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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

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Form 10-K

|/x/ | ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
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For the fiscal year ended June 30, 2001

or

|/ / | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
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Commission File Number 0-22987

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VALENTIS, INC.(Exact name of registrant as specified in its charter)

Delaware

94-3156660(State or other jurisdiction
of incorporation or organization)

(IRS Employer
Identification No.)863A Mitten Rd., Burlingame, CA

94010(Address of principal offices)

(Zip Code)


(650) 697-1900(Registrant's telephone number, including area code)

|                                                            |  |                              
|----------------------------------------------------------- |  | -----------------------------
|Securities registered pursuant to Section 12(b) of the Act: |  | None                         
|Securities registered pursuant to Section 12(g) of the Act: |  | Common Stock, Par Value $.001

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Indicate
by check mark whether the registrant (1) has filed all reports required by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding
12 months (or for such shorter 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 if disclosure of delinquent filers pursuant to Item 405 of regulation S-K is not contained herein, and will not be contained, to the best of
registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. /x/

The
aggregate market value of the common stock held by non-affiliates of the registrant, based upon the last sale price of the common stock reported on the National
Association of Securities Dealers Automated Quotation System on September 24, 2001 was $129,129,441.

The
number of registrant's Common Stock outstanding, as of September 24, 2001 was 29,908,504.

DOCUMENTS INCORPORATED BY REFERENCE

Portions
of the Registrant's proxy statement, which will be filed with the Commission pursuant to Section 14A in connection with the 2001 meeting of stockholders are
incorporated herein by reference in Part III of this Report.

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PART I

ITEM 1. BUSINESS

This Annual Report on Form 10-K contains certain forward-looking statements within the meaning of section 27A of the Securities Act
of 1933, as amended, and section 21E of the Securities Exchange Act of 1934, as amended. These statements relate to, among other things, our future financial position, products, business
development, strategy and our management's plans and objectives for future operations. Forward-looking statements generally can be identified by the use of forward-looking terminology such as.
"believe," "may," "will," "intend," "expect," "estimate," "continue," "ongoing," "predict," "potential," and "anticipate" or similar expressions or the negative of those terms or expressions. These
statements involve known and unknown risks, uncertainties and other factors, which may cause our actual results, performance or achievements to differ materially from those expressed or implied by
such forward-looking statements. Such factors include, among others, the information contained under the captions "Part I, Item 1. Business," and "Part II, Item 7. Management's
Discussion and Analysis of the Financial Condition and Results of Operations" in this Annual Report. The reader is cautioned not to put undue reliance on these forward-looking statements, which
reflect management's analysis only as of the date of this Annual Report. The reader is strongly urged to read the information set forth under the captions "Part I, Item 1. Business," and
"Part II, Item 7. Management's Discussion and Analysis of the Financial Condition and Results of Operations," in particular "Risk Factors," for a detailed description of these significant risks
and uncertainties.

COMPANY OVERVIEW

Valentis is a biopharmaceutical company applying proprietary synthetic gene delivery, gene regulation, and PEGylation technologies to create novel therapeutic
products based on genomic discoveries in the fields of cardiovascular disease, oncology, hematology, and infectious diseases. Enabled by our expertise in preclinical research and development, clinical
development, and manufacturing, Valentis has created a broad product portfolio of cutting edge biopharmaceuticals.

The
merger of Megabios Corp. and GeneMedicine, Inc. ("GeneMedicine") in March 1999 formed Valentis Inc., a Delaware corporation. In August 1999, Valentis
acquired U.K.-based PolyMASC Pharmaceuticals plc. Valentis has centers in three locations: Burlingame, California, which is the Company's headquarters, as well as the center for clinical development,
The Woodlands, Texas, which
houses personnel focused on research; and London, England, which focuses on research of PEGylation technologies. Valentis is in the process of closing the London facility and transferring research and
development of the PEGylation technologies to its facility in Texas.

Genemedicine Products

Valentis' Genemedicine products provide novel ways to achieve production of therapeutic proteins in their most natural and active form at specific
sites within the body. Upon delivery, genes formulated with synthetic delivery systems enter targeted cells and produce the therapeutic proteins. The fidelity, specificity, and duration of expression
within the target cells are controlled by Valentis proprietary gene regulation systems.

 Synthetic Gene Delivery Systems



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 Gene Regulation Systems



PEGylation Systems (Polymer-based biopharmaceutical delivery)

Valentis' OptiPEG family of technologies is based on polymer modification using polyethylene glycol ("PEG"), a compound with a long and safe
clinical history. We have developed breakthrough methods to directly couple our proprietary PEG ("OptiPEG") to proteins, peptides, antibodies and antibody fragments, viruses and
liposomes, to retain maximum biological activity of the material, and to protect the biopharmaceutical from inactivation by the immune system. OptiPEG technologies listed below provide
the potential to deliver products with improved safety, efficacy, and dosing regimens.



Current Good Manufacturing Practices manufacturing ("cGMP")

Valentis has developed proprietary scalable processes for the manufacture of plasmid DNA and Genemedicine biopharmaceuticals. Through our
pAlliance with DSM Biologics and QIAGEN N.V., we are able to produce material from lab to commercial scale using the same process. Valentis also has established manufacturing alliances
for our proprietary, biologically optimized PEG (OptiPEG).

Corporate Partners

Valentis itself, or through its PolyMASC subsidiary, currently has corporate collaborations with:



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Technology Licenses

Valentis itself, or through its PolyMASC subsidiary, currently has technology out-licenses with:



Valentis
has also licensed its proprietary GeneSwitch gene regulation technology on a non-exclusive basis to Wyeth-Ayerst Laboratories, the pharmaceutical
division of American Home Products, GlaxoSmithKline, Lexicon Genetics and Pfizer, Inc. for functional genomics research.

VALENTIS' PRODUCTS AND TECHNOLOGIES

Valentis focuses on the development of Genemedicine biopharmaceuticals and PEGylated biopharmaceuticals from preclinical stages through the
completion of Phase II clinical studies. We seek corporate partnerships with pharmaceutical and biotechnology companies, which assume responsibility for late-stage development, marketing
and commercialization. Valentis has extensive experience with respect to establishing and managing successful corporate partnerships. The table below summarizes Valentis' leading product candidates,
technology out-licenses, potential therapeutic indications, stage of development and corporate partner or licensee:

GENEMEDICINE PRODUCTS FOR CARDIOVASCULAR DISEASE

|Product Candidate |  | Indication                  |  | Partner     |  | Development Stage(1)
|----------------- |  | --------------------------- |  | ----------- |  | --------------------
|VEGF165           |  | Coronary artery disease     |  |            |  | Phase II            
|VEGF165           |  | Peripheral vascular disease |  |            |  | Phase II            
|Del-1             |  | Peripheral artery disease   |  | Proprietary |  | Phase I / II        
|Del-1             |  | Coronary artery disease     |  | Proprietary |  | Preclinical         
|eNOS              |  | Restenosis                  |  | Proprietary |  | Research            

GENEMEDICINE PRODUCTS FOR ONCOLOGY

|Product Candidate        |  | Indication                 |  | Partner     |  | Development Stage
|------------------------ |  | -------------------------- |  | ----------- |  | -----------------
|IL-2                     |  | Head and neck cancer       |  | Roche       |  | Phase II         
|IL-2 + INF-a combination |  | Melanoma                   |  | Roche       |  | Phase I / II     
|Intravenous IL-2         |  | Lung tumors and metastases |  | Proprietary |  | Phase I          
|IL-2 + superantigen B    |  | Melanoma                   |  | Proprietary |  | Phase I / II     
|IL-2 + superantigen A    |  | Solid tumors in dogs       |  | Heska       |  | Late Development 
|MnSOD                    |  | Prevention of Esophagitis  |  | Proprietary |  | Preclinical      
|PEDF                     |  | Anti-angiogenesis          |  | Proprietary |  | Research         

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GENEMEDICINE PRODUCTS FOR HEMATOLOGY

|Product Candidate |  | Indication |  | Partner     |  | Development Stage
|----------------- |  | ---------- |  | ----------- |  | -----------------
|EpoSwitch        |  | Anemia     |  | Proprietary |  | Preclinical      

GENEMEDICINE PRODUCTS FOR INFECTIOUS DISEASES

|Product Candidate |  | Indication  |  | Partner     |  | Development Stage
|----------------- |  | ----------- |  | ----------- |  | -----------------
|IFN-aSwitch      |  | Hepatitis C |  | Proprietary |  | Research         

TECHNOLOGY LICENSES

|Product Candidate                 |  | Indication               |  | Partner/Licenesee                                              |  | Development Stage
|--------------------------------- |  | ------------------------ |  | -------------------------------------------------------------- |  | -----------------
|Prophylactic/therapeutic vaccines |  | HIV and Hepatitis C      |  | Epimmune                                                       |  | Preclinical      
|VEGF165                           |  | Post-surgical restenosis |  | Ark Therapeutics                                               |  | Phase I          
|GeneSwitch                       |  | Genomics Research        |  | American Home Products
GlaxoSmithKline
Lexicon Genetics
Pfizer |  | Research         
|iNOS                              |  | Post-surgical restenosis |  | Cardion AG                                                     |  | Phase I          

PEG PRODUCTS

|Product Candidate            |  | Indication  |  | Partner/Licensee        |  | Development Stage
|---------------------------- |  | ----------- |  | ----------------------- |  | -----------------
|PEGylated Omniferon (IFN-a) |  | Hepatitis C |  | Viragen                 |  | Preclinical      
|PEGylated CI-1042            |  | Cancer      |  | Onyx                    |  | Preclinical      
|PEGylated proteins           |  | Undisclosed |  | Transkaryotic Therapies |  | Feasibility      
|PEGylated MetXia®            |  | Cancer      |  | Oxford Biomedica        |  | Feasibility      

|    |  |                    |  |                                                                                                                                                                                                         
|--- |  | ------------------ |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) |  | "Phase I"          |  | means that the compound is being tested in humans for safety in a limited patietn population.                                                                                                           
|    |  | "Phase II"         |  | means that the compound is being tested in humans for indications of efficacy in a limited patient population.                                                                                          
|    |  | "Preclinical"      |  | means that Valentis is conducting efficacy, pharmacology and/or toxicology testing of a gene delivery system in animal models or biochemical or cell culture assays.                                    
|    |  | "Research"         |  | includes the development of animal models and assay systems, discovery of prototype gene delivery systems, and evaluation and refinement of prototype gene delivery systems inin
vitroandin vivotesting.
|    |  | "Feasibility"      |  | means the development of models and assay systems, and evaluation and refinement of PEG delivery systems inin vitroandin
vivotesting.                                                                   
|    |  | "Late Development" |  | means testing for safety, toxicology and efficacy in companion animals.                                                                                                                                 

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GENEMEDICINE PRODUCTS

Angiogenic Genemedicine Products for Cardiovascular Disease

Vascular Endothelial Growth Factor ("VEGF165") Genemedicine Product

In March 1998, a VEGF165 Genemedicine product employing Valentis' proprietary cationic lipid gene delivery system became the
subject of two physician-initiated Phase II clinical trials, one for treating peripheral vascular disease ("PVD") and one for treating coronary artery disease ("CAD") due to ischemia caused by
atherosclerosis. The Genemedicine product is designed to prevent proliferation of smooth muscle cells and reclosure of the vessels in patients who are undergoing either coronary
angioplasty or peripheral angioplasty and to stimulate the formation of new blood vessels. Patients enrolled in the clinical trials received a plasmid-based, VEGF165
Genemedicine product, an adenovirus encoding VEGF165, or a placebo. The treatments are administered via catheter to patients immediately following angioplasty and stent
insertion. Dr. Seppo Ylä-Herttuala of the A.I. Virtanen Institute of the University of Kuopio, Finland, conducted the trials. Valentis provided its proprietary
cationic lipid gene delivery system (DOTMA) for the studies, which was combined with the Institute's plasmids encoding VEGF165.

In
November 1999 and 2000, interim analysis of angiographic data required by the Finnish Agency for Medicinal Products from
Dr. Ylä-Herttuala's double blind, placebo-controlled Phase II clinical trial for PVD revealed (1) an increase in the number of blood vessels in both the
plasmid and adenovirus groups, but not in the group given the placebo and (2) that there were serious adverse events noted in the patient group given the adenoviral VEGF165, but not
in the patient group given the plasmid-based VEGF165 Genemedicine product delivered using Valentis' cationic lipid delivery system. The coronary artery disease trial completed
its 90-patient enrollment in the fourth quarter of calendar 2000 and the peripheral vascular disease trial completed its enrollment of 45 patients in the first quarter of calendar 2001.

VEGF165
is a potent angiogenic factor that has also been shown to inhibit restenosis (the narrowing of the blood vessels following angioplasty or stent insertion). To
date, more than 140 patients with either PVD or CAD have been treated with the VEGF165 therapy. Results of the PVD trial are expected at the American Heart Association Meeting in
November 2001.

In
March 2000, Ark Therapeutics ("Ark" formerly Eurogene Ltd.) initiated a Phase I clinical trial of a gene therapy incorporating Ark's local collar-reservoir delivery
device, a Valentis proprietary cationic lipid gene delivery system, and a gene for VEGF165. The collar-reservoir device enables the gene to be delivered locally via the adventitial
(outside) surface of the blood vessels. The therapy is designed to prevent the post-surgical development of intimal hyperplasia (smooth muscle cell proliferation) in blood vessels. This is
a frequent complication after vascular surgery and may result in blockage of the vessels. The trial is being conducted at Kuopio, Tampere and Oulu, three university hospitals in Finland, under the
supervision of Dr. Ylä-Herttuala.

This
is the first study in humans to investigate the local delivery of a gene from the outside of the tissue to the specific site where it is needed using a biodegradable
collar-reservoir device and a non-viral, lipid-based delivery system. This method of delivery is aimed at enhancing local gene delivery while limiting systemic protein exposure.

The
study is designed to demonstrate that the VEGF165 gene, delivered locally to the outside surface of a blood vessel, will transfect and express VEGF165
protein in the smooth muscle cells of the vessel wall. Expression of VEGF165 protein should cause the vasculo-protective mechanism to be activated. The VEGF protein is known to increase
the production of nitric oxide in the endothelium that, in turn, is responsible for inhibiting the development of intimal hyperplasia in blood vessels.

Results
from preclinical experiments involving local delivery of a VEGF165 gene with Ark's extravascular collar have indicated that this method of delivery results in
significant transfection of smooth

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muscle cells in the vessel wall. Valentis has demonstrated that its proprietary DOTMA cationic lipid delivery system can be used with VEGF165 for vascular applications.

Del-1 Genemedicine Product

In April 1999, Valentis acquired the rights and intellectual property related to the Del-1 gene and protein. Del-1 is a novel
extracellular matrix protein involved in early growth and development of blood vessels that has been demonstrated to have potential application in the treatment of certain vascular diseases by
stimulating angiogenesis. Del-1 has the potential to be effective in the treatment of a variety of cardiovascular diseases, including peripheral vascular disease and coronary artery
disease.

Del-1
is a unique angiogenic factor that promotes vascular growth and inhibits endothelial cell death. It has a distinct mechanism of action from other known angiogenic
factors such as members of the VEGF and fibroblast growth factor (FGF) families. In June 2000, Valentis announced that its Del-1 Genemedicine product elicited
development of new blood vessels in studies of rabbits and mice. A single administration of the Del-1 gene in muscle had similar effects on development of new blood vessels in rabbit and
mouse models as a VEGF165 gene used as a comparator in both studies. Acute toxicities observed with the VEGF165 gene in dose-response studies were not observed with
the Del-1 gene at similar doses, suggesting that the Del-1 gene may have safety advantages over VEGF165.

Valentis
initiated a Phase I / II clinical trial for a Del-1 Genemedicine product for the treatment of peripheral vascular disease in June 2001. The
goal of this open-label, multi-center, dose escalation trial is to evaluate safety and to determine the maximum tolerated dose of the Del-1 Genemedicine product in
patients with peripheral arterial disease (PAD), where the patients suffer from a blockage of the blood vessels in their legs. The secondary objective of the trial is to obtain preliminary efficacy
data and evidence of angiogenic activity. For PAD, Valentis' Del-1 gene medicine is administered by intramuscular injection.

eNOS Gene Therapy

In 1998, Valentis acquired an exclusive worldwide license from Stanford University to intellectual property covering gene therapy for vascular disorders. The
license covers a series of patents and patent applications directed to the use of genes that increase nitric oxide levels for the treatment of cardiovascular diseases, including eNOS, iNOS and
potentially others.

Restenosis
of bypass grafts is a serious post-operative complication occurring in a significant fraction of patients undergoing arterial bypass surgery. Nitric oxide is
widely recognized as a potent inhibitor of the smooth muscle cell proliferation, which causes restenosis. Direct extravascular delivery of the gene encoding eNOS (endothelial nitric oxide synthase) to
the grafted vessel is a therapeutic approach designed to increase the local concentration of nitric oxide to inhibit restenosis.

In
August 2000, Valentis and Ark Therapeutics announced a collaboration to develop an eNOS gene therapy. The product will combine Valentis' proprietary gene formulation and
expression technologies and Ark's extravascular delivery collar to deliver and express the gene encoding the intracellular enzyme, eNOS. The initial indication for the product will be the inhibition
of restenosis following bypass graft surgery. Under the collaboration, Valentis and Ark will share research and development costs and potential revenues. We project that an eNOS gene medicine, jointly
developed by Ark and Valentis, could enter clinical trials within a year following successful preclinical studies.

Cytokine Genemedicine Products for Oncology

Valentis' most advanced programs are in the field of cancer immunotherapy. Three single cytokine genes, IL-2, IL-12 and
IFN-a, have all finished Phase I safety trials and our IL-2 Genemedicine product has completed a Phase II trial. In addition, the
combination Genemedicine products, IL-12 plus IFN-a

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and IL-2 plus Superantigen B, have been tested in Phase I / II trials and an intravenously delivered IL-2 Genemedicine product for cancers of the lung is in a
Phase I trial.

IL-2 Genemedicine Product

In June 1999, Valentis initiated a multi-center Phase II clinical trial with its IL-2 Genemedicine product for the treatment of
squamous cell carcinoma of the head and neck. More than 40,000 patients in the United States and 75,000 patients in Europe are diagnosed with head and neck cancer each year. While patients with
localized disease are successfully treated with radiation or surgery, a large number of patients with advanced or metastatic disease have few treatment options. Recurrence is common and the
five-year survival rate is less than 20%. The IL-2 Genemedicine product is intended to reduce the risk of disease recurrence and to prolong
disease-free survival. The goal of this randomized trial was to evaluate the safety and efficacy of the IL-2 Genemedicine product combined with chemotherapy, and
compare it to conventional chemotherapy alone in patients who have failed first line therapy. The clinical trial was conducted at 14 sites in Germany, the Czech Republic and Russia, and enrollment of
the trial's 80 patients was completed in January 2001.

In
June and September 2001, we reported results from the Phase II clinical trial that showed a positive trend favoring the patient group receiving the IL-2
Genemedicine product and chemotherapy as compared to the group receiving chemotherapy alone. The median time to progressive disease was 93 days in patients treated only with
chemotherapy as compared to 129 days for patients in the IL-2 plus chemotherapy group. Additionally, 40% of patients in the combined treatment group remained free of disease
progression at the conclusion of the trial, while only 17% of patients in the chemotherapy-alone group were progression-free. The treatments were injected directly into tumors of patients
with Stage III and Stage IV carcinoma of the head and neck.

The
IL-2 Genemedicine product is composed of a plasmid encoding the human IL-2 gene and a proprietary cationic lipid gene delivery system that
enhances uptake of the gene into the target cells after direct intratumoral injection. This product is designed to provide sustained, local expression of the IL-2 protein, which promotes a
local and systemic immune responses against tumors. The use of a non-viral gene delivery system is intended to enable repeat administration of the Genemedicine product in a
safe and effective manner.

IL-2
is an important human protein that has multiple functions in the body's immune response to infections and tumors. The application of the recombinant protein in the
treatment of cancer is limited by its short half-life and by significant toxicity when administered systemically. In contrast, the IL-2 Genemedicine product is
designed to initiate sustained production of the IL-2 protein within the tumor, which elicits a systemic immune response while avoiding the potentially harmful systemic levels of the
IL-2 protein.

Intravenous IL-2 Genemedicine Product ("IV IL-2 Genemedicine Product")

In April 2001, Valentis dosed the first patients in a Phase I clinical trial of our intravenously administered human IL-2
Genemedicineproduct. The goal of the trial is to determine the maximum tolerated dose of the IV IL-2 Genemedicine product in patients with cancers in the lung. By
expressing the IL-2 gene locally in the lung, the IV IL-2 Genemedicine product is designed to deliver the IL-2 protein to lung tumors while minimizing
systemic exposure to IL-2 protein and associated adverse events.

The
clinical trial is being conducted at the Sarah Cannon Cancer Center in Nashville, Tennessee and at the H. Lee Moffitt Cancer Center in Tampa, Florida. Up to 36 patients will be
enrolled in this multi-center clinical study. Upon entry into lung cells, the IV IL-2 Genemedicine product is intended to lead to human IL-2 protein expression in
the pulmonary and tumor vasculature which may lead to immune activation.

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The ability to deliver Genemedicine products intravenously should allow Valentis to treat far more patients than can be treated by injections directly into tumors. The IV
IL-2 Genemedicine product is designed to focus then amplify the immune response against both primary lung tumors as well as cancers having pulmonary metastases for which
chemotherapy has limited effectiveness.

Valentis'
studies in several animal models, including mouse, rabbit and non-human primates, verified the expression of human IL-2 in the lung following the
intravenous delivery of IV IL-2 Genemedicine product. Efficacy studies in mouse model systems, as well as in dogs with spontaneously occurring metastatic pulmonary neoplasms,
indicated anti-tumor activity as evidenced by a significant reduction in tumor burden.

The
IV IL-2 Genemedicine product uses an optimized synthetic cationic lipid-based gene delivery system that has been shown to efficiently localize in the
lungs, and preferentially in pulmonary tumor lesions, enabling tumor localization via intravenous administration.

Combination IL-12 plus IFN-a Genemedicine Product

In
addition to the IL-2 Genemedicine product, Valentis has a combination IL-12 plus IFN-a
Genemedicine product in a clinical study. Initially, IFN-a was studied in a Phase I / II clinical trial that began in March 1999 to study safety
and efficacy in patients with squamous cell carcinoma of the head and neck at the University of Pennsylvania and at the University of Kentucky. In July 1999, Valentis
initiated a U.S.-based multi-center Phase I / II clinical trial with its IL-12 Genemedicine product also for the treatment of squamous cell carcinoma of the head and neck. The
safety phase of the trial was conducted at the Dana Farber Cancer Institute (Harvard University) and the University of Pennsylvania. In December 2000, we announced that these initial trials
with the single cytokines IL-12 and IFN-a demonstrated that these genes delivered by Valentis' PINC polymer delivery system were generally
safe. This positive safety data allowed us to progress to the combination product clinical trial.

In
September 2000, Valentis received FDA clearance to initiate a Phase I / II clinical study of the combination IL-12 plus IFN-a
Genemedicine product in our proprietary polymer-based PINC gene delivery system. The trial is being conducted at the University of Pennsylvania, and is designed to determine
safety, tolerability and efficacy of the cytokine combination Genemedicine product for patients with squamous cell carcinoma of the head and neck.

Valentis
also announced the publication of results from preclinical studies with this same cytokine combination demonstrating a synergistic increase in anti-tumor response
against colon and renal cell carcinoma. The peer-reviewed article was published in the September 2000 issue of the journalHuman Gene
Therapy.

