                    | * *     | * *     |   | * *     |   | * * |
| Long-term deposits and marketable securities                                                                                                                                                              | * *     | 6            |   | 1,000        |   | 4,983 |
| *    Long-term  lease deposits*                                                                                                                                                       | * *     | * *     |   | 40           |   | 81 |
|     Severance  pay fund                                                                                                                                                               | * *     | * *     |   | 1,378        |   | 1,525 |
| * *                                                                                                                                                                                                  | * *     | * *     |   | * *     |   | * * |
| * *                                                                                                                                                                                                  | * *     | * *     |   | 2,418        |   | 6,589 |
| * *                                                                                                                                                                                                  | * *     | * *     |   | * *     |   | * * |
| PROPERTY AND EQUIPMENT, NET                                                                                                                                                                               | * *     | 8            |   | 2,179        |   | 3,020 |
| * *                                                                                                                                                                                                  | * *     | * *     |   | * *     |   | * * |
| Total assets                                                                                                                                                                                              | * *     | * *     |   | $30,856      |   | $42,106 |
| * *                                                                                                                                                                                                  | * *     | * *     |   | * *     |   | * * |
| LIABILITIES AND SHAREHOLDERS' EQUITY                                                                                                                                                                      | *** *** | *** *** |   | * *     |   | * * |
| CURRENT LIABILITIES:                                                                                                                                                                                      | * *     | * *     |   | * *     |   | * * |
| Trade payables                                                                                                                                                                                            | * *     | * *     |   | $831         |   | $1,088 |
| Other accounts payable and accrued expenses                                                                                                                                                               | * *     | 9            |   | 2,044        |   | 2,372 |
| Deferred revenue                                                                                                                                                                                          | * *     | * *     |   | 75           |   | 200 |
| * *                                                                                                                                                                                                  | * *     | * *     |   | * *     |   | * * |
| Total  current liabilities                                                                                                                                                                                | * *     | * *     |   | 2,950        |   | 3,660 |
| * *                                                                                                                                                                                                  | * *     | * *     |   | * *     |   | * * |
| LONG-TERM LIABILITIES:                                                                                                                                                                                    | * *     | * *     |   | * *     |   | * * |
| Long-term accounts payable                                                                                                                                                                                | * *     | * *     |   | 60           |   | 60 |
| Accrued severance pay                                                                                                                                                                                     | * *     | * *     |   | 1,483        |   | 1,659 |
| Excess of losses over investment in Evogene                                                                                                                                                               | * *     | 1b           |   | 466          |   | 466 |
| * *                                                                                                                                                                                                  | * *     | * *     |   | * *     |   | * * |
| Total  long-term liabilities                                                                                                                                                                              | * *     | * *     |   | 2,009        |   | 2,185 |
| * *                                                                                                                                                                                                  | * *     | * *     |   | * *     |   | * * |
| COMMITMENTS AND CONTINGENCIES                                                                                                                                                                             | * *     | 10, 4        |   | * *     |   | * * |
| * *                                                                                                                                                                                                  | * *     | * *     |   | * *     |   | * * |
| OPTIONS ISSUED TO EMPLOYEES AND CONSULTANTS BY A SUBSIDIARY                                                                                                                                               | * *     | * *     |   | 159          |   | 13 |
| * *                                                                                                                                                                                                  | * *     | * *     |   | * *     |   | * * |
| SHAREHOLDERS' EQUITY:                                                                                                                                                                                     | * *     | 11           |   | * *     |   | * * |
| Share capital:                                                                                                                                                                                            | * *     | * *     |   | * *     |   | * * |
| Ordinary shares of NIS 0.01 par  value; 50,000,000 shares authorized at December 31, 2006  and 2005; 28,162,202 and 27,846,420 shares issued and outstanding at December 31, 2006 and  2005, respectively | * *     | * *     |   | 76           |   | 75 |

**F-3** 

 
| Additional paid-in capital                             | * * | * * |   | 158,416   |   | 155,923   |
|--------------------------------------------------------|----------|----------|--------|-----------|--------|-----------|
| *    Deferred  stock compensation* | * * | * * |   | -         |   | (16)      |
| Accumulated deficit                                    | * * | * * |   | (132,754) |   | (119,734) |
| * *                                               | * * | * * |   | * *  |   | * *  |
| Total  shareholders' equity                            | * * | * * |   | 25,738    |   | 36,248    |
| * *                                               | * * | * * |   | * *  |   | * *  |
| Total  liabilities and shareholders' equity            | * * | * * |   | $30,856   |   | $42,106   |

* *

* *

The accompanying notes are anintegral part of the consolidated financial statements.

* *

* *

**F-4** 

**CONSOLIDATED STATEMENTS OF OPERATIONS**

**U.S. dollars in thousands(except share and per share data)**

* *
|                                                                                                                                                                              | ** ** |   |   | Year ended December 31, |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------|--------|-------------------------|
|                                                                                                                                                                              | ** ** | Note   |   | 2006                    |   | 2005 |   | 2004 |
|                                                                                                                                                                              |       |   |   |                    |   |   |   |   |
|                                                                                                                                                                              |       |   |   |                    |   |   |   |   |
| Revenues                                                                                                                                                                          |       | 12     |   | $215                    |   | $646 |   | $  2,630 |
|                                                                                                                                                                              |       |   |   |                    |   |   |   |   |
| Cost of revenues                                                                                                                                                                  |       |   |   | 6                       |   | 148 |   | 1,100 |
| Research and development expenses, net of governmental and  other grants amounted to $ 1,751, $ 2,254 and $ 1,397 for the  years 2006, 2005 and 2004, respectively |       | 4      |   | 9,810                   |   | 10,471 |   | 10,921 |
| Selling and marketing expenses                                                                                                                                                    |       |   |   | 1,719                   |   | 1,772 |   | 2,446 |
| General and administrative expenses                                                                                                                                               |       |   |   | 2,673                   |   | 3,133 |   | 3,740 |
|                                                                                                                                                                              |       |   |   | * *                |   | * * |   | * * |
| Total operating expenses *)                                                                                                                                                       |       |   |   | 14,208                  |   | 15,524 |   | 18,207 |
|                                                                                                                                                                              |       |   |   |                    |   |   |   |   |
| Operating loss                                                                                                                                                                    |       |   |   | (13,993)                |   | (14,878) |   | (15,577) |
| Financial income, net                                                                                                                                                             |       | 13     |   | 884                     |   | 682 |   | 1,417 |
| Other income, net                                                                                                                                                                 |       | 3      |   | 89                      |   | 218 |   | 438 |
|                                                                                                                                                                              |       |   |   |                    |   |   |   |   |
| Net loss                                                                                                                                                                          |       |   |   | $(13,020)               |   | $(13,978) |   | $(13,722) |
|                                                                                                                                                                              |       |   |   |                    |   |   |   |   |
|                                                                                                                                                                              |       |   |   |                    |   |   |   |   |
| Basic and diluted net loss per share                                                                                                                                              |       |   |   | $(0.47)                 |   | $(0.50) |   | $(0.50) |
|                                                                                                                                                                              |       |   |   |                    |   |   |   |   |
| Weighted average number of ordinaryshares used in computing basic and  diluted net loss per share                                                                                 |       |   |   | 27,985,957              |   | 27,774,535 |   | 27,473,341 |

 

 

*)         Includes stockbased compensation, see Note 11.

* *

* *

The accompanying notes are anintegral part of the consolidated financial statements.

**F-5** 

** **

**STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY**

**U.S. dollars in thousands(except share and per share data)**

 

 
| * *                                                                                                           | *** *** | Ordinary shares |   | **Additional paid-in** |   | **Deferred**

**stock** |   | **Accumulated** |   | **Total shareholders'** |
|--------------------------------------------------------------------------------------------------------------------|--------------|-----------------|--------|------------------------|--------|-------------------------|--------|-----------------|--------|-------------------------|
|                                                                                                               | * *     | Number          |   | Amount                 |   | capital                 |   | compensation    |   | deficit                 |   | equity |
|                                                                                                               | * *     | * *        |   | * *               |   | * *                |   | * *        |   | * *                |   | * * |
|                                                                                                               | * *     | * *        |   | * *               |   | * *                |   | * *        |   | * *                |   | * * |
| Balance as of January 1, 2004                                                                                      | * *     | 26,848,474      |   | $72                    |   | $152,271                |   | $(501)          |   | $(92,034)               |   | $ 59,808 |
|                                                                                                               | * *     | * *        |   | * *               |   | * *                |   | * *        |   | * *                |   | * * |
| Employee options exercised                                                                                         | * *     | 877,548         |   | 2                      |   | 2,723                   |   | -               |   | -                       |   | 2,725 |
| Amortization of deferred stock compensation                                                                        | * *     | -               |   | -                      |   | -                       |   | 298             |   | -                       |   | 298 |
| Stock compensation                                                                                                 | * *     | -               |   | -                      |   | 55                      |   | -               |   | -                       |   | 55 |
| Compensation relating to options and warrants issued to  scientific advisory board members, consultants and others | * *     | -               |   | -                      |   | 402                     |   | -               |   | -                       |   | 402 |
| Forfeited options                                                                                                  | * *     | -               |   | -                      |   | (7)                     |   | 7               |   | -                       |   | - |
| Net loss                                                                                                           | * *     | -               |   | -                      |   | -                       |   | -               |   | (13,722)                |   | (13,722) |
|                                                                                                               | * *     | * *        |   | * *               |   | * *                |   | * *        |   | * *                |   | * * |
| Balance as of December 31, 2004                                                                                    | * *     | 27,726,022      |   | 74                     |   | 155,444                 |   | (196)           |   | (105,756)               |   | 49,566 |
|                                                                                                               | * *     | * *        |   | * *               |   | * *                |   | * *        |   | * *                |   | * * |
| Employee options exercised                                                                                         | * *     | 120,398         |   | 1                      |   | 281                     |   | -               |   | -                       |   | 282 |
| Amortization of deferred stock compensation, net of  reversal due to forfeitures                                   | * *     | -               |   | -                      |   | -                       |   | (24)            |   | -                       |   | (24) |
| Stock compensation                                                                                                 | * *     | -               |   | -                      |   | 396                     |   | -               |   | -                       |   | 396 |
| Compensation relating to options and warrants issued to  scientific advisory board members, consultants and others | * *     | -               |   | -                      |   | 6                       |   | -               |   | -                       |   | 6 |
| Forfeited options                                                                                                  | * *     | -               |   | -                      |   | (204)                   |   | 204             |   | -                       |   | - |
| Net loss                                                                                                           | * *     | -               |   | -                      |   | -                       |   | -               |   | (13,978)                |   | (13,978) |
|                                                                                                               | * *     | * *        |   | * *               |   | * *                |   | * *        |   | * *                |   | * * |
| Balance as of December 31, 2005                                                                                    | * *     | 27,846,420      |   | 75                     |   | 155,923                 |   | (16)            |   | (119,734)               |   | 36,248 |
|                                                                                                               | * *     | * *        |   | * *               |   | * *                |   | * *        |   | * *                |   | * * |
| Employee options exercised                                                                                         | * *     | 315,782         |   | 1                      |   | 560                     |   | -               |   | -                       |   | 561 |
| Reclassification due to adoption of SFAS 123(R)                                                                    | * *     | -               |   | -                      |   | (16)                    |   | 16              |   | -                       |   | - |
| Compensation relating to options and warrants issued to  scientific advisory board members and consultants         | * *     | -               |   | -                      |   | (47)                    |   | -               |   | -                       |   | (47) |
| Compensation relating to options issued to employees                                                               | * *     | -               |   | -                      |   | 1,996                   |   | -               |   | -                       |   | 1,996 |
| Net loss                                                                                                           | * *     | -               |   | -                      |   | -                       |   | -               |   | (13,020)                |   | (13,020) |
|                                                                                                               | * *     | * *        |   | * *               |   | * *                |   | * *        |   | * *                |   | * * |
| Balance as of December 31, 2006                                                                                    | * *     | 28,162,202      |   | $76                    |   | $158,416                |   | $  -  |   | $(132,754)              |   | $25,738 |

