**SECURITIES ANDEXCHANGE 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, 2003      

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:**

None

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

        OrdinaryShares, par value New Israeli Shekels 0.01 per share      

(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: 

26,848,474Ordinary Shares

 

Indicate by check mark whether the registrant (1)has filed all reports required to be filed by Section 13 or 15(d) of theSecurities Exchange Act of 1934 during the preceding 12 months (or for suchshorter period that the registrant was required to file such reports), and (2)has been subject to such filing requirements for the past 90 days: 

Yes [x]      No [  ]

 

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

Item 17 [  ]  Item 18 [x]

**1** 

 

**TABLE OFCONTENT**

 

PART I. 4

ITEM 1.     IDENTITY OFDIRECTORS, SENIOR MANAGEMENT AND ADVISORS. 4

ITEM 2.     OFFER STATISTICSAND EXPECTED TIMETABLE.. 4

ITEM 3.     KEY INFORMATION.. 4

ITEM 4.          INFORMATION ON THE COMPANY. 20

ITEM 5.     OPERATING ANDFINANCIAL REVIEW AND PROSPECTS. 36

ITEM 6.     DIRECTORS,SENIOR MANAGEMENT AND EMPLOYEES. 51

ITEM 7.     MAJORSHAREHOLDERS AND RELATED PARTY TRANSACTIONS. 61

ITEM 8.     FINANCIALINFORMATION.. 64

ITEM 9.     THE OFFER ANDLISTING.. 66

ITEM 10.        ADDITIONAL INFORMATION.. 67

ITEM 11.        QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.. 81

ITEM 12.        DESCRIPTION OF SECURITIES OTHER THAN EQUITY SECURITIES. 81

PART II 82

ITEM 13.        DEFAULTS, DIVIDEND ARREARAGES AND DELINQUENCIES. 82

ITEM 14.        MATERIAL MODIFICATIONS TO THE RIGHTS OF SECURITY HOLDERS ANDUSE OF PROCEEDS  82

ITEM 15.        CONTROLS AND PROCEDURES. 82

ITEM 16.        RESERVED.. 82

ITEM 16A.      AUDIT COMMITTEE FINANCIAL EXPERT. 82

ITEM 16B.      CODE OF ETHICS. 82

ITEM 16C.     PRINCIPAL ACCOUNTANT FEES AND SERVICES. 83

PART III 84

ITEM 17.        FINANCIAL STATEMENTS. 84

ITEM 18.        FINANCIAL STATEMENTS. 84

ITEM 19.        EXHIBITS. 84

* *

**2** 

 

This annual report on Form 20-F includes"forward-looking" statements within the meaning of Section 21E of theSecurities Exchange Act of 1934. We have based these forward-looking statementson information available to us on the date hereof, and on our currentintentions, beliefs, expectations and projections about future events. Weassume no obligation to update any such forward-looking statements. Theseforward-looking statements are not guarantees of future performance and aresubject to risks, uncertainties and assumptions that could cause our actualresults to differ materially from our expectations or projections. Factors thatcould cause our actual results to differ materially from those projected in theforward-looking statements include the risk factors set forth under "Item 3.Risk Factors", the information about the Company set forth under "Item 4.Information about the Company", and information related to the Company`s financialcondition under "Item 5. Operating and Financial Review and Prospects." 

‐‐‐‐‐‐‐‐‐‐‐‐

 

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

‐‐‐‐‐‐‐‐‐‐‐‐

** **

**3** 

 

# PART I.

** **

### ITEM1.                  IDENTITY OF DIRECTORS, SENIOR MANAGEMENT AND ADVISORS

 

                Notapplicable.

 

### ITEM2.                  OFFER STATISTICS AND EXPECTED TIMETABLE

 

                Not applicable.

 

### ITEM3.                  KEY INFORMATION

 

**Selected Financial Data**

** **

The selected financial datais incorporated by reference to Item 5 of this annual report.

 

**Risk Factors**

 

Many factors could affect our financial condition,cash flows and results of operations. We are subject to various risks resultingfrom changing economic, political, social, industry, business and financialconditions. The principal risks are described below. 

 

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

*** ***

**We have a history of losses, we expect to incur futurelosses and we may never achieve or sustain profitability***.*

 

We incurred net losses of approximately $15.1million in 2001, $12.2 million in 2002 and $11.4 million in 2003. As of December 31, 2003, we had an accumulated deficit of approximately $67.1 million (notincluding approximately $24.9 million in accumulated deficit attributable tothe conversion of preferred shares upon the closing of our initial publicoffering). We expect to continue to incur net losses and negative cash flows inthe future due in part to high research and development expenses, includingenhancements to our technologies and investments in new technologies. As aresult, we will need to generate significantly higher revenues to achieveprofitability. We cannot assure you that we will ever achieve profitability.Even if we do achieve profitability, we may not be able to sustain or increaseprofitability.

 

**We may be required to allocate substantial additionalfunds in the future to our discovery activities, but we may never be able toachieve profitability.**

** **

We discover and develop therapeutic and diagnosticproduct candidates. In 2003 we allocated a substantial portion of our cash andother resources to our discovery activities. To date, our discovery activitieshave generated only negligible revenues, they may never generate significantrevenues and may never achieve profitability. Although we intend to allocateadditional cash and other resources to our discovery activities, we do notanticipate that this funding will enable us to achieve profitability in thenear future. As a result, our discovery activities may require substantialadditional funds in the future. If we are unable to obtain the required additionalfunds for our discovery activities, whether internally or from third parties oncommercially reasonable terms, we may have to curtail or cease our discoveryactivities, and our business may be materially harmed.

 

**4** 

**If we are unable to raise additional capital in thefuture, we may have to curtail or cease operations.**

** **

As of December 31, 2003, we had cash and cashequivalents, and short-term marketable securities of approximately $16.7million, and long-term marketable securities of approximately $43.8 million.Based on our current projections, we anticipate that our existing cash and cashequivalents, and short-term and long-term marketable securities will besufficient to support our operations for at least the next two years. We cannotassure you, however, that we will not need to raise additional capital prior tothat time or that we would be able to raise sufficient additional capital onfavorable terms, if at all. If we fail to raise sufficient funds, we may haveto curtail or cease operations, which would materially harm our business andfinancial results. If we raise additional capital by issuing equity securities,our shareholders may experience dilution. If we raise additional funds throughcollaboration and licensing arrangements, we may be required to relinquish somerights to our technologies and/or product candidates, or grant licenses onterms that are not favorable to us.  

* *

***Factors Related to our Discovery Activities andCommercialization of the Products of these Activities***

*** ***

**We may never make discoveriesthat will be suitable for developing into therapeutic or diagnostic productswith commercial potential.**

 

We are a genomics-based drug and diagnosticsdiscovery company. Our objective is to significantly increase the probabilityof successful discovery and development of novel drugs and diagnostic products,by incorporating ideas and methods from mathematics, computer science andphysics into the disciplines of biology, organic chemistry and medicine. 

 

Notwithstanding that we have already madediscoveries by using this approach, our approach and the technologies which weuse to implement our approach, are novel, and our discoveries are still at anearly stage. Our approach and our technologies may prove to be ineffective. 

 

Evenif we are able to discover genes, mRNAs and proteins, which are suitable fordeveloping into therapeutic or diagnostic product candidates, such productcandidates may not have sufficient or any commercial value and/or may not be ofinterest to potential third party collaborators or licensees.

 

If we are unable to make discoveriessuitable for therapeutic and diagnostic development and commercialization,based on the use of our technologies, our business may fail or we maynever become profitable.  

** **

**Since the discovery of drugs and diagnostic productsbased on the study of genomics is still an emerging discipline, we may beunable to discover genes and/or proteins on the basis of which we will be ableto develop therapeutic or diagnostic products.**

** **

Despite recent scientific advances in the lifesciences and our improved understanding of biology, the roles of genes andproteins, and their involvement in diseases and in other biological processesare not well understood and still evolving. Consequently, the process of discoveringdrugs and diagnostic products based on the study of genomics is still anemerging discipline. We may be unable to continue to discover genes or proteins that will be suitable for therapeutic ordiagnostic development. Our future success largely depends on ourability to continue to develop our genomics-based drug and diagnostic discoverytechnologies.

** **

**There are risks that are inherent in the developmentand commercialization of drugs, therapies, diagnostic products and other lifescience products, and if these risks materialize, our business may bematerially harmed.**

 

Even if we are able to continue to discover newtherapeutic or diagnostic product candidates, which are suitable fordevelopment, we or our collaborators may not be able to develop new productsbased on these discoveries. Even if we or our collaborators are able to developsuch products, we or our collaborators may not be able to commercialize them. 

**5** 

 

A number of risks of failure are inherent in theprocess of developing and commercializing drugs, therapies, diagnostic productsand other life science products. These risks include the possibility that: 

●*       *our product candidates will be found to bepharmaceutically ineffective or to be toxic or to have other side effects; 

●*       *we or our collaborators will fail to receiveapplicable regulatory approvals; 

●*       *we or our collaborators will fail to manufactureits products on a large scale; 

●*       *our products or product candidates will beuneconomical or not cost effective to market; 

●*       *we or our collaborators will fail to develop andmarket products prior to the successful marketing of similar or competingproducts; and/or

●*       *the development, marketing and/or sale of ourproducts or product candidates will infringe the proprietary rights of thirdparties.

 

Any of these risks, if they materialize, couldmaterially harm our business and financial results.

 

To date, we have identified a number of potentialtherapeutic proteins and diagnostic markers. Once developed, product candidatesmust undergo extensive investigation, including pre-clinical and human clinicaltrials, and obtain all regulatory approvals needed for commercialization. Evenif we are able to develop our potential therapeutic proteins and diagnosticmarkers candidates, we cannot assure you that these products, or any of them,would be commercially successful.  

** **

**We have limited corporate experience in and limitedresources for the discovery and development of new drugs, therapies anddiagnostic products, and if we fail to develop the appropriate experience, ourbusiness may be materially harmed.**

** **

We currently have very limited corporate experiencein the discovery and development of new drugs, therapies and diagnostic productcandidates. In order to successfully develop and commercialize therapeutic and diagnosticproduct candidates, we must improve our internal expertise, capabilities andfacilities.  

 

Even though we hired and intend to continue toengage key scientific experts, we may not be able to engage all of the expertsthat we need. 

 

Currently, we are also expanding our biologylaboratories by, among other things, acquiring equipment and recruiting expertsfor the purpose of strengthening our protein expression and purificationcapabilities.  If we do not succeed in properly planning and carryingout the expansion of our biology laboratory facilities, we may not havesuitable facilities to carry out the research activities that we intend topursue. If we are unable to engage suitable scientific experts to carry out ourlaboratory activities, we may not be able to effectively use these facilitiesand/or obtain any meaningful experimental results.

 

If we fail to develop the required corporateexperience and expertise in the discovery and development of new drugs,therapies and diagnostic product candidates, we may be unsuccessful in ourdiscovery activities, and 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. Our competitors include genomics-based, pharmaceutical,biotechnology and diagnostic companies, academic and research institutions andgovernment and other publicly funded agencies. Many of our competitors have substantiallygreater financial, technical, human resources, research and development,facilities, experience, and marketing resources than we do.

**6** 

 

Our competitors may discover and develop productsor market and sell products based on these discoveries, in advance of us or ofour collaborators or licensees. Our competitors may also obtain intellectualproperty rights that may prevent us from pursuing the development andcommercialization of our discoveries. 

 

Additionally, since ourdiscovery engines and related technologies are aimed at identifying, amongother things, novel alternatively spliced variants, third parties` therapeuticor diagnostic products based on genes or proteins which correspond to oursplice variants may compete with the corresponding splice variant based productthat we seek to develop. We have already encountered circumstances where thirdparties that develop such therapeutic or diagnostic products attained relatedintellectual property rights that precede our own and a developmental stage fortheir products that surpasses the stage to which we have been able to developour own product candidate. We expect to encounter similar such circumstances inrelation to other product candidates that we may wish to develop.

 

Additionally, there is a trend towardsconsolidation in the pharmaceutical and biotechnology industries. This trendusually involves larger companies acquiring smaller companies, which may resultin the remaining companies having greater financial resources and technologicalcapabilities, thus intensifying competition in the industry. 

 

**There may be a conflict of interests between ourinternal discovery activities and our business of providing our customersaccess to our technologies, which may result in our customers developing productsthat compete with our products, and this may harm our business.  **

 

Our internal discoveryactivities are largely based on our discovery engines and related technologies.We seek to establish intellectual property rights related to genes, gene-basedproducts, and proteins that we discover. We believe that our discovery enginesand other proprietary technologies provide us with a competitive advantage overthird party biotechnology, diagnostics and pharmaceutical companies and otherentities that seek patent protection relating to genes, gene-based products andproteins. 

 

When we make output of our LEADS-based technologiesavailable to our customers, primarily biotechnology, diagnostics andpharmaceutical companies, the competitive advantage of our internal discoveryactivities over these customers may be diminished or eliminated. 

 

If our customers, most of which have greaterfinancial and other resources than we have, research genes, gene-basedproducts, or proteins that we are also researching, they may establishintellectual property rights in such genes, gene-based products, or proteinsbefore we do. As a result, our business, financial condition and results ofoperations may be significantly harmed.

 

Many of our customers are also potential collaboratorsfor the development and commercialization of our internal discoveries. Bymaking the results of use of our LEADS-based technologies and related servicesavailable to these customers, we increase the risk of these customersdeveloping gene-based products which are similar or competitive to ours, and atthe same time, we decrease their potential as our future collaborators for thedevelopment and commercialization in our internal discoveries. As a result, ourbusiness, financial condition and results of operations may be significantlyharmed.  

 

**We depend significantly on our business partners forthe development and commercialization of our therapeutic product candidates,and if our relations with our existing business partners deteriorate, or if weare unable to enter into other agreements with business partners in the future,our business may be materially harmed.**

 

Our strategy for the development andcommercialization of therapeutic proteins depends on the formation ofcollaborations or licensing relationships with third parties that havecomplementary capabilities. We rely on our third party collaborators andlicensees to carry out product development and commercialization of ourtherapeutic and diagnostic product candidates. Potential third parties includepharmaceutical and biotechnology companies, diagnostic companies, and academicinstitutions. 

**7** 

 

Although to date, we have granted two licenses, onefor the development and commercialization of diagnostic markers and the otherfor cell and gene therapy, we cannot assure the successful development ofproduct candidates in relation to which we granted intellectual propertyrights. Even if our licensees succeed in developing such product candidates, wecannot assure you that such developed products will be commercially successful.Further, we cannot assure you that we will enter into any other agreement inthe future. 

 

**We may not be able to find collaborators or licenseesthat will agree to in-license our discoveries at an early stage, and if we donot find these collaborators or licensees, our business may be harmed.**

** **

Pharmaceutical and diagnostic companies may bereluctant or refuse to in-license our potential proteins and diagnostic markersat early stages of development. Even if we find a collaborator or licensee thatwill agree to in-license our discoveries at an early stage, such collaboratoror licensee may not agree to do so on terms that we would consider desirable.If we are unable to out-license our discoveries at an early stage, we may be requiredto further develop such discoveries internally, until they reach a more maturestage of development. Such development activities may require substantialadditional funding. If we are unable to obtain these required additional funds,whether from internal sources or from third parties on terms that we wouldconsider desirable, we may have to curtail or cease our discovery activities,and our business may be materially harmed.

** **

**Our dependence on licensing and other collaborationagreements with third parties presents a number of risks, and if these risksmaterialize, our business may be materially harmed.**

** **

The risks that we face inconnection with our collaborations, licenses and other business alliancesinclude the following:

●*       *we may not be able to enter into licensing or othercollaboration agreements on terms favorable to us; 

●*       *our collaborators may typically have significantdiscretion in electing whether to pursue any of the planned activities and themanner in which this will be done;  

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

●*       *our collaborators may not perform their obligationsas agreed or expected; 

●*       *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; 

●*       *our rights in any intellectual property or productsthat may result from our collaborations may depend on additional investment ofmoney that we may not be able or willing to make;

●*       *prospective collaborators may pursue alternativetechnologies, including those of our competitors; 

●*       *disputes may arise with respect to the ownership ofrights to any technology or product developed with any future collaborator; 

●*       *lengthy negotiations with potential collaboratorsor disagreements between us and our collaborators may lead to delays in ortermination of the collaboration or result in time-consuming and expensivelitigation or arbitration; and 

●*       *our collaborators may fail to develop orcommercialize successfully any product candidate to which they have obtainedrights from us.

 

In any of these cases, our business, financialcondition and results of operations may be significantly harmed. 

**8** 

 

**We may never be able to validate and commercialize thetechnology that we are developing**.

Our chemistry operation isin its early research and development stage. It is a high-risk operation becauseit consumes our funds and other resources and is uncertain of success. Althoughwe have made substantial progress since the initiation of this activityapproximately five years ago, the underlying scientific rationale has not yetbeen fully validated. We do not know whether the underlying technology willever be validated and, if validated, whether we will be able to commercializethis technology.

** **

***Factors Related to the Development andCommercialization of our Discovery Engines and other Technologies***

** **

**Our approach of incorporating ideas and methods frommathematics, computer science and physics into the disciplines of biology,organic chemistry and medicine is novel and may not be accepted by ourpotential customers and/or collaborators.**

** **

We are aleader in incorporating ideas and methods from mathematics, computer scienceand physics into the disciplines of biology, organic chemistry and medicine.Our objective is to significantly increase the probability of success of drugdiscovery and diagnostic development. Even though we have already madediscoveries by using this approach, our approach may prove to be ineffective ornot as effective as other methods, or may not be accepted by our potentialcustomers or collaborators. Our products and technologies may prove to beineffective if, for instance, they fail to account for the complexity of thelife processes that we are now attempting to model. If our customers orcollaborators do not accept our products or technologies and/or if ourtechnologies prove to be ineffective our business may be harmed. 

** **

**The industries in which we are active are continuouslyevolving, and we may be unable to keep pace with changes in technology.**

 

Thepharmaceutical and biotechnology industries are characterized by continuous technologicalchanges. These continuous changes have to some extent resulted, and maycontinue to result, in a reduced demand for some of our products. We may not beable to make the necessary modification or enhancements to our technologies inorder to compete successfully with newly emerging technologies. If we fail tokeep pace with technological changes, we may not be able to competesuccessfully with companies that offer products that are similar to ours. As aresult, our revenues may decline significantly and our business may bematerially harmed.  

 

In addition, human genomic sequence data isavailable to the public as a result of the US Federal Government`s funded HumanGenome Project and other projects, which are engaged in the study of genes. Thepublication of these data, including the publication of the human genome, maymake some of our discovery engines and other technologies less valuable orobsolete. 

** **

**We face intense competition with respect tocommercialization of discoveries that we generate from use of our discoveryengines, and if we cannot effectively compete, our business may be harmed.**

*** ***

Numerous entities in the United  States and elsewhere that provide products and services for the analysis ofgenomic information compete with our efforts to commercialize the output ofanalyses using our LEADS computational biology platform and other technologies,which include our discovery engines. While we believe that our Leads-based discovery engines and othertechnologies have a technological advantage over other available products andtechnologies, many of these entities have greater resources than we do, whichmay allow them to develop products that may be perceived to be more effectivethan ours.

**9** 

 

Some of our competitors,especially academic and research institutions and government and other publiclyfunded agencies, are already providing for free, and may continue to providefor free, services or data similar to the services and data that we provide toour customers for a fee. Also, since we are a small company with limited humanresources, we are not able to work with a large number of customers inparallel. If we are unable to compete successfully against existing orpotential competitors, our market share, revenues and margins may decline, andour financial results may be harmed.

 

Asmall number of customers account for a large portion of our revenues fromproducts and services, and if we lose any of these customers our revenues andresults of operations may be harmed.

** **

In the past a small number of our customersaccounted for a substantial amount of our revenues. By way of example, in 2001Warner-Lambert Company, a subsidiary of Pfizer, Inc., the U.S. Patent andTrademark Office and Novartis Pharma A.G. each accounted for more than 10% ofour revenues and together accounted for approximately 64% of our revenues. In2002, each of Warner-Lambert Company, Novartis Pharma A.G. and diaDexus Inc.accounted for more than 10% of our revenues and together accounted forapproximately 44% of our revenues. In 2003 Novartis Pharma A.G. and AbbottLaboratories each accounted for more than 10% of our revenues and togetheraccounted for approximately 52% of our revenues. We expect that a small numberof customers could continue to account for a large portion of our revenues inthe future. A loss of one or more of our significant customers could materiallyharm our business and financial results. 

 

**The trend towards consolidation in the pharmaceuticaland biotechnology industries may adversely affect us.**

 

The trend towards consolidation in thepharmaceutical and biotechnology industries may result in fewer customers forour products, including customers for the benefit of whom we may use ourLEADS-based discovery engines and other technologies. Also, if one of the consolidatingcompanies already uses the technologies or services of our competitors, we maylose existing customers as a result of such consolidation. This trend mayadversely affect our market share and our revenues.

 

***Factors Related to our Operations***

** **

**The sales cycle for most of our products islengthy and because of this we may expend substantial funds and managementeffort with no assurance of success**.

 

Our ability to enter intobusiness arrangements with collaborators and licensees for the development andcommercialization of our therapeutic or diagnostic product candidatessignificantly depends on our ability to validate and prove that each suchproduct candidate is suitable for our claimed therapeutic or diagnosticpurposes. Our ability to enter into such business arrangements will also dependon our ability to successfully negotiate terms and conditions for sucharrangements. The sales cycle for our therapeutic and diagnostic productcandidates is typically lengthy and may take more than 12 months.

 

Our ability to enter into transactions involvinguse of our LEADS-based discovery engines and related technologies and servicesdepends in large upon their perception that our technologies can advance theirefforts in drug and diagnostics discovery. In addition, we are often requiredto negotiate agreements containing terms unique to each customer. The salescycle for the products of our discovery engines and for some of our othertechnologies and services may take 12 months or longer. 

 

Our business development and sales effort mayrequire the effective demonstration of the benefits of our technologies to apotential customer. These departments may include key management personnel.Therefore, we expend and will need to continue expending substantial funds andmanagement effort with no assurance that we will be successful in reachingagreements or suitable business arrangements with potential customers,collaborators or licensees. 

**10** 

** **

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

** **

Our business is highlydependent upon the continued services of our senior management and keyscientific and technical personnel. While members of our senior management haveentered into employment or consulting agreements and non-competition andnon-disclosure agreements, we cannot assure you that these key personnel andothers will not leave us or compete with us, which could materially harm ourfinancial results and our ability to compete. We do not carry key person lifeinsurance on any member of our senior management. Furthermore, within ourgeographic location, it is difficult to encounter suitable and highly qualifiedpersonnel within our industry. Our business would be seriously harmed if wewere unable to retain our key employees, or to attract, integrate or retainother highly qualified personnel in the future.

*** ***

**Our ability to commercialize some of ourtechnologies may be limited because of Israeli government research anddevelopment grants that we receive.**

 

Some of the technologiesthat we develop have been and may in the future be partially financed by grantsthat we receive from the Office of the Chief Scientist (OCS) of the IsraeliMinistry of Industry, Commerce and Labor. By reason of receipt of these grants,Israeli law prescribes certain restrictions and limitations in relation to suchfinanced technologies. For instance, in order to transfer our OCS-fundedtechnologies to Israeli third parties, we need to obtain the Israeligovernment`s consent. Additionally, the transfer of our OCS-funded technologiesoutside of Israel may be prohibited. These restrictions may limit our abilityto commercialize some of our technologies. These restrictions do not apply tothe sale or to the export of products that we develop by using our OCS-fundedtechnologies.

 

**We may be subject to product liability claims if ourproducts, or products derived from our discoveries harm people, and this couldmaterially harm our business.**

** **

We may be held liable if any product that wedevelop, or any product that incorporates any of our discoveries, technologiesor data causes harm or is found otherwise unsuitable. These risks are inherentin the development, testing and marketing of therapeutic and diagnosticproducts. Since our strategy for the development and commercialization ofdiagnostic markers and therapeutic proteins depends on collaborations orlicensing relationships with third parties by which our collaborators orlicensees will complete development and market end products based on ourdiscoveries, we believe that the probability that such a claim will be madeagainst us is currently small. Nonetheless, if someone sues us for any harm orinjury caused by products derived from our discoveries, services or products,our liability could adversely and materially affect our business and financialconditions. In addition, such claims could cause us to incur substantial costsand subject us to negative publicity even if we prevail in our defense of suchclaims. 

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

 

We rely heavily on the use of and manipulation oflarge amounts of data and on the secure and continuous use of our internalcomputers, communications networks and of our software and hardware systems. Wehave implemented and maintain physical and software security measures topreserve and protect our computers, communications systems and hardware andsoftware as well as our data, our customers' data and other third parties`data. These measures are intended to safeguard against loss, corruption andmisappropriation caused by system failures or unauthorized access. We have alsoentered into confidentiality agreements with our employees, consultants,customers and collaborators who have access to such confidential or proprietaryinformation. 

**11** 

 

However, these methods may not protect us againstfire, storm, flood, power loss, earthquakes, telecommunications failures,physical or software break-ins and similar events. In addition, these measuresmay not be sufficient to prevent unauthorized access, use or publication ofsuch proprietary data. A party who is able to circumvent our security measurescould misappropriate or destroy proprietary information or cause interruptionsin our operations. In addition, a party who obtains unauthorized access to ourproprietary data or breaches a confidentiality agreement with us could publishor transfer large portions or all of our proprietary data. Such publication ofproprietary data could make some of our products less valuable or obsolete, orcould materially harm our IP position, thereby seriously harming our financialcondition. We also could be subject to liability claims by our licensors,customers or collaborators who have submitted their proprietary data to us foranalysis. These security problems, if significant, could cause our revenue todecline or our entire business to cease.   

*** ***

**We may be subject to claims related to thehazardous chemicals, radioactive and biological materials that we use, andclaims may harm our business.**

 

We use hazardous materials,including chemicals, radioactive and biological materials, in our laboratories.To our knowledge, our work is performed in accordance with all applicableenvironmental regulations. However, we cannot eliminate the risk of accidentalcontamination or discharge and any harm from these materials. We could besubject to civil damages and criminal penalties and be held liable for damagescaused in the event of our use of these hazardous materials, or in the event ofimproper or unauthorized release of, or exposure of individuals to, hazardousmaterials. In such event, our liability may exceed our insurance coverage. Inaddition, our insurance policy does not cover damages that result fromradioactive contamination.   

*** ***

**Products that we develop may be subject to governmentalregulation, which could reduce the commercial viability of our products.**

 

The process of obtaining regulatory approval in the United Statesand in other countries can be lengthy and complex. Changes in opinions,guidelines, policies and legislation could increase the complexity and thelength of the process of obtaining regulatory approvals. Even if we obtainregulatory approval, a product on the market and its manufacture are subject tocontinuous review. Problems with a product, such as the causation of unwantedside effects, may result in the withdrawal of a product from the market. 

 

We have not yet applied for or received anyregulatory approvals for any therapeutic, diagnostic or other products, eitherin the US or elsewhere. Regulatory approval for conducting clinical trials andfor the development or marketing of products based on our discoveries will berequired. Although we intend to become involved in initial clinical developmentphases in the future, we also expect to rely on our collaborators and licenseesto advance regulatory approval processes. We cannot be certain that we or ourcollaborators or licensees will be able to obtain such approvals for anyproduct that we may develop, on a timely basis, if at all. If our collaboratorsor licensees fail to obtain required governmental marketing approvals, it willprevent them from marketing therapeutic or diagnostic products until clearancecan be obtained, if at all. This will in turn reduce our chances of receivingvarious forms of payments, including those relating to sales of marketedtherapeutic or diagnostic products by our collaborators or licensees. If we orour collaborators or licensees do not succeed in obtaining the requiredregulatory approval for the development or marketing of products based on ourdiscoveries, our business may be harmed.

*** ***

***Factors Related to Intellectual Property***

*** ***

**We may not be able to protect our proprietary data,technologies or products, and this may materially harm our business.**

** **

If we are not able to adequately protect theintellectual property underlying our products and services, competitors may beable to develop and market the same or similar products and services. Thiscould erode our competitive advantage, including in countries in which theenforcement of intellectual property mechanisms are less robust than those inthe US.

**12** 

 

We rely heavily on our proprietary know-how andtrade secrets that we develop and that are not protectable or protected bypatents. We employ a number of measures to ensure that this know-how will notbe disclosed outside the company, and to the extent that it may be, we makeextensive use of confidentiality agreements. However, these measures may notprovide adequate protection for our trade secrets and know-how. Customers,employees, scientific advisors, collaborators and consultants may disclose ourproprietary know-how or trade secrets in violation of their obligations to us.We may not be able to meaningfully protect our proprietary know-how or tradesecrets against such unauthorized disclosure. We may not be able to adequatelyprotect our proprietary know-how or trade secrets from unauthorized access bythird parties, and its subsequent unauthorized use or publication. 

 

The success of our business depends, in large part,on our ability to obtain patents in our inventions that relate to genes andproteins. We have applied for patents covering some aspects of some of ourtechnologies and also covering genes and proteins we have discovered usingthese technologies. We plan to continue to apply for such patents as we deemappropriate, but we cannot assure you that our applications will be successful.  Ifwe do not succeed in obtaining patent protection for our inventions that relateto genes and proteins that we discover, our business and financial resultscould be materially harmed.

 

**We may not be able to obtain or maintain patentprotection for our inventions that relate to genes and proteins that wediscover, and if we fail to do so, our business may be materially harmed.**

** **

The process of obtaining apatent for inventions that relate to genes and proteins that we discover iscomplex. Factors, which may prevent us from obtaining patent protection for ourinventions, include:

●*       *the patent positions of biotechnology companies,including ours, are generally uncertain and involve complex legal and factualquestions; 

●*       *legislative and judicial changes, or changes in theexamination guidelines of governmental patents offices may negatively affectour ability to obtain patent protection for certain aspects of our intellectualproperty, especially with respect to genetic discoveries;

●*       *we face intense competition from otherbiotechnology and pharmaceutical companies some of which may have alreadysought patent protection relating to discoveries that we may intend to developand commercialize; 

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

●*       *even if we succeed in obtaining patent protection,our patents could be invalidated or may not be sufficiently broad to provide uswith any competitive advantages. 

 

**The existence of third party intellectual propertyrights may prevent us from developing our discoveries or require us to spendtime and money or modify our operations.**

** **

In selecting a gene orprotein for an in-house development project, we take into account, among otherconsiderations, the existence of third party intellectual property rights thatmay prevent us from pursuing our intended development or from ultimatelycommercializing the resulting product. Ordinarily, the content of US and otherpatent applications remain unavailable to the public for a period of eighteenmonths from their filing date. In some instances, the content of US patentapplications remains unavailable to the public until they are issued. As a result,we can never be certain that development projects that we commence will be freeof third party intellectual property rights.  If we become aware ofthe existence of third party intellectual property rights only after we havecommenced a particular research and development project:

●*       *we may consider that the risks presented by theexistence of such third party intellectual property undermines the merits ofthe particular research and development project;

●*       *we may need to invest substantial management andfinancial resources to in-license such third party intellectual property andcannot assure you that we will succeed in doing so; and 

●*       *we may have to forgo a particular research anddevelopment project after having invested in it substantial resources.

**13** 

 

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

 

If we infringe patents orproprietary rights of third parties, our business could be seriously harmed. Ifa third party commences litigation against us for the infringement of patent orother intellectual property rights, we may incur significant costs inlitigating, whether or not we prevail in such litigation. Typically, patentlitigation in the pharmaceutical and biotechnology industry is expensive. Coststhat we incur in defending third party infringement actions would also includediversion of management`s and technical personnel`s time and energy. Inaddition, parties making claims against us may be able to obtain injunctive orother equitable relief that could prevent us from being able to further developor commercialize our products. In the event of a successful claim ofinfringement against us, we may be required to pay damages and obtain one ormore licenses from third parties. If we are not able to obtain these licensesat a reasonable cost, if at all, we could encounter delays in productintroductions while we attempt to develop alternative methods or products.Defense of any lawsuit or failure to obtain any of these licenses could preventus or our partners from commercializing available products and could cause usto incur substantial expenditures.

 

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

*** ***

**Holders of our ordinary shares who are****United  States****residents may be required to pay additional income taxes.**

 

There is a significant risk that we will 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 holders of ourordinary shares and may cause a reduction in the value of these shares. For USFederal income tax purposes, we will be classified as a PFIC for any taxableyear in which either: (i) 75% or more of our gross income is passive income, or(ii) at least 50% of the average value of all of our assets for the taxableyear produce or are held for the production of passive income. For thispurpose, passive income includes dividends, interest, royalties, rents,annuities and the excess of gains over losses from the disposition of assetsthat produce passive income. If we were determined to be a PFIC for US Federalincome tax purposes, highly complex rules would apply to US taxpayers owningour ordinary shares. Accordingly, you are urged to consult your tax advisorsregarding the application of these rules.

 

As a result of our substantial cash position andthe relatively lower price of our stock in the earlier part of 2003, there is arisk that we will be classified as a PFIC under the asset test described in thepreceding paragraph. In addition, there can be no assurance that we will not beclassified as a PFIC in the future, because the determination of whether we area PFIC is based upon the composition of our income and assets from time totime, and such determination cannot be made with certainty until the end of acalendar year. 

 

United States residents should carefully read"Taxation, United States Federal Income Tax Consequences" under "Item 10.Additional Information" for a more complete discussion of the US Federal incometax risks related to owning and disposing of our ordinary shares. 

**14** 

 

**Our business is difficult to evaluate because we have alimited history of operations, and this may result in our shares trading at adiscount or in our share price being volatile.**

 

Since our incorporation in 1993, our researchfocus, the products that we developed and our business model have beencontinually evolving. Some of the products that we sold and some of thetechnologies that we developed, no longer constitute part of our business (forinstance, the Bioccelerator product line), and some of the products that in thepast were considered part of our core business (for instance, LabOnWeb), are nolonger considered to be such. In addition, since 1998, part of our business hasinvolved the research and development of therapeutic products and diagnosticmarkers. These products are typically developed over a period of approximatelytwelve years and four years, respectively. For these reasons, we have a historyof operations in which we believe there is insufficient information to identifyany historical pattern. Even if we could discern such a pattern, thecontinuously evolving nature of the biotechnology and pharmaceutical industriesin general and our business in particular would make it very difficult toidentify any meaningful information. Therefore, it would also be difficult tomake any projections about the future of our operations. This difficulty mayresult in our ordinary shares trading at a discount or the market price of ourshares to be volatile. 