The
recombinant IFN-a protein is approved for use in a number of indications including malignant melanoma, hairy cell leukemia,
AIDS-related Kaposi's sarcoma, chronic hepatitis B and chronic hepatitis C. In contrast, an IFN-a Genemedicine product is designed for both
local and systemic immunotherapy and also has been shown to provide an anti-angiogenic effect in preclinical cancer models. Preclinical studies with the IL-12
Genemedicine product demonstrated that local administration could induce a systemic immune response against cancer with a reduction in tumor growth or a complete remission in animals.
Valentis expects that, by expressing the protein locally at the tumor site, the products will have therapeutic benefits against both primary tumors and well as their sites of metastases without the
toxicity that has limited the utility of the IL-12 protein when given systemically.

Combination IL-2 plus Superantigen B Genemedicine Product

A physician-sponsored Phase I / II clinical study of a Genemedicine product that combines the IL-2 and Superantigen-B
(SEB) genes was initiated in May 1998 at the University of Colorado Health Sciences Center as a treatment for melanoma. The dose-ranging study examines the safety of the
two-gene

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combination that is injected directly into tumors. The costs of the trial were supported in part by a clinical grant from the National Cancer Institute.

In
October 2000, Valentis announced positive interim results from the trial and concluded that treatment with an IL-2 plus SEB combination Genemedicine
product appeared safe, generating no significant toxicity at any dose tested. This trial demonstrated that the delivery of cytokine genes with Valentis' proprietary lipid delivery system has the
potential of delivering the benefits of existing cytokine therapy without the toxicity associated with the recombinant proteins. Through this trial, we were able to induce effective local and systemic
anti-tumor responses without the serious side effects seen with systemic administration of cytokine proteins. Researchers believe that the two-gene combination being tested may
be more effective than either gene alone and may provide advantages over other immunotherapy approaches that have been tested.

Studies
with this two-gene combination therapy on dogs with advanced cases of spontaneously occurring oral melanoma resulted in tumor regression and increased survival
rates. Specifically, direct administration of this IL-2 plus SEB combination Genemedicine immunotherapeutic resulted in a systemic immune response to the tumors in the mouth
and, in some cases, their sites of metastasis. Based on these data, Valentis believes that this product may have applications in the treatment of other solid tumors such as breast, prostate, and head
and neck cancers.

Valentis
has exclusively licensed the patents covering the two-gene combination from National Jewish Medical and Research Center for use in non-viral gene
therapy applications for cancer. The patents cover the delivery of a cytokine gene and a superantigen gene for the treatment of cancer.

Combination IL-2 plus Superantigen A Genemedicine Product for Animals

Under a November 1998 agreement, Valentis and Heska are cooperating in the development of immunotherapies for the treatment of cancer and allergies in
companion animals. Valentis granted Heska an option to license certain proprietary delivery and manufacturing technology, and Heska is evaluating Valentis' technology in delivering immunomodulatory
genes in companion animals. In October 2000, Heska exercised its option and licensed gene delivery and DNA manufacturing technology from Valentis. The technology will be used by Heska to
complete development of a novel gene product for the treatment of canine cancer.

Other Oncology Therapies



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Hematology Genemedicine Therapies

EpoSwitch Therapy

Anemia resulting from insufficient or ineffective erythropoetin occurs in patients with end-stage renal disease, cancer or other chronic diseases.
The EpoSwitch Genemedicine is designed to produce erythropoetin from skeletal muscle when an oral drug is given. The oral drug turns on the GeneSwitch gene
regulation system and the resulting erythropoetin may increase hematocrit, avoid the need for transfusions or repeat intramuscular or intravenous administration of recombinant human EPO and thus
improve symptoms of fatigue and shortness of breath associated with anemia. The EpoSwitch product is administered as an intramuscular injection followed by electroporation. The use of
electroporation increases the uptake of the gene into the muscle cells and results in a marked increase in protein production.

Plasmids
encoding erythropoetin and the GeneSwitch gene regulation technology have been administered to mice, rats, dogs and pigs. When the oral drug is given,
significant increases in erythropoetin and/or hematocrit levels were observed. Expression of erythropoetin has been seen up to 300 days after treatment. These studies demonstrated that the
level and duration of erythropoetin expression could be controlled using the EpoSwitch Genemedicine.

Other Genemedicine Therapies

IFN-a Switch Therapy

Valentis is also developing an IFN-a Genemedicinetherapy that
incorporates our proprietary PINC polymer muscle delivery system to provide regulated blood levels of IFN-a. This therapy may provide prolonged and
regulated expression from muscle thus increasing efficacy and decreasing side effects associated with frequent dosing. This IFN-a
Switchtherapy may be an attractive potential immunotherapy for patients with chronic hepatitis C infection.

Cystic Fibrosis Transmembrane Regulator ("CFTR") with GlaxoSmithKline ("Glaxo")

In April 1994, Valentis entered into a collaborative agreement with Glaxo to develop a gene therapy for the treatment of cystic fibrosis ("CF"). A Phase
I clinical trial that was completed in October 1998, revealed that the gene therapeutic showed no evidence of inflammation. The trial utilized Valentis' delivery technology to deliver the CFTR
gene to the nasal passages of cystic fibrosis patients. The product was evaluated in a double blind, dose escalation study in eleven adult CF patients. There was no evidence of adverse blood chemistry
parameters or inflammation as a result of treatment. The Company and Glaxo have agreed to terminate this collaborative agreement.

Rheumatoid Gene Therapy with Boehringer Ingelheim International GmbH ("BI")

In September 1999, Valentis entered into a 15-month collaborative agreement with BI for the development of gene therapy for rheumatoid
arthritis. Under the terms of the agreement, BI and Valentis conducted evaluations of BI's proprietary genes with Valentis' proprietary gene delivery systems in several animal models of rheumatoid
arthritis. The collaboration, completed in December 2000, did not result in products that will be taken into a clinical program and the collaboration agreement expired according to its terms.

SCIENTIFIC AND INDUSTRY BACKGROUNDGENE THERAPY

Gene therapy is an approach to the treatment or prevention of certain diseases in which therapeutic genes are introduced into the body to cause the production
of specific proteins needed to bring about a therapeutic effect. For gene therapy to be effective, the therapeutic gene must be delivered to, and transported across, the outer membrane of a targeted
cell and into the nucleus where it can be expressed.

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The expressed protein may remain within the cell for an intracellular effect, be transported to the cell membrane to exert a cell-surface effect or be secreted into the bloodstream to have
a systemic effect. Most gene therapies utilize a delivery system, or vector, into which the therapeutic gene is incorporated to facilitate its delivery to, and uptake by, and expression in the target
cell.

Genes
provide the instructions or "code" for the productions of proteins, which determine the nature and function of cells and tissues in all living organisms. The study of genes and
their function ("genomics") provides the fundamental basis for understanding human health and disease and has led to the identification of many genes with potential therapeutic utility ("therapeutic
genes").

The
entire genetic content of an organism is known as its genome. In humans, the genome is believed to contain approximately 30,000 genes. These genes encode approximately 100,000
proteins. Proteins enable cells to carry out their normal biological functions. The process by which an organism utilizes genetic instructions and produces proteins is known as gene expression. The
expression of a defective gene, or the defective expression of a normal gene, is responsible for certain disease conditions. For example, the expression of a single defective gene is known to cause
cystic fibrosis and sickle cell anemia, and the defective expression of multiple genes is believed to be involved in the progression of diseases such as cancer, diabetes, and cardiovascular and
neurological diseases.

The
worldwide effort to decipher the human genome and to understand the function of its constituent genes is yielding important insights into the roles that genes play in disease
conditions, as well as how genes may be useful in the treatment of such diseases. It is estimated that about 40% of genes have a known function, many of which have been identified as potential
therapeutic genes. Various companies and academic institutions are investing substantial financial and human resources to identify additional therapeutic genes, and Valentis believes that this process
will create opportunities for gene therapies.

Gene Delivery Approaches

To date, a limiting factor in gene therapy has been the lack of safe, effective gene delivery systems. A number of gene delivery approaches are being
developed, each of which has exhibited certain limitations. These approaches may be categorized by their mode of administration asex vivo(outside the
body) orin vivo(inside the body), and by the nature of the gene delivery system (viral or plasmid-based (synthetic)).

The
first clinical trials of potential gene therapeutics usedex vivoviral gene delivery.Ex
vivogene therapies involve procedures in which selected cells are removed from the patient, transduced with the therapeutic gene, expanded in number, cleansed of contaminants
and then reintroduced into the same patient. This lengthy and labor-intensive process significantly differs from traditional pharmaceutical administration and may result in a complex,
high-cost procedure.

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Valentis is developing a broad technology platform consisting of severalin vivo, synthetic, plasmid-based, gene delivery systems. Each
delivery system consists primarily of two components: (i) a plasmid DNA (a circular segment of DNA that contains a therapeutic gene and components that regulate its expression in the cell) and
(ii) lipids, polymers and/or other non-viral agents to facilitate the delivery of the plasmid DNA into target cells by various modes of administration, including inhalation,
intravenous, intratumoral, intramuscular or intraperitoneal administration. These traditional modes of administration are familiar to physicians and may be more convenient and cost effective than ex vivoapproaches.

In
Valentis' cationic lipid gene delivery systems, we combine negatively charged DNA with novel, positively charged and neutral lipids to form tightly bound DNA:lipid complexes. These
complexes can be manufactured at a large scale to produce high-purity, stable products. Valentis' other gene delivery systems utilize polymers or peptides to form DNA:polymer or
DNA:peptide complexes that facilitate the delivery of DNA to cells.

Valentis
believes its proprietary plasmid-based gene delivery systems have advantages over other gene delivery systems. DNA formulated with our PINC (protective,
interactive, non-condensing) formulations have been shown to produce high and persistent protein levels. In addition, Valentis' gene delivery systems can preferentially accumulate in
specific tissues and cell types and can be handled and administered like traditional pharmaceuticals. We have demonstrated that we can produce clinical-grade plasmid DNA and plasmid-based DNA
formulations under controlled conditions, and we have developed manufacturing and production methods designed to be scaled to meet commercial requirements.

We
have tested our gene delivery systems in hundreds of animal experiments and in clinical trials. Our delivery systems allow for repeat administration of our
Genemedicine products for the treatment of chronic diseases, such as cardiovascular disease and cancer. While the results of preclinical animal studies may not predict safety or efficacy
in humans, when further clinical trials are conducted, Valentis believes that our experience in research and development will enable us to accelerate the development of Genemedicine
products and thereby attract corporate partners.

Valentis' In Vivo, Plasmid-Based Gene Delivery Approach

We believe our proprietary plasmid-based gene delivery systems may have the following benefits:



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Genemedicine Products and Technologies

Valentis is developing Genemedicine products and technologies based on three broad classes of delivery-enhancing materials: lipids, polymers and
peptides. Valentis has shown that gene delivery systems containing cationic lipids combined with neutral lipids enhance the cellular uptake of plasmid-based gene expression systems. These lipid-based
gene delivery systems have been demonstrated to enhance the entry of genes into tumor cells after intratumoral administration and also to deliver genes to the endothelium and epithelium of the lung
after intravenous administration and inhalation, respectively. Valentis or our collaborators are using our proprietary cationic lipid gene delivery systems in several of its Genemedicine
products intended for the treatment of cancer.

Valentis
also has developed Genemedicine products and technologies that employ polymers that have been approved for human use. We have shown that these polymers interact
with plasmids and facilitate the delivery of genes into muscle cells or tumor cells afterin vivoadministration. We are employing our proprietary
polymeric PINC gene delivery system in hematology Genemedicine products, in two Genemedicine products intended for the treatment of cancer and in two
Genemedicine products for the treatment of cardiovascular disorders. Valentis has demonstrated that the use of polymeric PINC gene delivery systems in muscle can lead to a
significant increase in both the level and the consistency of proteins produced compared to the administration of plasmids formulated in saline, or "naked" DNA.

We
are also creating and developing gene delivery systems made up of short synthetic peptides and peptides containing simple sugars or glycopeptides. The peptides are designed to bind
to plasmid DNA to form a tightly compacted complex, which we believe is important for DNA to enter certain types of cells. The glycopeptides are designed to interact specifically with natural
receptors present on the surfaces of target cells and to affect the entry of plasmid DNA into those cells. In addition, our peptides can be utilized in combination with other materials such as
cationic lipids. Valentis has exclusive and co-exclusive rights to materials in each of the foregoing classes of agents used for gene delivery systems.

We
have identified a number of potential therapeutic applications for our technologies and have developed several gene delivery systems that can use a variety of therapeutic genes. In
each case, the delivery and expression system developed for a specific product can be used in combination with other therapeutic genes to create multiple product opportunities for the same indication.

To
control the level and duration of selected genes in transgenic animals and cell cultures, Valentis researchers have developed the GeneSwitch gene regulation system
that can aid in the identification and characterization of a gene's function. The GeneSwitch technology may accelerate the throughput of genomics research because it has the unique
ability to control gene expression and assist in the identification and characterization of the function of selected genes.

PEGYLATED PRODUCTS AND TECHNOLOGIES

Valentis' OptiPEG PEGylation technology allows for the gentle coupling of polyethylene glycol (PEG) molecules directly to proteins
(protoMASC), antibodies (antiMASC), viruses (viraMASC) and liposomes (lipoMASC) in a manner that retains the biological activity of the material.
These PEG molecules can protect the biologic from degradation or attack by the immune system. This can yield products with improved safety, efficacy and dosing regimens.

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We have intellectual property rights relating to LipoMASC; a technology that PolyMASC, as part of the merger with Valentis in 1999, announced it would license or sell to
a single partner. Valentis now believes that we can realize greater value for the LipoMASC technology and exploitation of the PEG liposome intellectual property rights by pursuing a
licensing strategy on a product by product or on a field of use basis.

We
have corporate collaborations or technology out-licenses with Transkaryotic Therapies ("TKT"), and Viragen Inc. ("Viragen") to develop PEGylated versions of
proteins. We are developing PEGylated viruses through collaborations with Onyx Pharmaceuticals ("Onyx") and Oxford BioMedica ("Oxford"). The Viragen and Oxford collaborations are in the early stage of
feasibility. The TKT and Onyx collaborations are licensing agreements. See "Corporate Collaborations" below for additional details.

SCIENTIFIC AND INDUSTRY BACKGROUNDPEGYLATION

Some proteins have pharmacological profiles that could be improved with PEGylation. In order to achieve the levels required to exert a therapeutic effect at
the target site, relatively large doses of protein have to be administered. Rapid clearance by the kidney and liver creates the need for these large doses as well as the need for frequent dosing.
Intravenous bolus administration of the protein causes excessive initial blood levels of the therapeutic, which can create side effects. Subcutaneous administration, where feasible, is a better
alternative to intravenous administration. However, subcutaneous administration is associated with large losses of the protein (typically over 60%) at the injection site, resulting in low biologic
availability.

The
primary focus of Valentis' PEGylation research is the creation of improved biopharmaceuticals through the application of specialized PEGylation technologies. PEGylation is an
established technology that involves the attachment of the polymer polyethylene glycol to biological agents or chemical compounds to alter their pharmacokinetics (distribution in the body, metabolism
and excretion). The alteration of the pharmacokinetics of biologics due to PEGylation can lead to improved dosing intervals and may also have beneficial effects on safety and efficacy. PEGylation can
be applied to otherwise insoluble proteins or to hide a therapeutic agent from the immune system. With PEGylation, both recognition by existing antibodies and stimulation of immune responses
(immunogenicity) are potentially reduced.

Other
products approved by regulatory agencies have established validation for PEGylation as a delivery technology. Valentis' proprietary technologies are based on novel patented
Molecule Altering Structural Chemistry (MASC) techniques for attaching polymers such as PEG to other molecules or to carrier systems for pharmaceuticals. The MASC family of technologies is not
restricted to use with PEG. However, current applications are focused on PEG because it has an excellent safety record and is already approved for administration to humans. The attachment of PEG
chains has the potential to add considerable value to many pharmaceuticals, particularly proteins and peptides. As well as making them longer acting and less visible to the body's immune system,
PEGylation reduces wastage of the valuable active element of the therapy. PEGylation can also be used to link molecules together, an application for the assembly of new pharmaceutical agents.

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We have developed a number of proprietary applications for our technologies as follows:

| |  |   protoMASC |  | a process of masking protein or peptide pharmaceuticals to slow clearance from the body which gives excellent retention of biological activity;                            
| |  | ------------- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  |   viraMASC  |  | a process for coating viruses to increase efficacy in gene therapy and the treatment of cancer;                                                                            
| |  |   antiMASC  |  | a process for cloaking anti-tumor antibody fragments to delay clearance by the body, which provides improved tumor localization and penetration; and                       
| |  |   lipoMASC  |  | a process for coating liposomes, hollow lipid droplets, which leads to significantly improved tumor localization and has application in the delivery of anti-cancer agents.

Valentis'
technologies offer several advantages over conventional PEG techniques: (i) attachment of the PEG chain is done under mild conditions thereby retaining higher levels
of bioactivity of the target molecule; (ii) the PEG chain is attached to the target molecule without a linking coupler; and (iii) this technique utilizes a highly pure PEG, improving its
safety profile. Most PEGylation techniques require the use of a chemical linker to attach the PEG to the therapeutic agent. The linkers themselves can be damaging, but the process of attaching the
linkers to the therapeutic causes the most damage. Most PEG processes were developed for small molecules rather than for biological agents. Biological therapeutics are far less resilient than chemical
compounds and are often destroyed by harsh chemical processing of traditional PEGylation. Valentis' PEGylation differs from certain other methods in that it links PEG directly to the target and avoids
damaging coupling conditions. The direct linkage circumvents a range of problems introduced by linker groups. Our linkerless technique has what we believe to be an excellent record in the conservation
of bioactivity (and hence therapeutic activity) of delicate targets. Our technology confers advantages with respect to preserving biological function of the therapeutic, reducing toxicities, reducing
purification requirements and facilitating the manufacturing process. In addition, our technology can be applied more effectively to a broader range of therapeutic targets, thereby enabling novel
applications, such as linking different molecules to create novel compounds.

Valentis
is applying these PEG technologies to already approved therapeutics as well as novel therapeutics in development. They can also be applied to gene programs to mask viral
vectors. We have
established corporate agreements with Transkaryotic Therapies for the development of two undisclosed proteins, Onyx Pharmaceuticals for a PEGylated virus and Viragen for a PEGylated
IFN-á. Our technologies are covered by a family of patents and patent applications filed in all major jurisdictions. Currently, none of the products using our PEGylation
technologies have begun clinical trials.

Potential Advantages of PEGylation Technology



Traditional PEGylation Techniques

Traditional PEGylation techniques used different chemical linkers and chemical coupling methods to attach PEG to the target molecule. While PEGylation has been
successfully applied commercially, several features are not optimal. First, the use of linkers themselves often results in diminished biological activity

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of the target protein. Reductions in biological activity can range from 20-90% using traditional PEGylation techniques. Reduced biological activity is most problematic when
non-enzymatic proteins, such as cytokines and antibodies, are the target proteins. Enzymes typically require lower dosing because their activity is catalytic. Reduced activity is
attributable not only to the linkers themselves, but also to the coupling conditions required for the attachment of PEG to the target molecule, as well as changes induced in the therapeutics' surface
charge, which can obstruct binding. In addition to reduced biological activity, chemical linkers can be toxic. This is particularly true when the chemical linkers involve unstable bonds.

Specific Advantages of Our PEGylation Methods

Valentis has developed a platform that enables direct, linkerless attachment of the target therapeutic to PEG molecules. Our proprietary technology employs
tresyl chloride chemistry to produce tresyl monomethoxyPEG ("TMPEG"). We have developed a proprietary position on the use of TMPEG, as well as on methods for "biologically optimized" manufacturing of
TMPEG. Our patented technique is a form of Molecule Altering Structural Chemistry. While our efforts have been focused on PEG, the technology can be applied to other polymers and carrier systems. The
main advantage of our system is that it enables preserved biological activity.

The
primary advantage of the TMPEG method of PEGylation is that it conserves the biological activity of the target proteins. Enhanced biological activity is enabled by both the
linkerless PEG attachment as well as the mild coupling conditions. Optimization techniques have independently conferred improvements in retained biological activity. For example, we have demonstrated
99% retention of the biological activity of GM-CSF using our PEGylation technology, where PEGylated products made by others resulted in less than 35% of the biological activity. Our
technology has also demonstrated excellent preservation of the biologic activity of erythropoeitin, granulocyte colony stimulating factor and thrombopoeitin produced by three different commonly used
chemical coupling methods.

CORPORATE COLLABORATIONS

Valentis has corporate collaborative research and development agreements and is actively seeking additional collaborations with pharmaceutical and
biotechnology companies. In addition, we have a manufacturing collaboration, the pAlliance, with DSM Biologics and Qiagen N.V., based on our proprietary methods for the manufacture of
plasmid DNA and creating the first contract facility that can produce high-quality, ultrapure material for plasmid-based therapeutics on every scale, from preclinical toxicology studies to
commercial products. Many of Valentis' potential partners own identified therapeutic genes, but we believe many such companies do not possess the technology or the know-how to develop gene
therapeutics. In entering corporate collaborations, Valentis seeks license fees, funding for research and development, milestone payments and royalties on product sales in exchange for worldwide
commercial licenses to specific gene therapeutics and access to our development expertise.

Roche Holdings Ltd.

Pursuant to the merger with GeneMedicine in March 1999, Valentis acquired rights under a corporate collaboration agreement with Corange (the parent
company of Boehringer Mannheim, and now a subsidiary of Roche) originally signed in February 1995, providing funding for research and development of Genemedicine products to treat
head and neck tumors and melanoma (the "Roche Agreement").

In
August 1998, the Roche Agreement was amended and extended through February 2002. The amendment modified the field of the agreement to gene therapy using the
IL-2, IFN-a or IL-12 genes for the treatment of cancer, and required Valentis to conduct a Phase II clinical trial of the IL-2
Genemedicine product, and a Phase I / II clinical trial for each of the IFN-a and IL-12 Genemedicineproducts. As part of the
amendment, Valentis received the right to commercialize products developed under the agreement if Roche does not initiate Phase III clinical trials on products

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within twelve months after the completion of Phase II trials. Valentis also agreed to forego a $2 million equity purchase by Roche due on February 1, 1999 in return for a
$2 million payment to be made to Valentis by February 1, 2000 for reimbursement of development activities and an additional $2 million milestone upon enrollment of the first
patient in a Phase III clinical study. Subsequently, Valentis and Roche signed a further amendment, postponing the $2 million payment due on February 1, 2000 to February 1, 2001.
This $2 million fee was paid in fiscal 2001.

If
Valentis continues to meet the milestones for the development of Genemedicine products under the Roche Agreement, we may be entitled to milestone payments of up to
$8.3 million. Upon successful completion of Phase II clinical testing, Valentis may elect either to receive up to 50 percent of potential profits from worldwide product sales by agreeing
to share development and commercialization expenses or to receive royalty payments based on worldwide product sales, if any.

Also,
through the merger with GeneMedicine, Valentis acquired a worldwide exclusive license, with the right to sublicense, from Syntex (U.S.A.) Inc., now also a subsidiary of
Roche and renamed Roche Biosciences, for its cationic lipid gene delivery technology (DOTMA) forin vivogene therapy uses. The license rights under
this agreement continue even though the original agreement with Syntex ended.

pAlliance with DSM Biologics and Qiagen N.V.

In September 1998, Valentis and DSM Biologics (formerly Gist-Brocades/Bio-Intermediair) announced the formation of a broad,
strategic collaboration focused on the manufacture and supply of plasmid DNA and formulated DNA to the entire gene therapy industry. In May 1999, Qiagen N.V. joined the manufacturing alliance,
the pAlliance. The goal of this alliance is to provide the emerging gene therapy and genetic vaccination industry with early access to reliable, accepted plasmid DNA contract
manufacturing services.

Valentis
is contributing our process technologies and our expertise in DNA formulation and manufacturing to the pAlliance. DSM, as a leading supplier of contract
manufacturing services, brings manufacturing experience serving the needs of the pharmaceutical and biotechnology industry. Qiagen is contributing non-exclusive access to certain of its
technologies and its sales and marketing force.