 

 

The accompanying notes are anintegral part of the consolidated financial statements.

**F-6** 

**CONSOLIDATED STATEMENTS OFCASH FLOWS**

**U.S. dollars in thousands**
| * *                                                                                                           |     | Year ended December 31, |
|--------------------------------------------------------------------------------------------------------------------|----------|-------------------------|
| * *                                                                                                           |     | 2006                    |   | 2005 |   | 2004 |
|   Cash flows from operating activities:                                                                  |     | * *                |   | * * |   | * * |
| * *                                                                                                           |     | * *                |   | * * |   | * * |
| Net loss                                                                                                           |     | $(13,020)               |   | $(13,978) |   | $(13,722) |
| Adjustments required to reconcile net loss to net cash  used in operating activities:                              |     | * *                |   | * * |   | * * |
| Amortization of deferred stock compensation                                                                        |     | -                       |   | (24) |   | 298 |
| Compensation relating to options and warrants issued to  scientific advisory board members, consultants and others |     | (47)                    |   | 402 |   | 457 |
| Compensation relating to options  issued to employees                                                              |     | 1,996                   |   | - |   | - |
| Compensation relating to options issued to employees and  consultants by a Subsidiary                              |     | 146                     |   | 13 |   | - |
| Depreciation                                                                                                       |     | 996                     |   | 1,314 |   | 1,466 |
| Accrued severance pay, net                                                                                         |     | (29)                    |   | (205) |   | (130) |
| Interest and amortization of premium on deposits and  marketable  securities                             |     | 261                     |   | 1,096 |   | 1,163 |
| Capital gain                                                                                                       |     | (55)                    |   | - |   | - |
| Capital loss                                                                                                       |     | -                       |   | - |   | 167 |
| Decrease (increase) in trade receivables                                                                           |     | (10)                    |   | 143 |   | 113 |
| Decrease (increase) in other accounts receivable and  prepaid expenses                                             |     | (274)                   |   | 830 |   | (202) |
| Increase (decrease) in trade payables and other accounts  payable and accrued expenses                             |     | 228                     |   | (623) |   | (522) |
| Decrease in deferred revenue                                                                                       |     | (125)                   |   | (76) |   | (1,290) |
|                                                                                                               |     | * *                |   | * * |   | * * |
| Net cash used in operating activities                                                                              |     | (9,933)                 |   | (11,108) |   | (12,202) |
| * *                                                                                                           |     | * *                |   | * * |   | * * |
| Cash flows from investing activities:                                                                              |     | * *                |   | * * |   | * * |
| * *                                                                                                           |     | * *                |   | * * |   | * * |
| Purchase of marketable securities                                                                                  |     | (3,237)                 |   | - |   | (8,191) |
| Proceeds from redemption of deposits and marketable  securities                                                    |     | 22,302                  |   | 15,488 |   | 15,566 |
| Investment in bank deposits                                                                                        |     | (12,000)                |   | - |   | - |
| Purchase of property and equipment                                                                                 |     | (161)                   |   | (862) |   | (1,435) |
| Decrease (increase) in long-term lease deposits                                                                    |     | 41                      |   | 21 |   | (7) |
| Investment grants relating to fixed assets                                                                         |     | -                       |   | 406 |   | - |
| Proceeds from sale of property and equipment                                                                       |     | 82                      |   | 3 |   | - |
| * *                                                                                                           |     | * *                |   | * * |   | * * |
| Net cash provided by investing activities                                                                          |     | 7,027                   |   | 15,056 |   | 5,933 |
|                                                                                                               |     | * *                |   | * * |   | * * |
| Cash flows from financing activities:                                                                              |     | * *                |   | * * |   | * * |
| * *                                                                                                           |     | * *                |   | * * |   | * * |
| Exercise of options                                                                                                |     | 665                     |   | 178 |   | 2,725 |
|                                                                                                               | * * | * *                |   | * * |   | * * |
| Net cash provided by financing activities                                                                          | * * | 665                     |   | 178 |   | 2,725 |
|                                                                                                               | * * | * *                |   | * * |   | * * |
| Increase (decrease) in cash and cash equivalents                                                                   | * * | (2,241)                 |   | 4,126 |   | (3,544) |
| Cash and cash equivalents at the beginning of the year                                                             | * * | 8,492                   |   | 4,366 |   | 7,910 |
|                                                                                                               | * * | * *                |   | * * |   | * * |
| Cash and cash equivalents at the end of the year                                                                   | * * | $6,251                  |   | $8,492 |   | $4,366 |

 

**F-7** 

Supplemental informationon financing activities not involving cash flow:

 

In December 2005, the Companyissued shares as a result of exercise of options in the amount of $ 104.The Company received the proceeds from the exercise of the options in January2006. 

* *

* *

The accompanying notes are anintegral part of the consolidated financial statements.

**F-8** 

** **

** **

NOTE 1:-   GENERAL

 

a.*      *Compugen Ltd. ("the Company" or "Compugen") is abiotechnology discovery company focused on the discovery and licensing ofproduct candidates to the drug and diagnostic industry. The Company's discoveryengines enable the predictive discovery of numerous potential therapeutics anddiagnostic biomarkers. This capability results from the Company's understandingof important biological phenomena at the molecular level through theincorporation of ideas and methods from mathematics, computer science andphysics into biology, chemistry and medicine. To date, Compugen's diagnosticand therapeutic product discovery efforts and its initial discovery engineshave focused mainly within the areas of cancer, immune-related and cardiovasculardiseases. The Company's primary business goal is to out-license therapeutic anddiagnostic product candidates for commercialization by leading companies undermilestone and revenue sharing agreements. 

 

   During the years 2003to 2005 the Company's primary business activities evolved from using itsintellectual property, scientific know-how and computational biologycapabilities to develop and provide life science software products and servicesto others on a fee basis, to using such capabilities and assets  todiscover potential therapeutic and diagnostic product candidates for licensingunder development and commercialization agreements providing future milestonesand revenue sharing to Compugen. 

 

   The Company'sheadquarters and research facilities are located in Israel, with U.S.operations, through a wholly-owned subsidiary Compugen USA Inc. ("CompugenInc.") located in San Jose, California and Maryland. 

* *

b.*      *The Company holds an equity investment in Evogene Ltd.("Evogene"). Evogene is engaged in delivering improved plant traitsto the agbio industry through the use of a platform combining computationalgenomics, molecular biology and breeding methods.

 

Through December 31, 2005, Evogene raised $ 5,551 in convertible loans. As of December 31, 2005, the Company held the majority of the outstanding share capital of Evogene, and aminority holding on a fully-diluted basis. Based on irrevocable proxies thatthe Company gave to the convertible loan investors, the Company held minorityholdings of Evogene's voting rights as of December 31, 2005. 

 

In February 2006, Evogene completed anequity investment round with certain investors, amounting to approximately$11,000 that included the full conversion of the outstanding convertible loans,and applicable interest. Following the investment the Company's holdingsdiluted to less than 20% of Evogene's ordinary shares. The investment wasaccounted for under the Equity Method of Accounting, in accordance with APB 18,"The Equity Method of Accounting for Investment in Common Stock",through February 2006, and under the Cost Method, thereafter. As of December 31, 2006 and 2005, the Company had excess of losses over investment in Evogene inthe amount of $ 466.

**F-9** 

 

**NOTE 1:-      GENERAL(Cont.)**

 

c.*      *In August 2004, Compugen spun off its computational chemistry activityinto a wholly-owned subsidiary, Keddem BioScience Ltd. ("Keddem").The transaction was affected through a transfer of assets and liabilities inconsideration of issuance of ordinary shares. In 2005, the Company assigned toKeddem its entitlement to receive from the Investment Center of the IsraelMinistry of Industry and Trade certain grants on account of capitalexpenditures relating to the spun off activitiy (See also Note 4c). 

 

Through 2006, theCompany advanced Convertible Loans to Keddem amounting to $ 2,154 includingaccrued interest in the amount of $ 183). The outstanding principal ConvertibleLoans bear bear interest at an annual rate (each year considered separately)which is the greater of (i) 5%; and (ii) the 12 months LIBOR as determined onthe first business day after the corresponding anniversary, compoundedannually. The loan is convertible into Keddem's shares at Compugen'sdiscretion, until the earlier of: (x) the repayment date or (y) the merger,acquisition, IPO or similar event of Keddem. If not converted, the loan is tobe repaid by Keddem upon the earlier of (i) June 30, 2011, and (ii) Keddem defaulting under the loan agreement's terms.