** **

**Our share price has been volatile and we believe islikely to be volatile in the future.**

 

The market price of our ordinary shares has beenhighly volatile and we believe is likely to continue to be highly volatile.This is due to the risks and uncertainties described in this annual report, aswell as other factors, including:  

●*       *general economic conditions, including those thatspecifically relate to life science-related industries;

●*       *actual or anticipated fluctuations in our operatingresults; 

●*       *changes in expectations as to our future financialperformance or changes in financial estimates by the investment community;

●*       *technological innovations by us or by ourcompetitors; 

●*       *investors' perceptions or changes in marketvaluation of life science companies in general; 

●*       *relatively low volumes at which our shares havebeen traded at in the past and at which they may continue to trade; and

●*       *the operating and share price performance ofcomparable companies.

 

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. 

 

In the past, following periods of volatility in themarket price of some companies' securities, securities class action litigationhas been brought against them. We are not aware of any reason why suchlitigation would be brought against us. Nevertheless, we could become involvedin this type of litigation in the future. Litigation of this type is often veryexpensive and diverts management attention and resources. 

**15** 

 

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

****

Our quarterly operatingresults have fluctuated in the past and are likely to do so in the future.These fluctuations may cause our share price to fluctuate significantly. If ouroperating results fail to meet the expectations of the investment community,this may cause fluctuations in our share price. Consequently these resultsshould not be relied upon as indications of future performance, and comparisonsof quarterly results of operations may not be meaningful. Our operating resultsmay fluctuate as a result of:

●*       *the timing of our receipt of payments underarrangements with our current and future customers and collaborators;

●*       *our rate of success and timing of entering intotransactions for the commercialization of our products;

●*       *changes in demand for our existing products;

●*       *a drop in the financial resources available to ourcustomers; 

●*       *changes to our fee structure imposed by marketconstraints, or to our operating expenses; 

●*       *product quality problems; 

●*       *increased competition and the timing of the releaseof products and data by our competitors and academic and other non-profitorganizations; 

●*       *inflation/deflation in Israel or changes inthe conversion rate of New Israeli Shekel;

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

●*       *the time within which our collaborators willdevelop our therapeutic proteins and/or diagnostic marker candidates intomature products; and

●*       *a decrease in our entitlement to receive researchand development grants and certain tax benefits.

** **

**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 stock.**

** **

Israeli corporate law regulates acquisitions ofshares through tender offers. It requires special approvals for transactionsinvolving significant shareholders and regulates other matters that may berelevant to these types of transactions. The provisions of Israeli law maydelay or prevent an acquisition, or make it less desirable to a potentialacquirer and therefore depress the price of our shares. For information aboutthese limitations, see "Anti-Takeover Provisions under Israeli Law" Under "Item10. Additional Information". Further, Israeli tax considerations may makepotential transactions undesirable to us or to some of our shareholders.

** **

**Some of our existing shareholders can exert controlover us and may not make decisions that are in the best interests of allshareholders.**

** **

As of February 29, 2004, officers, directors andshareholders holding more than 5% of our outstanding shares collectivelycontrolled approximately 29.2% of our outstanding ordinary shares. As a result,these shareholders, if they act together, would be able to exert a significantdegree of influence over our management and affairs and over matters requiringshareholder approval, including the election of directors and approval ofsignificant corporate transactions. Accordingly, this concentration ofownership may harm the market price of our ordinary shares by delaying orpreventing a change in control of us, even if a change is in the best interestsof our other shareholders. 

 

In addition, the interests of this concentration ofownership may not always coincide with the interests of other shareholders, andaccordingly, they could cause us to enter into transactions or agreements thatwe would not otherwise consider.

**16** 

 

**Our ordinary shares are traded on more than one marketand this may result in price variations.**

 

Our ordinary shares are traded primarily on theNasdaq National Market and on the Tel Aviv Stock Exchange. Trading in ourordinary shares on these markets is made in different currencies (US dollars onthe Nasdaq National Market, and New Israeli Shekels on the Tel Aviv StockExchange), and at different times (resulting from different time zones,different trading days and different public holidays in the United States andIsrael). Consequently, the trading prices of our ordinary shares on these twomarkets often differ. Any decrease in the trading price of our ordinary shareson one of these markets could cause a decrease in the trading price of ourordinary shares on the other market.

*** ***

***RisksRelating to Operations in******Israel***

** **

**Conditions in the****Middle East****and in****Israel****may harm our ability to produce and sell our products and services.**

* *

Our principal offices and research and developmentfacilities and many of our suppliers are located in Israel. Political, economicand military conditions in Israel 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 conflict and terrorist actions. A state of hostility,varying in degree and intensity, has led to security and economic problems for Israel.There has been a significant increase in violence since September 2000, whichhas continued with varying levels of severity through to the present. To date,we do not believe that the political and security situation has had a materialadverse impact on our business. Any hostilities involving Israel or theinterruption or curtailment of trade between Israel and its present tradingpartners could adversely affect our operations and could make it more difficultfor us to raise capital. 

 

Our insurance does not cover losses that may occur,as 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. Anyfuture armed conflicts or political instability in the region would likelynegatively affect business conditions and could harm our results of operations.  

 

In the past, the State of Israel and companiesdoing business with the State of Israel have been subjected to an economicboycott. Several countries still restrict business with the State of Israel andwith Israeli companies. These restrictive laws and policies may have an adverseimpact on our operating results, financial condition or the expansion of ourbusiness.

* *

**Our results of operations may be negatively affected bythe obligation of key personnel to perform military service.**

** **

Some of our executive officers and employees areobligated to perform military reserve duty and are subject to being called toactive duty for extended periods of time under emergency conditions. To date,any calls to active duty have not affected us materially. However, it ispossible that there will be additional call-ups in the future, which may have amore material effect on us. The absence of one or more of our executiveofficers or key employees due to military service could disrupt our operations.Any disruption in our operations may have an adverse impact on our business.

**17** 

 

**Our results of operations may be adversely affected byinflation and currency fluctuations.**

** **

We generate a substantial portion of our revenuesin US dollars but incur a significant portion of our expenses, principallysalaries and related personnel expenses, in New Israeli Shekels. As a result,we are exposed to the risk that the rate of inflation in Israel will exceed therate of devaluation of the NIS in relation to the dollar or that the timing ofany devaluation may lag behind inflation in Israel. While in recent years therate of devaluation of the NIS against the dollar has exceeded the rate ofinflation, we cannot be sure that this trend will continue. If the dollar costof our operations in Israel increases, our dollar-measured results of operationswill be adversely affected. Our operations also could be adversely affected ifwe are unable to guard against currency fluctuations in the future.Accordingly, we may enter into currency hedging transactions to decrease therisk of financial exposure from fluctuations in the exchange rate of the dollaragainst the NIS. These measures, however, may not adequately protect us frommaterial adverse effects due to the impact of inflation in Israel.

** **

**We may not continue to receive research and developmentgrants and may not continue to be entitled to certain tax benefits.**

 

We currently receiveresearch and development grants and are entitled to certain grants and taxbenefits under Israeli government programs, particularly as a result of the"approved enterprise" status of our existing facilities in Israel (for moreinformation, see "Item 5. Operating and Financial Review and Prospects;Operating Results; Governmental Economic, Fiscal, Monetary or PoliticalPolicies that Materially Affected or Could Materially Affect our Operations")and research and development programs that are funded by the Office of ChiefScientist of the Israeli Ministry of Industry Trade and Labor. To maintain oureligibility for some of these programs and tax benefits, we must continue tomeet certain conditions, including making specified investments in fixed assetsand financing a percentage of investments with share capital. In addition, wemust continue to file periodic reports and pay royalties with respect to someof the grants received. If we fail to meet such conditions, we will becomeineligible for such grants and tax benefits and could be required to return allor part of the benefits received. We cannot assure you that we will continue toreceive grants at the same rate, if at all. In addition, some of these programsrestrict our ability to transfer the technologies funded by these grantsoutside of Israel (for more information, see "Item 5.****Operating andFinancial Review and Prospects; Research and Development, Patents and Licenses;Israeli******Government Research and Development Programs"). Fromtime to time, we submit requests for additional research and development grantsand expansions of our approved enterprise programs or for new programs. Theserequests might not be approved. The termination or reduction of these programsand tax benefits could have a material adverse effect on our business,financial condition and results of operations.******If these programsor tax benefits are terminated or reduced, we could lose a significant sourceof revenues or, if we generate taxable income in the future, we may be requiredto pay increased taxes on the taxable income that we generate from fundedtechnology. 

 

Israeli law and regulations prescribe an expirydate for the grant of new benefits. The expiry date has been extended severaltimes in the past. The last expiry date that was in effect was in June 2004,and no new benefits will be granted after that date unless the expiry date isagain extended. A government committee is reviewing the benefits program underthe law. There can be no assurance that new benefits will be available afterJune 2004, however benefits already granted will stay in effect throughout theplan period. 

 

**Terrorist attacks that occurred in New York andWashington on September 11, 2001 and other acts of violence or war maymaterially affect the markets on which our securities trade, the markets inwhich we operate, our operations and profitability.  **

 

In the aftermath of the September 11, 2001terrorist attacks on the United States, the United States-led coalition ofnations commenced a series of retaliatory military strikes in Afghanistan uponstrategic installations of the Taliban regime. In March of 2003, a UnitedStates-led coalition of nations commenced a war in Iraq, which resulted in thefall of Saddam Hussein`s regime in that country. 

**18** 

As a result, governmental intelligence authorities issuefrom time to time warnings of the imminent threat of further attacks againstcivilian and military installations. The uncertainty surrounding these issues,have had, and we expect will continue for the unforeseeable future to have, anadverse effect on the global economy generally, including the biotechnologyindustry. 

** **

**It may be difficult to enforce a US judgment againstus, or our officers and directors or to assert US securities law claims inIsrael.**

** **

Service of process upon us, which is incorporatedin Israel, and upon our directors and officers and our Israeli auditors, almostall of whom reside outside the United States, may be difficult to obtain withinthe United States. In addition, because substantially all of our assets andalmost all of our directors and officers are located outside the United States,any judgment obtained in the United States against us or any of our directorsand officers may not be collectible within the United States.

**19** 

### ITEM4.                  INFORMATION ON THE COMPANY

 

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

Our legal and commercial name is Compugen Ltd. Wewere established as a corporation under the laws of the State of Israel in1993, and we operate under the laws of the State of Israel. Our principaloffices are located at 72 Pinchas Rosen Street, Tel Aviv 69512, Israel, and ourtelephone number is +972-3-765-8585. The principal offices of Compugen USA,Inc. (formerly knows as Compugen, Inc.), our wholly-owned U.S. subsidiary, arelocated at 7 Centre Drive, Jamesburg, New Jersey 08831, and its telephonenumber is (609) 655-5105. Our primary Internet address is www.cgen.com. None ofthe information on our websites is incorporated by reference into this annualreport. 

 

In August 2000, we sold 5,000,000 of our ordinaryshares in the initial public offering of our shares on the Nasdaq NationalMarket at $10.00 per share. In September 2000, we sold an additional 750,000ordinary shares upon the exercise by our underwriters of their over-allotmentoption. In January 2002, we listed our shares for trading on the Tel Aviv StockExchange (TASE). 

 

We are a genomics-based drug and diagnosticdiscovery company, whose mission is to significantly increase the probabilityof successful development of novel drug and diagnostic products byincorporating ideas and methods from mathematics, computer science and physicsinto the disciplines of biology, organic chemistry and medicine. We believethat this unique capability results in powerful predictive models and discoveryengines and related technologies, which are both enabling the discovery ofputative therapeutic proteins and diagnostic markers, and advancing our understandingof important biological phenomena. 

 

We initially developed acomputer hardware system and software applications to accelerate homologysearches of biological sequences. This system and those applications werecommercialized under the name "Bioccelerator" since 1994. In 2003, we sold theBioccelerator product line (for more information regarding the sale of ourBioccelerator product line, see Note 3 of our 2003 Consolidated FinancialStatements). By divesting the Bioccelerator product line, we sought to increaseour focus on our two primary commercial offerings. These commercial offeringsare:

●*       *discovery-based collaborations by which we intendto offer the output of use of our discovery engines and other technologies toenable our collaborators to develop genomics-based discoveries; and

●*       *our therapeutic proteins and diagnostic markersthat we discover through our internal research and development activities. 

 

In 1997, we incorporated our wholly-owned USsubsidiary, Compugen USA, Inc. We conduct a large portion of our businessdevelopment, sales and marketing operations, as well as some of our customersupport activities, from the US.

 

Since 1997, we have directed a significant portionof our activities to the development of technologies that allow molecularbiologists to obtain significantly more information and more valuableinformation from genomic databases. An important aspect of the technologiesthat we developed is the analysis and rearrangement - also known as clusteringand assembly - of genomic and expressed sequence data in order to provideinformation that can lead to the discovery of new genes and proteins. Thisclustering and assembly technology can lead and has led to our discovery ofnovel genes and novel proteins. Some of these discoveries have been discoveriesof "splice variants". Splice variants are the product of the alternativesplicing of a gene, before it encodes a protein. Such splicing accounts for theexpression of more than one protein from the same gene.

**20** 

 

Since 1997, we have been developing our coretechnology, our LEADS computational biology platform. This platform analyzesgenomic and expressed sequence data to enable rapid discovery of genes, splicevariants and gene function. Our LEADS computational biology platform solves quantitativeand qualitative problems inherent in the analysis of EST (which are nucleotidesequences that encode for the expression of mRNA sequences, also referred to as"expressed sequences", or "expressed sequence tags") data and allows molecularbiologists to quickly identify genes from gene fragments. The LEADScomputational biology platform improves the quality of available genomic andexpressed sequence data. We licensed use of this technology to the leadingpharmaceutical companies Pfizer Inc., Novartis Pharma A.G. and AbbottLaboratories.

 

Since 2000, we applied our technologies, includingour LEADS computational biology platform, to the development of solutions foraddressing challenges in the fields of functional genomics, which is the studyof gene expression and gene function. We design probes, which are shortnucleotide sequences designed to be uniquely representative of much largercorresponding genes. Probes that we design can be used for gene expressionexperiments. Since our probe designs are based on, amongst other technologies,our Leads computational biologyplatform, they include the technological advantages that our Leads computational biology platformoffers. The probes that we design serve as the basis for our Oligolibrariesproducts. In 2001, we entered into a joint license and marketing agreement withSigma-Genosys for the development, marketing and production of ourOligolibraries products.

 

In 1998, we established our biology laboratory. Theinitial purpose of the laboratory was the validation of our computationalpredictions. Subsequently, we recognized that there is vast potential indiscovering novel proteins, rather than merely validating their existence, insupport of our computational technologies. 

 

Since 2002, we commenced to focus on the discoveryand development of novel therapeutic proteins and diagnostic markers. During2003 we further expanded our molecular biology laboratories by acquiringequipment and recruiting relevant employees and experts. At the moment we arein the process of strengthening our protein expression and purificationcapabilities. By using our proprietary discovery engines and other technologiesand by focusing on therapeutic proteins (drugs which are themselves proteinsand which are usually administered by injection) and diagnostic markers (whichindicate the presence or absence of a physiological condition, such as adisease), we have discovered novel proteins withpotential applications in the therapeutics and diagnostics fields. Weseek to commercialize these novel proteins and diagnostic markers by pursuingcommercial relationships with leading biotechnology, diagnostic andpharmaceutical companies. 

 

To date, we have commercialized two of our novel proteins:   

●*       *In December 2002, we granted an exclusive licenseto Diagnostic Products Corporation to develop and commercialize *in-vitro*diagnostic assays based on our two novel prostate-specific proteins (PSA-LM andK-LM proteins), for the use in the field of cancer immuno-diagnostics. Inconsideration for the grant of this license, we are entitled to receivemilestone payments and royalties based on the future commercialization of ourintellectual property.

●*       *In April 2003, we granted a non-exclusive licenseto MultiGene Vascular Systems Ltd. ("MGVS") to develop and commercialize geneand cell therapy products incorporating our novel VEGF114 splice variant foruse in the treatment of cardiovascular diseases. Under the terms of theagreement, we are entitled to receive an equity stake in MGVS and royalties onfuture product sales. 

 

In the first calendar quarter of 2001, we commencedto market our Genecarta product. Genecarta is a user-friendly databaseapplication that allows scientists in the field of genomics, functionalgenomics and proteomics to easily use the results of analyses performed withour Leads computational biologyplatform.  

**21** 

 

In the field of proteomics, we developed and, since2000, commercialized the Z3 and Z4000 software products. These products useadvanced computational techniques to carry out pattern recognition analyses andimage processing to analyze the results of certain protein separationexperiments. Currently, we do not actively market these products.

 

In 1999, we firstestablished a research program in chemistry, in which we integrate thedisciplines of organic chemistry with physics and advanced computationaltechnologies for the development of a method for the identification of smallmolecule lead compounds for protein targets, which does not rely on proteinstructure information or high-throughput screening of compound libraries.

 

Consistent with our continuing endeavors to focuson the in-house development of therapeutic protein and diagnostic markerproduct candidates, we are considering the divestiture of certain of the toolsand products that we developed. 

 

**Business Overview******

 

We are a genomics-based drug and diagnosticdiscovery company, whose mission is to significantly increase the probabilityof successful development of novel drug and diagnostic products by incorporatingideas and methods from mathematics, computer science and physics into thedisciplines of biology, organic chemistry and medicine. We believe that thisunique capability results in powerful predictive models and discovery enginesand other technologies, which enable the discovery of putative therapeuticproteins and diagnostic markers and advance our understanding of importantbiological phenomena. This unique capability is also the basis for ourdiscovery engines that we developed for the discoveryof drug targets, therapeutic proteins, and diagnostic markers. 

 

These engines andrelated technologies, which we base on our LEADScomputational biology platform, provide us with a deeper understanding ofimportant biological phenomena, such as alternative splicing and naturallyoccurring antisense genes, as well as enable us to identify and prioritizebiological products in our internal drug discovery efforts, therebyfacilitating the creation of our therapeutic and diagnostic products pipeline. Webelieve that our approach to drug discovery makes it possible for us toconstantly feed our pipeline with novel therapeutic and diagnostic candidates. Using our discovery engines, we have identified a varietyof novel genes and proteins. We intend that our discovery engines togetherwith our related technologies will form the basis fordiscovery-based collaborations by which we intend to offer to ourprospective customers the results of use of our discovery engines to enablethem to make genomics-based discoveries. 

 

***Background****- **Pharmaceutical andBiotechnological Research and Development***

 

*Biological Processes -*****Thecharacteristics of all living organisms are determined by DNA, a molecule foundin most living cells. DNA is comprised of pairs of four types of small chemicalunits, each called a nucleotide. DNA contains genes, which in general arecomprised of thousands of nucleotides. The Human Genome Project, aninternational research program designed to construct detailed genetic maps ofthe human genome (that is, all of the genetic information contained in thehuman genes), demonstrated that the human genome consists of a total ofapproximately 3 billion nucleotides and contains at least 30,000 genes.

 

Cells carry out most of their biological functionsby means of proteins. The production of proteins is encoded by DNA through aprocess known as gene expression. The first stage of gene expression involvesthe matching of the nucleotides in a gene with the nucleotides of a relatedmolecule called messenger RNA, or mRNA (this process is known astranscription). mRNA then instructs the cell to produce a protein by a processknown as translation. Proteins are the molecules that regulate or perform mostof the physiological functions of the body. 

**22** 

 

*The Relevance to Therapeutic and DiagnosticFields* -**Many human diseases are associated with the inadequate orinappropriate presence, production or performance of proteins. For this reason,genomics, functional genomics and proteomics can assist pharmaceutical andbiotechnology companies in developing diagnostic products,****therapies anddrugs that will interact with a protein that may be involved in a disease. Drugtherapies currently on the market address only several hundred specific proteintargets. However, we believe that as the functions of additional proteins arebetter understood, hundreds or thousands of additional potential drug targetswill be identified. As additional progress is achieved in genomics, functionalgenomics and proteomics research, new drugs, diagnostic markers and therapiesmay be developed to diagnose, and ultimately to cure diseases, rather than justtreat the symptoms. 

* *

*Genomics-Based Drug Discovery* - The processof genomics-based drug discovery is very complex. The first step may involveidentifying a gene that codes for a specific protein. 

 

*Therapeutic Proteins -*In some cases, theprotein itself may be a drug. A familiar example of such a drug is insulin,which is a protein. This category of proteins is referred to as"therapeutic proteins", because use or administration of the proteinitself may have the effect of preventing, treating or curing a disease. If atherapeutic protein candidate is identified, it must undergo robust and lengthytests, including clinical trials, to ensure its safety and efficacy for humanuse.

 

*Drug Targets -* In other cases, the proteinitself may be a target to which a drug binds, and is known as a "drug target".In these cases, by increasing or decreasing the amount of a protein or byactivating or inhibiting its activity, a disease may be prevented, treated orcured. Scientists try to find molecules that bind to a drug target, which wouldbe a protein of interest, and thereby intervene or alter that protein`sfunction or activity. Drug candidates may be identified by testing or"screening" for hundreds of thousands of chemical compounds with aselected drug target. When one or more compounds is found to have drugqualities and to produce a desired effect, similar compounds may be synthesizedin an attempt to identify a compound with an even more desirable effect. Thisprocess is known as "lead optimization" and results in a "drugcandidate". If a drug candidate is identified, it must undergo robust andlengthy tests, including clinical trials, to ensure its safety and efficacy forhuman use.

 

*Diagnostic Markers* - Another aspect of thepharmaceutical and biotechnological research and development process is theidentification of diseases and other physiological conditions. The levels ofpresence or absence of proteins or other molecules, may give information aboutthe presence or absence of a disease or of the particular stage of a disease orother physiological condition of the body. A molecule that provides thisinformation is known as a "diagnostic marker". For example, the presence orunusually increased presence of a certain protein in blood may indicate thepresence of a cancerous condition. In order to develop a diagnostic marker itis first necessary to identify a correlation between, on the one hand, thepresence (or levels of presence) or absence of a molecule or its increased ordecreased presence and, on the other hand, a disease or other physiologicalcondition. Once such a correlation is identified, it is then necessary todevelop a means of recognizing the correlation. The task of developing a methodof recognition which is easy to perform, sensitive, with high predictive value,safe, inexpensive and covering an attractive market segment is a challengefaced by the diagnostics, pharmaceutical and biotechnological industries.

 

*Challenges -*Increasingthe probability of successfully discovering and developing new drugs isprobably the single largest challenge that the pharmaceutical and biotechnologyindustries face today. This challenge is a direct result of the lack of sufficientpredictability in the drug discovery and development process. Thisproblem becomes even more pronounced as the generation of new drugs anddiagnostics products diminishes from year to year, while the amount of data andknowledge available to scientists, increases. One of the outcomes of the insufficient predictability in the drug discovery anddevelopment process is the long time and large expense associated withdeveloping drugs. Typically, ten to twelve years elapse from the time thatresearch begins to the time that a drug can reach the market. This process, onaverage, is estimated to cost more than $800 million per drug, taking intoaccount the expenses of development of drugs that ultimately do not reach themarket. 

**23** 

It is further estimated that only one to four percent (1%- 4%) of the research and development projects initiated by pharmaceuticalcompanies actually result in marketed products. 

 

***Our Approach to BiotechnologicalResearch***

 

There is an increasingpressure in the pharmaceutical, biotechnology and the diagnostics industries todiscover and develop effective and cost effective drugs and diagnosticproducts. Our mission is to significantly increase the probability ofsuccessful discovery and development of drug and diagnostic products byincorporating ideas and methods from mathematics, computer science and physicsinto the disciplines of biology, organic chemistry and medicine. Over the past decade, we have been developing technologies,including our discovery engines that enable researchersto accurately identify genes, mRNAs, and proteins of interest. Compugen'smultidisciplinary discovery process combines sophisticated mathematicalmodeling with experimental "wet" validation in an iterative process that isdesigned to investigate biological phenomena and discover potentially valuabledrug candidates, therapeutic proteins and diagnostic markers. 

 

We believe that the mathematical modeling ofsignificant biological phenomena will lead us to better research capabilitiesand to more efficient and effective development of therapeutic proteins anddiagnostic products. We further believe that our increasing understanding ofbiological phenomena can make drug discovery and development a shorter and moreefficient process.  

 

We rely on the iterative process that underlies theuse of our discovery engines and other technologies: predictive modeling,followed by experimental validation, followed by improvements to the predictivemodels, and so on. This process nurtures the continuing improvement and valueof our discovery engines and related technologies.

 

We believe that the understanding of one scientificphenomenon that is derived from an understanding of other scientific phenomenais made possible as science transforms and matures from largely observationalto more predictive. We believe that a deeper understanding of such phenomena isuseful for drug discovery. Below are two examples of biological phenomena thatwe discovered:

●*       **Alternative Splicing*- alternative splicingis a biological phenomenon whereby a single gene may express more than oneprotein. Since 1997, by applying our proprietary LEADS computational biologyplatform to the analysis of publicly available genomic information, wediscovered that the phenomenon of alternative splicing occurs in at least 30%of human genes. Previously, scientists believed that alternative splicingoccurred in only a very small number of genes. By having identified thewide-spread nature of the alternative splicing phenomenon and having developedthe computational technologies to identify it, we are able to discover unknownproteins that are encoded by known genes. Now it is commonly assumed to occurin the majority of the 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 morecommon that previously believed. We identified hundreds of antisense pairs ofgenes and published our findings in the April 2003 issue of Nature Biotechnology,Volume 21, No. 4. 

**24** 

***Challenges in Converting Genomic Data intoUseful Information***

** **

One of the key requirements for successfulgenomics-based drug and diagnostic discovery is the competent analysis of rawgenomic data. In recent years, both public and private endeavors, including theHuman Genome Project, have created vast amounts of raw genomic and related dataat an increasing rate. These endeavors led to the publication of the firstcomplete draft of the human genome in April of 2003 (with periodic updatessince) and to the publication of the genome of other organisms since 2002.Although these sets of data contain information that provides scientists withimportant insights into molecular biological processes, the data are difficultto analyze. This difficulty is a function of many factors, including thecomplexity of underlying biological processes, the limitations of existinglaboratory devices, and the enormous quantity of raw data that contain a highrate of errors and inaccuracies.

 

Although scientists are constantly generating newdata at an increasing rate, we believe that a substantial amount of the usefulinformation contained in the data that already exists, has not yet beenextracted.

 

A principal tool used to understand this dataconsists of biology laboratory techniques. However, scientists increasinglyalso use techniques from the exact and computational sciences for thesepurposes. In using these latter techniques, progress is achieved through thequantitative analysis of vast amounts of data and the use of mathematicalmodels to predict structures and processes in the fields of biology, chemistryand medicine. We believe that the use of techniques from the exact andcomputational sciences has the potential to significantly improve the researchand development processes in the pharmaceutical industry. The following aresome important challenges in making use of this new biological data:

 

*Computational Challenge - Vast Amounts of Data:*Publicdatabases today contain millions of randomly arranged short genomic segments,each representing a short fragment of a gene. In order to extract the fullcoding sequence of the gene from this data, scientists must be able toeffectively cluster and assemble these numerous expressed sequence tags (ESTs),a process which poses significant computational challenges.

 

*Experimental Challenge - Errors and Anomalies:*Experimental errors and anomalies, including sequencing errors, the fusion oftwo nucleotide sequences from different loci (which are known as chimericevents) and contaminations, introduce errors into data and complicate itsanalysis.

 

*Biological Challenge - Discovering and ModelingNew Biological Phenomena:* One of the challenges that molecular biologistsand scientists face today is how to discover unknown biological phenomena byanalyzing the genome. In addition, our industry is facing the challenge ofcomputationally modeling these phenomena for the purpose of accounting forthese in genomic analysis and predictions. The difficulty in differentiating betweenrandom occurrences that may create "noise" in the system and actual biologicalphenomena compounds this challenge. We believe that, in general, failure toidentify and account for the key phenomena may lead to erroneous analysis andpredictions. Two examples of biological phenomena in which we gained a deeperunderstanding are alternative splicing and naturally occurring antisense, whichare described above.

** **

*Challenges in DevelopingEfficient Gene Expression Experimental Devices*: The use of gene expressionexperimental devices enables scientists to perform thousands of measurements ofmRNA expression levels in a tissue sample in a single experiment. Whilescientists have made important advances in gene expression technology, currenttechnology does not usually account for the existence of splice variants.Scientists can now apply our technology towards designing probes that have thiscapacity. The main challenges in the selection of probes for gene expressionexperiments are:

●*       *selecting error-free probes that accurately reflectthe exact genes (or corresponding mRNA) of interest;

●*       *selecting probes that are unique to the genes (orcorresponding mRNA) of interest; 

●*       *designing probes that account for alternative  splicevariants of the genes; and

●*       *ensuring that the probes are constituted by asequence capable of effectively binding to corresponding portions of genes thatsuch probes represent (this is known as "hybridizing").

**25** 

**Our Technologies, Products andServices**

 

Our core technology and primary area of expertiseis the modeling of biological phenomena in the field of genomics and applyingthis modeling to the analysis of biological data. This technology andexpertise, which includes our clustering and assembly technology, has enabledus to efficiently and effectively extract valuable information from genomic,functional genomics and proteomic databases. It also forms the basis for ouriterative discovery process using discovery engines and other technologies thatcombine predictive mathematical modeling with hypothesis-drivenexperimentation.

 

We have applied our technology and expertise in thefields of functional genomics, to improve the design of probes for geneexpression experiments and also in proteomics. We have also createduser-friendly applications that allow scientists to quickly obtain resultsusing our modeling and analytical tools and related technologies.

*** ***

***OurLEADS Computational Biology Platform***

* *

Our LEADS computationalbiology platform analyzes genomic and expressed sequence data to enable rapiddiscovery of genes, proteins, including splice variants, and gene function. OurLEADS computational biology platform also accurately models many complex biologicalphenomena and provides a comprehensive research infrastructure, facilitatingthe development of drug targets and other biological products. It solvesquantitative and qualitative problems inherent in the analysis of EST data,thereby improving the quality of available genomic and expressed sequence databy, among other things:

●*       *eliminating overlapping regions of sequencesbelonging to the same gene, thus reducing the size of the databases and theamount of required analysis;

●*       *improving gene coverage by creating a fullerpicture of gene structure from EST fragments;

●*       *detecting and correcting sequencing errors; 

●*       *detecting and accounting for instances ofalternative splicing and antisense;

●*       *detecting other experimental anomalies, includingchimeric sequences, and contaminations; and

●*       *automatically annotating the resulting sequences. 

 

***Discovery Engines***

 

Our discovery engines areproprietary technologies that we developed for the identification andprioritization of drug targets and biological products. They are based on ourLEADS computational biology platform andextend its capabilities by incorporating sophisticated mining algorithms toselect (for instance) promising therapeutic proteins and diagnostic markersfrom the myriad of proteins identified by our technologies. We use ourdiscovery engines and related technologies inour internal drug discovery efforts to facilitate the creation of ourtherapeutic and diagnostic products pipeline. 

 

As an example of one ofour engines, the therapeutic protein variant engine, is designed to identifynovel splice variants of proteins that are known to have a therapeutic utility.It does so by combining knowledge arising from our unique modeling ofbiological phenomena with information about therapeutic proteins that are nowin the marketplace or in development by others. This engine also enables theselection of proteins based on properties such as the existence of a signalpeptide, tissue distribution information, and various functional domains. Theinput to our therapeutic discovery engine includes, in addition to the outputof our LEADS analysis, biological and medical knowledge and additional relevantdata types analyzed by both software and automated processes, and manualanalysis by our scientists and consulting experts. We constantly update andimprove the computational components of the engine and related technologies aswe gain additional knowledge from their use or from other research. Therefore,this engine is designed to provide scientists with the capability to discoverdruggable proteins with desired properties.

**26** 

 

***Genomics-BasedDiscovery Collaborations***

* *

We intend to offer ourprospective customers collaboration opportunities for the discovery ofpotential drug targets, therapeutic proteins and diagnostic markers within agiven area of interest and/or profile of requirements. We intend to use ourdiscovery engines and related technologies to analyze our customers`proprietary data, together with publicly available data and, based on thatanalysis, make discoveries that meet the criteria that our customers specify.We believe that the analysis of these data will enable us to identify potentialnovel drug targets, therapeutic proteins or diagnostic markers that willsatisfy a customer`s criteria. 

* *

***Genecarta***

 

Genecarta is an annotated database representing thegenome, transcriptome and proteome in a user-friendly manner. Genecartaconsists of a database, a graphical user interface, and query tools. Thedatabase is comprised of the data obtained from the periodic application of ourLEADS computational biology platform to various public databases. The browser interfaceprovides an intuitive graphic presentation of database elements and theirinter-relationships, which enables users to browse the genes efficiently. Thequery tools are suitable for various types of experimental approaches, andenable users to perform searches from multiple entry points. The currentversion of Genecarta includes data of human, mouse, rat, zebrafish andarabidopsis. 

 

We offer Genecarta as a viewer for our LEADScomputational biology platform analysis results.

* *

***OligoLibraries and**Oligo Design Services***

 

We have applied ourtechnology and expertise in the fields of functional genomics to design probesfor gene expression experiments. OligoLibraries, which we designed and which Sigma-Genosys manufactures, areoligonucleotide collections, representing genes, or sub-sets of genes, ofvarious organisms. We designed the Oligolibraries to provide scientists with amore accurate solution for the rapidly growing area of high-throughput analysisof gene function. We based our OligoLibraries on probe selection using ourLEADS computational biology platform and our proprietary probe designtechnologies. These technologies enable us to address redundancy, account foralternative splicing, choose oligos of high sequence quality, and considerspecificity and cross-homology while designing optimum oligos for geneexpression, drug discovery or functional assays. 

 

In addition, weapply our LEADS computational biology platform to design probes for geneexpression experiments. We design custom oligos to addressthe unique requirements of our clients, such as Novartis. 

 

***Our In-House Therapeutic Proteins andDiagnostic Markers Pipeline***

 

We use the capabilities of our discovery enginesand other technologies to identify genomic sequences and proteins. We seek todiscover novel proteins and mRNAs that have potential therapeutic or diagnosticuses. 

 

We review the discoveries that we make through useof our discovery engines and other technologies and select for validation andfurther development in our biology laboratory, those predicted proteins that webelieve are most likely to succeed, based on a set of criteria that isdeveloped and will be developed and used with each of our discovery engines andrelated technologies. 