The
agreement between the parties is intended to be the exclusive vehicle through which the parties will provide services in the area of contract current Good Manufacturing Practices
("cGMP") manufacturing of plasmid and formulated DNA for genetic vaccination and gene therapy purposes. Qiagen has begun marketing these contract-manufacturing services to the gene therapy and genetic
vaccination industry in lot sizes of up to the 3,000-liter fermentation scale.

This
manufacturing method has already been used to produce plasmid DNA for a Phase I / II trial for cystic fibrosis conducted by Glaxo, for a Phase I / II study for metastatic
melanoma conducted by Valentis and its academic collaborators at the University of Colorado Health Sciences Center and for the IL-2 cancer immunotherapy and Del-1 angiogenic
clinical studies that began during fiscal 2001.

Under
the agreement, Valentis has licensed our proprietary manufacturing technology for use in DSM facilities in Montreal, Canada and Groningen, The Netherlands for license and
milestone fees. To date, Valentis has earned $250,000 in milestone fees under the agreement. DSM, Qiagen and Valentis will share in the profits generated by the sale of material produced using
Valentis' process. In June 2001, the pAlliance announced that it had signed its first large commercial contract with the Wyeth-Lederle Vaccines business unit of American Home
Products Corporation. Revenue from this contract could be recognized beginning in fiscal 2002.

Oxford BioMedica

In December 2000, PolyMASC and Oxford BioMedica announced a collaborative agreement to develop a new version of MetXia®, Oxford BioMedica's
cancer drug, that will be designed to selectively

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target tumors following systemic administration of the product. The new version of MetXia® will be developed by adding PEG chains to the drug using PolyMASC's proprietary
viraMASC PEGylation technology.

Viragen, Inc.

In September 2000, PolyMASC and Viragen, Inc. signed an agreement to develop a new treatment for hepatitis C. The collaborators will utilize PolyMASC's
novel protoMASC process to PEGylate Viragen's lead drug,Omniferon, a natural alpha interferon currently in Phase II clinical
trials for hepatitis C. Hepatitis C is a serious and widespread liver disease estimated to afflict tens of millions of people worldwide. PolyMASC's PEGylation technology may improve the efficacy of Omniferonwhile reducing
the number of injections required for the treatment of hepatitis C patients. SinceOmniferonis a naturally occurring alpha interferon, it
is expected to have an improved side effect profile over recombinant products.

Bayer Corporation

In August 1999, PolyMASC and Bayer Corporation entered into an agreement whereby Bayer funded a feasibility study on the development of Factor VIII for
hemophilia A using our proprietary protoMASC technology. The study has completed and Bayer has decided not to enter into a broader agreement. The Bayer agreement expired according to its
terms.

TECHNOLOGY LICENSES

Valentis has technology out-license agreements and is actively seeking additional licensing agreements with pharmaceutical and biotechnology
companies.

Ark Therapeutics

In March 2000, Valentis and Ark Therapeutics initiated a Phase I clinical trial of a VEGF165 gene therapy incorporating Ark's local
collar-reservoir delivery device and one of Valentis' proprietary cationic lipid gene delivery systems. In August 2000 the companies announced a second collaboration to develop an endothelial
Nitric Oxide Synthase (eNOS) gene therapy for the prevention or treatment of restenosis following bypass graft surgery. The product will combine Valentis' proprietary gene formulation and expression
technologies and Ark's extravascular delivery collar to deliver and express the gene encoding the intracellular enzyme, eNOS. The collar-reservoir device enables the gene to be delivered locally via
the adventitial (outside) surface of the blood vessels. Under the collaboration, Valentis and Ark will share research and development costs and potential revenues.

Cardion AG

In November 1999, Valentis and Cardion (formerly Cardiogene Gentherapeutische Systeme AG) entered into an agreement under which Valentis licensed to
Cardion certain patent rights related to the use of the iNOS gene for the treatment or prevention of restenosis in exchange for upfront, milestone and royalty payments.

Epimmune

In December 2000, Epimmune licensed Valentis' proprietary PINC gene delivery technology for Epimmune's preventive and therapeutic DNA
vaccines in development against the human immunodeficiency virus (HIV) and the hepatitis C virus (HCV) in exchange for up front, milestone and royalty payments.

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Epimmune's genetic vaccines contain EpiGenes, DNA sequences from HIV or HCV, that code for protein fragments (epitopes) that stimulate cytotoxic and helper T cell
responses. These immune responses are important defenses against infection. Epimmune's preclinical data demonstrates that PINC formulations are very effective at delivering EpiGene
vaccines.

Heska Corporation

Under a November 1998 agreement, Valentis and Heska Corporation are cooperating in the development of immunotherapies for the treatment of cancer and
allergies in companion animals. Valentis granted Heska an option to license certain proprietary delivery and manufacturing technology, and Heska is evaluating Valentis' technology in delivering
immunomodulatory genes in companion animals. In October 2000, Heska exercised its option and licensed gene delivery and DNA manufacturing technology from Valentis. The technology will be used
by Heska to complete development of a novel gene therapy for the treatment of canine cancer.

Invitrogen Corporation

In November 1999, Valentis and Invitrogen Corporation announced the commercial launch of Valentis' proprietary GeneSwitch gene regulation
system to the life sciences research market. The GeneSwitch gene regulation system is a technology that enables precise control of gene expression using an inducer taken orally. The
introduction of the GeneSwitch marks the initial transfer of certain of Valentis'in vivogene therapy technologies for use as research
tools. Valentis recorded royalties from the license agreement with Invitrogen amounting to less than $3,000 for the period ended June 30, 2001.

Onyx Pharmaceuticals

In June 1997, Valentis' wholly owned subsidiary, PolyMASC, and Onyx Pharmaceuticals entered into a collaborative agreement to develop a PEGylated
version of Onyx's CI-1042 cancer therapeutic and, in April 1999, PolyMASC and Onyx signed a non-exclusive license for PEGylated versions of replicating adenoviruses.
Under the terms of the agreement, Onyx has the right to develop PEGylated replicating adenoviruses, and PolyMASC will supply the activated PEG species required to manufacture the PEGylated virus. The
goal is to assist CI-1042 in treating not only primary tumors but also sites of metastases.

Transkaryotic Therapies

In November 1997, PolyMASC and Transkaryotic Therapies ("TKT") signed a licensing agreement for the development of a PEGylated protein pharmaceutical
with an option, now exercised, to extend the license to a second protein pharmaceutical. Under the terms of the agreement, TKT will develop the PEGylated proteins. Upon TKT's completion of product
development, PolyMASC's sole remaining performance obligation is to supply the activated PEG species required to manufacture the PEGylated proteins, which TKT has yet to request. TKT paid
$1.0 million prior to the PolyMASC acquisition by Valentis in August 1999. PolyMASC can earn an additional $3.0 million upon completion of certain milestones.

Valentis' GeneSwitch Gene Regulation System

During fiscal 2001, Valentis negotiated two licenses of the GeneSwitch technology to pharmaceutical companies for their internal functional
genomics research efforts. A license with Wyeth-Ayerst Laboratories, the pharmaceutical division of American Home Products Corporation, was signed in February 2001 and a license with
GlaxoSmithKline was signed in April 2001. In July 2001, two additional GeneSwitch technology licenses were concluded with Lexicon Genetics and Pfizer. All licenses are

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non-exclusive licenses for research purposes only, and Valentis maintains all rights to clinical gene therapy applications of the GeneSwitch technology.

ACADEMIC LICENSES

Valentis actively monitors, investigates and licenses technologies under development at academic and other research institutions. We believe that such
institutions are an important source of breakthrough technologies, and we intend to enter into additional licensing arrangements to expand our core technologies.

Baylor College of Medicine

Valentis has three license agreements with Baylor College of Medicine pursuant to which Valentis has exclusive and non-exclusive rights to certain
current and future gene therapy technologies related to gene expression, gene delivery and gene regulation technology, including the GeneSwitch gene regulation system, as well as access
to certain additional technologies ("Baylor Licenses"). We are required to pay Baylor a royalty based on amounts received by Valentis for the commercialization of the patented technology. Baylor has
the ability to terminate the license for a material violation or material failure to perform any covenant under the license.

National Jewish Medical Research Center

In October 1997, Valentis obtained an exclusive license from the National Jewish Medical Research Center ("NJMRC") for patent rights related to the
non-viral delivery of a cytokine gene and a superantigen gene for the treatment of cancer (the "NJMRC License"). Under the terms of the NJMRC License, Valentis paid a license fee and is
obligated to make payments upon the completion of certain clinical milestones and royalty payments on sales of products, if any. We have certain obligations regarding the process and timing of
clinical activities and seeking FDA approval in the pursuit of development, manufacture and sale of products based on the claims contained in such patent applications. NJMRC may terminate the license
or convert it to a nonexclusive license if we fail to meet certain milestones. However, Valentis may extend the date by which such milestones must be completed up to three years upon payment of a
specified fee for each year a date is extended. In addition, NJMRC may also terminate the license for a material violation or material failure to perform any covenant under the license.

Regents of the University of California

Valentis has an exclusive license to certain patents and patent applications held by The Regents of the University of California related to in vivo, non-viral
delivery of genes using positively charged lipids, including delivery by various modes of administration and for use in
the treatment of cystic fibrosis ("The Regents License").

Under
the terms of The Regents License, we paid a license fee to The Regents and are obligated to make payments upon the achievement of certain clinical milestones and royalty
payments on sales of products, if any. We have certain diligence obligations regarding the process and timing of clinical activities and seeking FDA approval for the development, manufacture and sale
of products based on the claims contained in such patent applications. The Regents may terminate the license or convert it to a nonexclusive license upon 60 days notice if Valentis fails to
meet certain milestones. However, Valentis may extend the date by which such milestones must be completed up to three years upon payment of a specified fee for each year the date is extended. In
addition, The Regents may also terminate the license upon 60 days notice for a material violation or material failure to perform any covenant under the license.

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Stanford University

Valentis has obtained an exclusive license to patent rights from Stanford University relating to the use of genes that increase nitric oxide levels for the
treatment of certain cardiovascular diseases (the "Stanford License"). Under the terms of the Stanford License, Valentis has paid a license fee and will be obligated to pay milestone fees upon
completion of certain clinical milestones and royalty payments on sales of products, if any. Under the Stanford License, we have certain obligations regarding the process and timing of clinical
activities and seeking FDA approval in the pursuit of development, manufacture and sale of products based on the claims contained in such patent applications. Stanford has the ability to terminate the
license or convert it to a nonexclusive license if we fail to meet certain milestones. In addition, Stanford has the ability to terminate the license for a material violation or material failure to
perform any covenant under the license.

University of Pittsburgh Medical Center

In March of 1998, Valentis entered into a licensing and collaboration agreement with the University of Pittsburgh Medical Center ("UPMC") through which we
obtained an exclusive license to certain patent rights in the field of viral and plasmid-based gene therapy for rheumatology (the "UPMC License and Collaboration Agreement"). Under the terms of the
UPMC License and Collaboration Agreement Valentis issued 117,555 shares of common stock in exchange for the exclusive license to these patent rights. We are not obligated to pay additional royalty
payments upon the sale of products, if any, in the field of non-viral gene therapy, but are required to share revenue with UPMC at a specified rate upon sublicense of rights in the field
of viral gene therapy. Under the terms of the UPMC License and Collaboration Agreement, we are obligated to make payments upon the completion of certain milestones. Certain of the license rights may
revert back to UPMC in the event that Valentis fails to commit resources to the development of products in the field of rheumatology. In addition, the UPMC License and Collaboration Agreement
established collaborations between Valentis and several researchers at UPMC for the research and development of gene therapies in the field of rheumatology. Intellectual property developed by UPMC
under the collaboration will be included in the exclusive license to Valentis described above at no additional cost to us. The value of the common stock issued
in the transaction was $1.5 million, which was expensed to acquired in-process research and development in 1998 because the technology was not complete at the date of acquisition.

Vanderbilt University

Valentis has a worldwide license from Vanderbilt University to certain gene delivery technologies and improvements developed by Dr. Kenneth Brigham
("First Vanderbilt License"). The license pertains to rights under certain patents and patent applications covering cationic lipid-mediated gene delivery used for gene therapeutic products and gene
vaccines that are administered to patients systemically or by inhalation. The license is exclusive for systemic gene delivery and non-exclusive for gene delivery via inhalation. Under the
terms of the First Vanderbilt License, Valentis paid a license fee to Vanderbilt and is obligated to pay maintenance fees, to make payments upon the achievement of certain milestones and to make
royalty payments on sales of products, if any. Vanderbilt may terminate the license or convert it to a nonexclusive license if we fail to satisfy certain requirements for diligent development of
licensed products. In addition, Vanderbilt may terminate the license upon 60 days notice for a material violation or material failure to perform any covenant under the license.

Valentis
also has an exclusive license from Vanderbilt covering Vanderbilt's interest in the Del-1 gene and protein ("Second Vanderbilt License"). Valentis acquired the
Second Vanderbilt License by assignment from Progenitor, Inc. as part of the purchase in April 1999 of the Del-1 rights held by Progenitor. Under the terms of the Second
Vanderbilt License, Valentis is obligated to make payments upon the achievement of certain milestones, to share revenue received from sublicensing at a specified rate, and to make royalty payments on
sales of products, if any. Vanderbilt may terminate the license if we

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fail to satisfy certain requirements for diligent development of licensed products. In addition, Vanderbilt may terminate the license upon 60 days notice for a material violation or material
failure to perform any covenant under the license.

ACADEMIC COLLABORATIONS

National Jewish Medical Research Center

Valentis is collaborating with Dr. Steven Dow to develop anti-angiogenic gene therapy and cancer immunotherapeutics. Dr. Dow is
conducting studies in dogs with osteosarcoma and other diseases.

Stanford University

Valentis has established a consulting relationship with Dr. Thomas Quertermous, at Stanford University, in the field of angiogenesis.
Dr. Quertermous is the co-discoverer of the Del-1 gene, co-owned by Valentis, and will work with Valentis on the research of the Del-1 gene
therapy.

University of Colorado, Health Sciences

Valentis is collaborating with Dr. Pat Walsh on a physician-sponsored Phase I / II clinical study in melanoma patients using Valentis'
IL-2/Superantigen-B gene therapy.

University of Kuopio

Valentis is currently working with Dr. Seppo Ylä-Herttuala of the A.I. Virtanen Institute of the University of Kuopio,
Finland. Dr. Ylä-Herttuala is conducting two physician-sponsored Phase II trials (i) for treating restenosis related to peripheral vascular disease, and
(ii) for treating restenosis related to coronary artery disease. Valentis is providing its proprietary cationic lipid gene delivery system (DOTMA) for study with the Institute's plasmids
encoding a vascular endothelial growth factor (VEGF).

University of Maryland

Dr. Bert O'Malley Jr. completed the U.S. Phase I clinical trial using the IL-2 gene medicine for the treatment of head and neck cancer and
is collaborating on preclinical studies to evaluate combination therapies in terminal tumor models.

PATENTS AND PROPRIETARY TECHNOLOGIES

Patents and other proprietary rights are important to Valentis' business. Our policy is to file patent applications and protect inventions and improvements to
inventions that are commercially important to the development of our business. Valentis also relies on trade secrets, know-how, confidentiality agreements, continuing technology
innovations and licensing opportunities to protect its technology and develop and maintain its competitive position. To date, Valentis has filed or participated as a licensee in the filing of numerous
patent applications in the United States relating to our technology, as well as foreign counterparts of certain of these applications in many countries. Our failure to obtain patent
protection or otherwise protect our proprietary technology or proposed products may have a material adverse effect on Valentis' competitive position and business prospects. The patent application
process takes several years and entails considerable expense. There is no assurance that additional patents will issue from these applications or, if patents do issue that the claims allowed will be
sufficient to protect our technology.

Valentis
has numerous patents and patent applications worldwide covering its gene expression and delivery technology, and PEGylation technology as well as use patents for various
therapeutic applications, and patents and patent applications on its manufacturing technology. In addition to patents and patent applications filed and owned by Valentis, we have exclusive rights
under our licenses with Roche Biosciences, The Regents, Vanderbilt, NJMRC, Stanford, Baylor, and UPMC to patents and patent applications worldwide.

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Valentis has licensed from Roche Biosciences rights under certain U.S. and foreign patents claiming the use of DOTMA forin vivogene
delivery. We have licensed from Vanderbilt and The Regents exclusive rights to patents and patent applications covering the use of cationic lipids for gene delivery by systemic administration or by
inhalation. In a separate license with Vanderbilt, we have licensed rights to Vanderbilt's interest in the patents covering the Del-l gene and protein.

Valentis
has licensed from Baylor patent rights covering our GeneSwitch gene regulation technology, patent rights on the use of certain muscle-specific gene expression,
and patent rights covering gene delivery to the joint. We have licensed from UPMC a portfolio of patent rights in the field of gene therapy for rheumatology, including viral and plasmid-based gene
therapy. We have licensed from NJMRC patent rights related to the plasmid-based delivery of a cytokine gene and a superantigen gene for the treatment of cancer. We have licensed from Stanford patent
rights to the use of genes that increase nitric oxide levels for the treatment of certain cardiovascular diseases.

A
number of the biopharmaceuticals that Valentis and its corporate partners are investigating or may use in its products are or may become patented by others. As a result, Valentis or
its corporate partners may be required to obtain licenses to gene sequences, proteins, viruses or other technology to which it currently has no proprietary rights in order to use or market such
products. In addition, some of the products based on our delivery systems may require the use of multiple proprietary technologies. Consequently, Valentis or its corporate partners may be required to
make cumulative royalty payments to several third parties. Such cumulative royalties could reduce amounts paid to Valentis or be commercially prohibitive. In connection with our efforts to obtain
rights to gene sequences, proteins, viruses or other proprietary technology, Valentis may find it necessary to convey rights to its technology to others. There can be no assurance that Valentis or its
corporate partners will be able to obtain any required licenses on commercially reasonable terms or at all. If required licenses are not available to Valentis, we may not be able to develop or market
certain products.

The
patent positions of pharmaceutical and biotechnology firms are often uncertain and involve complex legal and factual questions. Further, the breadth of claims allowed in
biotechnology patents is unpredictable. Valentis cannot be certain that others have not filed patent applications for technology covered by our pending applications or that we were the first to invent
the technology that is the subject of such patent applications. Competitors may have filed applications for, or may have received, patents and may obtain additional patents and proprietary rights
relating to compounds, products or processes that block or compete with those of Valentis. Valentis is aware of patent applications filed and patents issued to third parties relating to genes, gene
delivery technologies and gene therapeutics, and there can be no assurance that any such patent applications or patents will not have a material adverse effect on products Valentis or its corporate
partners are developing or may seek to develop in the future. There can be no assurance that third parties will not assert patent or other intellectual property infringement claims against Valentis
with respect to its products or technology or other matters.

Patent
litigation is widespread in the biotechnology industry. Litigation may be necessary to defend against or assert claims of infringement, to enforce patents issued to Valentis,
to protect trade secrets or know-how owned or licensed by Valentis, or to determine the scope and validity of the proprietary rights of third parties. Although no third party has asserted
that Valentis is infringing such third party's patent rights or other intellectual property, there can be no assurance that litigation asserting such claims will not be initiated, that Valentis would
prevail in any such litigation, or that Valentis would be able to obtain any necessary licenses on reasonable terms, if at all. Any such claims against Valentis, with or without merit, as well as
claims initiated by Valentis against third parties, can be time-consuming and expensive to defend or prosecute and to resolve. If other companies prepare and file patent applications in
the United States that claim technology also claimed by Valentis, we may have to participate in interference proceedings to determine priority of invention, which could result in substantial cost to
Valentis even if the outcome is favorable to us.

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Valentis also relies on proprietary information and trade secrets, including its proprietary database of preclinicalin vivoexperiments, to develop and maintain its competitive position. There can be no assurance that third parties will not independently develop equivalent proprietary information or techniques, will not
gain access to Valentis' trade secrets or disclose such technology to the public, or that we can maintain and protect unpatented proprietary technology. Valentis typically requires its employees,
consultants, collaborators, advisors and corporate partners to execute confidentiality agreements upon commencement of employment or other relationships with Valentis. There can be no assurance,
however, that these agreements will provide meaningful protection or adequate remedies for Valentis technology in the event of unauthorized use or disclosure of such information, that the parties to
such agreements will not breach such agreements or that Valentis' trade secrets will not otherwise become known or be discovered independently by its competitors. For a description of our current
patent litigation, see "Item 3, Legal Proceedings," below.

MANUFACTURING AND COMMERCIALIZATION

Valentis' commercialization strategy is based on establishing corporate collaborations with pharmaceutical and biotechnology companies whereby we will
primarily pursue development up to Phase III clinical trials of gene therapeutics and PEGylated products, while our partners will be responsible for late stage clinical trials, sales, marketing, and
large-scale clinical and commercial manufacturing.

Valentis
intends that its large scale manufacturing of plasmid DNA will be conducted either through the pAlliance with DSM and Qiagen (as discussed in "Corporate
Collaborations" above) or with other contract manufacturing organizations as required. Through the pAlliance, we have demonstrated that we can manufacture plasmid DNA at commercial scales
using conventional and proprietary fermentation and purification processes. In addition, Valentis plans to augment contract manufacturing
organization (CMO) output with its own pilot manufacturing facility for the production of plasmid DNA at smaller scales. The facilitating agents of Valentis' gene delivery systems can be synthesized
using readily scalable, organic synthesis procedures. To date, we have obtained access to manufacturing of facilitating agents through arrangements with contract manufacturers. Preparation of the
final formulations has been carried out at our pilot manufacturing facility and at contract manufacturers.

Valenits'
intends that manufacturing of PEGylation products will be conducted with contract manufacturing organizations or at potential corporate partner facilities.

Valentis
itself does not currently operate manufacturing facilities for commercial production of its products. We have no experience in, and currently lack the resources and
capability needed for, the manufacture or marketing of any of our products on a commercial scale. Accordingly, Valentis will be dependent initially on corporate partners, licensees or other third
parties for commercial-scale manufacturing of our products. We are not aware of third parties that have demonstrated sustained large-scale commercial manufacturing of gene therapeutics. There can be
no assurance that our corporate partners will be able to develop adequate manufacturing capabilities for production of commercial-scale quantities of gene therapeutics or PEGylated products.

Under
the terms of the Roche Agreement, Roche has received exclusive rights to market and sell Valentis' gene therapeutics that are developed pursuant to this corporate collaboration.

GOVERNMENT REGULATION

The production and marketing of Valentis' products and our research and development activities are subject to extensive regulation for safety, efficacy and
quality by numerous governmental authorities in the United States and other countries. In the United States, pharmaceutical products are subject to rigorous regulation by the United States Food and
Drug Administration ("FDA"). We believe that the FDA and comparable foreign regulatory bodies will regulate the commercial uses of our products as biologics. Biologics are regulated under certain
provisions of the Public Health Service Act and the Federal Food,

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Drug, and Cosmetic Act. These laws and the related regulations govern, among other things, the testing, manufacturing, safety, efficacy, labeling, storage, record keeping, and the promotion, marketing
and distribution of biological products. At the FDA, the Center for Biologics Evaluation and Research is responsible for the regulation of biological products and has handled FDA's regulation of most
gene therapeutics to date. Gene therapy, however, is a relatively new technology, and it is uncertain whether any unique regulatory requirements may be imposed upon gene therapeutics. We are not aware
of any gene therapeutics that have received marketing approval from the FDA or any comparable foreign authorities.

The
necessary steps before a new biological product may be marketed in the United States include the following: (i) laboratory tests and animal studies; (ii) the
submission to the FDA of an IND for clinical testing, which must become effective before clinical trials commence; (iii) under certain circumstances, approval by a special advisory committee
convened to review clinical trial protocols involving gene therapeutics; (iv) adequate and well-controlled clinical trials to establish the safety and efficacy of the product;
(v) the submission to the FDA of a Biologics License Application ("BLA"), and (vi) FDA approval of the BLA prior to any commercial sale or shipment of the biologic.