 

Persuant to a ShareOption Plan, Keddem has granted employees and consultants 537,000 stock optionsto purchase its own ordinary shares in through December 31, 2006. Through December 31, 2006, 56,400 options were forfeited upon employee terminations. Thestock options were granted at fair market value per ordinary share. Accumulatedexpenses related to such stock options as of December 31, 2005 and 2006 are credited to "Options issued to employees and consultants by aSubsidiary", a separate account between Long-Term Liabilities andShareholders' Equity in the consolidated balance sheet.

 

Keddem has beenexperiencing recurring losses from operations and has a net capital deficiency.These matters raise substantial doubt about its ability to continue as a goingconcern. Management is seeking additional funding to fund operations until profitability is achieved. 

 

**F-10** 

 

**NOTE 2:-    SIGNIFICANTACCOUNTING POLICIES**

* *

Theconsolidated financial statements have been prepared in conformity withaccounting principles generally accepted in the United States ("U.S.GAAP"). 

* *

a.       Use of estimates:

 

         The preparation of financial statements in conformity withgenerally accepted accounting principles requires management to make estimatesand assumptions that affect the amounts reported in the financial statementsand accompanying notes. Actual results could differ from those estimates.

* *

b.*            *Financial statements in U.S. dollars:

 

        The functionalcurrency of the Company and its subsidiaries is the U.S. dollar, as theCompany's management believes that the U.S. dollar is the primary currency ofthe economic environment in which the Company and its subsidiaries haveoperated and expect to continue to operate in the foreseeable future. Amajority of the Company's sales were made and are expected to be made outside Israelin U.S. dollars. The majority of the Company and its subsidiaries' operationsare currently conducted in Israel and most of the expenses in Israel arecurrently paid in new Israeli shekels ("NIS"); however, most of theexpenses are denominated and determined in U.S. dollars. 

 

Accordingly, monetaryaccounts maintained in currencies other than the dollar are remeasured intoU.S. dollars in accordance with Statement of the Financial Accounting StandardBoard ("SFAS") No. 52 "Foreign Currency Translation." Alltransaction gains and losses of the remeasured monetary balance sheet items arereflected in the statement of operations as financial income or expenses, asappropriate.

 

c.       Basis of consolidation:

 

The consolidated financial statementsinclude the accounts of the Company and its wholly-owned subsidiaries, CompugenUSA Inc. and Keddem BioScience Ltd. Intercompany transactions and balances havebeen eliminated upon consolidation. 

 

d.       Cash and cash equivalents:

 

The Company considers all highly liquidinvestments that are convertible to cash with maturities of three months orless at their acquisition date as cash equivalents.

 

e.      Marketablesecurities:

 

The Company accountsfor its investments in marketable securities using SFAS No. 115, 

"Accounting forCertain Investments in Debt and Equity Securities."

 

Management determines the appropriateclassification of its investments in marketable debt at the time of purchaseand re-evaluates such determinations at each balance sheet date. To date, alldebt securities have been classified as held-to-maturity as the Company has thepositive intent and ability to hold the securities to maturity.

**F-11** 

 

 

NOTE 2:-  SIGNIFICANT ACCOUNTING POLICIES (Cont.)

 

These investments are stated at amortized cost,including accrued interest. Amortization of the premium and the accretion ofdiscounts and interest are included in financial income, net. The Company'sinvestment holdings have been classified in the consolidated balance sheetaccording to the maturity date.

* *

The Company accounts for its investment instructured notes in accordance with the provisions of EITF No. 96-12,"Recognition of Interest Income and Balance Sheet Classification ofStructured Notes", according to which the Company uses the"Retrospective interest method". 

* *

f.      Long-term lease deposits:

 

Long-term lease deposits includelong-term deposits as security for facilities and motor vehicles leases.

* *

g.      Propertyand equipment:

* *

Property and equipment are stated atcost, net of related investment grants and of accumulated depreciation.Depreciation is calculated using the straight-line method over the estimateduseful lives of the assets at the following annual rates:

 
| * *                                  | %                          |
|-------------------------------------------|----------------------------|
| * *                                  | * *                   |
| Computers, software and related equipment | 33                         |
| Laboratory equipment and office furniture | 6 - 30                     |
| Leasehold improvements                    | Over the term of the lease |

* *

h.       Impairment of long-livedassets:

 

The long-lived assets of the Company andits subsidiaries are reviewed for impairment in accordance with SFAS No. 144,"Accounting for the Impairment or Disposal of Long-Lived Assets",whenever events or changes in circumstances indicate that the carrying amountof an asset may not be recoverable. Recoverability of assets to be held andused is measured by a comparison of the carrying amount of an asset with the futureundiscounted cash flows expected to be generated by the assets. If such assetsare considered to be impaired, the impairment to be recognized is measured bythe amount by which the carrying amount of the assets exceeds the fair value ofthe assets. During the years 2004, 2005 and 2006, no impairment losses havebeen identified. 

 

i.*              *Revenue recognition:

 

During the years 2004,2005 and 2006 the Company and its subsidiaries derived most of their revenuesfrom collaborations and license fees for software products. The Company alsogenerated revenues from sales of services including maintenance, support,customization, professional services, integration and installation as well asthe sale of products 

**F-12** 

(OligoLibraries). TheCompany and its subsidiaries sold their products primarily through their directsales force and resellers, both of whom are considered end users. 

 

**NOTE 2:-        SIGNIFICANTACCOUNTING POLICIES (Cont.)**

*** ***

TheCompany and its subsidiaries recognize software license revenues in accordancewith Statement of Position ("SOP") 97-2, "Software RevenueRecognition" ("SOP 97-2"), as amended and SOP 98-9,"Modification of SOP 97-2, Software Revenue Recognition with Respect toCertain Transactions" ("SOP 98-9"). SOP 97-2 generally requiresrevenues earned on software arrangements involving multiple elements to beallocated to each element based on the relative fair value of the elements. SOP98-9 requires that revenues be recognized under the "Residual Method"when vendor specific objective evidence (VSOE) of fair value exists for allundelivered elements and no VSOE exists for the delivered elements and allrevenue recognition criteria of SOP 97-2, as amended, are satisfied.

* *

Revenuesfrom license fees are recognized when persuasive evidence of an agreementexists, delivery of the product has occurred, no significant obligations withregard to implementation remain, the fee is fixed or determinable, andcollectability is probable. 

* *

Maintenanceand support revenues included in these arrangements are deferred and recognizedon a straight-line basis over the term of the maintenance and supportagreement. The VSOE of fair value of the undelivered elements (maintenance,support and professional services) is determined based on the price charged forthe undelivered element when sold separately or based on renewal rate.

* *

TheCompany and its subsidiaries license products on either a perpetual or on aterm basis. License revenues arising from the sale of perpetual licenses andterm licenses for a period longer than one year are recognized in theaccounting period during which the sale took place. License revenue arisingfrom a term license for a period of one year or less is recognized over thecontractual term of the license.

* *

Revenuesfrom software license fees that involve customization of the Company's softwareto customer specific specifications, development services, integration andinstallation are recognized in accordance with SOP 81-1 "Accounting forPerformance of Construction-Type and Certain Production-Type Contracts"("SOP 81-1"), using contract accounting on a percentage of completionmethod, over the period from signing of the license through to customeracceptance in accordance with the "Input Method". The amount ofrevenue recognized is based on the total license fees under the licenseagreement and the percentage to completion achieved. The percentage tocompletion is measured by monitoring progress using records of actual timeincurred to date in the project compared to the total estimated projectrequirement, which corresponds to the costs related to earned revenues.Estimates of total project requirements are based on prior experience ofcustomization, delivery and acceptance of the same or similar technology andare reviewed and updated regularly by management. After delivery, ifuncertainty exists about customer acceptance of the software, license revenueis not recognized until acceptance. In the years ended December 31, 2006, 2005and 2004, the Company recognized revenues in accordance with SOP 81-1 in the amountof $ 200, $ 178 and $ 1,260 respectively. Provisions forestimated losses on uncompleted contracts are made in the period in which suchlosses are first determined, in the amount of the estimated loss on the entirecontract. During the years 2006, 2005 and 2004, no such estimated losses wereidentified. 

**F-13** 

 

**NOTE 2:-      SIGNIFICANTACCOUNTING POLICIES (Cont.)**

*** ***

The Company believes that the use of thepercentage of completion method is appropriate as the Company has the abilityto make reasonably dependable estimates of the extent of progress towardscompletion, contract revenues and contract costs. In addition, contractsexecuted include provisions that clearly specify the enforceable rightsregarding services to be provided and received by the parties to the contracts,the consideration to be exchanged and the manner and terms of settlement. Inall cases, the Company expects to perform its contractual obligations and itslicensees are expected to satisfy their obligations under the contract. 

 

During 2004, revenues from sales ofproducts (OligoLibraries) were recognized in accordance with Staff AccountingBulletin ("SAB") No. 104 "Revenue Recognition in FinancialStatements", and EITF No. 99-19 "Reporting gross revenues as a principalvs. net as an agent", when delivery has occurred, persuasive evidence ofan agreement exists, the vendor's fee is fixed or determinable, no furtherobligation exists and collectability is probable.

 

Deferred revenues include amountsreceived from customers for which revenue has not been recognized.

 

j.*              *Research and development expenses, net:

 

Research anddevelopment expenses are charged to the statement of operations as incurred.

 

SFAS No. 86,"Accounting for the Costs of Computer Software to be Sold, Leased orOtherwise Marketed", requires capitalization of certain softwaredevelopment costs subsequent to the establishment of technological feasibility.

 

Based on the Company'sproduct development process, technological feasibility is established uponcompletion of a working model. The Company does not incur material costsbetween the completion of the working model and the point at which the productsare ready for general release. Therefore, research and development costsassociated with the development of software products are also charged to thestatement of operations as incurred.

