SECURITIES AND EXCHANGE COMMISSION

**WASHINGTON, D.C. 20549**

**FORM 20-F**

 

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

**THE SECURITIES EXCHANGE ACT OF 1934**

 

FOR THE FISCAL YEAR ENDED DECEMBER 31, 2005      

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:**

Ordinary Shares, par value NewIsraeli 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: 

27,846,420 Ordinary 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 OFCONTENTS**

 

PART I. 4

ITEM 1.        IDENTITYOF DIRECTORS, SENIOR MANAGEMENT AND ADVISORS  4

ITEM 2.        OFFERSTATISTICS AND EXPECTED TIMETABLE  4

ITEM 3.        KEYINFORMATION   4

ITEM 4.        INFORMATIONON THE COMPANY   18

ITEM 5.        OPERATINGAND FINANCIAL REVIEW AND PROSPECTS  30

ITEM 6.        DIRECTORS,SENIOR MANAGEMENT AND EMPLOYEES  43

ITEM 7.        MAJORSHAREHOLDERS AND RELATED PARTY TRANSACTIONS  52

ITEM 8.        FINANCIALINFORMATION   55

ITEM 9.        THEOFFER AND LISTING   56

ITEM 10.      ADDITIONALINFORMATION   57

ITEM 11.      QUANTITATIVE ANDQUALITATIVE DISCLOSURES ABOUT MARKET RISK   70

ITEM 12.      DESCRIPTIONOF SECURITIES OTHER THAN EQUITY SECURITIES  70

PART II 71

ITEM 13.      DEFAULTS,DIVIDEND ARREARAGES AND DELINQUENCIES  71

ITEM 14.      MATERIAL MODIFICATIONS TOTHE RIGHTS OF SECURITY HOLDERS AND USE OF PROCEEDS  71

ITEM 15.      CONTROLSAND PROCEDURES  71

ITEM 16.      RESERVED   71

ITEM 16A.   AUDITCOMMITTEE FINANCIAL EXPERT   71

ITEM 16B.    CODEOF ETHICS  71

ITEM 16C.    PRINCIPALACCOUNTANT FEES AND SERVICES  72

PART III 73

ITEM 17.      FINANCIALSTATEMENTS  73

ITEM 18.      FINANCIALSTATEMENTS  73

ITEM 19.      EXHIBITS  73

 

**__2__** 

 

**CAUTIONARYSTATEMENT REGARDING**

**FORWARD-LOOKINGSTATEMENTS**

 

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

 

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

 

‐‐‐‐‐‐‐‐‐‐‐‐

 

We have prepared our consolidated financialstatements in United States dollars and in accordance with 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

 

Not applicable.

### ITEM2.              OFFER STATISTICS AND EXPECTED TIMETABLE

 

Not applicable.

### ITEM3.              KEY INFORMATION

 

**Selected Financial Data******

 
| ** **

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

****                                                                                                           |  

2001*                                                     |  

2002* |  

2003* |  

2004* |  

2005 |
|                                                                                                                       | **($ in thousands, except share and per share  data)**            |
| **Consolidated  Statements of Operations Data**                                                                            |                                                              |   |   |   |   |
| Revenues                                                                                                                   | $       10,366                      | $          9,262 | $          6,776 | $          2,630 | $              646 |
| Total  operating expenses **                                                                                               |  

29,385                                                    |  

24,306 |  

20,992 |  

18,207 |  

15,524 |
| Operating  loss                                                                                                            | (19,019)                                                          | (15,044) | (14,216) | (15,577) | (14,878) |
| Financial  income, net                                                                                                     | 3,875                                                             | 2,789 | 2,112 | 1,417 | 682 |
| Net  loss available to ordinary shares                                                                                     |  

(15,144)                                                  |  

(12,204) |  

(11,442) |  

(13,722) |  

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

$          (0.58) |  

$          (0.47) |  

$          (0.43) |  

$          (0.50) |  

$          (0.50) |
| Weighted  average number of ordinary shares used in computing basic and diluted net  loss per share                        |  

 

 

26,005,784                                |  

 

 

26,103,343 |  

 

 

26,409,180 |  

 

 

27,473,341 |  

 

 

27,774,535 |
| **Consolidated  Balance Sheet Data**                                                                                       |                                                              |   |   |   |   |
| Cash  and cash equivalents, short-term bank deposits, marketable securities and  cash held in favor of consortium partners |  

 

 

$32,347                                   |  

 

 

$48,402 |  

 

 

$16,707 |  

 

 

$20,574 |  

 

 

**{** $31,821 |
| Long-term  investments in marketable securities and bank deposits                                                          |  

 

46,148                                            |  

 

18,940 |  

 

43,803 |  

 

27,854 |  

 

4,983 |
| Total  assets                                                                                                              | 87,289                                                            | 77,257 | 67,526 | 55,353 | 42,106 |
| Accumulated  deficit                                                                                                       | (68,388)                                                          | (80,592) | (92,034) | (105,756) | (119,734) |
| Total  shareholders' equity                                                                                                | 80,062                                                            | 68,881 | 59,808 | 49,566 | 36,248 |

 

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

 

(**)     Includesdeferred stock compensation - see Note 11 of our 2005 consolidated financialstatements.

** **

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

 

**__4__** 

**Risk Factors**

 

Many factors could affect our financial condition, cash flows andresults of operations. We are subject to various risks resulting from changingeconomic, political, social, industry, business and financial conditions. Theprincipal 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 $11.4million in 2003, $13.7 million in 2004 and $14 million in 2005. As of December 31, 2005, we had an accumulated deficit of approximately $94.8 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 in the future due in partto the costs and expenses associated with our research and developmentactivities. We cannot assure you that we will ever achieve profitability. Evenif 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 and development activities, and we maynever be able to achieve profitability.**

** **

We discover and carry out early stage developmentof therapeutic and diagnostic product candidates. Product candidates aremolecules that we discover and identify as having a potential therapeutic ordiagnostic application. In 2005, we allocated a substantial portion of our cashand other resources to our discovery and development activities and we intendto continue to do so. To date, these activities have generated only negligiblerevenues. These activities may never generate significant revenues and we maynever achieve profitability. 

 

In December 2005, we underwent a re-organization inorder to focus our resources on our research and development and on ourcommercialization goals. Nevertheless, we do not anticipate that we will achieveprofitability in the near future. We expect that we will need additional fundsto continue financing our discovery and development and commercializationactivities. If we are unable to obtain the required additional financing,whether internally or from third parties, on commercially reasonable terms, wemay have to curtail or cease our discovery and development activities, and ourbusiness will likely be materially harmed.

 

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

** **

As of December 31, 2005, we had cash and cashequivalents, short-term marketable securities and cash held in favor ofconsortium partners of approximately $32 million, and long-term marketablesecurities of approximately $5 million. Based on our current projections andfollowing our re-organization in December 2005, we anticipate that our existingcash and cash equivalents, and short-term and long-term marketable securitieswill be sufficient to support our operations for at least the next two years.We expect that we will need to raise additional capital within the next twoyears. 

 

However, we cannot assure you that we would be ableto raise sufficient additional capital on favorable terms, if at all. If weraise additional capital by issuing equity securities, we expect that ourshareholders will experience dilution of their shareholdings. In December 2005,as part of a re-organization that we underwent, we curtailed certain of ouractivities that we determined not to directly support the achievement of ourcurrent corporate goals. If we fail to raise sufficient funds, we will likelyhave to further curtail or cease activities, which would materially harm ourbusiness and financial results. 

 

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

 

We receive research and development grants from theOffice of the Chief Scientist of the Israeli Ministry of Industry, Trade andLabor, from the Israel-U.S. Bi-national Industrial Research and DevelopmentFoundation and from the European Community, under the European Union`s 6thFramework Program. Our entitlement to receive these grants is dependent on,among other things, our compliance with the various grants` respective termsand conditions. In addition, the total value of grants that the Office of theChief Scientist makes available generally, and to each individual grantee, hadgradually decreased in recent years.

 

**__5__** 

If we do not comply with these terms and conditionsor if we do not succeed in obtaining these grants in the future, or if we willbe able to obtain only a reduced amount of grants, our business and financialresults may be materially harmed, and we may have to restrict or ceaseoperations. 

 

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

 

In 2004, we turned ourchemistry division, which was engaged in small-molecule drug discovery, into awholly-owned subsidiary, Keddem Bioscience Ltd. The transaction was effected byus transferring to Keddem Bioscience all of our assets and liabilities thatwere dedicated to the operation of our chemistry division. In connection withthis transaction, we agreed to loan to Keddem Bioscience $1,572,000. InNovember 2005, our board of directors also agreed to assign to KeddemBioscience what was at the time our entitlement to receive (and which we sincereceived) from the Investment Center of the Israeli Ministry of Industry, Tradeand Labor, an amount of approximately$400,000, on account of our investment in the expansion of, what was at thetime, our computational chemistry facilities and the building of a chemistrylaboratory for drug discovery. Pursuant to our board of directors` decision,Keddem Bioscience received the amount of approximately $400,000. We currentlyseek to raise third party funding for Keddem Bioscience. The continuation ofKeddem Bioscience`s operations depends on raising additional capital in orderto continue its operations. Keddem Bioscience`s external auditors have raisedsubstantial doubts on Keddem Bioscience`s ability to continue as a goingconcern. 

 

If Keddem Biosciencefails to raise additional capital in the next few months, it will likelyneed to cease its operations. If so, our investmentsin Keddem Bioscience will be lost, and this is likely to harm our financialresults. 

 

**The revision of SFAS No. 123, which will requireus to record employee stock-based compensation expense in connection withequity share based compensation, may significantly increase our financiallosses.**

 

On December 16, 2004, the Financial AccountingStandards Board (FASB) issued Statement No. 123 (revised 2004), entitled"Share-Based Payment", relating to accounting for stock-based compensation.SFAS No. 123 previously permitted stock-based payments to employees to berecognized based on their fair values, and following the revision, as of January 1, 2006, this permissive standard became a mandatory requirement. SFAS No. 123also revised, among other parameters, the measuring of fair value, classifyingan award as equity or as a liability and attributing compensation cost toreporting periods. Stock-based compensation is a tool at our disposal by whichwe are able to encourage our employees to achieve success and remain in ouremploy.

 

As a result of the revisions to SFAS No. 123,commencing in 2006, we will be required to record an expense in relation tostock-based compensation that we provide to our employees, and this expense mayincrease commensurate with, among other parameters, an increase in our shareprice and number of options granted. As a result of the provision of suchcompensation, our financial results could be materially harmed. If we seek tolimit this harm, our ability to continue to provide to our employeesstock-based compensation may be curtailed, which could hurt our ability torecruit or retain employees, and as a result our business may be materiallyharmed. 

 

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

*** ***

**Our approach of incorporating ideas and methods frommathematics, computer science and physics into biology, chemistry and medicinefor the purpose of discovery and development of novel therapeutic anddiagnostic product candidates, is itself novel and has not yet been fullyproven or validated. If this approach does not prove to be successful ourbusiness will be significantly harmed.**

 

We incorporateideas and methods from mathematics, computer science and physics into biology,chemistry and medicine. We attempt to discover novel potential therapeuticmolecules, including proteins and peptides, and diagnostics biomarkers on thebasis of which our collaborators and licensees may be able to develop noveldrugs and diagnostic products. By using this approach, we have alreadypredicted discoveries *in-silico*, which means prediction by computers. Wehave also initially validated the suitability fordiagnostic and therapeutic application of some of the diagnostic andtherapeutic product candidates respectively that we discovered *in-silico*.However, our approach has not yet been proven or validated beyond that initialvalidation.

*** ***

**__6__** 

If ourapproach is ultimately proven to be ineffective for making discoveries or if we may fail to make further discoveries, our business maybe materially harmed. If our potential customers or collaborators willnot accept that our approach provides value to them, or if we are not able tofind any biological activity for the therapeutic product candidates that wediscover, we may fail to commercialize discoveriesthat we make, and, as a result, our business will likely besignificantly harmed. 

** **

**We may never make discoveriesthat will be suitable for development into therapeutic or diagnostic products,and if we do not, our business may be significantly harmed and we may ceaseoperations.**

 

Even if our approach to discovering therapeutic and diagnostic product candidates by incorporatingideas and methods from mathematics, computer science and physics into biology,chemistry and medicine proves to be effective, our discoveries may be proven tobe unsuitable for the development intorevenue-producing products by our collaborators and licensees. 

 

One criterion that we applied in the past when choosing apotential therapeutic product candidate is that such candidate must have been avariant of a gene from which a known protein is derived. In focusing on suchvariants, we hope to benefit from the availability of biological and medicalinformation that relate to the biology and use of the known protein. However,to date, it has not been proven that such a variant is likely to havepharmacological characteristics or uses that are similar to or advantageousover the known protein to which it relates. Another example of a criterion thatwe apply when choosing one type of potential diagnostic product candidates isthat such candidates must be secreted into the blood stream. However, merepresence of a candidate molecule in blood does not necessarily ensure that itwill have all the characteristics necessary for it to function as an effectivediagnostic marker. 

 

If our approach todiscovering diagnostic and therapeutic product candidates proves to beineffective, we may fail to discover therapeutic and diagnostic productcandidates that are suitable for development into revenue-producing products byour collaborators and licensees, and as a result our business willlikely fail or we will likely never become profitable.  

** **

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

** **

Weface a number of risks of failure that are inherent in the process ofdeveloping and commercializing therapeutic and diagnostic products. These risksinclude, among other risks, the possibility that: 

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

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

●       our collaborators will fail to receive applicableregulatory approvals; 

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

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

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

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

 

Therefore, even if we areable to continue to discover new therapeutic or diagnostic product candidates,our collaborators or licensees may not be able to develop new products based onour discoveries. If any of these risks materialize our business andfinancial results may be materially harmed.

 

**We have limited experience in, and limited resourcesfor, the discovery and development of therapeutic and diagnostic product candidates,and if we fail to acquire the appropriate experience, our business may bematerially harmed.**

** **

**__7__** 

Our experience in the discovery and development oftherapeutic and diagnostic product candidates is limited. Although we believethat we have already acquired and are continuing to acquire experience andexpertise in the discovery and in certain aspects of the development oftherapeutic and diagnostic product candidates, in order to successfully developand commercialize therapeutic and diagnostic product candidates, we mustfurther improve our internal expertise, capabilities and facilities. We may notbe able to engage all of the experts that we need in order to do so. 

 

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

** **

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

 

The biotechnology and pharmaceutical industries arehighly competitive. Numerous entities in the United States and elsewherecompete with our efforts to discover, validate and commercialize therapeuticand diagnostic products or product candidates. Our competitors includepharmaceutical, biotechnology and diagnostic companies, academic and researchinstitutions and governmental and other publicly funded agencies. We face, andexpect to continue to face, competition from these entities to the extent thatthey develop products that have a function similar or identical to the functionof our therapeutic and diagnostic product candidates. We also face, and expectto continue to face, competition from entities that seek to developtechnologies that enable the discovery of novel therapeutic and diagnosticproduct candidates. 

 

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

 

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

** **

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

*** ***

There is a trend towards consolidation in thepharmaceutical and biotechnology industries. This consolidation trend mayresult in the remaining companies having greater financial resources andtechnological capabilities, thus intensifying competition in the industries.This trend may also result in fewer potential collaborators or licensees forour therapeutic and diagnostic product candidates. Also, if a consolidatingcompany is already doing business with our competitors, we may lose existinglicensees or collaborators as a result of such consolidation. 

 

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

 

**We depend significantly on our collaborators andlicensees for the development and commercialization of our therapeutic anddiagnostic product candidates, and if we are unable to enter into additionalagreements with collaborators and licensees in the future, our business willlikely be materially harmed.**

 

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

 

To date, we have granted a small amount of licensesfor the development and commercialization of our product candidates. Overapproximately the past one and a half years, we entered into three licensecollaboration agreements for the development and commercialization of amultiple number of diagnostic products. 

 

**__8__** 

Even though we have entered and intend to continueto enter into license and collaboration agreements for the development andcommercialization of our discoveries, we cannot assure you that any of theseagreements will result in the successful development or commercialization ofany products based on our discoveries. Further, we cannot assure you that wewill succeed in entering into any other agreements with third partycollaborators or licensees for the development and commercialization of ourtherapeutic and diagnostic product candidates. If we are unable to enter intonew collaborations or license agreements, our business will likely bematerially harmed. 

 

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

** **

Our strategy for the development andcommercialization of therapeutic and diagnostic product candidates is based onour discovery and early stage development of those product candidates. Weconsider early stage development in the case of diagnostic product candidatesto be a stage at which their existence in nature is validated. This stage mayalso involve us demonstrating that the product candidate is differentiallyexpressed in different physiological conditions, but in any case with noclinical proof. We consider early stage development in the case of atherapeutic product candidate, to be a stage at which we show biologicalactivity of that candidate. We ordinarily carry out certain such validationwork ourselves, and we ordinarily seek to rely on our collaborators andlicensees to carry out further product development.

 

Pharmaceutical anddiagnostic companies may be reluctant or refuse to in-license our therapeuticand diagnostic product candidates at these early stages of discovery ordevelopment. Even if additional potential collaborators or licensees agree toin-license our discoveries at an early stage, such additional collaborators orlicensees may not agree to do so on terms that we would consider commerciallydesirable.

 

If we are unable to out-license our discoveries atan early stage, we may need to develop our discoveries ourselves until weattain a more mature stage of development. Such development activities mayrequire us to expend substantial additional financial and other resources. Ifwe are unable to commit these required additional resources, we may have tocurtail or cease our discovery and development activities, and as a result ourbusiness will likely be materially harmed.

** **

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

** **

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

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

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

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

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

●       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 nor willing to make;

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

●       disagreements between us and our collaborators maylead to delays in, or termination of, the collaboration; and 

●       our collaborators may fail to develop orcommercialize successfully any products based on product candidates to whichthey have obtained rights from us.

 

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

** **

**__9__** 

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

** **

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

** **

Our discovery engines are proprietary computationalplatforms that are designed to identify therapeutic and diagnostic productcandidates in a specific therapeutic and diagnostic area of interest. By using our discovery engines and related technologies, weintend to constantly feed our pipeline of discoveries with novel therapeuticand diagnostic product candidates. Our success as a genomic-based discoverycompany largely depends on our ability to continue to develop and enhance ourdiscovery engines and related technologies.

 

Thepharmaceutical and biotechnology industries are characterized by continuoustechnological changes. We may not be able to make the necessary developmentsand enhancements to our discovery engines and related technologies in order tocompete successfully within these industries. 

 

This competition is intensified by the public andfree availability of human and other organisms` genomic sequence data, as aresult of the US Federal Government funded Human Genome Project and otherprojects engaged in the study of genes. Since we use these data to improve andenhance our discovery engines, the publication of these data may render ourdiscovery engines and related technologies less valuable or even obsolete.Although we believe that our discovery engines provide us with discoverycapabilities, this competition is also intensified by the availability to ourcompetitors of software that performs some functions that are performed by ourdiscovery engines.

 

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

** **

**We rely on access to public and commercial databases tofeed our discovery engines, and if we are denied access to these databases forany reason, our operations and business may be harmed.**

 

In carrying out our discovery and development oftherapeutic and diagnostic product candidates, we rely on our ability to accessand use public and commercially available databases. If we are denied access tothese databases, or if we are granted access to such databases on terms, whichare not commercially reasonable, our business and our results of operation maybe harmed. 

*** ***

***Factors Related to our Operations***

** **

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

*** ***

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

 

As a result we expend and believe that we will needto continue to expend substantial funds and management effort with no assuranceof successfully entering into agreements with potential collaborators andlicensees. 

** **

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

** **

Our business is highly dependent upon the continuedservices of our senior management and key scientific and technical personnel.While members of our senior management have entered into employment orconsulting agreements and non-competition and non-disclosure agreements, wecannot assure you that these key personnel and others will not leave us orcompete with us, which could harm our business activities and operations.Within our geographic location, it is difficult to find suitable and highlyqualified personnel in certain aspects of our industry. 

 

**__10__** 

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

 

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

*** ***

**Revenues that we generate from commercialization of ourtechnologies or discoveries may be limited because of Israeli governmentalgrants that we receive.**

 

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

 

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

 

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

 

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

 

We rely heavily on the use and manipulation oflarge amounts of data and on the secure and continuous use of our internalcomputers, communication networks and software and hardware systems. We haveimplemented and maintain physical and software security measures to preserveand protect our computers, communication, and hardware and software systems aswell as our data and third parties` data. These measures are intended tosafeguard against loss, corruption and misappropriation caused by systemfailures or unauthorized access. We have also entered into confidentialityagreements with our employees, consultants, customers and collaborators who mayhave access to such confidential or proprietary information. 

 

However, these methods may not protect us againstfire, storm, flood, power loss, earthquakes, telecommunications failures,physical or software break-ins or 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 materially harm our intellectual property position,thereby seriously harming our financial condition. These security problems, ifsignificant, could harm our operations and even cause our business to cease.  

*** ***

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

 

Our research and development activities in somecases involve the controlled use of biological and chemical materials, a smallamount of which could be considered to be hazardous. To our knowledge, our workis performed substantially in accordance with all applicable environmentalregulations. However, we cannot eliminate the risk of accidental contaminationor discharge of any of these materials. If hazardous biological or chemicalmaterials in our possession were to be improperly used, this could result inharm to persons or property and we could be subject to both civil damages andcriminal penalties. In such event, our liability may exceed our insurancecoverage.   

*** ***

**__11__** 

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

 

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

 

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

 

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

*** ***

***Factors Related to Intellectual Property***

*** ***

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

*** ***

We rely heavily on our proprietary know-how and tradesecrets that we develop and that are not protectable or protected by patents.We employ a number of measures to ensure that our know-how and trade secretswill not be disclosed outside our organization, and to the extent that they maybe, we make extensive use of confidentiality agreements. We believe thatprincipal aspects of our know-how and trade secrets relating to our technologyare complex and, as a result, difficult to copy or reproduce. Nevertheless, theprotective measures that we employ may not provide adequate protection for ourtrade secrets and know-how. Our business collaborators, employees, advisors andconsultants may disclose our proprietary know-how or trade secrets in violationof their obligations to us. We may not be able to meaningfully protect ourrights in our proprietary know-how or trade secrets against such unauthorizeddisclosure and any consequent unauthorized publication. 

 

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

 

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

*** ***

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

 

**__12__** 

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

●       the patenting of genes and gene-based inventions involves complex legal issues, many of whichhave not yet been settled; 

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

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

●       part of our discovery efforts are aimed atdiscovering novel variants of gene-based therapeutic products that belong tothird parties and, as such, those third parties mayhave already acquired intellectual property rights that precede and prevent usfrom obtaining patent protection for our variants;

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

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

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

 

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

 

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

*** ***

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

 

As a result of theexistence of such third party intellectual property rights, we may be requiredto:

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

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

 

We do not always have available to us, in a timelymanner, information of the existence of third party intellectual propertyrights related to our own discoveries. The content of US and other patentapplications remain unavailable to the public for a period of 18 months fromtheir filing date. In some instances, the content of US patent applicationsremain unavailable to the public until the patents are issued. As a result, wecan never be certain that development projects that we commence will be free ofthird party intellectual property rights. If we become aware of the existenceof third party intellectual property rights only after we have commenced aparticular development project, we may have to forgo such project after havinginvested in it substantial resources.

 

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

 

Our business philosophy is to respect theintellectual property rights of third parties. Nevertheless, if a third partyaccuses us of infringing its intellectual property rights or if a third partycommences litigation against us for the infringement of patent or otherintellectual property rights, we may incur significant costs in defending suchaction, whether or not we ultimately prevail. Typically, patent litigation inthe pharmaceutical and biotechnology industry is expensive. Costs that we incurin defending third party infringement actions would also include diversion ofmanagement`s and technical personnel`s time. In addition, parties making claimsagainst us may be able to obtain injunctive or other equitable relief thatcould prevent us from further developing our discoveries or commercializing ourproducts. In the event of a successful claim of infringement against us, we maybe required to pay damages and obtain one or more licenses from the prevailingthird party. If we are not able to obtain these licenses at a reasonable cost,if at all, we could encounter delays in product introductions and loss ofsubstantial resources while we attempt to develop alternative products. Defenseof any 

**__13__** 

lawsuit or failure to obtain any of these licenses couldprevent us or our partners from commercializing available products and couldcause us to 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 this purpose,passive income includes dividends, interest, royalties, rents, annuities andthe excess of gains over losses from the disposition of assets that producepassive income. If we were determined to be a PFIC for US Federal income taxpurposes, highly complex rules would apply to US taxpayers owning our ordinaryshares. Accordingly, **YOU ARE URGED TO CONSULT YOUR TAX ADVISORS REGARDINGTHE APPLICATION OF THESE RULES**.

 

As a result of our substantial cash position andthe relatively lower price of our stock in recent years, there is a risk thatwe will be classified as a PFIC under the asset test described in the precedingparagraph. There can be no assurance that we will not be classified as a PFICin the future, because the determination of whether we are a PFIC is based uponthe composition of our income and assets from time to time, and suchdetermination cannot be made with certainty until the end of a calendar 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. 

 

**Our business is difficult to evaluate because we have alimited history of operations and because we operate in industries that areconstantly evolving, and this may result in our shares trading at a discount orin our share price being volatile.**

 

Since our incorporation in 1993, our researchfocus, the products that we developed and our business model had continuallyevolved. Whereas in the past we used our intellectual property, scientificknow-how and computational capabilities to develop, market and sell to thirdparties life science software products and services, we now use thesecapabilities to discover therapeutic and diagnostic product candidates. 

 

In addition, since 1998, part of our business hasinvolved the discovery and development of therapeutic and diagnostic productcandidates. Therapeutic products are typically developed over a period ofapproximately 9-12 years and the development period for diagnostic products istypically four to six years. For these reasons, we have a history of operationsin which we believe there is insufficient information to identify a historicalpattern. 

 

Even if we could discern an historical pattern forour operations, the continuously evolving nature of the biotechnology andpharmaceutical industries in general and our business in particular would makeit very difficult to identify any meaningful information. Therefore, it wouldalso be difficult to make any projections about the future of our operations. 

 

These difficulties may result in our ordinaryshares trading at a discount or the market price of our shares to be volatile. 

** **

**Our share price has been volatile and we believethat it is likely to continue to be volatile.**

******

Themarket price of our ordinary shares has been highly volatile and we believethat it is likely to continue to be volatile. This is due to the risks anduncertainties described in this annual report, as well 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; 

**__14__** 

●       investors' perceptions or changes in marketvaluation of biotechnology 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. 

 

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

****

Our quarterly operating results have fluctuated inthe past and we believe that they will do so in the future. These fluctuationsmay cause our share price to fluctuate significantly. If our operating resultsfail to meet the expectations of the investment community, this may causefluctuations in our share price. These results should not be relied upon asindications of future performance, and comparisons of quarterly results ofoperations may not be any meaningful indication of our progress in the longterm. 

 

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

●       our rate of success and timing of entering intotransactions for the commercialization of our therapeutic and/or diagnosticproduct candidates;

●       a decrease in the financial resources available toour customers, collaborators or licensees; 

●       the timing of the release of products by ourcompetitors; 

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

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

●       the time within which our collaborators may developour therapeutic and/or diagnostic product candidates into revenue-producing products; 

●       our ability to secure research and developmentgrants.

 

**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. 

** **

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

** **

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

 

Our principal offices andresearch and development facilities 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 conflicts and terrorist actions. Since September 2000,there have been periods of time during which Israel experienced heightenedlevels of violence with varying levels of severity. This state of hostility hascaused security and economic problems for Israel. To date, we do not believethat the political and security situation has had a material adverse impact onour business but we cannot give you any assurance that this will continue to bethe case. However, if there were to be emergency conditions, some of our key employeesmay be called to active duty for extended periods of time and could adverselyaffect our operations. Any hostilities involving Israel or the interruption orcurtailment of trade between Israel and its present trading partners could alsoadversely affect our operations and could make it more difficult for us toraise capital. 

 

**__15__** 

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

 

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

** **

We hold most of our cash, cash equivalents andmarketable securities in US dollars but incur a significant portion of ourexpenses, principally salaries and related personnel expenses, in New IsraelShekels. As a result, we are exposed to the risk thatthe US dollar will be devalued against the New Israel Shekel. In addition, we are exposed to the risk that therate of inflation in Israel will exceed the rate of devaluation of the NewIsrael Shekel in relation to the dollar or that the timing of any devaluationmay lag behind inflation in Israel. However, since asignificant portion of our expenses are the cost of our salaries, which we payin New Israel Shekel, we believe that thisrisk is not significant. If the US dollar cost of our operations in Israelincreases, our dollar-measured results of operations will be adverselyaffected. Our operations could also be adversely affected if we will be unablein the future to guard against devaluation of the Dollar against the NewIsrael. To date, our business has not been materially adversely affected bychanges in the Israeli rate of inflation or by a decrease in the US dollar -New Israeli Shekel exchange rate. 

** **

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

*** ***

We currently receive 3 different types of researchand development grants and are entitled to certain grants and tax benefitsunder Israeli government programs. We receive funds in support of some of ourresearch and development programs from the Office of Chief Scientist of theIsrael Ministry of Industry, Trade and Labor, from the Israel-U.S. Bi-nationalIndustrial Research and Development Foundation and from the European Community,under the European Union`s 6th Framework Program. 