Facilities
used for the manufacture of biologics are subject to periodic inspection by the FDA and other authorities where applicable, and must comply with FDA's Good Manufacturing
Practice ("GMP") regulations. Manufacturers of biologics also must comply with FDA's general biological product standards and also may be subject to state regulation. Failure to comply with GMP or
other applicable regulatory requirements may result in withdrawal of marketing approval, criminal prosecution, civil penalties, recall or seizure of products, warning letters, total or partial
suspension of production, suspension of clinical trials, FDA refusal to review pending marketing approval applications or supplements to approved applications, or injunctions, as well as other legal
or regulatory action against Valentis or its corporate partners.

Clinical
trials are conducted in three sequential phases, but the phases may overlap. In Phase I, the initial introduction of the product into human subjects or patients, the
drug is tested to assess safety, metabolism, pharmacokinetics and pharmacological actions associated with increasing doses. Phase II usually involves studies in a limited patient population to
(i) determine the efficacy of the potential product for specific, targeted indications, (ii) determine dosage tolerance and optimal dosage and (iii) further identify possible
adverse effects and safety risks. If a compound is found to be effective and to have an acceptable safety profile in Phase II evaluations, Phase III trials are undertaken to evaluate
further clinical efficacy and to test further for safety within a broader patient population at geographically dispersed clinical sites. There can be no assurance that Phase I, Phase II
or Phase III testing will be completed successfully within any specific time period, if at all, with respect to any of Valentis' or its corporate partners' products subject to such testing. In
addition, after marketing approval is granted, the FDA may require post-marketing clinical studies that typically entail extensive patient monitoring and may result in restricted marketing
of the product for an extended period of time.

The
results of product development, preclinical animal studies and human studies are submitted to the FDA as part of the BLA. The BLA must also contain extensive manufacturing
information and each manufacturing facility must be inspected and approved by FDA before the BLA will be approved. Similar regulatory approval requirements exit for the marketing of these products
outside the United States (e.g. Europe and Japan). The testing and approval process is likely to require substantial time, effort and financial and human resources, and there can be no assurance that
any approval will be granted on a timely basis, if at all, or that any product developed by Valentis and its corporate partners will prove safe and effective in clinical trials or will meet all the
applicable regulatory requirements necessary to receive marketing approval from the FDA or the comparable regulatory body of other countries. Data obtained from preclinical studies and clinical trials
are subject to interpretations that could delay, limit or prevent regulatory approval. The FDA may deny the BLA if applicable regulatory criteria are not satisfied, require additional testing or
information, or require post-marketing testing and surveillance to monitor the safety or efficacy of a product. Moreover, if regulatory approval of a biological product is granted, such
approval

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may entail limitations on the indicated uses for which it may be marketed. Finally, product approvals may be withdrawn if compliance with regulatory standards is not maintained or if problems occur
following initial marketing. Among the conditions for BLA approval is the requirement that the prospective manufacturer's quality control and manufacturing procedures conform to the appropriate GMP
regulations, which must be followed at all times. In complying with standards set forth in these regulations, manufacturers must continue to expend time, financial resources and effort in the area of
production and quality control to ensure full compliance.

For
clinical investigation and marketing outside the United States, Valentis and our corporate partners may be subject to FDA as well as regulatory requirements of other countries.
The FDA regulates the export of biological products, whether for clinical investigation or commercial sale. In Europe, the approval process for the commencement of clinical trials varies from country
to country. The regulatory approval process in other countries includes requirements similar to those associated with FDA approval set forth above. Approval by the FDA does not ensure approval by the
regulatory authorities of other countries.

Valentis'
research and development processes involve the controlled use of hazardous materials, chemicals and radioactive materials, and produce waste products. We are subject to
federal, state and local laws and regulations governing the use, manufacture, storage, handling and disposal of such materials and waste products. Although we believe that our safety procedures for
handling and disposing of such materials comply with the standards prescribed by such laws and regulations, the risk of accidental contamination or injury from these materials cannot be eliminated
completely. In the event of such an accident, Valentis could be held liable for any damages that result, and any such liability could exceed our resources. Although we believe that we are in
compliance in all material respects with applicable environmental laws and regulations, there can be no assurance that we will not be required to incur significant costs to comply with environmental
laws and regulations in the future, or that any of the operations, business or assets of Valentis will not be materially adversely affected by current or future environmental laws or regulations.

COMPETITION

Gene delivery, gene therapies and PEGylation are relatively new, rapidly evolving areas of science in which significant and unexpected technological advances
are likely. Rapid technological development could result in our products or technologies becoming obsolete before we recover a significant portion of its related research, development and capital
expenditures. We are aware that several pharmaceutical and biotechnology companies are actively engaged in research and development in areas related to gene therapy and PEGylation, or have commenced
clinical trials of gene therapeutics and PEGylation. Many of these companies are addressing diseases that have been targeted by Valentis or our corporate partners. Valentis also may experience
competition from companies that have acquired or may acquire gene technology or PEGylation technology from universities and other research institutions. As
competitors develop their technologies, they may develop proprietary positions in certain aspects of gene delivery, gene therapeutics or PEGylation that may materially and adversely affect us. In
addition, we face and will continue to face competition from other companies for corporate collaborations with pharmaceutical and biotechnology companies, for establishing relationships with academic
and research institutions, and for licenses to proprietary technology, including intellectual property related to gene delivery systems or PEGylation. Corporate partners may also elect to internally
develop gene therapeutics that compete with our products. Lastly, many other companies are developing non-gene therapies or non-PEGylation technologies to treat these same
diseases.

Many
of our competitors and potential competitors have substantially greater product development capabilities and financial, scientific, manufacturing, managerial and human resources
than Valentis. There can be no assurance that research and development by others will not render our gene delivery systems, our PEGylation products, or the products developed by corporate partners
using our gene delivery systems

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or PEGylation obsolete or non-competitive, or that any product we or our corporate partners develop will be preferred to any existing or newly developed technologies. In addition, there
can be no assurance that our competitors will not develop safer, more effective or less costly gene delivery systems, gene therapeutics, PEGylated products, non-gene therapies, or other
therapies, achieve superior patent protection or obtain regulatory approval or product commercialization earlier than Valentis, any of which could have a material adverse effect on our business,
financial condition or results of operations.

PRODUCT LIABILITY INSURANCE

The manufacture and sale of human therapeutic products involve an inherent risk of product liability claims and associated adverse publicity. Valentis
currently has only limited product liability insurance, and there can be no assurance that we will be able to maintain existing or obtain additional product liability insurance on acceptable terms or
with adequate coverage against potential liabilities. Such insurance is expensive, difficult to obtain and may not be available in the future on acceptable terms, or at all. An inability to obtain
sufficient insurance coverage on reasonable terms or to otherwise protect against potential product liability claims could prevent or inhibit the commercialization of products by Valentis. A product
liability claim brought against us in excess of our insurance coverage, if any, or a product withdrawal, could have a material adverse effect upon our business, financial condition and results of
operations.

EMPLOYEES

As of August 31, 2001, Valentis employed 115 individuals full-time, including 33 who hold doctoral degrees. Of our total work force, 84
employees are engaged in or directly support research and
development activities, and 31 are engaged in business development, finance and administrative activities. Valentis employees are not represented by a collective bargaining agreement. We believe our
relationships with our employees are good.

RISK FACTORS

Development Of Our Products Will Take Several More Years And Our Products Will Require Approval Before They Can Be Sold

Because substantially all of our potential products currently are in research, preclinical development or the early stages of clinical testing, revenues from
sales of any products will not occur for at least the next several years, if at all. We cannot be certain that any of our products will be safe and effective or that we will obtain regulatory
approvals. In addition, any products that we develop may not be economical to manufacture on a commercial scale. Even if we develop a product that becomes available for commercial sale, we cannot be
certain that consumers will accept the product.

If
we cannot satisfy existing clinical and regulatory approval requirements, we, or our partners, may not be able to market our products. We may not obtain regulatory approval for the
commercial sale of any of our products or be able to demonstrate that a potential product is safe and effective for its intended use. We cannot be certain that we, or our corporate partners, will be
permitted to undertake clinical testing of our potential products and, if we are successful in initiating clinical trials, we may experience delays in conducting them.

While
we have demonstrated some evidence that our gene delivery systems have utility in preclinical studies, these results do not mean that the resulting products will be safe and
effective in humans. Our gene delivery systems may have undesirable and unintended side effects or other characteristics that may prevent or limit their use.

Gene
therapies and enhanced delivery of pharmaceuticals based on biologics are new and rapidly evolving technologies that are expected to undergo significant technological changes in
the future. Many

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other companies are seeking to identify therapeutic genes and understand their function in the development and progression of various diseases. However, only limited clinical data are available
regarding the safety and efficacy of gene therapeutics. We are not aware of any gene therapeutic that
has received marketing approval from the United States Food and Drug Administration, or FDA, or foreign regulatory authorities. As a result, clinical trials relating to gene therapeutics may take
longer to complete than clinical trials involving more traditional pharmaceuticals.

We
do not yet have products in the commercial markets. All of our potential products are in preclinical development or in the early stages of clinical testing. We cannot apply for
regulatory approval of our potential products until we have performed additional research and development and testing. Our clinical trials may not demonstrate the safety and efficacy of our potential
products, and we may encounter unacceptable side effects or other problems in the clinical trials. Should this occur, we may have to delay or discontinue development of the potential product that
causes the problem. After a successful clinical trial, we cannot market products in the United States until we receive regulatory approval. If we are able to gain regulatory approval of our products
after successful clinical trials and then commercialize and sell those products, we may be unable to manufacture enough products to maintain our business or secure additional financing to fund our
operations.

We Have A History Of Losses And May Never Be Profitable

We may never generate profits, and if we do become profitable, we may be unable to sustain or increase profitability on a quarterly or annual basis. As a
result, the trading price of our stock could decline.

Since
our inception, we have engaged in research and development activities. We have generated only small amounts of revenue and have experienced significant operating losses since we
began business. As of June 30, 2001, we have an accumulated deficit totaling $159.1 million. The process of developing our products will require significant additional research and
development, and regulatory approvals. These activities, together with general and administrative expenses, are expected to result in operating losses for the foreseeable future.

We Must Be Able To Continue To Secure Additional Financing

Developing and commercializing our potential products will require substantial additional financial resources. Because we cannot expect internally generated
cash flow to fund development and commercialization of our products, we will look to outside sources for funding. These sources could involve one or more of the following types of transactions:



Our
future capital requirements will depend on many factors, including:



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We
have financed our operations primarily through the sale of equity securities and through corporate collaborations. We have not generated significant royalty revenues from product
sales, and we do not expect to receive significant revenue from royalties for the foreseeable future, if ever. We expect that our existing resources will enable us to maintain our operations through
at least the year ending December 31, 2002. However, we may require additional funding prior to such time.

We
cannot be certain that additional financing to meet our funding requirements will be available. Even if financing is available, the terms may not be attractive. If we cannot obtain
additional financing when needed or on acceptable terms, we will be unable to fund continuing operations. In addition, if we raise additional funds by issuing equity securities, our shareholders will
likely experience significant dilution of their ownership interest.

We Must Attract And Retain Corporate Partners

Our business strategy is to attract business partners to fund or conduct research and development, preclinical studies, clinical trials, manufacturing,
marketing and sales of our products. Valentis is highly dependent upon our corporate collaborations. There can be no assurance that milestone payments contemplated by any of our corporate
collaborations will be received, that the Roche Agreement will be extended, or that any of our corporate collaborations will result in successfully commercialized products, or that Valentis will
receive any related royalty revenues. Should we fail to receive research funds or should milestones set forth in any or all of the corporate collaborations not be achieved, or should the corporate
collaborations be breached or terminated, our business, financial condition and results of operations could be materially adversely affected.

While
we believe that our partners will be motivated to develop, market and distribute potential products based on our technologies, they may not commit sufficient resources to
commercializing our products on a timely basis. They may also pursue the development or marketing of competing products. If our business partners do not successfully market and distribute our products
and we are unable to develop sufficient marketing and distribution capabilities on our own, our business will fail.

Valentis
will also need to enter into additional corporate collaborations, and there can be no assurance that we will be able to do so on favorable terms, or at all. Should any
corporate partner fail to develop or commercialize successfully any product to which it has obtained rights from Valentis, our business, financial condition and results of operations may be materially
adversely affected.

We Must Attract And Retain Qualified Employees And Consultants

Our success will depend on our ability to retain our executive officers and scientific staff to develop our potential products and formulate our research and
development strategy. We have programs in place to
retain personnel, including programs to create a positive work environment and competitive compensation packages. Because competition for employees in our field is intense, however, we may be unable
to retain our existing personnel or attract additional qualified employees. Our success also depends on the continued availability of outside scientific collaborators to perform research and develop
processes to advance and augment our internal research efforts. Competition for collaborators is intense. If we do not attract and retain qualified personnel and scientific collaborators, and if we
experience turnover or difficulties recruiting new employees, our research and development programs could be delayed and we could experience difficulties in generating sufficient revenue to maintain
our business.

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There Is Intense Competition In The Biopharmaceuticals Market

The pharmaceutical and biotechnology industries are highly competitive. The intense competition and rapid technological change in our market may result in
pricing pressures and failure of our products to achieve market acceptance.

We
are aware of several pharmaceutical and biotechnology companies that are pursuing gene therapeutics or are incorporating PEGylated technologies into new pharmaceuticals. Many of
these companies are addressing diseases that have been targeted by our corporate partners and us. We are also aware that some of our corporate partners are developing gene therapy and PEGylated
therapeutics with one or more of our competitors. We also face competition from companies developing cell-based therapies and from companies using more traditional approaches to treating
human diseases. Some of our competitors have substantially more experience and financial and infrastructure resources than we do in the following areas:



As
competitors develop their technologies, they may develop proprietary positions in a particular aspect of biologics delivery that could prevent us from developing our products.
Consequently, our competitors may be able to commercialize new products more rapidly than we do, or manufacture and market competitive products more successfully than we do. This could result in
pricing pressures or the failure of our products to achieve market acceptance.

Gene
therapy and enhanced delivery of biologics are new and rapidly evolving fields and are expected to continue to undergo significant and rapid technological change. Rapid
technological development by our competitors could result in our actual and proposed technologies, products or processes losing market share or becoming obsolete.

In
addition, we face intense competition from other companies for corporate collaborations, for establishing relationships with academic and research institutions and for licenses to
proprietary technology. Our competitors may develop safer, more effective or less costly biologic delivery systems, gene therapeutics or chemical-based therapies. In addition, competitors may achieve
superior patent protection or obtain regulatory approval or product commercialization earlier than we can.

We Must Obtain Rights To Proprietary Genes, Proteins Or Other Technologies

Alone, and with our corporate partners, we are investigating the use of gene sequences and proteins in our products. A number of these gene sequences and
proteins have been, or may be, patented by others. As a result, we may be required to obtain licenses to those gene sequences, proteins or other technologies. In addition, some of the products based
on our gene or PEGylation delivery systems will require the use of multiple proprietary technologies. We may not be able to obtain a license to those technologies at reasonable terms, if at all. As a
consequence, we might be prohibited from developing potential products or we might have to make cumulative royalty payments to several companies. These cumulative royalties would reduce amounts paid
to us and could make the costs of our products too expensive to introduce.

We May Be Unable To Protect Our Patents And Proprietary Rights

We may be unable to adequately protect our proprietary rights, which may limit our ability to compete effectively. Our success will depend to a significant
degree on our ability to:



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We
own or have licenses to patents on a number of genes, processes, practices and techniques critical to our present and potential products. If we fail to obtain and maintain patent
protection for our technologies, our competitors may market competing products that threaten our market position. The failure of our licensors to obtain and maintain patent protection for technology
they license to us could similarly harm our business. Patent positions in the field of biotechnology are highly uncertain and involve complex legal, scientific and factual questions. Our patent
applications may not result in issued patents. Even if we secure a patent, the patent may not afford adequate protection against our competitors. Intellectual property claims and litigation could
subject us to significant liability for damages and invalidation of our patent rights.

We
also rely on unpatented trade secret technologies. Because these technologies do not benefit from the protection of patents, we may be unable to meaningfully protect these trade
secret technologies from unauthorized use or misappropriation by a third party.

As
the biotechnology industry expands, the risks increase that other companies may claim that our processes and potential products infringe on their patents. Defending these claims
would be costly and would likely divert management's attention and resources away from our operations. If we infringe on another company's patented processes or technology, we may have to pay damages
or obtain a license in order to continue manufacturing or marketing the affected product or using the affected process. We may be unable to obtain a license on acceptable terms.

Our Products Must Satisfy Government Regulations

We may not receive approval from regulatory authorities to market any of our products. Also, delays or unexpected costs in obtaining approval of our products
or complying with governmental regulatory requirements could decrease our ability to sell products, generate revenue and would make funding our operations more difficult.

Prior
to marketing any drug or biological product in the U.S., a potential product must undergo rigorous preclinical studies and clinical trials. In addition, the product must receive
regulatory approval from the FDA. Satisfaction of the FDA requirements typically takes several years or more and costs a substantial amount of money. We cannot be certain that we will obtain
regulatory approval even if we devote substantial resources and time. The regulatory process in the biologics delivery industry is costly,
time-consuming and subject to unpredictable delays. Accordingly, we cannot predict with any certainty how long it will take or how much it will cost to obtain regulatory approvals for
clinical trials or for manufacturing or marketing our potential products. Delays in bringing a potential product to market or unexpected costs in obtaining regulatory approvals could decrease our
ability to generate revenue and make it more difficult to obtain additional financing necessary to fund our operations.

In
addition, drug-manufacturing facilities in the U.S. must comply with the FDA's good manufacturing process regulations. Such facilities are subject to periodic
inspection by the FDA and state authorities. Manufacturers of biologics also must comply with the FDA's general biological product standards and also may be subject to state regulation. While we
anticipate that we will be able to manufacture product that meets these requirements, we may be unable to attain or maintain compliance with current or future Good Manufacturing Practices
requirements. If we discover previously unknown problems after we receive regulatory approval of a potential product or fail to comply with applicable regulatory requirements, the FDA may permanently
suspend or delay clinical trials and place restrictions on our ability to market the product or conduct clinical trials, including the mandatory withdrawal of the product from the clinical trials or
the market. This, or an unexpected increase in the cost of compliance, could decrease our ability to generate revenue or become profitable.

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In August, 2001, we discovered manufacturing issues at our contract manufacturer that may impact Del-1 and intravenous IL-2 clinical trials. When we discovered the issues, we
postponed enrollment in the clinical trials for both products until we could fully assess their impact. Also, we informed the FDA of the issues. On September 19, 2001, FDA placed a clinical
hold on our Del-1 clinical trial. We currently are in discussions with the FDA, and are determining the impact of the manufacturing issues on the clinical trials. Although we cannot assure you that
our timelines will not be materially affected, based on our internal analysis and discussions with FDA to date, we do not anticipate that the timelines for the Del-1 and intravenous IL-2 clinical
trials will be materially affected by these issues.

We Must Obtain Foreign Regulatory Approvals To Make And Sell Products In Foreign Countries

We cannot be certain that we will obtain regulatory approvals in other countries. In order to market our products outside the US, alone and with our corporate
partners, we must comply with numerous and varying regulatory requirements of other countries regarding safety and quality. The approval procedures vary among countries and can involve additional
testing. The time required obtaining approval in other countries might differ from that required obtaining FDA approval. The regulatory approval process in other countries involves similar risks to
those associated with obtaining FDA approval set forth above. Approval by the FDA does not ensure approval by the regulatory authorities of any other country.

Our Products Must Be Accepted By Physicians And Insurers

Concerns have arisen regarding the potential safety and efficacy of gene therapeutics using viral delivery systems. While our gene delivery systems do not
contain viruses, these concerns could negatively affect physicians' and health care payers' evaluations of our products. Physicians and health care payers could conclude that our products or
technologies are not safe and effective. Our success is dependent on commercial acceptance of our products. We believe that recommendations by physicians and health care payers will be essential for
commercial acceptance of our products. If products developed by us and our corporate partners are not commercially accepted by patients, physicians or third-party payers, sales would be adversely
affected.

Adverse Events In The Field Of Gene Therapy May Negatively Impact Regulatory Approval Or Public Perception Of Our Potential Products

The death of a patient undergoing a physician-sponsored viral-based gene therapy trial has been widely publicized. This death and other adverse events in the
field of gene therapy that may occur in the future could result in greater governmental regulation of our potential products and potential regulatory delays relating to the testing or approval of our
potential products. For example, as a result of this death, the Recombinant DNA Advisory Committee of the National Institutes of Health may become more active in reviewing the clinical trials or
proposed clinical trials of all companies involved in gene therapy. It is uncertain what effect this increased scrutiny will have on our product development efforts or clinical trials.

The
commercial success of our potential products will depend in part on public acceptance of the use of gene therapy for the prevention or treatment of human diseases. Public
attitudes may be influenced by claims that gene therapy is unsafe, and consequently our products may not gain the acceptance of the public or the medical community. Negative public reaction to gene
therapy in general could result in greater government regulation and stricter labeling requirements of gene therapy products, including any of our products, and could cause a decrease in the demand
for products we may develop.

Our Products Must Obtain Adequate Reimbursement

Even if we, and our corporate partners, succeed in bringing products to market, we cannot be certain that reimbursement will be available. Sales volume and
price of any of our potential products will depend, in part, on the availability of third-party reimbursement for the cost of such products and related

32

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treatments. Reimbursement is generally provided by government health administration authorities, private health insurers and other organizations. Third-party payers are increasingly challenging the
price of medical products and services. Significant uncertainty exists as to the reimbursement status of newly approved health care products. Even if reimbursement is available, payers' reimbursement
policies may adversely affect our corporate partners' ability to sell such products on a profitable basis. If these corporate partners are unable to profitably sell our products, our royalty revenue
will be reduced.

The Success Of Our Potential Products In Animal Models Does Not Guarantee That These Results Will Be Replicated In Humans

Even though our product candidates have shown successful results in animal models, animals are different than humans and these results may not be replicated in
our clinical trials with humans. In addition, human clinical results could be different from our expectations following our preclinical studies with large animals. Consequently, there is no assurance
that the results in our animal models are predictive of the results that we will see in our clinical trials with humans.

We Have Limited Experience In Conducting Clinical Trials, Which May Cause Delays In Receiving Regulatory Approval Of Our Potential Products

Clinical trials must meet FDA regulatory requirements. We have limited experience in conducting the preclinical studies and clinical trials necessary to obtain
FDA regulatory approval. Consequently, we may encounter problems in clinical trials that may cause us, or the FDA, to delay, suspend or terminate these trials. Problems we may encounter include the
chance that we may not be able to conduct clinical trials at preferred sites, obtain sufficient test subjects or begin or successfully complete clinical trials in a timely fashion, if at all.
Furthermore, the FDA may suspend clinical trials at any time if it believes the subjects participating in trials are being exposed to unacceptable health risks or if it finds deficiencies in the
clinical trial process or conduct of the investigation.

Failure
to recruit patients could delay or prevent clinical trials of our potential products, which could cause a delay or inability to introduce products to market and a resulting
decrease in our ability to generate revenue. The timing of our clinical trials depends on the speed at which we can recruit patients to participate in testing our products. Delays in recruiting or
enrolling patients to test our products could result in increased costs, delays in advancing our product development, delays in proving the usefulness of our technology or termination of the clinical
trials altogether. If we are unable to introduce potential products to market after successful clinical trials on a timely basis, our ability to generate revenue may decrease and we may be unable to
secure additional financing.