 

Royalty andnon-royalty bearing grants from the Office of the Chief Scientist of the Israelministry of Industry, Trade &Labor - ("OCS")and from the Bi-national Industrial Research and Development Foundation("BIRD") for funding approved research and development projects, arerecognized at the time the Company is entitled to such grants, on the basis ofthe research and development expenses incurred. Such grants are presented as areduction from research and development expenses. 

 

Until 2004, theCompany presented governmental and other grants as part of Revenues and Grants,based on the single step income statement presentation approach. These amountshave been reclassified for all periods presented and are now shown as areduction from research and development expenses. The Company adjusted thefinancial statements in the amount of $ 1,397 for the year 2004 to conform tothis change. 

**F-14** 

 

**NOTE 2:-      SIGNIFICANTACCOUNTING POLICIES (Cont.)**

** **

k.*            *Severance pay:

* *

The Company's liability for severance pay for itsIsraeli employees is calculated pursuant to Israel's Severance Pay Law based on the most recent salaryof the employees multiplied by the number of years of employment, as of thebalance sheet date. Employees are entitled to one month's salary for each yearof employment or a portion thereof. The Company's liability for all of itsemployees is fully provided by monthly deposits with insurance policies and byan accrual. The value of these policies is recorded as an asset in theCompany's balance sheet.

* *

The deposited funds may be withdrawn only upon thefulfillment of the obligation pursuant to Israel's Severance Pay Law or labor agreements. The value ofthe deposited funds is based on the cash surrendered value of these policies,and includes immaterial profits accumulated up to the balance sheet date.

* *

Severance expenses for the years ended December 31, 2006,2005 and 2004 amounted to approximately $ 346, $ 443 and $ 650,respectively.

* *

l.*              *Accounting forstock-based compensation: 

* *

At December 31, 2006, the Company has three stock-basedemployee compensation plans, which are described more fully in Note 11. Priorto January 1, 2006, the Company accounted for those plans under the recognitionand measurement provisions of APB Opinion No. 25, "Accounting for StockIssued to Employees", and related Interpretations, as permitted by FASBStatement No. 123, "Accounting for Stock-Based Compensation"("FASB 123"). No stock-based employee compensation cost was recognizedin the Statement of Operations for the years ended December 31, 2005 and 2004,as all options granted under those plans had an exercise price equal to themarket value of the underlying common stock on the date of grant. 

* *

Effective January 1, 2006,the Company adopted the fair value recognition provisions of FASB Statement No.123(R), "Share-Based Payment", using themodified-prospective-transition method. Under that transition method,compensation cost recognized during 2006 includes: (a) compensation cost forall share-based payments granted prior to, but not yet vested as ofJanuary 1, 2006, based on the grant date fair value estimated inaccordance with the original provisions of Statement 123, and (b) compensationcost for all share-based payments granted subsequent to January 1, 2006,based on the grant-date fair value estimated in accordance with the provisionsof Statement 123(R). Results for prior periods have not been restated.

* *

As a result of adopting Statement 123(R) on January 1, 2006, theCompany's net loss for the year ended December 31, 2006,is $ 2,091 higher, than if it had continued to account for share-basedcompensation under Opinion 25. Basic and diluted loss per share for the yearended December 31, 2006, is $ 0.07 higher, than if the Company hadcontinued to account for share-based compensation under Opinion 25.

**F-15** 

 

**NOTE 2:-    ****SIGNIFICANT ACCOUNTING POLICIES (Cont.)**

* *

The following tableillustrates the effect on loss and loss per share if the Company and Keddem hadapplied the fair value recognition provisions of FASB 123 to options grantedunder the Company's stock option plans in all periods presented. For purposesof this pro forma disclosure, the value of the options is estimated using aBlack-Scholes option-pricing formula and amortized to expense over the options'vesting periods.

 
|                                                           | ** ** | Year ended December 31, |
|----------------------------------------------------------------|------------|-------------------------|
|                                                           |       | 2005                    |   | 2004 |
|                                                           |       |                    |   |   |
| Net loss as reported                                           |       | $(13,978)               |   | $(13,722) |
| Deduct (add) total stock-based compensation - intrinsic  value |       | (24)                    |   | 298 |
| Add - stock-based compensation - fair value (the Company)      |       | (1,423)                 |   | (1,414) |
| Add - stock-based compensation - fair value (Keddem)           |       | (326)                   |   | - |
|                                                           |       |                    |   |   |
| Pro forma net loss                                             |       | $(15,751)               |   | $(14,838) |
|                                                           |       |                    |   |   |
| Basic and diluted net loss per share - as reported             |       | $(0.50)                 |   | $(0.50) |
|                                                           |       |                    |   |   |
| Basic and diluted net loss per share - pro forma               |       | $(0.57)                 |   | $(0.54) |

 

The pro forma effectsof equity-based compensation expense on net income and earnings per share forthe 12 months ended December 31, 2005 and 2004 were estimated at the date ofgrant using the Black-Scholes model based on the following assumptions for theCompany and Keddem (annualized percentages):

 
| * *                | * * | Year ended December 31, |
|-------------------------|----------|-------------------------|
|                    | * * | 2005                    |   | 2004 |
|                    | * * | * *                |   | * * |
| Volatility              | * * | 51%                     |   | 44% |
| Risk-free interest rate | * * | 3.79%                   |   | 3.36% |
| Dividend yield          | * * | 0%                      |   | 0% |
| Expected life (years)   | * * | 3                       |   | 3.1 |

 

As of December 31, 2006, the total unrecognized estimated compensation cost related tonon-vested stock options granted prior to that date was $ 4,252, which isexpected to be recognized over a period of up to four years. During the yearended December 31, 2006, the Company recorded cash received from the exerciseof stock options of $ 665, out of which $ 104 were for options exercisedat the end of 2005. Total fair value of options vested during 2006 was $ 2,079.

 

m.        Concentrationsof credit risks:

* *

Financial instrumentsthat potentially subject the Company and its subsidiaries to concentrations ofcredit risk consist principally of cash and cash equivalents, structure notes,marketable securities, trade receivables and long-term lease deposits.

**F-16** 

 

**NOTE 2:-    SIGNIFICANT ACCOUNTINGPOLICIES (Cont.)**

 

Cash and cash equivalents are invested inmajor banks in Israel and the United States. Such investments in the United  States may be in excess of insured limits and are not insured in other jurisdictions.Management believes that the financial institutions that hold the Company'sinvestments are financially sound and, accordingly, minimal credit risk existswith respect to these investments.

 

The Company's marketable securitiesinclude investments in corporate bonds and U.S. government institutions.Management believes that those corporations are financially sound, theportfolio is well diversified, and accordingly, minimal credit risk exists withrespect to these marketable securities.

 

The Company and its subsidiaries have nosignificant off-balance-sheet concentration of credit risk such as foreignexchange contracts, option contracts or other foreign hedging arrangements.

 

n.       Income taxes:

 

The Company and its subsidiaries accountfor income taxes in accordance with SFAS No.109, "Accounting for IncomeTaxes" ("SFAS No.109"). This Statement prescribes the use of theliability method whereby deferred tax assets and liability account balances aredetermined based on differences between financial reporting and tax bases ofassets and liabilities and are measured using the enacted tax rates and lawsthat will be in effect when the differences are expected to reverse. TheCompany and its subsidiaries provide a valuation allowance, if necessary, toreduce deferred tax assets to their estimated realizable value.

* *

o.      Net loss per share:

* *

Basic net loss per share is calculatedbased on the weighted average number of ordinary shares outstanding during eachyear. Diluted net loss per share is calculated based on the weighted averagenumber of ordinary shares outstanding during each year, plus dilutive potentialin accordance with SFAS No. 128, "Earnings per Share."

 

All outstanding stock options have beenexcluded from the calculation of the diluted net loss per share because allsuch securities are anti-dilutive for all periods presented. The total numberof shares related to outstanding options excluded from the calculations ofdiluted net loss per share was 6,652,541, 4,733,307 and 4,114,036 for the yearsended December 31, 2006, 2005 and 2004, respectively.

p.      Fair value of financial instruments:

* *

The following methods and assumptions wereused by the Company and its subsidiaries in estimating their fair valuedisclosures for financial instruments:

 

The carrying amounts of cash and cashequivalents,, other accounts receivable, trade payables and other accountspayable approximate their fair value due to the short-term maturity of suchinstruments.

**F-17** 

 

**NOTE 2:-      ****SIGNIFICANT ACCOUNTING POLICIES (Cont.)**

* *

The fair value of marketable securitiesis based on quoted market prices and does not differ significantly from thecarrying amount (see Note 6).

 

q.       Recently issued accountingpronouncements: 

 

In June 2006, the FASB issued FASBInterpretation 48, "Accounting for Uncertainty in Income Taxes - aninterpretation of FASB Statement No. 109" ("FIN 48"). Thisinterpretation prescribes a recognition threshold and measurement attribute forthe financial statement recognition and measurement of a tax position taken orexpected to be taken in a tax return. The interpretation also provides guidanceon derecognition, classification and other matters. FIN 48 is effectivefor the fiscal year 2007, and the Company will adopt it accordingly. TheCompany is currently assessing the impact of the adoption of FIN 48.

 

In September 2006, the FASB issued SFASNo. 157, "Fair Value Measurements" ("SFAS No. 157").This statement defines fair value, establishes a framework for measuring fairvalue in generally accepted accounting principles, and expands disclosuresabout fair value measurements. The statement is effective in the first fiscalquarter of 2008 and the Company will adopt the statement at that time. TheCompany is currently assessing the impact of the adoption of SFAS No. 157.

 

In February 2007, the FASB issued SFASNo. 159, "The Fair Value Option for Financial Assets and FinancialLiabilities" ("SFAS No. 159"). SFAS No. 159 permitscompanies to choose to measure certain financial instruments and certain otheritems at fair value. The standard requires that unrealized gains and losses onitems for which the fair value option has been elected be reported in earnings.SFAS No. 159 is effective for financial statements issued for fiscal yearsbeginning after November 15, 2007 and interim periods within those fiscalyears, although earlier adoption is permitted. The Company is currentlyassessing the impact of the adoption of SFAS No. 159.