 

Oneof our most advanced discovery engines, theTherapeutic Protein Variant engine, is designed to identify novel splicevariants of proteins that are known to have therapeutic utility. This engine isdesigned to identify splice variants of proteins that satisfy threecriteria: 

●*       *novelty - we select proteins that are predicted tobe novel and unlikely to have been previously discovered without the use of ourproprietary technologies and discovery methods;

**27** 

●*       *close relationship with a known drug - in general,the chosen protein should be closely related to a drug on the market or to onethat is in advanced stages of development. In focusing on novel splice variantsof known drugs, we benefit from the availability of relevant biological andmedical information that relate to our novel splice variant. This method hasthe potential to significantly reduce the risks and costs typically associatedwith drug development; and 

●*       *pharmacological or other advantage - our chosenprotein variants should be predicted to have an advantage over the existingones, in terms of either efficacy, stability, toxicity, or otherpharmacological characteristics.

 

We believe that our approach to drug discoverymakes it possible for us to continually feed our pipeline with noveltherapeutic and diagnostic candidates. For example, the use of the therapeutic protein variant engine has resulted inthe selection of our initial therapeutic pipeline. Based on our belief of thecapabilities of this engine and related technologies it is our intention to addan additional six therapeutic protein candidates to our pipeline this year. 

 

During the past two years, we expanded ourdiscovery activities. We discover and intend to seek to commercialize potentialtherapeutic proteins and diagnostic markers, for which we intend to pursuecommercial relationships with leading biotechnology, diagnostic andpharmaceutical companies. During 2003 we expanded our biology laboratories byrecruiting people and adding new equipment. Currently, we are seeking tostrengthen our protein expression, purification and assaying capabilities. Atthe same time, we are seeking to recruit experienced personnel in variousrelated fields, for the purpose of building our internal capabilities in orderto further develop products ourselves should we decide to do so.

 

To date, our in-housetherapeutic proteins and diagnostic markers pipeline consists exclusively ofour own discoveries, enabled by our discovery engines and other technologiesand our internal experimental validation. 

 

Novel splice variants,which we discovered and commercialized to date, are: 

●*       *PSA-LM and K-LM - In February 2002, we announcedthe discovery of two novel prostate-specific proteins. These proteins areencoded by alternative mRNA splice variants of the genes for prostate specificantigen (PSA) and its related protein, human kallikrein 2 (hK2). The noveltranscripts were predicted using our LEADS computational biology platform andrelated analysis and then verified in our biology laboratory. These novelproteins may have important applications in developing additional diagnostictools for prostate cancer and for understanding the disease. PSA is the premiertumor marker for screening, diagnosis, monitoring and prognosis of prostatecancer. Despite the substantial experimental research of the PSA field, thevariant molecules that we discovered had not been discovered previously.

●*       *VEGF114 - In April 2003, we announced the discoveryof VEGF114, a variant protein expressed from the vascular endothelial growthfactor (the "VEGF") gene. We have been granted a United States patent coveringthe protein sequence of this novel VEGF splice variant, vectors and host cellscontaining VEGF114 sequences, and pharmaceutical drugs and detection methodsdeveloped using VEGF114 sequences. Modulation of VEGF activity may haveclinical applications in cancer, cardiovascular and related diseases, and infertility control. Although the VEGF gene has been the subject of extensiveworldwide research the existence of our splice variant was unknown. Ourdiscovery was made possible through the predictive capability of our LEADScomputational biology platform, coupled with additional proprietary discoverytechnologies and experimental validation in our biology laboratory. 

 

We intend to continue to commercialize our in-housediscoveries through licensing and other arrangements with third parties,primarily pharmaceutical, diagnostic and biotechnology companies. 

 

In addition, we intend to pursue collaborationswith pharmaceutical and biotechnology companies and research and academicorganizations for the joint discovery, development and commercialization oftherapeutic proteins and diagnostic markers.  

**28** 

 

***Chemistry  - Lead DiscoveryTechnology***

 

We have a researchprogram for the development of a unique technology platform that is intendedfor the identification of small molecule lead compounds for protein targets anddoes not rely on protein structure information or high-throughput screening ofcompound libraries.

 

Identifying a leadchemical for a potential target is a long, arduous and expensive undertaking,considered by many to be the principal bottleneck in small molecule drugdiscovery. Common methods for finding such small molecules, typically variantsof high-throughput screening and optimization or variants of structure-based drugdesign, suffer from low success rates and often fail to find candidatecompounds for some general target families, as well as for many specifictargets in more established families.

 

To address thisbottleneck, we are developing a unique approach according to which we areproposing to use a comprehensive, yet finite set of carefully designed smallmolecules. 

 

Accordingto our proposed approach: 

●*       *this set of moleculeswould serve as information-rich probes in a screening process, with afunctional assay for a given drug target, and would be designed to extractuseful information about the drug target; and 

●*       *we would then analyzethese molecules by use of proprietary algorithms that we are developing toprovide detailed information about the given drug target.

The purpose of carryingout these activities would be to facilitate the design of a variety of potentinhibitors that have drug-like properties.

 

Due to the innovative and unique nature of ourchemistry program and its early stage of development, we currently consider itto be a high-risk program. Although we are currently funding all of ourresearch and development in the field of chemistry, these activities havereached the stage where, for its continued progress, additional resources arerequired. We are currently seeking a potentialpartner for our chemistry program.  

**Our Selected Customers andCollaborations**

 

*Novartis -* In July 2001, we entered into aLicense and Development Agreement with Novartis Pharma A.G., under which wegranted Novartis a non-exclusive license to use our LEADS computational biologyplatform for analyzing genomic and expressed data for Novartis` internalresearch and development activities in exchange for an annual license fee. InJuly 2002, we amended our agreement with Novartis, under which Novartis and usengaged in joint research and collaboration to design molecules for RNAinterference. Pursuant to a second amendment in May 2003, we further amendedthe agreement , under which we extended the LEADS license, and Novartis engagedour services for the design of DNA probes and received an option to in-licenseour Genecarta viewer. Our agreement with Novartis, including the LEADS license,is for a term of three years, beginning in July 2001.

 

*Abbott -* On December 31, 2002, we enteredinto a License Agreement with Abbott Laboratories, under which we grantedAbbott a non-exclusive license to our LEADS computational biology platform forthe analysis of human genomic data and to our Genecarta viewer. On December 31,2003 we amended the agreement, by extending the license to use our Genecartaviewer.

**29** 

 

***Commercialization of our in-house discoveries***

 

To date, we have entered into two licensingagreements concerning our in-house discoveries:   

* *

●*       *In December 2002, we granted an exclusive licenseto Diagnostic Products Corporation, to develop and commercialize *in-vitro*diagnosticassays based on our two novel prostate-specific proteins (PSA-LM and K-LMproteins), for the use in the field of cancer immuno-diagnostics. Inconsideration for the grant of this license, we are entitled to receivemilestone payments and royalties based on the future commercialization of ourintellectual property. 

 

●*       *In April 2003, we granted a non-exclusive licenseMultiGene Vascular Systems Ltd. to develop and commercialize gene and celltherapy products incorporating our VEGF114 splice variant for use in thetreatment of cardiovascular diseases. Under the terms of the agreement, we areentitled to receive an equity stake in MGVS and royalties on future product sales.

** **

**Our Strategy******

 

Since 1994, our revenues have been generated fromlicensing use of our computational technologies, and providing relatedservices. In the future, we intend that the principal source of revenue willderive from the development and commercialization of therapeutic and diagnosticproduct candidates that we discover. The key elements of our business strategyare:

 

We intend to commercialize therapeutic proteins anddiagnostic marker candidates and intellectual property that we continue togenerate through our in-house research and development efforts. We intend tocommercialize our intellectual property portfolio with an emphasis on royaltybearing and other revenue-sharing arrangements with diagnostics, pharmaceuticaland biotechnology companies. 

 

We also intend to pursue collaborations for thecommercialization of results that we generate from use of our discovery enginesand related technologies. We intend to seek to participate, by way of royaltiesor other revenue-sharing arrangements with our collaborators, in revenues thatmay be earned from the products, developed and commercialized based ondiscoveries that we may generate from use of our discovery engines and relatedtechnologies and services. 

 

To date, we have partially implemented our strategyby granting an exclusive license to Diagnostic Products Corporation to developand commercialize *in-vitro*diagnostic assays based on our two novelprostate-specific proteins, for use in the field of cancer immuno-diagnostics.We also granted a non-exclusive license to MultiGene Vascular Systems Ltd., todevelop and commercialize gene and cell therapy products incorporating ournovel VEGF114 splice variant for use in the treatment of cardiovasculardiseases.

* *

**Agricultural Biotechnology Companyin which Compugen Has Equity Interest******

 

In October 1999, we formed a division focusing onagricultural biotechnology and plant genomics. On January 1, 2002, we spun-offthe business of this division into a majority-owned subsidiary, Evogene Ltd.("Evogene"), in which we hold 82% of the outstanding shares. On January 6,2003, Evogene entered into a Convertible Loan Agreement with a group of newlenders (the "Lenders") for the aggregate amount of $2 million dollars. Uponconversion of the loan, Evogene will issue to the Lenders Preferred A Shares,with certain preferences over ordinary and ordinary-1 shares, such aspreference in the case of liquidation or deemed liquidation, and full ratchetdilution protection. We did not participate in this financing round. Under theConvertible Loan Agreement, we agreed to: (i) forgo the entire loan that weextended to Evogene upon Evogene`s incorporation, in the amount of $900,000 andall accrued interest, and (ii) extend the term of the license to use certain ofour computational technologies free of charge, that was granted to Evogene uponEvogene`s incorporation, until December 31, 2005. Following the closing of theConvertible Loan transaction, we granted the Lenders an irrevocable proxyempowering them to vote 820,000 of the ordinary shares, which we hold (namely,50% of our shareholding in Evogene), subject to certain

**30** 

adjustments, based on the conversion of the loan, fromtime to time. Following the Convertible Loan transaction our shares in Evogenewere converted into ordinary-1 shares, to allow for certain preferences overordinary share holders, in the case of liquidation or deemed liquidation ofEvogene. In February 2004, Evogene and the Lenders entered into an Amended andRestated Convertible Loan Agreement, under which the amount of the ConvertibleLoan was increased by an additional $1,551,000. We did not participate in thissecond financing round. Under both transactions, the Lenders received warrantsto purchase shares of Evogene. (see Item 7. "Major Shareholders and RelatedParty Transactions. Related Party Transactions. Evogene Ltd.").

 

**Sales, Marketing and BusinessDevelopment**

 

Since our incorporation in 1993, we devoted most of our capital andhuman resources to research and development of our technologies, products andservices. Between 1999 and 2001, we significantly expanded our sales, businessdevelopment and marketing capabilities. We reduced our sales force in 2003, asa result of the evolution of our business, and the resulting shift in focusagainst commercializing software tools (such as the Bioccelerators and the Zproducts), and in favor of concentrating our efforts on discovery-basedcollaborations and in-house discovery activities. 

** **

In the US, we have marketing, sales and businessdevelopment presence in Sunnyvale, California, Jamesburg, New Jersey, andRockville, Maryland.    

 

The approximate geographical breakdown of our totalsales from products and services for the year ended December 31, 2003 was 66%in North America, 31% in Europe, 1% in the Far East and 2% in other countries.The approximate geographical breakdown of our total sales from products andservices for the year ended December 31, 2002 was 68% in North America, 20% inEurope, 7% in the Far East and 5% in other countries. The approximategeographical breakdown of our total sales from products and services for theyear ended December 31, 2001 was 68% in North America, 22% in Europe, 8% in theFar East and 2% in other countries. 

 

As of December31, 2003, our sales, marketing and business development staff consisted of tenemployees, with seven based in the US, two based in Israel and one based inEngland. 

 

We plan to continue toaggressively market some of our technologies and biological products topharmaceutical, diagnostics and biotechnology companies. 

** **

**Seasonality;Raw Materials**

 

Seasonality does not affectour main business; our business generally does not fluctuate based solely onthe time of year. 

 

The raw materials that we use in our business, are either freelyavailable, such as publicly available expressed sequence tags (or ESTs), oreasily available to us or to our customers and at reasonable prices, such ascomputer hardware and certain software.

 

**Intellectual Property Rights****  **

** **

We seek patent protection for certain components ofour technology platforms and in relation to our genomics-based therapeutic,diagnostic and other inventions. We rely heavily on our proprietary know-howand trade secrets that are not protectable or protected by patents. We uselicense agreements both to access third party technologies and to grantlicenses to third parties to use our intellectual property rights. We expectthat our commercial success will be dependent on, among other things, ourability to obtain commercially valuable patents, maintain the confidentialityof our trade secrets and otherwise protect our intellectual property. 

**31** 

 

Our strategy to apply for patents relates primarilyto certain aspects of our computational technologies and to our genomics-basedtherapeutic and diagnostic inventions. We currently have approximately 38patents applications, which does not include corresponding foreignapplications. To date, we obtained two issued patents and allowances for 5 ofour patent applications. 

 

We intend to continue to apply for patentprotection for our genomics-based therapeutic and diagnostic inventions,including those inventions that relate to novel genes and splice variants andto novel uses for them, which we discover through our research and discoveryprograms. 

 

Similarly to otherbiotechnology companies, the status of our patent portfolio is generallyuncertain and involves complex legal questions that are still evolving as wellas factual questions. Our business could be harmed by any of the following:

●*       *rejection of our pending patent applications by theUS Patent and Trademarks Office and by corresponding authorities in otherjurisdictions;

●*       *legislative and judicial changes or changes in theexamination guidelines of governmental patents offices negatively affecting ourability to obtain patent protection for certain aspects of our intellectualproperty, especially with respect to genetic discoveries.

●*       *the claims of any patents that we issue notproviding meaningful protection;

●*       *successful challenge on our patents by third parties;and

●*       *third party patents that prevent us from using theinventions or technology that we use or may wish to use.

 

The degree of protection for our intellectualproperty portfolio is therefore uncertain. Furthermore, others mayindependently develop similar or alternative technologies, duplicate any of ourtechnologies or, if patents are licensed or issued to us, design around thesepatented technologies. We could incur substantial legal costs if we arerequired to initiate suits to prevent infringement of our patents, once issued.These costs could significantly increase our expenses and our losses.  

 

Other companies and organizations are attempting toobtain patents relating to novel genes and proteins and relating to uses forthem and for known genes and proteins whose respective functions have not beencharacterized to date. These third parties may succeed in obtaining issuedpatents on genes, proteins or genomics-based products that are similar oridentical to those for which we may seek patent protection and whose rights mayhave priority over patent applications that we file. In such circumstances, wemay be prevented from using the technology for which we seek patent protection.

 

In circumstances where third parties assert againstus claims relating to infringement of their intellectual property, we may seeklicenses to this intellectual property. However, any required licenses may notbe made available on commercially viable terms, if at all. Failure to obtainany required license could prevent us from using or commercializing one or moreof our technologies or discoveries.

 

Should patent infringement suits be commencedagainst us or against our commercial partners, we may be subject to claims forpayment of damages and we may be enjoined from using our technology. We or ourcommercial partners may not prevail in any action. Our industry is verylitigious. We believe that we may become involved in litigation regardingpatent and other intellectual property rights. If we become involved in such litigation,it could consume a substantial portion of our managerial and financialresources and negatively affect our financial results.

**32** 

 

With respect to proprietary know-how that is notpatentable or that we choose not to patent, we rely on trade secret protectionand confidentiality agreements to protect our interests. Many elements of ourcomputational genomics, functional genomics and proteomics capabilities involveproprietary know-how, technology or data that are not covered by patents orpatent applications. We have implemented security measures to protect ourproprietary know-how and technologies and confidential data, including a rangeof confidentiality agreements with out employees, consultants and customers.While we require employees, consultants and customers to enter intoconfidentiality agreements, we cannot be sure that proprietary information willnot be disclosed in violation of these agreements, that others will notindependently develop substantially equivalent proprietary information andtechniques or that we can otherwise meaningfully protect our trade secrets. Inthe case of arrangements with our customers that require the sharing ofinformation, our policy is to make available to our customers only informationthat is relevant to our agreements with these customers, under controlledcircumstances, and only during the contractual term of those agreements, andsubject to a duty of confidentiality on the part of our customer. However,these measures may not adequately protect our information. Any material leak ofconfidential information into the public domain or to third parties may causeour business, financial condition and results of operations to be harmed.

 

We are a party to various license agreements thatgive us rights to use technologies and biological materials in our research anddevelopment processes. We may not be able to maintain these rights oncommercially reasonable terms, if at all. Our failure to maintain these rightscould harm our business.

 

**Competition**

** **

The biotechnology andpharmaceutical industries are highly competitive. We face intense competitionfrom numerous companies, many of which are more established, benefit fromgreater market recognition and have greater financial, research and developmentand marketing resources than we do. In light of many of our competitors`greater resources, these competitors may develop before us products based ontheir discoveries and development of genes, drug targets, lead compounds, drugdiscovery technologies or drugs. Moreover, our competitors may obtain patentprotection or other intellectual property rights that could limit our rights touse our technologies or commercialize our drug, therapeutics or diagnosticsproduct candidates. 

 

*Competition to ourin-house Discovery Activities -* We face, and expect to continue to facecompetition from pharmaceutical, biotechnology and diagnostic companies andfrom academic institutions that seek to discover genes, gene products orproteins that have a function similar or identical to the function for ourintended product candidates. Since our discovery engines and other technologiesare aimed at identifying, among other things, novel alternatively splicedvariants, we expect that third parties` therapeutic or diagnostic productsbased on genes or proteins which correspond to our splice variants, wouldnaturally compete with the corresponding spliced variant based product that weseek to develop. We have already encountered circumstances where third partiesthat develop such therapeutic or diagnostic products attained relatedintellectual property rights that precede our own. We expect to encountersimilar such circumstances in relation to other splice variants based productcandidates that we may wish to develop. 

 

Our in-house discovery program depends, in largepart, on our discovery engines and other technologies and our proprietary datato make inventions and establish intellectual property rights in genes andproteins. There are a number of other means by which such inventions andintellectual property can be generated. We believe that our computationaltechnologies, and specifically our Leads-based discovery engines, provide us with acompetitive advantage over pharmaceutical, diagnostic and biotechnologycompanies that are competing with us. However, we may lose this advantage whenwe provide our customers, primarily biotechnology, pharmaceutical anddiagnostic companies, access to our computational technologies and specificallyto results generated through the use of our discovery engines and proprietarydata. In addition, we may pursue opportunities in fields that could conflictwith those of our customers and thereby discourage potential customers fromworking with us.  

**33** 

 

*Competitionto our LEADS computational biology platform and related products -* Ourprincipal competitors with respect to our LEADS computational biology platformand the tool by which results of use of this platform can be viewed, arecompanies that also offer computational platforms for the analysis of genomicand expressed sequence data to enable genomics-based discoveries.  Suchentities include:

●*       *Celera Genomics Group - which provides genomic datathat may compete with our LEADS computational biology platform, Genecarta andour genomic services; 

●*       *Lion Bioscience AG, which provides genomic researchand infrastructure tools and services that may compete with our genomicservices; 

●*       *in-house research and development teams of ourprospective customers and of academic institutions, many of whom make theirfindings publicly available; and

●*       *academic, non-for-profit and governmentalinstitutions, such as the University of California Santa Cruz, the NationalCenter for Biotechnology Information at the NIH, and the Wellcome Trust SangerInstitute.

 

Although collaborations forthe development and commercialization of therapeutic and diagnostic productcandidates can assume many forms, to the extent that these will be based on useof our discovery engines and other technologies for the benefit of thecollaboration, we may be competing with companies such as Exelexis Inc.,Curagen Corporation and Myriad Genetics, Inc. all of whom seek to develop lifescience products based on an analysis of large amounts of information.

 

*Competitionto our OligoLibraries products -*Our principal competitors with respect toour OligoLibraries products include the following, each of which marketsproducts that compete with our OligoLibraries:

●*       *MWG-Biotech AG, 

●*       *Operon Technologies, Inc., whichis part of Qiagen; and 

●*       *Clonetech Laboratories, Inc. 

 

*Competition to OurChemistry Program -* Our chemistry program faces fierce competition from allfully integrated pharmaceutical companies and from companies engaged in drugdiscovery, such as Infinity pharmaceuticals, Pharmacopeia Inc., SunesisPharmaceuticals, Inc., Plexxikon, Inc., Vertex Pharmaceuticals Incorporated,Structural GenomiX Inc., Astex Technology, Syrrx, Inc. and Celera GenomicsGroup.

 

**Government Regulation**

** **

***Environmental Regulation***

* *

Our research and development activities in somecases involve the controlled use of biological and hazardous materials, such aschemicals and radioactive materials. We are subject to Israeli laws andregulations governing the use, storage, handling and disposal of thesematerials and resulting waste products. To our knowledge, we comply with theselaws and regulations. However, the risk of accidental contamination or injuryfrom these materials cannot be entirely eliminated. In the event of anaccident, we could be held liable for any resulting damages, and any liabilitycould exceed our resources. 

 

***Regulation of Use of Human Tissue***

* *

Our access to and use of human or other organisms`tissue samples in the expansion of our proprietary database or our productdevelopment may become subject to further government regulation, in the US,Israel and elsewhere. US and foreign governmental agencies may also imposerestrictions on the use of data derived from human or other tissue samples. Ifour access to or use of human tissue samples, or our customers' use of dataderived from these samples, is restricted, our business may suffer.

**34** 

 

***Regulation of Products Developed withGovernmental Support***

**

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**

 

Compugen is the parent of one wholly-ownedsubsidiary, Compugen USA, Inc., which is a corporation incorporated in Delawareand which has its principal place of business in New Jersey. Compugen alsoholds 82% of the outstanding shares of Evogene Ltd., which was formed under thelaws of the State of Israel and which has its principal place of business inRehovot, Israel (for more information about Evogene, see the section abovetitled "Agricultural biotechnology company in which Compugen has equityinterest", in this Item 4). 

  

#####  Property, Plant and Equipment

** **

We lease an aggregate of approximately 7,550 squarefeet of office and laboratory facilities in Tel Aviv, Israel, and approximately2,360 square feet of office and laboratory facilities in Ashqelon, Israel. Theleases in Tel Aviv expire in December 2006 and the lease in Ashqelon expires inSeptember 2006. 

 

In addition, Compugen USA, Inc. leasesapproximately 4,490 square feet of office space in Jamesburg, New Jersey,approximately 233 square feet of office space in Sunnyvale, California, andapproximately 250 square feet of office space in Rockville, Maryland. The leasein New Jersey expires in December 2005, and each of the leases in Sunnyvale andin Maryland expires in December 2004.  

 

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

 

There are no encumbrances onour rights in these leased properties or on any of the equipment that we own. 

 

To our knowledge, there areno environmental issues that affect our use of the properties that we lease.

 

**35** 

### ITEM5.                  OPERATING AND FINANCIAL REVIEW AND PROSPECTS

*** ***

#####  Forward-lookingStatement

 

This annual report contains forward-lookingstatements that reflect our current views about future events. We use the words"anticipate", "believe", "estimate", "expect", "intend", "may", "should" andother similar words and expressions to identify forward-looking statements.These forward-looking statements are subject to many risks and uncertainties,some of which are described under "Item 3. Key Information. Risk Factors".

 

If any of the risks or uncertainties occur, or ifany of the assumptions underlying any of our forward-looking statements proveto be incorrect, then our actual results may be materially different from thosewe express or imply in this annual report on form 20-F. We do not intend orassume any obligation to update these forward-looking statements, and each suchstatement speaks only as of the date on which it is made.

 

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, 2003, 2002and 2001 respectively, and with any other selected financial data includedelsewhere in this report.

** **

##### Background

 

We are a genomics-based drug and diagnosticdiscovery company, whose mission is to significantly increase the probabilityof successful development of novel drugs and diagnostic products, byincorporating ideas and methods from mathematics, computer science and physicsinto the disciplines of biology, organic chemistry and medicine. We believethat this unique capability has resulted in us developing powerful predictivemodels and discovery engines and other technologies, which both advance ourunderstanding of important biological phenomena and enable the discovery ofputative therapeutic proteins and diagnostic markers. 

 

We develop platforms, discovery engines and relatedtechnologies that enable the discovery and analysis of genes and proteins.These include our LEADS computational biology platform, Genecartadatabaseand viewer and (until recently) the Bioccelerator product line. In 2003 we soldthe Bioccelerator product line (see Note 3 of our Consolidated FinancialStatements). 

 

Based on our Leadstechnology we developed discovery engines and related technologies thatfacilitate the identification and prioritization ofdrug targets and other biological products, by applying sophisticated miningalgorithms to select the most promising therapeutic proteins and diagnosticmarkers from the myriad of proteins, which we identify with the use of ourproprietary technologies. 

 

We use our discovery engines and other technologiesfor our internal discovery. By using these engines and other technologies wehave discovered potentially novel therapeuticproteins and diagnostic markers that we believe are suitable for developingtherapeutic and diagnostic product candidates respectively. Based on ourbelief in the capabilities of our discovery engines and related technologies,it is our intention to add an additional six therapeutic protein candidates toour pipeline during 2004, and advance our efforts in the selection ofadditional diagnostic markers. Going forward, we plan on continually adding toour internal pipeline, on a regular basis, additional candidate products fordevelopment. Our mid-term goal is to reach the stage where a minimum of twoCompugen-discovered therapeutic proteins enter human clinical trials annually.We intend to pursue commercial relationships with leading biotechnology,diagnostic and pharmaceutical companies, for the commercialization of product candidates that we discover and develop through theuse of our discovery engines and related technologies. 

**36** 

 

A.            OPERATING RESULTS

 

#####  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, 2003, we had an accumulateddeficit of $67.1 million (not including approximately $24.9 million inaccumulated deficit attributable to the conversion of preferred shares upon theclosing of our initial public offering). 

 

In 2003 and in the year previous to that, animportant aspect of our commercialization activities involved the sale ofhardware and software platforms, tools, databases and other products, in whichwe incorporated certain aspects of our understandings and/or discoveries andmade them available to our customers. For example, in 2003, our revenues wereprimarily attributable to the commercialization of our computationally-basedproducts such as the LEADS computational biology platform, the Genecarta, theBioccelerator products, our Z3 and Z4000 proteomics software and ourOligoLibraries. We also recorded revenues both from royalty-bearing andnon-royalty bearing Israeli government grants. The commercialization of theseproducts is no longer at the focus of our business, and based on this shift infocus, we sold our Bioccelerator products line in 2003. Consistent with ourcontinuing efforts to focus on our two primary commercial offerings,discovery-based collaborations and our in-house therapeutic proteins anddiagnostic marker product candidates, we may divest other product lines, whichno longer comprise our business focus. 

 

We intend to commercialize output that we generatefrom use of our discovery engines and related technologies. To date, we haveused our discovery engines and related technologies only internally, and arecurrently evaluating various opportunities for collaborations based on use ofthese discovery engines. We intend to seek to obtain down stream participationin the products discovered through their use, such as by way of a right toreceive royalties based on commercialization of such products. During 2004, weplan to approach prospective partners with respect to such collaborations.  

 

We believe that the greatest long term andsustainable financial potential for us lies in the commercialization ofspecific therapeutic proteins and diagnostic product candidates that wediscovered and that we plan to continue to discover through the internal use ofour discovery engines and related technologies and through our intendedcollaborations. For the purpose of attaining this goal, we have decided toforgo our previous focus of commercializing our computational platforms andtools (such as Genecarta and OligoLibraries), all of which contributed to ourrevenues in the more immediate term. We believe that the commercialization ofour therapeutic protein and diagnostic product candidates has the potential togenerate revenues in the long term to a substantially greater extent than thelong-term potential revenue stream from commercializing our computationalplatforms and tools only. 

 

We believe that the continual commercialization ofour proprietary product candidates will support the value that we attribute toour overall approach to drug and diagnostic discovery and to our capabilitiesof continuously improving our technologies and discovery processes.

 

As we are shifting focus away from thecommercialization of our computationally-based products, our revenues, notincluding government grants, decreased by approximately 27% in year 2003compared to 2002, and by approximately 11% in year 2002 compared to year 2001.

**37** 

 

***Our research anddevelopment expenses are expected to account for more than 50% of our totaloperating expenses.***

 

Our research and developmentexpenses are expected to be our major expense in 2004, accounting for more than50% of our total 2004 operating expenses. Being a research and developmentcompany, our research and development expenses have always comprised asignificant portion of our expenses. However, approximately since 2001, thespecific research and development activities in which we invested our resourceshas changed, to accommodate our changing business focus. In 2003 wesignificantly increased the resources allocated to advance our internaltherapeutic proteins pipeline. 

 

Beginning in January 1, 2001, we record research grantsas part of revenues. Prior to January 1, 2001, we accounted for research grantsas a reduction in research and development expenses. We have changed ourfinancial statements for the years preceding 2001 to conform to this change. 

 

***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 subsection B in this Item 5, which is titled "Liquidity andCapital Resources". 

 

##### Compensation expenses attributed to optiongrants.

 

We recorded compensation expenses of approximately$2.6 million in 2001, approximately $900,000 in 2002 and approximately $1.1million in 2003, in connection with the grant of share options. These expensesare mostly attributable to options that we granted to Company employees duringthe year that preceded our IPO, at share prices lower than our IPO share price,to options granted to consultants under a variable plan, and to directors ofthe Company. These amounts are being amortized over the vesting periods of theindividual share options. Based on options granted through December 31, 2003,and based on our ordinary share price on that date, we estimated that ourfuture amortization of compensation expenses will be approximately $450,000 in2004 and approximately $200,000 in 2005. These estimates are subject to changesin the share price or in the amount of granted options at any given point intime. Our current policy is to grant options at the fair market value of theunderlying shares on the date of grant.  

** **

##### Impact of Inflationand Currency Fluctuations

 

We generate most of our revenues in US dollars andincur a significant portion of our expenses, principally salaries and relatedpersonnel expenses, in New Israeli Shekels. As a result, we are exposed to therisk that the rate of inflation in Israel will exceed the rate of devaluationof the NIS in relation to the US dollar or that the timing of this devaluationwill lag inflation in Israel. In addition, we are exposed to the risk that theUS dollar will be devalued against the NIS. We try to protect ourselves againstthis possibility by investing a portion of our cash in NIS deposits. While inrecent years the rate of devaluation of the NIS against the dollar has exceededthe rate of inflation, we cannot be sure that this reversal will continue. Todate, we have not been materially adversely affected by changes in the Israelirate of inflation or the exchange rates of the NIS compared to the US dollar.We do not currently use financial instruments for trading purposes and do notcurrently hold any derivative financial instruments that could expose us tosignificant market risks. 

* *

##### 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, allowance for doubtfuldebts, contingencies, and investment in Evogene Ltd.

**38** 

 

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***

 

We generate most of our revenues fromcollaborations and license fees related to the commercialization of oursoftware products. We also generate revenues from the sale of services,including from the provisions of maintenance, support, customization, trainingand installation services, and also from the sale of products (such as ourOligoLibraries). In addition, we recognized as revenues governmental researchand development grants that we received. We sell our products primarily throughour direct sales force. 

 

We recognize revenues from collaborationarrangements in accordance with Statement of Position 81-1 "Accounting forPerformance of Construction - Type and Certain Production - TypeContracts" ("SOP 81-1"). The reason for using this Statement of Positionis that the various elements of our collaboration arrangements are deemed to beinseparable portions of an overall solution. We believe that revenues that wegenerate from our collaborations under which we commercialize our softwareproducts should be recognized in accordance with the development plan of eachspecific collaboration, using contract accounting on a percentage of completionmethod - the input measure prescribed in SOP 81-1. As a result, revenues thatwe generate from these collaboration arrangements were recognized in accordancewith our estimate regarding the status of the collaborative project. Anyrevisions to estimates of the status of a project (and the consequentrecognizable revenues) are recorded in the period during which changes becomeknown to us. If we do not accurately estimate the resources required for or thescope of work to be performed under each such collaboration arrangement, or donot manage our projects properly within the planned periods of time or satisfyobligations under the contracts, then the service margins may be significantlyand negatively affected or losses on existing contracts may have to berecognized. We periodically check the possibility of losses from collaborationarrangements, which should be recognized immediately, in accordance with ourprojections. During 2003, no provision for losses was required.

 

We recognize software license revenues inaccordance with Statement of Position 97-2, "Software Revenue Recognition"("SOP 97-2") as amended. We recognize revenues when both parties sign anagreement or other persuasive evidence of an arrangement exists, when thesoftware has been shipped or electronically delivered, when the fees are fixedor determinable, and when collection of the resulting receivable is probable,and no other significant obligations remain. For multiple element arrangements,where vendor-specific objective evidence of fair value exists for allundelivered elements, we account for the delivered elements in accordance withthe "residual method" prescribed by Statement of Position 98-9,"Modification of SOP 97-2, Software Revenue Recognition with Respect to CertainTransactions" ("SOP 98-9"). Vendor-specific objective evidence of fair value isbased on the price a customer is required to pay when the element is soldseparately. We assess whether the fee is fixed or determinable and collectionis probable at the time of the transaction. In assessing whether the fee isfixed or determinable, we analyze the payment terms of the transaction andother factors, including the nature and class of customer, our historicalexperience of collecting under our payment terms without granting a concession,the possibility of the product becoming technologically obsolete before thepayments become due and the likelihood of the customer asking for a refund. Ifwe determine the fee is not fixed or determinable, we defer the revenue untilthe payments under the arrangement become due. We assess whether collection isprobable based on a number of factors, including the customer's pasttransaction history and credit worthiness. If we determine that collection of afee is not probable, we defer the fee and recognize revenue only at the timethat collection becomes probable, which is generally upon the receipt of cash. 

**39** 

 

We recognize revenues from product sales inaccordance with SAB 104 "Revenue Recognition" when shipment has occurred,persuasive evidence of an arrangement exists, the vendor`s fee is fixed ordeterminable, no future obligations exist and collection is probable.  Wegenerally do not grant rights of return. Determination of the probability ofcollection is based on management`s judgments regarding the payment of fees forservices rendered and products delivered. Should changes in conditions causemanagement to determine that this criteria is not met for certain futuretransactions, revenue recognized for any reporting period could be adverselyaffected.

 

Revenue from maintenance contracts is recognizedratably over the term of the maintenance contract. Revenues related to otherservices are recognized as the services are rendered.

 

Royalty and non non-royalty bearing grants from theGovernment of Israel through the Ministry of Industry, Trade and Labor - theOffice of the Chief Scientist (OCS) for funding research and developmentprojects, are recognized as revenues as the related research and developmentexpenses are incurred (for more information, see "Research and Development,Patents and Licenses", below).