The Results Of Our Early Clinical Trials Are Based On A Small Number Of Patients Over A Short Period Of Time And Our Success May Not Be Indicative Of
Results In A Large Number Of Patients Or Long Term Efficacy

Results in early phases of clinical testing are based upon limited numbers of patients. Actual results with more data points may show less favorable results.
In addition, we do not yet know if these early results will have a lasting effect. If a larger population of patients does not experience similar results, or if these results do not have a lasting
effect, our product candidates may not receive approval from the FDA. In addition, any report of clinical trial results that are below the expectations of financial analysts or investors would most
likely cause our stock price to drop dramatically.

We Must Demonstrate Large-Scale Manufacturing Capabilities

Our limited manufacturing experience may compromise our ability to successfully introduce our potential products. Although we entered into the
pAlliance, a strategic collaboration with DSM Biologics and Qiagen N.V., for manufacturing and supplying plasmid DNA to the gene therapy industry, neither

33

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DSM nor any third party has successfully manufactured plasmid DNA on a sustained large-scale commercial basis. The collaboration has the potential to create the first manufacturing facilities that can
produce high-quality, ultra-pure material for plasmid-based therapeutics on every scale, from preclinical toxicology studies to commercial products. Either DSM or another
contract manufacturing organization will have full responsibility for manufacturing material to be marketed to any company or institution working in the field of gene therapy. We will depend on DSM
and/or our corporate partners for commercial-scale manufacturing of our products. DSM and/or our corporate partners may be unable to develop adequate manufacturing capabilities for commercial-scale
quantities of gene products. If DSM or third parties are unable to establish and maintain large-scale manufacturing capabilities, we will be unable to introduce sufficient product to sustain our
business.

Delaware Law And Our Charter Could Make The Acquisition Of Our Company By Another Company More Difficult

We are incorporated in the State of Delaware. Provisions of Delaware law applicable to our company could delay a merger, tender offer or proxy contest or make
such a transaction more difficult. State laws prohibit a Delaware corporation from engaging in any business combination with any interested stockholder for a period of three years from the date the
person became an interested stockholder unless a number of conditions are met. In addition, our Board of Directors may issue shares of
preferred stock without Valentis stockholder approval. The rights of our common stockholders may be limited by the rights of any future preferred stockholders. In addition, our charter provides for:



These
provisions could delay, defer or prevent a change in control of our company or limit the price that investors might be willing to pay in the future for shares of our common
stock.

Our Insurance May Not Be Adequate

The costs of product liability claims and product recalls could exceed the amount of our insurance, which could significantly harm our results of operations or
our reputation and result in a decline in the value of our stock.

Our
business activities expose us to the risk of liability claims or product recalls and any adverse publicity that might result from a liability claim against us. We currently have
only limited amounts of product liability insurance, and the amounts of claims against us may exceed our insurance coverage. Product liability insurance is expensive and may not continue to be
available on acceptable terms. A product liability claim not covered by insurance or in excess of our insurance or a product recall could significantly harm our financial results or our reputation.
Either of these could result in a decrease in our stock price.

There Are Risks Associated With Acquiring Other Companies

Part of our strategy is to grow through mergers and acquisitions of products, companies and businesses, and we intend in the future to pursue additional
acquisitions of complementary product lines, technologies and businesses. We may have to issue debt or equity securities to pay for future acquisitions, which could be dilutive to existing
stockholders. We have also incurred and may continue to incur certain

34

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liabilities or other expenses in connection with acquisitions, which have and could continue to materially adversely affect our business, financial condition and results of operations. In addition,
mergers and acquisitions involve numerous other risks, including:



For
these reasons, we cannot be certain what effect existing or future acquisitions may have on our business, financial condition and results of operations.

We Use Hazardous Materials

Our research and development activities involve the controlled use of hazardous materials. Although we believe that our safety procedures for handling and
disposing of these materials comply with applicable laws and regulations, we cannot eliminate the risk of accidental contamination or injury from hazardous materials. If a hazardous material accident
occurred, we would be liable for any resulting damages. This liability could exceed our financial resources. Additionally, hazardous materials are subject to regulatory oversight. Accidents unrelated
to our operations could cause federal, state or local regulatory agencies to restrict our access to hazardous materials needed in our research and development efforts. If our access to these materials
is limited, we could experience delays in our research and development programs. Paying damages or experiencing delays caused by restricted access could reduce our ability to generate revenues and
make it more difficult to fund our operations.

The Stock Market Is Volatile And Our Stock Price Could Decline

Market fluctuations or volatility could cause the market price of our common stock to decline. In recent years the stock market in general and the market for
biotechnology-related companies in particular have experienced extreme price and volume fluctuations, often unrelated to the operating performances of the affected companies. Our common stock has
experienced, and is likely to continue to experience, these fluctuations in price, regardless of our performance. These fluctuations could cause the market price of our common stock to decline.

Conversion of Series A Preferred Shares and the Exercise of the Related Warrants Could Affect the Market Price of our Common Stock

On December 5, 2000, we issued 31,500 shares of our Series A convertible redeemable preferred stock, $1,000 stated value per share, and common
stock warrants to purchase an aggregate of 1,266,828 shares of our common stock with a current exercise price of $10.25 per share, subject to adjustment. The Series A preferred stock is
entitled to cumulative dividends that accrue at an annual rate of 5%, payable quarterly. Each share of Series A preferred stock, plus accrued and unpaid dividends, is convertible into shares of
the Company's common stock at a fixed conversion price of $9.00 per share, subject to adjustment. For additional information regarding the Series A preferred stock and the common stock
warrants, see "Summary of Our BusinessRecent DevelopmentsPrivate Placement of Series A Preferred Stock and Warrants."

To
the extent shares of Series A preferred stock are converted, the warrants are exercised and the dividends on the Series A preferred stock are paid in shares of common
stock rather than cash, a significant number of shares of common stock may be sold into the market, which could decrease the price of our common stock and may result in substantial dilution to the
interests of other holders of our common stock.

35

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The Sale and Issuance of the Series A Preferred Stock Will Have an Impact to Earnings Available to Common Stockholders

Of the proceeds from our sale of Series A convertible redeemable preferred stock, approximately $7.1 million will be allocated to the common
stock warrants and the conversion feature included with the subscription agreement, and will be reflected as an increase to additional paid-in capital and a decrease to the Series A
convertible redeemable preferred stock. This $7.1 million will be accreted to preferred stock over the term of the initial 3.5 years redemption period. This accretion, along with the
preferred stock dividend, will increase the net loss (reduce the net income) available to common stockholders.

ITEM 2. PROPERTIES

Valentis leases approximately 52,800 square feet in Burlingame, California ("The Burlingame Facility"), a 38,000 square-foot building in The
Woodlands, Texas (the Woodlands Facility"), and 5,020 square feet of lab and office space in London, England (the "PolyMASC Facility"), all of which are occupied as of June 30, 2001. The
facilities have been built to Valentis' specifications to accommodate our laboratory, support and administrative needs and include manufacturing facilities designed to supply material required for
preclinical research and development and initial clinical trials.

The
term of the lease for 42,200 square feet in use at the Burlingame facility expires in 2004, at which time we have the option to renew the lease for an additional period of five
years. An additional 10,600 square feet of the Burlingame Facility has been built-out for use as a pilot manufacturing facility. The term of the lease for this portion of the facility
expires in 2007, at which time we have the option to renew the lease for an additional period of five years.

The
initial term of the lease for the Woodlands Facility, which began in January 1995, is 10 years, after which time Valentis may renew the lease for an additional
period of five years. We also have an option to expand this facility by up to an additional 62,000 square feet during the first six years of the initial term of the lease.

PolyMASC
leases three properties totaling approximately 5,020 square feet in London, England. The initial terms of the leases for these facilities, which began between 1995 and 1998,
are from three to five years. In April 2001, Valentis announced that it would close its London facility and consolidate all of its PEGylation research activities into its preclinical research
and development center in The Woodlands, Texas. The Company's landlord in London has indicated that we will be able to withdraw from the remaining term of our lease without penalty or ongoing
obligation. Valentis believes that its facilities are adequate to meet its needs for the foreseeable future. Should we need additional space, management believes it will be able to secure such space
on reasonable terms.

ITEM 3. LEGAL PROCEEDINGS

On April 6, 2001, Valentis' wholly-owned subsidiary, PolyMASC Pharmaceuticals, filed a lawsuit against Alza Corporation (subsequently acquired by
Johnson & Johnson Inc.) for patent infringement based on Alza's manufacture and sale of its liposomal products, Doxil® and Caelyx®. The lawsuit was filed in the
U.S. District Court in Delaware and alleges infringement of U.S. Patent Number 6,132,763, titled "Liposomes." The patent, issued October 17, 2000, is directed towards PEGylated liposomes
(liposomes having PEG chains attached). Doxil® and Caelyx® are PEGylated liposomes encapsulating the drug doxorubicin. Doxil® is approved in the U.S. for the
treatment of refractory ovarian cancer and AIDS-related Kaposi's sarcoma; Caelyx® is marketed in Europe and Canada for the treatment of advanced ovarian cancer and
AIDS-related Kaposi's sarcoma and in Canada for breast cancer.
PolyMASC is seeking monetary damages and enhanced damages should the court find that Alza's infringement was willful.

ITEM 4. SUBMISSION OF MATERS TO A VOTE OF SECURITY HOLDERS

None.

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PART II

ITEM 5. MARKET FOR REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS

The Company's common stock began trading on the Nasdaq National Market as Megabios Corp. under the symbol "MBIO" on September 15, 1997. Prior to that
date, there was no public market for our common stock. In April 1999 Megabios was renamed Valentis and its stock-trading symbol was changed to "VLTS." The following table sets forth, for the
calendar periods indicated, the high and low sales prices of the common stock reported by Nasdaq.

High

Low1999First Quarter

$
6.75

$
4.06Second Quarter


5.56


3.38Third Quarter


7.00


3.66Fourth Quarter


10.00


3.382000First Quarter


20.13


8.56Second Quarter


12.31


6.25Third Quarter


11.50


7.00Fourth Quarter


10.94


5.002001First Quarter


8.69


4.44Second Quarter


7.08


3.63Third Quarter (through September 24, 2001)


4.05


3.20


On
September 24, 2001 the last sale price reported on the Nasdaq National Market for Valentis' common stock was $4.05 per share. At that date, there were approximately 599
stockholders of record of our common stock.

Valentis
sold no unregistered securities during the last quarter of the period covered by this report, but did issue 66,993 shares of its common stock to holders of Series A
Redeemable Preferred Stock as a
stock dividend for the period from March 16, 2001 to June 15, 2001. The issuance of these dividend shares was not registered under the Securities Act of 1933 because their issuance did
not constitute a sale under the Securities Act of 1933.

Valentis
has never paid any cash dividends on its capital stock and does not expect to pay any dividends in the foreseeable future.

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ITEM 6. SELECTED FINANCIAL DATA

The data set forth below should be read in conjunction with "Management's Discussion and Analysis of Financial Condition and Results of Operations" and the
Consolidated Financial Statements and related Notes included elsewhere in this report.

|                                                                       |                                                               | Year Ended June 30,      |        
|---------------------------------------------------------------------- | ------------------------------------------------------------- | ------------------------ | -------
|
|
|Consolidated Statements of Operations Data:                            |                                                               |                          |        
|Collaborative research and development revenue                         |                                                               | $                        | 4,297  
|Research and development grant revenue                                 |                                                               |                          | 349    
|                                                                       |                                                               |                          |        
|                                                                       | Total revenue                                                 |                          |        
|Operating expenses:                                                    |                                                               |                          |        
|                                                                       | Research and development                                      |                          |        
|                                                                       | General and administrative                                    |                          |        
|                                                                       | Acquired in-process research and development                  |                          |        
|                                                                       | Amortization of goodwill and other acquired intangible assets |                          |        
|                                                                       |                                                               |                          |        
|                                                                       |                                                               | Total operating expenses |        
|                                                                       |                                                               |                          |        
|Loss from operations                                                   |                                                               |                          | (39,495
|Interest and other income (expense), net                               |                                                               |                          | 1,296  
|                                                                       |                                                               |                          |        
|Net loss                                                               |                                                               | $                        | (38,199
|Deemed dividend                                                        |                                                               |                          | (1,479 
|Dividends on convertible preferred stock                               |                                                               |                          | (898   
|                                                                       |                                                               |                          |        
|Net loss applicable to common stockholders                             |                                                               | $                        | (40,576
|                                                                       |                                                               |                          |        
|Basic and diluted net loss per share applicable to common stockholders |                                                               | $                        | (1.37  
|                                                                       |                                                               |                          |        
|Shares used in computing basic and diluted net loss per common share   |                                                               |                          | 29,515 
|                                                                       |                                                               |                          |        

---

|                                                  |  | June 30, |         
|------------------------------------------------- |  | -------- | --------
|
|
|Consolidated Balance Sheet Data:                  |  |          |         
|Cash, cash equivalents and short-term investments |  | $        | 35,833  
|Working capital                                   |  |          | 25,191  
|Total assets                                      |  |          | 50,249  
|Long-term debt                                    |  |          | 138     
|Convertible redeemable preferred stock            |  |          | 23,895  
|Accumulated deficit                               |  |          | (159,120
|Total stockholders' equity                        |  |          | 14,512  

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ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The discussion in "Management's Discussion and Analysis of Financial Condition and Results of Operations" contains trend analysis and
other forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. These
forward-looking statements include, without limitation, statements containing the words "believes," "anticipates," "expects," and other words of similar import or the negative of those terms or
expressions. Such forward-looking statements will have known and unknown risks, uncertainties and other factors that may cause the actual results, performance or achievements of the Company, or
industry results, to be materially different from any future, result, performance or achievements expressed or implied by such forward-looking statements. Actual results could differ materially from
those set forth in such forward-looking statements as a result of the "Rick Factors" and other risks detailed in the Company's reports filed with the Securities and Exchange
Commission.

COMPANY OVERIEW

Valentis is a biopharmaceutical company applying proprietary synthetic gene delivery, gene regulation, and PEGylation technologies to create novel therapeutic
products based on genomic discoveries in the fields of cardiovascular disease, oncology, hematology, and infectious diseases. Enabled by our expertise in preclinical research and development, clinical
development, and manufacturing, Valentis has created a broad product portfolio of cutting edge biopharmaceuticals.

The
merger of Megabios Corp. and GeneMedicine, Inc. ("GeneMedicine") in March 1999 formed Valentis Inc., a Delaware corporation. In August 1999, Valentis
acquired U.K.-based PolyMASC Pharmaceuticals plc. Valentis has centers in three locations: Burlingame, California, which is the Company's headquarters, as well as the center for clinical development,
The Woodlands, Texas, which houses personnel focused on research; and London, England, which focuses on research of PEGylation technologies. Valentis is in the process of closing the London facility
and transferring research and development of the PEGylation technologies to its facility in Texas.

Genemedicine Products

Valentis' Genemedicine products provide novel ways to achieve production of therapeutic proteins in their most natural and active form at specific
sites within the body. Upon delivery, genes formulated with synthetic delivery systems enter targeted cells and produce the therapeutic proteins. The fidelity, specificity, and duration of expression
within the target cells are controlled by Valentis proprietary gene regulation systems.



39

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PEGylation Systems (Polymer-based biopharmaceutical delivery)

Valentis' OptiPEG family of technologies is based on polymer modification using polyethylene glycol ("PEG"), a compound with a long and safe
clinical history. We have developed breakthrough methods to directly couple our proprietary PEG ("OptiPEG") to proteins, peptides, antibody and antibody fragments, viruses and liposomes,
to retain maximum biological activity of the material, and to protect the biopharmaceutical from inactivation by the immune system. OptiPEG technologies listed below provide the potential
to deliver products with improved safety, efficacy, and dosing regimens.

| |  |   protoMASC |  | masks protein or peptide pharmaceuticals to slow clearance from the body with excellent retention of biological activity.
| |  | ------------- |  | -------------------------------------------------------------------------------------------------------------------------
| |  |   antiMASC  |  | cloaks antibody fragments to delay clearance by the body, which provides improved tumor localization and penetration.    
| |  |   viraMASC  |  | coats viruses to allow for improved tumor localization and to enable re-dosing.                                          
| |  |   lipoMASC  |  | is a process for coating liposomes, which has application in the delivery of anti-cancer and anti-inflammatory agents.   

Current Good Manufacturing Practices manufacturing ("cGMP")

Valentis has developed proprietary scalable processes for the manufacture of plasmid DNA and Genemedicine biopharmaceuticals. Through our
pAlliance with DSM Biologics and QIAGEN N.V., we are able to produce material from lab to commercial scale using the same process. Valentis also has established manufacturing alliances
for our proprietary, biologically optimized PEG (OptiPEG).

Corporate Partners

Valentis itself, or through its PolyMASC subsidiary, currently has corporate collaborations with:



40

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Technology Licenses

Valentis itself, or through its PolyMASC subsidiary, currently has technology out-licenses with:



Valentis
has also licensed its proprietary GeneSwitch gene regulation technology on a non-exclusive basis to Wyeth-Ayerst Laboratories, the pharmaceutical
division of American Home Products, GlaxoSmithKline, Lexicon Genetics and Pfizer, Inc. for functional genomics research.

On
March 18, 1999, Megabios Corp. completed its merger with GeneMedicine and on April 29, 1999, the combined company was renamed Valentis, Inc. Each outstanding
share of GeneMedicine common stock was converted into 0.571 of a share of the common stock of Valentis. The merger resulted in the issuance of approximately 9.1 million shares of Valentis'
common stock, valued at $38.7 million. The purchase price also included approximately $850,000 related to outstanding GeneMedicine stock options and outstanding warrants assumed by the Company
and $1.7 million of transaction costs, for an aggregate purchase price of $41.3 million.

The
merger transaction was accounted for as a purchase. A charge of $25.9 million for in-process research and development acquired from GeneMedicine was included in
Valentis' Consolidated Statements of Operations (see detailed discussion of "Acquisition of GeneMedicine Research and Development Programs" below). The intangible assets acquired were assigned a value
of $9.8 million and are being amortized over their estimated useful lives of 3 years.

On
August 27, 1999, Valentis acquired PolyMASC Pharmaceuticals plc. Under the terms of the acquisition agreement, each outstanding ordinary share of PolyMASC was exchanged, at
a fixed exchange ratio of 0.209, for newly issued shares of common stock of Valentis. This resulted in the issuance of approximately 4.4 million Valentis shares valued at about
$20.1 million. The purchase price also included approximately $837,000 of transaction costs, for an aggregate purchase price of $20.9 million. PolyMASC has been managed as a wholly owned
subsidiary of Valentis.

PEGylation
research and development programs are in various stages of preclinical development. Currently, none of the products utilizing PolyMASC's proprietary OptiPEG
technology has as yet entered any stage of human clinical testing or has been approved for marketing. Our strategy has been to develop and commercialize PEG products through alliances with
pharmaceutical and biotechnology companies.

The
acquisition of PolyMASC was accounted for as a purchase. A charge of $14.3 million for in-process research and development acquired from PolyMASC was included
in Valentis' Consolidated Statements of Operations (see detailed discussion under "Acquisition of PolyMASC Research and Development Programs" below). The intangible assets, consisting of assembled
workforce and goodwill, were assigned a value of $7.1 million and are being amortized over their estimated useful lives of three years.

41

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With the acquisition of London-based PolyMASC, Valentis expanded its delivery technologies and has a more diversified portfolio of products in preclinical development. The acquisition
broadened Valentis' intellectual property portfolio in biologics delivery, creating what it believes is the first company offering a broad array of technologies and intellectual property in biologics
delivery. PEGylation is an established technology that involves the attachment of the PEG to therapeutics to alter their pharmacokinetics (distribution in the body, metabolism and excretion). The
alteration of the pharmacokinetics of biologics due to PEGylation may lead to improved dosing intervals and may also have beneficial effects on safety and efficacy.

To
date, substantially all revenue has been generated by collaborative research and development agreements from corporate partners, and no revenue has been generated from product
sales. Under the terms of our corporate collaborations, Valentis generally receives research and development funding on a quarterly basis in advance of associated research and development costs. We
expect that future revenue will be derived in the short-term from research and development agreements and milestone payments and in the long-term from royalties on product
sales.

We
have incurred significant losses since inception and expect to incur substantial losses for the foreseeable future, primarily due to the expansion of our research and development
programs and because we do not expect to generate revenue from the sale of products in the foreseeable future, if at all. We expect that operating results will fluctuate from quarter to quarter and
that such fluctuations may be substantial. As of June 30, 2001, Valentis' accumulated deficit was approximately $159.1 million.

Results of Operations

Fiscal Years Ended June 30, 2001, 2000 and 1999

Revenue

Valentis' revenue was approximately $4.6 million for the year ended June 30, 2001 compared to $5.6 million and $4.1 million in 2000
and 1999, respectively.

The
2001, 2000 and 1999 revenue contributions attributable to milestone achievements and collaborative research and development performed under our corporate collaborations, and grant
revenues are (in thousands):

|                                                |                      | Year ended June 30,
|----------------------------------------------- | -------------------- | -------------------
|
|Collaborative research and development revenue: |                      |                    
|                                                | Roche Holdings, Ltd. |                    
|                                                | Boehringer Ingelheim |                    
|                                                | Eli Lilly            |                    
|                                                | DSM Biologics        |                    
|                                                | Other                |                    
|                                                |                      |                    
|                                                |                      |                    
|Grant Revenue                                   |                      |                    
|                                                |                      |                    
|Total Revenue                                   |                      | $                  
|                                                |                      |                    

Changes
in revenue for the fiscal years ended June 30, 2001 and 2000 compared to the previous year are explained below:



42

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Revenue
derived from corporate collaborations and grants may increase in the future if we are successful in establishing new collaborations, and are awarded additional SBIR grants.

Included
in deferred revenue at June 30, 2001, is $3.3 million related to Roche that will be fully recognized in fiscal year 2002. This deferred revenue will be earned
either upon the achievement of certain milestones or under certain circumstances, through the performance of additional contract research.

If
Valentis continues to meet the milestones for the development of Genemedicine products under the Roche Agreement, we may be entitled to milestone payments of up to
$8.3 million. Upon successful completion of Phase II clinical testing, Valentis may elect either to receive up to 50 percent of potential profits from worldwide product sales by agreeing
to share development and commercialization expenses or to receive royalty payments based on worldwide product sales, if any.

Expenses

Research and development expenses increased to $30.2 million for the year ended June 30, 2001 from $27.3 million in 2000 and
$17.8 million in 1999. The increase for the period ending June 30, 2001 as compared to 2000 was primarily attributable to higher expenses for two new clinical trials that commenced
during the period. The increase for the period ended June 30, 2000 as compared to 1999 was attributable to the addition of staff, facilities and projects resulting from the mergers of
GeneMedicine in March 1999 and PolyMASC in August 2000. Valentis expects research and development expenses to continue to increase as additional product candidates progress into and
through clinical trials.

General
and administrative expenses increased to $8.2 million for the year ended June 30, 2001 from $7.3 million in 2000 and $5.1 million in 1999. The
increase for the period ended June 30, 2001 as compared to 2000 was primarily due to the additions of staff and facilities to support our increased research and development efforts. The
increase for the period ended June 30, 2000 as compared to 1999 was attributable to the addition of staff and facilities resulting from the mergers of GeneMedicine in March 1999 and
PolyMASC in August 2000. We expect general and administrative expenses to continue to

43

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increase due to increased business development activities and to support expanded research and development activities.

In
2000, Valentis recorded $14.3 million of acquired in-process research and development as part of the acquisition of PolyMASC. In 1999, $26.8 million of
acquired in-process research and development was recorded as part of the merger with GeneMedicine and the acquisition of rights to the Del-1 gene. Details of the mergers and
acquisitions are described below.

Valentis
recorded $5.7 million, $5.0 million and $819,000 for amortization of goodwill and other intangible assets in fiscal years 2001, 2000 and 1999, respectively,
which is associated with the acquisitions of GeneMedicine in fiscal 1999 and PolyMASC in fiscal 2000. Details of the mergers and acquisitions are described below.