 

** **

**NOTE 3:-      ****BIOACCELERATOR BUSINESS**

* *

On July 1, 2003("the effective date"), the Company and Biocceleration Ltd.("Biocceleration") a company established by one of Compugen'sfounders entered into an agreement whereby Biocceleration bought Compugen'sBioaccelerator ("BioXL") assets related to the business for cashpayments to be paid by way of: (i) quarterly installments during 2003 - 2005,and (ii) royalties based on Biocceleration's revenues during 2006-2010. Thetransaction was closed on November 26, 2003. The sale of the BioXL businessincluded the transfer to Biocceleration of Compugen's BioXL related accountsreceivable commencing from the effective date, inventory, equipment dedicatedto the BioXL business and intellectual property subsisting in the BioXLsoftware and hardware, certain trademarks including the "Bioaccelerator"trademark and the copyright subsisting in written technical and marketingmaterials. With regard to the liabilities under the OCS program, whichsupported the development of the BioXL, Biocceleration reimbursed Compugen forall royalties paid by Compugen to the OCS in respect of revenues that Compugengenerated after the effective date. 

**F-18** 

 

**NOTE 3:-      ****BIOACCELERATOR BUSINESS (Cont.)**

 

In addition, Compugenreimbursed Biocceleration for all amounts received with respect to revenuesrelated to the BioXL business generated on or after the effective date. Inconnection with the transaction for the years ended December 31, 2006, 2005 and 2004, the Company recognized other income in the amount of $ 34,$ 218 and $ 343, respectively.

*** ***

*** ***

**NOTE 4:-   GOVERNMENTALAND OTHER GRANTS**

* *

The company received several grants as follows: 

* *

Royalty and non-royaltybearing grants from the Office of the Chief Scientist of the Israel Ministry ofIndustry, Trade&Labor - ("OCS") and from the Bi-nationalIndustrial Research and Development Foundation ("BIRD") for fundingapproved research and development projects, are presented as a reduction fromresearch and development expenses.  

* *

a.       Under the OCS royalty bearing programs, the Company is notobligated to repay any amounts received from the OCS if it does not generateany income from the results of the funded research program. If income isgenerated and the research program is successful, the Company is committed topay royalties at a rate of 3% to 5% of sales of the products arising from suchresearch program, up to a maximum of 100% of the amount received, linked to the$ US (for grants received under programs approved subsequent to January 1,1999, the maximum to be repaid is 100% plus interest at LIBOR). For the years endedDecember 31, 2006, 2005 and 2004, the Company has an aggregate of paid andaccrued royalties to the OCS in the amount of $ 7, $ 18 and $ 0,respectively. 

* *

b.       Underthe BIRD royalty bearing program, the Company is not obligated to repay anyamounts received from BIRD if no income is generated from the results of thefunded research program. If such income is generated, the Company is requiredto repay BIRD 100% of the grant that the Company received provided that therepayment to BIRD is made within the first year following expiry of the term ofthe project. For every year that the Company does not make these repayments,the amounts to be repaid incrementally increase up to an amount of 150% in thefifth year following expiry of the term of the project. All amounts to berepaid to BIRD are linked to the U.S. Consumer Price Index.

* *

As of December 31, 2006, theCompany's aggregate contingent obligation for payments to OCS and BIRD, basedon royalty-bearing participation received or accrued, net of royalties paid oraccrued, totaled approximately $ 7,880. The liability for royalties isrecorded as cost of revenues at the time the related royalty-bearing sales arerecognized as revenues in the statement of operations.

**F-19** 

 

**NOTE 4:      ****GOVERNMENTAL AND OTHER GRANTS (Cont.)**

* *

c.       In November2005, Keddem has received from the Investment Center of the Israeli Ministry of Industry and Trade andLabor, an amount of approximately $ 400 on account of the investment made bythe Company, prior to the spin off of Keddem. The cost of the fixed assets ispresented at its net value, after deduction of the above grant. Keddem's entitlementto above grant and future grants is conditional upon fulfilling the conditionsstipulated by the Law, regulations published thereunder and the letter ofapproval for the specific investments in "Approved Enterprises" (seeNote 14b). In the event of failure to comply with the conditions, the grant maybe canceled and Keddem may be required to refund the amount of the grants, inwhole or in part including interest and linked to the Israeli Consumer PriceIndex. To guarantee Keddem obligations to the investment center all the fixedassets of Keddem, are pledged in favor of the Investment Center (seeNote 1c).

 

d.    The Company is coordinating a consortium,SIMAP, in a three year collaborative project, which commenced on January 1, 2006, funded by the European 6th framework. The grants the Company receivesfrom this project do not bear any repayment royalties. The Company will enjoythe generic knowledge accumulated in the collaborative project. As acoordinator of this project, the Company receives the consortium funds from theEuropean Commission and distributes those funds to the consortium members basedon an agreement between the consortium members. As of December 31, 2005, theCompany held a pre-payment from the European Commission amounting to $ 834that have been distributed to the consortium members during 2006, according tothe payment schedule detailed in the consortium agreement. The Companypresented this amount as "Cash held in favor of other consortiumpartners". 

* *

* *

**NOTE 5:-   CASHAND CASH EQUIVALENTS**

** **
|                                                                                                      | ** ** | December 31, |
|-----------------------------------------------------------------------------------------------------------|------------|--------------|
|                                                                                                      | ** ** | 2006         |   | 2005 |
|                                                                                                      |       |         |   |   |
| Bank deposits in U.S. dollars (bearing an annual average  interest rate of 4.99% and 4.09%, respectively) |       | $4,907       |   | $6,592 |
| Bank deposits in Euro (bearing an annual average interest  rate of 2.19% and 1.75%, respectively)         |       | 20           |   | 185 |
| Bank deposits in NIS (bearing an annual average interest  rate of 4.97% and 3.73%, respectively)          |       | 462          |   | 985 |
| Cash in banks (current accounts)                                                                          |       | 862          |   | 730 |
|                                                                                                      |       |         |   |   |
|                                                                                                      |       | $6,251       |   | $8,492 |

** **

**F-20** 

** **

**NOTE 6:-     DEPOSITS AND MARKETABLESECURITIES**

 
|                    | *** *** | Amortized  cost |   | Gross unrealized

gains |   | Gross unrealized

losses |   | Fair value   |
|-------------------------|--------------|---------------------------|--------|-------------------------|--------|--------------------------|--------|--------------|
|                    | *** *** | December 31,              |   | December 31,            |   | December 31,             |   | December 31, |
|                    | *** *** | 2006                      |   | 2005                    |   | 2006                     |   | 2005         |   | 2006 |   | 2005 |   | 2006 |   | 2005 |
|                    | * *     | * *                  |   | * *                |   | * *                 |   | * *     |   | * * |   | * * |   | * * |   | * * |
| Corporate bonds         | * *     | $3,196                    |   | $7,849                  |   | $-                       |   | $-           |   | $11 |   | $72 |   | $3,185 |   | $7,777 |
| U.S Government agencies | * *     | -                         |   | 5,723                   |   | -                        |   | -            |   | - |   | 57 |   | - |   | 5,666 |
| Structured notes        | * *     | 4,956                     |   | 13,906                  |   | -                        |   | -            |   | - |   | - |   | 4,956 |   | 13,906 |
| Bank deposits           | * *     | 12,000                    |   | -                       |   | -                        |   | -            |   | - |   | - |   | 12,000 |   | - |
|                    | * *     | * *                  |   | * *                |   | * *                 |   | * *     |   | * * |   | * * |   | * * |   | * * |
|                    | * *     | $20,152                   |   | $27,478                 |   | $-                       |   | $-           |   | $11 |   | $129 |   | $20,141 |   | $27,349 |

 

As of December 31, 2006 and 2005, all the Company's securities were classified asheld-to-maturity (see Note 2e).

 

In the years 2006, 2005and 2004, the Company did not sell any securities prior to their maturity andaccordingly, did not realize any gains or losses on held-to-maturitysecurities. 

 

The unrealized losses onthe Company's investments in held-to-maturity securities were caused mainly byinterest rate increases, and are considered insignificant. The contractualterms of these investments do not permit the issuer to settle the securities ata price less than the amortized cost of the investment. Since these unrealizedlosses are insignificant, and since the Company has the ability and intent tohold these investments until the maturity date, the Company does not considerthese investments to be other-than-temporarily impaired at December 31, 2006.

 

The Company's managementbelieves that the unrealized losses for each of the bonds are consideredtemporary since the Company has an intent and ability to hold debt securitiesuntil maturity. In addition, the unrealized losses are in continuous positionfor a period not more than twelve months.

 

The scheduled maturities of held-to-maturity securities at December 31, 2006, are as follows:

 
| ** **                            | ** ** | Amortized |   | Estimated  |
|---------------------------------------|------------|-----------|--------|------------|
|                                  | ** ** | cost      |   | fair value |
| Held-to-maturity:                     |       |      |   |       |
| Due within one year                   |       | $19,152   |   | $19,141    |
| Due after one year through four years |       | 1,000     |   | 1,000      |
|                                  |       |      |   |       |
|                                  |       | $20,152   |   | $20,141    |

 

**F-21** 

 

 

#####  NOTE 7:-   OTHER ACCOUNTSRECEIVABLE AND PREPAID EXPENSES

** **
|                                                     | * * | December 31, |
|----------------------------------------------------------|----------|--------------|
|                                                     | * * | 2006         |   | 2005 |
|                                                     |     |         |   |   |
| Grants receivable from the Office of the Chief Scientist |     | $139         |   | $133 |
| Government authorities                                   |     | 41           |   | 82 |
| Receivables on account of options exercised              |     | -            |   | 104 |
| Prepaid expenses                                         |     | 251          |   | 249 |
| Receivables on account of the sale of BioXL business     |     | 22           |   | 73 |
| Accrued interest                                         |     | 315          |   | - |
| Other                                                    |     | 78           |   | 35 |
|                                                     |     |         |   |   |
|                                                     |     | $846         |   | $676 |

** **

** **

**NOTE 8:-     PROPERTY AND EQUIPMENT,NET**
|                                      |       | December 31, |
|-------------------------------------------|------------|--------------|
|                                      |       | 2006         |   | 2005 |
| Cost:                                     |       |         |   |   |
| Computers, software and related equipment |       | $4,892       |   | $4,905 |
| Laboratory equipment and office furniture |       | 2,486        |   | 2,546 |
| Leasehold improvements                    | ** ** | 2,269        |   | 2,328 |
|                                      |       |         |   |   |
|                                      |       | 9,647        |   | 9,779 |
| Accumulated depreciation:                 |       |         |   |   |
| Computers, software and related equipment |       | 4,569        |   | 4,316 |
| Laboratory equipment and office furniture |       | 1,963        |   | 1,718 |
| Leasehold improvements                    | ** ** | 936          |   | 725 |
|                                      |       |         |   |   |
|                                      |       | 7,468        |   | 6,759 |
|                                      |       |         |   |   |
| Depreciated cost                          |       | $2,179       |   | $3,020 |

** **

In 2005, Keddem received from the Investment Centera grant in the amount of approximately $ 400. The cost of the fixed assetsis presented in its net value, after deduction of the above grant (seeNote 4c).