 

***Allowance for Doubtful Debts***

 

Management continually reviews the collectibilityof trade accounts receivable and the adequacy of the allowance for doubtfuldebts against the trade accounts receivable. Management specifically analyzescustomer accounts, account receivable aging reports, history of bad debts andthe business or industry sector to which they belong, customer concentrations,customer credit worthiness, current economic trends and any other pertinentfactors. Management is able to make reasonably objective judgments on theadequacy of other provisions relating to trade accruals. We have not made anyprovision for contingent liabilities, which has involved significant managementjudgment that either we will prevail in the case of material litigation or thatwe have sufficient insurance to cover any adverse outcome.

 

***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 currently involved in certain legalproceedings and are required to assess the likelihood of any adverse judgmentsor outcomes of these proceedings as well as potential ranges of probablelosses. A determination of the amount of accruals required, if any, for thesecontingencies is made after careful analysis. As of December 31, 2003, webelieve that the status of legal proceedings (described in Item 8.****"FinancialInformation; Consolidated Statements and Other Financial Information; LegalProceedings") will not have a material impact on our financial condition,results of operations or cash flows. It is possible, however, that futureresults of operations for any particular quarter or annual period could bematerially affected by changes in our assumptions or as a result of theeffectiveness of our strategies related to these legal proceedings.

 

***Investment in Evogene Ltd.***

 

In accounting for our investment in Evogene Ltd.("Evogene"), we adopted FIN 46 on July 1, 2003. Under FIN 46, we determinedthat Evogene qualified as a Variable Interest Entity ("VIE"), an entity whichhas one of the following: (1) an insufficient amount of equity to carry on itsprincipal operations, without additional subordinated financial support fromother parties, (2) a group of equity owners that are unable to make decisionsabout the entity`s activities, or (3) equity that does not absorb the entity`slosses or receive the benefits of the entity. 

**40** 

 

FIN 46 requires consideration and estimates ofsignificant number of possible future outcomes of the VIE as well as theprobability that each of the outcomes will occur. The results of each possibleoutcome are allocated to the parties holding interests in the VIE. Based on theallocation of possible outcomes, a calculation is performed to determine whichparty, if any, has a majority of potential negative outcome (expected losses)or a majority of the potential positive outcomes (expected residual returns).That party, if any, is the VIE`s primary beneficiary and is required toconsolidate the VIE. Calculating the expected losses and expected residualreturns is highly subjective and requires the use of significant estimates. 

 

We have examined the potential future results ofEvogene, assigning probabilities to each potential outcome, and allocated thesepotential outcomes to the VIE`s variable interest holders. We have determinedthat we are not the primary beneficiary of Evogene Ltd., since we do not absorbthe majority of the entity's expected losses or its expected residual returns. 

 

Under FIN 46, the reconsideration of a VIE`sprimary beneficiary status requires a triggering event, such as any of thefollowing: (1) the entity`s governing documents or contractual arrangementamong the parties have been changed, (2) sales of part of the variableinterests to unrelated parties, (3) acquirement of newly issued variableinterest in the entity or a portion of the primary beneficiary`s interest, or(4) decrease in assets due to losses incurred by the VIE. 

 

#####  Results of Operations

 

***Selected Financial Data***

 

The following discussion and analysis is based onand should be read in connection with our audited consolidated financialstatements, including the related notes, contained in "Item 18 - FinancialStatements" and the other financial information appearing elsewhere in thisannual report. 

**41** 

*** ***
| ** **

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

****                                                                                   |  

1999*                                                 |  

2000* |  

2001* |  

2002* |  

2003 |
|                                                                                               | **(US$ in thousands,  except share and per share data)**      |
| **Consolidated Statements of Operations Data**                                                     |                                                               |  |  |  |  |
| Revenues:                                                                                          |                                                               |  |  |  |  |
|   Products and service                                                                   | $        3,237        | $            6,891 | $          10,366 | $            9,262 | $          6,776 |
|   Research and development grants                                                        |  

507                                                   |  

466 |  

994 |  

1,835 |  

2,050 |
|   Total revenues                                                                         | 3,744                                                         | 7,357 | 11,360 | 11,097 | 8,826 |
|                                                                                               |                                                          |   |   |   |   |
|   Cost of Products and Services                                                          |  

1,091                                                 |  

1,720 |  

3,455 |  

2,819 |  

2,275 |
| Research and development expenses                                                                  |  

7,183                                                 |  

12,635 |  

15,976 |  

14,170 |  

13,306 |
| Sales and marketing expenses                                                                       |  

1,166                                                 |  

3,781 |  

6,565 |  

5,538 |  

3,811 |
| General and administrative Expenses                                                                |  

3,152                                                 |  

5,397 |  

4,383 |  

3,614 |  

6,650 |
|   Total operating expenses **                                                            |  

12,592                                                |  

23,533 |  

30,379 |  

26,141 |  

23,042 |
|        Operating loss                                                | (8,848)                                                       | (16,176) | (19,019) | (15,044) | (14,216) |
| Financial and other income, net                                                                    |  

719                                                   |  

2,772 |  

3,875 |  

2,840 |  

2,774 |
| Net loss                                                                                           | $      (8,129)                            | $        (13,404) | $        (15,144) | $        (12,204) | $        (11,442) |
| Dividends related to convertible preferred shares                                                  |  

1,886                                                 |  

24,923 |  

- |  

- |  

- |
| Net loss available to ordinary shares                                                              |  

(10,015)                                              |  

(38,327) |  

(15,144) |  

(12,204) |  

(11,442) |
| Basic and diluted net loss per ordinary share ***                                                  |  

$        (1.70)         |  

$            (2.75) |  

$            (0.58) |  

$            (0.47) |  

$            (0.43) |
| Weighted average number of ordinary shares used in  computing basic and diluted net loss per share |  

 

 

5,896,780                             |  

 

 

13,914,485 |  

 

 

26,005,784 |  

 

 

26,103,343 |  

 

 

26,409,180 |
| Pro forma basic and diluted net loss Per share  (unaudited) ****                                   |  

 

$        (0.58) |  

 

$            (0.69) |  

 

- |  

 

- |  

 

- |
| Pro forma weighted average number of shares outstanding  (unaudited) ****                          |  

 

14,102,899                                    |  

 

19,305,553 |  

 

- |  

 

- |  

 

- |

 

**42** 

 
|                                                                           | As of December 31,     |
|--------------------------------------------------------------------------------|------------------------|
| ** **                                                                     | ** **             | ** ** | ** ** | ** ** | ** ** |
| ** **                                                                     | 1999                   | 2000 | 2001 | 2002 | 2003 |
|                                                                           | **(US$ in thousands)** |
| **Consolidated Balance Sheet Data:**                                           |                        |  |  |  |  |
| Cash and cash equivalents, short-term bank deposits and  marketable securities | $11,436                | $90,675 | $32,347 | $48,402 | $16,707 |
| Long-term investments in marketable securities and bank  deposits              | -                      | - | 46,148 | 18,940 | 43,803 |
| Receivables, net                                                               | 710                    | 2,720 | 3,159 | 4,581 | 1,401 |
| Inventory                                                                      | 380                    | 347 | 134 | 111 | - |
| Total assets                                                                   | 15,518                 | 97,872 | 87,289 | 77,257 | 67,526 |
| Accumulated deficit                                                            | (14,917)               | (53,244) | (68,388) | (80,592) | (92,034) |
| Total shareholders' equity                                                     | 12,787                 | 92,510 | 80,062 | 68,881 | 59,808 |

 

(*)       Reclassified 

 

(**) Includes deferred stock compensation - seeNote 11 of our 2003 consolidated financial statements.

 

(***) Basic and diluted net loss and pro-formabasic and diluted net loss, for the year ended December 31, 2000 exclude thenon-cash dividend recorded in the amount of $24.9 million related to thebeneficial conversion feature of the issuance of 5,538,462 Series C preferredshares (at a price of $6.50 per share). As per their terms, all preferredshares were converted to ordinary shares upon the closing of Compugen`s initialpublic offering ("IPO") in August 2000.

 

(****) Pro-forma basic and diluted net loss pershare and pro-forma weighted average number of shares outstanding for the yearended December 31, 2000 give effect to the automatic conversion of thepreferred shares which occurred in August 2000 upon the closing of the IPO(using the "as-if converted" method from original date of issuance).

 

***Years Ended December 31, 2003 and 2002***

* *

*Revenues.* Total revenues decreased by 20% toapproximately $8.8 million in 2003 from approximately $11.1 million in 2002.The decrease in revenues was primarily due to decreased sales of ourBioccelerator products line (which we have divested), decreased sales of LEADS,decreased sales of Genecarta, decreased sales of Oligolibraries, and decreasedsales of Z3 and Z4000. The decrease in the sales of these products isattributable to the shift in focus away from commercializing our computationalproducts in favor of generating long-term revenues from commercializing thetherapeutic and diagnostic product candidates that we discover and develop.Revenues from research and development grants increased 12% to approximately $2million for 2003 from approximately $1.8 million for 2002. This increase wasdue to an increase in grants received from the Office of the Chief Scientist ofthe Israeli Ministry of Industry, Trade and Labor. Revenues from Novartis andAbbott represented 52% of our products and services revenues in 2003.

 

*Cost of Revenues.*Cost of revenues decreased19% to approximately $2.3 million for 2003 from approximately $2.8 million for2002. This decrease was primarily due to decreased costs related to the sale ofLEADS, Bioccelerator systems and OligoLibraries. 

**43** 

 

*Research and Development Expenses.*Researchand development expenses decreased 6% to approximately $13.3 million for 2003from approximately $14.2 million for 2002. The decrease in research anddevelopment expenses was primarily due to the devaluation of the Israeli shekelagainst the US dollar and the decrease in stock based compensation expenses toapproximately $308,000 for 2003 from approximately $621,000 for 2002. Researchand development expenses as a percentage of total revenues increased from 128%in 2002 to 151% in 2003.   

* *

*Sales and Marketing Expenses*. Sales andmarketing expenses decreased 31% to approximately $3.8 million for 2003 fromapproximately $5.5 million for 2002. This decrease was due to the devaluationof the Israeli shekel against the US dollar, the decrease in stock basedcompensation expenses to approximately $79,000 for 2003 from approximately$197,000 for 2002, and a decrease in promotional costs and marketing expenses.This later decrease is attributable to our decision to decrease our marketingand sales for some of our existing hardware and software tools products andrelated services. Sales and marketing expenses as a percentage of totalrevenues decreased from 50% in 2002 to 43.2% in 2003.

* *

*General and Administrative Expenses.*Generaland administrative expenses increased 1% to approximately $3.7 million for 2003from approximately $3.6 million for 2002. This increase was primarily due to anincrease of approximately $602,000 in stock based compensation expenses.Without taking into account the stock based compensation expenses, general andadministrative expenses decreased by 16% to approximately $3 million for 2003from approximately $3.5 million for 2002. This decrease was primarily due tothe devaluation of the Israeli shekel against the US dollar. General andadministrative expenses as a percentage of total revenues increased from 33%for 2002 to 41% for 2003. 

* *

*Financial Income, Net.*Financial  income,net decreased by 24% to approximately $2.1 million for 2003 from approximately$2.8 million for 2002. This decrease was attributable to lower levels of cashand cash related accounts, and lower interest rates we received on short-termbank deposits and short and long-term marketable securities. This decrease waspartially offset by other income, consisting of approximately $218,000 receivedfrom the sale by our subsidiary, Compugen USA, Inc., of its New Jersey netoperating losses carryover, and of approximately $459,000 attributed to capitalgains in connection with the sale of our Bioccelerator product line (see Note 3of our 2003 Consolidated Financial Statements). Financial income, net as apercentage of total revenues decreased from 25% for 2002 to 24% for 2003. 

 

***Years Ended December 31, 2002 and 2001***

* *

*Revenues.* Total revenues decreased 2% toapproximately $11.1 million for 2002 from approximately $11.4 million for 2001.The decrease in revenues was primarily due to decreased sales of Biocceleratorsystems, decreased sales of LEADS and decreased sales of Genecarta, which werepartially offset by increased sales of OligoLibraries. Revenues from researchand development grants increased 85% to approximately $1.8 million for 2002from approximately $994,000 for 2001. This increase was due to an increase ingrants received from the Office of the Chief Scientist of the Ministry ofIndustry and Trade of the State of Israel (OCS). Revenues from Pfizer, Novartisand diaDexus represented 44% of our products and services revenues in 2002.

 

*Cost of Revenues.*Cost of revenues decreased18% to approximately $2.8 million for 2002 from approximately $3.5 million for2001. This decrease was primarily due to decreased costs related to the sale ofBioccelerator systems and Genecarta, which were partially offset by the cost ofsales related to our OligoLibraries. 

* *

*Research and Development Expenses.*Researchand development expenses decreased 11% to approximately $14.2 million for 2002from approximately $16.0 million for 2001. The decrease in research and developmentexpenses was primarily due to the devaluation of the Israeli shekel against theUS dollar and a decrease in amortization of deferred compensation toapproximately $621,000 for 2002 from approximately $1.6 million for 2001.Research and development expenses as a percentage of total revenues decreasedfrom 141% in 2001 to 128% in 2002.   

**44** 

 

*Sales and MarketingExpenses*. Sales and marketing expenses decreased 16% to approximately $5.5million for 2002 from approximately $6.6 million for 2001. This decrease wasdue to the devaluation of the Israeli shekel against the US dollar, a decreasein amortization of stock based compensation expenses to approximately $197,000for 2002 from approximately $510,000 for 2001, and a decrease in promotionalcosts and marketing expenses. Sales and marketing expenses as a percentage oftotal revenues decreased from 58% in 2001 to 50% in 2002.

* *

*General and Administrative Expenses.*Generaland administrative expenses decreased 18% to approximately $3.6 million for2002 from approximately $4.4 million for 2001. This decrease was primarily dueto a decrease of approximately $384,000 in stock based compensation expensesrecorded in connection with options issued to employees and consultants.Without taking into account the stock based compensation expenses, general andadministrative expenses decreased 10% to approximately $3.5 million for 2002from approximately $3.9 million for 2001. This decrease was primarily due tothe devaluation of the Israeli shekel against the US dollar. General andadministrative expenses as a percentage of total revenues decreased from 39%for 2001 to 33% for 2002. 

* *

*Financial and Other Income, Net.*Financialand other income, net decreased 27% to approximately $2.8 million for 2002 fromapproximately $3.9 million for 2001. This decrease was attributable to lowerlevels of cash and cash related accounts, and lower interest rates we receivedon short and long-term bank deposits and marketable securities. Financial andother income, net as a percentage of total revenues decreased from 34% for 2001to 26% for 2002.

 

GovernmentalEconomic, Fiscal, Monetary or Political Policies that Materially Affected orCould Materially Affect Our Operations

 

Israeli companies are generally subject to incometax at the corporate tax rate of 36%. However, several investment programs atour manufacturing facility in Tel Aviv have been granted approved enterprisestatus and we are, therefore, eligible for the reduced tax benefits under theLaw for the Encouragement of Capital Investments, 1959. We have derived, andexpect to continue to derive, a substantial portion of our income from theapproved enterprise programs at our manufacturing facility. Subject tocompliance with applicable requirements, the portion of our revenues derivedfrom the approved enterprise programs will be tax-exempt for a period of twoyears commencing in the first year in which we generate taxable income and willbe subject, for a period of five to eight years, to a reduced corporate tax ofup to 25%, depending on the percentage of non-Israeli investors holding ourordinary shares. The period of tax benefits with respect to our approvedenterprise programs has not yet commenced, because we have yet to realizetaxable income. These benefits should result in income recognized by us beingtax exempt or taxed at a lower rate for a specified period after we begin toreport taxable income and exhaust any net operating loss carry-forwards.However, these benefits may not be applied to reduce the tax rate for anyincome derived by our U.S. subsidiary. There can be no assurance that such taxbenefits will continue in the future at their current levels or otherwise.

 

As of December 31, 2003 we did not have any taxableincome. As of December 31, 2003, our net operating loss carry-forwards forIsraeli tax purposes amounted to approximately $47 million. Under Israeli law,these net-operating losses may be carried forward indefinitely and offsetagainst certain future taxable income.

 

As of December 31, 2003, the net operating losscarry-forwards of our U.S. subsidiary for U.S. tax purposes amounted toapproximately $13 million. These losses are available to offset any future U.S.taxable income of our U.S. subsidiary and will expire between the years 2012and 2023. 

 

Use of our U.S. 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.

**45** 

 

For a description of Israeligovernment policies that affect our research and development expenses, and thefinancing of our research and development, see Subsection C in this Item 5below, entitled "Research and Development, Patents and Licenses; IsraeliGovernment Research and Development Programs".

 

 

B.            LIQUIDITY AND CAPITALRESOURCES

** **

In 2003, as in 2002 and 2001, our sources of cashcame from a private placement that took place in July 2000 our IPO, which tookplace in August 2000, from revenues generated from sales, from Israeligovernment grants, and from financing activities. We used these funds primarilyto finance our business operations. 

** **

***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,government grants and loans. Financing activities from private placements ofpreferred and ordinary shares, net of issuance costs, provided cash ofapproximately $14.8 million in 1998, approximately $19,000 in 1999 andapproximately $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 NationalMarket, and in September 2000, we sold an additional 750,000 ordinary sharesupon the exercise by our underwriters of their over-allotment option. Ouraggregate consideration from these sales was $57.5 million ($51.1 million netof issuance 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 used in operating activities wasapproximately $9.0 million in 2001, approximately $9.1 million in 2002, andapproximately $5.6 million in 2003. These amounts were used to fund our netlosses for these periods, adjusted for non-cash expenses and changes inoperating assets and liabilities. 

 

***Net Cash Used in Investing Activities***

 

Net cash used in investing activities consists ofpurchase of marketable securities, purchases of short-term and long-termdeposits, purchases of property and equipment, and proceeds from redemption ofmarketable securities. Net cash provided by (used in) investing activities wasapproximately $(63.4) million in 2001, approximately $5.8 million in 2002, andapproximately $4.9 million in 2003. The decrease in net cash provided byinvesting activities in 2003 is mainly attributable to the proceeds ofapproximately $30.2 million received from short-term and long-term deposits,the investment of approximately $39.6 million in marketable securities, theproceeds from sale of marketable securities, of approximately $17.9 million,and the de-consolidation of Evogene Ltd., of approximately $1.4 million. 

 

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

 

Our net cash provided by financing activities wasapproximately $104,000 in 2001, approximately $161,000 in 2002, andapproximately $3.3 million in 2003. The principal sources of cash provided byfinancing activities in 2001 and 2002 were derived from proceeds received fromthe issuance of Ordinary Shares as result of the exercise of options byemployees. The increase in net cash provided by financing activates in 2003attributable to proceeds that we received from the issuance of ordinary sharesas result of the exercise of options by employees, and from proceeds ofapproximately $2 million that our then-consolidated subsidiary, Evogene Ltd.,raised through a convertible loan (See Note 1 of our 2003 ConsolidatedFinancial Statements).

**46** 

 

***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 marketablesecurities. As of December 31, 2003, we had cash and cash equivalents, andshort-term marketable securities of approximately $16.7 million, and long-termmarketable securities of approximately $43.8 million. We believe that ourexisting cash and cash equivalents, and short-term and long-term marketablesecurities will be sufficient to fund our operations for at least the next twoyears. However, we may need additional equity or debt financing in the futureto fund our operations or to finance potential acquisitions of otherbusinesses, products or technologies.

** **

C.            RESEARCH ANDDEVELOPMENT, PATENTS AND LICENSES

** **

We invest heavily in research and development.Research and development expenses were our major expenditure, representing morethan 50% of the total operating expenses for each of 2001, 2002 and 2003. Ourresearch and development expenses were $13.3 million in 2003 compared to $14.2million in 2002, and $16.0 million in 2001. As of December 31, 2003, 103 of ouremployees were engaged in research and development on a full-time basis. Thisrepresents approximately 67% of our entire work force.

 

Consistent with our changed focus in favor ofdeveloping drug and diagnostic products based on our internal discoveries (see"Item 4. Business Overview"), our research and development efforts are focusedon the development of our proprietary technological infrastructures, discoveryengines, and of our internal drug and diagnostic product candidate pipeline. Weexpect that in 2004 our research and development expenses will continue to beour major expenditure, representing more than 50% our 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 markers, which we intend todiscover through the use of our discovery engines and related technologies andvalidate in our biological laboratories.

* *

***Israeli Government Research and DevelopmentPrograms***

 

We participate in programs offered by the Office ofthe Chief Scientist under the Industry, Trade and Labor Ministry of Israel (the"OCS") that supports research and development activities. We received grantsand other forms of consideration from the OCS of approximately $994,000******in2001, approximately $1.8 million in 2002, and approximately $2.1 million in2003. We have applied for grants from the OCS for the year 2004.

 

We received grants from the OCS for several projects.Under the terms of these grants, we will be required to pay a royalty rangingbetween 3% to 5% of the net sales of products developed from an OCS fundedproject, beginning with the commencement of sales of such products and endingwhen 100% of the dollar value of the grant is repaid (100% plus LIBOR interestapplicable to grants received on or after January 1, 1999). As of December 31,2003, our contingent accrued obligation for royalties, based on royalty-bearinggovernment grants, net of royalties already paid, totaled approximately $2.9million, which represents the percentage payable on future net sales ofproducts that were developed under OCS-funded projects. 

**47** 

 

Israeli law requires that the manufacture ofproducts developed with government grants be carried out in Israel, unless theOCS provides a special approval to the contrary. This approval, if provided, isgenerally conditioned on an increase in the total amount to be repaid to theOCS, to between 120% and 300% of the amount of funds granted. The specificincrease within this range would depend on the extent of the manufacturing tobe conducted outside of Israel. Alternatively, the restriction on manufacturingoutside of Israel shall not apply to the extent that plans to manufacture weredisclosed when filing the application for funding (and provided the applicationwas approved based on the information disclosed in the application). In suchcircumstances, the OCS will take into account the proposal that OCS-fundedprojects will have an overseas manufacturing component. Under applicableIsraeli law, Israeli government consent is required to transfer to Israelithird parties technologies developed under projects, which the governmentfunded. Transfer of OCS-funded technologies outside of Israel is prohibited.Israeli law further specifies that both the transfer of know-how as well as thetransfer of intellectual property rights in such know-how are prohibited. Theserestrictions do not apply to exports from Israel or the sale of products developedwith these technologies.

 

In addition to the OCS programs described above, weparticipate 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 MAGNETprogram sponsors these consortia. Under the terms of the MAGNET program, theOCS contributes 66% of the consortium`s research budget that the OCS approvesand the consortium industry members contribute the remaining 34%. No royaltiesare payable to the OCS with respect to this funding. Expenses in excess of theapproved budget are borne by the consortium members. 

 

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 the manufacture of products using technologydeveloped in the context of the program outside of Israel nor the transfer oftechnology developed under the program to any Israeli third party, without theprior written consent of the OCS. Transfer of OCS-funded technologies outsideof Israel is strictly prohibited. Israeli law further specifies that both thetransfer of know-how as well as the transfer of intellectual property rights insuch know-how are prohibited. These restrictions do not apply to exports fromIsrael of products developed with these technologies.

** **

D.            TREND INFORMATION

** **

***Trend Towards Consolidation***

* *

 There is a trend towards consolidation in thepharmaceutical and biotechnology industries, which may negatively affect ourability to enter into agreements. This trend often involves larger companiesacquiring smaller companies, and this may result in the remaining companieshaving greater financial resources and technological capabilities, thusintensifying competition in the industry. This trend towards consolidation inthe pharmaceutical and biotechnology industries may also result in there beingfewer customers for our products and services. Also, if one of theconsolidating companies already uses the technologies or services of ourcompetitors, we may lose existing customers as a result of such consolidation. 

**48** 

** **

***Trend Towards MakingGenomic Data and Related Software Publicly Available***

* *

 Large amounts of genomicdata are increasingly becoming available to the general public. To date, mostof the public efforts relating to human genomics involved producing data underthe Human Genome Project. Following the publication of the first draft of thehuman genome, there has been an increase in public efforts to develop analysistools for understanding genomic, functional genomic and proteomic data. Theseefforts have already resulted and may further result in the future in thedevelopment of products, which are competitive to ours and that are availablefree of charge. Such developments could require us to lower our prices, couldcause some of our products to be less commercially viable or to be obsolete, orcould assist third parties to discover genes or proteins that are of interestto us.

 

***The Pharmaceutical industry is reluctant toin-license potential therapeutic products, which are at the early stage oftheir development***

 

In the past, pharmaceutical companies were willing to in-licensepotential therapeutic product candidates that were in an early developmentalstage. Genomics-based drug discovery and development companies were able tocommercialize their intellectual property based only on initial developmentalwork, and without necessarily performing any preclinical or clinicalexperiments. This trend recently shifted towards a reluctance on the part ofpharmaceutical and biotechnological companies to in-license product candidatesunless such products attained an advanced developmental stage, typically PhaseII clinical trials. Even more recently, pharmaceutical and biotechnologicalcompanies have been inclined to in-license product candidates at a stage ofdevelopment which is significantly earlier than Phase II clinical trials sothat they can themselves control and manage the development of productcandidates.

 

The impact on us of the most recent trend (thatfavors the in-licensing of product candidates at a relatively earlydevelopmental stage), if it persists, is that the money and other resourcesthat we may be required to invest in our product candidates in advance ofcommercializing them may be reduced. However, if this trend does not persist,we may be required to invest a substantial amount of money and other resourcesin each product candidate, without assurance that its product candidates willbe commercialized and the number of product candidates in which we will be ableto invest our research and development resources will be limited. 

 

If we are successful in commercializing some of ourproduct candidates at an earlier developmental stage, the consideration that wecan expect to receive for our product candidates would be commensurately low.

** **

E.             OFF-BALANCE SHEET ARRANGEMENTS

 

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

** **

F.             TABULAR DISCLOSUREOF CONTRACTUAL OBLIGATIONS

** **

The table below summarizes our contractualobligations as of December 31, 2003 and should be read together with theaccompanying comments that follow.

** **
|                                                                                                                      | Payments due by  period |
|---------------------------------------------------------------------------------------------------------------------------|-------------------------|
|                                                                                                                      | Total                   | Less than 1 year | 1-3 years | 3-5 years |
| Operating Lease Obligations                                                                                               | 2,602                   | 1,090 | 1,512 | - |
| Other Long-Term Liabilities  Reflected on the Company`s Balance Sheet under the GAAP of the primary  financial statements | 60                      | - | - | 60 |
| Total                                                                                                                     | 2,662                   | 1,090 | 1,512 | 60 |

**49** 

 

The above table does not include royalties that wemay be required to pay to the OCS (See "Section C. Research and Development,Patents and Licenses" in this Item 5). We are unable to reasonably estimate thetime and the amounts that we will eventually be required to pay to the OCS, ifat all, since these amounts and times depend on our ability to sell productsbased on the OCS-funded technologies and the timing of any such sales.

 

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. 

 

**50** 

### ITEM6.                  DIRECTORS, SENIOR MANAGEMENT AND EMPLOYEES

** **

#####  Directors and Senior Management

** **

The following sets forth information with respectto our directors and executive officers as of February 29, 2004.

** **
| Name                     | Age | Positions                                                                     |
|--------------------------|-----|-------------------------------------------------------------------------------|
| Martin S. Gerstel        | 62  | Chairman of the Board of Directors                                            |
| Mor Amitai, Ph.D         | 38  | Chief Executive Officer, President and Director                               |
| David Haselkorn, Ph.D    | 59  | Director                                                                      |
| Rimon Ben-Shaoul         | 59  | Director                                                                      |
| Orna Berry, Ph.D         | 54  | Director                                                                      |
| David Schlachet          | 58  | Director                                                                      |
| Ruben Krupik             | 52  | Director                                                                      |
| Nurit Benjamini          | 37  | Chief Financial Officer                                                       |
| Erez Chimovits           | 40  | President, Compugen USA, and Executive Vice President,  Commercial Operations |
| Kinneret Savitsky, Ph.D. | 36  | Vice President, Biology, Research and Development                             |
| Dror Ofer, Ph.D.         | 40  | Vice President, Chemistry, Research and Development                           |
| Dorit Bitter             | 35  | Vice President, Computational Life Sciences, Research  and Development        |
| Ronit Weinstein          | 41  | Vice President, Human Resources                                               |

** **

**Martin S. Gerstel** has served as our chairmansince August 1997. Prior to relocating to Israel in 1994, Mr. Gerstel was co-chairman and CEO of ALZA Corporation, apharmaceutical company developing advanced drug delivery mechanisms, which hehelped found in 1968. Mr. Gerstel is also the co-founder and co-chairman ofItamar Medical, a medical device company headquartered in Israel, and serves as adirector of Evogene, Symyx Technologies, and the Foundation for the NationalMedals of Science and Technology. He is a member of the Board of Governors andthe Executive Committee of The Weizmann Institute of Science and the Board ofGovernors of The Hebrew University of Jerusalem, and is an advisor to theBurrill Life Science Funds and the board of the Israel-U.S. Bi-nationalIndustrial Research and Development (BIRD) Foundation. Mr. Gerstel holds a B.S.from YaleUniversity and an MBAfrom StanfordUniversity.

 

**Mor Amitai, Ph.D.** joinedCompugen in 1994. He held several positions, including Chief Scientist and Headof Research, before assuming his current position at the Company in 1997.Between 1991 and 1994, Dr. Amitai worked as a digital signal processingengineer, developing speech recognition technologies, at Comverse Technologies(NASDAQ: CMVT). Previously, Dr. Amitai carried out algorithm and communicationssystem development for five years in the Israeli Defense Forces, which he leftas a captain. Dr. Amitai holds a B.S. in Mathematics and Physics, and an M.S.and a Ph.D. in Mathematics, all from The Hebrew University of Jerusalem.

**51** 

 

**David Haselkorn, Ph.D.**has served as adirector since December 1998. From 1998 to 2003 Dr. Haselkorn served as theChief Executive Officer of Clal Biotechnology Industries Ltd. From 1987 to1998, Dr. Haselkorn served as a Managing Director and Chief Operating Officerof Bio-Technology General Corp. Dr. Haselkorn is also on the board of directorsof several privately-held companies. Dr. Haselkorn holds a B.Sc. in Chemistryand an M.Sc. in Biochemistry from Hebrew University, and a Ph.D. in ChemicalImmunology from the Weizmann Institute of Science.

 

**Rimon Ben-Shaoul** has been Co-Chairman,President and Chief Executive Officer of Koonras Technologies Ltd., aninvestment company controlled by Polar Investments Ltd. since February 2001.From June 1997 to February 2001, he was President and Chief Executive Officerof Clal Industries and Investments Ltd., one of Israel`s largest holdingcompanies. During that period, Mr. Ben-Shaoul also served on the Boards ofDirectors of Clal (Israel) Ltd. and several of its subsidiaries.  From1985 to June 1997, Mr. Ben-Shaoul was President and Chief Executive Officer ofClal Insurance Company Ltd. and a member of its Board of Directors, andChairman or member of the Board of Directors of various subsidiaries of ClalInsurance Company Ltd. He holds a B.A. in economics and an MBA from Tel Aviv University.

** **

**Orna Berry, Ph.D**joined our Board as anoutside director in June 2001. She is a Venture Partner at Gemini Israel Funds,and the Chairperson at Lambda Crossing, Ltd. and at Riverhead Inc. From 1997 to2000, she was the Chief Scientist of the Ministry of Industry and Trade of theGovernment of Israel. Dr. Berry was the co-founder of ORNET Data CommunicationTechnologies Ltd. She served as the Chief Scientist of Fibronics and as asenior research 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, respectively. Dr. Berry serves as an outsidedirector on our Board for a fixed term, which expires in June 2004. 

** **

**David Schlachet**joined our Board as anoutside director in June 2001.  He is a managing partner of BioComManagement and Investment (2002) Ltd, which serves as the managing company ofBioCom venture capital fund, focused on life sciences.  He alsoserves on the Boards of Directors of the following companies: Poalim CapitalMarkets & Investments Ltd., Harel Capital Markets Ltd., Taya InvestmentCompany Ltd., United Studios Ltd., Pharmos Ltd., Taldor Ltd., ProSeed VentureCapital Fund Ltd and Israel Discount Bank Limited. From 1997 to July 2000, hewas Chairman of the Board of Directors of Elite Industries Ltd. From 1996 toJanuary 2000, Mr. Schlachet served as Vice President of the Strauss Group ofcompanies. From 1990 to 1996, he was Vice President, Finance and Administrationat the Weizmann Institute of Science. From 1989 to 1990, Mr. Schlachet wasChief Executive Officer of Yeda Research and Development Ltd. of the WeizmannInstitute of Science. From 1974 to 1988, he was a senior manager at theInvestment Company of Bank Poalim Ltd. Mr. Schlachet holds a B.Sc. degree inchemical engineering from the Technion, Israel Institute of Technology and anMBA degree from Tel Aviv University. Mr. Schlachet serves as an outsidedirector on our Board for a fixed term, which expires in June 2004.

** **

**Ruben Krupik** joined our board in 2003. Mr.Krupik serves as the President and CEO of ARTE - Arison Technologies Ltd.,which provides a framework of business development, investments and managementfor Arison Holdings` high-tech interests. Mr. Krupik serves as the activechairman of Steps Ventures, the general manager of Biomedical Investments, anda manager of the Arison Group's technology division. He also serves as adirector in a number of leading Israeli hi-tech companies. From 1991 to 2000Mr. Krupik held a number of positions, including the President and CEO of RDCRafael Development Corporation Ltd. Prior to that, Mr. Krupik held a number ofsenior management positions at Tadiran Communications Group. Mr. Krupik holdsan LL.B. in law from the Tel Aviv University and BA in Economics and PoliticalSciences from the Hebrew University.

**52** 

** **

**Nurit Benjamini**joined Compugen in 2000 bringing over ten years ofexperience in the Israeli and international economic field. Prior to herposition at Compugen, Ms. Benjamini served as CFO of Phone-Or Ltd. Between 1993and 1998, Ms. Benjamini was CFO at Aladdin Knowledge Systems Ltd. (NASDAQ:ALDN). Previously, she worked as a Chief Financial Analyst and Economist withCubital Ltd., and as an economist on the Tel Aviv Stock Exchange. Ms. Benjaminiholds a B.A. in Economics and Business and an MBA in Finance, both from Bar Ilan University, Israel.

 

**Erez Chimovits**joined Compugen in 1999, holding several senior businessdevelopment and sales positions before assuming his current position in 2001.Prior to joining Compugen, Mr. Chimovits held various positions in businessdevelopment, marketing and sales at Saifan Ltd. Mr. Chimovits holds a B.S. inBiology, an M.S. in Microbiology, and an MBA, all from Tel Aviv University,Israel.  