 

In addition, our subsidiary Keddem Bioscience, iscurrently entitled to certain grants and tax benefits under Israeli governmentprograms and receives funds in support of some of its research and development programsfrom the Office of Chief Scientist of the Israel Ministry of Industry, Tradeand Labor.

 

To maintain our eligibility to receive these funds,we must file periodic reports and pay royalties with respect to some of thegrants that we received. 

 

We intend to submit requests for additionalresearch and development funds from the Office of Chief Scientist, from theEuropean Community as well as from other funds that offer financial grants insupport of our research and development programs. However, we cannot assure youthat we will continue to receive such funds at the same rate, if at all. In2005 we received an aggregate of $2.3 million funds in support of some of ourresearch and development programs. For more information, see "Item 5.****Operatingand Financial Review and Prospects; Research and Development, Patents andLicenses; Research and Development Programs." 

 

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

 

The termination or reduction of the funding that wereceive, could have a material adverse effect on our business, financialcondition and results of operations.  

 

If we cease to become entitled to these tax benefits,we may be required to pay increased taxes on the taxable income that we maygenerate in the future from funded technology. 

 

**__16__** 

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

** **

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

###  

**__17__** 

### 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 known as Compugen, Inc.), our wholly-owned US subsidiary, arelocated at 560 S. Winchester Blvd., Suite 500, San Jose, California95128, and itstelephone number is (408) 236-7336. Ourprimary Internet address is www.cgen.com. None of the information on ourwebsites is incorporated by reference into this annual report. 

We initially developed a computer hardware systemand software applications to accelerate homology searches of biologicalsequences. This system and those applications were commercialized under thename "Bioccelerator" since 1994. In 2003, we sold the Bioccelerator productline. For more information regarding the sale of our Bioccelerator productline, see Note 3 of our 2005 Consolidated Financial Statements. The divestmentof our Bioccelerator product line, was part of an evolution that we underwent.Whereas in the past we used our intellectual property, scientific know-how andcomputational capabilities to develop, market and sell to third parties lifescience software products and services, we now use these capabilities to discovertherapeutic and diagnostic product candidates. For more information about ourevolution, see in this Item 4 "Business Overview." 

In 1997, we incorporated our wholly-owned USsubsidiary, Compugen USA, Inc. We conduct most of our business development andmarketing operations from the US.

 

Since 1997, we directed a significant portion ofour activities to the development of computational biology platforms andtechnologies that allow molecular biologists to obtain significantly morevaluable information from genomic and related databases. The technologies thatwe developed solve quantitative and qualitative problems inherent in theanalysis of genomic and expressed sequence data. Our first major technologyplatform was our LEADS computational biology platform, which among otherfunctions, analyses and rearranges - also known as clustering and assembly -genomic and expressed sequence data. With the use of our computationalplatforms, we have been able to discover novel genes and gene-based products,including novel transcripts and proteins. Throughout the years, we licensed useof this technology to a number of pharmaceutical and biotechnology companies,including Pfizer, Inc., Novartis Pharma A.G. and Abbott Laboratories. 

 

In 1998, we established our biology laboratory, theinitial purpose of which was to validate our computationally generatedpredictions. Subsequently, we recognized that there is vast potential indiscovering and developing novel therapeutic and diagnostic product candidates,rather than merely validating our computational capabilities and technologies. 

 

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).  

 

Between the years 2000 and 2004 we pursued a numberof commercial activities, including the marketing and sale of computationaltools, by applying our intellectual property, scientific know-how andcomputational technologies to the development of solutions for addressingchallenges in the fields of functional genomics, which is the study of geneexpression and gene function. We no longer seek to sell computational tools, for the same reason that we divested theBioccelerator product line, which is to use our intellectual property,scientific know-how and computational capabilities in-house, to discover andcarry out the initial development of novel therapeutic and diagnostic productcandidates. 

 

Commencing in 2000, we designed probes, which areshort nucleotide sequences designed to be uniquely representative of much largercorresponding genes. Probes that we designed can be used for gene expressionexperiment and served as the basis for our Oligolibraries products. In 2001, weentered into a joint license and marketing agreement with Sigma-Genosys for thedevelopment, marketing and production of these products. This agreementterminated on December 31, 2004, following which, we no longer market ourOligolibraries products. 

 

In 2001, we launched product named "Genecarta", auser-friendly database application that allows scientists in the field ofgenomics, functional genomics and proteomics to easily use the results ofanalyses performed with our Leads computationalbiology platform. We no longer market the Genecarta product.

**__18__** 

 

In 1999, we established adivision focusing on agricultural biotechnology and plant genomics. On January 1, 2002, we transferredthe business of this division to what was at the time a majority-ownedsubsidiary, Evogene Ltd. For more information about this transaction andour holdings in Evogene, see Item 7, "Major Shareholders and Related PartyTransactions; Related Party Transactions; Evogene Ltd."

 

In 2000, we launched our Z3 software product, andin 2003 our Z4000 software product, both of which use advanced computationaltechniques to carry out pattern recognition analyses and image processing toanalyze the results of certain protein separation experiments.  We nolonger market the Z software products.

 

In 1999, we established achemistry division to carry out a researchprogram in which we integrated the disciplines of organic chemistry withphysics and advanced computational technologies for the development of a methodto substantially increase the predictability and success rates of smallmolecule drug discovery. This transaction bywhich we created our wholly-owned subsidiary Keddem Bioscience was part of ourcontinuing efforts to focus on the enhancement of our discovery engines and thediscovery and development of novel therapeutic proteins and diagnosticbiomarkers. On August 1, 2004 we turned our chemistry division into a whollyowned subsidiary by transferring all of our assetsand liabilities that were dedicated to the operation of our chemistry division into Keddem Bioscience.

 

Since 2002, we have been focusing on the discoveryof novel therapeutic proteins (these are proteins that are themselves drugs andthat are usually administered by injection) and diagnostic biomarker (whichindicate the presence or absence of a physiological condition, such as adisease) product candidates through the use of the intellectual property,scientific know-how and computational biology capabilities that we haddeveloped. During 2003 and 2004 we expanded our biology laboratory by, amongother things, expanding its floor space and adding new functions and equipment.We also recruited experts for the purpose of strengthening our proteinexpression, production, purification and analysis capabilities. We seek togenerate revenue from commercializing the novel therapeutic protein anddiagnostic biomarker candidates that we discover, by pursuing commercialrelationships with potential collaborators and licensees, including leadingdiagnostic, biotechnology and pharmaceutical companies. We intend for theserevenues to be in the form of milestone and royalty payments. 

*** ***

In December 2005, we underwent a re-organization.Part of this re-organization comprised the establishment of three research anddevelopment units in order to continue to focus on the discovery, validationand commercialization of our therapeutic and diagnostic biomarker productcandidates. Our recently formed three research and development units consist ofa therapeutics unit, a diagnostic biomarkers unit, and a research and discoveryunit. This re-organization included a reduction of approximately twenty fivepercent in the number of our employees across the company.  Wecurrently continue to operate under a single reporting segment and our threeresearch and development units are not measured separately by our company`smanagement.

*** ***

##### Business Overview

*** ***

We are a biotechnology discovery company focused ontherapeutic and diagnostic product candidates. The Company`s powerfulpredictive models and discovery engines enable the discovery of numerouspotential therapeutics and diagnostic biomarkers. This capability results fromthe Company`s pioneering and on-going incorporation of ideas and methods frommathematics, computer science, and physics into biology, chemistry andmedicine.  To date, our discovery efforts have focused mainly oncancer, cardiovascular and immune-related diseases. Product development ispursued both in-house and through collaborative arrangements. The Company'sprimary business goal is to out-license therapeutic and diagnostic productcandidates for commercialization by leading companies under milestone andrevenue sharing agreements. 

 

We have three principal research and developmentunits comprising a therapeutics unit, a diagnostic biomarkers unit and aresearch and discovery unit. These units are serviced and supported by our otherunits, which include finance, legal and business development units.

*** ***

***Therapeutics Unit***

 

The therapeutics unit selects and validatestherapeutic protein product candidates that we discover in-house with the useof our predictive discovery engines. This unit is responsible for carrying out *in-vitro*and *in-vivo* experimental validation of selected potential therapeuticprotein candidates. *In-vitro* and *in-vivo*experiments areexperiments outside the living body, in an artificial environment andexperiments in a living body respectively. This validation is done internallyand by outsourcing to third party laboratories and includes protein production,purification and analysis, and *in-vitro* and *in-vivo* bioassays. 

**__19__** 

 

We use the capabilities of our LEADS computationalplatform and discovery engines and related technologies to discover proteinsthat we believe are potential therapeutic product candidates. Once we identifytherapeutic product candidates *in-silico,* we select candidate moleculesfor validation in a biology laboratory. The molecules that we select forvalidation and further development, are those molecules that we believe aremost likely to succeed, based on a set of criteria that we continually developand use in our discovery process. One criterion for our selection of proteinsis that they are predicted to be novel and are found not to be covered by thirdparty patents. Another criterion, that we applied to splice variants, is thatthe selected splice variant should be closely related to an already marketeddrug, drug target or to one that is in advanced stages of development. Infocusing on the discovery of such proteins, we seek to benefit from theavailability of relevant biological and medical information that relate to ournovel splice variant. 

 

The first biology laboratory activity that we carryout on the selected molecules is either to validate their existence in natureat the RNA level and/or to synthesize them. Thevalidation at the RNA level is achieved by biology laboratory techniques suchas quantitative RT-PCR, which is a method for isolating and amplifying desiredRNA sequences. Synthesis of these molecules is achieved by either chemicalsynthesis in the case of short peptides, or by genetic engineering techniquesin the case of longer proteins. 

*** ***

We are currently pursuing *in-vitro* and *in-vivo*experiments to assess the activity of a large number of our therapeutic proteinproduct candidates. We expect to complete this assessment in 2006. Our abilityto seek partners for development and commercialization for our therapeuticprotein candidates will depend on those proteins` suitability to becometherapeutic proteins and on our ability to generate experimental data insupport of that suitability. 

 

***Diagnostics Unit***

*** ***

The diagnostics unit selects and prioritizes diagnostic product candidates that wediscover in-house with the use of our predictive discovery engines. This unitis responsible for carrying out initial validation of the potential diagnosticcandidates that it selects.

 

Similarly to the use of our discovery engines andrelated technologies to discover therapeutic product candidates, we also usediscovery engines and related technologies to discover proteins that we believeare potential diagnostic biomarker product candidates. We first identifydiagnostic product candidates *in-silico* and then select for validationat the RNA level those molecules that webelieve are most likely to succeed, based on a set of criteria that wedeveloped. 

 

Thereare three principal selection criteria that we apply to select for validationand further development diagnostic product candidates that we identify *in-silico*.These are:

●       Novelty and freedom to operate - we selectmolecules that are predicted to be novel and found not to be covered by thirdparty patents. 

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

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

 

We believe that in 2004 and 2005, we havedemonstrated our ability to discover biomarker candidates, primarily forvarious cancers and cardiovascular diseases, that are of interest for furtherdevelopment and commercialization by leading companies in the field ofimmunoassay diagnostics. Our discovery engines togetherwith our related technologies have already formed thebasis for a broad discovery-based collaboration with Diagnostic ProductCorporation, Ortho-Clinical Diagnostics, a Johnson & Johnson company, andwith Biosite, all for the development and commercialization of immunoassaydiagnostic products based on the output of our diagnostic discovery engines.For more information about these transactions, see the Section entitled "OurSelected Customers and Collaborators" in this Item 4. 

 

We expect that during 2006 and 2007, together withour licensees and partners, we will validate and develop products based on thefirst wave of discoveries from our immunoassay based diagnostic discoveryengines. We also intend to continue our discovery activities, which arecurrently targeted at cancer and cardiovascular diseases, and we have alreadycommenced to extend our efforts to other disease areas.

 

**__20__** 

Our development activities with respect to nucleicacid based diagnostics, which rely on slightly modified versions of ourimmunoassay discovery engines, are approximately one year behind ourimmunoassay based diagnostic development activities. We intend to beginentering into agreements for the commercialization of our nucleic acid baseddiagnostic product candidates in the second half of 2006. 

 

***Research and Discovery Unit***

 

Our research and discovery unit has generated ourdiscoveries of therapeutic protein and diagnostic product candidates (althoughthis was done before it was formally reorganized as such). These discoverieshave all been made *in-silico*. We intend for this unit to continue togenerate discoveries of therapeutic and diagnostic product candidates as wellas create additional discovery engines and other platforms and technologiesthat will enable us to add to and improve upon our predictive biologycapabilities. 

 

Our ability to discover therapeutic protein anddiagnostic product candidates is enabled by the computational platforms,discovery engines and related technologies that we have developed and continueto develop. These platforms include our LEADS computational biology platform,and our discovery engines, including our therapeutic protein discovery engineand our diagnostic biomarkers discovery engines. 

 

We have begun an analysis in order to select newprojects for the development of new platforms and technologies. We intend tocontinue to develop platforms and technologies that will enable us to discovercategories of therapeutic and diagnostic product candidates that we had notdiscovered to date. It is our current intention that after proof of concept issuccessfully achieved for these new platforms and technologies, their furtherdevelopment and the commercialization of therapeutic or diagnostic productcandidates that we discover with these new platforms and technologies will bethe subject of a major collaboration with a pharmaceutical or biotechnologypartner.

 

 

**Our Enabling Technologies**

*** ***

***OurLEADS Computational Biology Platform***

* *

Our LEADS computational biology platform analyzesgenomic and expressed sequence data to enable rapid discovery of genes,transcripts, and proteins, including their splice variants, and informationabout their potential respective functions. Our LEADScomputational biology platform models a widevariety of complex biological phenomena and provides a comprehensive researchinfrastructure, facilitating the discovery of therapeutic and diagnosticproduct candidates and other biological products. This technology and expertisehas enabled us to efficiently and effectively extract valuable information fromgenomic, proteomic and related databases.

** **

***Discovery Engines***

 

Our discovery engines are proprietary computationalplatforms that extend the capabilities of our LEADS platform by incorporatingsophisticated search and analysis algorithms. Our discovery engines aredesigned to enable our researchers to identify proteins and transcripts thatare suitable for the development of therapeutic and diagnostic productcandidates. We use our discovery engines and related technologies in ourinternal therapeutic and diagnostics discovery efforts. By using these enginesand related technologies, we intend to constantly feed our pipeline ofdiscoveries with novel therapeutic and diagnostic product candidates. 

 

Although to date, we haveused our discovery engines to discover therapeutic protein and diagnosticproduct candidates, our approach to discovering novel product candidates may beequally useful for the discovery and selection of potential targets for smallmolecules, antibodies and other types of gene products with clinical value,such as DNA polymorphisms, which are changes in the DNA nucleotide base pairsequence. 

 

*Therapeutic ProteinDiscovery Engines -*Our**therapeuticprotein discovery engines are designed to identify proteins for which there issubstantial evidence indicating a therapeutic utility. One such engine isdesigned to identify novel splice variants of known proteins. This engine alsoenables the selection of proteins based on their predicted biologicalproperties such as the existence of a signal peptide, which is a biologicalsignal on the protein directing it to be secreted out of the cell into theblood stream. The input into our therapeutic proteindiscovery engines is analyzed by proprietary software and automatedprocesses. Its output is thereafter manually analyzed by our scientists andconsulting experts to evaluate each molecule`s potential to be a therapeuticproduct candidate. 

 

**__21__** 

*Diagnostic BiomarkerDiscovery Engines* - Another example of ourdiscovery engines is our series of diagnostic biomarker discovery engines.These engines are designated to identify novel transcripts and splice variantsof genes, and proteins, that are differentially expressed in specific tissuesor pathological conditions, and which may therefore serve as biomarkers fordiagnosis. Genes, transcripts and proteins that are involved in variousdiseases may be differentially expressed in such conditions. Our approach toidentify such genes, transcripts and proteins is to search *in-silico*for,among other things, patterns of differential expression, and then to attempt toverify these predictions by experimental methods in our biology laboratory. Inaddition, we seek to discover splice variants of proteins with a knowndiagnostic utility since these splice variants may themselves have a diagnosticutility. 

 

Our diagnostic biomarker discovery engines consistof disease driven biomarker engines and **applicationdriven biomarker engines. The**disease driven biomarker enginesidentify transcripts and proteins that are expressed differently in diseasesituations, compared to the expression levels of such transcripts and proteinsin normal physiological conditions. The diseases that these engines target arevarious cancers, autoimmune diseases and heart related diseases. **The**application driven biomarkerengines identify transcripts and proteins that are characterized by selectedfeatures or their suitability for certain diagnostic applications. Thesecategories of biomarkers are secreted forms of known biomarkers that can befound in serum, biomarkers that are membrane-bound which are suitable for *in-vivo*imaging applications and biomarkers that can be used at the nucleic acid level,primarily in the field of cancer.

 

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

*** ***

By incorporating ideas and methods frommathematics, computer science and physics into biology, chemistry and medicine,we attempt to discover novel potential therapeutic and diagnostic product candidates.Over approximately the past decade, we have beendeveloping technologies, including our discoveryengines, which enable researchers to identify genes, transcripts, and proteinsthat can be the basis for the development of therapeutic and diagnosticproducts of interest. Our multidisciplinary discoveryprocess combines sophisticated mathematical modeling with experimental "wet"biological validation in an iterative process that is designed to investigatebiological phenomena and discover potentially valuable drug targets,therapeutic proteins and diagnostic biomarkers.We believe that our approach to drug and diagnostic discovery makes itpossible for us to further discover novel therapeutic and diagnostic productcandidates.

 

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

 

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

 

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

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

●       *Antisense* - antisense is a biologicalphenomenon of the existence of two genes that are located on opposite strandsof DNA and, therefore, have complementary nucleic acid sequences. In 2002, byapplying our proprietary LEADS computational biology platform to the analysisof publicly available genomic information, we discovered that the phenomenon ofnaturally occurring antisense in the human genome was significantly more commonthan previously believed. We identified hundreds of antisense pairs of genesand published our findings in the April 2003 issue of Nature Biotechnology, Volume21, No. 4. 

**__22__** 

●       *RNA Editing* - RNA editing is a biologicalphenomenon in which small nucleotide changes occur in RNA after itstranscription from DNA. Although it has been known that RNA editing is anessential factor for mammalian development and although recent evidence hassuggested that it may be a fairly common phenomenon, very few RNA editing siteshad been actually discovered and it was generally believed to be impossible tosystematically discover such sites with current experimental and computationalprocedures and tools. We developed and proved systematic identification ofadenosine to inosine (A to I) RNA editing sites in the human transcriptome, andincreased the number of known A to I RNA editing sites from approximately 100to 12,723. Our discovery was published in the August 2004 issue of NatureBiotechnology, Volume 22, No. 8. 

●       Processed Pseudogenes - processed pseudogenes arenaturally occurring copies of genes that were created through reversetranscription of mature spliced mRNAs and then reinserted into the genome at anew location. These genomic sequences are generally considered "junk DNA".However, through analysis of thousands of such human pseudogenes with an *in-silico*predictive methodology, we were able to predict the existence of hundreds ofnovel transcript variants, a selected subset of which were then experimentallyvalidated in our biology laboratories. Our discovery was published in theJanuary 2006 edition of the Proceedings of the National Academy of Sciences (USA).  

*** ***

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

 

*Biological Processes -*****Thecharacteristics of all living organisms are determined by DNA, a molecule foundin virtually every living cell. DNA is comprised of pairs of four types of smallchemical units, each called a nucleotide. DNA contains genes, which 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. These nucleotides are arranged in up to25,000 genes.

 

Cells carry out a major part of their biologicalfunctions by means of proteins. The production of proteins is encoded by DNAthrough a process known as gene expression. Therefore, by identifying a gene,it is possible to identify a protein or proteins that are expressed from thatgene. The first stage of gene expression is transcription, which involves thematching of the DNA nucleotides in a gene with the nucleotides of a relatedmolecule called messenger RNA, or mRNA. mRNA then instructs the cell to producea protein by a process known as translation. Proteins are the molecules thatregulate or perform most of the physiological functions of the body. 

 

*Diagnostic Biomarkers* - A major aspect ofthe pharmaceutical and biotechnological research and development process is theidentification of diseases and other physiological conditions. In the case ofcertain types of cancers, such as breast cancer, early detection can becritical to their treatment and even cure. The early detection of certain typesof cancers is currently an unmet medical need. The levels of presence orabsence of proteins or other molecules, may give information about the presenceor absence of a disease or a particular stage of a disease or otherphysiological condition. A molecule that provides this information is known asa "diagnostic biomarker". For example, the presence or abnormal increasedpresence of a certain protein in blood may indicate a cancerous condition. Inorder to develop a diagnostic biomarker, it is first necessary to identify acorrelation between, on the one hand, the presence or levels of presence of amolecule and, on the other hand, a disease or other physiological condition.Once such a correlation is identified, it is then necessary to develop a methodfor identifying the changes in levels of the diagnostic biomarker. The task ofdeveloping a method that will be easy to perform, that is sensitive, that has ahigh predictive value, that is safe, reliable, inexpensive, and that covers anattractive market segment, is a challenge that the diagnostics, pharmaceuticaland biotechnological industries face.

* *

*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 therapeuticproteins, because use or administration of the protein itself may have theeffect of preventing, treating or curing a disease. Therapeutic proteins areusually administered by injection.

* *

*Drug Targets -* In other cases, a protein maybe a target to which a drug binds, and is known as a drug target. By increasingor decreasing the amount of a target protein or by activating or inhibiting itsactivity, a disease may be prevented, treated or cured. 

 

**__23__** 

**Our Products and Commercial Offerings**

*** ***

Our therapeutic and diagnostic product candidates,that we offer for out-licensing, exclusively comprise our own discoveries,which are enabled by our proprietary discovery engines and internalexperimental validation. We believe that our unique approach to drug discoverymakes it possible for us to identify additional novel therapeutic anddiagnostic product candidates. 

 

Our most commercially advanced product area isimmunoassay diagnostics, and we have signed agreements for the development andcommercialization of a series of these products with three leading diagnosticcompanies. For more information about these transactions, see "Our SelectedCustomers and Collaborators." We expect to enter into nucleic acid developmentand commercialization agreements in the second half of 2006.

 

For our therapeutic product candidates, we expectto reach the stage of seeking partners for development and commercialization ofour therapeutic product candidates once we will have generated experimentaldata in support of their suitability to becoming therapeutic productcandidates. 

 

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

 

We offer to ourprospective collaborators a license to develop and commercialize therapeuticand diagnostic product candidates that we discover through use of our discoveryengines. We are able to offer such candidates that are within a given area ofinterest to them. By collaborating with us, our prospective collaborators,primarily pharmaceutical, diagnostic and biotechnology companies, would be able to gain access to the advantages offered byuse of our proprietary discovery engines and multidisciplinary team of experts.Ultimately, these collaborations are intended to yield novel putative genes andgene-based products, including transcripts and proteins, to enable ourcollaborators and licensees to develop and commercialize therapeutic anddiagnostic products based on our discoveries. 

* *

**Our Selected Customers andCollaborators**

** **

We intend to continue to focus on licensing-out ournovel therapeutic and diagnostic product candidates, which we discovered andcontinue to discover internally, to pharmaceutical, biotechnology anddiagnostics companies, with the aim that they will develop and commercializeour discoveries into therapeutic or diagnostic products. In these commercialarrangements we seek to receive payments upon the successful completion ofcertain predetermined developmental stages and milestones, and royalties fromthe sales of the drugs and/or diagnostics applications, which will be based onour discoveries.

 

In June 2005, we announced our entry into acollaboration with Ortho-Clinical Diagnostics, Inc. ("OCD"), for thedevelopment and commercialization of immunoassay based diagnostic products thatare based on the output of our diagnostic discovery engines. The terms of thisagreement allow OCD to select up to nine diagnostic biomarkers and then we willcollaborate on the initial clinical validation of the selected biomarkers.Under the agreement, successfully validated biomarkers will be developed intoproducts and commercialized by OCD, and we will receive milestone payments andlicense fees for each commercialized biomarker, in addition to revenue-basedroyalties. We applied together with OCD for a grant from the Israel-U.S.Bi-national Industrial Research and Development Foundation for contribution toour research and development expenditures under our joint collaborativeproject. For more information about this grant, see "Item 5.****Operatingand Financial Review and Prospects; Research and Development, Patents andLicenses."

 

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

 

**__24__** 

In April 2005, we announced a joint pilot researchproject with Novartis in the field of systems biology. Under the agreement, wewere required to generate information about biological interaction networksthrough the development of a proprietary platform for research and analysis ofmicroarray and other biological data. Novartis obtained sole rights to thespecific results of the project, and we retained all rights to the research anddiscovery systems developed through the collaboration.

 

In August 2004, we entered into a broad pipeline discovery-based collaboration withDiagnostic Product Corporation, for the development and commercialization ofdiagnostic products based on the output of our diagnostic discovery engines,with an anticipated focus on cancer and cardiovascular disease. The terms ofthis agreement allow Diagnostic Product Corporation to develop andcommercialize immunoassay and nucleic-acid based diagnostic products that arebased on candidate biomarkers that we already discovered, as well as additionalcandidates that may arise out of the collaboration. We are entitled to receivemilestone payments and royalties from the sales of each diagnostic productemerging from the collaboration.

 

**Our Strategy******

 

We seek to generate revenues from our collaboratorsand licensees commercializing therapeutic and diagnostic products that arebased on our discoveries and which is enabled by the use of the intellectualproperty, scientific know-how and computational biology capabilities that wehad developed and continue to develop. We believe that we can commercializediscoveries that result from our in-house discovery programs or that resultfrom collaboration discovery projects aimed at a given area of interest to our collaboratorsand/or their profile of requirements. We intend to focus onlicensing-out our product candidates to diagnostics, biotechnology andpharmaceutical companies, and we intend that they will further develop andcommercialize those product candidates into revenue generating therapeutic anddiagnostic products. We intend to receive from these commercial arrangementspayments upon the successful completion of certain predetermined developmentstages and milestones, and royalties from the sales of the drugs or diagnosticsproducts, which will be based on our discoveries.

 

To date, wehave commenced to implement this strategy by entering into a collaboration andlicense agreement with each of Diagnostic Products Corporation, Ortho-ClinicalDiagnostics, and Biosite, for the development and commercialization of noveldiagnostic products.

 

**Subsidiaries**

*** ***

***Keddem Bioscience Ltd.***

 

In 1999, we formed achemistry division that focused on substantially increasing thepredictability and success rates of small molecule drug discovery. On August 1, 2004, we turned our chemistry division into a wholly-ownedsubsidiary, Keddem Bioscience. For more information on Keddem Bioscience,see Item 7. "Major Shareholders and Related Party Transactions; Related PartyTransactions. Keddem Bioscience Ltd.". 

 

Keddem Bioscience is adrug discovery company that aims to improve the success rate for the discoveryof new drug products by developing and applying a technology platform thatconsistently enables the design of small molecules which can potentiallymodulate a given protein target. Keddem's method does not rely on proteinstructure information or high-throughput screening of very large compoundlibraries. 

 

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 involvinghigh-throughput screening of drug like compounds, have low success rates and oftenfail to find any candidate compound for a given target.

 

Keddem Bioscience`sapproach is based on the proposed creation of a comprehensive, yet relativelysmall set of approximately 70,000 carefully designed molecules and a set ofalgorithms. Keddem Bioscience intends******to synthesize this set ofmolecules and then use it in a screening process, in which the activity of drugtargets will be tested against the screening library molecules. KeddemBioscience`s ability to implement its intention to synthesize a set ofapproximately 70,000 molecules will depend on the availability to it of all thenecessary resources, including funding. The design of Keddem`s set of moleculesis aimed at obtaining information that, when analyzed by its proprietaryalgorithms, will provide accurate and comprehensive three-dimensionalinformation about a drug target`s active site. Keddem believes that this 

**__25__** 

information can then be used todesign a variety of potent inhibitors satisfying desired drug-like properties.Keddem`s approach is unique in that it is designed to generate informationrelating to a protein`s active sites, sufficient to enable the design of smallmolecules drug candidates. It does not seek to discover among its screening setlead molecules, which are molecules that react with protein targets and thatmay be optimized to generate a therapeutic effect. 

 

The continuation ofKeddem Bioscience`s operations depends on raising additional capital in orderto continue its operations. Keddem Bioscience`s external auditors have raisedsubstantial doubts on Keddem Bioscience`s ability to continue as a goingconcern.

** **

***Evogene Ltd.***

*** ***

In 1999, we formed a division focusing on agriculturalbiotechnology and plant genomics. On January 1, 2002, we turned the business ofthis division into a majority-owned subsidiary, Evogene Ltd. As of December 31, 2005, we held approximately 84.7% of Evogene`s issued and outstanding sharecapital, but only 23.36% of Evogene`s share capital, on a fully-diluted basis.Following our grant of irrevocable proxies to certain investors in Evogene,those investors were empowered to vote, in a manner determined in theirdiscretion, with approximately 50% of our holdings in Evogene, as existed atthe date of grant of such proxy. As a result, in 2005, we had the power to vote34.89% of Evogene's share capital. For more information on our holdings inEvogene, see Item 7. "Major Shareholders and Related Party Transactions;Related Party Transactions; Evogene Ltd." 