Interest and Other Income (Expense), Net

Interest and other income (expense), net was $1.3 million in 2001, $773,000 in 2000 and $1.6 million in 1999. The increase in interest and other
income (expense), net in 2001 compared to 2000 resulted primarily from increased interest income derived from higher investment balances. The decrease in interest and other income (expense), net in
2000 compared to 1999 resulted primarily from a reduction
in the interest income derived from lower investment balances and by an increase in property, use and state taxes.

Deemed Dividends Related to Series A Redeemable Convertible Preferred Stock

The deemed dividends related to Series A redeemable convertible preferred stock (see note 12) include the accretion of Class A and B
warrants, the accretion of beneficial conversion feature and the accretion of related issuance costs. Below are the accretion values for Class A and B warrants and issuance costs.

The
accretion of Class A and B warrants for the year ended June 30, 2001 was approximately $984,000. The accretion of the beneficial conversion feature for the year
ended June 30, 2001 was approximately $179,000. The aggregate accretion value associated with the warrants and beneficial conversion feature were included in the calculation of net loss
applicable to common stockholders.

The
accretion of issuance costs of approximately $1.9 million were accounted for as a discount on the redeemable preferred stock and are accreted over the 3.5-year
redemption period. Accretion of approximately $316,000 for the year ended June 30, 2001 was included in the calculation of net loss applicable to common stockholders.

Dividends on Series A Redeemable Convertible Preferred Stock

Dividends on Series A redeemable convertible preferred stock (see note 12) are calculated at the rate of 5% per annum and were approximately
$898,000 for the year ended June 30, 2001. These dividends were charged against additional-paid-in-capital and included in the calculation of net loss
applicable to common stockholders.

Acquisition of PolyMASC Research and Development Programs

PEGylation is the primary research and development technology that Valentis acquired from PolyMASC in August 1999. Valentis' management is responsible
for estimating the fair value of the purchased in-process research and development. The program has been valued based on a discounted probable future cash flow analysis using a discount
rate of 40%, which management believes adequately reflects the substantial risk of biologics delivery research and development. In the valuation model, it was assumed that for product candidates based
on PolyMASC's technology, preclinical studies and clinical trials are successfully completed, regulatory approval to market the product candidates is obtained, a marketing partner is secured and we
are able to manufacture the product in commercial quantities. Each

44

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of these activities is subject to significant risks and uncertainties and no product utilizing the technology has been successfully developed to date. The PEGylation technology that we acquired was
valued at $14.3 million. PolyMASC currently has corporate collaborations with Onyx Pharmaceuticals, Transkaryotic Technologies, and Viragen.

Before
a product can be successfully marketed, we, or our corporate partners, must fund the completion of preclinical studies, clinical studies and, if successfully completed, the
market introduction of the new PEGylated therapies. Product efficacy and dose responsiveness must be proven in Phase II and Phase III human clinical trials and FDA approval is required before market
introduction. We currently estimate that clinical development activities will not be completed and revenues will not begin to accrue to the Company for the next several years. Management estimates
that to complete the work on these products, the remaining research and development efforts, offset by estimated revenue generated from potential corporate collaborators, will total more than
$8 million. This amount could vary significantly depending on the success of preclinical development efforts, clinical trial results, our success in attracting and retaining corporate
collaborators and the ability of our collaborators to successfully manufacture and market any resulting products.

Acquisition of GeneMedicine Research and Development Programs

We acquired seven primary GeneMedicine research and development programs in March 1999. Prior to the merger of GeneMedicine with Megabios in
March 1999, over the previous five years, GeneMedicine, Inc. incurred approximately $50 million of research and development expenses in the development of these research and
development programs. Costs to complete these projects could aggregate to approximately $50 million over the next four to six years.

At
the date of the acquisition, Valentis recorded a charge of $25.9 million for acquired in-process research and development. The acquired in-process
research and development has been valued based on a discounted probable future cash flow analysis using a discount rate of 40%, which management believes adequately reflects the substantial risk of
gene therapy research and development. In the valuation model, it was assumed that for each program, preclinical studies and clinical trials are successfully completed, regulatory approval to market
the product candidates is obtained, a marketing partner is secured and we are able to manufacture the product in commercial quantities.

The
nature of the efforts required for developing the acquired in-process research and development into technologically feasible and commercially viable products
principally relates to the successful performance of additional preclinical studies and clinical trials. Though the Company expects that some of the acquired in-process technology will be
successfully developed, there can be no assurance that commercial or technical viability of these products will be achieved. While the expectations and promise of gene therapy are great, clinical
efficacy has not yet been demonstrated. Pharmaceutical and
biotechnology companies are pursuing many approaches to gene therapy, but there are currently no marketed gene therapy products and none are expected for the next several years.

In
determining our research and development priorities, we decided to defer additional work on three of the programs acquired in the merger with GeneMedicine. Work on any of the
growth factor gene products (IGF-1), pulmonary gene products (AAT) and the vaccine programs (APC) is not expected to be pursued unless or until a corporate partner is identified to provide
funding for further development.

As
a result of the mergers with GeneMedicine and PolyMASC, Valentis' focus became one of transforming its technologies into products. At June 30, 2001, Valentis had seven
clinical trials in progress for six different cardiovascular and oncology gene therapies. An additional two gene therapy product candidates are scheduled to begin clinical trials in the next year. If
these trials and Phase III clinical studies for our Genemedicine products are successfully completed and our corporate collaborators subsequently market the products, Valentis will be
entitled to receive royalties on the resulting product sales.

45

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Other Acquired Technology

In April 1999, Valentis acquired rights and intellectual property related to the Del-1 gene and protein. Del-1 is a novel
extracellular matrix protein involved in early growth and development of blood vessels and bone that has been demonstrated to have potential application in the treatment of certain vascular diseases
by stimulating angiogenesis. The acquisition of Del-1 strengthens our product development in the area of cardiovascular disease. We expensed the cost of $900,000 for Del-1 as
acquired in-process research and development as the technology was not complete at the date of acquisition.

New Accounting Pronouncements

In June 2001, the FASB issued SFAS 141,Business Combinationsand SFAS 142, Goodwill and Other Intangible
Assets.SFAS 141 prohibits the use of the pooling-of-interest method for business
combinations initiated after June 30, 2001 and also applies to all business combinations accounted for by the purchase method that are completed after June 30, 2001. There are also
transitions that apply to business combinations completed before July 1, 2001, that were accounted for by the purchase method. SFAS 142 is effective for fiscal years beginning after
December 15, 2001 to all goodwill and other intangible assets recognized in an entity's statement of financial position at that date, regardless of when those assets were initially recognized.
Under the new rules, goodwill will no longer be amortized but will be subject to annual impairment tests in accordance with the statements. The Company is currently evaluating the impact of the
provisions of SFAS 141 and SFAS 142.

Liquidity and Capital Resources

As of June 30, 2001, Valentis had $37.3 million in cash, cash equivalents and investments compared to $37.7 million at June 30,
2000 and $39.1 million at June 30, 1999. Net cash used in our operations was $27.9 million in 2001, $22.9 million in 2000 and $20.0 million in 1999. Cash was used
primarily to fund increasing levels of research and development and general and administrative activities. Our capital expenditures were $311,000 in 2001, $895,000 in 2000 and $5.5 million in
1999. Capital expenditures in 1999 primarily reflect expenditures for the construction of Valentis' pilot manufacturing facility at its Burlingame location. Valentis expects its capital expenditures
in the future to increase as we upgrade our pilot manufacturing facility at the Burlingame facility to comply with GMP standards.

Since
its inception, Valentis has financed its operations principally through public and private issuances of its common and preferred stock and funding from collaborative
arrangements. On December 5, 2000, we completed the private placement of 31,500 shares of Series A convertible redeemable preferred stock, at a purchase price of $1,000 per share, for an
aggregate purchase price of $31.5 million. In connection with the sale of the preferred stock, we issued common stock purchase warrants exercisable for up to an aggregate of 1,126,828 shares of
our common stock and warrants to purchase up to an aggregate of 140,000 shares of our common stock as compensation to certain Series A preferred stockholders who acted as placement agents or
financial advisors in the private transaction.

Additional
details associated with our December 5, 2000 private placement of Series A Preferred Stock and Warrants can be obtained from the Notes to Consolidated
Financial Statements for the year ended June 30, 2001 or from the Registration Statement on Form S-3 (File No. 333-54066) filed with the Securities and
Exchange Commission on January 19, 2001.

On
April 14, 2000, Valentis completed a private placement of 1,915,000 shares of newly issued common stock at $10.00 per share, resulting in net proceeds of approximately
$18.8 million.

In
October 1998, we entered into an equipment financing agreement with a financing company. We financed $366,000 in equipment purchases under this agreement structured as
loans. The equipment loans are being repaid over 43 months at an interest rate of 10.1% and are secured by the related equipment. As

46

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of June 30, 2001, the outstanding balance under this financing agreement was $230,000. Valentis has fully utilized the borrowing capacity under this agreement.

In
May 1996, Valentis entered into an equipment financing agreement for up to $2.7 million with a financing company. We financed $2.7 million in equipment
purchases under this agreement structured as loans. The equipment loans are to be repaid over 48 months at interest rates ranging from 15.2% to 16.2% and are secured by the related equipment.
As of June 30, 2001, the outstanding balance under this financing agreement was $299,000. Valentis has fully utilized the borrowing capacity under this agreement.

In
June 1995, Valentis established a line of credit for $8.0 million with a commercial bank. In May 1998 in accordance with the terms of the agreement, the entire
balance was converted into a term loan at the bank's prime rate plus 0.5% with payments due in equal monthly installments. At June 30, 2001, the outstanding balance was $2.2 million. The
loan is secured by tangible personal property, other than the assets securing the equipment financing, accounts receivable and funds on deposit. As a condition of the credit line, Valentis must
maintain a minimum cash and short-term investments balance of not less than the prior two quarters net cash usage and Valentis' net worth must remain in excess of 90% of the total
principal drawn under the line of credit. Valentis has fully utilized the borrowing capacity under this agreement.

Valentis
anticipates that its cash, cash equivalents and investments, committed funding from existing corporate collaborations and projected interest income, will enable us to
maintain our current and planned operations at least through December 31, 2002. However, we may require additional funding prior to such time. Valentis' future capital requirements will depend
on many factors, including scientific progress in its research and development programs, the size and complexity of such programs, the scope and results of preclinical studies and clinical trials, the
ability of Valentis to establish and maintain corporate collaborations, the time and costs involved in obtaining regulatory approvals, the time and costs involved in filing, prosecuting and enforcing
patent claims, competing technological and market developments, the cost of manufacturing preclinical and clinical materials and other factors not within Valentis' control. We are seeking additional
collaborative agreements with corporate partners and may seek additional funding through public or private equity or debt financing. We may not be able to enter into any such agreements, however, or
if entered into, any such agreements may not reduce our funding requirements. We expect that additional equity or debt financing may be required to fund our operations. Additional financing to meet
our funding requirements may not be available on acceptable terms or at all.

If
we raise additional funds by issuing equity securities, substantial dilution to existing stockholders may result. Insufficient funds may require us to delay, scale back or
eliminate some or all of its research or development programs or to relinquish greater or all rights to products at an earlier stage of development or on less favorable terms than we would otherwise
seek to obtain, which could materially adversely affect Valentis' business, financial condition and results of operations.

ITEM 7A. FINANCIAL MARKET RISK

Valentis' exposure to market risk for changes in interest rates relates primarily to our investment portfolio and long-term debt obligations. We
maintain a strict investment policy that ensures the safety and preservation of invested funds by limiting default risk, market risk, and reinvestment risk. Our investments
consist primarily of commercial paper, medium term notes, U.S. Treasury notes and obligations of U.S. Government agencies and corporate bonds. The table below presents notional amounts and related

47

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weighted-average interest rates by year of maturity for our investment portfolio (in thousands, except percentages).

|                            |              | 2001 |        | 2002   |   | 2003   |        | Total |      
|--------------------------- | ------------ | ---- | ------ | ------ | - | ------ | ------ | ----- | -----
|Cash equivalents            |              |      |        |        |   |        |        |       |      
|                            | Fixed rate   |      | $      | 12,042 |   | $      |       |       | $    
|                            | Average rate |      |        | 4.21   | % |        |       |       |      
|Short-term investments      |              |      |        |        |   |        |        |       |      
|                            | Fixed rate   |      | $      | 11,869 |   | $      | 10,273 |       |      
|                            | Average rate |      |        | 6.22   | % |        | 5.63   | %     |      
|Long-term investments       |              |      |        |        |   |        |        |       |      
|                            | Fixed rate   |      |        |       |   |        |       |       | $    
|                            | Average rate |      |        |       |   |        |       |       |      
|                            |              |      |        |        |   |        |        |       |      
|Total investment securities |              | $    | 23,911 |        | $ | 10,273 |        | $     | 1,439
|Average rate                |              |      | 5.21   | %      |   | 5.63   | %      |       | 4.76 

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

Valentis' Financial Statements and notes thereto appear on pages 54 to 78 of this Annual Report on Form 10-K.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE

Not Applicable.

48

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PART III

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

The information required by this item concerning our directors and executive officers is incorporated by reference from Valentis' Definitive Proxy Statement to
be filed not later than 120 days following the close of the fiscal year (the "Definitive Proxy Statement").

ITEM 11. EXECUTIVE COMPENSATION

The information required by this item is hereby incorporated by reference from the Definitive Proxy Statement.

ITEM 12. SECURITY OWNERSHIP CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

The information required by this item is hereby incorporated by reference from the Definitive Proxy Statement.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

The information required by this item is hereby incorporated by reference from the Definitive Proxy Statement.

PART IV

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K

(a)(1)  Index to Financial Statements



Page No.Report of Ernst & Young LLP, Independent Auditors

54Consolidated Balance Sheets

55Consolidated Statements of Operations

56Consolidated Statement of Redeemable Convertible Preferred Stock and Stockholders' Equity

57Consolidated Statements of Cash Flows

58Notes to Consolidated Financial Statements

59-78


(a)(2)No schedules have been filed, as they were not required or are inapplicable and therefore have been omitted.

(a)(3)  Exhibits

|Exhibit
Footnote |  | Exhibit
Number |  | Description of Document                                                                                                      
|---------------- |  | -------------- |  | -----------------------------------------------------------------------------------------------------------------------------
|(1)              |  | 3.1            |  | Amended and Restated Certificate of Incorporation of the Registrant                                                          
|(1)              |  | 3.2            |  | Bylaws of the Registrant                                                                                                     
|(5)              |  | 3.3            |  | Certification of Destinations of Series A Convertible Redeemable Preferred Stock                                             
|                 |  | 4.1            |  | Reference is made to Exhibits 3.1 and 3.2                                                                                    
|(1)              |  | 4.2            |  | Specimen stock certificate                                                                                                   
|(1)              |  | 4.3            |  | Amended and Restated Investor Rights Agreement, dated as of May 23, 1997 among the Registrant and the investors named therein

49

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|(1)  |  | 4.4   |  | Preferred Stock Warrant issued to Imperial Bank, dated June 1, 1995                                                                                                                                                     
|---- |  | ----- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1)  |  | 4.5   |  | Series C Preferred Stock Warrant issued to Phoenix Leasing Incorporated, dated April 30, 1996                                                                                                                           
|(1)  |  | 4.6   |  | Stock purchase Agreement between Registrant and Pfizer Inc., dated May 30, 1996                                                                                                                                         
|(5)  |  | 4.7   |  | Form of Common Stock Purchase Warrant, Class A.                                                                                                                                                                         
|(5)  |  | 4.8   |  | Form of Common Stock Purchase Warrant, Class B.                                                                                                                                                                         
|(1)  |  | 10.1  |  | 1997 Equity Incentive Plan                                                                                                                                                                                              
|(1)  |  | 10.2  |  | Form of Incentive Stock Option Grant                                                                                                                                                                                    
|(1)  |  | 10.3  |  | Form of Non-Incentive Stock Option                                                                                                                                                                                      
|(1)  |  | 10.4  |  | 1997 Employee Stock Purchase Plan                                                                                                                                                                                       
|(1)  |  | 10.5  |  | Form of Indemnification Agreement entered into between the Registrant and its directors and executive officers                                                                                                          
|(1)  |  | 10.6  |  | Letter Agreement between the Registrant and Benjamin F. McGraw, III, Pharm.D.                                                                                                                                           
|(3)  |  | 10.8  |  | Letter Agreement between the Registrant and Bennet Weintraub                                                                                                                                                            
|(1)  |  | 10.10 |  | Lease Agreement between the Registrant and Provident Life and Accident Insurance Company ("Provident"), dated December 21, 1993                                                                                         
|(1)  |  | 10.11 |  | First Amendment to Lease Agreement between the Registrant and SFO Associates LLC (successor in interest to Provident)                                                                                                   
|(1)  |  | 10.12 |  | Lease Agreement between the Registrant and SFO Associates LLC, dated March 18, 1997                                                                                                                                     
|(1)  |  | 10.13 |  | Credit Agreement between the Registrant and Imperial Bank, dated as of August 31, 1995                                                                                                                                  
|(1)  |  | 10.14 |  | Lease Agreement between the Registrant and LMSI, dated May 13, 1994, as amended as of May 13, 1994                                                                                                                      
|(1)  |  | 10.15 |  | Senior Loan and Security Agreement between the Registrant and Phoenix Leasing Incorporated, dated as of April 22, 1996                                                                                                  
|(1)* |  | 10.16 |  | Research and License Agreement between the Registrant and Glaxo Wellcome Group Limited, dated April 11, 1994, as amended as of May 31, 1996                                                                             
|(1)* |  | 10.17 |  | Exclusive License Agreement between the Registrant and Regents of the University of California, dated May 9, 1996, as amended May 15, 1997                                                                              
|(3)  |  | 10.21 |  | Promissory Note for $8,000,000 from Megabios Corp. to Imperial Bank, dated May 13, 1998                                                                                                                                 
|(2)* |  | 10.22 |  | First Amendment and Restatement of License Agreement between Registrant and Baylor College of Medicine dated March 7, 1994                                                                                              
|(2)* |  | 10.23 |  | First Amendment and Restatement of License Agreement  Woo between Registrant and Baylor College of Medicine date March 7, 1994                                                                                         
|(2)* |  | 10.24 |  | First Amendment and Restatement of License Agreement  GeneSwitch between Registrant and Baylor College of Medicine dated March 7, 1994                                                                                
|(2)  |  | 10.30 |  | Lease Agreement between Registrant and The Woodlands Corporation dated October 29, 1993                                                                                                                                 
|(2)* |  | 10.31 |  | Collaborative Alliance Agreement between Registrant and Syntex (U.S.A.) Inc. dated April 8, 1994                                                                                                                        
|(2)* |  | 10.32 |  | License Agreement between Registrant and Syntex (U.S.A.) Inc. dated April 8, 1994                                                                                                                                       
|*    |  | 10.33 |  | Alliance Agreement between Registrant and Corange International Ltd. effective February 3, 1995. Exhibit 10.21 to GeneMedicine's Form 10-Q for the quarter ended September 30, 1995 is incorporated herein by
reference.
|(4)  |  | 10.34 |  | Form of Subscription Agreement between the Registrant and each of the selling security holders, dated as of November 20, 2000.                                                                                          
|     |  | 12.1  |  | Statement regarding Computation of Ratios.                                                                                                                                                                              

50

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| |  | 21.1 |  | As of August 30, 1999, PolyMASC Pharmaceuticals plc ("PolyMASC") became a subsidiary of the Registrant. PolyMASC is incorporated under the laws of England and Wales
| |  | ---- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | 23.1 |  | Consent of Ernst & Young LLP, Independent Auditors                                                                                                                  

---

(b)  Reports on Form 8-K.

None.

51

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SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities Act of 1934, the Registrant has duly caused this Annual Report on
Form 10-K to be signed on its behalf by the undersigned, thereunto duly authorized, on September 27, 2001.

| |  | VALENTIS, INC.
| |  | --------------
| |  | By:           

KNOW
ALL PERSONS BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints Benjamin F. McGraw III and Bennet Weintraub, and each or any one of them,
his true and lawful attorney-in-fact and agent, with full power of substitution and resubstitution, for him and in his name, place and stead, in any and all capacities, to sign
any and all amendments (including post-effective amendments) to this Annual Report, and to file the same, with all exhibits thereto, and other documents in connection therewith, with the
Securities and Exchange Commission, granting unto said attorneys-in-fact and agents, and each of them, full power and authority to do and perform each and every act and thing
requisite and necessary to be done in connection therewith, as fully to all intents and purposes as he might or could do in person, hereby ratifying and confirming all that said
attorneys-in-fact and agents, or any of them, or their or his substitutes or substitute, may lawfully do or cause to be done by virtue hereof.

Pursuant
to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and
on the dates indicated.

|Signature                                            |  | Title                                                                                                   |  | Date              
|---------------------------------------------------- |  | ------------------------------------------------------------------------------------------------------- |  | ------------------
|                                                     |  |                                                                                                         |  |                   
|/s/BENJAMIN F. MCGRAW III(Benjamin F. McGraw III)    |  | Chairman of the Board of Directors, President and Chief Executive Officer (Principal Executive Officer) |  | September 27, 2001
|/s/BENNET WEINTRAUB(Bennet L. Weintraub)             |  | Vice President Finance and Chief Financial Officer (Principal Financial and Accounting Officer)         |  | September 27, 2001
|/s/STANLEY T. CROOKE(Stanley T. Crooke, M.D., Ph.D.) |  | Director                                                                                                |  | September 27, 2001
|/s/PATRICK G. ENRIGHT(Patrick G. Enright)            |  | Director                                                                                                |  | September 27, 2001

52

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|/s/RAJU KUCHERLAPATI, PH.D.(Raju Kucherlapati, Ph.D.) |  | Director |  | September 27, 2001
|----------------------------------------------------- |  | -------- |  | ------------------
|/s/MARK MCDADE(Mark McDade)                           |  | Director |  | September 18, 2001
|/s/ALAN C. MENDELSON(Alan C. Mendelson)               |  | Director |  | September 27, 2001
|/s/BERT W. O'MALLEY, M.D.(Bert W. O'Malley, M.D.)     |  | Director |  | September 17, 2001
|/s/ARTHUR M. PAPPAS(Arthur M. Pappas)                 |  | Director |  | September 27, 2001

53

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REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS

The
Board of Directors and Stockholders
Valentis, Inc.

We
have audited the accompanying consolidated balance sheets of Valentis, Inc. as of June 30, 2001 and 2000, and the related consolidated statements of operations,
redeemable convertible preferred stock and stockholders' equity and cash flows for each of the three years in the period ended June 30, 2001. These financial statements are the responsibility
of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.

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

In
our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Valentis, Inc. as of June 30,
2001 and 2000, and the consolidated results of its operations and its cash flows for each of the three years in the period ended June 30, 2001, in conformity with accounting principles
generally accepted in the United States.