 

For the years ended December 31, 2006, 2005 and 2004, depreciation expenses were approximately $ 996, $ 1,314and $ 1,466, respectively.

 

**F-22** 

** **

** **

**NOTE 9:-     OTHER ACCOUNTS PAYABLEAND ACCRUED EXPENSES**

** **
|                                                                  |   | December 31, |
|-----------------------------------------------------------------------|--------|--------------|
|                                                                  |   | 2006         |   | 2005 |
|                                                                  |   |         |   |   |
| Employees and related accruals                                        |   | $1,256       |   | $755 |
| Commitments related to European grant plan (a)                        |   | -            |   | 834 |
| Restructuring costs                                                   |   | -            |   | 99 |
| Unrecognized grants (a)                                               |   | 170          |   | 184 |
| Consultants and Board members                                         |   | 261          |   | 140 |
| Commitment for capital expenditures                                   |   | -            |   | 142 |
| Accrued expenses and other accounts payable                           |   | 339          |   | 202 |
| Accrued expenses related to Intellectual Property and  legal expenses |   | 18           |   | 16 |
|                                                                  |   |         |   |   |
|                                                                  |   | $2,044       |   | $2,372 |

(a)     See Note 4. 

** **

** **

**NOTE 10:-    COMMITMENTS ANDCONTINGENCIES**

** **

a.*            *The Company'sheadquarters and research facilities are located in Israel. TheCompany's U.S. 

operationsare located in San Jose, California and Maryland. Annual minimum future rental commitments under suchnon-cancelable operating leases are approximately as follows:

 
| December 31, |   |   |
|--------------|--------|--------|
|         |   |   |
| 2007         |   | 564    |
| 2008         |   | 535    |
| 2009         |   | 535    |
|         |   |   |
|         |   | 1,634  |

 

Rent expenses for the Company andsubsidiaries facilities were approximately $ 579, $ 580 and$ 685 for the years ended December 31, 2006, 2005 and 2004,respectively. 

 

b.       Fixed assets of Keddem, in the net book value of$ 412 are pledged to secure Keddem's obligations to the Investment Centerof the Ministry of Industry, Trade & Labor.

** **

c.       The Company provided a bank guarantee in the amount of$ 99 in favor of its offices' lessor in Israel.

 

d.       See Note 4 for details on commitments in favor ofgovernmental and other grants. 

 

**F-23** 

** **

**NOTE 11:-  SHAREHOLDERS'EQUITY**

* *

a.       Ordinary shares:

* *

         The Ordinary shares conferupon their holders the right to receive notice to participate and vote ingeneral shareholders meetings of the Company and to receive dividends, ifdeclared.

* *

b.*             *Share option plans:

* *

In September 1996, the Company adopted the Compugen Ltd. Employee ShareOption Plan,(1996) "the Plan"), which provides for the grant ofoptions to purchase 559,750 ordinary shares to employees and consultants of theCompany and its subsidiaries. The Company does not intend to grant additionaloptions under this plan.

* *

        In June 1998, the Company adopted the Compugen Ltd. ShareOption Plan (1998) ("the 1998 Plan"), which provides for the grant ofoptions to purchase up to an aggregate of 2,500,000 ordinary shares todirectors, employees and consultants of the Company and its subsidiaries. InMarch 2000, the Company adopted the Compugen Ltd. Share Option Plan (2000)("the 2000 Plan"), which provides for the grant of options topurchase 1,500,000 ordinary shares to employees and consultants of the Companyand its subsidiaries. The number of shares authorized for issuance under the2000 Plan automatically increases each January 1 by the lesser of 1,500,000 or4% of the total number of the Company's then outstanding shares or such loweramount as shall be determined by the board of directors. 

* *

In general, options granted under these plans vest over a four-yearperiod and expire 10 years from the date of issuance. The exercise price of theoptions granted under the plans may not be less than the nominal amount of theshares into which such options are exercised. Any options that are cancelled orforfeited before expiration become available for future grants. Subject to the1998 and 2000 plans, there were 672,216 and 935,716 options to purchase sharesavailable for future grants as of December 31, 2006,respectively.

* *

Transactions related to the grant of options to employees, directorsand consultants under the above plans during the years ended December 31, 2006,2005 and 2004, were as follows:

**F-24** 

* *

**NOTE 11:-      SHAREHOLDERS'EQUITY (Cont.)**

* *
|                                                            | * * | Year ended December 31, |
|-----------------------------------------------------------------|----------|-------------------------|
|                                                            | * * | 2006                    |   | 2005 | * * | 2004 |
|                                                            | * * | Amount of options       |   | Weighted average exercise price |   | Amount of options |   | Weighted average exercise price |   | Amount of options |   | Weighted average exercise price |
|                                                            | * * | * *                |   | $ |   | * * |   | $ |   |   |   | $ |
| Options outstanding at beginning of year                        | * * | 4,733,307               |   | 4.10 |   | 4,114,036 |   | 4.24 |   | 4,952,593 |   | 3.78 |
| Options granted                                                 | * * | 2,934,500               |   | 3.73 |   | 1,154,800 |   | 3.86 |   | 893,941 |   | 6.09 |
| Options exercised                                               | * * | (315,782)               |   | 1.78 |   | (120,398) |   | 2.34 |   | (877,548) |  | 3.11 |
| Options forfeited                                               | * * | (699,484)               |   | 4.36 |   | (415,131) |   | 5.27 |   | (854,950) |   | 4.68 |
|                                                            | * * | * *                |   | * * |   | * * |   | * * |   | * * |   | * * |
| Options outstanding at end of year                              | * * | 6,652,541               |   | 4.02 |   | 4,733,307 |   | 4.10 |   | 4,114,036 |   | 4.24 |
|                                                            | * * | * *                |   | * * |   | * * |   | * * |   | * * |   | * * |
| Options vested and expected to vest at end of year (*)          | * * | 3,363,925               |   | 4.00 |   | * * |   | * * |   | * * |   | * * |
|                                                            | * * | * *                |   | * * |   | * * |   | * * |   | * * |   | * * |
| Weighted average fair value of options granted during the  year | * * | * *                |   | 1.15 |   |   |   | 1.48 |   | * * |   | 2.04 |
| * *                                                        | * * | * *                |   | * * |   | * * | * * | * * |   | * * | * * | * * |

* *

(*)    The options expected to vest are based on the Company'shistorical forfeiture rate.

 

The aggregate intrinsic value of the Company's options is thedifference between the fair value of the Company's Ordinary shares and theexercise price, times the number of options. The total intrinsic value ofoptions exercised during the year ended December 31, 2006 was $ 479. The total intrinsic value of options outstanding at December 31, 2006 was $ 417 as of December 31, 2006. The total intrinsic value of options vested and expectedto vest at December 31, 2006 was $ 417 as of December 31, 2006.

**F-25** 

* *

Thefollowing table summarizes information about options outstanding at December 31, 2006:

* *
| * *                | * * | Options outstanding                     |     | Options exercisable                         |
|-------------------------|----------|-----------------------------------------|----------|---------------------------------------------|
| Range of exercise price |     | Number outstanding at December 31, 2006 |     | Weighted average remaining contractual life |   | Weighted average exercise 

price |   | Number outstanding at December 31, 2006 |   | Weighted average exercise 

price |
| $                       | * * | * *                                | * * | Years                                       | * * | $ | * * | * * | * * | $ |
| * *                | * * | * *                                | * * | * *                                    | * * | * * | * * | * * | * * | * * |
| 1.33 - 1.80             | * * | 315,261                                 | * * | 1.92                                        | * * | 1.67 | * * | 315,261 |   | 1.67 |
| 2.04 - 2.38             | * * | 510,943                                 | * * | 2.39                                        | * * | 2.34 | * * | 503,219 |   | 2.34 |
| 3.00 - 3.91             | * * | 2,143,309                               | * * | 5.94                                        | * * | 3.15 | * * | 615,314 |   | 3.32 |
| 4.13                    | * * | 3,387,063                               | * * | 7.25                                        | * * | 4.13 | * * | 1,774,045 |   | 4.13 |
| 4.27-6.84               | * * | 295,965                                 | * * | 4.02                                        | * * | 5.81 | * * | 237,854 |   | 5.69 |
| * *                | * * | * *                                | * * | * *                                    | * * | * * | * * | * * | * * | * * |
| * *                | * * | 6,652,541                               | * * | * *                                    | * * | * * | * * | 3,445,693 | * * | * * |

** **

** **

**NOTE 11:-      SHAREHOLDERS'EQUITY (Cont.)**

* *

Compensation expenses (income) which areamortized over the vesting period and recognized by the Company, related to itsemployee stock-based compensation awards, amounted to $ 1,980, $ (24)and $ 298 for the years ended December 31, 2006, 2005 and 2004,respectively. Compensation expenses related to the granting of stock options toconsultants amounted to $ (47), $ 6 and $ 457 for the yearsended December 31, 2006, 2005 and 2004, respectively (see also c below). 

 

In 2004, the Company extended the termof the vested employee stock options held by the Company's former CEO on thedate of his departure. As a result, the Company recorded in 2005 compensationexpenses in an amount of $ 396. The employee stock options that wereunvested as at the above date, were forfeited, and the deferred stockcompensation in the amount of $ 204 was canceled.