 

In February 2006, Evogene completed a financinground with certain investors, under which, among other things, it received $7million dollars and those of its investors who until that date were creditorsof Evogene under various convertible loan agreements, converted their loansinto shares. The round of investment included $2 million dollars that Evogenereceived in January 2005 by way of a convertible bridge loan. We did notparticipate in the investment in Evogene under this most recent financinground. As a result, as of February 16, 2006, we own approximately 14.76% ofEvogene`s issued and outstanding capital.

 

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

**Sales, Marketing and Business Development**

 

Since our incorporation in 1993, we devoted most of our capital andhuman resources to research and development of our technologies, discoveries,products and services. Since 2003 we moved away from commercializing oursoftware tools and software products and began concentrating our efforts on ourin-house discovery activities and commercializing those discoveries. Inconnection with this shift in strategy, we reduced the number of our marketing,sales and business development staff from 19 employees in 2002 to fiveemployees by the end of 2005.  

** **

The approximate geographical breakdown of ourrevenues for the year ended December 31, 2005 was 65% in North America, 34% in Europeand less than one percent in other countries. The approximate geographicalbreakdown of our revenues for the year ended December 31, 2004 was 40% in North America, 48% in Europe, 10% in the Far East and 2% in other countries. Theapproximate geographical breakdown of our revenues for the year ended December 31, 2003 was 66% in North America, 31% in Europe, 1% in the Far East and 2% inother countries. 

 

In the US, we have business development presence in  San Jose, California and in Rockville, Maryland.   

*** ***

**Seasonality;Raw Materials**

 

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

 

We use a large range of raw materials in our research. Our research anddiscovery unit uses bioinformatics databases such as databases of ESTs, whichare short nucleotide sequences that code for the expression of partial mRNA,gene expression databases, including from microarrays, protein interactionpathway databases and databases that match drugs 

**__26__** 

with their respective targets. Our therapeutic unituses a large range of biological reagents such as cell growth media, enzymes,antibodies and chromatographic resins. Our diagnostic unit also uses biologicalreagents, which include human tissue samples, cell lines and certain enzymes.These raw materials are either freely available or easily available to us or toour customers at reasonable prices. 

 

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

 

**Intellectual Property Rights  **

** **

Our intellectual property assets are among ourprincipal assets. These assets include the intellectual property rightssubsisting in our proprietary know-how and trade secrets, the copyrightssubsisting in our software and related documentation and in our patents andpatent applications. We seek to vigorously protect our rights and interests inour intellectual property. We expect that our commercial success will dependon, among other things, our ability to obtain commercially valuable patentsespecially for our therapeutic and diagnostic product candidates, maintain theconfidentiality of our proprietary know-how and trade secrets and otherwiseprotect our intellectual property.

 

We seek patent protection for inventions thatrelate to our therapeutic and diagnostic potential product candidates as wellas certain components of our technology platforms. We currently have 7registered patents of which 6 are registered in the United States and 1 isregistered in Australia. We also have 117 pending patent applications, whichinclude 60 patent applications that have been filed in the United States andapplications that have been filed under the Patent Cooperation Treaty for whichwe have not yet designated the countries of filing. We intend to continue toapply for patent protection for our therapeutic and diagnostic inventions,including for related inventions such as antibodies and peptides. 

 

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

 

**Competition**

** **

The biotechnology and pharmaceutical industries arehighly competitive. Numerous entities in the United States and elsewherecompete with our efforts to commercialize our discoveries. Our competitorsinclude pharmaceutical, biotechnology and diagnostic companies, academic andresearch institutions and governmental and other publicly funded agencies. 

 

Many of our competitors are more established,benefit from greater market recognition and have greater financial, technical,human, research and development and marketing resources, as well as facilitiesand experience, than we do. These competitors may discover and develop productcandidates, or market and sell products based on their discoveries, in advanceof us or our collaborators and licensees. They may also obtain patentprotection or other intellectual property rights that could limit or prevent usfrom pursuing the development and commercialization of our discoveries. Thisprospect is particularly pertinent to us since our discovery engines andrelated technologies are aimed at identifying, among other discoveries, novelalternatively spliced variants of genes that are the basis of third parties`respective gene-based therapeutic or diagnostic products. We have alreadyencountered circumstances where third parties attained intellectual propertyrights in their respective therapeutic or diagnostic products that preceded andinterfered with the rights that we obtained. We expect to encounter similarsuch circumstances in relation to other therapeutic or diagnostic productcandidates that we may wish to develop. 

 

The human genomic pool isfinite. To our knowledge, third parties, including our competitors, have beenfiling wide patent applications covering an increasing portion of thehuman genomic pool. We believe that our ability to continue and extract or usenew information through EST-based methods is already limited compared toour ability two and three years ago respectively. This limitation results from,among other things, the existence of third parties` intellectual propertyrights subsisting in genomic based discoveries, which precede our rights.

 

**__27__** 

Our discovery program depends, in large part, onour discovery engines and other technologies and our proprietary data to makeinventions and establish intellectual property rights in genes and gene-based products,including mRNAs, proteins and peptides. There are a number of other means bywhich such inventions and intellectual property can be generated. We believethat our computational technologies, and specifically our Leads-based discovery engines, provide us with a competitive advantagein the field of predicting gene based products, and occasionally gain someinformation on their biological importance. We believe that this advantage ismade possible by the incorporation of ideas and methods from mathematics andcomputer science into biology, and by the modeling of significant biologicalphenomena and the resultant better research capabilities that we developed.Nevertheless, we may lose this advantage if our existing or future competitorsmake scientific and technological progress. In addition, we may discover andpursue the development of therapeutic or diagnostic product candidates thatcould conflict with our collaborators` discovery and development plans,including licensees or collaborators to whom we granted in the past a licenseto use our LEADS computational platform. The prospect of such a conflictarising is particularly pertinent in relation to those collaborators andlicensees that received from us a license to use our LEADS computational platformto analyze raw data which is the same or similar to the raw data that we mayanalyze through LEADS.  

 

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

 

**Government Regulation**

** **

***Environmental Regulation***

 

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

 

***Regulation of Use ofHuman Tissue***

* *

We need to access and usevarious human or other organisms` tissue samples for the purpose of developmentof some of our products. Our access and use of these samples is subject togovernment regulation, in the US, Israel and elsewhere and may become subjectto further regulation. US and other governmental agencies may also imposerestrictions on the use of data derived from human or other tissue samples. Toour knowledge, we substantially comply with these regulatory requirements. 

 

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

* *

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

** **

**Organizational Structure**

 

We are the parent of two wholly-owned subsidiaries,Compugen USA, Inc., which is a corporation incorporated in Delaware and has itsprincipal place of business in California, and Keddem Bioscience Ltd., which isa company incorporated in Israel and has its principal place of business in Ashqelon, Israel. 

*** ***

**__28__** 

As of December 31, 2005, we also held approximately84.7% of the outstanding share capital of Evogene Ltd., but only 23.36% of itsshare capital, on a fully-diluted basis. As of December 31, 2005, we had the power to vote 34.89% of Evogene's share capital, due to our granting ofirrevocable proxies to a group of Evogene's investors. The proxies entitledtheir respective proxy holders to vote in a manner that they determined intheir discretion. For more information on Evogene, see Item 7. "MajorShareholders and Related Party Transactions; Related Party Transactions;Evogene Ltd." As of February 16, 2006, Evogene completed a series of agreementswith certain investors, under which it raised $7 million dollars and, as aresult, we held approximately 14.76% of Evogene Ltd.`s issued share capitalandthe power to vote approximately 14.76% of Evogene's share capital. Evogene isnot consolidated into our consolidated financial statements for the year 2005.For an explanation of our reason for not consolidating Evogene into ourfinancial statement, see Item 5. "Operating And Financial Review AndProspects;" "Critical Accounting Policies;" "Investment in Evogene Ltd."Evogene was formed under the laws of the State of Israel and has its principalplace of business in Rehovot, Israel. 

*** ***

##### Property, Plant andEquipment

** **

We lease an aggregate of approximately 28,200square feet of office and biology laboratory facilities in Tel Aviv, Israel.The leases in Tel Aviv expire in December 2009. 

 

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

 

In addition, Compugen USA leases approximately 406square feet of office space in San Jose, California which expires on May 30, 2006, and we have an option to extend it for one additional year. During 2005Compugen USA also leased approximately 145 square feet in Rockville, Maryland.The term of our lease in Maryland expired in January 2006.  

 

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

 

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

 

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

**__29__** 

### ITEM5.              OPERATING AND FINANCIAL REVIEW AND PROSPECTS

*** ***

The following discussion of our critical accountingpolicies and our financial condition and operating results should be read inconjunction with our consolidated financial statements and related notes,prepared in accordance with US GAAP for the years ended December 31, 2005, 2004and 2003 respectively, and with any other selected financial data includedelsewhere in this annual report.

*** ***

##### Background

*** ***

We are a biotechnology discovery company focused ontherapeutic and diagnostic product candidates. The Company`s powerfulpredictive models and discovery engines enable the discovery of numerouspotential therapeutics and diagnostic biomarkers. This capability results fromthe Company`s pioneering and on-going incorporation of ideas and methods frommathematics, computer science, and physics into biology, chemistry andmedicine.  To date, our discovery efforts have focused mainly oncancer, cardiovascular and immune-related diseases. Product development ispursued both in-house and through collaborative arrangements. The Company'sprimary business goal is to out-license therapeutic and diagnostic productcandidates for commercialization by leading companies under milestone andrevenue sharing agreements.

 

During 2003 to 2005 our primary business activitiesevolved from using our intellectual property, scientific know-how andcomputational biology capabilities to develop, market and sell to third partieslife science software products and services, to using these assets andcapabilities for the in-house discovery of therapeutic and diagnostic productcandidates.  

 

We carry out our research activities through threeunits, which is designed to enable us to continue to focus on the discovery,validation and commercialization of our therapeutic and diagnostic biomarkerproduct candidates. These three units consist of a therapeutics unit, adiagnostic biomarkers unit, and a research and discovery unit. These units areserviced and supported by our other units, which include finance, legal andbusiness development units.

 

We develop technological platforms, discoveryengines and other related technologies that enable the discovery and analysisof genes and gene-based products, including transcripts and proteins. Theseinclude our discovery engines, such as our therapeutic protein discovery engineand our diagnostic biomarkers discovery engines.  

 

Our discovery engines areproprietary technologies that are designed to enable our researchers toidentify proteins and transcripts that aresuitable for the development of therapeutic and/or diagnostic productcandidates. Our discovery engines extend the capabilities of our LEADS platformby incorporating sophisticated search and analysis algorithms to select themost promising therapeutic proteins and diagnostic biomarkers in a specificcategory or area of interest, from the many proteins identified by ourtechnologies. 

 

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

 

OPERATINGRESULTS

*** ***

##### Overview

 

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

 

Since our inception, we haveincurred significant losses and, as of December 31, 2005, we had an accumulateddeficit of $94.8 million (not including approximately $24.9 million inaccumulated deficit attributable to the conversion of preferred shares upon theclosing of our initial public offering). We expect to continue to incur netlosses in the near future. 

 

**__30__** 

Prior to 2004, an important aspect of ourcommercialization activities involved the sale of hardware and softwareplatforms, tools and databases, in which we incorporated certain aspects of ourunderstandings and/or discoveries and made them available to our customers. Forexample, in 2004, our revenues were primarily attributable to thecommercialization of our LEADS platform, Genecarta and OligoLibraries. Thecommercialization of these products is no longer pursued.  

 

We now intend to commercialize the therapeutic anddiagnostic product candidates that we discover by applying our intellectualproperty, scientific know-how and computational biology capabilities, includingour discovery engines. To date, discoveries that we have generated from use ofour discovery engines and related technologies have formed the basis of ourcollaborations with Diagnostic Products Corporation, Ortho-Clinical Diagnosticsand Biosite. We continue to evaluate various opportunities for additionalcollaborations based on use of our discovery engines. We intend to continue tofocus on the licensing out of our novel therapeutic and diagnostic productcandidates, which we discovered and intend to continue to discover internally orwith our collaborators. We intend that such licensing-out arrangements will bewith pharmaceutical, biotechnology and diagnostics companies, who will developand commercialize therapeutic or diagnostic products based on our discoveries.We intend that under these commercial arrangements we will receive milestonepayments upon the successful completion of predetermined developmental stagesand royalties from the sales of the therapeutic or diagnostics products, basedon our discoveries. 

 

During 2006 and beyond, we intend to continue inour efforts to enter into royalty and milestones bearing agreements with ourprospective collaborators and licensees. We intend that the basis of theseagreements will continue to be the licensing out of our intellectual propertyrights subsisting in our therapeutic and diagnostic product candidatesgenerated from use of our discovery engines and related technologies. 

 

We believe that the greatest long term andsustainable financial potential for us lies in the commercialization ofspecific therapeutic and diagnostic biomarker product candidates. For thepurpose of attaining this goal, we have shifted our focus away fromcommercializing our computational platforms and tools (such as Genecarta andOligoLibraries), all of which yielded revenues in the short term. We believethat the commercialization of our therapeutic and diagnostic product candidateshas the potential to generate revenues, in the long term, to a substantiallygreater extent than the long-term potential revenue-stream that could begenerated from commercializing our hardware and software platforms, tools anddatabases. 

 

Since we shifted focus away from commercializingour computationally-based products to the internal use of our capabilities, ourrevenues, decreased by approximately 75% in 2005, compared to 2004 and byapproximately 61% in 2004 compared to 2003.  

 

***Our net research and development expenses areexpected to account for more than 60% of our total operating expenses.***

 

Our net research and development expenses areexpected to be our major operating expense in 2006, accounting for more than60% of our total 2006 operating expenses. Our research and development expenseshave always comprised a significant portion of our expenses. In 2004 and 2005we increased the resources allocated to advance our internal therapeutic anddiagnostic biomarkers pipeline. 

 

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

 

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

*** ***

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

 

##### Compensation expenses attributed to optiongrants.

 

We recorded compensation expenses of approximately$1.1 million in 2003, approximately $755,000 in 2004, and approximately$378,000 in 2005, in connection with the grant of share options. These expensesare mostly attributable to options that we granted to our consultants and tothose of our employees and directors to whom we granted employee stock optionsat an exercise price below the fair market value at the date of grant.****Theseamounts are amortized over the vesting 

**__31__** 

periods of the individual share options. Based on optionsgranted through December 31, 2005, and based on our ordinary share price onthat date, we estimated that our future amortization of compensation expenseswill be approximately $1.2 million in 2006 and approximately $550,000 in 2007.Since January 2006, new accounting standard FAS 123R applies. Standard FAS 123Rdetermines the accounting treatment for share-based compensation to employees.The above future amortization of compensation expense estimates for 2006 and2007 reflect the application of this standard. These estimates are subject tothe amount of granted options at any given point in time. Our current policy isto grant options at the higher of the fair market value known on the date ofgrant or the average of our share price during the thirty trading dayspreceding the date of grant.  

 

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

We hold most of our cash, cash equivalents andmarketable securities in US dollars but incur a significant portion of ourexpenses, principally salaries and related personnel expenses, in New IsraelShekels. As a result, we are exposed to the risk thatthe US dollar will be devalued against the New Israel Shekels. In addition, we are exposed to the risk that the rate ofinflation in Israel will exceed the rate of devaluation of the NewIsrael Shekels in relation to the US dollar or thatthe timing of this devaluation will lag inflation in Israel. Since asignificant portion of our expenses are salaries and related expenses, whichare paid in New Israel Shekels, this is asmall risk. To date, our business has not been materially adverselyaffected by changes in the Israeli rate of inflation or the exchange rates ofthe NIS compared to the US dollar. 

 
Critical AccountingPolicies
 

The preparation of our consolidated financial statementsand other financial information appearing in this annual report requires ourmanagement to make estimates and judgments that affect the reported amounts ofassets, liabilities, revenues and expenses, and related disclosure ofcontingent assets and liabilities. We evaluate on an on-going basis theseestimates, mainly related to revenues, allowance for doubtful debts,contingencies, and investment in affiliates. 

 

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

 

***Revenue Recognition***

*** ***

During 2003, 2004 and 2005 we generated most of ourrevenues from license fees related to the commercialization of our softwareproducts. We also generated revenues from the sale of services, including fromthe provisions of maintenance, support, customization, training andinstallation services, and also from the sale of products (such as ourOligoLibraries products). 

 

We recognized 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 wegenerated from our collaborations under which we commercialized 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 generated from these collaboration arrangements were recognized inaccordance with our estimate regarding the status of the collaborative project.Any revisions to estimates of the status of a project (and the consequentrecognizable revenues) are recorded in the period during which we become awareof these changes. If we do not accurately estimate the resources required foror the scope of work to be performed under each such collaboration arrangement,or do not manage our projects properly within the planned periods of time orsatisfy obligations under the contracts, then the service margins may besignificantly and negatively affected or losses on existing contracts may haveto be recognized. We periodically check the possibility of losses fromcollaboration arrangements, which should be recognized immediately, inaccordance with our projections. During 2005, no provision for losses wasrequired.

 

We recognized software license revenues inaccordance with Statement of Position 97-2, "Software Revenue Recognition"("SOP 97-2") as amended. We recognized 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 

**__32__** 

multiple element arrangements, where vendor-specificobjective evidence of fair value exists for all undelivered elements, weaccount for the delivered elements in accordance with the "residualmethod" prescribed by Statement of Position 98-9, "Modification of SOP97-2, Software Revenue Recognition with Respect to Certain Transactions" ("SOP98-9"). Vendor-specific objective evidence of fair value is based on the pricea customer is required to pay when the element is sold separately. We assesswhether the fee is fixed or determinable and collection is probable at the timeof the transaction. In assessing whether the fee is fixed or determinable, weanalyze the payment terms of the transaction and other factors, including thenature and class of customer, our historical experience of collecting under ourpayment terms without granting a concession, the possibility of the productbecoming technologically obsolete before the payments become due and thelikelihood of the customer asking for a refund. If we determine the fee is notfixed or determinable, we defer the revenue until the payments under thearrangement become due. We assess whether collection is probable based on anumber of factors, including the customer's past transaction history and creditworthiness. If we determine that collection of a fee is not probable, we deferthe fee and recognize revenue only at the time that collection becomesprobable, which is generally upon the receipt of cash. 

 

We recognized 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.

*** ***

***Contingencies***

 

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

 

We are not currently involved in any legalproceedings and are not required to assess the likelihood of any specificadverse judgments or outcomes of such proceedings or of any potential ranges ofprobable losses. A determination of the amount of any accruals, if required,for these contingencies would be made after careful analysis. We believe thatas of December 31, 2005, the status of legal proceedings will not have amaterial impact on our financial condition, results of operations or cashflows. For more information in relation to legal proceedings, see "Item 8.****FinancialInformation; Consolidated Statements and Other Financial Information; LegalProceedings." It is possible, however, that future results of operations forany particular quarter or annual period could be materially affected by changesin our assumptions or as a result of the effectiveness of our strategiesrelated to these legal proceedings.

 

***Investment in Evogene Ltd.***

 

In accounting for our investment in Evogene, weadopted FIN 46 on July 1, 2003. Under FIN 46, we determined that Evogene qualifiedas a Variable Interest Entity, an entity which has one of the following: (1) aninsufficient amount of equity to carry on its principal operations, withoutadditional subordinated financial support from other parties, (2) a group ofequity owners that are unable to make decisions about the entity`s activities,or (3) equity that does not absorb the entity`s losses or receive the benefitsof the entity. 

 

FIN 46 requires consideration and estimates of asignificant number of possible future outcomes of the Variable Interest Entityas well as the probability that each of the outcomes will occur. The results ofeach possible outcome are allocated to the parties holding interests in theVariable Interest Entity. Based on the allocation of possible outcomes, acalculation is performed to determine which party, if any, has a majority ofpotential negative outcomes (expected losses) or a majority of the potentialpositive outcomes (expected residual returns). That party, if any, is theVariable Interest Entity`s primary beneficiary and is required to consolidatethe Variable Interest Entity. Calculating the expected losses and expectedresidual returns is highly subjective and requires the use of significantestimates. 

 

**__33__** 

We have examined the potential future results of Evogene,assigning probabilities to each potential outcome, and allocated thesepotential outcomes to the Variable Interest Entity`s variable interest holders.We have determined that we are not the primary beneficiary of Evogene, since wedo not absorb the majority of the entity's expected losses or its expectedresidual returns. In 2005, we had the power to vote approximately 34.89% ofEvogene's share capital due to our granting irrevocable proxies to a group ofEvogene's investors with respect to most of our shares in Evogene. As ofFebruary 16, 2006, following a series of agreements that Evogene completed withcertain investors, we held approximately 14.76% of the issued share capital ofEvogene Ltd. and the power to vote approximately 14.76% of Evogene's sharecapital. For more information about our voting power in Evogene, see "Item 7.Major Shareholders and Related Party Transactions; Related Party Transactions;Evogene Ltd."

 

Under FIN 46, the reconsideration of a VariableInterest Entity`s primary beneficiary status requires a triggering event, suchas any of the following: (1) the entity`s governing documents or contractualarrangement among the parties have been changed, (2) sales of part of thevariable interests to unrelated parties, (3) acquirement of newly issuedvariable interest in the entity or a portion of the primary beneficiary`sinterest, or (4) decrease in assets due to losses incurred by the VariableInterest Entity. In 2005, we again evaluated FIN 46 following the consummationof an amended and restated convertible loan agreementin January 2005, between Evogene and certain investors.  Formore information on this transaction, see "Item 7. Major Shareholders andRelated Party Transactions." Our conclusion from this evaluation is that we arestill not the primary beneficiary of Evogene.  

 
****__34__** **Results of Operations
 

***Selected FinancialData***

 

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

*** ***

** **

****

Year ended December 31

** **

****

 

2001*

 

2002*

 

2003*

 

2004*

 

2005

 

**(US$ in thousands, except share and per share  data)**

**Consolidated  Statements of Operations Data**

 

                          

                          

                          

                          

 

 

 

 

 

 

  Revenues

$        10,366

$        9,262

$        6,776

$        2,630

$        646

 

 

          

 

 

 

  Cost  of revenues

 

3,455

 

2,819

 

2,275

 

1,100

148

Research  and   development expenses

 

15,976

 

14,170

 

13,306

 

12,318

12,725

Less -  governmental and other grants *

 

(994)

 

(1,835)

 

(2,050)

 

(1,397)

(2,254)

Research  and   development expenses, net *

 

 

14,982

 

 

12,335

 

 

11,256

 

 

10,921

10,471

Selling  and marketing expenses

 

6,565

 

5,538

 

3,811

 

2,446

1,772

General  and administrative expenses

 

4,383

 

3,614

 

3,650

 

3,740

3,133

  Total  operating expenses **

 

29,385

 

24,306

 

20,992

 

18,207

 

15,524

        Operating loss 

(19,019)

(15,044)

(14,216)

(15,577)

(14,878)

Financial  and other income, net

 

3,875

 

2,840

 

2,774

 

1,855

 

900

Net  loss

$      (15,144)

$      (12,204)

$      (11,442)

$      (13,722)

$      (13,978)

Net  loss available to ordinary shares

 

(15,144)

 

(12,204)

 

(11,442)

 

(13,722)

 

(13,978)

Basic  and diluted net loss per ordinary share 

 

$          (0.58)

 

$          (0.47)

 

$          (0.43)

 

$          (0.50)

 

$          (0.50)

Weighted  average number of ordinary shares used in computing basic and diluted net  loss per share

 

 

 

 

26,005,784

 

 

 

 

26,103,343

 

 

 

 

26,409,180

 

 

 

 

27,473,341

 

 

 

 

27,774,535

 

**__35__** 

 

 

As of December 31,

** **

2001*

2002*

2003*

2004*

2005

 

**(US$ in thousands)**

**Consolidated Balance Sheet Data:**

                

                  

                

                  

 

Cash and cash equivalents, short-term deposits,  marketable securities and cash held in favor of consortium partners

$32,347

$48,402

$16,707

$20,574

$31,821

Long-term investments in marketable securities and bank  deposits

46,148

18,940

43,803

27,854

4,983

Receivables, net

3,163

4,601

1,456

1,545

676

Inventory

134

111

-

-

-

Total assets

87,289

77,257

67,526

55,353

42,106

Accumulated deficit

(68,388)

(80,592)

(92,034)

(105,756)

(119,734)

Total shareholders' equity

 

80,062

 

68,881

 

59,808

 

49,566

 

36,248

 

(*)        Reclassified - previously, we presented governmental and other grants as acomponent of our revenues and grants, based on the single step income statement presentationapproach. These amounts have been reclassified for all periods presented andare now shown as a deduction from research and development expenses.

 

(**)        Includesdeferred stock compensation - see Note 11 of our 2005 consolidated financialstatements.

 

*** ***

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

*** ***

*Revenues.*

 

Previously, we presented governmental and othergrants as a component of our revenues and grants, based on the single stepincome statement presentation approach. These amounts have been reclassifiedfor all periods presented and are now shown as a deduction from research anddevelopment expenses. Governmental and other grants for 2005 and 2004 wereapproximately $2.3 million and $1.4 million, respectively. 

Revenues decreased by 75% to approximately $646,000in 2005 from approximately $2.6 million in 2004. The decrease in revenues wasprimarily due to decreased sales of LEADS and Oligolibraries. The decrease inthe sales of these products is attributable to the shift in focus away fromcommercializing our computational products in favor of generating long-termrevenues from commercializing the therapeutic and diagnostic product candidatesthat we discover and may initially develop. Revenues from Novartis and Abbottrepresented 97% of our revenues in 2005. Our agreement with Abbott expired in2005.  

 

*Cost of Revenues.*Cost of revenues decreasedby 86.5% to approximately $148,000 for 2005 from approximately $1.1 million for2004. This decrease was primarily due to decreased costs related to the sale ofour OligoLibraries and LEADS products. 

**__36__** 

 

*Research and Development Expenses, Net.*Researchand development expenses, net decreased by 4%, to approximately $10.5 millionfor 2005 from approximately $10.9 million for 2004. The decrease in ourresearch and development expenses, net, was primarily due to an increase ingovernmental and other research and development grants that we received.Research and development expenses, net, as a percentage of revenues, increasedfrom 415% in 2004 to 1,621% in 2005.   

* *

*Selling and Marketing Expenses*. Selling andmarketing expenses decreased by 28% to approximately $1.8 million for 2005 fromapproximately $2.4 million for 2004. This decrease was due to our decision todecrease our marketing and sales efforts for our computational products andrelated services. Selling and marketing expenses, as a percentage of revenues,increased from 93% in 2004 to 274% in 2005.

* *

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

* *

*Financial Income, Net.*Financial income, net,decreased by 52% to approximately $682,000 for 2005 from approximately $1.4million for 2004. This decrease was attributable to manner in which we earnedinterest on three structured notes, at par value totaling $14 million. Whetheror not these structured notes bear interest depends upon the rate forsix-months LIBOR. For each day on which the six-month dollar LIBOR is below anagreed annual fixed rate, the investments bear coupon interest at the rate of3.15%, 3.625% and 4.1% per annum******respectively. For each day onwhich the six-month dollar LIBOR is above an agreed annual fixed rate, theinvestments, do not bear interest at all. The decrease was also attributable tolower levels of cash and cash related accounts. Financial income, net, as apercentage of revenues increased from 54% for 2004 to 106% for 2005. 

*** ***

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

* *

*Revenues.* Revenues decreased by 61% toapproximately $2.6 million in 2004 from approximately $6.8 million in 2003. Thedecrease in revenues was primarily due to decreased sales of LEADS, Genecarta,and Oligolibraries. The decrease in sales of these products is attributable tothe shift in focus away from commercializing our computational products infavor of generating long-term revenues from commercializing the therapeutic anddiagnostic product candidates that we discover and develop. Revenues fromNovartis and Sigma-Genosys represented 61% of our revenues in 2004. Ouragreement with Sigma-Genosys terminated in 2004. 

 

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

 

*Research and Development Expenses, net.*Researchand development expenses, net decreased by 3% to approximately $10.9 millionfor 2004 from approximately $11.3 million for 2003. The decrease in researchand development expenses, net was primarily due to decrease in cost of salariesdue to a reduction of employees, and decrease of depreciation expenses.Research and development expenses, net, as a percentage of revenues increasedfrom 166% in 2003 to 415% in 2004.   

* *

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

* *

*General and Administrative Expenses.*Generaland administrative expenses increased by 2% to approximately $3.7 million for2004 from approximately $3.65**million for 2003. This increase wasprimarily due to an increase in our CEO`s salary, and to the costs associatedwith the closing of our offices in New Jersey. General and administrativeexpenses, as a percentage of revenues, increased from 54% for 2003 to 142% in2004. 