Palo
Alto, California
August 15, 2001

54

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VALENTIS, INC.        CONSOLIDATED BALANCE SHEETS        (in thousands, except share amounts)

|                                                                                                                                                                                   |                            | June 30,                                   |         
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | -------------------------- | ------------------------------------------ | --------
|
|ASSETS                                                                                                                                                                             |                            |                                            |         
|Current assets:                                                                                                                                                                    |                            |                                            |         
|Cash and cash equivalents                                                                                                                                                          |                            | $                                          | 13,691  
|Short-term investments                                                                                                                                                             |                            |                                            | 22,142  
|Other receivables                                                                                                                                                                  |                            |                                            | 569     
|Prepaid expenses and other current assets                                                                                                                                          |                            |                                            | 493     
|                                                                                                                                                                                   |                            |                                            |         
|                                                                                                                                                                                   | Total current assets       |                                            |         
|Property and equipment, net                                                                                                                                                        |                            |                                            | 6,537   
|Long-term investments                                                                                                                                                              |                            |                                            | 1,439   
|Goodwill and other assets, net                                                                                                                                                     |                            |                                            | 5,378   
|                                                                                                                                                                                   |                            |                                            |         
|                                                                                                                                                                                   | Total assets               |                                            | $       
|                                                                                                                                                                                   |                            |                                            |         
|LIABILITIES AND STOCKHOLDERS' EQUITY                                                                                                                                               |                            |                                            |         
|Current liabilities:                                                                                                                                                               |                            |                                            |         
|Accounts payable                                                                                                                                                                   |                            | $                                          | 398     
|Accrued compensation                                                                                                                                                               |                            |                                            | 1,619   
|Other accrued liabilities                                                                                                                                                          |                            |                                            | 3,778   
|Deferred revenue                                                                                                                                                                   |                            |                                            | 3,333   
|Current portion of long-term debt                                                                                                                                                  |                            |                                            | 2,576   
|                                                                                                                                                                                   |                            |                                            |         
|                                                                                                                                                                                   | Total current liabilities  |                                            |         
|Long-term debt                                                                                                                                                                     |                            |                                            | 138     
|Commitments                                                                                                                                                                        |                            |                                            |         
|Redeemable convertible preferred stock, no par value, 10,000,000 shares authorized, issuable in series, 31,500 and zero shares outstanding at June 30, 2001 and 2000, respectively |                            |                                            | 23,895  
|Stockholders' equity:                                                                                                                                                              |                            |                                            |         
|Common stock, $.001 par value, 45,000,000 shares authorized; 29,739,384 and 29,343,830 shares issued and outstanding at June 30, 2001 and 2000, respectively                       |                            |                                            | 30      
|Additional paid-in capital                                                                                                                                                         |                            |                                            | 172,962 
|Deferred compensation, net of amortization                                                                                                                                         |                            |                                            | (10     
|Accumulated other comprehensive income                                                                                                                                             |                            |                                            | 650     
|Accumulated deficit                                                                                                                                                                |                            |                                            | (159,120
|                                                                                                                                                                                   |                            |                                            |         
|                                                                                                                                                                                   | Total stockholders' equity |                                            |         
|                                                                                                                                                                                   |                            |                                            |         
|                                                                                                                                                                                   |                            | Total liabilities and stockholders' equity |         
|                                                                                                                                                                                   |                            |                                            |         

See
accompanying notes.

55

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VALENTIS, INC.        CONSOLIDATED STATEMENTS OF OPERATIONS        (in thousands, except share amounts)

|                                                                       |                                                               | Year ended June 30,      |        
|---------------------------------------------------------------------- | ------------------------------------------------------------- | ------------------------ | -------
|
|Collaborative research and development revenue                         |                                                               | $                        | 4,297  
|Research and development grant revenue                                 |                                                               |                          | 349    
|                                                                       |                                                               |                          |        
|                                                                       |                                                               | Total revenue            |        
|Operating expenses:                                                    |                                                               |                          |        
|                                                                       | Research and development                                      |                          |        
|                                                                       | General and administrative                                    |                          |        
|                                                                       | Acquired in-process research and development                  |                          |        
|                                                                       | Amortization of goodwill and other acquired intangible assets |                          |        
|                                                                       |                                                               |                          |        
|                                                                       |                                                               | Total operating expenses |        
|                                                                       |                                                               |                          |        
|Loss from operations                                                   |                                                               |                          | (39,495
|Interest income                                                        |                                                               |                          | 2,324  
|Interest expense and other                                             |                                                               |                          | (1,028 
|                                                                       |                                                               |                          |        
|Net loss                                                               |                                                               | $                        | (38,199
|Deemed dividend                                                        |                                                               |                          | (1,479 
|Dividends on convertible preferred stock                               |                                                               |                          | (898   
|                                                                       |                                                               |                          |        
|Net loss applicable to common stockholders                             |                                                               | $                        | (40,576
|                                                                       |                                                               |                          |        
|Basic and diluted net loss per share applicable to common stockholders |                                                               | $                        | (1.37  
|                                                                       |                                                               |                          |        
|Shares used in computing basic and diluted net loss per common share   |                                                               |                          | 29,515 
|                                                                       |                                                               |                          |        

See
accompanying notes.

56

---

VALENTIS, INC.

CONSOLIDATED STATEMENT OF REDEEMABLE CONVERTIBLE PREFERRED STOCK AND STOCKHOLDERS' EQUITY

(in thousands, except share amounts)

|                                                                                                 |  | Redeemable Convertible
Preferred Stock |  | Common Stock |        |   |            |   |   |    |  |   |         |   |  
|------------------------------------------------------------------------------------------------ |  | -------------------------------------- |  | ------------ | ------ | - | ---------- | - | - | -- |  | - | ------- | - | -
|
|
|
|Balance at June 30, 1998                                                                         |  |                                       |  | $            |       |   | 12,880,978 |   | $ | 13 |  | $ | 79,838  |   | $
|Issuance of common stock for GeneMedicine, Inc. merger                                           |  |                                       |  |              |       |   | 9,117,794  |   |   | 9  |  |   | 39,510  |   |  
|Exercise of stock options                                                                        |  |                                       |  |              |       |   | 46,042     |   |   |   |  |   | 85      |   |  
|Repurchase of common stock from employees                                                        |  |                                       |  |              |       |   | (42,936    | ) |   |   |  |   | (42     | ) |  
|Issuance of common stock pursuant to Employee Stock Purchase Plan                                |  |                                       |  |              |       |   | 70,144     |   |   |   |  |   | 355     |   |  
|Amortization of deferred compensation                                                            |  |                                       |  |              |       |   |           |   |   |   |  |   |        |   |  
|Net loss                                                                                         |  |                                       |  |              |       |   |           |   |   |   |  |   |        |   |  
|Net unrealized loss on available-for-sale securities                                             |  |                                       |  |              |       |   |           |   |   |   |  |   |        |   |  
|                                                                                                 |  |                                        |  |              |        |   |            |   |   |    |  |   |         |   |  
|Comprehensive loss                                                                               |  |                                        |  |              |        |   |            |   |   |    |  |   |         |   |  
|                                                                                                 |  |                                        |  |              |        |   |            |   |   |    |  |   |         |   |  
|Balance at June 30, 1999                                                                         |  |                                       |  |              |       |   | 22,072,022 |   |   | 22 |  |   | 119,746 |   |  
|Issuance of common stock for PolyMASC Pharmaceuticals plc. merger, net of issuance costs of $837 |  |                                       |  |              |       |   | 4,400,000  |   |   | 4  |  |   | 20,062  |   |  
|Exercise of stock options and warrants, net of repurchases                                       |  |                                       |  |              |       |   | 876,646    |   |   | 1  |  |   | 5,807   |   |  
|Stock options granted to non-employees for services rendered                                     |  |                                       |  |              |       |   |           |   |   |   |  |   | 696     |   |  
|Repurchase of common stock from employees                                                        |  |                                       |  |              |       |   | (1,373     | ) |   |   |  |   | (1      | ) |  
|Issuance of common stock pursuant to Employee Stock Purchase Plan and
401(k) Plan                |  |                                       |  |              |       |   | 81,535     |   |   |   |  |   | 298     |   |  
|Issuance of common stock, net of offering costs of $390                                          |  |                                       |  |              |       |   | 1,915,000  |   |   | 2  |  |   | 18,758  |   |  
|Amortization of deferred compensation                                                            |  |                                       |  |              |       |   |           |   |   |   |  |   |        |   |  
|Net loss                                                                                         |  |                                       |  |              |       |   |           |   |   |   |  |   |        |   |  
|Net unrealized gain on available-for-sale securities                                             |  |                                       |  |              |       |   |           |   |   |   |  |   |        |   |  
|Foreign currency translation adjustment                                                          |  |                                       |  |              |       |   |           |   |   |   |  |   |        |   |  
|                                                                                                 |  |                                        |  |              |        |   |            |   |   |    |  |   |         |   |  
|Comprehensive loss                                                                               |  |                                        |  |              |        |   |            |   |   |    |  |   |         |   |  
|                                                                                                 |  |                                        |  |              |        |   |            |   |   |    |  |   |         |   |  
|Balance at June 30, 2000                                                                         |  |                                       |  |              |       |   | 29,343,830 |   |   | 29 |  |   | 165,366 |   |  
|Exercise of stock options                                                                        |  |                                       |  |              |       |   | 152,288    |   |   | 1  |  |   | 887     |   |  
|Stock options granted to non-employees for services rendered                                     |  |                                       |  |              |       |   |           |   |   |   |  |   | 784     |   |  
|Issuance of common stock pursuant to Employee Stock Purchase Plan and
401(k) Plan                |  |                                       |  |              |       |   | 111,212    |   |   |   |  |   | 473     |   |  
|Issuance of redeemable convertible preferred stock, net of issuance costs of $1,943              |  | 31,500                                 |  |              | 29,557 |   |           |   |   |   |  |   |        |   |  
|Redeemable convertible preferred stock warrants and accretion                                    |  |                                       |  |              | (5,058 | ) |           |   |   |   |  |   | 5,058   |   |  
|Redeemable convertible preferred stock beneficial conversion feature and accretion               |  |                                       |  |              | (920   | ) |           |   |   |   |  |   | 920     |   |  
|Accretion of redeemable convertible preferred stock issuance costs                               |  |                                       |  |              | 316    |   |           |   |   |   |  |   | (316    | ) |  
|Redeemable convertible preferred stock dividends                                                 |  |                                       |  |              |       |   |           |   |   |   |  |   | (898    | ) |  
|Redeemable convertible preferred stock dividends paid in common stock                            |  |                                       |  |              |       |   | 132,054    |   |   |   |  |   | 831     |   |  
|Amortization of deferred compensation                                                            |  |                                       |  |              |       |   |           |   |   |   |  |   |        |   |  
|Reversal of deferred compensation related to terminated employees                                |  |                                       |  |              |       |   |           |   |   |   |  |   | (143    | ) |  
|Net loss                                                                                         |  |                                       |  |              |       |   |           |   |   |   |  |   |        |   |  
|Net unrealized gain on available-for-sale securities                                             |  |                                       |  |              |       |   |           |   |   |   |  |   |        |   |  
|Foreign currency translation adjustment                                                          |  |                                       |  |              |       |   |           |   |   |   |  |   |        |   |  
|                                                                                                 |  |                                        |  |              |        |   |            |   |   |    |  |   |         |   |  
|Comprehensive loss                                                                               |  |                                        |  |              |        |   |            |   |   |    |  |   |         |   |  
|                                                                                                 |  |                                        |  |              |        |   |            |   |   |    |  |   |         |   |  
|Balance at June 30, 2001                                                                         |  | 31,500                                 |  | $            | 23,895 |   | 29,739,384 |   | $ | 30 |  | $ | 172,962 |   | $
|                                                                                                 |  |                                        |  |              |        |   |            |   |   |    |  |   |         |   |  

See accompanying notes

57

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VALENTIS, INC.        CONSOLIDATED STATEMENTS OF CASH FLOWS        (in thousands)

|                                                     |                                                                                                                  | Year ended June 30,                                          |                                        
|---------------------------------------------------- | ---------------------------------------------------------------------------------------------------------------- | ------------------------------------------------------------ | ---------------------------------------
|
|Cash flows from operating activities                 |                                                                                                                  |                                                              |                                        
|                                                     | Net loss                                                                                                         |                                                              | $                                      
|                                                     | Adjustments to reconcile net loss to net cash used in operations:                                                |                                                              |                                        
|                                                     |                                                                                                                  | Depreciation                                                 |                                        
|                                                     |                                                                                                                  | Amortization of intangibles                                  |                                        
|                                                     |                                                                                                                  | Amortization of deferred compensation                        |                                        
|                                                     |                                                                                                                  | Stock options granted to non-employees for services rendered |                                        
|                                                     |                                                                                                                  | Acquired in-process research and development                 |                                        
|                                                     |                                                                                                                  | Changes in operating assets and liabilities:                 |                                        
|                                                     |                                                                                                                  |                                                              | Other receivables                      
|                                                     |                                                                                                                  |                                                              | Prepaid expenses and other assets      
|                                                     |                                                                                                                  |                                                              | Deferred revenue                       
|                                                     |                                                                                                                  |                                                              | Accounts payable                       
|                                                     |                                                                                                                  |                                                              | Accrued liabilities                    
|                                                     |                                                                                                                  |                                                              | Foreign currency translation adjustment
|                                                     |                                                                                                                  |                                                              |                                        
|                                                     |                                                                                                                  |                                                              |                                        
|                                                     |                                                                                                                  |                                                              |                                        
|Cash flows from investing activities                 |                                                                                                                  |                                                              |                                        
|                                                     | Cash acquired in acquisitions                                                                                    |                                                              |                                        
|                                                     | Note receivable from PolyMASC Pharmaceuticals plc                                                                |                                                              |                                        
|                                                     | Purchase of property and equipment                                                                               |                                                              |                                        
|                                                     | Deposits and other assets                                                                                        |                                                              |                                        
|                                                     | Purchases of available-for-sale investments                                                                      |                                                              |                                        
|                                                     | Maturities of available-for-sale investments                                                                     |                                                              |                                        
|                                                     |                                                                                                                  |                                                              |                                        
|                                                     |                                                                                                                  |                                                              |                                        
|                                                     |                                                                                                                  |                                                              |                                        
|Cash flows from financing activities                 |                                                                                                                  |                                                              |                                        
|                                                     | Proceeds from issuance of long-term debt                                                                         |                                                              |                                        
|                                                     | Payments on long-term debt                                                                                       |                                                              |                                        
|                                                     | Proceeds from issuance of convertible redeemable preferred stock, net of issuance costs                          |                                                              |                                        
|                                                     | Proceeds from issuance of common stock, net of repurchases                                                       |                                                              |                                        
|                                                     |                                                                                                                  |                                                              |                                        
|                                                     |                                                                                                                  |                                                              |                                        
|                                                     |                                                                                                                  |                                                              |                                        
|Net increase (decrease) in cash and cash equivalents |                                                                                                                  |                                                              | (4,768                                 
|Cash and cash equivalents, beginning of year         |                                                                                                                  |                                                              | 18,459                                 
|                                                     |                                                                                                                  |                                                              |                                        
|Cash and cash equivalents, end of year               |                                                                                                                  | $                                                            | 13,691                                 
|                                                     |                                                                                                                  |                                                              |                                        
|Supplemental disclosure of cash flow information:    |                                                                                                                  |                                                              |                                        
|                                                     | Interest paid                                                                                                    |                                                              | $                                      
|                                                     |                                                                                                                  |                                                              |                                        
|                                                     | Income tax paid                                                                                                  |                                                              | $                                      
|                                                     |                                                                                                                  |                                                              |                                        
|Schedule of non-cash transactions:                   |                                                                                                                  |                                                              |                                        
|                                                     | Construction-in-progress included in accrued liabilities                                                         |                                                              | $                                      
|                                                     |                                                                                                                  |                                                              |                                        
|                                                     | Net exercise of warrants to purchase common stock, 38,206 shares                                                 |                                                              | $                                      
|                                                     |                                                                                                                  |                                                              |                                        
|                                                     | Tangible and intangible assets acquired for shares of common stock, net of cash acquired and liabilities assumed |                                                              | $                                      
|                                                     |                                                                                                                  |                                                              |                                        
|                                                     | Preferred stock dividends paid in common stock                                                                   |                                                              | $                                      
|                                                     |                                                                                                                  |                                                              |                                        

See accompanying notes.

58

---



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS        June 30, 2001

1.  ORGANIZATIONS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Organization and Basis of Presentation

Valentis, Inc. ("Valentis", "we", "us", "our" or "the Company") was formed from the merger of Megabios Corp. and GeneMedicine, Inc.
("GeneMedicine") in March 1999. The Company acquired PolyMASC Pharmaceuticals plc ("PolyMASC") in August 1999. Valentis is a leader in the field of biopharmaceutical delivery. We develop
multiple proprietary gene delivery and gene expression systems and PEGylation technologies and apply our preclinical and early clinical development expertise to create novel therapeutics and improved
versions of currently marketed biopharmaceuticals. Valentis has what it believes to be the broadest array of technologies and intellectual property for the delivery of biopharmaceuticals, including
genes, proteins, peptides, peptidomimetics (synthetic peptide compounds), and antibodies and replicating and non-replicating viruses. This portfolio of delivery technologies potentially
allows us to develop new products, create improved versions of currently marketed products and solve safety, efficacy and dosing compliance issues with products in development. We focus on research,
preclinical development and early-stage clinical development of products in several therapeutic areas including cardiovascular disorders, oncology, hematology and immunology. Our commercial strategy
is to enter into corporate collaborations for full-scale clinical development, marketing and sales of products. Valentis is incorporated in the State of Delaware.

The
consolidated financial statements include the accounts of Valentis and our wholly owned subsidiary, PolyMASC. We translate the assets and liabilities of our foreign subsidiary
stated in local functional currency to U.S. dollars at the rates of exchange in effect at the end of the period. Revenues and expenses are translated using rates of exchange in effect during the
period. Gains and losses from currency translation are included in other comprehensive income (loss). Currency transaction gains or losses are recognized in interest expense and other and have not
been significant to our operating results in any period.

Valentis
may require additional financial resources to complete development and commercialization of its products. Management plans to continue to finance the Company primarily
through issuances of equity securities, collaborative research and development arrangements and debt financing. Prior to product commercialization, if the financing arrangements contemplated by
management are not consummated, we may have to seek other sources of capital or re-evaluate our operating plans.

On
April 17, 2001 the Company announced that it would consolidate all of its PEGylation research activities from its facilities in London, England into its preclinical research
and development center in The Woodlands, Texas.

Revenue Recognition

Non-refundable up-front payments received in connection with research and development collaboration agreements, including technology
advancement funding that is intended for the development of the Company's core technology, are deferred and recognized on a straight-line basis over the relevant periods specified in the
agreement, generally the research term.

Revenue
related to collaborative research with the Company's corporate collaborators is recognized as research services are performed over the related funding periods for each
contract. Under these agreements, the Company is required to perform research and development activities as specified in each respective agreement. The payments received under each respective
agreement are not refundable and are generally based on a contractual cost per full-time equivalent employee working on the project. Research

59

---

and development expenses under the collaborative research agreements approximate or exceed the revenue recognized under such agreements over the term of the respective agreements. Deferred revenue may
result when the Company does not incur the required level of effort during a specific period in comparison to funds received under the respective contracts. Milestone and royalty payments, if any,
will be recognized pursuant to collaborative agreements upon the achievement of specified milestones.

Research and Development Expenses

Research and development expenses, which are expensed as incurred, consist of costs incurred for independent and collaborative research and development. These
include direct and research-related overhead expenses and the costs of funding clinical studies.

Cash, Cash Equivalents and Investments

Cash equivalents consist of highly liquid investments with original maturities at the date of purchase of three months or less. Short-term
investments mature in less than one year from the balance sheet date. Long-term investments have maturities greater than one year from the balance sheet date.

Valentis
accounts for its cash equivalents and investments under Statement of Financial Accounting Standards No. 115,Accounting for Certain Investments
in Debt and Equity Securities("SFAS 115"). Under the provisions of SFAS 115, we have classified our cash equivalents and investments as
"available-for-sale." Such investments are recorded at fair value, determined based on quoted market prices, and unrealized gains and losses, which are considered to be
temporary, are recorded as other comprehensive income (loss) in a separate component of stockholders' equity until realized.

Fair Value of Assets and Liabilities

Our cash and cash equivalents, other receivables and accounts payable are carried at historical cost, which approximates their fair value because of the
short-term nature of these accounts.

Depreciation and Amortization

Property and equipment are stated at cost, less accumulated depreciation. Depreciation is provided using the straight-line method over the
estimated useful lives of the respective assets (generally three to seven years). Leasehold improvements are amortized over the shorter of the estimated useful lives of the assets or the applicable
lease term.

Acquired Intangible Assets

Acquired intangible assets consist of the assembled workforce and goodwill related to Valentis' acquisition of GeneMedicine and PolyMASC accounted for using
the purchase method (see Note 2). Amortization of these purchased intangibles is calculated on the straight-line basis over the respective estimated useful lives of the intangible
assets of three years. Amortization of assembled workforce and goodwill is included as a separate item on our Consolidated Statements of Operations. Acquired in-process research and
development without alternative future use is expensed when acquired.

Long-Lived Assets

Valentis accounts for its long-lived assets under Statement of Financial Accounting Standards No. 121,Accounting
for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed of("SFAS 121"). In accordance with SFAS 121, Valentis
identifies and records impairment losses, as

60

---

circumstances dictate, on long-lived assets used in operations when events and circumstances indicate that the assets might be impaired and the undiscounted cash flows estimated to be
generated by those assets are less than the carrying amounts of those assets. No such events have occurred with respect to our long-lived assets, which consist primarily of machinery and
equipment, leasehold improvements, and acquired intangible assets.

Stock-Based Compensation

Valentis generally grants stock options to employees for a fixed number of shares with an exercise price equal to the fair value of the shares at the date of
grant. In accordance with the provisions of Statements of Financial Accounting Standards No. 123,Accounting for Stock-Based Compensation("SFAS 123"), Valentis has elected to follow Accounting Principles Board Opinion No. 25,Accounting for Stock Issued to Employees("APB
25"), and related interpretations in accounting for option grants to employees under its employee stock option plan and to adopt the pro forma disclosure alternative as described in SFAS 123
(see Note 12).

All
stock-based awards to non-employees are accounted for at their fair value, as calculated using the Black-Scholes model, in accordance with SFAS 123 and Emerging
Issued Task Force Issue 96-18 ("EITF 96-18"). Stock-based awards to non-employees not immediately vested are subject to periodic re-valuation over their
vesting terms.

Use of Estimates

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

Net Loss Per Share

Basic earnings per share is computed by dividing income or loss applicable to common stockholders by the weighted-average number of common shares outstanding
for the period, net of certain common shares outstanding which are subject to continued vesting and Valentis' right of repurchase. Diluted earnings per share include the effect of options, warrants
and convertible securities, if dilutive. Diluted net loss per share has not been presented separately as, given our net loss position for all periods presented, the result would be
anti-dilutive.

The
calculation of basic net loss per share for the years ended June 30, 2000 and 1999, excludes 13,473 shares of common stock and 56,150 shares of common stock, respectively,
which are outstanding but are subject to Valentis' right of repurchase which expires ratably over four years.

The
following have been excluded from the calculation of diluted net loss per share for the year ended June 30, 2001 because the effect of inclusion would be antidilutive:
options to purchase 3,080,932 shares of common stock at a weighted average price of $7.54 per share.

The
following have been excluded from the calculation of diluted net loss per share for the year ended June 30, 2000 because the effect of inclusion would be antidilutive:
options to purchase 2,072,344 shares of common stock at a weighted average price of $6.69 per share.

The
following have been excluded from the calculation of diluted net loss per share for the year ended June 30, 1999 because the effect of inclusion would be antidilutive:
options to purchase approximately 2,459,000 shares of common stock at a weighted average price of $6.99 per share and warrants to purchase 138,511 shares of common stock at a weighted average exercise
price of $14.74 per share.

61

---

In connection with the sale of 31,500 shares of Series A convertible redeemable preferred stock (see Note 12), at a purchase price of $1,000 per share, we issued common
stock purchase warrants exercisable for up to an aggregate of 1,126,828 shares of our common stock and warrants to purchase up to an aggregate of 140,000 shares of our common stock as compensation to
certain Series A preferred stockholders who acted as placement agents or financial advisors in the private transaction. Additionally, the Series A convertible redeemable preferred stock
is convertible into 3,499,996 shares of common stock.

The
options, convertible redeemable preferred stock and stock purchase warrants will be included in the calculation of net income per share at such time as the effect is no longer
antidilutive, as calculated using the treasury stock method for options and warrants and the if-converted method for the preferred stock.