 

**Kinneret Savitsky, Ph.D.**joined Compugen in 1997 as a senior scientist in theCompany's then newly founded laboratory. In 2000, she assumed her currentposition within the Company. Dr. Savitsky completed her Ph.D. in the Departmentof Human Genetics at TelAvivUniversity on the subject of identification of genes related togenetic diseases. Dr. Savitsky also holds a B.S. in Life Sciences from TheHebrew University of Jerusalem, and an M.S. from the Department of HumanGenetics at Tel Aviv University, Israel.

 

**Dror Ofer, Ph.D.** joinedCompugen in 1998 as a research scientist, and soon became involved in thechemical aspects of drug discovery. In 2001, he assumed his current position.Prior to joining Compugen, Dr. Ofer served as a senior research physicist at anational laboratory. Dr. Ofer holds a B.S. in physics from The HebrewUniversity of Jerusalem, an M.S. in physics from Ben-GurionUniversity, and a Ph.D.in physics from The Weizmann Institute of Science, all in Israel.

 

**Dorit Bitter** joinedCompugen in 2001, holding several senior positions in research and developmentbefore assuming her current position in 2002. Prior to joining Compugen, Ms.Bitter worked at Cimatron, where she held various R&D management positionsduring her seven-year tenure at the company. Ms. Bitter earned a B.S. inmathematics and computer science and an M.S. in mathematics, both from TheHebrew University of Jerusalem.

 

**Ronit Weinstein** joined Compugen in 2003 withalmost 10 years of experience in human resources and organizational consulting.Most recently, Ms. Weinstein was Vice President of Human Resources at EnavisNetworks, a subsidiary of ECI Telecom (NASDAQ: ECIL). Prior to working forEnavis, Ms. Weinstein served as Director of Human Resources for ECI Telecom andTadiran Telecommunications Transport Network Division. Previously, Ms.Weinstein served as Human Resources Manager at Comtek. Ms. Weinstein alsoworked as an organizational consultant for Lotem for four years. Prior to 1993,Ms. Weinstein was a research assistant and lecturer at Tel Aviv University andat the Tel Aviv College of Management. Ms. Weinstein holds a BA in Sociologyand Political Science from Tel Aviv University and an MA in Sociology fromUCLA. 

 

#####  Compensation

 

The aggregate compensation paid by us and by oursubsidiaries to all persons who served as directors or senior management forthe year 2003 (13 persons) was $1,216,427. This amountincludes $335,035 set aside or accrued to provide pension, severance,retirement or similar benefits.

 

During 2003, we granted a total of 755,000 optionsto purchase ordinary shares to our directors and senior management, as a group.These options are exercisable at a range of between $2.38 and $5.91 per share,and each expires ten years after their respective date of grant, except for theoptions granted to Mr. Gerstel, which will expire six years after their grant(See Item 7. "Major Shareholders and Related Party Transactions; Related PartyTransactions; Consulting Agreement with Shomar Corporation"). As of December 31, 2003, there were a total of 2,041,991 outstanding options to purchaseordinary shares that were granted to our directors and senior management, and75,000 outstanding options that were granted to the members of our scientificadvisory board.

**53** 

 

All members of our Board who are not employees orconsultants of the company 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, 2003 was approximately $55,230. These fees are adjustedsemi-annually to reflect changes prescribed by regulations under the CompaniesLaw, for payment to outside directors. Members of our scientific advisory boardreceive cash compensation and, have been granted and may be granted furthershare options for their services.  

** **

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

 

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

●*       *first, our Audit Committee reviews the proposal forcompensation;

●*       *second, provided that the Audit Committee approvesthe proposed compensation, the proposal is then submitted to our entire Boardfor review, except that a director who is the beneficiary of the proposedcompensation does not participate in any discussion or voting with respect tosuch proposal; and

●*       *finally, if the Board approves the proposal, itmust then submit its recommendation to our shareholders, which is usually donein the forum of our shareholders` general meeting; 

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

 

#####  Board Practices

* *

***Electionof Directors and Terms of Office***

 

Our board of directorscurrently consists of seven members, including our chairman and chief executiveofficer. Other than our two outside directors, our directors are elected by anordinary resolution at the annual general meeting of our shareholders. InAugust 2003, our Board appointed Ruben Krupik to serve as a director of theCompany. Unless they resign before the end of their term or are removed inaccordance with our Articles of Association, all our directors, other than ouroutside directors, will serve as directors until our next annual generalmeeting of shareholders.  

 

Dr. Orna Berry and Mr. David Schlachet serve asoutside directors pursuant to the provisions of the Israeli Companies Law,5759-1999 (the "Companies Law") for a three-year term ending in June 2004.After this date, their term of service may be renewed for one additionalthree-year term, by an ordinary resolution by the annual general meeting of ourshareholders. 

 

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, exceptfor Dr. Mor Amitai who is entitled to severance as an employee, pursuant to theterms of his employment agreement.  

 

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

**54** 

 

***Alternate Directors***

** **

Our Articles of Association provide that a directormay appoint, by written notice to us, any individual to serve as an alternatedirector, provided that the director is not currently serving as a director oras an alternate director. An alternate director will have the right to be paid,as well as all of the rights and obligations of the director appointing him orher, except the power to appoint an alternate, unless the instrument appointinghim or her provides otherwise. The alternate director may not act at any meetingat which the director appointing him or her is present. Unless the time periodor scope of any appointment is limited by the appointing director, theappointment is effective for all purposes, but will expire upon the expirationof the appointing director's term.

 

***Outside andIndependent Directors***

 

TheIsraeli Companies Law, 5759 - 1999 (the "Companies Law") requires Israelicompanies with shares that have been offered to the public either in or outsideof Israel to appoint two outside directors. No person may be appointed as anoutside director if that person or that person's relative, partner, employer orany entity under the person's control, has or had, on or within the two yearspreceding the date of that person's appointment to serve as an outside director,had any affiliation with the company or any entity controlling, controlled byor under common control with the company. The term affiliation 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 may otherwiseinterfere with his/her ability to serve as an outside director. If, at the timeoutside directors are to be appointed, all current members of the board ofdirectors are of the same gender, then at least one outside director must be ofthe other gender.

 

Outsidedirectors are to be elected 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. Outside directorsmay be removed only by the same percentage of shareholders as is required fortheir election, or by a court, and then only if the outside directors cease tomeet the statutory qualifications for their appointment or if they violatetheir duty of loyalty to the company. Each committee of a company's board ofdirectors must include at 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.

 

In addition, since we are a Foreign Private Issuerunder the Nasdaq Marker Rules, the Nasdaq National Market requires us to haveat least two independent directors on our board of directors and to establishan audit committee, at least a majority of whose members are directorsindependent of management. 

**55** 

 

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.

 

***Audit Committee***

 

The Companies Law requirespublic companies to appoint an audit committee. The responsibilities of theaudit committee include identifying irregularities in the management of thecompany's business and approving related party transactions as required by law.An audit committee must consist of at least three directors, including all ofits outside directors. The chairman of the board of directors, any directoremployed by or otherwise providing services to the company, and a controllingshareholder or any relative of a controlling shareholder, may not be a memberof the audit committee. An audit committee may not approve an action or atransaction with a controlling shareholder, or with an office holder, unless atthe time of approval two outside directors are serving as members of the auditcommittee and at least one of the outside directors was present at the meetingin which an approval was granted. 

 

Our audit committee is currently comprised of Dr.Orna Berry, Mr. David Schlachet and Mr. Rimon Ben-Shaoul. Mr. Rimon Ben-Shaoulserves as the Chairman of our Audit Committee.

** **

***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 (as defined above), or an affiliate, or a relative of an office holderor affiliate, and he or she may not be the company's independent accountant orits representative.  

 

***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 the advisory board recommends whichprojects to pursue and in what priority. Our scientific advisory boardcurrently includes: 

*** ***
| Name                        | Affiliation                                                                                                                                                         |
|-----------------------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| Richard  Durbin, Ph.D.      | Head of Informatics and Deputy Director,  Welcome Trust Sanger Institute, United    Kingdom                                                                         |
| C. Ronald  Kahn, M.D.       | President and Director, JoslinDiabetesCenter,  Mary K. Iacocca Professor, HarvardMedicalSchool                                                                      |
| 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               |

**56** 

 

#####  Employees

** **

The following table sets forth for the last threefiscal years, the number of our employees engaged in the specified activities,by geographic location. 
| **Year Ended December 31,**                                                                                           | **2003**                | **2002**                | **2001**                  |
|-----------------------------------------------------------------------------------------------------------------------|-------------------------|-------------------------|---------------------------|
| Research &  Development 

  Israel

  U.S.

  United Kingdom                        |  

95

7

1        |  

109

15

1      |  

108

17

-        |
| Administration, Accounting and Operations

  Israel

  U.S.                                       |  

 

24

4   |  

 

23

3   |  

 

22

4     |
| Sales, Marketing, Business Development and Support 

  Israel

  U.S.

  United Kingdom |  

 

2

7

1 |  

 

8

9

2 |  

 

12

13

- |
|  

Total                                                                                                         |  

141             |  

170             |  

176               |

 

We and our Israeli employees are subject toprovisions of the collective bargaining agreements between the Histadrut, the GeneralFederation of Labor in Israel and the Coordination Bureau of EconomicOrganizations, including the Industrialists Associations, by order of theIsraeli Ministry of Labor and Welfare. These provisions principally concerncost of living increases, recreation pay, travel expenses and other conditionsof employment. We provide our employees with benefits and working conditionsequal to or above the required minimum. Our employees are not represented by alabor union. We have written employment contracts with our employees and webelieve that our relations with our employees are good. 

 

#####  Share Ownership

 

***Share Ownership by Directors and SeniorManagement***

*** ***

All of the persons listed above under the caption"Directors and Senior Management" own ordinary shares and/or options topurchase ordinary shares. Except as set forth in the table below, none of thedirectors or executive officers owns shares and/or options amounting to 1% ormore of the outstanding ordinary shares. The following table sets forth certaininformation as of February 29, 2004, regarding the beneficial ownership by ourdirectors and executive officers. All numbers quoted in the table are inclusiveof options to purchase shares that are exercisable within 60 days after February 29, 2004.

**57** 

 
| **Beneficial Owner**                            | **Amount Owned** | **Percent of Class** |
|-------------------------------------------------|------------------|----------------------|
| Martin S. Gerstel (1)                           | 1,748,008        | 5.8%                 |
| Mor Amitai, Ph.D. (2)                           | 568,350          | 1.9%                 |
| All directors and senior  management as a group | 2,841,888        | 9.5%                 |

*** ***

(1)       Includes550,000 shares held by Shomar Corporation, an affiliate of Mr. Gerstel,1,119,888 shares held by Merrill Lynch IRA for Martin Gerstel, of which MartinGerstel is the beneficiary, and options to purchase 78,120 shares that areexercisable within 60 days of February 29, 2004.  Based oninformation disclosed by Mr. Martin Gerstel on his Form 13G, as filed with theSEC on February 17, 2004. 

 

(2)       Includesoptions to purchase 568,350 shares that are exercisable within 60 days of February 29, 2004. 

 

***Share Option Plans***

** **

We maintain the following share option plans forour and our subsidiaries' employees, directors and consultants. In addition tothe discussion below, see Note 11 of our Consolidated Financial Statements.

*** ***

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 29, 2004, options to purchase 125,500 ordinary shares, granted at a weighted average exercise price ofapproximately $1.98 per share, remained outstanding under the plan. Theseoptions expire ten years after the date of grant or four weeks aftertermination of a grantee`s employment or other relationship with us, withoutcause. If we terminate the grantee for cause, the options expire immediately.We do not intend 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 2,289,250 ordinary shares to employees,directors and consultants of Compugen and its subsidiaries. As of February 29, 2004, options to purchase 786,323 ordinary shares were outstanding under theplan at a weighted average exercise price of approximately $2.18 per share.Options to purchase 1,075,656 ordinary shares under the plan have previously beenexercised at an exercise price of approximately $1.56, and options to purchase638,021 ordinary shares remain available for future grant. If a grantee leaveshis or her employment or other relationship with us, his or her unexercisedvested options expire 90 days later. 

 

*Compugen Share Option Plan (2000)*

* *

Under the Compugen Share Option Plan (2000), we maygrant options for up to an aggregate of 5,701,627ordinary shares to our and our subsidiaries' employees, directors andconsultants. This total number automatically increases every January 1 by thelesser of 1,500,000 shares or 4% of the total number of our then-outstandingshares, or such lower amount as shall be determined by the board of directors.If a grantee leaves his or her employment or other relationship with us, or ifhis or her relationship with us is terminated without cause, his or herunexercised options will expire 90 days later. As of February 29, 2004, options to purchase 3,544,479 ordinary shares were outstanding under the plan at aweighted average exercise price of approximately $4.27 per share. 

**58** 

 

Options to purchase 387,546 ordinary shares underthe plan have previously been exercised at an exercise price of approximately$4.013, and options to purchase 1,760,689 ordinary shares remain available forfuture 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 with the revised provisions of Section 102of the Income Tax Ordinance (Amendment No. 132), 5762-2002 (the "Ordinance"),on February 4, 2003 our board of directors adopted an addendum to our shareoption plan which applies to options granted as of January 1, 2003 to granteeswho are residents of Israel (the "Addendum"). The Addendum does not affectgrantees that are not residents of Israel. 

 

On February 4, 2003 our Board further resolved toelect the "Capital Gains Track" (as defined in Section 102(b)(2) of theOrdinance) for the grant of options to Israeli grantees. Generally, under theCapital Gains Track the tax liability to a Grantee resulting from the grant andexercise of options will be postponed until the time that shares that areacquired 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 end of the tax year in which theaward was made. Under the Capital Gains Track, a fixed rate of 25% apply togains that are realized from the sale of shares issued upon exercise of options(i.e. for sales proceeds in excess of the exercise price of the options,assuming that the exercise price is equal to the fair market value of theshares on the date of the award), and provided that the sale occurs after therequired 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 requirements will apply and be carried out by the employing companyin accordance with applicable laws, regulations and rules. 

 

 Neither Compugen nor the grantee will be liablefor payment of national insurance payments or health tax in connection with thegranting or exercise of options that are exercised under the Capital GainsTrack mechanism, or upon the sale of the shares underlying such options or uponthe release of such shares from the trust, provided that such sale or releaseoccurs after the required holding period. 

 

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

 

*Non-Plan Options*

* *

In 1996, we granted options to purchase a total of249,250 ordinary shares to three of our employees. 133,847 of these options wereforfeited without being exercised in November 1999. In addition, 54,663 ofthese options have been exercised to date. The terms of these options are thesame as those granted under the Compugen Share Option Plan (1998). We do notintend to grant additional options under this plan.  

 

*Directors` Options*

* *

Prior to our initial public offering, we adopted aplan to grant options to our directors, effective as of the closing of ourinitial public offering. Pursuant to such plan, effective as of the closing of ourinitial public offering, we granted options to purchase 20,000 ordinary sharesat an exercise price of $10.00 per share to each of our directors (serving onour board on the date of the closing of our initial public offering) who werenot our employees or consultants. Of these options, options to purchase 1,250ordinary shares vest at the end of every three-month period following the dateof grant. Pursuant to this plan, we also granted and will continue to grant toeach new non-employee director options to purchase 20,000 ordinary shares atthe time he or she becomes a director. Of these options, options to purchase5,000 ordinary shares vest on the

**59** 

first anniversary of the grant date, and options topurchase 1,250 ordinary shares vest at the end of every three-month periodafterwards. In addition, pursuant to the plan, we grant each director optionsto purchase an additional 5,000 ordinary shares on each anniversary of theinitial date of grant of options to such director. Of these options, options topurchase 1,250 ordinary shares vest at the end of every three-month periodduring the fourth year after the date of grant. All of the options describedabove have been and will be granted under, and subject to, the terms of shareoption plans of Compugen in effect on the date of the grant of the option. 

 

On September 3, 2002 our shareholders approved thefollowing grants to our Board members: (i) each audit committee member shall beentitled to an annual grant of options to purchase 2,000 ordinary shares, (ii)each executive committee member shall be entitled to an annual grant of optionsto purchase 2,000 ordinary shares, and (iii) in addition to the previousgrants, the chairmen of the Audit Committee and the Executive Committeerespectively, shall each be granted additional options to purchase 2,000ordinary shares, each year. All of these options shall vest over a four-yearperiod. As of February 29, 2004, 16,000 of these options have been granted toour directors, at an exercise price of $2.89 per share. The rest of theseoptions shall be granted at the exercise price equal to the fair market valueof Compugen`s shares, at the time of grant. 

 

On September 3, 2002 our shareholders approved thefollowing grants to Dr. David Haselkorn: (i) the grant of options to purchase2,000 ordinary shares, and (ii) upon each anniversary of said grant, the grantof additional options to purchase 2,000 ordinary shares, subject to Dr.Haselkorn`s continued provision of service to Evogene. The options shall vestover a four-year period. The exercise price of the first 4,000 options is $2.89per share. The exercise price for the other options shall be equal to the fairmarket value of Compugen`s shares on the date of each grant. 

 

On July 30, 2003, our shareholders approved the following grants toMr. Gerstel, our active Chairman of the Board of Directors: 

* *

(i)*            *the grant of options to purchase 150,000 of our ordinaryshares at the exercise price of $2.38 per share, in consideration of Shomar`swaiver of the annual consulting fees of $150,000 for each of the years 2003through 2006, to which it was entitled under the Consulting Agreement datedOctober 1998 between Shomar Corporation and the Company, as amended (for moreinformation about this agreement, see: "Item 7. Major Shareholders and RelatedParty Transactions; Related Party Transactions; Consulting Agreement withShomar Corporation"); and 

 

(ii)*          *the grant of options to purchase 100,000 of our ordinaryshares, at the exercise price of $2.38 per share, in consideration for Mr. Gerstel`sservices as active Chairman of the Company`s Board of Directors.

 

These options were granted under the terms of ourShare Option Plan (2000), and are subject to vesting over a period of fouryears, commencing as of January 1, 2003, in a manner that 1/48 of the optionsvest at the end of each calendar month, and will expire six years after thedate of their grant.

 

On July 30, 2003, our shareholders approved thefollowing grant of options to Dr. Mor Amitai, the Company`s Chief ExecutiveOfficer and President: Dr. Amitai was granted options to purchase 200,000ordinary shares of the Company, at the exercise price of $2.38 per share. Theoptions were granted under the terms of our Share Option Plan (2000), and aresubject to vesting over a period of four years, commencing as of April 1, 2003, in a manner that 1/48 of the options vest at the end of each calendarmonth, and will expire ten years after the date of their grant. 

 

**60** 

### ITEM7.                  MAJOR SHAREHOLDERS AND RELATED PARTY TRANSACTIONS

** **

#####  Major Shareholders

** **

The following table sets forth certain informationregarding beneficial ownership of our ordinary shares as of February 29, 2004 by each person who is known by us to own beneficially more than 5% ofour outstanding ordinary shares. The voting rights of our major shareholders donot differ from the voting rights of other holders of our ordinary shares. 

 

To our knowledge, Apax (OCS) Nominees Limitedceased to be a major shareholder of Compugen during 2003. 

** **
| ** **

Beneficial Owner               | **Number of  Ordinary Shares Beneficially Owned** | **Percent of  Ownership** |
|--------------------------------------------|---------------------------------------------------|---------------------------|
| Martin Gerstel (1)                         | 1,748,008                                         | 5.8%                      |
| Clal Industries & Investments Ltd. (2) | 3,056,274                                         | 10.2%                     |
| AXA Assurances I.A.R.D. Mutuelle (3)       | 3,230,070                                         | 10.8%                     |

 

(1)       Includes 550,000 shares heldby Shomar Corporation, an affiliate of Mr. Gerstel, 1,119,888 shares held byMerrill Lynch IRA for Martin Gerstel, of which Martin Gerstel is thebeneficiary, and options to purchase 78,120 shares that are exercisable within60 days of February 29, 2004. Based on information disclosed by Mr. MartinGerstel on his Form 13G, filed with the SEC on February 17, 2004.

(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 its Form13G, as filed with the SEC on May 19, 2003.

 

(3)       This disclosure is based oninformation disclosed by AXA Assurances I.A.R.D. Mutuelle on its Form 13G, asfield with the SEC on November 30, 2003. 

 

As of February 29, 2004, there were a total of 127holders of record of our ordinary shares, of which 72 were registered withaddresses in the United States. Such United States holders were, as of suchdate, the holders of record of approximately 86% of the outstanding ordinaryshares.  ****

** **

#####  Related Party Transactions 

 

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 segments in which we operate and the terms of our transactionswith unaffiliated third parties, we believe that all of the transactionsdescribed below met our policy standards at the time they occurred. 

**61** 

 

***Evogene Ltd.***

 

In October 1999, we formed adivision focusing on agricultural biotechnology and plant genomics. On January 1, 2002, we spun-off the business of this division into a majority-owned subsidiary,Evogene Ltd. ("Evogene") in which we hold 82% of Evogene`s outstanding sharecapital. On January 6, 2003, a group of investors, led by Martin Gerstel, theChairman of our board of directors (the "Lenders"), extended to Evogene Ltd. aloan, convertible into equity, in the amount of $2,000,000. Upon conversion ofthe loan, Evogene will issue to the Lenders Preferred A Shares (convertibleinto ordinary shares), with certain preferences over ordinary and ordinary-1shares, such as preference in the case of liquidation or deemed liquidation,and full ratchet dilution protection.******We did not participate inthis financing round. The convertible loan was extended by new lenders after wedetermined that we do not wish to invest additional capital in Evogene, sinceEvogene`s business is outside the scope of our strategic focus of developingtechnologies in the field of human health. Under the convertible loan, weagreed to: (1) forgo the entire loan that it extended to Evogene upon Evogene`sincorporation, in the amount of $900,000 plus all accrued interest, and (2)extend until December 31, 2005 the term of the license to use our computationalplatform free of charge, that was granted to Evogene upon Evogene`sincorporation. We also waived, in connection with the convertible loan, ourright to appoint the majority of the directors in Evogene, and we now have theright to appoint only two out of the six directors in Evogene. Mr. AmosMeltzer, our employee and General Counsel is a director appointed by our Boardto Evogene`s board of directors. Following the closing of the Convertible Loantransaction, we granted the Lenders an irrevocable proxy empowering them tovote 820,000 of our shares in Evogene (which constituted 50% of ourshareholding of Evogene), subject to certain adjustments, based on theconversion of the Loan, from time to time. Following the Convertible Loantransaction our shares in Evogene were converted into ordinary-1 shares(convertible into ordinary shares), to allow for certain preferences over ordinaryshare holders, in the case of liquidation or deemed liquidation of Evogene. InFebruary 2004, Evogene and the Lenders entered into an Amended and RestatedConvertible Loan Agreement, under which the amount of the Convertible Loan wasincreased by an additional $1,551,000. We did not participate in this secondfinancing round. Under both transactions, certain Lenders received warrants topurchase shares of Evogene.

** **

***Registration Rights***

* *

On July 17, 2000 and pursuant to an Investor RightsAgreement of that date between the Company and its shareholders, we issued5,538,462 Series C preferred shares to certain entities, some of which wereshareholders of Compugen at the time of issuance. Upon the closing of theinitial public offering of our ordinary shares in August 2000, each Series Cpreferred share was converted into one ordinary share and all preferred rightsgranted to the series C preferred shareholders expired, except for theregistration rights that were granted under the terms of the Investor RightsAgreement dated July 17, 2000. The holders of registration rights are entitledto request that we effect the registration of their Compugen ordinary sharesunder the Securities Act of 1933. Pursuant to the Investor Rights Agreement, atthe request of any holder of demand registration rights, we must use our bestefforts to register at least 20% of the shares held by that holder if they arenot freely tradable under the Securities Act. These demand rights may beexercised at least six months following any other registration of our shares.Certain groups of shareholders may only make one demand for us to registershares. Other of our shareholders and a warrant holder will have the right toinclude their shares in these registrations, subject to specified limitations.  

 

At any time when we are eligible to registersecurities on Form F-3, subject to specified exceptions, the holders ofregistration rights will have the right to request that we register theirordinary shares that are not freely tradable under the Securities Act. Theminimum aggregate offering price of the securities to be registered is at least$500,000.

 

The holders of registration rights will also havethe right to include their shares in any registration statements filed by usfor purposes of a public offering, subject to specified limitations. Anunderwriter participating in an offering may limit the number of shares offeredfor marketing reasons, in which case the number of shares to be registeredwould be reduced pro rata among the holders requesting registration of theirshares.

**62** 

 

We will pay all expenses in connection with anyregistration, other than underwriting fees or discounts. These registrationrights are transferable under specified circumstances and may be amended orwaived only with our written consent and a specified number of the affectedholders. 

 

***Consulting Agreement with Shomar Corporation,a company controlled by Martin Gerstel, our active Chairman of the board ofdirectors***

* *

In October 1998, we entered into a consultingagreement with Shomar Corporation ("Shomar"), a company controlled by Martin S.Gerstel, our active Chairman of the Board of Directors. The agreement renewsautomatically each year unless terminated by either party. Under the agreement,as amended, Mr. Gerstel provides consulting services to us and is required todevote at least 50% of his business time to us. As compensation for hisservices under this agreement, we pay Shomar Corporation an annual consultingfee of $150,000, plus reimbursement of Mr. Gerstel's reasonable out-of-pocketexpenses. The agreement includes non-disclosure and non-competition obligationsin our favor. 

 

On July 30, 2003, our shareholders ratified ourBoard`s decision to grant to Martin Gerstel options to purchase 150,000 of ourordinary shares at an exercise price of $2.38 per share, under the terms of our2000 Option Plan, in consideration of Shomar`s waiver of the annual consultingfees of $150,000 for each of the years 2003 through 2006. 

 

On July 30, 2003, our shareholders ratified ourBoard`s decision to grant to Martin Gerstel, through Shomar, options topurchase 100,000 of our ordinary shares, at the exercise price of $2.38 pershare, under the terms of our 2000 Option Plan, in consideration for hisservices as active Chairman of our Board of Directors. 

 

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. 

**63** 

### ITEM8.                  FINANCIAL INFORMATION

 

#####  Consolidated Statements and Other FinancialInformation

** **

Our consolidated financial statements areincorporated herein by reference to pages F-1 through F-28.  

 

***Legal Proceedings***

*** ***

Currently, we are not a party to any material pendinglegal proceedings. Except for the sets of correspondence described below, thereare no legal proceedings pending or, to our knowledge, threatened against us orour subsidiaries 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. 

** **

On December 26, 2002, we received a letter fromOxford Gene Technology IP Ltd. ("OGT"), a company which has represented that itowns a number of patents in the microarray field. OGT inquired whether ouractivities in making and selling our OligoLibraries product infringes any ofthe OGT patents. We are not in the business of making or selling microarrays.By a letter dated March 12, 2003 from OGT to us, OGT acknowledged that we arenot in the business of manufacturing microarrays, and queried whether we offerproducts or services that could comprise components of OGT`s patentedinventions. 

 

On July 15, 2003, we and OGT held a discussion inwhich it was proposed by both parties that the above matter can be resolved.Following that discussion, written correspondence was exchanged and Compugencarried out those actions that it undertook to carry out in thiscorrespondence. In our meeting with OGT on July 15, 2003, we and OGT agreed that this matter should be resolved upon our giving to OGT a report advisingOGT of completion of those actions for which we gave OGT an undertaking.However, OGT made an additional request that we sign an agreement concerningthe settlement of this matter. We are currently considering that request, whichprimarily relates to a requirement that we inform our customers of thepermitted and the prohibited uses of our OligoLibraries products. There has notbeen any proposal for payment of any amounts of money.

** **

On February 24, 2003, we received a letter onbehalf of the Carnegie Institution of Washington, ("Carnegie"), which claims toown a patent regarding certain RNAi technology. Carnegie enquired whether wemay require a license from it in relation thereto. By a letter dated July 24,2003, from our external counsel, Finnegan, Henderson, Farabow, Garrett &Dunner, LLP, we advised Carnegie that we do not require a license, as proposed,on account of our activities. This matter has been dormant since that time.  

 

On January 5, 2004, we received a letter fromGenetic Technologies Limited ("GT"), in which GT claims to own certain patentsrelating to non-coding DNA polymorphisms. We believe that there is no legal orother basis for GT`s claim. 

** **

On February 23, 2004, we received a letter from thelaw offices of I. Gornitzky & Co., acting on behalf of Eli Mintz ("Mintz"),a previous employee and officer of ours and one of the co-founders of Compugen.By that letter, Mintz is requesting that we provide to him his full rights,including those rights that relate to his share options. At the moment, we areunable to evaluate whether there is any legal basis to Mintz`s request.

** **

If OGT, Carnegie, GT and/or Mintz were to institutelitigation against us, the cost of such litigation, if instituted, could besubstantial whether or not we prevail.

 

***Dividend Distributions***

*** ***

We have never paid any cash dividends on ourordinary shares and we do not intend to pay cash dividends on our ordinaryshares in the foreseeable future. Our current policy is to retain earnings foruse in our business.

**64** 

 

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%.See Note 15 of our Consolidated Financial Statements and "Item 10.Taxation". Cash dividends may be paid by an Israeli company only out ofretained earnings as calculated under Israeli law.

 

#####  Significant Changes

 

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

**65** 

### ITEM9.                  THE OFFER AND LISTING

 

*Markets and Share Price History*

 

The primary trading market for our ordinary sharesis the Nasdaq National Market, where our shares have been listed and tradedunder the symbol "CGEN" since our initial public offering in August, 2000. Ourshares have also been traded on the Tel Aviv Stock Market under the symbol"CGEN" since January 7, 2002.  The following table setsforth, for the periods indicated, the high and low reported sales prices of theordinary shares on the Nasdaq National Market and on the Tel Aviv StockExchange: 

 
| ** **                                                    | **Nasdaq** | **TASE** |
|---------------------------------------------------------------|------------|----------|
| **Last Six Calendar Months**                                  | **High**   | **Low**  | **High** | Low |
| February 2004                                                 | 7.500$     | 6.500$   | $7.111 | $6.504 |
| January 2004                                                  | 8.090$     | 5.010$   | $7.651 | $5.148 |
| December 2003                                                 | 5.760$     | 5.000$   | $5.529 | $5.049 |
| November 2003                                                 | 5.370$     | 4.670$   | $5.132 | $4.586 |
| October 2003                                                  | 5.750$     | 4.320$   | $5.461 | $4.463 |
| September 2003                                                | 5.990$     | 4.270$   | $5.953 | $4.279 |
|                                                          |       |     |   |   |
| **Financial Quarters During the Past Two Full  Fiscal Years** |       |     |   |   |
| Fourth Quarter of 2003                                        | 5.760$     | 4.320$   | $5.132 | $4.463 |
| Third Quarter 2003                                            | 5.990$     | 4.000$   | $5.593 | $4.155 |
| Second Quarter of 2003                                        | 6.090$     | 1.750$   | $6.086 | $1.866 |
| First Quarter 2003                                            | $2.490     | $1.500   | $2.629 | $1.506 |
| Fourth Quarter 2002                                           | $2.250     | $0.910   | $2.197 | $0.894 |
| Third Quarter 2002                                            | $2.260     | $1.000   | $2.268 | $1.129 |
| Second Quarter 2002                                           | $3.730     | $1.810   | $4.160 | $1.947 |
| First Quarter 2002                                            | $5.240     | $3.130   | $6.335 | $3.212 |
|                                                          |       |     |   |   |
| **Last Five Full Financial Years**                            |       |     |   |   |
| 2003                                                          | 6.090$     | 1.500$   | $6.086 | $1.505 |
| 2002                                                          | $5.240     | $0.910   | $6.335 | $0.894 |
| 2001                                                          | $8.625     | $2.600   | -- | -- |
| 2000 - commencing August 11, 2000                             | $19.500    | $5.063   | -- | -- |

 

**66** 

### ITEM10.                ADDITIONAL INFORMATION

 

#####  Memorandum and Articles of Association

** **

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

** **

We are registered under the Companies Law as apublic company with the name Compugen Ltd. and registration 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 is 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 exploiting anybusiness opportunity of the company in order to receive personal advantage 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 an office holder of Compugen. Under the Companies Law, all arrangements asto compensation of office holders who are not directors require approval of theboard of directors, or a committee thereof. Arrangements regarding thecompensation of directors also require audit committee and shareholdersapproval, with the exception of compensation to outside directors in theamounts specified in the regulations discussed 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.

**67** 

 

In the case of a transaction, which is not anextraordinary transaction, after the office holder complies with the abovedisclosure requirement, only board approval is required unless the Articles ofAssociation of the company provides otherwise. The 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.

 

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 or any other position with the company, andincludes a shareholder that holds 25% or more of the voting rights if no othershareholder 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 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, shareholders 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 voting rightsin 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, including,among other things, voting in the general meeting of shareholders on thefollowing matters:

●*       *any amendment to the Articles of Association; 

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

●*       *a merger; or 

●*       *approval of interested party transactions thatrequire shareholders approval.

 

In addition, any controlling shareholder, anyshareholder who knows it can determine the outcome of a shareholders vote andany shareholder who, under a company's Articles of Association, can appoint orprevent the appointment of an office holder, is under a duty to act withfairness towards the company. The Companies Law does not describe the substanceof this duty. The Companies Law requires that specified types of transactions,actions and 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 dulyconvened meeting. 

**68** 

 

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."

** **

***Rights Attached toOrdinary Shares***

** **

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. 

** **

***Dividend and Liquidation Rights***

** **

We may declare a dividend to be paid to the holdersof ordinary shares according to their rights and interests in our profits. Inthe event of our liquidation, after satisfaction of liabilities to creditors,our assets will be distributed to the holders of ordinary shares in proportionto the nominal value of their holdings. This right may be affected by the grantof preferential dividend or distribution rights to the holders of a class ofshares with preferential rights that may be authorized in the future. Pursuantto Israel's securities laws, a company registering its shares for trade on theTel Aviv Stock Exchange may not have more than one class of shares for a periodof one year following registration, after which it is permitted to issuepreference shares. Under the Companies Law, the declaration of a dividend doesnot require the approval of the shareholders of the company, unless thecompany's Articles of Association require otherwise. Our Articles of Associationprovide that the board of directors may declare and distribute dividendswithout the approval of the shareholders.

** **

***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 must convene a specialmeeting and send out notices setting forth the date, time and place of themeeting. Such notice must be given at least 21 days but not more than 35 daysprior 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.  