* *

*Financial Income, Net.*Financial income,net, decreased by 33% to approximately $1.4 million for 2004 from approximately$2.1 million for 2003. This decrease was attributable to lower levels of cashand cash related accounts, and lower interest rates we received on short andlong-term marketable securities., Financial income, net, as a percentage ofrevenues, increased from 31% for 2003 to 54% for 2004. 
***__37__** *
* *

Governmental Policies that Materially Affected orCould Materially Affect Our Operations

 

Israeli companies aregenerally subject to income tax at the corporate tax rate of 31%, which isexpected to be reduced to 29% in January 2007, and is expected to be furtherreduced to 27% in 2008 to 26% in 2009 and to 25% in 2010 and thereafter.However, several investment programs at our facility in Tel Aviv have beengranted Approved Enterprise status under which we are eligible for a reducedcorporate tax under the Law for the Encouragement of Capital Investments, 1959.Subject to compliance with applicable requirements, the portion of our profitsthat may be derived from the approved enterprise programs will be tax-exemptfor a period of two years commencing in the first year in which we generatetaxable income from the applicable Approved Enterprise. The portion of ourprofits that may be derived from our approved enterprise programs will besubject, for an additional period of five or eight years, to reduced corporatetax rates of between 10% and 25%. The tax rate within the range of 10% and 25%that may actually become payable is a function of the percentage of non-Israeliinvestors holding our ordinary shares. Thesereduced corporate tax rates will cease to apply upon the expiry of the earlier of twelve years from thetime at which we attain a prescribed level of investment in our approvedenterprise (known as "commencement of production") or 14 years from the date onwhich we received approval for an Approved Enterprise. The period of taxbenefits with respect to our approved enterprise programs has not yet commenced,because we have not yet generated any taxable income. These benefits shouldresult in income recognized by us being tax exempt or taxed at a lower rate fora specified period of time after we begin to report taxable income and exhaustany net operating loss carry-forwards. However, these benefits may not beapplied to reduce the US federal tax rate for any income that our US subsidiarymay generate. There can be no assurance that such tax benefits will continue inthe future at their current levels, if at all.

 

As of December 31, 2005, we did not have anytaxable income. As of December 31, 2005, our net operating loss carry-forwardsfor Israeli tax purposes amounted to approximately $62million. Under Israeli law, these net-operating losses may be carriedforward indefinitely and offset against certain future taxable income. 

 

Until December 31, 2005, the net operating losscarry-forwards of our US subsidiary for US tax purposes amounted toapproximately $15 million. These losses are available to offset any future UStaxable income of our US subsidiary and will expire between the years 2012 and2024. 

 

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

 

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

 

 

LIQUIDITY AND CAPITAL RESOURCES

** **

In 2005, as in 2004 and 2003, our sources of cashcame from a private placement that took place in July 2000, from our IPO, whichtook place in August 2000, from revenues generated from sales, fromgovernmental and other grants, receipts from the exercise of employee stockoptions, and from financing income. We used these funds primarily to financeour 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, governmentaland other 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 proceeds from these sales were $57.5 million ($51.1 million net ofissuance expenses). All outstanding preferred shares were converted intoordinary shares upon the closing of the initial public offering. 

**__38__** 

 

We expect that we will need additional financing inthe future to fund our activities.

 

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

 

Net cash used in operating activities wasapproximately $5.6 million in 2003, approximately $12.2 million in 2004, andapproximately $11.1 million in 2005. These amounts were used to fund our netlosses for these periods, adjusted for non-cash expenses and changes inoperating assets and liabilities. The sources of the cash that we used in ouractivities through 2005 was the cash we had in the bank, revenues andgovernmental and other grants that we received, the receipts from the exerciseof employee stock options, and financing income. We expect that our sources ofcash for 2006 will be similar. Our subsidiaries are not restricted from transferringfunds to Compugen, although we do not expect any cash to flow in from them.  

 

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

 

Net cash used in investing activities consists ofproceeds from redemption of marketable securities, net of purchases of propertyand equipment, plus investment grants relating to fixed assets. Net cashgenerated by investing activities was approximately $4.9 million in 2003,approximately $5.9 million in 2004, and approximately $15.1 million in 2005.The increase in net cash provided by investing activities in 2005 is mainlyattributable to us not purchasing any marketable securities in 2005 as opposedto 2004 during which we purchased marketable securities in the amount ofapproximately $8.2 million. 

 

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

 

Our net cash provided by financing activities wasapproximately $3.3 million in 2003, approximately $2.7 in 2004, andapproximately $178,000 in 2005. The principal sources of cash provided byfinancing activities in 2005 were proceeds that we received from the issuanceof ordinary shares as result of the exercise of stock options by employees. 

 

***Net Liquidity***

*** ***

Liquidity refers to theliquid financial assets we have available to fund our business operations andpay for near term future obligations. These liquid financial assets consist ofcash and cash equivalents as well as short-term and long-term marketablesecurities. As of December 31, 2005, we had cash and cash equivalents, cashheld for the benefit of consortium partners, and short-term deposits andmarketable securities of approximately $31.8 million, and long-term marketablesecurities of approximately $5 million. We believe that our existing cash andcash equivalents, short-term deposits and short-term and long-term marketable securitieswill be sufficient to fund our operations for at least the next two years.However, we expect that we will need additional financing in the future to fundour activities. 

** **

As of December 31, 2005, Keddem Bioscience had cashand cash equivalents and short-term deposits of approximately $767,000. Webelieve that Keddem Bioscience`s existing cashand cash equivalents will be sufficient to fund its operations forapproximately 7 months. Keddem Bioscience`s externalauditors have raised substantial doubts on Keddem BioScience`s ability tocontinue as a going concern.

** **

We have a commitment for capital expenditures inthe amount of approximately $142,000 that relates to construction of ourmolecular biology laboratories and which comprises part of our currentliabilities.

** **

RESEARCHAND DEVELOPMENT, PATENTS AND LICENSES

*** ***

We invest heavily inresearch and development. Research and development expenses, net, were ourmajor operating expenses, representing more than 50% of the total operatingexpenses for each of 2003, 2004, and 2005. Our research and developmentexpenses were $10.5 million in 2005, compared with $10.9 million in 2004 and$11.3 million in 2003. As of December 31, 2005, 92 of our employees wereengaged in research and development on a full-time basis. This representsapproximately 76% of our entire work force. As a result of the re-organizationthat we underwent in December 2005, as of January 31, 2006, 72 of our employees were engaged in research and development on a full-time basis,representing approximately 73% of our entire work force. 

 

**__39__** 

Consistent with our shift in focus away fromselling our computational and software products, we now focus our research anddevelopment efforts on the development of our discovery engines and relatedtechnologies, and of our therapeutic proteins and diagnostic biomarker productcandidates. We expect that in 2006 our research and development expenses willcontinue to be our major operating expense, representing more than 60% of ourtotal operating expenses. 

 

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

* *

***Research and Development Grants***

 

We participate in programs offered both by theOffice of the Chief Scientist under the Industry and Trade Ministry of Israel("OCS") that supports research and development activities, by the Israel-U.S.Bi-national Industrial Research and Development Foundation ("BIRD") and by theEuropean Community, under the European Union`s 6th FrameworkProgram. We received grants and other forms of consideration from the OCS ofapproximately $2.1 million in 2003, approximately $1.4 million in 2004 and, in2005, from both the OCS and BIRD, in the aggregate amount of approximately $2.3million. We have applied for additional grants from the Office of the ChiefScientist for research, technological development and demonstration activitiesin 2006. 

 

***The Office of the Chief Scientist***

* *

We received grants from the Office of the ChiefScientist for several projects. Under the terms of these grants, we will berequired to pay royalties ranging between 3% to 5% of the net sales of productsdeveloped from the OCS-funded projects, beginning with the commencement ofsales of such products and ending when 100% of the dollar value of the grant isrepaid (100% plus LIBOR interest applicable to grants received on or afterJanuary 1, 1999). The royalty rate (between 3% and 5%) varies depending on theamount of years that lapse between receipt of the grant and its repayment byus. As of December 31, 2005, our contingent accrued obligation for royalties,based on royalty-bearing government grants, net of royalties already paid,totaled approximately $6.5 million, payable out of future net sales of productsthat were developed under Office of the Chief Scientist -funded projects. 

 

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

 

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

**__40__** 

transferred under any circumstances to any entity outsideof the consortium. The terms of the program prohibit both the manufacture ofproducts using technology developed in the context of the program outside of Israeland the transfer of technology developed under the program to any Israeli thirdparty, without the prior written consent of the OCS.

*  *

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

*** ***

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

 

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

 

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

* *

*The European Union`s 6th FrameworkProgram*

 

In 2005 we joined two research consortia under theEuropean Community 6th Framework Program, which is a program basedon the Treaty establishing the European Union, with the aim of promotingresearch and technology among the European Community members. 

 

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

 

The terms of the grant from the European Communitydo not require us to repay the grant monies that we receive, unless we or anyof our consortium members default in our obligations such as carrying out theresearch that we undertook to perform, or in reporting the progress of theresearch. We received a portion of the grant and currently hold approximately$834,000 on behalf of other consortium members. This amount is due to bedistributed to them in accordance with an agreement between the consortiummembers. See Notes 4 and 9 of our 2005 Consolidated Financial Statements. 

 

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 larger companies havinggreater financial resources and technological capabilities. This trend towardsconsolidation in the pharmaceutical and biotechnology industries may alsoresult in there being fewer customers for our products and services. Also, ifone of the consolidating companies already uses the technologies or services ofour competitors, we may lose existing customers as a result of suchconsolidation. 

** **

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

* *

Large amounts of genomic data are increasinglybecoming available to the general public. To date, most of the public effortsrelating to human genomics involved producing data under the Human GenomeProject. Following the publication of the first draft of the human genome, therehas been an increase in public efforts to develop analysis tools forunderstanding genomic, functional genomic and proteomic data. These effortshave already resulted and may further result in the future in the developmentof products, which are competitive to ours and that are available free ofcharge. Such developments could require us to lower our prices, could causesome of our products to be less commercially viable or to be obsolete, or couldassist third parties to discover genes or proteins that are of interest to us.

**__41__** 

 

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

 

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

 

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

 

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

** **

** **

OFF-BALANCE SHEET ARRANGEMENTS

 

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

** **

TABULAR DISCLOSURE OF CONTRACTUAL OBLIGATIONS

*** ***

The table below summarizes our contractualobligations as of December 31, 2005, 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

2,866

996

1,368

502

Accrued Severance Pay  Reflected on our Balance 

1,659

 

 

1,659

Other Long-Term Liabilities  Reflected on our Balance Sheet under the GAAP of the Primary Financial  Statements

60

 

20

40

Total

4,585

996

1,388

2,201

 

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

 

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. 

**__42__** 
ITEM6.              DIRECTORS, SENIOR MANAGEMENT AND EMPLOYEES
** **
Directors and SeniorManagement
** **

The following sets forth information with respectto our directors and executive officers as of February 1, 2006.

** **

Name

Age

Positions

Martin S. Gerstel

64

Chairman of the Board of Directors

1Alex  Kotzer

60

Chief Executive Officer, President and Director

Orna Berry, Ph.D

56

Director

David Schlachet

60

Director

Ruben Krupik

54

Director

Nurit Benjamini

39

Chief Financial Officer

Erez Chimovits

42

President, Compugen USA, Inc., and Executive Vice  President, Commercial Operations

Noam Shani, Ph.D

43

Vice President, Therapeutics

2D`vorah Graeser,  Ph.D

38

Vice President, Intellectual Property

 

 

 

3Anat Cohen  Dayag, Ph.D

39

Vice President, Diagnostic Biomarkers

3Yossi Cohen**,**M.D**.**

34

Vice President, Research and Discovery

** **

1             AlexKotzer`s appointment as our President and Chief Executive Officer becameeffective on September 1, 2005

2             D`vorah Graeser will nolonger be an executive officer as of April 1, 2006 

3             AnatCohen Dayag and Yossi Cohen each assumed theirposition as executive officers in January 2006.

** **

**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,which he helped found in 1968. Mr. Gerstel is also the Chairman of Evogene Ltd.and Keddem Bioscience Ltd., co-founder and co-chairman of Itamar Medical, andserves as a director of Symyx Technologies, Yissum Ltd., Yeda Ltd. and theFoundation for the National Medals of Science and Technology. He is a member ofthe Board of Governors and the Executive Committee of The Weizmann Institute ofScience and The Board of Governors of The Hebrew University of Jerusalem, andis an advisor to the Burrill Life Science Funds and the board of the Israel-USBi-national Industrial Research and Development (BIRD) Foundation. Mr. Gerstelholds a B.S. from YaleUniversity and an MBA from StanfordUniversity.

 

**Alex Kotzer**joined Compugen in September2005 as President and Chief Executive Officer and a director. Mr. Kotzer bringswith him over thirty years of senior managerial experience in variousindustries. Prior to joining Compugen, he served for twelve years at Serono(virt-x: SEO and NYSE: SRA), a global biotechnology leader, headquartered in Switzerland.During his tenure at Serono, Mr. Kotzer held several senior positions, mostrecently as Vice President of Biotechnology Manufacturing. Previously, Mr.Kotzer was President and Chief Executive Officer of InterPharm, Serono'sIsraeli affiliate. Before joining Serono, he held a variety of managerialpositions in the food and chemical industries. Mr. Kotzer received his B.Sc. inChemical Engineering from the Technion, Israel Institute of Technology, of Haifa, Israel.

** **

**Orna Berry, Ph.D**joined our board ofdirectors as an outside director in June 2001. She is a Venture Partner atGemini Israel Funds, and the Chairperson at Lambda Crossing, Ltd. and atAdamind Ltd. From 1997 to 2000, she was the Chief Scientist of the Ministry ofIndustry, Trade and Labor of the Government of Israel. Dr. Berry was theco-founder of ORNET Data Communication Technologies Ltd. She served as theChief Scientist of Fibronics and as a senior research engineer in 

**__43__** 

several companies, including IBM and UNISYS.  Dr.  Berry received her Ph.D. in computer science from the University of Southern  California and her M.A. and B.A. degrees in statistics and mathematics fromTel Aviv and Haifa Universities in Israel, respectively. Dr. Berry serves as anoutside director on our board of directors for a fixed term, which expires inJune 2007.

** **

**David Schlachet**joined our board ofdirectors as an outside director in June 2001. He is a managing partner ofBioCom Management and Investment (2002) Ltd, which serves as the managingcompany of BioCom venture capital fund, focused on life sciences, and since2005 he serves as the CEO of Syneron Medical Ltd. (Nasdaq: Elos). He also serves on the Boards ofDirectors of the following companies: Poalim Capital Markets & InvestmentsLtd., Harel Capital Markets Ltd., Taya Investment Company Ltd., United StudiosLtd., Pharmos Ltd., Edgar Development and Investment 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. in chemicalengineering from the Technion, Israel Institute of Technology and an MBA fromthe Tel Aviv University, Israel. Mr. Schlachet serves as an outside director onour board of directors for a fixed term, which expires in June 2007.

** **

**Ruben Krupik**joined our board of directorsin 2003. Mr. Krupik serves as the President and CEO of Arte Venture Group Ltd.,which provides a framework of business development, investments and Managementfor various large investment entities in Israel. Mr. Krupik serves as theExecutive Director of Clal Biotechnology Industries, the general manager ofBiomedical Investments, the active chairman of Steps Ventures, and the managerof the Arison Group's technology division. From 1991 to 2000 Mr. Krupik held anumber of positions, including the President and CEO of RDC (Rafael DevelopmentCorporation Ltd.). Prior to that, Mr. Krupik held a number of senior managementpositions at Tadiran Communications Group. Mr. Krupik holds an LL.B. in lawfrom the Tel Aviv University and a BA in Economics and Political Science fromthe Hebrew University, Israel.

**Nurit Benjamini**joinedus in 2000 bringing over ten years of experience in the Israeli andinternational economic field. Prior to joining us, Ms. Benjamini served as CFOof Phone-Or Ltd. Between 1993 and 1998, Ms. Benjamini was CFO at AladdinKnowledge Systems Ltd. (NASDAQ: ALDN). Ms. Benjamini holds a B.A. in Economicsand Business and an MBA in Finance, both from Bar  Ilan University, Israel.

 

**Erez Chimovits**joinedus in 1999, holding several senior business development and sales positionsbefore assuming his current position in 2001. Prior to joining us, Mr.Chimovits held various positions in business development, marketing and salesat Saifan Ltd. Mr. Chimovits holds a B.S. in Biology, an M.S. in Microbiology,and an MBA, all from the Tel Aviv University, Israel.  

 

**Noam Shani, Ph.D.**joined us in 2004from Medgenics Inc., where he served as Vice President of Research andDevelopment and led the development of the company's technologies andapplications, including all biological and clinical research. Prior toMedgenics, Dr. Shani was a senior scientist and project manager atBiotechnology General Ltd. In this capacity, he headed the company's genericrecombinant protein drug development activities. Dr. Shani holds a  B.S.in Biology from the Ben Gurion University, Israel and a M.S. and Ph.D. inBiology, both from the Weizmann Institute of Science, Israel. He completeda postdoctoral fellowship at Johns Hopkins University's School of Medicine, Maryland.

 

**D'vorah Graeser, Ph.D.** commenced workingwith us in 2004, bringing with her eight years of patent experience in bothlife science and computer-related fields. Prior to joining us, Dr. Graeserfounded a boutique patent firm, which eventually merged with Ehrlich &Partners, a leading patent firm in Israel. Dr. Graeser was a partner at thisfirm until she joined us. Previously Dr. Graeser worked as a US Patent Agent atDr. Mark Friedman Ltd., where she headed the department for computer-relatedpatents and applications. Dr. Graeser holds a B.A. in Biochemistry from Harvard University and a Ph.D. in Pharmacology from the University of Michigan, Ann  Arbor. She completed post-doctoral fellowships at both the Institute forBiomedical Computing at Washington University in St. Louis, Missouri and at theImperial Cancer Research Fund in London, performing computer programming andexperimental work for the Human Genome Project. 

** **
****__44__** **
**Anat Cohen-Dayag, Ph.D**. joined Compugen in2002. Prior to joining Compugen, she was head of research and development andmember of the Executive Management at Mindsense Biosystems Ltd. Prior toMindsense Biosystems, Dr. Cohen-Dayag served as a scientist at the R&Ddepartment of Orgenic. Dr. Cohen-Dayag holds a B.Sc. in Biology from theBen-Gurion University, Israel, and an M.Sc. in Chemical Immunology and a Ph.D.in Cellular Biology, both from the Weizmann Institute of Science, Israel.

** **

**Yossi Cohen, M.D.**joined Compugen in 2001.Dr. Cohen's diverse prior experience includes serving as a physician in theIsrael Defense Forces and holding various software development positions in theIsraeli hi-tech industry. Dr. Cohen has a B.Sc. in Electrical and ElectronicsEngineering from the Tel-Aviv University, Israel, and an M.Sc. in Neurobiologyand an M.D., both from the Hebrew University, Israel.

 
Compensation
 

The aggregate compensation paid by us and by ourwholly-owned subsidiaries to all persons who served as directors or seniormanagement for the year 2005 (12 persons) was approximately $1,461,000. Thisamount includes approximately $86,000 set aside or accrued to provide pension,severance, retirement or similar benefits.

 

During 2005, we granted a total of 944,000 optionsto purchase ordinary shares to our directors and senior management, as a group.These options are exercisable at a range of between $3.2 and $6.1****pershare, and expire ten years after their respective date of grant in the case ofour employees and directors, and six years after their respective date of grantin the case of our consultants. As of December 31, 2005, there were a total of2,533,420****outstanding options to purchase ordinary shares that weregranted to our directors and senior management, and 192,100 outstanding optionsthat were granted to the members of our scientific advisory board.

 

All members of our board of directors who are notour employees or consultants are reimbursed for their expenses for each meetingattended and are eligible to receive share options under our share optionplans. The aggregate amount paid to all of our non-employee directors for theyear ended December 31, 2005 was approximately $36,000. These fees are adjustedsemi-annually to reflect changes prescribed by regulations under the IsraelCompanies Law, 5759-199 (the "Companies Law"), for payment to outsidedirectors. Members of our scientific advisory board receive cash compensationand, have been granted and may be granted further stock options for theirservices.  

** **

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

 

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

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

●       second, provided that the audit committee approvesthe proposed compensation, the proposal is then submitted to our board ofdirectors for review,   except that a director who is the beneficiaryof the proposed compensation does not participate in any discussion or votingwith respect to such proposal; 

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

●       the approval of a majority of our shareholders is requiredto implement any such compensation proposal.

 

**Board Practices**

*** ***

***Election of Directorsand Terms of Office***

 

Our board of directors currently consists of fivemembers, including our chairman and chief executive officer. Other than our twooutside directors, our directors are elected by an ordinary resolution at theannual general meeting of our shareholders. In August 2003, our board ofdirectors appointed Mr. Ruben Krupik to serve as one of our directors. By ashareholders` resolution dated August 30, 2005, our shareholders appointed Mr.Alex Kotzer to serve as a director of our company and Dr. Mor Amitai, who wasnot nominated by our board of directors to serve another term, ceased being adirector on that date.

 

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

 

**__45__** 

Dr. Orna Berry and Mr. David Schlachet serve asoutside directors pursuant to the provisions of the Israel Companies Law for asecond three-year term ending in June 2007. After this date, their term ofservice can not be renewed. 

 

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 Mr. Alex Kotzer, who is entitled pursuant to the terms of his employmentagreement, to receive severance in the amount of a multiple of six times hisgross monthly salary, as may be updated from time to time if the companyterminates his employment without justifiable cause. Mr. Alex Kotzer`sentitlement to this severance payment is in addition to severance payment towhich he would be entitled to receive under law in such circumstances. 

 

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

 

***Outside and Independent Directors***

 

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

●       an employment relationship; 

●       a business or professional relationship maintainedon a regular basis;

●       control; and 

●       service as an office holder. 

 

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

 

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

 

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

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

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

 

The initial term of an outside director is threeyears and may be extended for an additional three years term. 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 entitledto compensation as provided in regulations adopted under the Companies Law andis otherwise prohibited from receiving any other compensation, directly orindirectly, in connection with service provided as an outside director.

 

**__46__** 

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

 

In addition to the requirements of the CompaniesLaw as described above, since our shares are listed on the Nasdaq NationalMarket, a majority of our directors must be independent (as defined by theNasdaq National Market`s Marketplace Rules), and our audit committee must becomprised of at least three members, all of whom must be independent (subjectto limited exceptions). We currently meet these requirements. 

 

***Audit Committee***

 

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

 

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

 

***Other Committees***

** **

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

** **

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

** **

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

 

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

 

***Internal Auditor***

** **

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

 

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

 

***Scientific Advisory Board***

*** ***

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

**__47__** 

 
NameAffiliation
 

 

Nabil Hannah, Ph.D.

Former Executive Vice President, Research, Biogen Idec  Inc.

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

*** ***
Employees
** **

The following table sets out the number of our employees engaged inspecified activities, by geographic location both for the last three fiscalyears and as of January 31, 2006.****

**Year Ended December 31,**

** **

**2005**

**2004**

**2003**

** **

**Jan 31, 2006**

** **

** **

** **

Research & Development 

  Israel

  USA

  United    Kingdom

 

71

0

1

 

92

0

 

90

2

 

95

7

1

Administration,  Accounting and Operations

  Israel

  USA

 

 

21

0

 

 

23

0

 

 

24

1

 

 

24

4

Sales,  Marketing, Business Development and Support 

  Israel

  USA

  United    Kingdom

 

 

0

5

0

 

 

0

5

1

 

 

1

4

1

 

 

2

7

1

 

Total 

 

98

 

121

 

123

 

141

 

The number of our employees as of January 31, 2006 was added to illustrate the impact the re-organization that we underwentin December 2005. The effective date for termination of most of our employeeswhose employment was terminated as part of the re-organization, was December 31, 2005. The effective date of termination of the employment of another 8employees was in February 2006 or is in March 2006. 

 

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

**__48__** 

 
Share Ownership
 

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

*** ***

All of the persons listedabove under the caption "Directors and Senior Management" own ordinary sharesand/or options to purchase ordinary shares. Except as set forth in the tablebelow, none of the directors or executive officers owns shares and/or optionsamounting to 1% or more of the outstanding ordinary shares. The following tablesets forth certain information as of January 31, 2006, regarding the beneficialownership by our directors and executive officers. All numbers quoted in thetable are inclusive of options to purchase shares that are exercisable within60 days after January 31, 2006. 

 

**Beneficial Owner**

**Amount Owned**

**Percent of Class**

Martin S. Gerstel (1)

1,895,680

6.8%

All directors and senior  management as a group (2)

2,404,773

8.6%

*** ***

(1)       Includes 550,000 shares held by Shomar Corporation, anaffiliate of Mr. S. Gerstel, 1,142,568 shares held by Merrill Lynch IRA for Martin Gerstel,of which Martin Gerstel is the beneficiary, and options to purchase 203,112shares that are exercisable within 60 days of January 31, 2006. Based oninformation disclosed by Mr. Martin S. Gerstel on Form 13G, filed with the SECon February 6, 2006. 

 

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

 

***Share Option Plans***

** **

We maintain three share option plans for our andour subsidiaries' employees, directors and consultants. In addition to thediscussion below, see Note 11 of our 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 January 31, 2006, options to purchase 79,000 ordinary shares, granted at a weighted average exercise price ofapproximately $2.01****per share, remained outstanding under the plan.These options 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 our and oursubsidiaries` employees, directors and consultants. As of January 31, 2006, options to purchase 624,909 ordinary shares were outstanding under the plan at aweighted average exercise price of approximately $2.26 per share. Options topurchase 1,216,875 ordinary shares under the plan have previously beenexercised at an exercise price of approximately $1.56, and options to purchase658,216 ordinary shares remain available for future grant. If a grantee leaveshis or her employment or other relationship with us, the term of his or herunexercised vested options expire 90 days later. 

**__49__** 

 

*Compugen Share Option Plan (2000)*

*** ***

Under the Compugen ShareOption Plan (2000), we may grant options for up to an aggregate of 7,924,525 ordinaryshares to our employees, directors and consultants and our subsidiaries'respective employees, directors and consultants. This total numberautomatically increases on January 1 of every year by the lesser of 1,500,000shares or 4% of the total number of our then-outstanding shares, or such loweramount as shall be determined by the board of directors. If a grantee leaveshis or her employment or other relationship with us, or if his or herrelationship with us is terminated without cause, the term of his or herunexercised options will expire 90 days later. As of January 31, 2006, options to purchase 3,782,500 ordinary shares were outstanding under the plan at aweighted average exercise price of approximately $4.46 per share. Options topurchase 760,500 ordinary shares under the plan have previously been exercisedat an exercise price of approximately $3.66, and options to purchase 3,381,524ordinary shares remain available for future grant. 

 

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

 

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

 

If a grantee sells shares or releases them fromtrust prior to expiration of the required holding period, the grantee will besubject to income tax on his gains at a rate which is his or her marginalincome tax rate (currently up to 49%), as well as payment of associated healthtax and national insurance payments. Additionally, in such circumstances,withholding requirements will apply and be carried out by the employing companyin accordance with applicable laws, regulations and rules. 

 

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

 

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

 

*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 optionswere forfeited without being exercised in November 1999. In addition, 115,403of these options have been exercised to date. The terms of these options arethe same as those granted under the Compugen Share Option Plan (1998). We donot intend to grant additional options under this plan.***  ***

**__50__** 

 

*Directors` Options*

* *

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

 

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

**__51__** 
ITEM7.              MAJOR SHAREHOLDERS AND RELATED PARTY TRANSACTIONS
** **
Major Shareholders
** **

The following table sets forth certain informationregarding beneficial ownership of our ordinary shares as of December 31, 2005 by each person who is known by us to own beneficially more than 5% of ouroutstanding ordinary shares. The voting rights of our major shareholders do notdiffer from the voting rights of other holders of our ordinary shares. 

** **

** **

Beneficial Owner

**Number of  Ordinary Shares Beneficially Owned**

**Percent of  Ownership**

Martin Gerstel (1)

1,692,568

6.1%

Clal Industries & Investments Ltd. (2)

3,056,274

11%

AXA Assurances I.A.R.D. Mutuelle (3)

4,718,037

16.9%

 

(1)       Includes 550,000 shares heldby Shomar Corporation, an affiliate of Mr. Gerstel, 1,142,568 shares held byMerrill Lynch IRA for Martin Gerstel, of which Martin Gerstel is thebeneficiary. Based on information disclosed by Mr. Martin Gerstel on Form 13G,filed with the SEC on February 6, 2006.

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

 

(3)       This disclosure is based oninformation disclosed by AXA Assurances I.A.R.D. Mutuelle on Form 13G, fieldwith the SEC on February 14, 2006.

 

As of January 31, 2006, there were a total of 101holders of record of our ordinary shares, of which 65 were registered withaddresses in the United States. Such United States holders were, as of suchdate, the holders of record of approximately 88.87% of the outstanding ordinaryshares.  ****

** **
Related PartyTransactions
 

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

 

***Evogene Ltd.***

 

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

 

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

 

**__52__** 

As a result of a series of transactions relating toan additional investment in Evogene, that closed on February 15, 2006, all those investors who extended to Evogene convertible loans, became the holders ofshares in Evogene. We did not participate in the investment in Evogene. As aresult of the most recent series of transactions, as of 16 February 2006, we own approximately 14.76% of Evogene`s issued capital.