 

The Company estimates the fair value ofstock options granted using the Black-Scholes- option pricing model. The optionpricing model requires a number of assumptions, of which the most significantare the expected stock price volatility and the expected option term. Expectedvolatility was calculated based upon actual historical stock price movements.The expected term of options granted is based upon the simplified method underSAB 107, "Share-based payment". The risk-free interest rate is basedon the yield from U.S. treasury bonds with an equivalent term. The Company hashistorically not paid dividends and has no foreseeable plans to pay dividends.

 

The Company used the followingweighted-average assumptions for options granted in 2006: expected volatilityof 62%, risk free interest rates of 4.72%, dividend yields of 0%, and aweighted-average expected life of the options of 2.9 years.

**F-26** 

 

* *

The stock based compensation expensesare based on the straight line method and included in the following expensecategories: 

 
|                                | * * | Year ended December 31, |
|-------------------------------------|----------|-------------------------|
|                                | * * | 2006                    |   | 2005 |   | 2004 |
|                                |     |                    |   |   |   |   |
| Research and development expenses   |     | 1,400                   |   | 17 |   | 279 |
| Selling and marketing expenses      |     | 269                     |   | - |   | 68 |
| General and administrative expenses |     | 264                     |   | 361 |   | 408 |
|                                |     |                    |   |   |   |   |
|                                |     | $1,933                  |   | $378 |   | $755 |

** **

On March 10, 2006, the Company's Board of Directors approved to reduce the exercise price  of 1,793,149stock options that had been granted to employees and not exercised as at thedate of the resolution. Such employee stock options with an exercise pricehigher than $ 4.13 were reduced to the share price as of the close of the lasttrading day immediately preceding the time of the resolution, which was $ 4.13.As a result, the Company recorded compensation expenses in the amount of $ 428in the year ended December 31, 2006.

**F-27** 

** **

** **

**NOTE 11:-  SHAREHOLDERS'EQUITY (Cont.)**

 

c.  Options toconsultants:

* *
| Issuance date            |     | In connection 

with |     | Number 

of options granted |     | Options exercised through December 31, 2006 |     | Options exercisable as of December 31, 2006 |     | Options forfeited 

or expired through December 31, 2006 |     | Exercise price per share |     | Exercisable through |
|--------------------------|----------|----------------------|----------|-----------------------------|----------|---------------------------------------------|----------|---------------------------------------------|----------|----------------------------------------------------------|----------|--------------------------|----------|---------------------|
| * *                 | * * | * *             | * * | * *                    | * * | * *                                    | * * | * *                                    | * * | * *                                                 | * * | **$**                    | * * | * *            |
| * *                 | * * | * *             | * * | * *                    | * * | * *                                    | * * | * *                                    | * * | * *                                                 | * * | * *                 | * * | * *            |
| October  1998            | * * | Advisory  board      | * * | 30,000                      |     | 12,900                                      |     | 17,100                                      |     | -                                                        |     | 1.33                     | * * | October  2008       |
| July  1999               | * * | Advisory  board      | * * | 15,000                      |     | -                                           |     | 15,000                                      |     | -                                                        |     | 1.35                     | * * | July  2009          |
| July  1999               | * * | Consulting           | * * | 150,000                     |     | 150,000                                     |     | -                                           |     | -                                                        |     | 1.35                     | * * | July  2009          |
| October  1999            | * * | Advisory  board      | * * | 15,000                      |     | -                                           |     | 15,000                                      |     | -                                                        |     | 1.33                     | * * | October  2009       |
| March  2000              | * * | Consulting           | * * | 75,000                      |     | -                                           |     | 75,000                                      |     | -                                                        | * * | 5.00                     | * * | March  2010         |
| May  2000                | * * | Consulting           | * * | 10,000                      |     | -                                           |     | 10,000                                      |     | -                                                        | * * | 3.00                     | * * | May  2010           |
| May  2000                | * * | Consulting           | * * | 35,000                      |     | -                                           |     | -                                           |     | 35,000                                                   | * * | 10.00                    | * * | May  2005           |
| January  2002            | * * | Consulting           | * * | 20,000                      |     | -                                           |     | -                                           |     | 20,000                                                   | * * | 4.49                     | * * | January  2012       |
| July  2003               | * * | Consulting           | * * | 150,000                     |     | -                                           |     | 146,866                                     |     | -                                                        | * * | 2.38                     | * * | April  2009         |
| February  2004           | * * | Consulting           | * * | 60,000                      |     | -                                           |     | 41,250                                      |     | -                                                        | * * | 4.13                     | * * | March  2010         |
| April  2004              | * * | Advisory  board      | * * | 50,000                      |     | -                                           |     | 36,505                                      |     | -                                                        | * * | 6.84                     | * * | April  2010         |
| April  2004              | * * | Consulting           | * * | 50,000                      |     | -                                           |     | 23,965                                      |     | 26,035                                                   | * * | 6.84                     | * * | April  2010         |
| April  2004              | * * | Consulting           | * * | 60,000                      | * * | -                                           | * * | 40,000                                      |     | -                                                        |     | 6.84                     | * * | April  2010         |
| February  2005           | * * | Consulting           | * * | 25,000                      |     | -                                           |     | 11,462                                      |     | -                                                        | * * | 4.13                     | * * | February  2011      |
| June  2005               | * * | Advisory  board      | * * | 20,000                      |     | -                                           |     | 7,502                                       |     | -                                                        | * * | 3.37                     | * * | June  2015          |
| November  2005 | * * | Consulting           | * * | 120,000                     |     | -                                           |     | 84,000                                      |     | -                                                        | * * | 3.02                     | * * | November  2011      |
| March  2006              | * * | Advisory  board      | * * | 100,000                     |     | -                                           |     | 25,008                                      |     |                                                     | * * | 4.13                     | * * | March  2012         |
| March  2006              | * * | Consulting           | * * | 52,000                      |     | -                                           |     | 19,212                                      |     | -                                                        | * * | 4.13                     | * * | March  2012         |
| * *                 | * * | * *             | * * | * *                    | * * | * *                                    | * * | * *                                    |     | * *                                                 |     | * *                 | * * | * *            |
| * *                 | * * | * *             | * * | 1,037,000                   | * * | 162,900                                     | * * | 567,870                                     |     | 81,035                                                   |     | * *                 | * * | * *            |

 

The Company accounts for its options andwarrants to consultants under the fair value method of SFAS No. 123 and EITFNo. 96-18, "Accounting for Equity Instruments That Are Issued to OtherThan Employees for Acquiring, or in Conjunction with Selling, Goods orServices". The fair value of these options was estimated using a Black& Scholes option-pricing model with the following weighted-averageassumptions for 2006, 2005 and 2004 risk-free interest rates of 4.83%, 3.79%and 3.36%, respectively, dividend yields of 0%, volatility factors of theexpected market price of the Company's ordinary shares of 56%, 51% and 44%,respectively and a weighted-average contractual life of the options of sixyears. As for compensation expenses, see also b above.

 

 

 

**F-28** 

* *

* *

**NOTE 12:- GEOGRAPHICINFORMATION AND MAJOR CUSTOMERS**

* *

The Company'sbusiness is currently comprised of one operating segment, the research,development and commercialization of therapeutic and diagnostic biomarkerproduct candidates. The nature of the products and services provided by theCompany and the type of customers for these products and services are similar.Operations in Israel and the United States include research and development,sales and business development. The Company follows SFAS No. 131"Disclosures about Segments of an Enterprise and RelatedInformation." Total revenues are attributed to geographic areas based onthe location of the end customer. The following represents the total revenuesfor the years ended December 31, 2006, 2005 and 2004 and long-lived assets asof December 31, 2006, 2005 and 2004:

 
|                                           | * * | Year ended December 31, |
|------------------------------------------------|----------|-------------------------|
|                                           | * * | 2006                    |   | 2005 |   | 2004 |
| Revenues from sales to unaffiliated customers: | * * |                    |   |   |   |   |
| United States                                  |     | $15                     |   | $423 |   | $1,051 |
| Europe                                         |     | 200                     |   | 218 |   | 1,260 |
| Far East                                       |     | -                       |   | - |   | 265 |
| Israel                                         |     | -                       |   | 5 |   | 43 |
| Other                                          |     | -                       |   | - |   | 11 |
|                                           |     |                    |   |   |   |   |
| Total revenues                                 |     | $215                    |   | $646 |   | $*)  2,630 |

* *

*)      Reclassified.

* *
|               | * * | December 31, |
|--------------------|----------|--------------|
|               | * * | 2006         |   | 2005 |   | 2004 |
| Long-lived assets: |     |         |   |   |   |   |
| Israel             |     | $2,172       |   | $3,005 |   | $3,710 |
| United States      |     | 7            |   | 15 |   | 29 |
|               |     |         |   |   |   |   |
|               |     | $2,179       |   | $3,020 |   | $3,739 |

 
|                                      | * * | Year ended December 31, |
|-------------------------------------------|----------|-------------------------|
|                                      | * * | 2006                    |   | 2005 |   | 2004 |
|                                      |     | %                       |
| Sales to a single customer exceeding 10%: |     |                    |   |   |   |   |
| Customer A                                |     | 93                      |   | 59 |   | 48 |
| Customer B                                |     | -                       |   | 39 |   | - |
| Customer C                                |     | -                       |   | - |   | 13 |
|                                           |          |                         |  |  |  |  |  |  |

 

 

**F-29** 

 

 

**NOTE 13:- FINANCIALINCOME, NET**

*** ***
|                      | * * | Year ended December 31, |
|---------------------------|----------|-------------------------|
|                      | * * | 2006                    | * * | 2005 | * * | 2004 |
| Income (expense):         |     |                    |   |   |   |   |
| Interest income           |     | $905                    |   | $770 |   | $1,454 |
| Bank fees                 |     | (41)                    |   | (39) |   | (56) |
| Exchange rate differences |     | 20                      |   | (49) |   | 19 |
|                      |     |                    |   |   |   |   |
|                      |     | $884                    |   | $682 |   | $1,417 |

 

** **

**NOTE14:- TAXES ON INCOME**

 

a.       Measurementof taxable income under the Income Tax (Inflationary Adjustments) Law, 1985:

 

         Results for tax purposes aremeasured in terms of earnings in NIS after certain adjustments for increases in  Israel's Consumer Price Index ("CPI"). As explained in Note 2b, thefinancial statements are measured in U.S. dollars. The difference between theannual change in Israel's CPI and in the NIS/dollar exchange rate causes afurther difference between taxable income and the income before taxes shown inthe financial statements. In accordance with paragraph 9(f) of SFAS No. 109,the Company has not provided deferred income taxes on the difference betweenthe functional currency and the tax bases of assets and liabilities.