**69** 

 

***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 ordinary shares.

 

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

** **

TheCompanies Law provides that an acquisition of shares in a public company mustbe made by means of a tender offer if, as a result of such acquisition, thepurchaser would become shareholder with over 25% of the voting rights in thecompany. This rule does not apply if there is already another shareholder ofthe company with 25% or more of the voting rights. Similarly, the Companies Lawprovides that an acquisition of shares in a public company must be made bymeans of a tender offer if, as a result of the acquisition, the purchaser`sshareholdings would entitle the purchaser to over 45% of the voting rights inthe company, unless there is a shareholder with 50% or more of the votingrights in the company. These rules do not apply if the acquisition is made byway of a merger. Regulations promulgated under the Companies Law provide thatthese tender offer requirements do not apply to companies whose shares arelisted for trading outside of Israel if, according to the law in the country inwhich the shares are traded, including the rules and regulations of the stockexchange or which the shares are traded, either:

●*       *there is a limitation on acquisition of any levelof control of the company; or

●*       *the acquisition of any level of control requiresthe purchaser to do so by means of a tender offer to the public.

 

Finally, in general, Israeli tax law treatsspecified acquisitions less favorably than does U.S. tax law. However, Israelitax law has been amended to provide for tax deferral in specified acquisitions,including transactions where the consideration for the sale of shares is thereceipt of shares of the acquiring company, making Israeli tax consequencesmore favorable than they had been in the past for shareholders who exchangetheir ordinary shares for shares in a foreign corporation under certain circumstances.

**70** 

 

#####  Material Contracts 

** **

***Convertible Loan Agreement in Evogene Ltd.***

 

In December 2002, Evogene Ltd., our majority-ownedsubsidiary, entered into a Convertible Loan Agreement with a group of lenders,led by Martin Gerstel, our active chairman of the Board of Directors, pursuantto which these lenders lent $2,000,000 to Evogene, at a pre-money valuation ofthe company of $2,000,000. Following the closing of the Convertible Loantransaction, we granted the lenders an irrevocable proxy empowering them tovote 820,000 of the ordinary shares which we hold (this constitutes 50% of ourshareholding in Evogene), subject to certain adjustments, based on theconversion of the Loan, from time to time. In February 2004, Evogene and thelenders entered into an Amended and Restated Convertible Loan Agreement, underwhich the amount of the Convertible Loan was increased by an additional$1,551,000. Compugen did not participate in any of these loans. For moreinformation on this transaction see "Item 7. Major Shareholders and RelatedParty Transactions; Related Party Transactions; Evogene Ltd." 

#####  Exchange Controls

 

Under Israeli Law, Israeli non-residents whopurchase ordinary shares with certain non-Israeli currencies (includingdollars) may freely repatriate in such non-Israeli currencies all amountsreceived in Israeli currency in respect of the ordinary shares, whether as adividend, as a liquidating distribution, or as proceeds from any sale in Israelof the ordinary shares, provided in each case that any applicable Israeliincome tax is paid or withheld on such amounts. The conversion into thenon-Israeli currency must be made at the rate of exchange prevailing at thetime of conversion.  

 

#####  Taxation

 

The following discussion of Israeli and UnitedStates tax consequences material to our shareholders is not intended and shouldnot be construed as legal or professional tax advice and does not exhaust allpossible tax considerations. To the extent that the discussion is based on newtax legislation, which has not been subject to judicial or administrativeinterpretation, the views expressed in the discussion might not be accepted bythe 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 Tax Considerations***

 

The following discussion refers to the current taxlaw applicable to companies in Israel, with special reference to its effect onus. This discussion also includes specified Israeli tax consequences to holdersof our ordinary shares and Israeli Government programs benefiting us.  

*** ***

*Tax Reform*

 

On January 1, 2003 a comprehensive tax reform tookeffect in Israel. Pursuant to the reform, resident companies are subject toIsraeli tax on income accrued or derived inside or outside of Israel. Inaddition, the concept of controlled foreign corporation was introducedaccording to which an Israeli company may become subject to Israeli taxes oncertain income of a non-Israeli subsidiary if the subsidiary`s primary sourceof income is passive income (such as interest, dividends, royalties, rentalincome or certain capital gains). The tax reform also substantially changed thesystem of taxation of capital gains.

**71** 

 

*General Corporate Tax Structure*

* *

Israeli companies are generally subject to companytax at the rate of 36% of taxable income. However, the effective tax ratepayable by a company which derives income from an approved enterprise may beconsiderably less, as further discussed below.

 

*Tax Benefits Under the Law for the Encouragementof Capital Investments, 1959*

* *

The Law for the Encouragement of CapitalInvestment, 1959, as amended, commonly referred to as the Investment Law,provides that a proposed capital investment in eligible facilities may, uponapplication to the Investment Center of the Ministry of Industry and Trade ofthe State of Israel, be designated as an approved enterprise. Each certificateof approval for an approved enterprise relates to a specific investment programdelineated both by its financial scope, including its capital sources, and byits physical characteristics, for example, the equipment to be purchased andutilized under the program. The tax benefits derived from any certificate ofapproval relate only to taxable income attributable to the specific approvedenterprise. If a company has more than one approval or only a portion of itscapital investments is approved, its effective tax rate is the result of aweighted average of the applicable rates.

 

Taxable income of a companyderived from an approved enterprise is subject to company tax at the maximumrate of 25%, rather than 36%, for the benefit period. This period is ordinarilyseven years, or ten years if the company qualifies as a foreign investors'company as described below, commencing with the year in which the approvedenterprise first generates taxable income. However, this period is limited to12 years from commencement of production or 14 years from the date of approval,whichever is earlier.

 

A company owning an approved enterprise may electto forego entitlement to grants otherwise available as a result of an approvedenterprise in return for an alternative package of benefits. Under thealternative package of benefits, a company's undistributed income derived froman approved enterprise will be exempt from company tax for a period of betweentwo and ten years from the first year of taxable income, depending on thegeographic location of the approved enterprise within Israel, and the companywill be eligible for a reduced tax rate for the remainder of the benefitsperiod.  

 

A company that has elected the alternative packageof benefits and that subsequently pays a dividend out of income derived fromthe approved enterprise during the tax exemption period will be subject to taxon the amount distributed, including any Company tax on these amounts, at therate which would have been applicable had it not elected the alternativepackage of benefits, generally 10%-25%, depending on the percentage of thecompany's shares held by foreign shareholders. The dividend recipient is taxedat the reduced rate applicable to dividends from approved enterprises, which is15%, if the dividend is distributed during the tax exemption period or within12 years after this period, or in the case of a foreign investors' company,without time limitation. The company must withhold this tax at source,regardless of whether the dividend is converted into or paid in foreigncurrency.

 

A company that has an approved enterprise programis eligible for further tax benefits if it qualifies as a foreign investors'company. A foreign investors' company is a company more than 25% of whose sharecapital and combined share and loan capital is owned by non-Israeli residents.A company which qualifies as a foreign investors' company and has an approvedenterprise program is eligible for tax benefits for a ten-year benefit period.The company tax rate applicable to income earned from approved enterpriseprograms in the benefit period by a company meeting these qualifications is asfollows:

**72** 

 
| **For a company with foreign investment of** | Company Tax Rate |
|----------------------------------------------|------------------|
| More than 25% and less than 49%              | 25%              |
| 49% or more and less than 74%                | 20%              |
| 74% or more and less than 90%                | 15%              |
| 90% or more                                  | 10%              |

 

Subject to applicable provisions concerning incomeunder the alternative package of benefits, all dividends are considered to beattributable to the entire enterprise and their effective tax rate is theresult of a weighted average of the various applicable tax rates. Under theInvestment Law, a company that has elected the alternative package of benefitsis not obliged to attribute part of the dividend to exempt profits, and maygenerally decide from which year's profits to declare dividends. We currentlyintend to reinvest any income derived from our approved enterprise programs andnot to distribute the income as a dividend.

 

The Investment Center bases its decision whether ornot to approve an application on the criteria set forth in the Investment Lawand regulations, the then prevailing policy of the Investment Center, and thespecific objectives and financial criteria of the applicant. Therefore, wecannot assure you that any applications we may make in the future will beapproved. In addition, the benefits available to an approved enterprise areconditioned upon the fulfillment of conditions stipulated in the Investment Lawand its regulations and in the criteria in the specific certificate ofapproval, as described above. If a company does not meet these conditions, itwould be required to refund the amount of tax benefits, together with consumerprice index linkage adjustment and interest.

 

The Investment Center hasgranted approved enterprise status to three of our investment programs. Taxableincome derived from these programs will be tax exempt for a period of two yearsbeginning with the year in which we first generate taxable income, and thereafterwill be subject to a reduced tax rate of 25% or less, if we qualify as aforeign investors' company, for a period of between five and eight years,depending on the percentage of our capital held by non-Israeli shareholders. Todate, we have not generated taxable income.

 

*Tax Benefits for Research and Development*

 

Israeli tax law allows, under specific conditions,a tax deduction in the year incurred for expenditures, including capitalexpenditures, relating to scientific research and development projects, if theexpenditures are approved by the relevant Israeli government ministry,determined by the field of research, and the research and development is forthe promotion of the company and is carried out by or on behalf of the companyseeking the deduction. Expenditures not so approved are deductible over athree-year period. Expenditures made out of proceeds made available to usthrough government grants are automatically deducted during a one year period. 

 

*Tax Benefits Under the Law for the Encouragementof Industry (Taxes), 1969*

* *

The Law for the Encouragement of Industry (Taxes),1969, generally referred to as the Industry Encouragement Law, provides severaltax benefits for industrial companies. An industrial company is defined as acompany resident in Israel, at least 90% of the income of which in a given taxyear exclusive of income from specified government loans, capital gains,interest and dividends, is derived from an industrial enterprise owned by it.An industrial enterprise is defined as an enterprise whose major activity in agiven tax year is industrial production activity.

**73** 

 

Underthe Industry Encouragement Law, industrial companies are entitled to a numberof corporate tax benefits, including:

●*       *deduction of purchase of know-how and patents overan eight-year period; and

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

 

Under some tax laws and regulations, an industrialenterprise may be eligible for special depreciation rates for machinery,equipment and buildings. These rates differ based on various factors, includingthe date the operations begin and the number of work shifts. An industrialcompany owning an approved enterprise may choose between these specialdepreciation rates and the depreciation rates available to the approvedenterprise.

 

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

 

We believe that we currently qualify as anindustrial company within the definition of the Industry Encouragement Law. Wecannot assure you that the Israeli tax authorities will agree that we qualify,or, if we qualify, that we will continue to qualify as an industrial company orthat the benefits described above will be available to us in the future.

 

*Special Provisions Relating to Taxation underInflationary Conditions*

 

The Income Tax Law (Inflationary Adjustments),1985, generally referred to as the Inflationary Adjustments Law, represents anattempt to overcome the problems presented to a traditional tax system by aneconomy undergoing rapid inflation. The Inflationary Adjustments Law is highlycomplex. Its features, which are material to us, can be described as follows:

●*       *there is a special tax adjustment for thepreservation of equity which classifies corporate assets into fixed assets andnon-fixed assets. Where a company's equity, as defined in the law, exceeds thedepreciated cost of fixed assets, a deduction from taxable income that takesinto account the effect of the applicable annual rate of inflation on theexcess is allowed up to a ceiling of 70% of taxable income in any single taxyear, with the unused portion permitted to be carried forward on a linkedbasis. If the depreciated cost of fixed assets exceeds a company's equity, thenthe excess multiplied by the applicable annual rate of inflation is added totaxable income;

●*       *subject to specified limitations, depreciationdeductions on fixed assets and losses carried forward are adjusted forinflation based on the increase in the consumer price index; and

●*       *in specified circumstances, gains on tradedsecurities, which might otherwise be eligible for reduced rates of tax, will beliable to company tax at the rate of 36%. 

** **

*Capital Gains Tax on Sale of our Ordinary Sharesby both residents and non-residents of Israel.*

** **

Israeli law generally imposes a capital gains taxon the sale of capital assets located in Israel, including shares in Israeliresident companies, by both residents and non-residents of Israel, unless aspecific exemption is available or unless a treaty between Israel and thecountry of the non-resident provides otherwise. Regulations promulgated underthe Israeli Income Tax Ordinance provided for an exemption from Israeli capitalgains tax for gains accrued before January 1, 2003 and derived from the sale ofshares of an "Industrial Company", as defined by the Industry EncouragementLaw, that are traded on specified non-Israeli markets, including The NASDAQNational Market, provided that the sellers purchased their shares either in thecompany`s initial public offering or in public market transactions thereafter.

**74** 

 

This exemption does not apply to shareholders whoare in the business of trading securities, or to shareholders that are Israeliresident companies subject to the Income Tax (Adjustments for Inflation) Law-1985, or to shareholders who acquired their shares prior to an initial publicoffering. The Company believes that it is currently an Industrial Company, asdefined by the Industry Encouragement Law. The status of a company as anIndustrial Company may be reviewed by the tax authorities from time to time.There can be no assurance that the Israeli tax authorities will not deny theCompany`s status as an Industrial Company, possibly with retroactive effect. 

 

On January 1, 2003, the Law for Amendment of theIncome Tax Ordinance (Amendment No.132), 5762-2002, known as the tax reform,came into effect thus imposing capital gains tax at a rate of 15% on gainsaccrued on or after January 1, 2003 from the sale of shares in Israelicompanies publicly traded on a recognized stock exchange outside of Israel.This tax rate does not apply to: (1) dealers in securities; (2) shareholdersthat report in accordance with the Income Tax Law (Inflationary Adjustment) -1985; or (3) shareholders who acquired their shares prior to an initial publicoffering. The tax basis of shares acquired prior to January 1, 2003 will bedetermined in accordance with the average closing share price in the threetrading days preceding January 1, 2003. Non-Israeli residents shall be exemptfrom Israeli capital gains tax on any gains derived from the sale of sharespublicly traded on a stock exchange recognized by the Israeli Ministry ofFinance, provided such shareholders did not acquire their shares prior to aninitial public offering. In any event, the provisions of the tax reform shallnot affect the exemption from capital gains tax for gains accrued beforeJanuary 1, 2003, as described in the previous paragraph.

 

In addition, pursuant to the Convention Between theGovernment of the United States of America and the Government of Israel withRespect to Taxes on Income, as amended (the "United States- Israel TaxTreaty"), the sale, exchange or disposition of ordinary shares by a person whoqualifies as a resident of the United States within the meaning of the UnitedStates-Israel Tax Treaty and who is entitled to claim the benefits afforded tosuch person by the United States- Israel Tax Treaty (a "Treaty United StatesResident") generally will not be subject to the Israeli capital gains taxunless such "Treaty United States Resident" holds, directly or indirectly,shares representing 10% or more of the Company`s voting power during any partof the twelve- month period preceding such sale, exchange or disposition,subject to certain conditions. However, under the United States-Israel TaxTreaty, such "Treaty United States Resident" would be permitted to claim acredit for such taxes against the United States federal income tax imposed withrespect to such sale, exchange or disposition, subject to the limitations inUnited States laws applicable to foreign tax credits. The United States-IsraelTax Treaty does not relate to United States state or local taxes. 

 

Non-residents of Israel aresubject to income tax on income accrued or derived from sources in Israel.These sources of income include passive income, including dividends, royaltiesand interest, as well as non-passive income from services rendered in Israel.On distribution of dividends other than bonus shares or stock dividends, incometax is withheld at source, at the rate of 25%, or 12.5% for dividends notgenerated by an approved enterprise if the non-resident is a U.S. corporationand holds at least 10% of our voting power, and 15% for dividends generated byan approved enterprise, unless in each case a different rate is provided in atreaty between Israel and shareholder's country of residence. Under theU.S.-Israel tax treaty, the maximum tax on dividends paid to a holder ofordinary shares who is a U.S. resident will be 25%. However, under theInvestment Law, dividends generated by an approved enterprise are taxed at therate of 15%.

*** ***

***United States Federal Income TaxConsiderations***

 

The following discusses thematerial United States federal income tax consequences to a holder of ourordinary shares and qualifies as a U.S. Holder, which is defined as:

●*       *a citizen or resident of the United States; 

●*       *a corporation created or organized under the lawsof the United States, the District of Columbia, or any state; or

●*       *a trust or estate, treated, for United Statesfederal income tax purposes, as a domestic trust or estate.

**75** 

 

This opinion is based oncurrent provisions of the Internal Revenue Code of 1986 (the "Code"), asamended, current and proposed Treasury regulations promulgated under the Code,and administrative and judicial decisions as of the date of this prospectus,all of which are subject to change, possibly on a retroactive basis. Thisopinion does not address any aspect of state, local or non-United States taxlaws.

 

Further, this opinion doesnot purport to be a comprehensive description of all of the tax considerationsthat may be relevant to U.S. Holders entitled to special treatment under UnitedStates federal income tax laws, for example, financial institutions, insurancecompanies, tax-exempt organizations and broker-dealers, and it does not addressall aspects of United States federal income taxation that may be relevant toany particular shareholder based on the shareholder's individual circumstances.In particular, this opinion does not address the potential application of thealternative minimum tax, nor the special United States federal income tax rulesapplicable in special circumstances, including to U.S. Holders who:

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

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

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

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

 

Additionally, this opiniondoes not consider the tax treatment of partnerships or persons who holdordinary shares through a partnership or other pass-through entity or thepossible application of United States federal gift or estate taxes. Materialaspects of United States federal income tax relevant to a holder other than aU.S. Holder are also described below.

 

***Taxation of Dividends Paid On Ordinary Shares***

 

A U.S. Holder will berequired to include in gross income as ordinary income the amount of anydistribution paid on ordinary shares, including any Israeli taxes withheld fromthe amount paid, to the extent the distribution is paid out of our current oraccumulated earnings and profits as determined for United States federal incometax purposes. Distributions in excess of these earnings and profits will beapplied against and will reduce the U.S. Holder's basis in the ordinary sharesand, to the extent in excess of this basis, will be treated as gain from thesale or exchange of ordinary shares.

 

Recently enacted amendmentsto the Code, as amended, provide that dividend income may be eligible for areduced rate of taxation. Dividend income will be taxed at the applicablelong-term capital gains rate if the dividend is received from a "qualifiedforeign corporation," and the shareholder of such foreign corporationholds such stock for more than 60 days during the 120 day period that begins onthe date that is 60 days before the ex-dividend date for the stock. The holdingperiod is tolled for any days on which the shareholder has reduced his risk ofloss. A "qualified foreign corporation" is one that is eligible forthe benefits of a comprehensive income tax treaty with the United States. Aforeign corporation will be treated as qualified with respect to any dividendpaid, if its stock is readily tradable on an established securities market.However, a foreign corporation will not be treated as qualified if it is aPassive Foreign Investment Company (as discussed below) for the year in whichthe dividend was paid or the preceding year.

 

Distributions of current oraccumulated earnings and profits paid in foreign currency to a U.S. Holder willbe includible in the income of a U.S. Holder in a U.S. dollar amount calculatedby reference to the exchange rate on the day the distribution is received. AU.S. Holder that receives a foreign currency distribution and converts theforeign currency into U.S. dollars subsequent to receipt will have foreignexchange gain or loss based on any appreciation or depreciation in the value ofthe foreign currency against the U.S. dollar, which will generally be U.S.source ordinary income or loss.

**76** 

 

As described above, we willgenerally be required to withhold Israeli income tax from any dividends paid toholders who are not resident in Israel. See "Israeli Tax Considerations -Taxation of Non-Resident Holders of Shares." If a U.S. Holder receives adividend from Compugen that is subject to Israeli withholding, the followingwould apply:

●*       *You must include the gross amount of the dividend,not reduced by the amount of Israeli tax withheld, in your U.S. taxable income.

●*       *You may be able to claim the Israeli tax withheldas a foreign tax credit against your U.S. income tax liability.

●*       *The foreign tax credit is subject to significantand complex limitations. Generally, the credit can offset only the part of yourU.S. tax attributable to your net foreign source passive income. Additionalspecial rules apply to taxpayers predominantly engaged in the active conduct ofa banking, insurance, financing or similar business. Additionally, if we paydividends at a time when 50% or more of our stock is owned by U.S. persons, youmay be required to treat the part of the dividend attributable to U.S. sourceearnings and profits as U.S. source income, possibly reducing the allowablecredit, unless you elect to calculate your foreign tax credit separately withrespect to Compugen dividends.

●*       *A U.S. Holder will be denied a foreign tax creditwith respect to Israeli income tax withheld from dividends received on theordinary shares to the extent the U.S. Holder has not held the ordinary sharesfor at least 16 days of the 30-day period beginning on the date which is 15days before the ex-dividend date or to the extent the U.S. Holder is under anobligation to make related payments with respect to substantially similar orrelated property. Any days during which a U.S. Holder has substantiallydiminished its risk of loss on the ordinary shares are not counted towardmeeting the 16-day holding period required by the statute.

●*       *If you do not elect to claim foreign taxes as acredit, you will be entitled to deduct the Israeli income tax withheld fromyour Compugen dividends in determining your taxable income. Individuals who donot claim itemized deductions, but instead utilize the standard deduction, maynot claim a deduction for the amount of the Israeli income taxes withheld.

●*       *If you are a U.S. corporation holding our stock,you cannot claim the dividends-received deduction with respect to ourdividends.

 

Special rules, describedbelow, apply if Compugen is a passive foreign investment company.

 

***Taxation of the Disposition of OrdinaryShares***

* *

Subject to the description of the passive foreigninvestment company rules below, upon the sale, exchange or other disposition ofour ordinary shares, a U.S. Holder will recognize capital gain or loss in anamount equal to the difference between the U.S. Holder's basis in the ordinaryshares, which is usually the cost of these shares, and the amount realized onthe disposition. If, as anticipated, the ordinary shares are publicly traded, adisposition of shares will be considered to occur on the trade date, regardlessof the holder's method of accounting. Capital gain from the sale, exchange orother disposition of ordinary shares held more than one year is long-termcapital gain and is eligible for a reduced rate of taxation for non-corporateholders. Gain or loss recognized by a U.S. Holder on a sale, exchange or otherdisposition of ordinary shares generally will be treated as United Statessource income or loss for United States foreign tax credit purposes. Thedeductibility of capital losses is subject to limitations for both corporateand individual shareholders.

 

A U.S. Holder that uses the cash method ofaccounting calculates the U.S. dollar value of the proceeds received from asale of ordinary shares as of the date that the sale settles, and willgenerally have no additional foreign currency gain or loss on the sale, while aU.S. Holder that uses the accrual method of accounting is required to calculatethe value of the proceeds of the sale as of the trade date and may thereforerealize foreign currency gain or loss, unless the U.S. Holder has elected touse the settlement date to determine its proceeds of sale for purposes ofcalculating this foreign currency gain or loss. In addition, a U.S. Holder thatreceives foreign currency upon disposition of our ordinary shares and convertsthe foreign

**77** 

currency into U.S. dollars subsequent to receipt will haveforeign exchange gain or loss based on any appreciation or depreciation in thevalue of the foreign currency against the U.S. dollar, which will generally beU.S. source ordinary income or loss.

 

***Tax Consequences If We Are a Passive ForeignInvestment Company***

* *

Generally, a foreign corporation is treated as apassive foreign investment company ("PFIC") for United States federal incometax purposes for any tax year if, in such tax year, either (i) 75% or more ofits gross income is passive in nature (the "Income Test"), or (ii) the averagepercentage of its assets during such tax year that produce, or are held for theproduction of, passive income (determined by averaging the percentage of thefair market value of its total assets which are passive assets as of the end ofeach quarter of such year) is 50% or more (the "Asset Test").

* *

Because less than 75% of our gross income in 2003and in prior years constituted passive income, as defined for purposes of theIncome Test, we do not believe that application of the Income Test would haveresulted in our classification as a PFIC for any of such years. 

 

For 2001, 2002 and 2003, however, it is possiblethat we could be classified as a PFIC under the Asset Test principally becausea significant portion of our assets continued to consist of the cash raised inconnection with both a public offering and a private offering of our ordinaryshares in 2000, coupled with the decline in the public market value of ourordinary shares during 2001, 2002 and through the beginning of 2003 and thetiming of the required valuations, although there is no definitive methodprescribed in the Code, United States Treasury Regulations or administrative orjudicial interpretations thereof for determining the value of a foreigncorporation`s assets for purposes of the Asset Test. While the legislativehistory of the United States Taxpayer Relief Act of 1997 indicates that "thetotal value of a publicly-traded foreign corporation`s assets generally will betreated as equal to the sum of the aggregate value of its outstanding stockplus its liabilities", there remains substantial uncertainty regarding thevaluation of a publicly-traded foreign corporation`s assets for purposes of theAsset Test, and it is arguable that under alternative valuation methodologies,the value of our total assets as of the relevant valuation dates in 2001, 2002and/or 2003 would not result in our classification as a PFIC during any or allof such years.

 

In view of the uncertainty regarding the valuationof our assets for purposes of the Asset Test and the complexity of the issuesregarding our treatment as a PFIC, U.S. Shareholders are urged to consult theirown tax advisors for guidance as to our status as a PFIC. For those U.S.Shareholders who determine that we were a PFIC and notify us in writing oftheir request for the information required in order to effectuate the QEFElection described below, we will promptly make such information available tothem. 

 

If we are treated as a PFIC for United Statesfederal income tax purposes for any year during a U.S. Shareholder`s holdingperiod of ordinary shares and the U.S. Shareholder does not make a QEF Electionor a "mark-to-market" election (both as described below), any gain recognizedby the U.S. Shareholder upon the sale of ordinary shares (or the receipt ofcertain distributions) would be treated as ordinary income. This income wouldbe allocated over the U.S. Shareholder`s holding period with respect to hisordinary shares and an interest charge would be imposed on the amount ofdeferred tax on the income allocated to prior taxable years.

 

Although we generally will be treated as a PFIC asto any U.S. Shareholder if we are a PFIC for any year during the U.S.Shareholder`s holding period, if we cease to satisfy the requirements for PFICclassification, then under such circumstances, the U.S. Shareholder may avoidthe consequences of PFIC classification for subsequent years if he elects torecognize gain based on the unrealized appreciation in the ordinary sharesthrough the close of the tax year in which we cease to be a PFIC. Additionally,if we are treated as a PFIC, a U.S. Shareholder who acquires ordinary sharesfrom a decedent would be denied the normally available step-up in tax basis forthese ordinary shares to fair market value at the date of death and insteadwould have a tax basis equal to the decedent`s tax basis in these ordinaryshares.

 

**78** 

For any tax year in which we are treated as a PFIC,a U.S. Shareholder may elect to treat his ordinary shares as an interest in aqualified electing fund (a "QEF Election"), in which case, the U.S. Shareholderwould be required to include in income currently his proportionate share of ourearnings and profits in years in which we are a PFIC regardless of whetherdistributions of our earnings and profits are actually distributed to the U.S.Shareholder. Any gain subsequently recognized upon the sale by the U.S.Shareholder of his ordinary shares, however, generally would be taxed ascapital gain.

 

As an alternative to a QEF Election, a U.S.Shareholder may elect to mark his ordinary shares to market annually,recognizing ordinary income or loss (subject to certain limitations) equal tothe difference between the fair market value of his ordinary shares and theadjusted tax basis of his ordinary shares. Losses would be allowed only to theextent of net mark-to-market gain accrued under the election.

 

We cannot assure you that we will avoid becoming aPFIC. U.S. holders who hold ordinary shares during a period when we are a PFICwill be subject to the foregoing rules, even if we cease to be a PFIC. U.S.Holders are urged to consult their tax advisors about the PFIC rules, includingQEF elections.

*** ***

***United States Federal Income Tax Consequencesfor Non-U.S. Holders of Ordinary Shares***

 

Except as described in "Information Reportingand Back-up Withholding" below, a Non-U.S. Holder of ordinary shares willnot be subject to U.S. federal income or withholding tax on the payment ofdividends on, and the proceeds from the disposition of, ordinary shares,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 tax treaty with the United States,the item is attributable to a permanent establishment or, in the case of anindividual, a fixed place of business, in the United States;

●*       *the Non-U.S. Holder is an individual who holds theordinary shares as a capital asset and is present in the United States for 183days or more in the taxable year of the disposition and does not qualify for anexemption; or

●*       *the Non-U.S. Holder is subject to tax under theprovisions of United States tax law applicable to U.S. expatriates.

 

***Information Reporting and Back-up Withholding***

 

U.S. Holders generally are subject to informationreporting requirements with respect to dividends paid in the United States onordinary shares. Existing regulations impose back-up withholding on dividendspaid in the United States on ordinary shares unless the U.S. Holder providesIRS Form W-9 or otherwise establishes an exemption. U.S. Holders are subject toinformation reporting and back-up withholding at a rate of 28% on proceeds paidfrom the disposition of ordinary shares unless the U.S. Holder provides IRSForm W-9 or otherwise establishes an exemption.

 

Non-U.S. Holders generally are not subject toinformation reporting or back-up withholding with respect to dividends paid on,or upon the disposition of, ordinary shares, provided that the non-U.S. Holderprovides a taxpayer identification number, certifies to its foreign status, orotherwise establishes an exemption.

 

Prospective investors should consult their taxadvisors concerning the effect, if any, of these Treasury regulations on aninvestment in ordinary shares. The amount of any back-up withholding will beallowed as a credit against a U.S. or Non-U.S. Holder's United States federalincome tax liability and may entitle the Holder to a refund, provided thatspecified required information is furnished to the IRS.

**79** 

** **

#####  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 Room 1024, Judiciary Plaza, 450 Fifth Street, N.W., Washington, D.C. 20549and at the regional office of the SEC located at the Northwestern Atrium Center,500 West Madison Street, Suite 1400, Chicago, Illinois 60661. You may alsoobtain copies of such materials from the Public Reference Section of the SEC,Room 1024, Judiciary Plaza, 450 Fifth Street, N.W., Washington, D.C. 20549, atprescribed rates. You may call the SEC at 1-800-SEC-0330 for furtherinformation on the public reference rooms. As a foreign private issuer we wereonly required to file through the SEC`s EDGAR system as of November 2002. Ourperiodic filings are therefore available on the SEC`s Website from that date.You may read and copy any reports, statements or other information that we filewith the SEC, through the SEC`s EDGAR system available on the SEC`s website andat the SEC facilities listed above. These SEC filings are also available to thepublic from commercial document retrieval 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.

**80** 

### 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. OnDecember 31, 2003 and December 31, 2002, we did not own any market risksensitive instruments. However, we may in the future undertake hedging or othersimilar transactions or invest in market risk sensitive instruments ifmanagement determines that it is necessary to offset these risks.

 

#####  Interest Rate Risk

 

As of December 31, 2003, we had $60.5 million incash, cash equivalents, bank deposits and marketable securities. We invest ourcash surplus in time deposits, bank deposits, and corporate bonds. Since theseinvestments typically carry fixed interest rate and since our policy andpractice is to hold these investments to maturity, financial income over theholding period is not sensitive to changes in rates interest.

 

#####  Foreign Currency Exchange Risk and Inflation 

** **

Since the majority of our revenues are paid in USdollars, we believe that inflation and fluctuations in the NIS/US dollarexchange rate have no material effect on our revenues. 

 

We incur a significant portion of our expenses,principally salaries and related personnel expenses, in New Israeli Shekels, orNIS. As a result, we are exposed to the risk that the rate of inflation inIsrael will exceed the rate of devaluation of the NIS in relation to the USdollar or that the timing of this devaluation lags behind inflation in Israel.In addition, we are exposed to the risk that the US dollar will be devaluedagainst the NIS. We try to protect ourselves against this possibility byinvesting a portion of our cash in NIS deposits. To date, we have not beenmaterially affected by changes in the Israeli rate of inflation or the exchangerates of the NIS compared to the US dollar. 

** **

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

 

Not applicable.

**81** 

 

# PART II

 

### ITEM13.                DEFAULTS, DIVIDEND ARREARAGES AND DELINQUENCIES

 

None. 

 

### ITEM14.                MATERIAL MODIFICATIONS TO THE RIGHTS OF SECURITY HOLDERS ANDUSE OF PROCEEDS

 

#####  Material Modifications to the Rights of SecurityHolders

 

None. 

 

#####  Use of Proceeds 

** **

None. 

** **

### ITEM15.                CONTROLS AND PROCEDURES

 

Our disclosure controls and procedures are designedto provide reasonable assurance that information required to be disclosed in thisreport is recorded, processed, summarized and reported on a timely basis. Underthe supervision and with the participation of our Disclosure Committee and ourChief Executive Officer and Chief Financial Officer, we conducted an evaluationof our disclosure controls and procedures, as such term is defined under Rule13a-15(e) and 15d-15(e) promulgated under the Securities Exchange Act of 1934.Based on this evaluation, our Chief Executive Officer and Chief FinancialOfficer concluded that our disclosure controls and procedures were effective asof the end of the period covered by this report. Our Chief Executive Officerand Chief Financial Officer have also concluded that there were no significantchanges in the Company`s internal controls or in other factors that couldsignificantly affect the internal controls subsequent to that date ofevaluation, including any corrective actions with regard to significantdeficiencies and material weaknesses.

 

### ITEM16.                RESERVED

** **

### ITEM16A.            AUDIT COMMITTEE FINANCIAL EXPERT

 

Our Board of Directors has determined that Mr.David Schlachet, is an "audit committee financial expert". 

 

### ITEM16B.             CODE OF ETHICS

 

Our Board adopted a code of ethics that applies tothe Company`s principal executive officer, principal financial officer,principal accounting officer or controller, or persons performing similarfunctions. 

 

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

**82** 

 

### 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, 2003 and 2002:

 
|                | 2003         | 2002         |
|---------------------|--------------|--------------|
| Audit  Fees         | $ 55,000     | $ 51,000     |
| Audit  Related Fees | $ 7,000      | --           |
| Tax  Fees           | $ 18,000     | $ 26,500     |
| All Other Fees      | $ 6,250      | $  15,000    |
| **Total**           | **$ 86,250** | **$ 92,500** |

 

"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 the Company.

 

**83** 

# PART III

*** ***

### ITEM17.                FINANCIAL STATEMENTS

 

                We have elected to furnish financialstatements and related information specified in Item 18.

 

### ITEM18.                FINANCIAL STATEMENTS

 

                See pages F-1 to F-28.

 

### ITEM19.                EXHIBITS

*** ***

##### Index to Exhibits

 
| **Exhibit Number** | **Description**                                                                                      |
|--------------------|------------------------------------------------------------------------------------------------------|
| *1.1               | Form of Articles of Association of Issuer                                                            |
| 10.1               | Consent of Kost Forer & Gabbay, a member of  Ernst & Young Global, dated April 5, 2004       |
| 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 to our registrationstatement on Form F-1, registration number 333-12316, as amended, filed withthe Securities and Exchange Commission, and is hereby incorporated byreference.