 

As of December 31, 2005, we held approximately84.7% of Evogene`s issued and outstanding share capital, but only 23.36% ofEvogene`s share capital, on a fully-diluted basis. As a result of us grantingirrevocable proxies to investors in Evogene empowering them to vote 820,000 ofour shares in Evogene in a manner that they determined in their discretion (andwhich constituted 50% of our shareholding of Evogene at the time of the grant)and of the issuance to us of 350,000 ordinary shares of Evogene under aComputational Tools License Agreement, with Evogene, as of December 31, 2005 wehad the power to vote 34.89% of Evogene's share capital. For more information,see Note 1 of our 2005 Consolidated Financial Statements and "Item 5.Operating and Financial Review and Prospects; Critical Accounting Policies;Investment in Evogene. 

 

As of December 31, 2005, Martin Gerstel, ourchairman of the board, held approximately 7.52% of Evogene`s issued andoutstanding share capital (approximately 7.09% of Evogene`s share capital, on afully-diluted basis), and the power to vote approximately 10.94% of Evogene`sshare capital. Since December 19, 2004, Martin Gerstel has served as thechairman of Evogene`s board of directors. 

 

As of December 31, 2005, we did not have control over Evogene for the following reasons:

●       We had less than 50% voting power in Evogene;

●       Other investors in Evogene had the right to coverttheir loan to Evogene into preference shares, which they did in February 2006; 

●       Of the five directors serving on Evogene`s board ofdirectors in 2005, we had and continue to have only one representative; 

●       We had not been and continue not to be involved inthe daily management of Evogene; and

●       Under the FASB issued Interpretation No. 46,"Consolidation of Variable Interest Entities", we were not andcontinue not to be a primary beneficiary of Evogene`s business.

 

On August 1, 2004, we entered into an ExtensionAgreement to a Computational Tools License Agreement, with Evogene. Theoriginal license was granted to Evogene upon Evogene`s incorporation on January 1, 2002. Under the extension agreement, the license was extended for twoadditional years, until December 31, 2007, in consideration of the issuance tous of 350,000 ordinary shares of Evogene. During these two years we areobligated to provide to Evogene limited support services at no additionalcharge. We consider the fair value of the equity instruments received to datein connection with Evogene to be minimal and as a result we did not recognizeany revenues from these transactions.

 

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

*** ***

***Keddem Bioscience Ltd.***

*** ***

On August 1, 2004, we turned ourchemistry division into a wholly-owned subsidiary, Keddem Bioscience Ltd. Thetransaction was effected by way of a transfer to Keddem Bioscience of all ofour assets and liabilities that were dedicated to the operation of ourchemistry division, in consideration of the issuance to us of 2,999,900ordinary shares NIS0.01 par value of Keddem Bioscience. On July 29, 2004 we entered into aConvertible Loan Agreement with Keddem Bioscience, under which we agreed toloan to Keddem Bioscience up to US$1,572,000. The outstanding principalloan amount bears interest at an annual rate (each year considered separately)which is the greater of (i) 5%; and (ii) the 12 month LIBOR as determined onthe first business day after the corresponding anniversary, compoundedannually. The loan is convertible into Keddem Bioscience`sshares at our discretion, until the earlier of: (x) the repayment date or (y)the merger, acquisition, IPO or similar event ofKeddem Bioscience. If not converted, the loan is to be repaid by KeddemBioscience upon the earlier of (i) June 30, 2011, and (ii) Keddem Bioscience defaulting under the loanagreement`s terms. 

 

**__53__** 

On June 16, 2005, our board ofdirectors resolved to advance to Keddem an amount of $100,000 for a period ofone year, bearing interest at an annual rate of 5%. On November 1, 2005 ourboard of directors also resolved to assign to Keddem our entitlement to receivefrom the Investment Center of the Israel Ministry of Industry, Trade andLabor (the "Investment Center"), an amount ofapproximately $400,000 - on account of our investment in the expansion of, whatwas at the time, our Ashqelon computational chemistry facilities and thebuilding of a laboratory there for drug development. In accordance with theterms of the loan, in January 2006, Keddem repaid to us the full amount of the$100,000 loan following its receipt of approximately $400,000 from the InvestmentCenter.   

** **

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

* *

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

 

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

 

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

 

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

**__54__** 
ITEM8.              FINANCIAL INFORMATION
 
ConsolidatedStatements and Other Financial Information
** **

Our consolidated financial statements are includedon pages F-1 through F-35 of this annual report.  

 

***Legal Proceedings***

*** ***

Currently, we are not a party to any materialpending legal proceedings. There are no legal proceedings pending or, to ourknowledge, threatened against us or our subsidiaries and we are not involved inany legal proceedings that our management believes, individually or in theaggregate, would have a material adverse effect on our business, financialconditions or operating results. 

*** ***

***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.

 

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

 
Significant Changes
 

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

**__55__** 
ITEM9.                THEOFFER AND LISTING
 

*Markets and Share Price History*

 

The principal trading market for our ordinaryshares is 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 Hebrew  symbolwhich is equivalent to "CGEN" since January 7, 2002. The following table sets forth, for the periods indicated, the high and low reported salesprices of the ordinary shares on the Nasdaq National Market and on the Tel AvivStock Exchange: 

 

** **

**Nasdaq**

***TASE**

**Last Six Calendar Months**

**High**

**Low**

**High**

Low

January 2006

$5.220

$4.050

$5.304

$3.457

December 2005

$4.350

$2.550

$4.064

$2.578

November 2005

$3.200

$2.500

$2.996

$2.581

October 2005

$3.310

$2.460

$3.404

$2.698

September 2005

$3.840

$3.070

$3.822

$3.198

August 2005

$4.100

$3.360

$3.903

$3.352

 

 

 

 

 

**Financial Quarters During the Past Two Full  Fiscal Years**

 

 

 

 

Fourth Quarter of 2005

$4.350

$2.460

$4.064

$2.578

Third Quarter 2005

$4.100

$2.820

$3.903

$2.974

Second Quarter 2005

$4.380

$2.740

$4.276

$2.665

First Quarter 2005

$6.540

$3.800

$6.557

$3.844

Fourth Quarter of 2004

$5.250

$3.650

$5.262

$3.725

Third Quarter 2004

$5.410

$3.180

$5.180

$3.042

Second Quarter 2004

$7.190

$4.280

$7.055

$4.336

First Quarter 2004

$8.090

$5.010

$8.130

$5.127

 

 

 

 

 

**Last Five Full Financial Years**

 

 

 

 

2005

$6.540

$2.460

$6.557

$2.578

2004

$8.090

$3.180

$8.130

$3.042

2003

$6.300

1.500$

$6.086

$1.505

2002

$5.240

$0.910

$6.335

$0.894

2001

$8.625

$2.600

--

--

 

 

 

 

 

*the currency by which ourstock is traded on the Tel Aviv Stock Exchange is the New Israel Shekels. Theabove dollar amounts represent a conversion from New Israel Shekels to Dollaramounts in accordance with the Dollar - New Israel Shekel conversion rate as ofthe relevant date of trade.

**__56__** 
ITEM 10.              ADDITIONALINFORMATION
 
Memorandum and Articles of Association
** **

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

** **

We are registered under Israel's Companies Law,1999 ("Companies Law") as a public company under the name CompugenLtd. and public company number 51-177-963-9. The objective stated in ourArticles of Association is to engage in any lawful activity. 

** **

***Powers of the Directors***

** **

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

** **

***Approval of Certain Transactions***

 

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

 

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

 

In the case of a transaction which is not anextraordinary transaction, after the office holder complies with the abovedisclosure requirement, only board of directors` approval is required unlessthe Articles of Association of the company provide otherwise. A transactionmust not be adverse 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.

 

**__57__** 

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

 

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

 

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

 

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

●       any amendment to the Articles of Association; 

●       an increase of the company's authorized sharecapital; 

●       a merger; and 

●       approval of interested party transactions.

 

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

 

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

** **

***Rights Attached 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 theshareholders of our ordinary shares according to their rights and interests inour profits. In the event of our liquidation, after satisfaction of liabilitiesto creditors, our assets will be distributed to the shareholders of ourordinary shares in proportion to the nominal value of their shareholdings. Thisright may be affected by 

**__58__** 

the grant of preferential dividend or distribution rightsto the shareholders of a class of shares with preferential rights that may beauthorized in the future. Pursuant to Israel's securities laws, a companyregistering its shares for trade on the Tel Aviv Stock Exchange (TASE) may nothave more than one class of shares for a period of one year followingregistration, after which it is permitted to issue preference shares. Under theCompanies Law, the declaration of a dividend does not require the approval ofthe shareholders of the company, unless the company's Articles of Associationrequire otherwise. Our Articles of Association provide that the board ofdirectors may declare and distribute dividends without the approval of theshareholders.

 

To date, we have not declared or distributed anydividend.

** **

***Annual and Extraordinary General Meetings***

*** ***

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

*** ***

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

 

***Voting Rights***

 

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

* *

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

 

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

 

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

** **

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

 

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

** **

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

**__59__** 

 

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

 
Material Contracts
 

In June 2005, we announced the entry into acollaboration with Ortho-Clinical Diagnostics, Inc. ("OCD"), for thedevelopment and commercialization of immunoassay based diagnostic products thatare based on the output of our diagnostic discovery engines. The terms of thisagreement allow OCD to select up to nine diagnostic biomarkers and then we willcollaborate on the initial clinical validation of the selected biomarkers.Under the agreement, successfully validated biomarkers will be developed intoproducts and commercialized by OCD, and we will receive milestone payments andlicense fees for each commercialized biomarker, in addition to revenue-basedroyalties. We received together with OCD a grant from the Israel-U.S. Bi-nationalIndustrial Research and Development Foundation for contribution to our researchand development expenditures under our joint collaborative project. 

 

In June 2005, we also announced the entry into acollaboration with Biosite Incorporated, for the development andcommercialization of immunoassay based diagnostic products based on the outputof our diagnostic discovery engines. Under the terms of this agreement, wegranted to Biosite an exclusive license in the diagnostic field to use certainof our targets for immunoassay based diagnostic applications. In return forthis grant, we are entitled to receive milestone payments and royalties fromthe sales of each diagnostic product emerging from the collaboration. We alsoretained the exclusive right to pursue further development of these targets inthe therapeutic field, and for which Biosite will be entitled to receive fromus milestone payments and royalties arising from any successful therapeuticapplication.

 

In April 2005, we announced a joint pilot researchproject with Novartis in the field of systems biology. Under the agreement, wewere required to generate information about biological interaction networksthrough the development of a proprietary platform for research and analysis ofmicroarray and other biological data. In consideration for a one time paymentby Novartis, Novartis obtained sole rights to the specific results of theproject. We retained all rights to the research and discovery systems developedthrough the collaboration.

 

In August 2004, we entered into a broad pipeline discovery-based collaboration withDiagnostic Product Corporation ("DPC"), for the development andcommercialization of diagnostic products based on the output of our diagnosticdiscovery engines, with an anticipated focus on cancer and cardiovasculardisease. The terms of this agreement allow DPC to develop and commercializeimmunoassay and nucleic-acid based diagnostic products that are based oncandidate biomarkers that we already discovered, as well as additionalcandidates that may arise out of the collaboration.

 
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. Under Israeli law, both residents and non-residents of Israelmay freely hold, vote and trade ordinary shares.
 Taxation
 

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

 

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

* *
*****__60__** ***
***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.  

*** ***

*General Corporate Tax Structure*

** **

Israeli companies are generally subject to companytax at the rate of 31% (in the 2006 tax year), which will be reduced to 29% inJanuary 2007, and will be further reduced to 27% in 2008, 26% in 2009 and 25%in 2010 and thereafter. However, the effective tax rate payable by a companywhich derives income from an approved enterprise may be less, as furtherdiscussed below.

 

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

 

The Law for the Encouragement of CapitalInvestment, 1959 (the "Investment Law") provides that a proposed capitalinvestment in production facilities or other eligible facilities may bedesignated as an "Approved Enterprise". To obtain an "ApprovedEnterprise" status, an application to the Investment Center of the Ministry ofIndustry, Trade and Labor (the "Investment Center") needs to be submitted. Eachinstrument of approval for an Approved Enterprise relates to a specificinvestment program that is defined both by the financial scope of theinvestment, including sources of funds, and by the physical characteristics ofthe facility or other assets. 

 

The tax benefits available under any instrument ofapproval relate only to taxable profits attributable to the specific programand are contingent upon meeting the criteria set out in the instrument ofapproval. If a company has more than one approval or only a portion of itscapital investments are approved, its effective tax rate is the weightedaverage of the applicable rates***.***However,****subject tocertain qualifications, if a company with one or more approvals distributesdividends, the dividends are deemed attributable to the entire enterprise 

** **

*Tax benefits for income from ApprovedEnterprises approved before**April 1, 2005*

 

Before April 1, 2005 an Approved Enterprise wasentitled to receive either a grant from the Government of Israel or analternative package of tax benefits ("Alternative Benefits"). We have electedto forego the entitlement to grants and have applied for the AlternativeBenefits, under which undistributed income that we generate from our ApprovedEnterprises will be completely tax exempt (a "tax exemption") for two yearscommencing from the year that we first produce taxable income from theapplicable Approved Enterprise. The portion of our profits derived from ourapproved enterprise programs will be subject to a tax rate of between 10% and25% for an additional five to eight years. The tax rate within the range of 10%and 25% that may actually become payable is a function of the percentage ofnon-Israeli investors holding our ordinary shares.******These reduced corporate tax rates will cease toapply upon the expiry of theearlier of twelve years from the time at which we attain a prescribed level ofinvestment in our approved enterprise (known as "commencement of production")or 14 years from the date on which we received approval for an ApprovedEnterprise.

*** ***

As a result of the transfer of certain assets toKeddem Bioscience under the Asset Purchase Agreement between us and Keddem Bioscience,Keddem Bioscience has also received the Approved Enterprise status under theAlternative Benefits track applying to the transferred assets. For moreinformation about our agreement with Keddem Bioscience, see "Item 10.Additional Information; Material Contracts; Keddem Bioscience Ltd."  

 

Alternative Benefits are available until theearlier of (i) seven or ten consecutive years, commencing in the year in whichthe specific Approved Enterprise first generates taxable income, (ii) 12 yearsfrom commencement of production, and (iii) 14 years from the date of approvalof the Approved Enterprise status.

 

Dividends paid out of income generated by anApproved Enterprise (or out of dividends received from a company whose incomeis generated by an Approved Enterprise) are generally subject to withholdingtax at the rate of 15%. This withholding tax is deductible at source by theApproved Enterprise. The 15% tax rate is limited to dividends and distributionsout of income derived during the benefits period and actually paid at any timeup to 12 years after commencement of production. Since we elected theAlternative Benefits track, we will be subject to pay corporate tax at the rateof 25% in respect of the gross amount of the dividend that we may distribute.If we will also be deemed to be a "Foreign Investors' Company" which is atleast 49% owned by non-Israeli residents, the corporate tax rate paid by us inrespect of dividend that we may distribute from income derived by our ApprovedEnterprises during the tax exemption 

**__61__** 

period, may be taxed at a lower rate. Subject to certainconditions, a Foreign Investors' Company or "FIC" is a company with a level offoreign investment of more than 25%. The level of foreign investment ismeasured as the percentage of rights in the company (in terms of shares, rightsto profits, voting and appointment of directors), and of combined share andloan capital, that are owned, directly or indirectly, by persons who are notresidents of Israel.

 

Since we have elected the Alternative Benefitspackage, we are not obliged to attribute any part of dividend that we maydistribute to exempt profits, and we may decide from which year's profits to declaredividends. We currently intend to reinvest any income that we may in the futurederive from our Approved Enterprise programs and not to distribute the incomeas a dividend. 

 

If we will qualify as a FIC, our ApprovedEnterprises will be entitled to additional tax benefits and we will be eligiblefor an extension of the period during which we will be entitled to tax benefitsunder our Approved Enterprise status (so that the benefit periods may be up toten years) and for further tax benefits if the level of foreign investmentexceeds 49%. 

 

The benefits available to an Approved Enterpriseare subject to the fulfillment of conditions stipulated in the Investment Lawand its regulations and the criteria in the specific certificate of approval,as described above. If we do not meet these conditions, we would be required torefund the amount of tax benefits, linked to the consumer price index andinterest. 

 

*Tax benefits under an Amendment that becameeffective on April 1, 2005*

 

On April 1, 2005, a significant amendment to theInvestment Law became effective (the "Amendment"). The Amendment does not applyto benefits included in any certificate of approval that was granted before theAmendment came into effect, which will remain subject to the provisions of theInvestment Law as they were on the date of such approval. 

 

Under the Amendment, "Approved Enterprise" statuswill continue to be granted by the Investment Center to qualifying investments.However, the Amendment limits the scope of enterprises which may be approved bythe Investment Center, by setting criteria for the approval of a facility as anApproved Enterprise, such as provisions generally requiring that at least 25%of the Approved Enterprise`s income will be derived from export.

 

The Amendment provides that Approved Enterprisestatus will only be necessary for receiving grants. As a result, it is nolonger necessary for a company to acquire Approved Enterprise status in orderto receive the tax benefits previously available under the Alternative Benefitsprovisions. Rather, a company may claim the tax benefits offered by theInvestment Law directly in its tax returns, provided that its facilities meetthe criteria for tax benefits set out by the Amendment. Companies are entitledto approach the Israeli Tax Authority for a pre-ruling regarding theireligibility for benefits under the Amendment. 

 

Tax benefits are available under the Amendment toproduction facilities (or other eligible facilities),whichare generally required to derive morethan 25% of theirbusiness income from export. In order to receive the tax benefits, theAmendment states that the company must make an investment which meets all theconditions set out in the Amendment for tax benefits and exceeds a minimumamount and a minimum percentage of the value of the company`s production assetsat the end of the calendar year preceding the expansion, that is specified inthe Investment Law. Such investment allows the company to receive a"Benefited Enterprise" status, and may be made over a period of nomore than three years ending at the end of the year in which the companyrequested to have the tax benefits apply to the Benefited Enterprise (the "Yearof Election"). Where the company requests to have the tax benefits apply to anexpansion of existing facilities, only the expansion will be considered to be aBenefited Enterprise and the company`s effective tax rate will be the weightedaverage of the applicable rates. In this case, the minimum investment requiredin order to qualify as a Benefited Enterprise is required to exceed a minimumamount and a minimum percentage of the value of the company`s production assetsat the end of the calendar year preceding the expansion. 

 

The extent of the tax benefits available under theAmendment to qualifying income of a Benefited Enterprise are determined by thegeographic location of the Benefited Enterprise. The location will alsodetermine the period for which tax benefits are available. 

 

Dividends paid out of income derived by a BenefitedEnterprise will be treated similarly to payment of dividends by an ApprovedEnterprise under the Alternative Benefits track. Therefore, dividends paid outof income derived by a Benefited Enterprise (or out of dividends received froma company whose income is derived from a Benefited Enterprise) are generallysubject to withholding tax at the rate of 15%, deductible at source. Thereduced rate of 15% is limited to dividends and distributions out of incomederived from a Benefited Enterprise during the benefits period and actuallypaid at any time 

**__62__** 

up to 12 years thereafter. A company qualifying for taxbenefits under the Amendment which pays a dividend out of income derived by itsBenefited Enterprise during the tax exemption period will be subject to tax inrespect of the gross amount of the dividend at the otherwise applicable rate of25%, (or lower in the case of a qualified "FIC" which is at least 49% owned bynon-Israeli residents). The dividend recipient would be subject to tax at therate of 15% on the amount received which tax would be deducted at source.

 

The Amendment sets a minimal amount of foreigninvestment required for a company to be regarded a FIC.  

* *

*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. 

 

*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.

 

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 industrial enterprisemay be eligible for special depreciation rates for machinery, equipment andbuildings. These rates differ based on various factors, including the date theoperations begin and the number of work shifts. An industrial company owning anapproved enterprise may choose between these special depreciation rates and thedepreciation rates available to the approved enterprise. We are entitled tochoose an accelerated rate of depreciation. 

 

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 InflationaryAdjustments Law, represents an attempt to overcome the problems presented to atraditional tax system by an economy undergoing rapid inflation. TheInflationary Adjustments Law is highly complex. Its features, which arematerial 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; and 

●       subject to specified limitations, depreciationdeductions on fixed assets and losses carried forward are adjusted forinflation based on the increase in the consumer price index. 
****__63__** **
** **

*Capital Gains Tax on**Sale**of ourPublicly Traded Ordinary Shares by 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, unless a specific exemption is available or unless a treatybetween Israel and the country of the non-resident provides otherwise. 

 

On January 1, 2006 an amendment to the Israeli taxregime became effective (the "2006 Tax Reform"). The 2006 Tax Reformsignificantly changed the tax rates applicable to income derived from shares. 

 

According to the 2006 Tax Reform, an individual issubject to a 20% tax rate on real capital gains derived from the sale ofshares, as long as the individual is not a "substantial shareholder"(generally a shareholder with 10% or more of the right to profits, right tonominate a director and voting rights) of the company issuing the shares. Therate on the gains from publicly traded shares applicable to gains that wererealized before January 1, 2006 was 15%. 

 

A substantial shareholder will be subject to tax ata rate of 25% in respect of real capital gains derived from the sale of sharesissued by the company in which he is a substantial shareholder. Thedetermination of whether the individual is a substantial shareholder will bemade on the date that the securities are sold. In addition, the individual willbe deemed to be a substantial shareholder if at any time during the 12 monthspreceding this date he had been a substantial shareholder.

 

With respect to gains accrued before January 1, 2003,regulations promulgated under the Israeli Income Tax Ordinance provided for anexemption from Israeli capital gains tax on gains that were derived from thesale of shares of an "Industrial Company", as defined by the IndustryEncouragement Law. This exemption only applied to shares that were traded onspecified non-Israeli markets, including the NASDAQ National Market, providedthat the sellers purchased their shares either in the company`s initial publicoffering or in public market transactions thereafter. The exemption did notapply to shareholders who are in the business of trading securities, or toshareholders that are Israeli resident companies and subject to the Income TaxLaw (Inflationary Adjustments) - 1985. We believe that we are currently anIndustrial Company, as defined by the Industry Encouragement Law. The status ofa company as an Industrial Company may be reviewed by the tax authorities fromtime to time. There can be no assurance that the Israeli tax authorities willnot deny our status as an Industrial Company, possibly with retroactive effect.

 

Corporations are subject to corporate tax rates inrespect of total income, including capital gains. The 2006 Tax Reform providesthat the corporate tax rate will be reduced gradually from 34% in 2005 to 31%in 2006, 29% in 2007, 27% in 2008, 26% in 2009 and 25% in 2010. However,between 2006 and 2009, corporations whose taxable income was not determinedimmediately before the 2006 Tax Reform was published, pursuant to part B of theIsraeli Income Tax Law (Inflationary Adjustments), 1985 or pursuant to theIncome Tax Regulations (Rules on Bookkeeping by Foreign Invested Companies andCertain Partnership and Determination of their Chargeable Income), 1984("Dollar Regulations") will generally be taxed at a rate of 25% on theircapital gains from the sale of their shares.

 

Non-residents of Israel will generally be exemptfrom any capital gains tax from the sale of publicly traded shares so long asthe gains are not derived through a permanent establishment that thenon-resident maintains in Israel, and so long as the shares remain listed fortrading on a designated stock market. These provisions dealing with capitalgains are not applicable to a person whose gains from selling or otherwisedisposing of the Shares are deemed to be business income. 

 

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 Tax Treaty"),the sale, exchange or disposition of ordinary shares by a person who qualifiesas 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 our voting power during any part of the12-month period preceding such sale, exchange or disposition, subject tocertain conditions. However, under the United States-Israel Tax Treaty, such"Treaty United States Resident" would be permitted to claim a credit for suchtaxes against the United States federal income tax imposed with respect to suchsale, exchange or disposition, subject to the limitations in United States lawsapplicable to foreign tax credits. The United States-Israel Tax Treaty does notrelate to United States state or local taxes. 

 

**__64__** 

Non-residents of Israel are subject to income taxon income accrued or derived from sources in Israel. These sources of incomeinclude passive income, including dividends, royalties and interest, as well asnon-passive income from services rendered in Israel. On distribution ofdividends other than bonus shares or stock dividends, income tax is withheld atsource, at the rate of 20% for dividends paid to an individual who is not asubstantial share holder, 25% for dividends paid to a substantial shareholderor a foreign corporation, and 15% for dividends generated by an approvedenterprise, unless in each case a different rate is provided in a treatybetween Israel and shareholder's country of residence. Under the US-Israel taxtreaty, the maximum tax on dividends paid to a holder of ordinary shares who isa US resident will be 25%. However, the maximum tax rate on dividends notgenerated by an approved enterprise paid to a US corporation holding at least10% of our voting power is 12.5%.

*** ***

***United States**Federal IncomeTax Considerations***

 

Thefollowing discusses the material United States federal income tax consequencesto a holder of our ordinary shares who qualifies as a US Holder, which isdefined 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  States federal income tax purposes, as a domestic trust or estate.

 

This definition 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. Thisdefinition does not encompass any aspect of state, local or non-United Statestax laws.

 

Further,this definition does not purport to be a comprehensive description of all ofthe tax considerations that may be relevant to US Holders entitled to specialtreatment under United States federal income tax laws, for example, financialinstitutions, insurance companies, tax-exempt organizations and broker-dealers,and it does not address all aspects of United States federal income taxationthat may be relevant to any particular shareholder based on the shareholder'sindividual circumstances. In particular, this definition does not address thepotential application of the alternative minimum tax, nor the special UnitedStates federal income tax rules applicable in special circumstances, includingto US 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 USdollar. 

 

Additionally, this definition does not consider thetax treatment of partnerships or persons who hold ordinary shares through apartnership or other pass-through entity or the possible application of United  States federal gift or estate taxes. Material aspects of United Statesfederal income tax relevant to a holder other than a US Holder are alsodescribed below.

 

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

*** ***

A US Holder will be required to include in grossincome as ordinary income the amount of any distribution paid on ordinaryshares, including any Israeli taxes withheld from the amount paid, to theextent the distribution is paid out of our current or accumulated earnings andprofits as determined for United States federal income tax purposes.Distributions in excess of these earnings and profits will be applied againstand will reduce the US Holder's basis in the ordinary shares and, to the extentin excess of this basis, will be treated as gain from the sale or exchange ofordinary shares.

**__65__** 

Dividend income earned byindividuals may be eligible for a reduced rate of taxation. Dividend incomewill be taxed at the applicable long-term capital gains rate if the dividend isreceived from a "qualified foreign corporation," and the shareholderof such foreign corporation holds such stock for more than 60 days during the120 day period that begins on the date that is 60 days before the ex-dividenddate for the stock. The holding period is tolled for any days on which theshareholder has reduced his risk of loss. A "qualified foreigncorporation" is one that is eligible for the benefits of a comprehensiveincome tax treaty with the United States. A foreign corporation will be treatedas qualified with respect to any dividend paid, if its stock is readilytradable on an established securities market. However, a foreign corporationwill not be treated as qualified if it is a Passive Foreign Investment Company(as discussed below) for the year in which the dividend was paid or thepreceding year.

 

Distributions of current oraccumulated earnings and profits paid in foreign currency to a US Holder willbe includible in the income of a US Holder in a US dollar amount calculated byreference to the exchange rate on the day the distribution is received. A USHolder that receives a foreign currency distribution and converts the foreigncurrency into US dollars subsequent to receipt will have foreign exchange gainor loss based on any appreciation or depreciation in the value of the foreigncurrency against the US dollar, which will generally be US source ordinaryincome or loss.

 

Asdescribed above, we will generally be required to withhold Israeli income taxfrom any dividends paid to holders who are not resident in Israel. See"Israeli Tax Considerations - Taxation of Non-Resident Holders ofShares." If a US Holder receives a dividend from us that is subject toIsraeli withholding, the following would apply:

●       You must include the gross amount of the dividend,not reduced by the amount of Israeli tax withheld, in your US taxableincome.

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

●       The foreign tax credit is subject to significantand complex limitations. Generally, the credit can offset only the portion ofyour US tax attributable to your net foreign source passive income.Additional special rules apply to taxpayers predominantly engaged in the activeconduct of a banking, insurance, financing or similar business. Additionally,if we pay dividends at a time when 50% or more of our stock is owned by USpersons, you may be required to treat the part of the dividend attributable toUS source earnings and profits as US source income, possibly reducing theallowable credit, unless you elect to calculate your foreign tax creditseparately with respect to our dividends.

●       A US Holder will be denied a foreign tax creditwith respect to Israeli income tax withheld from dividends received on theordinary shares to the extent the US 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 US Holder is under anobligation to make related payments with respect to substantially similar orrelated property. Any days during which a US 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 US corporation holding ourstock, you cannot claim the dividends-received deduction with respect to ourdividends.

 

Special rules, describedbelow, apply if we are 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 US Holder will recognize capital gain or loss in anamount equal to the difference between the US 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 US 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.