 

c.*            *Tax benefits under the Law for the Encouragement ofCapital Investments, 1959 ("the Law"):

 

        In 1994, theproduction facilities of the Company related to its computational technologieswere granted the status of an "Approved Enterprise" under the Law. In1996 and 2000, two expansion programs related to the Company's computationaltechnologies were granted the status of "Approved Enterprise". In1999 and 2003, the production facilities of the Company related to theCompany's molecular biology "wet lab" were granted the status of an"Approved Enterprise".

 

According to theprovisions of the Law, the Company has chosen to enjoy the "AlternativeBenefits" track. Accordingly, its income from the "ApprovedEnterprise" will be tax-exempt for a period of two years, commencing inthe first year the Company has taxable income (after commencement of productionas defined in the Law), and subject to an additional period of five to eightyears of reduced tax rates between 10% to 25%, depending upon the proportion offoreign ownership in the Company in each tax year. Due to the reported losses,the benefit period has not commenced. The period during which reduced tax ratesof between 10% and 25% apply expires on the earlier of 12 years from thecommencement of production, or 14 years, from the date of approval, all inaccordance with the final approval of the investment center. Given theaforementioned conditions, the period of the reduced tax rates (but not the twoyear period of tax exemption) will terminate in 2008 and 2017.

**F-30** 

 

 

**NOTE 14:-            TAXESON INCOME (Cont.)**

* *

        The entitlement to the abovebenefits is conditional upon the Company's fulfilling the conditions stipulatedby the above Law, regulations published thereunder and the letters of approvalfor the specific investments in "Approved Enterprises". In the eventof failure to comply with these conditions, the benefits may be canceled andthe Company may be required to refund the amount of the benefits, in whole orin part including interest and linked to the Israeli Consumer Price Index.

* *

        As of December 31, 2006, management believes that the Company meets all of the aforementioned conditions.

 

        If the Company pays a dividendout of income derived from the approved enterprise during the tax exemptionperiod, it will be subject to corporate tax in respect of the amountdistributed, including any taxes thereon, at the rate which would have beenapplicable had it not enjoyed the alternative benefits, generally 10%-25%,depending on the percentage of the Company's Ordinary shares held by foreignshareholders. The dividend recipient is subject to withholding tax at the rateof 15% applicable to dividends from approved enterprises, if the dividend isdistributed during the tax exemption period or within twelve years thereafter

 

        Should the Company deriveincome from sources other than the "Approved Enterprise" during the relevantperiod of benefits, such income will be taxable at the regular corporate taxrate.  

 

        In addition, in December 2003the production facilities of the Company related to its Chemistry Division weregranted the status of an "Approved Enterprise" under the Law. TheCompany has chosen the "grants" track, according to which the totalapproved investments amounted to $ 3,500. Until December 31, 2006, Keddem already made investments in the amount of approximately $ 1,700. Theinvestment grants are 24% from its investments in the approved enterprises. Thetax benefits portion of the "grants" track are identical to the taxbenefits portion of the "Alternative Benefits" track. In connectionwith the divestment of the Company's computational chemistry activities (seeNote 1c), the Company transferred its benefits and liability under this programto Keddem. Keddem was required to commence investing until December 2006, inorder to benefit from the program. Keddem requested to extend the eligibilityperiod until December 2007 inclusive (see Note 1c).

 

        The Investment Law wassignificantly amended effective April 1, 2005. The amendment includes revisionsto the criteria for investments qualified to receive tax benefits as anApproved Enterprise and among other things, simplifies the approval process.The amendment applies to new investment programs. Therefore, investmentprograms commencing after December 31, 2004, do not affect the approvedprograms of the Company. 

**F-31** 

 

**NOTE 14:-    ****TAXES ON INCOME (Cont.)**

* *

c.       Tax benefit under the Law for the Encouragement ofIndustry (Taxation), 1969:

* *

Management believes that the Company iscurrently qualified as an "industrial company" under the above lawand as such, enjoys tax benefits, including:

 

(1)  Deduction of purchase of know-how and patents and/or right to use a patent over an eight-yearperiod; 

(2)  The right to elect, under specified conditions, tofile a consolidated tax return with additional related Israeli industrialcompanies and an industrial holding company;

(3)  Accelerated depreciation rates on equipment andbuildings; and

(4)  Expenses related to a public offering on theTel-Aviv Stock Exchange and as of 1.1.2003 on recognized stock markets outsideof Israel, are deductible in equal amounts over three years.

 

d.       Net operating losses carryforward:

 

As of December 31, 2006, the Company's and Keddem's net operating loss carryforward for tax purposes in Israelamounted to approximately $ 83,500. These net operating losses may becarried forward indefinitely and may be offset against future taxable income.The Company expects that during the period in which these tax losses areutilized its income would be substantially tax-exempt.

 

Compugen Inc. is subject to U.S. incometaxes.  As of December 31, 2006, Compugen Inc. has net operating losscarryforwards for federal income tax purposes of approximately $15 millionwhich expires in the years 2019 to 2024. Compugen Inc. also has net operatingloss carryforwards for state income tax purposes of approximately $1.5 millionwhich expires in the years 2013 to 2024.  Utilization of the U.S. netoperating losses may be subject to substantial annual limitation due to the"change in ownership" provisions of the Internal Revenue Code of 1986and similar state provisions. The annual limitation may result in theexpiration of net operating losses before utilization.

 

e.       Loss (income) before taxes is comprised as follows:

 
|              | * * | Year ended December 31, |
|-------------------|----------|-------------------------|
|              | * * | 2006                    | * * | 2005 | * * | 2004 |
|              | * * |                    |   |   |   |   |
| Domestic (Israel) |     | $13,099                 |   | $14,047 |   | $11,443 |
| Foreign           | * * | (79)                    |   | (69) |   | 2,279 |
|              | * * | * *                |   | * * |   | * * |
|              | * * | $13,020                 |   | $13,978 |   | $13,722 |

 

**F-32** 

 

**NOTE 14:-    TAXES ON INCOME (Cont.)**

 

f.       Deferred taxes:

 

Deferred income taxes reflect the net taxeffects of temporary differences between the carrying amounts of assets andliabilities for financial reporting purposes and the amounts used for incometax purposes. The Company and its subsidiaries' deferred tax assets arecomprised of operating los`s carryforward and other temporary differences.Significant components of the Company and its subsidiaries deferred tax assetsare as follows:

 
|                                              |   | December 31, |
|---------------------------------------------------|--------|--------------|
|                                              |   | 2006         |   | 2005 |
|                                              |   |         |   |   |
| Operating loss carryforward                       |   | $5,857       |   | $6,354 |
|                                              |   |         |   |   |
| Net deferred tax asset before valuation allowance |   | 5,857        |   | 6,354 |
| Valuation allowance                               |   | (5,857)      |   | (6,354) |
|                                              |   |         |   |   |
| Net deferred tax asset                            |   | $-           |   | $- |

 

The Company and its subsidiaries haveprovided valuation allowances in respect of deferred tax assets resulting fromoperating loss carryforward and other temporary differences.  

 

Management currently believes thatsince the Company and its subsidiaries have a history of losses it is morelikely than not that the deferred tax regarding the loss carryforward and othertemporary differences will not be realized in the foreseeable future.

 

g.       Reconciliation of the theoretical tax expense (benefit) tothe actual tax expense (benefit):

 

The main reconciling items between thestatutory tax rate of the Company and the effective tax rate are thenon-recognition of tax benefits from accumulated net operating lossescarryforward among the Company andvarious subsidiaries dueto the uncertainty of the realization of such tax benefits and the effect ofapproved enterprise.

 

h.       The State of New Jersey enacted legislation permittingemerging technology and/or biotechnology companies located in New Jersey to selltheir New Jersey Net Operating Loss ("NOL") Carryover and Researchand Development Tax Credits ("R&D Credits") to corporatetaxpayers in New Jersey. During 2004, the State of New Jersey approved thetotal tax benefit in the amount of $ 1,178 for possible sale by theCompany. In December 2004, the Company received $ 262 from the sale of anaggregate of $ 305 tax benefit, which was recognized as other income forthe fiscal year 2004.

 

i.        Tax rates applicable to the income of the Company:

 

In June 2004, an amendment to the IncomeTax Ordinance (No. 140 and Temporary Provision), 2004 was passed by the"Knesset" (Israeli parliament) and on July 25, 2005, another law was passed, the amendment to the Income Tax Ordinance (No. 147) 2005,

**F-33** 

*** ***

**NOTE 14:- TAXES ON INCOME(Cont.)**

 

according to which the corporate taxrate is to be progressively reduced to the following tax  

rates: 2004 - 35%, 2005 - 34%, 2006 -31%, 2007 - 29%, 2008 - 27%, 2009 - 26%, 2010 and 

thereafter - 25%.

* *

* *

**NOTE 15:- RELATED PARTY TRANSACTIONS**

* *

The Company is grantingbookkeeping services to Evogene, for which it is fully reimbursed on armslength basis. During the years ended December 31, 2006, 2005 and 2004 servicesreimbursed by Evogene amounted to $ 8, $ 6 and $ 6, respectively.

 

In August 2006, theCompany entered into a Software License Agreement with Evogene, under which theCompany agreed to grant Evogene a license to certain software. In considerationfor the grant of the license, Evogene agreed to issue the Company 40,000 ordinaryshares before December 31, 2006 and an additional 20,000 ordinary shares withinone month of Evogene entering into its first significant agreement. To date,the Company has been issued 60,000 ordinary shares under the software licenseagreement.

 

The Company providesadministrative services (including book-keeping) to Keddem, for which it isfully reimbursed. During the years ended December 31, 2006, 2005 and 2004services reimbursed by Keddem amounted to $ 37, $ 48 and $ 26,respectively.

 

 

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**F-34**