 

**84** 

**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 duly authorizedon this 7th day of April, 2004.

 

 

** **

** **

**COMPUGEN LTD.**

 

 

 

Signature:      \s\ Dr. Mor Amitai

 

Name:             Mor Amitai, Ph.D.

Title:               President, Chief ExecutiveOfficer and Director

Date:               April 7, 2004

 

**85** 

 

 

 

 

 

 

**COMPUGEN LTD. AND ITS SUBSIDIARIES**

** **

** **

**CONSOLIDATED FINANCIAL STATEMENTS**

** **

** **

**AS OF****DECEMBER 31, 2003**

** **

** **

**IN U.S. DOLLARS**

 

 

 

 

 

**INDEX**

** **

 

| ** **                                        | **Page**   |
|---------------------------------------------------|------------|
| ** **                                        | ** ** |
| ** **                                        | ** ** |
| **Report of Independent Auditors**                | **2**      |
| ** **                                        | ** ** |
| **Consolidated Balance Sheets**                   | **3**      |
| ** **                                        | ** ** |
| **Consolidated Statements of Operations**         | **4**      |
| ** **                                        | ** ** |
| **Statements of Changes in Shareholders' Equity** | **5**      |
| ** **                                        | ** ** |
| **Consolidated Statements of Cash Flows**         | **6-7**    |
| ** **                                        | ** ** |
| **Notes to Consolidated Financial Statements**    | **8-28**   |

** **

** **

** **

**- - - - - - - - - - - - -**

** **

**F -1** 

** **
|  |
|--|

** **

** **

** **

** **

** **

**REPORT OF INDEPENDENT AUDITORS**

** **

** **

** **

**To the Shareholders' of**

** **

**COMPUGEN LTD.**

 

 

 

We have audited the accompanying consolidatedbalance sheets of Compugen Ltd. ("the Company") and its subsidiariesas of December 31, 2003 and 2002, and the related consolidated statements ofoperations, changes in shareholders' equity and cash flows for each of the twoyears in the period then ended. These financial statements are theresponsibility of the Company's management. Our responsibility is to express anopinion on these financial statements based on our audits. The financialstatements of Compugen Ltd and its subsidiaries as of December 31, 2001 and forthe year then ended were audited by other auditors who have ceased operationsas a foreign associated firm of the Securities and Exchange Commission PracticeSection of the American Institute of Certificate Public Accountants and whosereport dated February 12, 2002 expressed an unqualified opinion on thosestatements.

 

 

We conducted our audits in accordance with auditingstandards generally accepted in the United States. Those standards require thatwe plan and perform the audit to obtain reasonable assurance about whether thefinancial statements are free of material misstatement. An audit includesexamining, on a test basis, evidence supporting the amounts and disclosures inthe financial statements. An audit also includes assessing the accountingprinciples used and significant estimates made by management, as well asevaluating the overall financial statement presentation. We believe that ouraudits provide a reasonable basis for our opinion.

 

 

In our opinion, the consolidated financialstatements referred to above present fairly, in all material respects, theconsolidated financial position of Compugen Ltd. and its subsidiaries as ofDecember 31, 2003 and 2002, and the consolidated results of their operationsand cash flows for each of the two years in period then ended, in conformitywith accounting principles generally accepted in the United States.

 

 

 

 
| Tel-Aviv, Israel | KOST FORER GABBAY & KASIERER     |
|------------------|--------------------------------------|
| February 4, 2004 | A Member of Ernst & Young Global |

* *

**F -2** 

* *
|                                                                                                                                                                                                         | ** ** | ** ** | ** ** | December 31,                                              |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------|------------|-----------------------------------------------------------|
|                                                                                                                                                                                                    | ** ** | Note       | ** ** | 2003                                                      |   | 2002 |
| ASSETS                                                                                                                                                                                                  |       |       |       |                                                      |   |   |
| CURRENT ASSETS:                                                                                                                                                                                         |       |       |       |                                                      |   |   |
| Cash and cash equivalents                                                                                                                                                                               |       | 4          |       | $             7,910                                       |   | $             5,289 |
| Short-term bank deposits                                                                                                                                                                                |       | 5          |       | -                                                         |   | 30,195 |
| Marketable securities                                                                                                                                                                                   |       | 6          |       | 8,797                                                     |   | 12,918 |
| Trade receivables                                                                                                                                                                                       |       |       |       | 256                                                       |   | *) 1,874 |
| Other accounts receivable  and prepaid expenses                                                                                                                                                         |       | 7          |       | 1,145                                                     |   | *) 2,707 |
| Inventories                                                                                                                                                                                             |       |       |       | -                                                         |   | 111 |
|                                                                                                                                                                                                    |       |       |       |                                                      |   |   |
| Total current assets                                                                                                                                                                                    |       |       |       | 18,108                                                    |   | 53,094 |
|                                                                                                                                                                                                    |       |       |       |                                                      |   |   |
| LONG-TERM INVESTMENTS:                                                                                                                                                                                  |       |       |       |                                                      |   |   |
| Marketable securities                                                                                                                                                                                   |       | 6          |       | 43,803                                                    |   | 18,940 |
| Long-term lease deposits                                                                                                                                                                                |       |       |       | 150                                                       |   | 156 |
| Severance pay fund                                                                                                                                                                                      |       |       |       | 1,528                                                     |   | 1,266 |
|                                                                                                                                                                                                    |       |       |       |                                                      |   |   |
|                                                                                                                                                                                                    |       |       |       | 45,481                                                    |   | 20,362 |
|                                                                                                                                                                                                    |       |       |       |                                                      |   |   |
| PROPERTY AND EQUIPMENT, NET                                                                                                                                                                             |       | 8          |       | 3,937                                                     |   | 3,801 |
|                                                                                                                                                                                                    |       |       |       |                                                      |   |   |
| Total assets                                                                                                                                                                                            |       |       |       | $          67,526 |   | $          77,257 |
|                                                                                                                                                                                                    |       |       |       |                                                      |   |   |
| LIABILITIES AND SHAREHOLDERS` EQUITY                                                                                                                                                                    | ** ** | ** ** | ** ** |                                                      |   |   |
| CURRENT LIABILITIES:                                                                                                                                                                                    |       |       |       |                                                      |   |   |
| Trade payables                                                                                                                                                                                          |       |       |       | $             1,583                                       |   | $      *) 2,479 |
| Other accounts payable and accrued expenses                                                                                                                                                             |       | 9          |       | 2,046                                                     |   | 2,330 |
| Deferred revenue                                                                                                                                                                                        |       |       |       | 1,566                                                     |   | 1,595 |
|                                                                                                                                                                                                    |       |       |       |                                                      |   |   |
| Total current liabilities                                                                                                                                                                               |       |       |       | 5,195                                                     |   | 6,404 |
|                                                                                                                                                                                                    |       |       |       |                                                      |   |   |
| LONG-TERM LIABILITIES:                                                                                                                                                                                  |       |       |       |                                                      |   |   |
| Long-term accounts payable                                                                                                                                                                              |       |       |       | 60                                                        |   | *) 140 |
| Accrued severance pay                                                                                                                                                                                   |       |       |       | 1,997                                                     |   | 1,832 |
| Excess of losses over investment in Evogene                                                                                                                                                             |       | 1b         |       | 466                                                       |   | - |
|                                                                                                                                                                                                    |       |       |       |                                                      |   |   |
| Total current liabilities                                                                                                                                                                               |       |       |       | 2,523                                                     |   | 1,972 |
|                                                                                                                                                                                                    |       |       |       |                                                      |   |   |
| COMMITMENTS AND CONTINGENCIES                                                                                                                                                                           |       | 10         |       |                                                      |   |   |
|                                                                                                                                                                                                    |       |       |       |                                                      |   |   |
| SHAREHOLDERS` EQUITY:                                                                                                                                                                                   |       | 11         |       |                                                      |   |   |
| Share capital:                                                                                                                                                                                          |       |       |       |                                                      |   |   |
| Ordinary shares of NIS  0.01 par value; 50,000,000 shares authorized at December 31, 2003 and 2002, 26,848,474 and 26,162,405 shares issued and outstanding at December 31, 2003 and 2002, respectively |       |       |       | 72                                                        |   | 71 |
| Additional paid-in capital                                                                                                                                                                              |       |       |       | 152,271                                                   |   | 149,982 |
| Deferred stock  compensation                                                                                                                                                                            |       |       |       | (501)                                                     |   | (580) |
| Accumulated deficit                                                                                                                                                                                     |       |       |       | (92,034)                                                  |   | (80,592) |
|                                                                                                                                                                                                    |       |       |       |                                                      |   |   |
| Total shareholders` equity                                                                                                                                                                              |       |       |       | 59,808                                                    |   | 68,881 |
|                                                                                                                                                                                                    |       |       |       |                                                      |   |   |
| Total liabilities and shareholders` equity                                                                                                                                                              |       |       |       | $             67,526                                      |   | $             77,257 |

*)            Reclassified.
| February 4, 2004                              |   |                                                        |   | ** **                               |
|-----------------------------------------------|--------|-------------------------------------------------------------|--------|------------------------------------------|
| Date of approval of the

financial statements |   | Mor Amitai, Ph.D. 

President & Chief Executive Officer |   | Nurit Benjamini

Chief Financial Officer |

The accompanying notes are an integral part of theconsolidated financial statements.

**F -3** 

 
|                                                                                               | ** ** | ** ** | ** ** | **Year ended**                                                      |
|----------------------------------------------------------------------------------------------------|------------|------------|------------|---------------------------------------------------------------------|
|                                                                                               | ** ** |       | ** ** | December 31,                                                        |
|                                                                                               | ** ** | Note       | ** ** | 2003                                                                |   | 2002 |   | 2001 |
|                                                                                               |       |       |       |                                                                |   |   |   |   |
| Revenues:                                                                                          |       | 12         |       |                                                                |   |   |   |   |
| Products and service                                                                               |       |       |       | $             6,776                                                 |   | $             9,262 |   | $          10,366 |
| Research and development grants                                                                    |       |       |       | 2,050                                                               |   | 1,835 |   | 994 |
|                                                                                               |       |       |       |                                                                |   |   |   |   |
| Total revenues                                                                                     |       |       |       | 8,826                                                               |   | 11,097 |   | 11,360 |
|                                                                                               |       |       |       |                                                                |   |   |   |   |
|                                                                                               |       |       |       |                                                                |   |   |   |   |
| Cost of products and services                                                                      |       |       |       | 2,275                                                               |   | 2,819 |   | 3,455 |
| Research and development expenses                                                                  |       |       |       | 13,306                                                              |   | 14,170 |   | 15,976 |
| Selling and marketing expenses                                                                     |       |       |       | 3,811                                                               |   | 5,538 |   | 6,565 |
| General and administrative expenses                                                                |       |       |       | 3,650                                                               |   | 3,614 |   | 4,383 |
|                                                                                               |       |       |       | * *                                                            |   |   |   |   |
| Total operating expenses (*)                                                                       |       |       |       | 23,042                                                              |   | 26,141 |   | 30,379 |
|                                                                                               |       |       |       |                                                                |   |   |   |   |
| Operating loss                                                                                     |       |       |       | (14,216)                                                            |   | (15,044) |   | (19,019) |
| Financial income, net                                                                              |       | 13         |       | 2,112                                                               |   | 2,789 |   | 3,875 |
| Other income                                                                                       |       | 3,14       |       | 662                                                                 |   | - |   | - |
| Minority interest in loss of subsidiary (**)                                                       |       |       |       | -                                                                   |   | 51 |   | - |
|                                                                                               |       |       |       |                                                                |   |   |   |   |
| Net loss                                                                                           |       |       |       | $      (11,442)                                 |   | $      (12,204) |   | $      (15,144) |
|                                                                                               |       |       |       |                                                                |   |   |   |   |
|                                                                                               |       |       |       |                                                                |   |   |   |   |
| Basic and diluted net loss per share                                                               |       |       |       | $          (0.43) |   | $          (0.47) |   | $          (0.58) |
|                                                                                               |       |       |       |                                                                |   |   |   |   |
| Weighted average number  of Ordinaryshares  used in computing basic and diluted net loss per share |       |       |       | 26,409,180                                                          |   | 26,103,343 |   | 26,005,784 |

 

(*)        Includesdeferred stock compensation - see Note 11.

(**)     Reclassified.

 

Theaccompanying notes are an integral part of the consolidated financialstatements.

**F -4** 

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

**stock** | * * | **Accumulated**                                                    | * * | **Total shareholders'**             |
|---------------------------------------------------------------------------------------------------------------------|--------------|-----------------|----------|-----------------------------------------------------|----------|-------------------------|----------|--------------------------------------------------------------------|----------|-------------------------------------|
| * *                                                                                                            | * *     | Number          | * * | Amount                                              | * * | capital                 | * * | compensation                                                       | * * | deficit                             | * * | equity |
| * *                                                                                                            | * *     | * *        | * * | * *                                            | * * | * *                | * * | * *                                                           | * * | * *                            | * * | * * |
| Balance as of December 31, 2000                                                                                     | * *     | 25,981,416      | * * | $        71 | * * | $   150,380   | * * | $       (4,697)                      | * * | $     (53,244)  | * * | $        92,510 |
| Employee options exercised                                                                                          | * *     | 66,968          | * * | *)                                                  | * * | 104                     | * * | -                                                                  | * * | -                                   | * * | 104 |
| Amortization of deferred  stock compensation                                                                        | * *     | -               | * * | -                                                   | * * | -                       | * * | 2,593                                                              | * * | -                                   | * * | 2,593 |
| Compensation relating to  options and warrants issued to scientific advisory board members, consultants  and others | * *     |   -   | * * | -                                                   | * * |   (1)         | * * |   -                                                      | * * |   -                       | * * |   (1) |
| Forfeited options                                                                                                   | * *     | -               | * * | -                                                   | * * | (65)                    | * * | 65                                                                 | * * | -                                   | * * | - |
| Net loss                                                                                                            | * *     | -               | * * | -                                                   | * * | -                       | * * | -                                                                  | * * | (15,144)                            | * * | (15,144) |
|                                                                                                                | * *     | * *        | * * | * *                                            | * * | * *                | * * | * *                                                           | * * | * *                            | * * | * * |
| Balance as of December 31, 2001                                                                                     | * *     | 26,048,384      | * * | 71                                                  | * * | 150,418                 | * * | (2,039)                                                            | * * | (68,388)                            | * * | 80,062 |
| Employee options exercised                                                                                          | * *     | 114,021         | * * | *)                                                  | * * | 161                     | * * | -                                                                  | * * | -                                   | * * | 161 |
| Amortization of deferred  stock compensation                                                                        | * *     | -               | * * | -                                                   | * * | -                       | * * | 1,001                                                              | * * | -                                   | * * | 1,001 |
| Compensation relating to  options and warrants issued to scientific advisory board members, consultants  and others | * *     | -               | * * | -                                                   | * * | (139)                   | * * | -                                                                  | * * | -                                   | * * | (139) |
| Forfeited options                                                                                                   | * *     | -               | * * | -                                                   | * * | (458)                   | * * | 458                                                                | * * | -                                   | * * | - |
| Net loss                                                                                                            | * *     | -               | * * | -                                                   | * * | -                       | * * | -                                                                  | * * | (12,204)                            | * * | (12,204) |
|                                                                                                                | * *     | * *        | * * | * *                                            | * * | * *                | * * | * *                                                           | * * | * *                            | * * | * * |
| Balance as of December 31, 2002                                                                                     | * *     | 26,162,405      | * * | 71                                                  | * * | 149,982                 | * * | (580)                                                              | * * | (80,592)                            | * * | 68,881 |
|                                                                                                                | * *     | * *        | * * | * *                                            | * * | * *                | * * | * *                                                           | * * | * *                            | * * | * * |
| Employee options exercised                                                                                          | * *     | 686,069         | * * | 1                                                   | * * | 1,306                   | * * | -                                                                  | * * | -                                   | * * | 1,307 |
| Deferred stock compensation                                                                                         | * *     | -               | * * | -                                                   | * * | 826                     | * * | (826)                                                              | * * | -                                   | * * | - |
| Amortization of deferred  stock compensation                                                                        | * *     | -               | * * | -                                                   | * * | -                       | * * | 786                                                                | * * | -                                   | * * | 786 |
| Compensation relating to  options and warrants issued to scientific advisory board members, consultants  and others | * *     | -               | * * | -                                                   | * * | 276                     | * * | -                                                                  | * * | -                                   | * * | 276 |
| Forfeited options                                                                                                   | * *     | -               | * * | -                                                   | * * | (119)                   | * * | 119                                                                | * * | -                                   | * * | - |
| Net loss                                                                                                            | * *     | -               | * * | -                                                   | * * | -                       | * * | -                                                                  | * * | (11,442)                            | * * | (11,442) |
|                                                                                                                | * *     | * *        | * * | * *                                            | * * | * *                | * * | * *                                                           | * * | * *                            | * * | * * |
| Balance as of December 31, 2003                                                                                     | * *     | 26,848,474      | * * | $        72 | * * | $    152,271  | * * | $          (501) | * * | $      (92,034) | * * | $          59,808 |

 

 

*)       Represents anamount lower than $1

 

Theaccompanying notes are an integral part of the consolidated financialstatements.

 

**F -5** 

* *
|                                                                                                                | ** ** | Year ended December 31                                 |
|---------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------|
|                                                                                                                | ** ** | 2003                                                   |   | 2002 |   | 2001 |
| Cash flows from operating activities:                                                                               |       |                                                   |   |   |   |   |
| Net loss                                                                                                            |       | $      (11,442)          |   | $      (12,204) |   | $     (15,144) |
| Adjustments required to  reconcile net loss to net cash used in operating activities:                               |       |                                                   |   |   |   |   |
| Capital gain from sale of  BioXL business                                                                           |       | (459)                                                  |   | - |   | - |
| Amortization of deferred  stock compensation                                                                        |       | 786                                                    |   | 1,001 |   | 2,593 |
| Compensation relating to  options and warrants issued to scientific advisory board members, consultants  and others |       | 276                                                    |   | (139) |   | (1) |
| Depreciation                                                                                                        |       | 1,889                                                  |   | 1,897 |   | 1,682 |
| Accrued severance pay,  net                                                                                         |       | (95)                                                   |   | 278 |   | 55 |
| Interest and amortization of premium on marketable  securities                                                      |       | 1,001                                                  |   | 793 |   | 547 |
| Decrease (increase) in trade receivables                                                                            |       | 1,612                                                  |   | *)     (181) |   | *)  (490) |
| Decrease (increase) in  other accounts receivable and prepaid expenses                                              |       | 1,246                                                  |   | *)  (1,241) |   | *)     13 |
| Decrease in inventories                                                                                             |       | 80                                                     |   | 23 |   | 251 |
| Increase (decrease) in trade payables and other  accounts payable and accrued expenses                              |       | (796)                                                  |   | 62 |   | 1,769 |
| Increase (decrease) in  deferred revenue                                                                            |       | 329                                                    |   | 635 |   | (225) |
|                                                                                                                |       |                                                   |   |   |   |   |
| Net cash used in operating activities                                                                               |       | (5,573)                                                |   | (9,076) |   | (8,950) |
|                                                                                                                |       |                                                   |   |   |   |   |
| Cash flows from investing activities:                                                                               |       |                                                   |   |   |   |   |
| Purchase of marketable  securities                                                                                  |       | (39,648)                                               |   | (15,934) |   | (35,547) |
| Proceeds from redemption  of marketable securities                                                                  |       | 17,905                                                 |   | 13,904 |   | 4,379 |
| Proceeds from (purchase  of) short-term and long-term bank deposits                                                 |       | 30,195                                                 |   | 9,241 |   | (29,436) |
| Purchase of property and equipment                                                                                  |       | (2,326)                                                |   | (1,426) |   | (2,765) |
| Increase in lease deposits                                                                                          |       | (2)                                                    |   | (19) |   | (22) |
| Deconsolidation of Evogene (1)                                                                                      |       | (1,400)                                                |   | - |   | - |
| Proceeds from sale of BioXL business                                                                                |       | 126                                                    |   | - |   | - |
|                                                                                                                |       |                                                   |   |   |   |   |
| Net cash provided by  (used in) investing activities                                                                |       | 4,850                                                  |   | 5,766 |   | (63,391) |
|                                                                                                                |       |                                                   |   |   |   |   |
| Cash flows from financing activities:                                                                               |       |                                                   |   |   |   |   |
| Exercise of options                                                                                                 |       | 1,307                                                  |   | 161 |   | 104 |
| Convertible loan in Evogene                                                                                         |       | 2,037                                                  |   | - |   | - |
|                                                                                                                |       |                                                   |   |   |   |   |
| Net cash provided by financing activities                                                                           |       | 3,344                                                  |   | 161 |   | 104 |
|                                                                                                                     |       |                                                   |   |   |   |   |
| Increase (decrease) in  cash and cash equivalents                                                                   |       | 2,621                                                  |   | (3,149) |   | (72,237) |
| Cash and cash equivalents  at beginning of year                                                                     |       | 5,289                                                  |   | 8,438 |   | 80,675 |
|                                                                                                                |       |                                                   |   |   |   |   |
| Cash and cash equivalents at end of year                                                                            |       | $        7,910 |   | $        5,289 |   | $        8,438 |

*)            Reclassified.

 

The accompanyingnotes are an integral part of the consolidated financial statements.

**F -6** 

* *
|                                                                                                                                                               |   | Year ended December 31, 2003                                                  |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|-------------------------------------------------------------------------------|
| (1)   Deconsolidation of  Evogene:                                                                                                                                 |   |                                                                          |
| The Company  deconsolidated Evogene effective July 1, 2003 (see Note 1). Assets and  liabilities of subsidiary previously consolidated at date of deconsolidation: |   |                                                                          |
| Working capital (excluding cash and cash equivalents)                                                                                                              |   | $              56 |
| Property and equipment, net                                                                                                                                        |   | (301)                                                                         |
| Long-term lease deposits                                                                                                                                           |   | (8)                                                                           |
| Accrued severance pay, net                                                                                                                                         |   | 2                                                                             |
| Convertible loan                                                                                                                                                   |   | 2,037                                                                         |
| Long-term accounts payable                                                                                                                                         |   | 80                                                                            |
| Excess of losses over investment in Evogene                                                                                                                        |   | (466)                                                                         |
|                                                                                                                                                               |   | * *                                                                      |
|                                                                                                                                                               |   | $          1,400            |

 

* *

The accompanying notes are an integral part of theconsolidated financial statements.

 

**F -7** 

**NOTE 1:-               GENERAL**

 

a.*                   *Compugen is a genomics-based drug and diagnostic discoverycompany, whose mission is to increase the probability of successful developmentof novel drug and diagnostic products by incorporating ideas and methods frommathematics, computer science, and physics into the disciplines of biology, organicchemistry, and medicine. This capability is used for in-house discovery and forproviding high value products and services to leading biotechnology andpharmaceutical companies (see Note 12 for information regarding majorcustomers). The Company`s headquarters and research facilities are located in Israel,with U.S. operations, through a wholly-owned subsidiary Compugen Inc.("Compugen Inc.") located in Jamesburg, New Jersey, Maryland, and Sunnyvale, California.

 

b.*                  *In 2000 Compugen and certain individuals (the"Founders") reached an understanding as to the formation of anagricultural biology activity ("AgBio"). During the entrepreneurialphase, and until the establishment of a company dedicated to the Agbioactivity, such activity was conducted in house at Compugen.

 

On January 1, 2002, the Company established amajority owned Israeli subsidiary (82% ownership) together with the Founders bythe name of Evogene Ltd. ("Evogene"). Evogene and Compugen enteredinto an Asset Purchase Agreement, whereby certain property and equipment(valued at $286), motor vehicle leasing contracts, patents and intellectualproperty, were transferred, in consideration of the issuance of 1,640,000Ordinary shares of Evogene. In addition, Compugen granted to Evogene a licenseto use its computational tools free of charge until December 31, 2003. In connection with the formation of Evogene, Compugen recorded expenses in theamount of $51. On January 10, 2002, the Company signed a convertible loanagreement with Evogene, pursuant to which, Evogene received an amount of $900from Compugen. 

 

On January 6, 2003, Evogene entered into aconvertible loan agreement with new investors ("the Investors") forthe aggregate amount of $2,000 ("the Transaction"), the initialclosing of the Transaction took place on January 6, 2003. The overalloutstanding loan is convertible at the option of the Investors at any timeprior to the repayment date (as defined below) into Evogene's Preferred Ashares, with certain preferences over Ordinary and Ordinary-1 shares. To theextent that the loan shall not be converted into Evogene's Preferred A shares,Evogene must repay the loan amount plus interest at the rate of 5% per annum on March 31, 2007 ("the repayment date"). The loan shall beautomatically converted into Evogene's Preferred A shares upon: (i) an InitialPublic Offering (ii) a merger, or (iii) an acquisition of all or substantiallyall of the assets of Evogene ("a conversion event"). Compugen did notparticipate in the investment round. Furthermore, Compugen agreed to forgivethe entire outstanding Compugen convertible loan amount and all accruedinterest, to extend the term of the license to use certain computational toolsgranted by it to Evogene until December 31, 2005, and to give the Investors anirrevocable proxy empowering them to vote with 50% of the Company`s holdings inEvogene, subject to adjustments based on the conversion of the loan. As of December 31, 2003 the Company holds 82% of Evogene`s ordinary shares. 

**F -8** 

** **

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

 

Following the Transaction, the Company`s shares inEvogene were converted into Ordinary-1 shares, to allow for certain preferencesover ordinary shareholders, in the case of liquidation or deemed liquidation ofEvogene. In addition, Evogene granted to certain of the Investors options topurchase additional Evogene Preferred A shares. The options are exercisableduring the period commencing on the date of the conversion event andterminating 24 months after such date, unless such conversion event is a mergeror consolidation of Evogene in which Evogene is the surviving entity, in whichcase, the options expire immediately upon the closing of such conversion event.

 

In addition, Compugen is granting certain servicesto Evogene, i.e. accounting, legal etc. for which it is fully reimbursed onarms length basis. During the year ended December 31, 2003 and 2002, services reimbursed by Evogene amounted to $7 and $26, respectively.

 

In January 2003, the FASB issued Interpretation No.46, "Consolidation of Variable Interest Entities" ("FIN46"). The objective of FIN 46 is to improve financial reporting bycompanies involved with variable interest entities. A variable interest entityis a corporation, partnership, trust, or any other legal structure used forbusiness purposes that either (a) does not have equity investors with votingrights or (b) has equity investors that do not provide sufficient financialresources for the entity to support its activities. FIN 46 requires a variableinterest entity to be consolidated by a company if that company is subject to amajority of the risk of loss from the variable interest entity's activities orentitled to receive a majority of the entity's residual returns or both. FIN 46also requires disclosures about variable interest entities that the company isnot required to consolidate but in which it has a significant variableinterest. The consolidation requirements of FIN 46 apply immediately tovariable interest entities created after January 31, 2003. The consolidation requirements apply to older entities in the first fiscal year or interimperiod ending after March 15, 2004. Certain of the disclosure requirementsapply in all financial statements issued after January 31, 2003, regardless of when the variable interest entity was established. 

 

The Company has evaluated the effects of theissuance of the Interpretation in accounting for its ownership interests inEvogene and in July 1, 2003, the Company has deconsolidated Evogene (under theearly implementation provisions), because it believes it is not Evogene'sprimary beneficiary under the Interpretation`s requirements

 

As of December 31, 2003, the Company has excess oflosses over investment in Evogene in the amount of $466.

 

**NOTE 2:-               SIGNIFICANTACCOUNTING POLICIES**

 

The consolidated financial statements have beenprepared in conformity with accounting principles generally accepted in the United  States ("U.S. GAAP"). 

* *

a.*                   *Use of estimates:

 

The preparation of financial statements inconformity with generally accepted accounting principles requires management tomake estimates and assumptions that affect the amounts reported in thefinancial statements and accompanying notes. Actual results could differ fromthose estimates.

**F -9** 

** **

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

 

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

 

The functional currency of the Company, itssubsidiaries and Evogene is the U.S. dollar, as the Company`s managementbelieves that the U.S. dollar is the primary currency of the economicenvironment in which the Company its subsidiaries and Evogene have operated andexpect to continue to operate in the foreseeable future. A majority of theCompany`s sales are made outside Israel in U.S. dollars. The majority of theCompany's and its subsidiaries' operations are currently conducted in Israeland most of the expenses in Israel are currently paid in new Israeli shekels("NIS"); however, most of the expenses are denominated and determinedin U.S. dollars. 

 

Accordingly, monetary accounts maintained incurrencies other than the dollar are remeasured into U. S dollars in accordancewith Statement of the Financial Accounting Standard Board ("SFAS") No. 52"Foreign Currency Translation." All transaction gains and losses ofthe remeasured monetary balance sheet items are reflected in the statement ofoperations as financial income or expenses, as appropriate.

 

c.*                   *Basis of consolidation:

 

The consolidated financial statements include theaccounts of the Company and its wholly-owned subsidiary, Compugen, Inc.Intercompany transactions and balances have been eliminated upon consolidation.Evogene`s results of operations are included in the Company`s consolidatedresults of operations until July 1, 2003, (see note 1b).

 

d.*                  *Cash equivalents:

 

The Company considers all highly liquid investmentsthat are convertible to cash with maturities of three months or less at theiracquisition date as cash equivalents.

 

e.*                   *Short-term bank deposits:

 

Bank deposits with maturities of more than threemonths but less than one year are included in short-term bank deposits. Theshort-term bank deposits are presented at their cost.

 

f.*                    *Marketable securities:

 

The Company accounts for its investments inmarketable securities using SFAS No. 115, "Accounting for CertainInvestments in Debt and Equity Securities."

 

Management determines the appropriateclassification of its investments in marketable debt at the time of purchaseand reevaluates 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 -10** 

** **

**NOTE 2:-               SIGNIFICANTACCOUNTING 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 structured notes inaccordance with the provisions of FASB Emerging Issues Task Force ("EITF")Issue No. 96-12, "Recognition of Interest Income and Balance SheetClassification of Structured Notes", according to which the Company usesthe "Retrospective interest method".

 

g.*                  *Inventories:

 

Inventories are stated at the lower of cost ormarket value. Inventory write-offs are provided to cover risks arising fromslow-moving items, technological obsolescence, discontinued products, and formarket prices lower than cost. To date, the Company`s write-offs have not beenmaterial. In 2003, the Company sold certain inventories and consumed the restfor internal research and development purposes.

 

Cost is determined as follows:

Raw materials, parts and supplies - using the"first-in, first-out" method.

Work-in-progress - represents the cost ofmanufacturing with the addition of allocable indirect costs.

Finished products - on the basis of directmanufacturing costs with the addition of allocable indirect manufacturingcosts.

 

h.*                  *Long-term lease deposits:

 

Long-term lease deposits include long-term depositsas security for facilities and motor vehicles leases.

 

i.*                    *Property and equipment:

 

Property and equipment are stated at cost, net ofaccumulated depreciation. Depreciation is calculated using the straight-linemethod over the estimated useful lives of the assets at the following annualrates:
| * *                                  | %                           |
|-------------------------------------------|-----------------------------|
| * *                                  | * *                    |
| Computers, software and related equipment | 33                          |
| Office furniture and laboratory equipment | 6 - 33                      |
| Leasehold improvements                    | Over the  term of the lease |

 

The long-lived assets of the Company and itssubsidiaries 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 thefuture undiscounted cash flows expected to be generated by the assets.

 

If such assets are considered to be impaired, theimpairment to be recognized is measured by the amount by which the carryingamount of the assets exceeds the fair value of the assets. Through December 31, 2003, no impairment losses have been identified.

**F -11** 

 

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

 

j.*                    *Investment in affiliated companies:

 

In these financial statements, affiliated companiesare companies held to the extent of 20% or more (which are not subsidiaries),where the Company can exercise significant influence over operating andfinancial policies of the affiliate. The investment in affiliated companies isaccounted for by the equity method. Profits on intercompany sales, not realizedoutside the Group, were eliminated.

 

k.*                   *Research and development costs:

 

Research and development costs are charged to thestatement of operations as incurred.

 

SFAS No. 86, "Accounting for the Costs ofComputer Software to be Sold, Leased or Otherwise Marketed", requirescapitalization of certain software development costs subsequent to theestablishment of technological feasibility.

 

Based on the Company's product development process,technological feasibility is established upon completion of a working model.The Company does not incur material costs between the completion of the workingmodel and the point at which the products are ready for general release.Therefore, research and development costs associated with the development ofsoftware products are also charged to the statement of operations as incurred.

 

l.*                    *Revenue recognition:

 

To date, the Company and its subsidiaries havederived most of their revenues from collaborations and license fees forsoftware products. The Company also generates revenues from sales of servicesincluding maintenance, support, customization, professional services,integration and installation as well as the sale of products (OligoLibraries).In addition, the Company recognized revenues from research and developmentgrants (as described below). The Company and its subsidiaries sell theirproducts primarily through their direct sales force and resellers, both of whomare considered end users. 

 

The Company and its subsidiaries recognize softwarelicense revenues in accordance with Statement of Position ("SOP")97-2, "Software Revenue Recognition", as amended and SOP 98-9,"Modification of SOP 97-2, Software Revenue Recognition with Respect toCertain Transactions." SOP 97-2 generally requires revenues earned onsoftware arrangements involving multiple elements to be allocated to eachelement based on the relative fair value of the elements. SOP 98-9 requiresthat revenues be recognized under the "Residual Method" when vendorspecific objective evidence (VSOE) of fair value exists for all undeliveredelements and no VSOE exists for the delivered elements and all revenuerecognition criteria of SOP 97-2, as amended, are satisfied.

**F -12** 

** **

** **

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

 

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 collectibility is probable. 

 

Maintenance and support revenues included in thesearrangements are deferred and recognized on a straight-line basis over the termof the maintenance and support agreement. The VSOE of fair value of theundelivered elements (maintenance, support and professional services) isdetermined based on the price charged for the undelivered element when soldseparately or based on renewal rate.

 

The Company and its subsidiaries license productson either a perpetual or on a term basis. License revenues arising from thesale of perpetual licenses and term licenses for a period longer than one yearare recognized in the accounting period during which the sale took place.License revenue arising from a term license for a period of less than one yearis recognized over the contractual term of the license.