 

**__66__** 

A US Holder that uses the cash method of accountingcalculates the US dollar value of the proceeds received from a sale of ordinaryshares as of the date that the sale settles, and will generally have noadditional foreign currency gain or loss on the sale, while a US Holder thatuses the accrual method of accounting is required to calculate the value of theproceeds of the sale as of the trade date and may therefore realize foreigncurrency gain or loss, unless the US Holder has elected to use the settlementdate to determine its proceeds of sale for purposes of calculating this foreigncurrency gain or loss. In addition, a US Holder that receives foreign currencyupon disposition of our ordinary shares and converts the foreign currency intoUS dollars subsequent to receipt will have foreign exchange gain or loss basedon any appreciation or depreciation in the value of the foreign currencyagainst the US dollar, which will generally be US source ordinary income orloss.

 

***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 2005and in prior years constituted passive income, as defined for purposes of theIncome Test, we believe that application of the Income Test would have not 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 consisted of the cash raised in connectionwith both a public offering and a private offering of our ordinary shares in2000, coupled with the decline in the public market value of our ordinaryshares during 2001, 2002 and through the beginning of 2003 and the timing ofthe required valuations, although there is no definitive method prescribed inthe Code, United States Treasury Regulations or administrative or judicialinterpretations thereof for determining the value of a foreign corporation`sassets for purposes of the Asset Test. While the legislative history of theUnited States Taxpayer Relief Act of 1997 indicates that "the total value of apublicly-traded foreign corporation`s assets generally will be treated as equalto the sum of the aggregate value of its outstanding stock plus itsliabilities", there remains substantial uncertainty regarding the valuation ofa publicly-traded foreign corporation`s assets for purposes of the Asset Test.

 

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, US shareholders are urged to consult theirown tax advisors for guidance as to our status as a PFIC. For those USshareholders 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 US shareholder`s holdingperiod of ordinary shares and the US shareholder does not make a QEF Electionor a "mark-to-market" election (both as described below), any gain recognizedby the US shareholder upon the sale of ordinary shares (or the receipt ofcertain distributions) would be treated as ordinary income. This income wouldbe allocated over the US 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 will be generally treated as a PFIC asto any US 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 US shareholder may avoid theconsequences 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 US shareholder who acquires ordinary shares froma 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.

 

For any tax year in which we are treated as a PFIC,a US shareholder may elect to treat his ordinary shares as an interest in aqualified electing fund (a "QEF Election"), in which case, the US 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 USshareholder. Any gain subsequently recognized upon the sale by the USshareholder of his ordinary shares, however, generally would be taxed ascapital gain.

**__67__** 

 

As an alternative to a QEF Election, a USshareholder 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. US 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. USHolders are urged to consult their tax advisors about the PFIC rules, includingQEF elections.

*** ***

***United States**Federal IncomeTax Consequences for Non-US Holders of Ordinary Shares***

 

Except as described in"Information Reporting and Back-up Withholding" below, a Non-USHolder of ordinary shares will not be subject to US federal income orwithholding tax on the payment of dividends on, and the proceeds from thedisposition of, ordinary shares, unless:

●       the item is effectively connected with the conductby the Non-US 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-US 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-US Holder is subject to tax under theprovisions of United States tax law applicable to US expatriates.

 

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

 

US 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 US Holder provides IRSForm W-9 or otherwise establishes an exemption. US Holders are subject toinformation reporting and back-up withholding at a rate of 28% on proceeds paidfrom the disposition of ordinary shares unless the US Holder provides IRS FormW-9 or otherwise establishes an exemption.

 

Non-US 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-US 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 US or Non-US Holder's United States federalincome tax liability and may entitle the Holder to a refund, provided thatspecified required information is furnished to the IRS.

** **
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 are exemptfrom the reporting and other provisions in Section 16 of the Exchange Act.

 

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 AtriumCenter, 500 West Madison Street, Suite 1400, Chicago, Illinois 60661 and at theoffices of the Israel Securities Authority at 22 Kanfei Nesharim St.,Jerusalem, Israel. You may also obtain copies of such materials from the PublicReference Section of the SEC, Room 1024, Judiciary Plaza, 450 Fifth Street,  N.W., Washington, D.C. 20549, at prescribed rates. You may call the SEC at1-800-SEC-0330 for further information on the public reference 

**__68__** 

rooms. As a foreign private issuer we were only requiredto file through the SEC`s EDGAR system as of November 2002. Our periodicfilings are therefore available on the SEC`s Website www.sec.gov from thatdate. You may read and copy any reports, statements or other information thatwe file with the SEC, through the SEC`s EDGAR system available on the SEC`swebsite and at the SEC facilities listed above. These SEC filings are also availableto the public on the Israel Securities Authority`s website at www.isa.gov.iland 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.

**__69__** 
ITEM 11.            QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
 

 We are exposed to a variety of risks, includingchanges in interest rates and foreign currency exchange risk and inflation. On December 31, 2005 and December 31, 2004, $14 million of our available cash was invested inmarket risk sensitive instruments. These instruments are three structured notesthat we acquired from three separate and unaffiliated issuers. These bear aninterest rate, which is dependent upon the six-months LIBOR rate. For moreinformation on the manner in which the interest rate is calculated, see Note 6of our 2005 Consolidated Financial Statements.

 

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

As of December 31, 2005, we had $36.8 million incash, cash equivalents and marketable securities. We invest our cash surplus inbank deposits and marketable securities. Since these investments typicallycarry fixed interest rate, excluding our structure note, and since our policyand practice is to hold these investments to maturity, financial income overthe holding period is not sensitive to changes in interest rates.

 
Foreign CurrencyExchange Risk and Inflation
** **

Since the majority of our cash, cash equivalentsand marketable securities are held in US dollars, we believe that inflation andfluctuations in the NIS/US dollar exchange rate have no material effect on ourrevenues. 

 

We incur a significant portion of our expenses,principally salaries and related personnel expenses, in New Israel Shekels, or NIS.As a result, we are exposed to the risk that the rate of inflation in Israelwill exceed the rate of devaluation of the NIS in relation to the US dollar orthat the timing of this devaluation lags behind inflation in Israel. Inaddition, we are exposed to the risk that the US dollar will be devaluedagainst the NIS. To date, we have not been materially affected by changes inthe Israeli rate of inflation or the exchange rates of the NIS compared to theUS dollar. 
ITEM12.            DESCRIPTION OF SECURITIES OTHER THAN EQUITY SECURITIES
 

  Not applicable.

**__70__** 

 
PART II
 
ITEM13.            DEFAULTS, DIVIDEND ARREARAGES AND DELINQUENCIES
 

None. 
ITEM14.              MATERIALMODIFICATIONS TO THE RIGHTS OF SECURITY HOLDERS AND USE OF PROCEEDS
 
Material Modificationsto the Rights of Security Holders
 

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 inthis report is recorded, processed, summarized and reported on a timely basis.Under the supervision of our Chief Executive Officer and Chief FinancialOfficer, we conducted an evaluation of our disclosure controls and procedures,as such term is defined under Rule 13a-15(e) and 15d-15(e) promulgated underthe Securities Exchange Act of 1934. Based on this evaluation, our ChiefExecutive Officer and Chief Financial Officer concluded that our disclosurecontrols and procedures were effective as of the end of the period covered bythis annual report. Our Chief Executive Officer and Chief Financial Officerhave also concluded that there were no significant changes in our internalcontrols or in other factors that could significantly affect the internalcontrols subsequent to that date of evaluation, including any correctiveactions with regard to significant deficiencies and material weaknesses.
ITEM16.            RESERVEDITEM16A.          AUDIT COMMITTEEFINANCIAL EXPERT
 

Our board of directors has determined that Mr.David Schlachet, who chairs our audit committee, is our "audit committeefinancial expert". Mr. Schlachet is "independent" as defined byNasdaq.
ITEM16B.          CODE OF ETHICS
 

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

 

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

**__71__** 

 
ITEM 16C.          PRINCIPALACCOUNTANT FEES AND SERVICES
 

The following table presentsthe fees paid to our external auditors for professional services rendered inthe years ended December 31, 2005 and 2004: 

 

 

2005

2004

Audit Fees

$55,000

$55,000

Audit Related Fees

-

-

Tax Fees

$10,000

$13,000

All Other Fees

$2,120

$1,935

**Total**

**$67,120**

**$69,935**

 

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

 

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

 

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

 

"All Other Fees" are fees for consulting servicesrendered to us.
ITEM 16D.          EXEMPTIONSFROM THE LISTING STANDARDS FOR AUDIT COMMITTEES
None.
ITEM 16E.          PURCHASESOF EQUITY SECURITIES BY THE ISSUER AND AFFILIATED PURCHASERS
None.
****__72__** **PART III
*** ***
ITEM17.            FINANCIAL STATEMENTS
 

We have elected to furnish financial statements andrelated information specified in Item 18.
ITEM18.            FINANCIAL STATEMENTS
 

See pages F-1 to F-34.
ITEM19.            EXHIBITS
*** ***
Index to Exhibits
 

**Exhibit Number**

**Description**

 

 

*1.1

Form of Articles of Association of Issuer

10.1

Consent of Kost Forer Gabbay & Kasierer, a member of  Ernst & Young Global, dated 23rd March 2006.

10.2

Consent  of Kesselman & Kesselman, member of PriceWaterhouseCoopers, independent  auditors of Keddem Bioscience, dated March 27, 2006.

10.3

Audit Report by Kesselman & Kesselman, member of  PriceWaterhouseCoopers, independent auditors of Keddem Bioscience, dated February 6, 2005.

12.1

Certification by Chief Executive Officer pursuant to  section 302 of the Sarbanes-Oxley Act of 2002.

12.2

Certification by Chief Financial Officer pursuant to  section 302 of the Sarbanes-Oxley Act of 2002.

12.3

Certification by Chief Executive Officer pursuant to  section 906 of the Sarbanes-Oxley Act of 2002.

12.4

Certification by Chief Financial Officer pursuant to  section 906 of the Sarbanes-Oxley Act of 2002.

 

*  Filed as exhibit toour registration statement on Form F-1, registration number 333-12316, asamended, filed with the Securities and Exchange Commission, and is herebyincorporated by reference.
****__73__** **
SIGNATURES

 

Pursuant to the requirements of Section 12 of theSecurities Exchange Act of 1934, the registrant hereby certifies that it meetsall the requirements for filing on Form 20-F and has duly caused this annualreport to be signed on its behalf by the undersigned, thereunto dulyauthorized, in the city of Tel Aviv, State of Israel, on this 27th day ofMarch, 2006.

 

 

** **

** **

**COMPUGEN LTD.**

 

 

 

Signature:   \s\ Mr. Alex Kotzer

 

Name:         AlexKotzer

Title:          President, Chief Executive Officer and Director

Date:           March 27, 2006

**__74__** 

 

Exhibit12.1

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

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

 

I, Mr. AlexKotzer, certify that:

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

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

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

4.             The company's other certifying officer and Iare responsible for establishing and maintaining disclosure controls and procedures(as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal controlover financial reporting (as defined in Exchange Act Rules 13a-15(f) and15d-15(f)) for the company and have: 

a.             designed such disclosure controls and procedures, or causedsuch disclosure controls and procedures to be designed under our supervision,to ensure that material information relating to the company, including itsconsolidated subsidiaries, is made known to us by others within those entities,particularly during the period in which this report is being prepared; 

b.             designed such internal control over financial reporting,or caused such internal control over financial reporting to be designed underour supervision, to provide reasonable assurance regarding the reliability offinancial reporting and the preparation of financial statements for externalpurposes in accordance with generally accepted accounting principles;

c.             evaluated the effectiveness of the company's disclosurecontrols and procedures and presented in this report our conclusions about theeffectiveness of the disclosure controls and procedures, as of the end of theperiod covered by this report based on such evaluation ; and 

d.             disclosed in this report any change in the company'sinternal control over financial reporting that occurred during the periodcovered by the annual report that has materially affected, or is reasonablylikely to materially affect, the company's internal control over financialreporting; and 

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

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

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

 

\s\ Alex Kotzer

 

Title:      President,Chief Executive Officer and Director

Date:      March 27,2006

**__75__** 

 

Exhibit 12.2

**CERTIFICATION PURSUANT TO SECTION 302**

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

 

I, Nurit Benjamini, certify that:

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

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

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

4.             The company's other certifying officer and Iare responsible for establishing and maintaining disclosure controls andprocedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) andinternal control over financial reporting (as defined in Exchange Act Rules13a-15(f) and 15d-15(f)) for the company and have: 

a.             designed such disclosure controls and procedures, orcaused such disclosure controls and procedures to be designed under oursupervision, to ensure that material information relating to the company,including its consolidated subsidiaries, is made known to us by others withinthose entities, particularly during the period in which this report is beingprepared; 

b.             designed such internal control over financial reporting,or caused such internal control over financial reporting to be designed underour supervision, to provide reasonable assurance regarding the reliability offinancial reporting and the preparation of financial statements for externalpurposes in accordance with generally accepted accounting principles;

c.             evaluated the effectiveness of the company's disclosurecontrols and procedures and presented in this report our conclusions about theeffectiveness of the disclosure controls and procedures, as of the end of theperiod covered by this report based on such evaluation ; and 

d.             disclosed in this report any change in the company'sinternal control over financial reporting that occurred during the periodcovered by the annual report that has materially affected, or is reasonablylikely to materially affect, the company's internal control over financialreporting; and 

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

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

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

** **

\s\ Nurit Benjamini

 

Title:      ChiefFinancial Officer 

Date:      March 27, 2006

 

**__76__** 

 

Exhibit 12.3

**CERTIFICATION PURSUANT TO SECTION 906**

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

 

In connectionwith the annual report of Compugen Ltd. (the "Company") on Form 20-F for theperiods ending December 31, 2005 as filed with the Securities and ExchangeCommission on the date hereof (the "Report"), I the undersigned, being thePresident and Chief Executive Officer of the Company, certify, pursuant to 18U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-OxleyAct of 2002, that to my knowledge:****

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

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

 

 

\s\ Alex Kotzer

 

Title:      President,Chief Executive Officer and Director

Date:      March 27, 2006

 

The foregoing certification is being furnished solely toaccompany the Report pursuant to 18 U.S.C. No. 1350, and is not being filed forpurposes of Section 18 of the Securities Exchange Act of 1934, as amended, andis not to be incorporated by reference into any filing of the Company, whethermade before or after the date hereof, regardless of any general incorporationlanguage in such filing.

 

 

**__77__** 

 

Exhibit 12.4

**CERTIFICATION PURSUANT TO SECTION 906**
 OF THE SARBANES-OXLEY ACT OF 2002 
 

In connectionwith the annual report of Compugen Ltd. (the "Company") on Form 20-F for theperiods ending December 31, 2005 as filed with the Securities and ExchangeCommission on the date hereof (the "Report"), I the undersigned, being theChief Financial Officer of the Company, certify, pursuant to 18 U.S.C. Section1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002,that to my knowledge:****

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

2.             The information contained in the Reportfairly presents, in all material respects, the financial condition and resultsof operations of the Company.

 

 

** **

\s\ Nurit Benjamini

 

Title:    Chief Financial Officer 

Date:     March 27, 2006

 

 

The foregoing certification is being furnished solely toaccompany the Report pursuant to 18 U.S.C. No. 1350, and is not being filed forpurposes of Section 18 of the Securities Exchange Act of 1934, as amended, andis not to be incorporated by reference into any filing of the Company, whethermade before or after the date hereof, regardless of any general incorporationlanguage in such filing.

 

**__78__** 

 

 

 

** **

** **

**COMPUGENLTD. AND ITS SUBSIDIARIES**

 

 

**CONSOLIDATEDFINANCIAL STATEMENTS**

** **

** **

AS OF DECEMBER 31, 2005

 

 

**IN U.S. DOLLARS**

 

 

 

 

 

**INDEX**

 

 

** **

**Page**

** **

** **

**Report of  Independent Registered Public Accounting Firm**

**2**

** **

** **

**Consolidated  Balance Sheets**

**3**

** **

** **

**Consolidated  Statements of Operations**

**4**

** **

** **

**Statements  of Changes in Shareholders' Equity**

**5**

** **

** **

**Consolidated  Statements of Cash Flows**

**6 - 7**

** **

** **

**Notes to  Consolidated Financial Statements**

**8 - 35**

 

**F1** 

 

 

 

 

 

 

 

** **

**REPORTOF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**

 

**To the Board ofDirectors and Shareholders of**

** **

**COMPUGEN LTD.**

 

We have audited the accompanyingconsolidated balance sheets of Compugen Ltd. ("the Company") and itssubsidiaries as of December 31, 2005 and 2004, and the related consolidatedstatements of operations, changes in shareholders' equity and cash flows foreach of the three years in the period ended December 31, 2005. These financial statements are the responsibility of the Company's management. Ourresponsibility is to express an opinion on these financial statements based onour audits. We did not audit the financial statements of Keddem BioScience Ltd.,a wholly-owned subsidiary, for the years ended December 31, 2005 and 2004 which statements reflect total assets constituting 3% and 4% and no revenues, in2005 and 2004, respectively, of the related consolidated totals. Thosestatements were audited by other auditors whose unqualified report which hasbeen furnished to us included an explanatory paragraph on circumstances whichraise substantial doubts on Keddem BioScience Ltd.`s ability to continue as agoing concern. Our opinion, insofar as it relates to the amounts included forKeddem BioScience Ltd. is based solely on the report of the other auditors.

 

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

 

In our opinion, based on ouraudits and the report of other auditors, the consolidated financial statementsreferred to above present fairly, in all material respects, the consolidatedfinancial position of the Company and its subsidiaries as of December 31, 2005and 2004, and the consolidated results of their operations and their cash flowsfor each of the three years in the period ended December 31, 2005, inconformity with U.S. generally accepted accounting principles.

 

As discussed in Note 1c to thefinancial statements, Keddem BioScience Ltd.`s operating losses and accumulateddeficit raise substantial doubt about its ability to continue as a goingconcern. The abovementioned financial statements have been prepared assumingthat Keddem BioScience Ltd. will continue to operate as a going concern. KeddemBioScience Ltd. has not yet derived income from its operations and itscontinuance as a going concern is contingent upon obtaining financial supportfrom its shareholders and other investors until profitable results areachieved. The financial statements do not include any adjustments that mightresult from the outcome of this uncertainty.

**F2** 

 

Tel-Aviv, Israel

KOST FORER GABBAY & KASIERER

February 7, 2006, except for Note 16,

to which  the date is February 15, 2006 

A Member of Ernst & Young Global

 

 

** **

** **

** **

December 31,

 

** **

Note

** **

2005

 

2004

ASSETS

 

 

 

 

 

 

CURRENT ASSETS:

 

 

 

 

 

 

Cash and cash equivalents

 

5

 

$        8,492

 

$        4,366

Cash held in favor of other  consortium partners

 

4

 

834

 

-

Short-term deposits and  marketable securities

 

6

 

22,495

 

16,208

Trade receivables 

 

 

 

-

 

143

Other accounts receivable and  prepaid expenses 

 

7

 

676

 

1,402

 

 

 

 

 

 

 

Total current assets

 

 

 

32,497

 

22,119

 

 

 

 

 

 

 

LONG-TERM INVESTMENTS:

 

 

 

 

 

 

Long-term deposits and  marketable securities

 

6

 

4,983

 

27,854

Long-term lease deposits 

 

 

 

81

 

102

Severance pay fund

 

 

 

1,525

 

1,539

 

 

 

 

 

 

 

 

 

 

 

6,589

 

29,495

 

 

 

 

 

 

 

PROPERTY AND EQUIPMENT, NET

 

8

 

3,020

 

3,739

 

 

 

 

 

 

 

Total assets

 

 

 

$      42,106

 

$      55,353

 

 

 

 

 

 

 

LIABILITIES AND SHAREHOLDERS'  EQUITY

** **

** **

** **

 

 

 

CURRENT LIABILITIES:

 

 

 

 

 

 

Trade payables 

 

 

 

$        1,088

 

$        1,425

Other accounts payable and  accrued expenses

 

9

 

2,385

 

1,682

Deferred revenue

 

 

 

200

 

276

 

 

 

 

 

 

 

Total current  liabilities

 

 

 

3,673

 

3,383

 

 

 

 

 

 

 

LONG-TERM LIABILITIES:

 

 

 

 

 

 

Long-term accounts payable

 

 

 

60

 

60

Accrued severance pay

 

 

 

1,659

 

1,878

Excess of losses over  investment in Evogene

 

1b

 

466

 

466

 

 

 

 

 

 

 

Total long-term  liabilities

 

 

 

2,185

 

2,404

 

 

 

 

 

 

 

COMMITMENTS AND CONTINGENCIES

 

10, 4

 

 

 

 

 

 

 

 

 

 

 

SHAREHOLDERS' EQUITY:

 

11

 

 

 

 

Share capital:

 

 

 

 

 

 

Ordinary shares of NIS 0.01 par  value; 50,000,000 shares authorized at December 31, 2005 and 2004, 27,846,420 and 27,726,022 shares issued and outstanding at December 31, 2005 and 2004, respectively

 

 

 

75

 

74

Additional paid-in capital

 

 

 

155,923

 

155,444

Deferred stock compensation

 

 

 

(16)

 

(196)

Accumulated deficit

 

 

 

(119,734)

 

(105,756)

 

 

 

 

 

 

 

Total shareholders'  equity 

 

 

 

36,248

 

49,566

 

 

 

 

 

 

 

Total liabilities and  shareholders' equity

 

 

 

$        42,106

 

$        55,353

 

**F3** 

 

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

 

February 7,   2005

 

 

 

** **

Date of approval of the

financial statements

 

Alex Kotzer 

President & Chief Executive Officer

 

Nurit Benjamini

Chief Financial Officer

 

 

 

 

** **

** **

** **

Year ended

 

** **

 

** **

December 31,

 

** **

Note

** **

2005

 

2004

 

2003

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Revenues*

 

12

 

            $646

 

$    *)  2,630

 

$    *)  6,776

 

 

 

 

 

 

 

 

 

Cost of  revenues

 

 

 

148

 

1,100

 

2,275

Research and  development expenses, net of Government and other grants amounted to $2,254,  $1,397 and $2,050 for the years 2005, 2004 and 2003, respectively

 

4

 

10,471

 

10,921

 

11,256

Selling and  marketing expenses 

 

 

 

1,772

 

2,446

 

3,811

General and  administrative expenses

 

 

 

3,133

 

3,740

 

3,650

 

 

 

 

 

 

 

 

 

Total  operating expenses **)

 

 

 

15,524

 

18,207

 

20,992

 

 

 

 

 

 

 

 

 

Operating  loss

 

 

 

(14,878)

 

(15,577)

 

(14,216)

Financial  income, net

 

13

 

682

 

1,417

 

2,112

Other income

 

3,14

 

218

 

605

 

662

Capital loss

 

 

 

-

 

(167)

 

-

 

 

 

 

 

 

 

 

 

Net loss 

 

 

 

$    (13,978)

 

$    (13,722)

 

$    (11,442)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Basic and  diluted net loss per share 

 

 

 

$        (0.50)

 

$        (0.50)

 

$        (0.43)

 

 

 

 

 

 

 

 

 

Weighted average number of ordinaryshares used in computing basic and diluted net loss  per share

 

 

 

27,774,535

 

27,473,341

 

26,409,180

 

 

*)          Reclassified - See Note 2h.  

**)         Includesdeferred stock compensation - see Note 11.

**F4** 

 

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

 

 

** **

Ordinary shares

 

Additional paid-in 

 

Deferred

stock 

 

Accumulated 

 

Total shareholders'

 

 

Number

 

Amount

 

capital

 

compensation

 

deficit

 

Equity

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Balance as of January 1, 2003

 

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

 

 

 

 

 

 

 

 

 

 

 

 

 

Employee options exercised

 

877,548

 

2

 

2,723

 

-

 

-

 

2,725

Amortization of deferred stock  compensation

 

-

 

-

 

-

 

298

 

-

 

298

Stock compensation 

 

-

 

-

 

55

 

-

 

-

 

55

Compensation relating to options and  warrants issued to scientific advisory board members, consultants and others

 

-

 

-

 

402

 

-

 

-

 

402

Forfeited options

 

-

 

-

 

(7)

 

7

 

-

 

-

Net loss

 

-

 

-

 

-

 

-

 

(13,722)

 

(13,722)

 

 

 

 

 

 

 

 

 

 

 

 

 

Balance as of December 31, 2004

 

27,726,022

 

74

 

155,444

 

 (196)

 

 (105,756)

 

49,566

 

 

 

 

 

 

 

 

 

 

 

 

 

Employee options exercised

 

120,398

 

1

 

281

 

-

 

-

 

282

Amortization of deferred stock  compensation, net of reversal due to forfeitures

 

-

 

-

 

-

 

(24)

 

-

 

(24)

Stock compensation

 

-

 

-

 

396

 

-

 

-

 

396

Compensation relating to options and  warrants issued to scientific advisory board members, consultants and others

 

-

 

-

 

6

 

-

 

-

 

6

Forfeited options

 

-

 

-

 

(204)

 

204

 

-

 

-

Net loss

 

-

 

-

 

-

 

-

 

(13,978)

 

(13,978)

 

 

 

 

 

 

 

 

 

 

 

 

 

Balance as of December 31, 2005

 

27,846,420

 

$      75

 

$155,923

 

$          (16)

 

$   (119,734)

 

$        36,248

 

 

 

**F5** 

 

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

 

 

** **

Year ended December 31,

 

** **

2005

 

2004

 

2003

Cash flows from operating activities:

 

 

 

 

 

 

 

 

 

 

 

 

 

Net loss

 

$     (13,978)

 

$     (13,722)

 

$     (11,442)

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

 

(24)

 

298

 

786

Compensation relating to options and  warrants issued to scientific advisory board members, consultants and others

 

402

 

457

 

276

Depreciation

 

1,314

 

1,466

 

1,889

Accrued severance pay, net

 

(205)

 

(130)

 

(95)

Interest and amortization of premium on marketable securities

 

1,096

 

1,163

 

1,001

Capital loss

 

-

 

167

 

-

Decrease in trade receivables

 

143

 

113

 

1,612

Decrease (increase) in other accounts  receivable and prepaid expenses

 

830

 

(202)

 

1,211

Decrease in inventories

 

-

 

-

 

80

Decrease in trade payables and other  accounts payable and accrued expenses

 

(610)

 

(522)

 

(796)

Increase (decrease) in deferred revenue

 

(76)

 

(1,290)

 

329

 

 

 

 

 

 

 

Net cash used in operating activities

 

(11,108)

 

(12,202)

 

(5,608)

 

 

 

 

 

 

 

Cash flows from investing activities:

 

 

 

 

 

 

Purchase of marketable securities

 

-

 

(8,191)

 

(39,648)

Proceeds from redemption of marketable  securities

 

15,488

 

15,566

 

17,905

Proceeds from short-term and long-term  bank deposits

 

-

 

-

 

30,195

Purchase of property and equipment

 

(862)

 

(1,435)

 

(2,326)

Decrease (increase) in long-term lease deposits

 

21

 

(7)

 

33

Deconsolidation of Evogene (1)

 

-

 

-

 

(1,400)

Investment grants relating to fixed  assets

 

406

 

-

 

-

Proceeds from sale of property and  equipment

 

3

 

-

 

-

Proceeds from sale of BioXL business 

 

-

 

-

 

126

 

 

 

 

 

 

 

Net cash provided by investing  activities

 

15,056

 

5,933

 

4,885

 

 

 

 

 

 

 

Cash flows from financing activities:

 

 

 

 

 

 

Exercise of options

 

178

 

2,725

 

1,307

Convertible loan in Evogene

 

-

 

-

 

2,037

 

 

 

 

 

 

 

Net  cash provided by financing activities

 

178

 

2,725

 

3,344

 

 

 

 

 

 

Increase (decrease) in cash and cash  equivalents

 

4,126

 

(3,544)

 

2,621

Cash and cash equivalents at the  beginning of the year

 

4,366

 

7,910

 

5,289

 

 

 

 

 

 

 

Cash and cash equivalents at the end of the year

 

$          8,492

 

$          4,366

 

$          7,910

 

Supplemental information on financing activities notinvolving cash flow:

In December 2005, the Company issued shares as a result ofexercise of options in the amount of $ 104. The Company received the money forthose shares in January 2006. 

**F6** 

 

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

 

 

 

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.
****F7** **
** **

**NOTE 1:-              GENERAL**

 

a.     Compugen Ltd. ("the Company") isa biotechnology discovery company focused on therapeutic and diagnosticproducts. The Company's powerful predictive models and discovery engines enablethe discovery of numerous potential therapeutics and diagnostic biomarkers.This capability results from the Company's pioneering and on-goingincorporation of ideas and methods from mathematics, computer science andphysics into biology, chemistry and medicine. Product development is pursuedboth in-house and through collaborative arrangements. The Company's primarybusiness goal is to out-license therapeutic and diagnostic product candidatesfor commercialization by leading companies under milestone and revenue sharingagreements. 

 

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

The Company'sheadquarters and research facilities are located in Israel, with U.S.operations, through a wholly-owned subsidiary Compugen USA Inc. ("CompugenInc.") located in San Jose, California and Maryland. Compugen Inc.'sheadquarters, which were located in New Jersey, were relocated to the Company'sexisting business development, sales, and marketing offices in San Jose,California. This process was completed in 2004. The associated charges relatedto the above, consist of employee termination benefits of seven employees inthe amount of approximately $ 184 (which were recorded as follows: $ 103 asresearch and development expenses and $ 81 as general and administrativeexpenses) and costs associated with termination of lease commitments ofapproximately $ 48, which were recorded as general and administrative expenses.As of December 31, 2004, approximately $ 191 was paid and the remainingobligation was paid during January 2005. In addition, certain long lived assetshave been sold in consideration of their amortized costs and certain long livedassets have been abandoned resulting in a capital loss of approximately $ 160.

 

b.        In 2000, Compugenand certain individuals, (the "Founders") reached an understanding asto the formation of an agricultural biology activity ("AgBio").During the entrepreneurial phase, and until the establishment of a companydedicated to the Agbio activity, such activity was conducted in house atCompugen.

 

           On January 1, 2002, the Company established Evogene Ltd. ("Evogene") a majorityowned Israeli subsidiary (then 82% ownership) together with the Founders.Evogene and Compugen entered into AgBio Asset Purchase Agreement, wherebycertain property and equipment (valued at $ 286), motor vehicle leasingcontracts, patents and intellectual property, were transferred, inconsideration of the issuance of 1,640,000 Ordinary shares of Evogene. Inconnection 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 the Company. 

**F8** 

** **

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

 

On January 6, 2003, Evogene entered into a convertible loan agreement with new investors("the Investors") for the aggregate amount of $ 2,000 ("theTransaction"). The initial closing of the Transaction took place on January 6, 2003. Compugen did not participate in the investment round. Furthermore,Compugen agreed to forgive the entire outstanding Compugen convertible loanamount and all accrued interest, to extend the term of the license to usecertain computational tools granted by it to Evogene until December 31,2005 (additional extension indicated below), and to give the investors anirrevocable proxy empowering them to vote with 50% of Company's holdings inEvogene at the time, subject to adjustments based on the conversion of theloan. 

 

Following theTransaction, Compugen's shares in Evogene were converted into Ordinary-1shares, to allow for certain preferences over ordinary share holders, in thecase of liquidation or deemed liquidation of Evogene. 

 

In addition,Evogene granted to certain of the investors options to purchase additionalEvogene Preferred A shares. The options are exercisable during the periodcommencing on the date of a conversion event and terminating 24 months aftersuch date, unless such conversion event is a merger or consolidation of Evogenein which Evogene is the surviving entity, in which case, the options expireimmediately upon the closing of such conversion event.

 

In addition,Compugen is granting bookkeeping services to Evogene, for which it is fullyreimbursed on arms length basis. During the years ended December 31, 2005, 2004 and 2003, services reimbursed by Evogene amounted to $ 6, $6 and $ 7,respectively.

 

In January2003, the FASB issued Interpretation No. 46, "Consolidation of VariableInterest Entities" ("FIN 46"). The objective of FIN 46 was toimprove financial reporting by companies involved with variable interest entities.A variable interest entity is a corporation, partnership, trust, or any otherlegal structure used for business purposes that has one of the following: (1)an insufficient amount of equity to carry on its principal operations, withoutadditional subordinated financial support from other parties, (2) a group ofequity owners that are unable to make decisions about the entity's activities,or (3) equity that does not absorb the entity's losses or receive the benefitsof the entity. FIN 46 requires a variable interest entity to be consolidated bya company if that company is subject to a majority of the risk of loss from thevariable interest entity's activities or entitled to receive a majority of theentity's residual returns or both. FIN 46 also requires disclosures aboutvariable interest entities that the company is not required to consolidate butin which it has a significant variable interest. The consolidation requirementsof FIN 46 applied immediately to variable interest entities created after January 31, 2003. The consolidation requirements apply to older entities in the firstfiscal year or interim period ending after March 15, 2004. 

 

The Companyhas evaluated the effects of the issuance of the Interpretation on accountingfor its ownership interests in Evogene and on July 1, 2003, the Company deconsolidated Evogene (under the early implementation provisions), because itbelieved it is not Evogene's primary beneficiary under the Interpretation'srequirements.

**F9** 

 

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

 

In February2004 and January 2005, Evogene and the Investors entered into an amended andrestated convertible loan agreements, under which the amount of the convertibleloan was increased by additional $ 3,551. Compugen did not participate inthese financing rounds. Under these transactions, the Investors receivedadditional warrants to purchase shares of Evogene. 

 

In August2004, the Company entered into an extension agreement to a computational toolslicense agreement with Evogene. The original license was granted to Evogeneupon Evogene's incorporation on January 1, 2002. Under the Extension Agreement,the license was extended for 2 additional years, until December 31, 2007, in consideration for the issuance of 350,000 Ordinary shares of Evogene toCompugen. During these two years Compugen is obligated to provide Evogene withlimited support services at no additional cost. The Company accounted for thistransaction in accordance with EITF No. 00-08 "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.

 

The Companyhas evaluated the effects of FIN 46, with regards to the above (the additionalconvertible loan and the extension of the license agreement), resulting in nochanges in the accounting treatment, since the Company still believes it is notEvogene's primary beneficiary under the interpretation's requirements. 

 

As of December 31, 2005 and 2004, the Company held 84.7% of Evogene's share capital but only23.36% of Evogene`s share capital, on a fully-diluted basis. Based onirrevocable proxies that the Company gave to Investors, the Company held only34.89% of Evogene's voting rights, and had excess of losses over investment inEvogene in the amount of $ 466. Also See Note 16 - "SubsequentEvents".

 

c.        In 2002, the Companyestablished a wholly-owned Israeli shelf subsidiary by the name of Keddem BioScienceLtd. ("Keddem"). On August 1, 2004, Compugen spun off itscomputational chemistry activity into a wholly-owned subsidiary, KeddemBioScience Ltd. ("Keddem"). The transaction was affected through anAsset Purchase Agreement ("APA"), under which Compugen transferred toKeddem the assets related to its chemistry business, including all assets andliabilities related thereto, in consideration for the issuance of 2,999,900ordinary shares NIS 0.01 par value each of Keddem. In addition, theCompany, on the closing date, granted to Keddem a license to use certainutility software that it owns, software that does not form part of the coretechnology of the Company's activities. On July 29, 2004, Compugen entered into a Convertible Loan Agreement with Keddem, under which Compugen agreed toloan to Keddem $ 1,571. The outstanding principal loan amount shall bearinterest at an annual rate (each year considered separately) which is thegreater of (i) 5%; and (ii) the 12 months LIBOR as determined on the first businessday after the corresponding anniversary, compounded annually. The loan isconvertible into Keddem's shares at Compugen's discretion, until the earlierof: (x) the repayment date or (y) the merger, acquisition, IPO or similar event
****F10** **
** **

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

 

of Keddem. Ifnot converted, the loan is to be repaid by Keddem upon the earlier of (i) June 30, 2011, and (ii) Keddem defaulting under the loan agreement's terms.

 

In connection with thistransaction, the Company extended the term for exercise of the vested portionof certain of its stock options for employees whose employment with the Companywas terminated and who were then employed by Keddem. The Company has appliedAPB No. 25, "Accounting for Stock Issued to Employees" and FIN No. 44"Accounting for Certain Transactions Involving Stock Compensation",in accounting for this extension and recorded in 2004 compensation expenses inthe amount of $ 55 as part of operating expenses.

 

OnNovember 1, 2005, the Company assigned to Keddem the Company's entitlement toreceive from the Investment Center of the Israel Ministry of Industry and Trade(the "Investment Center"), an amount of approximately $ 400 - onaccount of the Company  investment in the expansion of, what was atthe time, the Company computational chemistry facilities. (See also note 4(c)) 

 

On October 1, 2005, the Company granted Keddem a short-term bridge loan in the amount of $ 100. Keddemrepaid this loan on February 1, 2006. All amounts were eliminated uponconsolidation 

 

Keddem has been experiencingoperating losses and has accumulated a deficit of $960 at December 31, 2005.  Keddem's ability to continue, as agoing concern in the next year is dependent on its ability to raise additionalfunding until the stage at which its operations may become profitable. Keddemis actively seeking additional funding from government sources, pharmaceuticalcompanies and from venture capital funds. 

 

**NOTE 2:-              SIGNIFICANT ACCOUNTING POLICIES**

 

The consolidated financial statementshave been prepared in conformity with accounting principles generally acceptedin the United States ("U.S. GAAP"). 

 

a.     Use ofestimates:

 

The preparation of financialstatements in conformity with generally accepted accounting principles requiresmanagement to make estimates and assumptions that affect the amounts reportedin the financial statements and accompanying notes. Actual results could differfrom those estimates.

 

b.    Financial statements in U.S. dollars:

 

The functional currency of theCompany and its subsidiaries 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 and its subsidiaries have operated and expectto continue to operate in the foreseeable future. A majority of the Company'ssales are made outside Israel in U.S. dollars. The majority of the Company andits subsidiaries' operations are currently conducted in Israel and most of theexpenses in Israel are currently paid in new Israeli shekels ("NIS");however, most of the expenses are denominated and determined in U.S. dollars. 

**F11** 

 

NOTE 2:-            SIGNIFICANTACCOUNTING POLICIES (Cont.)

 

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

 

c.    Basisof consolidation:

 

The consolidated financialstatements include the accounts of the Company and its wholly-ownedsubsidiaries, Compugen USA Inc. and Keddem Bioscience. Intercompany transactionsand balances have been eliminated upon consolidation. Evogene's results ofoperations are included in the Company's consolidated results of operationsuntil July 1, 2003, (see note 1b).

 

d.     Cashequivalents:

 

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

 

e.    Marketable securities:

 

The Company accounts for itsinvestments in marketable securities using SFAS No. 115, "Accounting forCertain Investments in Debt and Equity Securities."

 

Management determines theappropriate classification of its investments in marketable debt at the time ofpurchase and re-evaluates such determinations at each balance sheet date. Todate, all debt securities have been classified as held-to-maturity as theCompany has the positive intent and ability to hold the securities to maturity.

 

These investments are stated atamortized cost, including accrued interest. Amortization of the premium and theaccretion of discounts and interest are included in financial income, net. TheCompany's investment holdings have been classified in the consolidated balancesheet according to the maturity date.

 

The Company accounts for itsstructured notes in accordance with the provisions of FASB Emerging Issues TaskForce ("EITF") Issue No. 96-12, "Recognition of Interest Incomeand Balance Sheet Classification of Structured Notes", according to whichthe Company uses the "Retrospective interest method".

 

f.    Long-term lease deposits:

 

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

**F12** 

 

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

 

g.      Propertyand equipment:

 

Property andequipment are stated at cost, net of related investment grants and 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 - 30

Leasehold  improvements

Over the term of the lease

 

The long-livedassets of the Company and its subsidiaries are reviewed for impairment inaccordance with SFAS No. 144, "Accounting for the Impairment or Disposalof Long-Lived Assets", whenever events or changes in circumstancesindicate that the carrying amount of an asset may not be recoverable.Recoverability of assets to be held and used is measured by a comparison of thecarrying amount of an asset with the future undiscounted cash flows expected tobe generated by the assets.

 

If such assetsare considered to be impaired, the impairment to be recognized is measured bythe amount by which the carrying amount of the assets exceeds the fair value ofthe assets. During the years 2003, 2004 and 2005, no impairment losses havebeen identified. 

h.    Research and development expenses, net:

 

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

 

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

 

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

 

Royalty andnon-royalty bearing grants from the Office of the Chief Scientist of the Israelministry of Industry, Trade &Labor -("OCS") and from the Bi-national Industrial Research and DevelopmentFoundation (" BIRD") for funding approved research and developmentprojects, are recognized at the time the Company is entitled to such grants, onthe basis of the research and development expenses incurred. Such grants areincluded as a research and development expenses.

**F13** 

 

NOTE 2:-          SIGNIFICANT ACCOUNTING POLICIES (Cont.)

 

Until 2005,the Company presented governmental and other grants as part of Revenues and Grants,based on the single step income statement presentation approach. These amountshave been reclassified for all periods presented and are now shown as areduction from research and development expenses. The Company adjusted thefinancial statements for the years preceding 2005 to conform to this change.The amounts that have been reclassified were $ 2,254, $1,397 and $2,050 for theyears ended December 31, 2005, 2004 and 2003, respectively.

 

i.    Revenue recognition:

 

During theyears 2003, 2004 and 2005 the Company and its subsidiaries derived most oftheir revenues from collaborations and license fees for software products. TheCompany also generated revenues from sales of services including maintenance,support, customization, professional services, integration and installation aswell as the sale of products (OligoLibraries). The Company and its subsidiariessell their products primarily through their direct sales force and resellers,both of whom are considered end users. 

 

The Companyand its subsidiaries recognize software license revenues in accordance withStatement of Position ("SOP") 97-2, "Software RevenueRecognition", as amended and SOP 98-9, "Modification of SOP 97-2,Software Revenue Recognition with Respect to Certain Transactions." SOP 97-2generally requires revenues earned on software arrangements involving multipleelements to be allocated to each element based on the relative fair value ofthe elements. SOP 98-9 requires that revenues be recognized under the"Residual Method" when vendor specific objective evidence (VSOE) offair value exists for all undelivered elements and no VSOE exists for thedelivered elements and all revenue recognition criteria of SOP 97-2, asamended, are satisfied.

 

Revenues fromlicense fees are recognized when persuasive evidence of an agreement exists,delivery of the product has occurred, no significant obligations with regard toimplementation remain, the fee is fixed or determinable, and collectability isprobable. 

 

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

 

The Companyand its subsidiaries license products on either a perpetual or on a term basis.License revenues arising from the sale of perpetual licenses and term licensesfor a period longer than one year are recognized in the accounting periodduring which the sale took place. License revenue arising from a term licensefor a period of one year or less is recognized over the contractual term of thelicense.

**F14** 

** **

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

 

Revenues fromsoftware license fees that involve customization of the Company's software tocustomer specific specifications, development services, integration andinstallation are recognized in accordance with SOP 81-1 "Accounting forPerformance of Construction-Type and Certain Production-Type Contracts",using contract accounting on a percentage of completion method, over the periodfrom signing of the license through to customer acceptance in accordance withthe "Input Method". The amount of revenue recognized is based on thetotal license fees under the license agreement and the percentage to completionachieved. The percentage to completion is measured by monitoring progress usingrecords of actual time incurred to date in the project compared to the totalestimated project requirement, which corresponds to the costs related to earnedrevenues. Estimates of total project requirements are based on prior experienceof customization, delivery and acceptance of the same or similar technology andare reviewed and updated regularly by management. After delivery, ifuncertainty exists about customer acceptance of the software, license revenueis not recognized until acceptance. In the years ended December 31, 2005, 2004and 2003, the Company recognized revenues in accordance with SOP 81-1 in theamount of $ 178, $ 1,260 and $ 522 respectively. Provisions for estimatedlosses on uncompleted contracts are made in the period in which such losses arefirst determined, in the amount of the estimated loss on the entire contract.During the years 2005, 2004 and 2003, no such estimated losses were identified.

 

The Companybelieves that the use of the percentage of completion method is appropriate asthe Company has the ability to make reasonably dependable estimates of theextent of progress towards completion, contract revenues and contract costs. Inaddition, contracts executed include provisions that clearly specify theenforceable rights regarding services to be provided and received by theparties to the contracts, the consideration to be exchanged and the manner andterms of settlement. In all cases, the Company expects to perform itscontractual obligations and its licensees are expected to satisfy theirobligations under the contract. 

 

Revenues fromsales of products (OligoLibraries) are recognized in accordance with StaffAccounting Bulletin ("SAB") No. 104 "Revenue Recognition inFinancial Statements", and EITF No. 99-19 "Reporting gross revenues asa principal vs. net as an agent", when delivery has occurred, persuasiveevidence of an agreement exists, the vendor's fee is fixed or determinable, nofurther obligation exists and collectability is probable. 

 

The Companyaccounts for equity instruments received in accordance with EITF No.00-08"Accounting by a Grantee for Equity Instruments to be received inConjunction with Providing Goods or Services." The Company deems the fairvalue of the equity instruments received to date to be minimal and as a resultno revenues were recognized.

 

Deferred revenues include amounts received from customers for whichrevenue has not been recognized.

**F15** 

** **

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

 

j.      Income taxes:

 

The Companyand its subsidiaries account for income taxes in accordance with SFAS No.109,"Accounting for Income Taxes" ("SFAS No.109"). ThisStatement prescribes the use of the liability method whereby deferred taxassets and liability account balances are determined based on differencesbetween financial reporting and tax bases of assets and liabilities and aremeasured using the enacted tax rates and laws that will be in effect when thedifferences are expected to reverse. The Company and its subsidiaries provide avaluation allowance, if necessary, to reduce deferred tax assets to theirestimated realizable value.

 

k.      Fair value of financialinstruments:

 

The followingmethods and assumptions were used by the Company and its subsidiaries inestimating their fair value disclosures for financial instruments:

 

The carryingamounts of cash and cash equivalents, trade receivables, other accountsreceivable, trade payables and other accounts payable approximate their fairvalue due to the short-term maturity of such instruments.

 

The fair valueof marketable securities is based on quoted market prices and does not differsignificantly from the carrying amount (see Note 6).

 

l.      Stock-based compensation: 

 

The Companyhas elected to follow APB No. 25 "Accounting for Stock Issued toEmployees" and FIN No. 44 "Accounting for Certain TransactionsInvolving Stock Compensation" in accounting for its employee stock optionplans. Under APB No. 25, when the exercise price of the Company's stock optionsis less than the market price of the underlying shares on the date of grant,compensation expense is recognized. Compensation expenses are amortized overthe vesting period based on the accelerated attribution method.

 

The Companyapplies SFAS No. 123 "Accounting for Stock Based Compensation"("SFAS 123") and EITF 96-18 "Accounting for Equity Instrumentsthat are Issued to Other than Employees for Acquiring, or in Conjunction withSelling, Goods or Services" ("EITF 96-18") with respect tooptions issued to non-employees. SFAS No.123 requires use of an optionvaluation model to measure the fair value of the options on the date of grant.

 

The Companyadopted the disclosure provisions of SFAS No. 148, "Accounting forStock-Based Compensation - transition and disclosure", which amendedcertain provisions of SFAS 123 to provide alternative methods of transition foran entity that voluntarily changes to the fair value based method of accountingfor stock-based employee compensation, effective as of the beginning of thefiscal year. The Company continues to apply the provisions of APB No. 25, inaccounting for stock-based compensation (see also Note 11c).

**F16** 

 

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

 

Pro formainformation regarding the Company's net loss and net loss per share is requiredunder SFAS No. 123 and has been determined as if the Company had accounted forits employee stock options under the fair value method prescribed by SFAS No.123.

 

For thepurposes of pro forma disclosure, the estimated fair value of the options isamortized to expenses over the options vesting period that is generally fouryears based on an accelerated method.

 

The fair valueof each option granted is estimated on the date of grant using theBlack & Scholes option valuation model with the followingweighted-average assumptions for 2005, 2004 and 2003: expected life of 3, 3.1and 2.1 respectively, dividend yield of 0% for all years; average expectedvolatility of 51%, 44% and 43%, respectively, and average risk-free interestrate of 3.79%, 3.36% and 1%, respectively.

 

The followingtable illustrates the effect on net loss and net loss per share, assuming thatthe Company had applied the fair value recognition provision of SFAS No. 123 onits stock-based employee compensation:

 

 

** **

Year ended December 31,

 

** **

2005

 

2004

 

2003

 

 

 

 

 

 

 

Net loss as reported

 

$    (13,978)

 

$    (13,722)

 

$    (11,442)

Deduct (add) total stock-based compensation - intrinsic value 

 

(24)

 

298

 

786

Add - stock-based compensation - fair value

 

(1,423)

 

(1,414)

 

(2,068)

 

 

 

 

 

 

 

Pro forma net loss

 

$    (15,425)

 

$    (14,838)

 

$    (12,724)

 

 

 

 

 

 

 

Basic and diluted net loss per share - as reported

 

$        (0.50)

 

$        (0.50)

 

$        (0.43)

 

 

 

 

 

 

 

Basic and diluted net loss per share - pro forma

 

$        (0.56)

 

$        (0.54)

 

$        (0.48)

 

m.    Net loss per share:

 

Basic net lossper share is calculated based on the weighted average number of ordinary sharesoutstanding during each year. Diluted net loss per share is calculated based onthe weighted average number of ordinary shares outstanding during each year,plus dilutive potential in accordance with SFAS No. 128, "Earnings perShare."

 

Alloutstanding stock options have been excluded from the calculation of thediluted net loss per share because all such securities are anti-dilutive forall periods presented. The total number of shares related to outstandingoptions excluded from the calculations of diluted net loss per share was4,733,307, 4,149,036 and 4,987,593 for the years ended December 31, 2005, 2004 and 2003, respectively.

 

 

**F17** 

 

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

 

n.      Concentrationsof credit risks:

 

Financialinstruments that potentially subject the Company and its affiliates toconcentrations of credit risk consist principally of cash and cash equivalents,marketable securities, trade receivables and long-term lease deposits.

 

Cash and cashequivalents are invested in major banks in Israel and the United States. Suchinvestments in the United States may be in excess of insured limits and are notinsured in other jurisdictions. Management believes that the financialinstitutions that hold the Company's investments are financially sound and,accordingly, minimal credit risk exists with respect to these investments. 

 

The tradereceivables of the Company and its subsidiaries are mainly derived from salesto customers located primarily in the United States, Europe and the Far East(see also Note 12). The Company and its subsidiaries perform ongoing creditevaluations of its customers and to date have not experienced any materiallosses. An allowance for doubtful accounts is determined with respect tospecific amounts that the Company and its subsidiaries have determined to bedoubtful of collection. As of December 31, 2005 and 2004, allowance fordoubtful accounts were recorded in the amounts of $5 and $0, respectively.

 

The Company'smarketable securities include investments in corporate bonds and U.S.government institutions. Management believes that those corporations are financiallysound, the portfolio is well diversified, and accordingly, minimal credit riskexists with respect to these marketable securities.

 

The Companyand its subsidiaries have no significant off-balance-sheet concentration ofcredit risk such as foreign exchange contracts, option contracts or otherforeign hedging arrangements.

** **

o.      Severance pay:

 

The Company'sliability for severance pay for its Israeli employees is calculated pursuant to  Israel's Severance Pay Law based on the most recent salary of the employeesmultiplied by the number of years of employment, as of the balance sheet date.Employees are entitled to one month's salary for each year of employment or aportion thereof. The Company's liability for all of its employees is fully providedby monthly deposits with insurance policies and by an accrual. The value ofthese policies is recorded as an asset in the Company's balance sheet.

 

The depositedfunds may be withdrawn only upon the fulfillment of the obligation pursuant to Israel'sSeverance Pay Law or labor agreements. The value of the deposited funds isbased on the cash surrendered value of these policies, and includes immaterialprofits accumulated up to the balance sheet date.

 

Severanceexpenses for the years ended December 31, 2005, 2004 and 2003 amounted toapproximately $ 443, $ 650 and $ 395, respectively.

**F18** 

 

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

** **

p.        Reclassification:

 

Certain prioryear amounts have been reclassified to conform to the current yearpresentation, including Government and other grants - see Note 2h.

 

q.        Recentlyissued accounting pronouncements: 

 

On December 16, 2004, the Financial Accounting Standards Board (FASB) issuedFASB Statement No. 123 (revised 2004), Share-Based Payment, which is a revisionof FASB Statement No. 123, Accounting for Stock-Based Compensation. Statement123(R) supersedes APB Opinion No. 25, Accounting for Stock Issued to Employees,and amends FASB Statement No. 95, Statement of Cash Flows. Generally, theapproach in Statement 123(R) is similar to the approach described in Statement123. However, Statement 123(R) requires all share-based payments to employees,including grants of employee stock options, to be recognized in the incomestatement based on their fair values. Pro forma disclosure is no longer analternative. Early adoption will be permitted in periods in which financialstatements have not yet been issued. The Company will adopt Statement 123(R)effective January 1, 2006.

 

Statement 123(R) permits public companies to adopt itsrequirements using one of two methods:

 

A "modified prospective" method in whichcompensation cost is recognized beginning with the effective date (a) based onthe requirements of Statement 123(R) for all share-based payments granted afterthe effective date and (b) based on the grant date fair value calculated forStatement 123 for all awards granted to employees prior to the effective dateof Statement 123(R) that remain unvested on the effective date.

 

A "modified retrospective" method which includesthe requirements of the modified prospective method described above, but alsopermits entities to restate based on the amounts previously recognized underStatement 123 for purposes of pro forma disclosures either (a) all priorperiods presented or (b) prior interim periods of the year of adoption.

 

The company plans to adopt Statement 123(R) using the modifiedprospective method.

 

As permitted by Statement 123, the company currentlyaccounts for share-based payments to employees using Opinion 25`s intrinsicvalue method and, as such, generally recognizes no compensation cost foremployee stock options. In addition, non-compensatory plans under APB 25 willbe considered compensatory for FAS 123(R) purposes. Accordingly, the adoptionof Statement 123(R)`s fair value method will result in a significant reductionof  the Company`s result of operations, although it will have noimpact on the Company overall financial position. The amount of the impact ofadoption of Statement 123(R) cannot be predicted at this time because it willdepend on levels of share-based payments granted in the future. However, hadthe Company adopted Statement 123(R) in prior periods, the impact of thatstandard would have approximated the 

**F19** 

** **

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

 

impact ofStatement 123 as described in the disclosure of pro forma net income andearnings per share in Note 2l to the consolidated financial statements.

 

In March 2005,the SEC released SEC Staff Accounting Bulletin No. 107, "Share BasedPayment" ("SAB 107"). SAB 107 provides the SEC`s staff positionregarding the application of FAS 123(R) and contains interpretive guidancerelating to the interaction between FAS 123(R) and certain SEC rules andregulations, and also provides the SEC staff`s view regarding the valuation ofshare-based payment arrangements for public companies. SAB 107 highlights theimportance of disclosures made relating to the accounting for share-basedpayment transactions. The Company is currently reviewing the effect of SAB 107;however it does not believe that SAB 107 will have a material effect on itsfinancial position, results of operations or cash flows beyond that alreadydescribed for statement 123(R). 

 

In May 2005,the FASB issued Statement of Financial Accounting Standard No. 154 ("SFAS154"), "Accounting Changes and Error Corrections" - areplacement of APB No. 20, "Accounting Changes" and SFAS No. 3,"Reporting Accounting Changes in Interim Financial Statements". SFAS154 provides guidance on the accounting for and reporting of accounting changesand error corrections. APB Opinion 20 previously required that most voluntarychanges in accounting principle be recognized by including in net income of theperiod of the change the cumulative effect of changing to the new accountingprinciple. SFAS 154 requires retrospective application to prior periods'financial statements of a voluntary change in accounting principle unless it isimpracticable. SFAS 154 is effective for accounting changes and corrections oferrors made in fiscal years beginning after December 15, 2005. The Company believes SFAS 154 has no impact on its results of operations, financialcondition and liquidity.

 

In November 2005, the FASB released FASBStaff Position Nos. FAS 115-1 and FAS 124-1, "The Meaning ofOther-Than-Temporary Impairment and Its Application to CertainInvestments" ("FSP 115-1"), which effectively replaces EITFIssue No. 03-1. FSP 115-1 contains a three-step model for evaluatingimpairments and carries forward the disclosure requirements in EITF IssueNo. 03-1 pertaining to securities in an unrealized loss position. Underthe model, any security in an unrealized loss position is considered impaired;an evaluation is made to determine whether the impairment isother-than-temporary; and, if an impairment is considered other-than-temporary,a realized loss is recognized to write the security's cost or amortized costbasis down to fair value. FSP 115-1 references existing other-than-temporaryimpairment guidance for determining when an impairment is other-than-temporaryand clarifies that subsequent to the recognition of an other-than-temporaryimpairment loss for debt securities, an investor shall account for the securityusing the constant effective yield method. FSP 115-1 is effective for reportingperiods beginning after December 15, 2005, with earlier applicationpermitted. The Company adopted FSP 115-1 upon issuance. The adoption did nothave a material effect on the Company's consolidated financial condition orresults of operations.

 

** **
****F20** **
** **

**NOTE 3:-      BIOACCELERATOR BUSINESS**

 

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

 

In addition,Compugen reimbursed Biocceleration for all amounts received with respect torevenues related to the BioXL business generated on or after the effectivedate. In connection with the transaction, in 2003 Compugen recognized $ 459 incapital gain included under other income. The Company is recognizing additionalother income for each installment that is paid under this agreement. For theyears ended December 31, 2005 and 2004, the Company recognized other income inthe amount of $ 218, and $ 343, respectively.

** **

**NOTE 4:-     GOVERNMENTAL AND OTHERGRANTS**

 

The companyreceived several grants as follows: 

 

Royalty andnon-royalty bearing grants from the Office of the Chief Scientist of the IsraelMinistry of Industry, Trade&Labor- ("OCS")and from the Bi-national Industrial Research and DevelopmentFoundation (" BIRD") for funding approved research and developmentprojects, are presented as a reduction from the research and developmentexpenses.  