 

Revenues from software license fees that involvecustomization of the Company's software to customer specific specifications,development services, integration and installation are recognized in accordancewith SOP 81-1 "Accounting for Performance of Construction-Type and CertainProduction-Type Contracts", using contract accounting on a percentage ofcompletion method, over the period from signing of the license through tocustomer acceptance in accordance with the "Input Method". The amountof revenue recognized is based on the total license fees under the licenseagreement and the percentage to completion achieved. The percentage to completionis measured by monitoring progress using records of actual time incurred todate in the project compared to the total estimated project requirement, whichcorresponds to 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. As of December 31, 2003, no such estimated losses wereidentified. 

 

The Company believes that the use of the percentageof completion method is appropriate as the Company has the ability to makereasonably dependable estimates of the extent of progress towards completion,contract revenues and contract costs. In addition, contracts executed includeprovisions that clearly specify the enforceable rights regarding services to beprovided and received by the parties to the contracts, the consideration to beexchanged and the manner and terms of settlement. In all cases the Companyexpects to perform its contractual obligations and its licensees are expectedto satisfy their obligations under the contract. 

 

Revenues from sales of products (OligoLibraries)are recognized in accordance with Staff Accounting Bulletin ("SAB")No. 104 "Revenue Recognition in Financial Statements", and EITF No.99-19 "Reporting gross revenues as a principal vs. net as an agent",when delivery has occurred, persuasive evidence of an agreement exists, thevendor`s fee is fixed or determinable, no further obligation exists andcollectability is probable. 

**F -13** 

 

 

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

 

In November 2002, EITF reached a consensus on IssueNo. 00-21, "Revenue Arrangements with Multiple Deliverables." EITF Issue No.00-21 provides guidance on how to account for arrangements that involve thedelivery or performance of multiple products, services and/or rights to useassets. The provisions of EITF Issue No. 00-21 applied to revenue arrangementsentered into in fiscal periods beginning after June 15, 2003. Additionally, companies will be permitted to apply the consensus guidance in this issue to allexisting arrangements as the cumulative effect of a change in accountingprinciple in accordance with Accounting Principal Board ("APB") No. 20,"Accounting Changes". The adoption of EITF Issue No. 00-21 did nothave a material impact upon the Company's financial position, cash flows orresults of operations. 

 

The Company accounts for equity instrumentsreceived in accordance with EITF No.0-08 "Accounting by a Grantee forEquity Instruments to be received in Conjunction with Providing Goods orServices." The Company deems the fair value of the equity instrumentsreceived to date to be minimal and as a result no revenues were recognized.

 

Royalty and non-royalty bearing grants from theGovernment of Israel through the Ministry of Industry and Trade - the Office ofthe Chief Scientist of Israel ("OCS") for funding approved researchand development projects, are recognized as revenues as the related researchand development expenses are incurred. The Company is not obligated to repayany amounts received from the OCS if the research effort is unsuccessful, (SeeNote 10).

 

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

 

m.*                 *Income taxes:

 

The Company and its subsidiaries account for incometaxes in accordance with SFAS No.109, "Accounting for Income Taxes"("SFAS No.109"). This Statement prescribes the use of the liabilitymethod 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.

 

n.*                  *Fair value of financial instruments:

 

The following methods and assumptions were used bythe Company and its subsidiaries in estimating their fair value disclosures forfinancial instruments:

 

The carrying amounts of cash and cash equivalents,short-term bank deposits, trade receivables, and trade payables approximatetheir fair value due to the short-term maturity of such instruments.

**F -14** 

 

** **

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

 

The fair value of marketable securities is based onquoted market prices and does not differ significantly from the carryingamount. (See note 6).

 

o.*                  *Stock-based compensation:

 

The Company has elected to follow APB No. 25"Accounting for Stock Issued to Employees" and FIN No. 44"Accounting for Certain Transactions Involving Stock Compensation" inaccounting for its employee stock option plans. Under APB 25, when the exerciseprice of the Company`s stock options is less than the market price of theunderlying shares on the date of grant, compensation expense is recognized. 

 

The Company applies SFAS No. 123 "Accountingfor Stock Based Compensation" ("SFAS 123") and EITF 96-18"Accounting for Equity Instruments that are Issued to Other than Employeesfor Acquiring, or in Conjunction with Selling, Goods or Services" ("EITF96-18") with respect to options issued to non-employees. SFAS No.123 requires useof an option valuation model to measure the fair value of the options on thedate of grant.

 

The Company adopted the disclosure provisions ofSFAS No. 148, "Accounting for Stock-Based Compensation - transition anddisclosure", which amended certain provisions of SFAS 123 to providealternative methods of transition for an entity that voluntarily changes to thefair value based method of accounting for stock-based employee compensation,effective as of the beginning of the fiscal year. The Company continues toapply the provisions of APB No. 25, in accounting for stock-based compensation.(See also Note 11c).

 

Pro forma information regarding the Company`s netloss and net loss per share is required under SFAS No. 123 and has beendetermined as if the Company had accounted for its employee stock options underthe fair value method prescribed by SFAS No. 123.

 

For the purposes of pro forma disclosure, theestimated fair value of the options is amortized to expenses over the optionsvesting period that is generally four years based on an accelerated method.

 

The fair value of each option granted is estimatedon the date of grant using the Black & Scholes option valuationmodel with the following weighted-average assumptions for 2003, 2002 and 2001:expected life of 2.1, 2.1 and 2.5 years, respectively; dividend yield of 0% forall years; expected volatility of 43%, 74% and 72%, respectively, and risk-freeinterest rate of 1%, 1.25% and 1.75%, respectively.

 

The following table illustrates the effect on netloss and net loss per share, assuming that the Company had applied the fairvalue recognition provision of SFAS No. 123 on its stock-based employeecompensation:

**F -15** 

 

** **

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

 
|                                                       | ** ** | Year ended December 31,                                             |
|------------------------------------------------------------|------------|---------------------------------------------------------------------|
|                                                       | ** ** | 2003                                                                |   | 2002 |   | 2001 |
|                                                       |       |                                                                |   |   |   |   |
| Net  loss as reported                                      |       | $      (11,442)                       |   | $      (12,204) |   | $      (15,144) |
| Deduct  - total stock-based compensation - intrinsic value |       | 786                                                                 |   | 1,001 |   | 2,593 |
| Add  - stock-based compensation - fair value               |       | (2,068)                                                             |   | (3,189) |   | (4,721) |
|                                                       |       |                                                                |   |   |   |   |
| Pro forma net loss                                         |       | $      (12,724)                       |   | $      (14,392) |   | $      (17,272) |
|                                                       |       |                                                                |   |   |   |   |
| Basic and diluted net  loss per share - as reported        |       | $          (0.43) |   | $          (0.47) |   | $          (0.58) |
|                                                       |       |                                                                |   |   |   |   |
| Basic and diluted net  loss per share - pro forma          |       | $          (0.48) |   | $          (0.55) |   | $          (0.66) |

 

p.*                  *Net loss per share:

 

Basic net loss per share is calculated based on theweighted average number of Ordinary shares outstanding during each year.Diluted net loss per share is calculated based on the weighted average numberof Ordinary shares outstanding during each year, plus dilutive potential inaccordance with SFAS No. 128, "Earnings per Share".

 

All outstanding stock options have been excludedfrom the calculation of the diluted net loss per share because all such securitiesare anti-dilutive for all periods presented. The total weighted average numberof shares related to outstanding options excluded from the calculations ofdiluted net loss per share was 4,987,593, 4,969,057 and, 5,212,416 for theyears ended December 31, 2003, 2002 and 2001, respectively.

 

q.*                  *Concentrations of credit risks:

 

Financial instruments that potentially subject theCompany and its subsidiaries to concentrations of credit risk consistprincipally of cash and cash equivalents, short-term bank deposits, marketablesecurities, trade receivables and long-term lease deposits.

 

Cash and cash equivalents, and short-term depositsare invested in major banks in Israel and the United States. Such deposits inthe United States may be in excess of insured limits and are not insured inother jurisdictions. Management believes that the financial institutions thathold the Company`s investments are financially sound and, accordingly, minimalcredit risk exists with respect to these investments. 

 

The trade receivables of the Company and itssubsidiaries are mainly derived from sales to customers located primarily inthe United States, Europe and the Far East (see also Note 12). The Company andits subsidiaries perform ongoing credit evaluations of its customers and todate have not experienced any material losses. An allowance for doubtfulaccounts is determined with respect to specific amounts that the Company andits subsidiaries have determined to be doubtful of collection. 

**F -16** 

 

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

 

The Company`s marketable securities includeinvestments in corporate bonds and U.S. government institutions. Managementbelieves that those corporations are financially sound, the portfolio is welldiversified, and accordingly, minimal credit risk exists with respect to thesemarketable 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.

 

r.*                    *Severance pay:

 

The Company`s liability for severance pay iscalculated pursuant to Israel's Severance Pay Law based on the most recentsalary of the employees multiplied by the number of years of employment, as ofthe balance sheet date. Employees are entitled to one month`s salary for eachyear of 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 laboragreements. The value of the deposited funds is based on the cash surrenderedvalue of these policies, and includes immaterial profits accumulated up to thebalance sheet date.

 

Severance expenses for the years ended December 31,2003, 2002 and 2001 amounted to approximately $395, $724 and $747,respectively.

 

s.*                   *Reclassification:

 

Certain prior year amounts have been reclassifiedto conform to the current year presentation.

 

**NOTE 3:-               BIOACCELERATOR BUSINESS**

 

On July 1, 2003 ("the effective date"),Compugen and Biocceleration Ltd. ("Biocceleration") a companyestablished by one of Compugen`s founders entered into an agreement wherebyBiocceleration bought Compugen`s Bioaccelerator ("BioXL") businessfor cash payments to be paid by way of: (i) quarterly installments during 2003- 2005, and (ii) royalties based on Biocceleration`s revenues during 2006-2010.The transaction was closed on November 26, 2003. The sale of the BioXL businessincludes the transfer to Biocceleration of Compugen`s BioXL related accountsreceivables 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 writtentechnical and marketing materials. With regard to the liabilities under the OCSprogram, which supported the development of the BioXL, Biocceleration shallreimburse Compugen for all royalties paid by Compugen to the OCS in respect ofrevenues that Compugen generated and will continue to generate after theeffective date. In addition, Compugen shall reimburse to Biocceleration allamounts received with respect to revenues related to the BioXL businessgenerated on or after the effective date. In connection with the transaction,Compugen recognized $459 in capital gain included under other income. TheCompany will recognize additional capital gains with each future installmentthat will be paid.

**F -17** 

**NOTE 4:-               CASH AND CASH EQUIVALENTS**
|                                                                                                       | ** ** | December 31,                                                         |
|------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------|
|                                                                                                       | ** ** | 2003                                                                 |   | 2002 |
| Bank deposits in U.S.  dollars (bearing an annual average interest rate of 1.05% and 0.73%,  respectively) |       | $             6,444                                                  |   | $             2,568 |
| Bank deposits in NIS  (bearing an annual average interest rate of 4.6% and 8.77%, respectively)            |       | 608                                                                  |   | 2,400 |
| Cash in banks (current accounts)                                                                           |       | 858                                                                  |   | 321 |
|                                                                                                       |       |                                                                 |   |   |
|                                                                                                       |       | $            7,910 |   | $            5,289 |

** **

#####  NOTE 5:-               SHORT-TERM BANK DEPOSITS

|   | ** ** | December 31, |  
 

** **

2003

 

2002

 
 

 

 

 

 

 
Bank deposits in U.S.  dollars (bearing an annual average interest rate of 4.7%)

 

$                    -

 

$        30,195

** **

**NOTE 6:-               MARKETABLE SECURITIES**

*** ***

*** ***

Amortized

 cost

*** ***

Gross unrealized

 gains

*** ***

Gross unrealized

losses

*** ***

Estimated 

fair value

*** ***

*** ***

December 31,

*** ***

December 31,

*** ***

December 31,

*** ***

December 31,

*** ***

*** ***

2003

*** ***

2002

*** ***

2003

*** ***

2002

*** ***

2003

*** ***

2002

*** ***

2003

*** ***

2002

* *

* *

* *

* *

* *

* *

* *

* *

* *

* *

* *

* *

* *

* *

* *

* *

* *

Corporate bonds

* *

$31,851

* *

$ 30,365

* *

$      260

* *

$      440

* *

$        81

* *

$            -

* *

$ 32,030

* *

$ 30,805

U.S government institutions

* *

6,743

* *

1,493

* *

13

* *

4

* *

4

* *

-

* *

6,752

* *

1,497

Structured notes*

* *

14,006

* *

-

* *

-

* *

-

* *

-

* *

-

* *

14,006

* *

-

* *

* *

* *

* *

* *

* *

* *

* *

* *

* *

* *

* *

* *

* *

* *

* *

* *

* *

* *

$52,600

* *

$  31,858

* *

$      273

* *

$      444

* *

$        85

* *

$            -

* *

$  52,788

* *

$  32,302

 

As of December 31, 2003 and 2002, all the Company'ssecurities were classified as held-to-maturity.

 

In 2003 and 2002 the Company did not sell anysecurities prior to their maturity and accordingly, did not realize any gainsor losses on held-to-maturity securities in these years.

 

Company`s management believes that the unrealizedlosses are considered temporary as the decline per bond is consideredinsignificant. In addition, the unrealized losses are in continuous positionfor a period not more than twelve months.

 

The scheduled maturities of held-to-maturitysecurities at December 31, 2003 are as follows:

** **

** **

**Amortized**

** **

**Estimated**

** **

** **

cost

** **

fair value

Held-to-maturity:

 

 

 

 

 

 

 

 

 

Due  within one year

 

$            8,797

 

$            8,931

Due  after one year through four years

 

43,803

 

43,857

 

 

 

 

 

 

 

$          52,600

 

$          52,788
****F -18** **
** **

**NOTE 6:-               MARKETABLE SECURITIES (Cont.)**

 

*)                During 2003, the Company investedin three structured notes at par value totaling $14 million, maturing in July2006, August 2006 and June 2007. The notes were acquired from separateunaffiliated issuers and were categorized as held-to-maturity under thearrangement with the banks, whether or not the investments bear interestdepends upon the rate for six-months LIBOR. The issuers have the right to callthe structured notes. For each day on which the six-months dollar LIBOR isbelow an agreed annual fixed rate, the investments bear coupon interest at therate of 3.15%, 3.625% and 4.1% per annum, respectively. On all other days, theinvestments do not bear any interest at all. The balance as of December 31,2003, includes accrued interest of approximately $66. The notes were accountedfor in accordance with the provisions of EITF Issue No. 96-12,"Recognition of Interest Income and Balance Sheet Classification ofStructured Notes." 

 
 NOTE 7:-               OTHER ACCOUNTS RECEIVABLE AND PREPAID EXPENSES
 

 

 

December 31, 

 

 

2003

 

2002

 

 

 

 

 

Accrued  interest on deposits

 

$                4

 

$          1,661

Grants  receivable from the Office of the Chief Scientist

 

317

 

392

Government  authorities

 

226

 

176

Employee  loans

 

44

 

46

Prepaid  expenses and other

 

554 

 

 *) 432

 

 

 

 

 

 

 

$          1,145

 

$          2,707

 

*) Reclassified.

 
 NOTE 8:-               PROPERTY AND EQUIPMENT
 

 

December 31,

 

 

2003

 

2002

 

 

 

 

 

Cost

 

 

 

 

Computers,  software and related equipment

 

$          7,907

 

$          7,031

Laboratory equipment and office furniture

 

3,666

 

2,622

Leasehold  improvements

** **

507

 

622

 

 

 

 

 

 

 

12,080

 

10,275

Accumulated  Depreciation

 

 

 

 

Computers,  software and related equipment

 

6,358

 

5,202

Laboratory equipment and office furniture

 

1,576

 

1,098

Leasehold  improvements

** **

209

 

174

 

 

 

 

 

 

 

(8,143)

 

(6,474)

 

 

 

 

 

Depreciated  cost

 

$            3,937

 

$            3,801

 

**F -19** 

 

** **

**NOTE 8:-               PROPERTY AND EQUIPMENT (Cont.)**

 

For the years ended December 31, 2003, 2002 and2001, depreciation expenses were approximately $1,889, $1,897 and $1,682,respectively.

 

**NOTE 9:-               OTHER ACCOUNTS PAYABLE AND ACCRUEDEXPENSES**

*** ***

 

 

December 31,

 

 

2003

 

2002

 

 

 

 

 

Employees  and related accruals

 

$          1,323

 

$            1,358

Other  accrued expenses

 

723

 

  972

 

 

 

 

 

 

 

$          3,629

 

$            4,809

** **

**NOTE 10:-            COMMITMENTS AND CONTINGENCIES**

 

a.*                   *The Company`s research and development efforts have beenpartially financed through both royalty bearing and non-royalty bearingprograms sponsored by the Office of the Chief Scientist of Israel("OCS"). Under the royalty bearing programs, the Company is notobligated to repay any amounts received from the OCS if the research programthat such grant relates to is unsuccessful. If the research program issuccessful, the Company is committed to pay royalties at a rate of 3% to 5% ofsales of the products arising from such research program, up to a maximum of100% of the amount received linked to the $ US (for grants received underprograms approved subsequent to January 1, 1999, the maximum to be repaid is100% plus interest at LIBOR).

 

For the years ended December 31, 2003, 2002 and2001, the Company has paid and accrued royalties to the OCS in the amount of$58, $40 and $49, respectively. As of December 31, 2003, the Company`scontingent obligation for royalties, based on royalty-bearing Governmentparticipation received or accrued, net of royalties paid or accrued, totaledapproximately $2,909. The liability for royalties to the OCS is recorded ascost of revenues at the time the related royalty-bearing sales are recognizedas revenues in the statement of operations.

 

b.*                  *The Company`s headquarters and research facilities arelocated in Israel. The Company`s U.S. operations are located in Jamesburg, NewJersey, Maryland, and Sunnyvale, California. Annual minimum future rentalcommitments under non-cancelable operating leases for such facilities as wellas operating lease agreements for motor vehicles are approximately as follows:

 

December 31, 

 

 

2004

 

$             657

2005

 

601

2006

 

601

 

 

 

 

 

$          1,859

 

Rent expenses were approximately $557, $675 and$1,020 for the years ended December 31, 2003, 2002 and 2001, respectively.

**F -20** 

 

 

**NOTE 11:-            SHAREHOLDERS` EQUITY**

 

a.*                   *Ordinary shares:

 

The Ordinary shares confer upon their holders theright to receive notice to participate and vote in general shareholdersmeetings of the Company and to receive dividends, if declared.

 

b.*                  *Public offering:

 

The Company's shares are listed for trade on theNASDAQ National Market and on the Tel-Aviv Stock Exchange.

 

c.*                   *Share option plans:

 

In September 1996, the Company adopted the CompugenLtd. Employee Share Option Plan, (1996) ("the Plan"), which providesfor the grant of options to purchase 559,750 Ordinary shares to employees andconsultants of the Company and its subsidiaries. The Company does not intend togrant additional options under this plan.

 

In June 1998, the Company adopted the Compugen Ltd.Share Option Plan (1998) ("the 1998 Plan"), which provides for thegrant of options 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 vestover a four-year period and expire 10 years from the date of issuance. Theexercise price of the options granted under the plans may not be less than thenominal amount of the shares into which such options are exercised. Any optionsthat are cancelled or forfeited before expiration become available for futuregrants. Subject to the 1998 and 2000 plans, there were 638,021 and 686,750options to purchase shares available for future grants as of December 31, 2003,respectively.

 

Transactions related to the grant of options toemployees, directors and consultants under the above plans during the yearsended December 31, 2003, 2002 and 2001, were as follows:

 

**F -21** 

 

**NOTE 11:-SHAREHOLDERS' EQUITY (Cont.)**

 

 

 

Year ended December 31,

 

 

2003

 

2002

 

2001

 

 

Shares

 

Weighted average  exercise price 

 

Shares

 

Weighted average  exercise price 

 

Shares

 

Weighted average  exercise price 

 

 

 

 

$

 

 

 

$

 

 

 

$

 

 

 

 

 

 

 

 

 

 

 

 

 

Options outstanding at the beginning of the  year

 

4,934,057

 

3.65

 

4,877,416

 

3.71

 

3,446,916

 

3.66

Options granted

 

1,216,500

 

3.65

 

1,416,019

 

3.50

 

1,828,500

 

4.16

Options exercised

 

      (686,069)

 

1.91

 

(114,022)

 

1.41

 

(66,968)

 

1.64

Options forfeited

 

  (511,895)

 

4.68

 

(1,245,356)

 

4.18

 

(331,032)

 

6.04

 

 

 

 

 

 

 

 

 

 

 

 

 

Options outstanding at the end of the year

 

4,952,593

 

3.78

 

4,934,057

 

3.65

 

4,877,416

 

3.71

 

 

 

 

 

 

 

 

 

 

 

 

 

Exercisable at end of year

 

2,883,872

 

3.78

 

2,664,721

 

3.34

 

2,095,792

 

2.53

 

 

 

 

 

 

 

 

 

 

 

 

 

Weighted average fair value of options granted at fair market value 

 

 

 

1.36

 

 

 

1.49

 

 

 

1.68

Weighted average fair value of options granted below fair market  value 

 

 

 

2.74

 

 

 

-

 

 

 

-

 

The following table summarizes information aboutoptions outstanding at December 31, 2003:

 

 

 

Options outstanding

 

Options exercisable

Range of exercise price

 

Number outstanding at December 31, 2003

 

Weighted-average remaining contractual life

 

Weighted-average exercise price

 

Number outstanding at December 31, 2003

 

Weighted-average exercise price

$

 

 

 

Years

 

$

 

 

 

$

1.33 - 1.80

 

1,178,722

 

5.91

 

1.53

 

912,242

 

1.52

2.03 - 2.38

 

752,667

 

7.01

 

2.32

 

242,454

 

2.22

3.00 - 4.86

 

1,742,708

 

7.14

 

4.21

 

1,005,251

 

4.21

5.00 - 6.88

 

1,013,309

 

7.75

 

5.36

 

490,905

 

5.39

9.00 - 10.00

 

265,187

 

5.34

 

9.08

 

233,020

 

9.07

 

 

 

 

 

 

 

 

 

 

 

 

 

4,952,593

 

 

 

3.78

 

2,883,872

 

3.78

 

**F -22** 

** **

**NOTE 11:****-****SHAREHOLDERS'EQUITY (Cont.)**

 

Compensation expenses which are amortized over thevesting period and recognized by the Company, related to its employeestock-based compensation awards, amounted to $786, $1,001 and $2,593 for theyears ended December 31, 2003, 2002 and 2001, respectively. Compensationexpenses (income) related to the granting of stock options to consultantsamounted to $276, $(139) and $(1) for the years ended December 31, 2003, 2002and 2001, respectively (see also d below), and are included in the followingexpense categories:

 

 

Year ended December 31,

 

 

2003

 

2002

 

2001

 

 

 

 

 

 

 

Cost of  revenues

 

$                    -

 

$              (29)

 

$                (11)

Research and  development expenses

 

308

 

621

 

1,636

Selling and  marketing expenses

 

79

 

197

 

510

General and  administrative expenses

 

675

 

73

 

457

 

 

 

 

 

 

 

 

 

$            1,062

 

$              862

 

$              2,592

 

d.*                  *Options to consultants:

Issuance date

 

In connection with

 

Number of options granted

 

Options exercisable

 

Exercise price per share

 

Exercisable through

* *

 

* *

 

 

 

* *

 

**$**

 

 

October 1998

 

Advisory board

 

30,000

 

30,000

 

1.33

 

October 2008

July 1999

 

Advisory board

 

15,000

 

15,000

 

1.35

 

July 2009

October 1999

 

Advisory board

 

30,000

* *

30,000

 

1.33

 

October 2009

July 1999

 

Consulting

* *

150,000

* *

150,000

 

1.35

 

July 2009

March 2000

 

Consulting

* *

75,000

* *

70,335

* *

5.00

 

March 2010

May 2000

* *

Consulting

* *

10,000

* *

9,792

* *

3.00

 

May 2010

May 2000

* *

Consulting

* *

35,000

 

35,000

* *

10.00

 

May 2005

January 2002

* *

Consulting

* *

20,000

 

14,591

* *

4.49

 

January 2012

July 2003

* *

Consulting

* *

150,000

 

34,373

* *

2.38

 

July 2009

* *

* *

* *

* *

* *

 

* *

* *

* *

 

 

* *

* *

* *

* *

515,000

 

389,091

* *

 

 

 

 

The Company accounts for its options and warrantsto consultants under the fair value method of SFAS No. 123 and EITF 96-18. Thefair value of these options was estimated using a Black-Scholes option-pricingmodel with the following weighted-average assumptions for 2003 risk-freeinterest rates of 3%, dividend yields of 0%, volatility factors of the expectedmarket price of the Company's Ordinary shares of 43%, and a weighted-averageexpected life of the options of six years. Changes in the fair value of theoptions and warrants prior to completion of performance are reflected as anadjustment to the expense to be included in future periods over the vestingperiod. As for compensation expenses, see also c above.

**F -23** 

**NOTE 12:-            GEOGRAPHIC INFORMATION AND MAJORCUSTOMERS**

 

The Company`s business iscurrently comprised of one operating segment, the research, development andcommercialization of products and services in the field of computationalgenomics and proteomics. The nature of the products and services provided bythe Company and the type of customers for these products and services aresimilar. Operation in Israel and the United States include research anddevelopment, sales and business development. Total revenues are attributed togeographic areas based on the location of the end customer. The Company followsSFAS No. 131 "Disclosures About Segments of an Enterprise and RelatedInformation."

 

The following represents the total revenues for theyears ended December 31, 2003, 2002 and 2001 and long-lived assets as of December 31, 2003, 2002 and 2001:

 

* *

Year ended December 31, 

 

* *

2003

 

2002

 

2001

Revenues from sales to unaffiliated customers:

* *

 

 

 

 

 

United States

 

$          4,497

 

$             6,273

 

$          7,061

Europe

 

2,118

 

1,822

 

2,235

Far East

 

50

 

680

 

875

Israel

 

36

 

13

 

90

Other

 

82

 

474

 

105

 

 

 

 

 

 

 

 

 

6,776

 

9,262

 

10,366

Revenues  from research and development grants

 

2,050

 

1,835

 

994

Total  revenues

 

$          8,826

 

$        11,097

 

$        11,360

* *

 

* *

December 31, 

 

* *

2003

 

2002

 

2001

Long-lived  assets:

 

 

 

 

 

 

    Israel

 

$        3,482

 

$             3,145

 

$            3,249

    United    States 

 

455

 

656

 

1,023

 

 

 

 

 

 

 

 

 

$          3,937

 

$             3,801

 

$            4,272

* *

 

* *

Year ended December 31, 

 

* *

2003

 

2002

 

2001

 

 

%

 

%

 

%

Sales to a  single customer exceeding 10%:

 

 

 

 

 

 

    Customer A

 

(*)

 

14

 

30

    Customer B

 

(*)

 

(*)

 

17

    Customer C

 

31

 

18

 

17

    Customer D

 

-

 

12

 

-

   Customer E

 

21

 

-

 

-

 

(*)   Less than 10%.

**F -24** 

** **
 NOTE 13:-            FINANCIAL INCOME
*** ***

 

 

Year ended December 31,

 

 

2003

 

2002

 

2001

Income (expense):

 

 

 

 

 

 

Interest income

 

$             2,027

 

$             3,262

 

$             4,253

Interest expense and bank fees

 

(71)

 

(48)

 

(30)

Exchange rate differences

 

156

 

(425)

 

(348)

 

 

 

 

 

 

 

 

 

$             2,112

 

$             2,789

 

$             3,875

 

**NOTE 14:-            TAXES ON INCOME**

 

a.*                   *Measurement of taxable income under the Income Tax(Inflationary Adjustments) Law, 1985:

 

Results for tax purposes are measured in terms ofearnings in NIS after certain adjustments for increases in Israel's ConsumerPrice Index ("CPI"). As explained in Note 2b, the financialstatements are measured in U.S. dollars. The difference between the annualchange in Israel's CPI and in the NIS/dollar exchange rate causes a furtherdifference between taxable income and the income before taxes shown in thefinancial statements. In accordance with paragraph 9(f) of SFAS No. 109, theCompany has not provided deferred income taxes on the difference between thefunctional currency and the tax bases of assets and liabilities.

 

b.*                  *Tax benefits under the Law for the Encouragement ofCapital Investments, 1959 ("the Law"):

 

In 1994 the production facilities of the Companyrelated to its computational technologies were granted the status of an"Approved Enterprise" under the Law. In 1996 and 2000, two expansionprograms related to the Company's computational technologies were granted thestatus of "Approved Enterprise". In 1999 and 2003, the productionfacilities of the Company related to the Company`s molecular biology "wetlab" and manufacturing of seed species were granted the status of an"Approved Enterprise".

 

According to the provisions of the Law, the Companyhas chosen to enjoy the "Alternative Benefits" track and,accordingly, its income from the "Approved Enterprise" is tax-exemptfor a period of two years, commencing in the first year the Company has taxableincome, and subject to an additional period of five to eight years of reducedtax rates between 10% to 25%, depending upon the proportion of foreignownership in the Company in each tax year. Due to the reported losses, thebenefit period has not commenced. The period of tax benefits is subject tolimits of the earlier of 12 years from the commencement of production, or 14years, from the approval date. Given the aforementioned conditions, the periodof tax benefits will terminate 2008 and 2017.

 

**F -25** 

** **

**NOTE 14:-            TAXESON INCOME (Cont.)**

 

The entitlement to the above benefits isconditional upon the Company's fulfilling the conditions stipulated by the aboveLaw, regulations published thereunder and the letters of approval for thespecific investments in "Approved Enterprises". In the event offailure to comply with these conditions, the benefits may be canceled and theCompany may be required to refund the amount of the benefits, in whole or inpart including interest.

 

As of December 31, 2003, management believes thatthe Company is meeting all of the aforementioned conditions.

 

In the event of a distribution of cash dividendsfrom income that is tax-exempt as mentioned above, the Company would have topay income tax equal to 10% to 25% of the amount distributed. The tax-exemptincome attributable to the "Approved Enterprise" can be distributedto shareholders without subjecting the Company to taxes only upon the completeliquidation of the Company. The Company currently has no plans to distributedividends and intends to retain future earnings to finance the development ofits business.

 

Should the Company derive income from sources otherthan the "Approved Enterprise" during the relevant period ofbenefits, such income will be taxable at the regular corporate tax rate of 36%.

 

In addition, in December 2003 the productionfacilities of the Company related to its Chemistry Division were granted thestatus of an "Approved Enterprise" under the Law.  TheCompany has chosen the "grants" track, according to which the totalapproved investments amounted to $3,500, and the investment grants will be 24%from its investments in the approved enterprises. The Company is required tocommence investing until December 2005, in order to benefit from the program.

 

c.*                   *Tax benefit under the Law for the Encouragement ofIndustry (Taxation), 1969:

 

The Company is currently qualified as an"industrial company" under the above law and as such is entitled tocertain tax benefits, including accelerated depreciation and deduction ofpublic offering expenses in three equal installments.

 

d.*                  *Net operating losses carryforwards:

 

Compugen Ltd. has a tax loss carryforward resultingfrom the years up to and including 2003 amounting to approximately $47 million,which may be carried forward indefinitely. 

Compugen Inc. is subject to U.S. income taxes andhas a loss carryforward resulting from the years up to and including 2003amounting to approximately $13 million, which expires in the years 2012 to2023.

 

Utilization of the U.S. net operating losses may besubject to substantial annual limitation due to the "change inownership" provisions of the Internal Revenue Code of 1986 and similarstate provisions. The annual limitation may result on the expiration of netoperating losses before utilization.

**F -26** 

** **

**NOTE 14:-            TAXESON INCOME (Cont.)**

 

e.*                   *Loss before taxes is comprised as follows:

 

 

Year ended December 31,

 

 

2003

 

2002

 

2001

 

 

 

 

 

 

 

Domestic (Israel)

 

$          10,173

 

$             7,532

 

$             9,627

Foreign

 

1,269

 

4,672

 

5,517

 

 

 

 

 

 

 

 

 

$          11,442

* *

$          12,204

* *

$          15,144

 

f.*                    *Deferred taxes:

 

The Company and its subsidiaries' deferred taxassets amounted to approximately $15,333 and $14,200 as of December 31, 2003and 2002, respectively and are comprised of operating loss carryforwards,non-cash dividends related to convertible preferred shares and other temporarydifferences, mainly reserves and allowances.

 

As of December 31, 2003 and 2002, the Company andits subsidiaries have provided valuation allowances of approximately $15,333and $14,200, respectively, in respect of deferred tax assets resulting fromoperating loss carryforwards, non-cash dividend related to convertiblepreferred shares and other temporary differences. For the years ended December 31, 2003, the valuation allowance increased by $1,133.

 

Management currently believes that since theCompany and its subsidiary have a history of losses it is more likely than notthat the deferred tax regarding the loss carryforwards and other temporarydifferences 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 the statutorytax rate of the Company and the effective tax rate are the non-recognition oftax benefits from accumulated net operating losses carry forward among thevarious subsidiaries due to the uncertainty of the realization of such taxbenefits and the effect of approved enterprise.

 

h.*                  *The State of New Jersey enacted legislationpermitting emerging technology and/or biotechnology companies located in New  Jersey to sell their New Jersey Net Operating Loss ("NOL")Carryover and Research and Development Tax Credits ("R&DCredits") to corporate taxpayers in New Jersey. During 2003, the State of New  Jersey approved the total tax benefit in the amount of $645 for possible saleby the Company. In December 2003, the Company received $218 from the sale of anaggregate of $254 tax benefit, which was recognized as other income for thefiscal year 2003. The Company will attempt to sell the remaining balance of itstax benefits in the amount of approximately $391 during 2004, subject to allexisting laws of the State of New Jersey. However, there is no assurance thatthe Company will be able to find a buyer for its tax benefits or that suchfunds will be available in a timely manner.

**F -27** 

 

**NOTE 15:-            RELATEDPARTY TRANSACTIONS**

 

 

 

Year ended December 31,

 

 

2003

 

2002

 

2001

 

 

 

 

 

 

 

Consulting fees to director and  shareholder

 

$             -

 

$             150

 

$             165

 

Evogene Ltd. - see Note 1b.

 

 

**NOTE 16:-            SUBSEQUENT EVENTS (UNAUDITED)**

 

In February 2004, Evogene and the Investors (seeNote 1b) entered into an amended and restated convertible loan agreement, underwhich the amount of the convertible loan was increased by additional $1,551.Compugen did not participate in this financing round. Under this transaction,the Investors received additional warrants to purchase shares of Evogene. 

 

**F -28**  |
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