 

a.   Under the OCS royalty bearing programs, the Company isnot obligated to repay any amounts received from the OCS if it does notgenerate any income from the results of the funded research program. If incomewill be generated the research program is successful, the Company is committedto pay royalties at a rate of 3% to 5% of sales of the products arising fromsuch research program, up to a maximum of 100% of the amount received, linkedto the $ US (for grants received under programs approved subsequent to January1, 1999, the maximum to be repaid is 100% plus interest at LIBOR). For theyears ended December 31, 2005, 2004 and 2003, the Company has an aggregate ofpaid and accrued royalties to the OCS in the amount of $ 18, $ 0 and $ 58,respectively. 

 

b.   Under the BIRD royalty bearing program, the Company isnot obligated to repay any amounts received from BIRD if no income will begenerated from the results of the funded research program. If income will begenerated the Company is required to repay BIRD 100% of the grant that theCompany received provided that the repayment to BIRD is made within the firstyear following expiry of the term of the project. For every year that theCompany does not make these repayments, the amounts to be repaid incrementallyincrease up to an amount of 150% in the fifth year following expiry of the termof the project. All amounts to be repaid to BIRD are linked to the U.S.Consumer Price Index.

** **
****F21** **
** **

**NOTE 4:-     GOVERNMENTAL AND OTHERGRANTS (Cont.)**

 

As ofDecember 31, 2005, the Company's aggregate contingent obligation forpayments to OCS and BIRD, based on royalty-bearing participation received oraccrued, net of royalties paid or accrued, totaled approximately $ 6,490. Theliability for royalties is recorded as cost of revenues at the time the relatedroyalty-bearing sales are recognized as revenues in the statement ofoperations.

 

c.   In November 2005, Keddem has received from the Investment Center of the Israeli Ministry of Industry and Trade and Labor, an amount ofapproximately $400 on account of the investment made by the Company, prior tothe spin off of Keddem. The cost of the fixed assets is presented at its netvalue, after deduction of the above grant. Keddem`s entitlement to above grantand future grants is conditional upon the Company's fulfilling the conditionsstipulated by the Law, regulations published thereunder and the letter ofapproval for the specific investments in "Approved Enterprises." (seeNote 14b) In the event of failure to comply with the conditions, the grant maybe canceled and Keddem may be required to refund the amount of the grants, inwhole or in part including interest and linked to the Israeli Consumer PriceIndex. To guarantee Keddem obligations to the investment center all the fixedassets of Keddem, are pledged in favor of the Investment Center (see note1(c)).

 

d.    The Company is coordinating a consortium,SIMAP, in a three year collaborative project, which will commence on January 1, 2006, funded by the European 6th framework. The grants the Company will receivefrom this project do not bear any repayment royalties. The Company will enjoythe generic knowledge accumulated in the collaborative project. As acoordinator of this project, the Company receives the consortium funds from theEuropean Commission and distributes those funds to the consortium members basedon an agreement between the consortium members. As of December 31, 2005, the Company holds a pre-payment from the European Commission amounting to $ 834that will be distributed to the consortium members during 2006, according tothe payment schedule detailed in the consortium agreement. The Company presentsthis amount as "Cash held in favor of other consortium partners". An amount of$ 184, presented as "unrecognized grants" in Other liabilities (Seenote 9), represents the Company's portion of the grant prepayment and will berecognized as expense reduction during 2006. 

 

 

**NOTE 5:-          CASHAND CASH EQUIVALENTS**

** **

 

** **

December 31,

 

** **

2005

 

2004

 

 

 

 

 

Bank deposits in U.S. dollars (bearing an annual average interest  rate of 4.09% and 1.81%, respectively)

 

$          6,592

 

$          2,609

Bank deposits in Euro (bearing an annual average interest rate of  1.75% )

 

185

 

-

Bank deposits in NIS (bearing an annual average interest rate of  3.73% and 3.16%, respectively)

 

985

 

323

Cash in  banks (current accounts)

 

730

 

1,434

 

 

 

 

 

 

 

$          8,492

 

$            4,366

** **
****F22** **
** **

**NOTE 6:-          DEPOSITSAND MARKETABLE SECURITIES**

 

** **

** **

Amortized

 cost

** **

Gross unrealized

 gains

** **

Gross unrealized

losses

** **

Fair value

** **

** **

December 31,

** **

December 31,

** **

December 31,

** **

December 31,

** **

** **

2005

** **

2004

** **

2005

** **

2004

** **

2005

** **

2004

** **

2005

** **

2004

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Corporate bonds

 

$ 7,849

 

$ 24,316

 

$            -

 

$          12

 

$        72

 

$        142

 

$   7,777

 

$ 24,186

U.S government institutions

 

5,723

 

5,718

 

-

 

-

 

57

 

37

 

5,666

 

5,681

Structured notes

 

13,906

 

14,028

 

-

 

-

 

-

 

-

 

13,906

 

14,028

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

$ 27,478

 

$ 44,062

 

$          -

 

$         12

 

$      129

 

$      179

 

$  27,349

 

$  43,895

 

As of December 31, 2005 and 2004, all the Company's securities were classified asheld-to-maturity.

 

In the years2005, 2004 and 2003 the Company did not sell any securities prior to theirmaturity and accordingly, did not realize any gains or losses onheld-to-maturity securities. 

 

The Company'smanagement believes that the unrealized losses for each of the bonds areconsidered temporary since the Company has an intent and ability to hold debtsecurities until maturity. In addition, the unrealized losses are in continuousposition for a period not more than twelve months.

 

The scheduledmaturities of held-to-maturity securities at December 31, 2005 are as follows:

 

** **

** **

**Amortized**

** **

**Estimated**

** **

** **

cost

** **

fair value

Held-to-maturity:

 

 

 

 

Due  within one year

 

$          22,495

 

$          22,366

Due  after one year through four years

 

4,983

 

4,983

 

 

 

 

 

 

 

$          27,478

 

$          27,349

 

The following table summarizesthe fair value and gross unrealized losses related to held-to-maturitysecurities, aggregated by investment category and length of time thatindividual securities have been in a continuous unrealized loss position, at December 31, 2005:

 

** **

** **

Less Than 12 Months

** **

12 Months or More

** **

Total

** **

** **

Fair value

** **

Gross unrealized losses

** **

Fair value

** **

Gross unrealized losses

** **

Fair value

** **

Gross unrealized losses

 

 

 

 

 

 

 

 

 

 

 

 

 

Corporate bonds

 

$            -

 

$            -

 

$      7,777

 

$            72

 

$      7,777

 

$        72

U.S government institutions

 

-

 

-

 

5,666

 

58

 

5,666

 

58

Structured notes 

 

13,906

 

-

 

-

 

-

 

13,906

 

-

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

$   13,906

 

$            -

 

$     13,443

 

$          130

 

$     27,349

 

$       130

 

**F23** 

 

**NOTE 6:-    DEPOSITS AND MARKETABLESECURITIES (Cont.)**

 

The unrealizedlosses on the Company's investments in held-to-maturity securities were causedmainly by interest rate increases, and are considered insignificant. The contractualterms of these investments do not permit the issuer to settle the securities ata price less than the amortized cost of the investment. Since these unrealizedlosses are insignificant, and since the Company has the ability and intent tohold these investments until the maturity date, the Company does not considerthese investments to be other-than-temporarily impaired at December 31, 2005. 

 
   NOTE 7:-   OTHER ACCOUNTSRECEIVABLE AND PREPAID EXPENSES
** **

 

 

December 31, 

 

 

2005

 

2004

 

 

 

 

 

Grants receivable from the Office of the Chief Scientist

 

$              133

 

$              504

Government authorities

 

82

 

254

Receivables on account of options exercise

 

104

 

19

Prepaid expenses 

 

249

 

408

Receivables on account of the sale of BioXL business

 

73

 

148

Other

 

35

 

69

 

 

 

 

 

 

 

$                676

 

$            1,402

** **

**NOTE 8:-      PROPERTY ANDEQUIPMENT**

** **

 

 

December 31,

 

 

2005

 

2004

Cost

 

 

 

 

Computers,  software and related equipment

 

$          4,905

 

$          5,805

Laboratory equipment and office furniture

 

2,546

 

2,334

Leasehold  improvements

** **

2,328

 

2,189

 

 

 

 

 

 

 

9,779

 

10,328

Accumulated  Depreciation

 

 

 

 

Computers,  software and related equipment

 

4,316

 

4,894

Laboratory equipment and office furniture

 

1,718

 

1,207

Leasehold  improvements

** **

725

 

488

 

 

 

 

 

 

 

6,759

 

6,589

 

 

 

 

 

Depreciated  cost

 

$            3,020

 

$            3,739

 

In 2005,Keddem received from the Investment Center a grant in the amount ofapproximately $ 400. The cost of the fixed assets is presented in its netvalue, after deduction of the above grant (See Note 4)

 

For the yearsended December 31, 2005, 2004 and 2003, depreciation expenses wereapproximately $ 1,314, $ 1,466 and $ 1,889, respectively.

**F24** 

 

** **

**NOTE 9:-      OTHERACCOUNTS PAYABLE AND ACCRUED EXPENSES**

** **

 

 

December 31,

 

 

2005

 

2004

 

 

 

 

 

Employees and related accruals

 

$              755

 

$            1,013

Commitments related to European grant plan (a)

 

834

 

-

Restructuring costs

 

99

 

-

Unrecognized grants (a)

 

184

 

-

Consultants & Board members

 

153

 

59

Commitment for capital expenditures

 

142

 

190

Accrued expenses and other accounts payable

 

202

 

193

Accrued expenses related to IP & Legal expenses

 

16

 

227

 

 

 

 

 

 

 

$            2,385

 

$            1,682

** **

(a)           See Note 4. 

 

** **

**NOTE 10:-**            **COMMITMENTS AND CONTINGENCIES**

 

a.        TheCompany's headquarters and research facilities are located in Israel. TheCompany's U.S. operations are located in San Jose, California and Maryland.Annual minimum future rental commitments under non-cancelable operating leasesfor such are approximately as follows:

 

**December  31,**

 

 

 

 

 

2006

 

$        536

2007

 

502

2008

 

502

2009

 

502

 

 

 

 

 

$      2,042

 

Rent expensesfor the Company and subsidiaries facilities were approximately $ 580, $ 685 and$ 557 for the years ended December 31, 2005, 2004 and 2003, respectively. 

** **

b.    Fixed assets of Keddem, in the net bookvalue of $ 412 are pledged to secure Keddem's obligations to the Investment Centerof the Ministry of Industry, Trade &Labor.

 

c.    The Company provided a bank guarantee in theamount of $ 99 in favor of its lessor in Israel

 

d.    See Note 4 for details on commitments in favor of Government and other grants. 

 

** **
****F25** **
** **

**NOTE 11:-              SHAREHOLDERS'EQUITY**

 

a.         Ordinary shares:

 

The Ordinaryshares confer upon their holders the right to receive notice to participate andvote in general shareholders meetings of the Company and to receive dividends,if declared.

 

b.        Public offering:

 

The Company'sshares are listed for trade on the NASDAQ National Market and on the Tel-AvivStock Exchange.

 

c.         Share option plans:

 

In September1996, the Company adopted the Compugen Ltd. Employee Share Option Plan, (1996)("the Plan"), which provides for the grant of options to purchase559,750 ordinary shares to employees and consultants of the Company and itssubsidiaries. The Company does not intend to grant additional options underthis plan.

 

In June 1998,the Company adopted the Compugen Ltd. Share Option Plan (1998) ("the 1998Plan"), which provides for the grant of options to purchase up to anaggregate of 2,500,000 ordinary shares to directors, employees and consultantsof the Company and its subsidiaries. In March 2000, the Company adopted theCompugen Ltd. Share Option Plan (2000) ("the 2000 Plan"), whichprovides for the grant of options to purchase 1,500,000 ordinary shares toemployees and consultants of the Company and its subsidiaries. The number ofshares authorized for issuance under the 2000 Plan automatically increases eachJanuary 1 by the lesser of 1,500,000 or 4% of the total number of the Company'sthen outstanding shares or such lower amount as shall be determined by theboard of directors. 

 

In general,options granted under these plans vest over a four-year period and expire 10years from the date of issuance. The exercise price of the options grantedunder the plans may not be less than the nominal amount of the shares intowhich such options are exercised. Any options that are cancelled or forfeitedbefore expiration become available for future grants. Subject to the 1998 and2000 plans, there were 658,216 and 2,070,875 options to purchase sharesavailable for future grants as of December 31, 2005, respectively.

 

**F26** 

 

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

 

Transactions related to the grantof options to employees, directors and consultants under the above plans duringthe years ended December 31, 2005, 2004 and 2003, were as follows:

 

 

 

Year ended December 31,

 

 

2005

 

2004

 

2003

 

 

Shares

 

Weighted average exercise price 

 

Shares

 

Weighted average exercise price 

 

Shares

 

Weighted average exercise price 

 

 

 

 

$

 

 

 

$

 

 

 

$

 

 

 

 

 

 

 

 

 

 

 

 

 

Options outstanding at the beginning of the year

 

4,114,036

 

4.24

 

4,952,593

 

3.78

 

4,934,057

 

3.65

Options granted

 

1,154,800

 

3.86

 

893,941

 

6.09

 

1,216,500

 

3.65

Options exercised

 

(120,398)

 

2.34

 

(877,548)

3.11

 

      (686,069)

 

1.91

Options forfeited

 

(415,131)

 

5.27

 

(854,950)

 

4.68

 

  (511,895)

 

4.68

 

 

 

 

 

 

 

 

 

 

 

 

 

Options outstanding at the end of the year

 

4,733,307

 

4.10

 

4,114,036

 

4.24

 

4,952,593

 

3.78

 

 

 

 

 

 

 

 

 

 

 

 

 

Exercisable at end of year

 

2,909,798

 

3.96

 

2,561,583

 

3.86

 

2,883,872

 

3.78

 

 

 

 

 

 

 

 

 

 

 

 

 

Weighted average fair value of options granted at fair market value 

 

 

 

1.48

 

 

 

2.04

 

 

 

1.36

Weighted average fair value of options granted below fair market  value 

 

 

 

-

 

 

 

-

 

 

 

2.74

 

The followingtable summarizes information about options outstanding at December 31, 2005:

 

 

 

Options outstanding

 

Options exercisable

Range of exercise price

 

Number outstanding at December 31, 2005

 

Weighted average remaining contractual life

 

Weighted average exercise price

 

Number outstanding at December 31, 2005

 

Weighted average exercise price

$

 

 

 

Years

 

$

 

 

 

$

 

 

 

 

 

 

 

 

 

 

 

1.33 - 1.80

 

541,696

 

2.97

 

1.57

 

538,292

 

1.56

2.04 - 2.38

 

590,843

 

3.72

 

2.32

 

485,833

 

2.28

3.00 - 3.65

 

1,100,680

 

7.32

 

3.27

 

330,261

 

3.53

3.73 - 4.49

 

875,759

 

6.11

 

4.37

 

615,052

 

4.13

4.81 - 5.96

 

836,692

 

6.58

 

5.19

 

554,891

 

5.16

6.10 - 9.00

 

787,637

 

6.35

 

6.90

 

385,469

 

6.86

 

 

 

 

 

 

 

 

 

 

 

 

 

4,733,307

 

 

 

 

 

2,909,798

 

 

 

** **

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

 

Compensationexpenses (income) which are amortized over the vesting period and recognized bythe Company, related to its employee stock-based compensation awards, amountedto $ (24), $ 298 and $ 786 for the years ended December 31, 2005, 2004 and 2003, respectively. Compensation expenses related to the granting of stock optionsto consultants amounted to $ 6, $ 457 and $ 276 for the years ended December31, 2005, 2004 and 2003, respectively (see also d below), 

 

The Companyextended the term of the vested employee stock options held by the Company'sformer CEO on the date of his departure. As a result, the Company recorded in2005 compensation expenses in an amount of $ 396. The employee stock optionsthat were unvested as at the above date, were forfeited, and the deferred stockcompensation in the amount of $ 204 was canceled.

 

Thecompensation expenses are included in the following expense categories: 

 

 

 

Year ended December 31,

 

 

2005

 

2004

 

2003

 

 

 

 

 

 

 

Research and development expenses

 

17

 

279

 

308

Selling and marketing expenses

 

-

 

68

 

79

General and administrative expenses

 

361

 

408

 

675

 

 

 

 

 

 

 

 

 

$                378

 

$                755

 

$            1,062

 

d.        Options toconsultants:

 

Issuance date

 

In connection with

 

Number of options granted

 

Options exercised

 

Options exercisable

 

Options forfeited or expired

 

Exercise price per share

 

Exercisable through

 

 

 

 

 

 

 

 

 

 

 

 

**$**

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

October 1998

 

Advisory board

 

30,000

 

12,900

 

17,100

 

-

 

1.33

 

October  2008

July 1999

 

Advisory board

 

30,000

 

-

 

30,000

 

-

 

1.35

 

July  2009

July 1999

 

Consulting

 

150,000

 

-

 

150,000

 

-

 

1.35

 

July  2009

October 1999

 

Advisory board

 

15,000

 

-

 

15,000

 

-

 

1.33

 

October  2009

March 2000

 

Consulting

 

75,000

 

-

 

75,000

 

-

 

5.00

 

March  2010

May 2000

 

Consulting

 

10,000

 

-

 

10,000

 

-

 

3.00

 

 May  2010

May 2000

 

Consulting

 

35,000

 

-

 

-

 

35,000

 

10.00

 

 May  2005

January 2002

 

Consulting

 

20,000

 

-

 

-

 

20,000

 

4.49

 

January  2012

July 2003

 

Consulting

 

150,000

 

-

 

109,368

 

-

 

2.38

 

April 2009

February 2004

 

Consulting

 

60,000

 

-

 

26,250

 

-

 

7.27

 

March 2010

April 2004

 

Advisory board

 

50,000

 

-

 

23,989

 

-

 

6.84

 

April 2010

April 2004

 

Consulting

 

50,000

 

-

 

23,966

 

-

 

6.84

 

April 2010

April 2004

 

Consulting

 

60,000

 

-

 

25,000

 

-

 

6.84

 

April 2010

February 2005

 

Consulting

 

25,000

 

-

 

5,210

 

-

 

6.10

 

February 2011

June 2005

 

Advisory board

 

20,000

 

-

 

-

 

-

 

3.37

 

June 2015

November  2005

 

Consulting

 

120,000

 

-

 

-

 

-

 

3.02

 

November 2011

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

900,000

 

12,900

 

510,883

 

55,000

 

 

 

 

 

**F27** 

 

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

 

The Companyaccounts for its options and warrants to consultants under the fair valuemethod of SFAS No. 123 and EITF 96-18. The fair value of these options wasestimated using a Black & Scholes option-pricing model with the followingweighted-average assumptions for 2005, 2004 and 2003 risk-free interest ratesof 3.79%, 3.36% and 1%, respectively, dividend yields of 0%, volatility factorsof the expected market price of the Company's ordinary shares of 51%, 44% and43% respectively and a weighted-average contractual life of the options of sixyears. Changes in the fair value of the options and warrants prior tocompletion of performance are reflected as an adjustment to the expense to beincluded in future periods over the services period. As for compensationexpenses, see also c above.

 

e.        Thenet loss of the Company is equal to comprehensive loss.

 

 

**NOTE 12:-            GEOGRAPHIC INFORMATION AND MAJOR CUSTOMERS**

 

The Company'sbusiness is currently comprised of one operating segment, the research,development and commercialization of therapeutic and diagnostic biomarkerproduct candidates.  The nature of the products and services providedby the Company and the type of customers for these products and services aresimilar. Operations in Israel and the United States include research anddevelopment, sales and business development. The Company follows SFAS No. 131"Disclosures about Segments of an Enterprise and RelatedInformation." Total revenues are attributed to geographic areas based onthe location of the end customer. The following represents the total revenuesfor the years ended December 31, 2005, 2004 and 2003 and long-lived assets asof December 31, 2005, 2004 and 2003:

 

 

 

Year ended December 31, 

 

 

2005

 

2004

 

2003

Revenues from sales to unaffiliated customers:

 

 

 

 

 

 

United States

 

$              423

 

$            1,051

 

$            4,497

Europe

 

218

 

1,260

 

2,111

Far East

 

-

 

265

 

50

Israel

 

5

 

43

 

36

Other

 

-

 

11

 

82

 

 

 

 

 

 

 

Total revenues

 

$              646

 

$        2,630*)

 

$          6,776*)

 

*)                Reclassified - See Note 2h

 

 

 

December 31, 

 

 

2005

 

2004

 

2003

Long-lived assets:

 

 

 

 

 

 

Israel

 

$            3,005

 

$            3,710

 

$            3,482

United States 

 

15

 

29

 

455

 

 

 

 

 

 

 

 

 

$            3,020

 

$            3,739

 

$            3,937

 

**F28** 

 

**NOTE 12:-   GEOGRAPHIC INFORMATION AND MAJORCUSTOMERS (Cont.)**

 

 

 

 

Year ended December 31, 

 

 

2005

 

2004

 

2003

 

 

%

Sales to a single customer exceeding 10%:

 

 

 

 

 

 

Customer A

 

59

 

48

 

31

Customer B

 

39

 

-

 

21

Customer C

 

-

 

13

 

*)

 

 *)      Lessthan 10%.

 

**NOTE 13:-   FINANCIAL INCOME, NET**

** **

 

 

Year ended December 31,

 

 

2005

 

2004

 

2003

Income  (expense):

 

 

 

 

 

 

Interest  income

 

              $770

 

          $1,454

 

          $2,027

Bank fees

 

(39)

 

(56)

 

(71)

Exchange rate  differences

 

(49)

 

19

 

156

 

 

 

 

 

 

 

 

 

              $682

 

          $1,417

 

          $2,112

 

** **

**NOTE 14:-   TAXES ON INCOME**

 

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

 

Results fortax purposes are measured in terms of earnings in NIS after certain adjustmentsfor increases in Israel's Consumer Price Index ("CPI"). As explainedin Note 2b, the financial statements are measured in U.S. dollars. Thedifference between the annual change in Israel's CPI and in the NIS/dollarexchange rate causes a further difference between taxable income and the incomebefore taxes shown in the financial statements. In accordance with paragraph9(f) of SFAS No. 109, the Company has not provided deferred income taxes on thedifference between the functional currency and the tax bases of assets andliabilities.

 

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

 

In 1994, theproduction facilities of the Company related to its computational technologieswere granted the status of an "Approved Enterprise" under the Law. In1996 and 2000, two expansion programs related to the Company's computationaltechnologies were granted the status of "Approved Enterprise". In1999 and 2003, the production facilities of the Company related to theCompany's molecular biology "wet lab" were granted the status of an"Approved Enterprise".

**F29** 

 

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

 

According tothe provisions of the Law, the Company has chosen to enjoy the"Alternative Benefits" track and. Accordingly, its income from the"Approved Enterprise" will be tax-exempt for a period of two years,commencing in the first year the Company has taxable income (and aftercommencement of production as defined in the Law), and subject to an additionalperiod of five to eight years of reduced tax rates between 10% to 25%,depending upon the proportion of foreign ownership in the Company in each taxyear. Due to the reported losses, the benefit period has not commenced. Theperiod during which reduced tax rates of between 10% and 25% apply expires onthe earlier of 12 years from the commencement of production, or 14 years, fromthe approval date, all in accordance with the final approval of the investmentcenter. Given the aforementioned conditions, the period of the reduced taxrates (but not the two year perid of tax exemption) will terminate in 2008 and2017.

 

The entitlementto the above benefits is conditional upon the Company's fulfilling theconditions stipulated by the above Law, regulations published thereunder andthe letters of approval for the specific investments in "Approved Enterprises".In the event of failure to comply with these conditions, the benefits may becanceled and the Company may be required to refund the amount of the benefits,in whole or in part including interest and linked to the Israeli Consumer PriceIndex.

 

As of December 31, 2005, management believes that the Company meets all of the aforementionedconditions.

 

In the event ofa distribution of cash dividends from income that is tax-exempt as mentionedabove, the Company would have to pay income tax equal to 10% to 25% of thegrossed up amount distributed (depending upon the proportion of foreignownership in the Company in each tax year) in addition to dividend tax whichwill be paid by the Company's shareholders equal to 15% of the cash dividend.The Company currently has no plans to distribute dividends and intends toretain future earnings to finance the development of its business.

 

 

Should theCompany derive income from sources other than the "ApprovedEnterprise" during the relevant period of benefits, such income will betaxable at the regular corporate tax rate.  

 

In addition, inDecember 2003 the production facilities of the Company related to its ChemistryDivision were granted the status of an "Approved Enterprise" underthe Law. The Company has chosen the "grants" track, according towhich the total approved investments amounted to $ 3,500. Until December 31 2005, Keddem already made investments in the amount of approximately $ 1,700.The investment grants are 24% from its investments in the approved enterprises.The tax benefits portion of the "grants" track are identical to thetax benefits portion of the "Alternative Benefits" track. Inconnection with the divestment of the Company's computational chemistryactivities (see Note 1c), the Company transferred its benefits and liability underthis program to Keddem.  Keddem is required to commence investinguntil December 2005, in order to benefit from the program. Keddem requested toextend the eligibility period until December 2006 inclusive (See note 1(c)).

 

The InvestmentLaw was significantly amended effective April 1, 2005. The amendment includesrevisions to the criteria for investments qualified to receive tax benefits asan 

**F30** 

 

** **

**NOTE 14:-            TAXES ON INCOME (Cont.)**

 

 

Approved Enterpriseand among other things, simplifies the approval process. The amendment appliesto new investment programs and investment programs commencing after December 31, 2004, therefore, does not affect the approved programs of the company.. 

 

c.     Tax benefit under the Law for theEncouragement of Industry (Taxation), 1969:

 

The Company iscurrently qualified as an "industrial company" under the above lawand as such, enjoys tax benefits.

 

d.     Netoperating losses carryforwards:

 

As of December 31, 2005, the Company's and Keddem`s net operating loss carryforwards fortax purposes in Israel amounted to approximately $62 million. These netoperating losses may be carried forward indefinitely and may be offset againstfuture taxable income. The Company expects that during the period in whichthese tax losses are utilized its income would be substantially tax-exempt. 

 

Compugen Inc.is subject to U.S. income taxes and has a loss carryforward resulting from theyears up to and including 2005 amounting to approximately $ 15 million, whichexpires in the years 2012 to 2024. Utilization of the U.S. net operating lossesmay be subject 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 in the expiration of netoperating losses before utilization.

 

e.    Loss before taxes is comprised as follows:

 

 

 

Year ended December 31,

 

 

2005

 

2004

 

2003

 

 

 

 

 

 

 

Domestic (Israel)

 

$        12,552

 

$        11,443

 

$        10,173

Foreign

 

1,426

 

2,279

 

1,269

 

 

 

 

 

 

 

 

 

$        13,978

 

$        13,722

 

$        11,442

 

**F31** 

 

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

 

 

f.      Deferredtaxes:

 

Deferred income taxes reflect thenet tax effects of temporary differences between the carrying amounts of assetsand liabilities for financial reporting purposes and the amounts used forincome tax purposes. The Company and its subsidiaries' deferred tax assets arecomprised of operating loss carryforwards and other temporary differences.Significant components of the Company and its subsidiaries deferred tax assetsare as follows:

 

 

 

December 31,

 

 

2005

 

2004

 

 

 

 

 

Operating loss carryforward

 

$        6,354

 

$       6,420

 

 

 

 

 

Net deferred tax asset before valuation allowance

 

6,354

 

6,420

Valuation allowance

 

(6,354)

 

(6,420)

 

 

 

 

 

Net deferred tax asset

 

$                   -

 

$                  -

 

The Companyand its subsidiaries have provided valuation allowances in respect of deferredtax assets resulting from operating loss carryforwards and other temporarydifferences.  

 

Managementcurrently believes that since the Company and its subsidiaries have a historyof losses it is more likely than not that the deferred tax regarding the losscarryforwards and other temporary differences will not be realized in theforeseeable future.

 

g.    Reconciliation of the theoretical taxexpense (benefit) to the actual tax expense   (benefit):

 

The mainreconciling items between the statutory tax rate of the Company and the effectivetax rate are the non-recognition of tax benefits from accumulated net operatinglosses carryforward among the Company andvarious subsidiariesdue to the uncertainty of the realization of such tax benefits and the effectof 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 and 2004, theState of New Jersey approved the total tax benefit in the amount of $ 1,178 forpossible sale by the Company. In December 2003, the Company received $ 218 fromthe sale of an aggregate of $ 254 tax benefit, which was recognized as otherincome for the fiscal year 2003. In December 2004, the Company received $ 262from the sale of an aggregate of $ 305 tax benefit, which was recognized asother income for the fiscal year 2004. 

** **

** **
****F32** **
** **

** **

**NOTE 15:-        RELATED****PARTY TRANSACTIONS**

 

Evogene Ltd. -see Note 1b.

KeddemBioSciense Ltd. - see Note 1c.

 

 

** **

**NOTE 16:-**          **SUBSEQUENTEVENT**

 

In February 15, 2006, Evogene has signed an equity investment agreement with certaininvestors, amounting to $7,000 of which approximately $2,000 was originallyreceived as a bridge loan in January 2005. In addition, pursuant to the equityagreement, the investors agreed to convert all outstanding loans (see note 1b)into equity. Due to these conversions, the Company's holdings were diluted to14.76% of Evogene's ordinary shares. 

**F33**