A
reconciliation of shares used in the calculation of basic and diluted net loss per share follows:

|                                                                                                |  | Year ended June 30, |        
|----------------------------------------------------------------------------------------------- |  | ------------------- | -------
|
|
|Net loss applicable to common stockholders                                                      |  | $                   | (40,576
|                                                                                                |  |                     |        
|Basic and Diluted                                                                               |  |                     |        
|Weighted average shares of common stock outstanding                                             |  |                     | 29,515 
|Shares subject to repurchase                                                                    |  |                     |       
|                                                                                                |  |                     |        
|Weighted average shares of common stock outstanding used in computing net loss per common share |  |                     | 29,515 
|                                                                                                |  |                     |        
|Basic and diluted net loss per share applicable to common stockholders                          |  | $                   | (1.37  
|                                                                                                |  |                     |        

Comprehensive Income

The components of accumulated other comprehensive income (loss) are as follows (in thousands):

|                                                        |  | June 30, 2001 |     | June 30, 2000 |  
|------------------------------------------------------- |  | ------------- | --- | ------------- | -
|Unrealized gain (loss) on available-for sale securities |  | $             | 107 |               | $
|Foreign currency translation adjustments                |  |               | 543 |               |  
|                                                        |  |               |     |               |  
|Accumulated other comprehensive income (loss)           |  | $             | 650 |               | $
|                                                        |  |               |     |               |  

Current Vulnerability to Certain Concentrations

Valentis has contracted with third-party manufacturers to produce GMP biopharmaceuticals. The Company has also contracted for drug formulation filling and
finishing. Should the Company not be able to obtain sufficient quantities of GMP biopharmaceuticals, or sufficient drug formulation and finishing capacity from its third-party suppliers, or additional
third-party GMP contact manufacturing organizations or drug formulation filling and finishing suppliers, certain development and clinical activities may be delayed.

62

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Recent Accounting Pronouncements

In June 1998, the Financial Accounting Standards Board ("FASB") issued SFAS No. 133,Accounting for Derivative
Instruments and Hedging Activities, which establishes accounting and reporting standards for derivative instruments, including forward exchange contracts and hedging
activities. In June 1999, the
FASB issued SFAS No. 137,Accounting for Derivative Instruments and Hedging ActivitiesDeferral of the Effective Date of FASB Statement
No. 133. We adopted SFAS No. 133 on July 1, 2000. The impact of SFAS No. 133 was immaterial, as Valentis has no hedging activities or derivatives.

In
December 1999, the Securities and Exchange Commission issued Staff Accounting Bulletin No. 101,Revenue Recognition in Financial
Statements("SAB 101"). Among other things, SAB 101 requires that license and other upfront fees from research collaborators be recognized over the term of the agreement unless
the fee is in exchange for products delivered or services performed that represent the culmination of a separate earnings process. We adopted SAB 101 during fiscal year 2001. The adoption did not have
a material impact on our results of operations.

In
March 2000, the Financial Accounting Standards Board issued Interpretation No. 44, Accounting for Certain Transactions Involving Stock Compensationan
Interpretation of APB Opinion No. 25 ("FIN 44"). FIN 44 clarifies the application of APB 25 with respect to stock-related compensation. Valentis adopted FIN 44 on July 1, 2000 and the
adoption did not have a material effect on the financial position or results of operations of Valentis.

In
June 2001, the FASB issued SFAS 141,Business Combinationsand SFAS 142,Goodwill and
Other Intangible Assets.SFAS 141 prohibits the use of the pooling-of-interest method for business combinations initiated after June 30,
2001 and also applies to all business combinations accounted for by the purchase method that are completed after June 30, 2001. There are also transition provisions that apply to business
combinations completed before July 1, 2001, that were accounted for by the purchase method. SFAS 142 is effective for fiscal years beginning after December 15, 2001 to all
goodwill and other intangible assets recognized in an entity's statement of financial position at that date, regardless of when those assets were initially recognized. Under the new rules, goodwill
will no longer be amortized but will be subject to annual impairment tests in accordance with the statements. The Company is currently evaluating the impact of the provisions of SFAS 141 and
SFAS 142.

Business Segments

The Company has adopted Statement of Financial Accounting Standards No. 131,Disclosures about Segments of an Enterprise and
Related Informationand has determined that it operates in one business segment, the research of biopharmaceutical medicines and delivery technologies.

Reclassifications

We have reclassified certain prior year amounts on the Consolidated Balance Sheet, Consolidated Statements of Cash Flows and Notes to Consolidated Financial
Statements to conform to current year presentation.

2.  ACQUISITIONS

Acquisition of PolyMASC Pharmaceuticals plc

On August 27, 1999, Valentis acquired PolyMASC Pharmaceuticals plc ("PolyMASC") for approximately 4.4 million shares of Valentis common stock,
valued at about $20.1 million based on an

63

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average Valentis stock price of $4.56 at the date the transaction was announced. The acquisition was accounted for as a purchase.

The
total cost of the merger was approximately $20.9 million, determined as follows (in thousands):

Fair value of Valentis common stock issued

$
20,066Transaction costs


837$
20,903


Based
on a valuation of tangible and intangible assets and liabilities assumed, Valentis has allocated the total cost of the acquisition to the net assets of PolyMASC as follows (in
thousands):

Tangible assets acquired

$
1,600In-process research and development


14,347Intangible assets  assembled workforce and goodwill


7,061Liabilities assumed (including PolyMASC transaction costs)


(2,105
)$
20,903


PolyMASC's
PEGylation research and development programs are in various stages of preclinical development. Currently, none of the products utilizing our PEGylation technology has
entered any stage of human clinical testing or been approved for marketing. Our strategy has been to develop and commercialize products through alliances with pharmaceutical and biotechnology
companies.

A
valuation of the purchased assets was undertaken to assist us in determining the fair value of each identifiable intangible asset and in allocating the purchase price among the
acquired assets, including the portion of the purchase price attributed to in-process research and development projects. Standard
valuation procedures and techniques were utilized in determining the fair value of the acquired in-process research and development. To determine the value of the technology in the
development stage, we considered, among other factors, the stage of development of each project, the time and resources needed to complete each project, expected income and associated risks.
Associated risks included the inherent difficulties and uncertainties in completing pharmaceutical research and development and obtaining regulatory approval to sell the resulting products. The
analysis resulted in $14.3 million of the purchase price being charged to in-process research and development. The intangible assets, consisting of assembled workforce and goodwill,
were assigned a value of $7.1 million and are being amortized over their estimated useful lives of three years. Management believes that the amounts are reasonable and reflect the fair value of
the assets acquired.

The
unaudited pro forma information for Valentis for the years ended June 30, 2000 and 1999, had the acquisition occurred at the beginning of each fiscal year, is as follows
(in thousands except share amounts):

Year ended June 30,2000

1999Net revenue

$
5,592

$
5,009Net loss

$
(33,825
)
$
(47,663
)Net loss per common share

$
(1.25
)
$
(2.45
)


The
unaudited pro forma combined results for the year ended June 30, 2000 exclude, the effect of the charge for acquired in-process research and development of
$14.3 million, as such amount is

64

---

non-recurring. The unaudited pro forma information is presented for illustrative purposes only and is not necessarily indicative of the operating results that would have occurred had the
transaction been completed at the beginning of each period indicated, nor is it necessarily indicative of future operating results.

In
April 2001, the Company announced that it would reorganize all of its PEGylation research activities from its facilities in London, England into its preclinical research and
development center in The Woodlands, Texas. Twenty-one full time research and development and general and administrative employees in London were affected. The consolidation is expected to
be complete by October 31, 2001. An accrual of approximately $342,000 has been provided for the closure of the London facilities, severance for the affected employees and other expenses
associated with the reorganization and is expected to be fully paid in cash by December 31, 2001.

Acquisition of GeneMedicine, Inc.

On March 18, 1999, the Company completed its merger with GeneMedicine. On March 29, 1999, the combined company was renamed Valentis, Inc.
Under the terms of the merger agreement, each outstanding share of GeneMedicine common stock was converted into 0.571 of a share of the Company's common stock. This resulted in the issuance of
approximately 9.1 million shares of the Company's common stock, valued at $38.7 million. The purchase price also included approximately $850,000 related to GeneMedicine's stock options
and outstanding warrants assumed by the Company and $1.7 million of transaction costs, for an aggregate purchase price of $41.3 million. The transaction was accounted for as a purchase.

The
following is a summary of the purchase price allocation (in thousands):

Tangible assets acquired

$
14,410In-process research and development


25,870Intangible assets-assembled workforce and goodwill


9,831Liabilities assumed (including GeneMedicine transaction costs and other obligations due upon close of the merger)


(8,801
)$
41,310


A
valuation of the purchased assets was undertaken to assist the Company in determining the fair value of each identifiable intangible asset and in allocating the purchase price among
the acquired assets, including the portion of the purchase price attributed to in-process research and development projects. Standard valuation procedures and techniques were utilized in
determining the fair value of the acquired in-process research and development. To determine the value of the technology in the development stage, the Company considered, among other
factors, the stage of development of each project, the time and resources needed to complete each project, expected income and associated risks. Associated risks included the inherent difficulties and
uncertainties in completing the project and thereby achieving technological feasibility, and the risks related to the viability of and potential changes to future target markets. The analysis resulted
in $25.9 million of the purchase price being charged to in-process research and development. The intangible assets, consisting of assembled workforce and goodwill, were assigned a
value of $9.8 million and are being amortized over their estimated useful lives of three years. Management believes that the amounts are reasonable and reflect the fair value of the assets
acquired.

65

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The unaudited pro forma information for Valentis for the year ended June 30, 1999, had the acquisition occurred at the beginning of the fiscal year, is as follows (in thousands
except per share amounts):

1999Net revenue

$
7,264Net loss

$
(29,063
)Net loss per common share

$
(1.34
)


The
unaudited pro forma condensed combined results for the year ended June 30, 1999 exclude, the effects of the write-off of acquired in-process
research and development and other merger costs of $28.9 million, as such amounts are non-recurring. The unaudited pro forma information is presented for illustrative purposes only
and is not necessarily indicative of the operating results that would have occurred had the transaction been completed at the beginnings of the periods indicated, nor is it necessarily indicative of
future operating results.

3.  INVESTMENTS

Investments consist of the following (in thousands):

|                                                  |  | Amortized
Cost |         | Unrealized
Gain/(Loss) |   | Estimated
Fair Value |  
|------------------------------------------------- |  | -------------- | ------- | ---------------------- | - | -------------------- | -
|June 30, 2001                                     |  |                |         |                        |   |                      |  
|Money market funds                                |  | $              | 9,048   |                        | $ |                     |  
|Commercial paper                                  |  |                | 2,992   |                        |   | 2                    |  
|Corporate debt securities                         |  |                | 23,473  |                        |   | 108                  |  
|                                                  |  |                |         |                        |   |                      |  
|                                                  |  |                | 35,513  |                        |   | 110                  |  
|Less amounts classified as cash equivalents       |  |                | (12,040 | )                      |   | (2                   | )
|                                                  |  |                |         |                        |   |                      |  
|Total short-term investments                      |  |                | 22,021  |                        |   | 121                  |  
|Long-term investments (corporate debt securities) |  |                | 1,453   |                        |   | (14                  | )
|                                                  |  |                |         |                        |   |                      |  
|Total investments                                 |  | $              | 23,474  |                        | $ | 107                  |  
|                                                  |  |                |         |                        |   |                      |  
|June 30, 2000                                     |  |                |         |                        |   |                      |  
|Money market funds                                |  | $              | 9,352   |                        | $ |                     |  
|Commercial paper                                  |  |                | 7,991   |                        |   | 5                    |  
|Corporate debt securities                         |  |                | 14,698  |                        |   | (37                  | )
|                                                  |  |                |         |                        |   |                      |  
|                                                  |  |                | 32,041  |                        |   | (32                  | )
|Less amounts classified as cash equivalents       |  |                | (17,343 | )                      |   | (5                   | )
|                                                  |  |                |         |                        |   |                      |  
|Total short-term investments                      |  |                | 14,698  |                        |   | (37                  | )
|Long-term investments (corporate debt securities) |  |                | 4,556   |                        |   | (4                   | )
|                                                  |  |                |         |                        |   |                      |  
|Total investments                                 |  | $              | 19,254  |                        | $ | (41                  | )
|                                                  |  |                |         |                        |   |                      |  

Unrealized
gains or losses have not been material and have been presented net. We had no realized gains or losses in any period presented.

At
June 30, 2001, the contractual maturities of short-term investments were all due in one year or less, while all long-term investments have
contractual maturities of between one and two years from the balance date.

66

---

4.  COLLABORATIVE AGREEMENTS

Roche Holdings Ltd. ("Roche")

Pursuant to the merger with GeneMedicine in March 1999, Valentis acquired the rights under a corporate collaboration agreement with Corange, the parent
company of Boehringer Mannheim and now a subsidiary of Roche, originally signed in February 1995. The agreement provides for research and development of Genemedicine products to
treat head and neck tumors and melanoma (the "Roche Agreement"). Pursuant to the Roche Agreement, Roche agreed to fund $25.0 million of research and development at $5.0 million per year
plus certain amounts for the achievement of milestones of which $20.9 million had been funded prior to the merger with GeneMedicine. Roche also made equity investments in GeneMedicine that were
converted into 611,785 shares of Valentis common stock at the time of the merger and acquired a five-year warrant to purchase 611,785 shares of Valentis common stock at an exercise price
of $36.78 per share. The warrant was not exercised and expired on April 11, 1999. Revenue recognized under the collaborative research agreement with Roche, after the merger with GeneMedicine
was $3.0 million (64% of total revenue), $3.8 million (68% of total revenue) and $1.0 million (24% of total revenue) for the years ended June 30, 2001, 2000 and 1999,
respectively. Fiscal year 2000 revenue included $3.0 million of research and development funding and a milestone payment of $750,000.

In
August 1998, the Roche Agreement was amended and extended through February 2002. The amendment modified the field of the agreement to gene therapy using the
IL-2, IFN-a or IL-12 genes for the treatment of cancer, and required Valentis to conduct a Phase II clinical trial of the IL-2
gene medicine, and a Phase I / II clinical trial for each of the IFN-a and IL-12 Genemedicine products. As part of the amendment, we
received the right to commercialize products developed under the agreement if Roche does not initiate Phase III clinical trials on products within twelve months after the completion of Phase II
trials. Valentis also agreed to forego a $2 million equity purchase by Roche due on February 1, 1999 in return for a $2 million payment to be made to us by February 1, 2000
for reimbursement of development activities and an additional $2 million milestone upon enrollment of the
first patient in a Phase III clinical study. Subsequently, Valentis and Roche signed a further amendment postponing the $2 million payment due on February 1, 2000 to February 1,
2001.

Included
in deferred revenue at June 30, 2001, is $3.3 million related to Roche that will be fully recognized in fiscal year 2002. This deferred revenue will be earned
either upon the achievement of certain milestones or under certain circumstances, through the performance of additional contract research.

If
Valentis continues to meet the milestones for the development of Genemedicine products under the Roche Agreement, we may be entitled to milestone payments of up to
$8.3 million. Upon successful completion of Phase II clinical testing, Valentis may elect either to receive up to 50 percent of potential profits on worldwide product sales by agreeing
to share development and commercialization expenses or to receive royalty payments based on worldwide product sales.

Also
through the merger with GeneMedicine, Valentis acquired a worldwide exclusive license, with the right to sublicense, from Syntex (U.S.A.) Inc., now also a subsidiary of
Roche, for its cationic lipid gene delivery technology (DOTMA) forin vivogene therapy uses. The rights under this agreement continue even though the
original agreement with Syntex ended.

Boehringer Ingelheim International GmbH ("BI")

In September 1999, Valentis entered into a 15-month collaborative agreement with BI for the development of Genemedicine
products for rheumatoid arthritis. Under the terms of the agreement, BI

67

---

and Valentis conducted evaluations of BI's proprietary genes with Valentis' proprietary gene delivery systems in several animal models of rheumatoid arthritis. The collaboration, completed in
November 2000, did not result in products that will be taken into a clinical program and the collaboration agreement expired according to its terms.

pAlliance with DSM Biologics ("DSM")Qiagen N.V. ("Qiagen")

In September 1998, Valentis and DSM Biologics (formerly Gist-Brocades/Bio-Intermediair) announced the formation of a strategic
collaboration focused on the manufacture and supply of plasmid DNA and formulated DNA to the gene therapy industry. In May 1999 Qiagen N.V. joined the manufacturing alliance, subsequently named
the pAlliance. The goal of the pAlliance is to provide the emerging gene therapy and genetic vaccination industry with early access to a reliable, accepted contract
manufacturing services platform.

Under
the agreement, Valentis has licensed its proprietary manufacturing technology for use in DSM facilities in Montreal, Canada and Groningen, The Netherlands for license and
milestone fees. To date, Valentis has earned $250,000 in milestone fees under the agreement and has no performance obligations under the contract. DSM, Qiagen and Valentis will share in the profits
generated by the sale of material produced using Valentis' process. In June 2001, the pAlliance announced that it had signed its first commercial contract with the Wyeth-Lederle
Vaccines business unit of American Home Products Corporation.

5.  LICENSE AND RESEARCH AGREEMENTS

Valentis has entered into several research agreements with universities and other organizations. These agreements are generally cancelable by either party upon
written notice and may be extended by mutual consent of both parties. Research and development expenses are recognized as the related services are performed, generally ratably over the period of
service. Expenses under these agreements were approximately $1.7 million, $1.8 million, and $2.5 million for the years ended June 30, 2001, 2000 and 1999, respectively.

6.  OTHER ACQUIRED TECHNOLOGY

In April 1999, Valentis acquired rights to intellectual property related to the Del-1 gene and protein. Del-1 is a novel
extracellular matrix protein involved in early growth and development of blood vessels and bone
that has been demonstrated to have potential application in the treatment of certain vascular diseases by stimulating angiogenesis. We expensed the cost of $900,000 for Del-1 as acquired
in-process research and development as the technology was not complete at the date of acquisition. Valentis is obligated to make payments to Vanderbilt University upon the achievement of
certain milestones, to share revenue received from sublicensing at a specified rate, and to make royalty payments on sales of products, if any.

68

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

June 30, 2001

7.  PROPERTIES AND EQUIPMENT

Property and equipment consist of the following (in thousands):

June 30,2001

2000Machinery and equipment

$
8,134

$
7,998Furniture and fixtures


2,194


1,968Leasehold improvements


10,834


10,88521,162


20,851Less accumulated depreciation


(14,625
)

(11,523
)Property and equipment, net

$
6,537

$
9,328


8.  ACQUIRED INTANGIBLE ASSETS

Acquired intangible assets consist of the following (in thousands):

June 30,2001

2000Assembled workforce

$
1,558

$
1,558Goodwill


15,334


15,33416,892


16,892Accumulated amortization


(11,569
)

(5,836
)$
5,323

$
11,056


9.  OTHER ACCRUED LIABILITIES

Other accrued liabilities consist of the following (in thousands):

June 30,2001

2000Accrued research and development expenses

$
1,037

$
1,005Accrued clinical trial costs


1,887


1,093Accrued PolyMASC's close-down costs


342


Accrued payroll taxes





379Other


512


366Total

$
3,778

$
2,843


10. LONG-TERM DEBT

Operating Line of Credit

In June 1995, Valentis established a line of credit for $8.0 million with a commercial bank. In May 1998 in accordance with the terms of
the agreement, the entire balance was converted into a term loan at the bank's prime rate plus 0.5% with payments due in equal monthly installments. At June 30, 2001, the outstanding balance
was $2.2 million. For the period ending June 30, 2001, interest rates associated

69

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with this loan ranged from 7.25% to 10%. The loan is secured by tangible personal property, other than the assets securing the equipment financing, accounts receivable and funds on deposit. As a
condition of the credit line, Valentis must maintain a minimum cash and short-term investments balance of not less than the prior two quarters net cash usage and Valentis' net worth must
remain in excess of 90% of the total principal drawn under the line of credit. Valentis has fully utilized the borrowing capacity under this agreement.

Equipment Financing

In October 1998, Valentis entered into an equipment financing agreement with a financing company. We financed $366,000 in equipment purchases under this
agreement structured as a loan. The equipment loan is being repaid over 43 months at an interest rate of 10.1% and is secured by the related equipment. As of June 30, 2001, the
outstanding balance under this financing agreement was $230,000. Valentis has fully utilized the borrowing capacity under this agreement.

In
May 1996, Valentis entered into an equipment financing agreement for up to $2.7 million with a financing company. We have financed $2.7 million in equipment
purchases under this agreement structured as loans. The equipment loans are to be repaid over 48 months at interest rates ranging from 15.2% to 16.2% and are secured by the related equipment.
As of June 30, 2001, the outstanding balance under this financing agreement was $299,000. Valentis has fully utilized the borrowing capacity under this agreement. In conjunction with this
equipment financing agreement, we issued a warrant to purchase 38,238 shares of common stock at $3.88 per share. The warrant was exercised in January 2000 for a net issuance of 25,600 shares
(see Note 12).

Following
is a schedule of future minimum principal payments under the operating lines of credit and equipment financing arrangements at June 30, 2001 (in thousands):

Year ended June 30,2002

$
2,5762003


138$
2,714


The
carrying amounts of these long-term debt obligations approximate their fair value determined using a discounted cash flow model and Valentis' current incremental
borrowing rate.

11. OPERATING LEASE COMMITMENTS

Valentis leases its facilities and certain equipment under operating leases. These leases expire between April 2001 and October 2007 with renewal
options at the end of the initial terms of the facilities leases.

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Minimal annual rental commitments under the operating leases at June 30, 2001 are as follows (in thousands):

Year ended June 30,2002

$
1,6172003


1,6482004


1,6622005


9402006


249Thereafter


321$
6,437


Rent
expense for the years ended June 30, 2001, 2000 and 1999 was approximately $1.3 million, $1.7 million and $804,000, respectively.

12. REDEEMABLE CONVERTIBLE PREFERRED STOCK AND STOCKHOLDERS' EQUITY

Redeemable Convertible Preferred Stock and Common Stock Warrants

On December 5, 2000, we completed the private placement of 31,500 shares of Series A redeemable convertible preferred stock ("Series A
preferred stock"), at a purchase price of $1,000 per share, for an aggregate purchase price of $31.5 million. In connection with the sale of the preferred stock, we issued Class A and
Class B common stock purchase warrants exercisable for up to an aggregate of 1,126,828 shares of our common stock and warrants to purchase up to an aggregate of 140,000 shares of our
common stock as compensation to certain Series A preferred stockholders who acted as placement agents or financial advisors in the private transaction.

Series A Preferred Stock

The Series A preferred stock is entitled to cumulative dividends, which shall accrue at an annual rate of 5%, payable quarterly, in cash, or, at our
election, in shares of common stock. If we elect to pay dividends in shares of our common stock, those shares will be valued at the average closing bid price for our common stock during the twenty
consecutive trading days ending on and including the trading day immediately prior to the dividend payment date. The number of common stock shares issued for dividends during 2001 was 132,054 shares.
The accrued dividends as of June 30, 2001 were approximately $67,000.

Each
share of Series A preferred stock, together with accrued and unpaid dividends, is convertible, at the option of the holder, into that number of shares of our common stock
that is calculated by dividing the stated value, plus accrued and unpaid dividends, by a fixed conversion price of $9.00, subject to certain anti-dilution adjustments.

Furthermore,
in the event of our liquidation, the holders of the Series A preferred stock will be entitled to a liquidation preference, equal to $1,000 per share plus accrued
and unpaid dividends, before any amounts are paid to the holders of our common stock.

The
Series A preferred stock shall be redeemed by us on June 4, 2004, subject to a one-year extension at the option of the holder, at a redemption price
equal to $1,000 per share plus accrued and unpaid dividends. The holders of the Series A preferred stock may also require that we redeem their shares, at a price equal to $1,000 per share plus
accrued and unpaid dividends per share, under certain circumstances,

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including in the event that our common stock ceases to be listed on the Nasdaq National Market, there is a fundamental change in control of our company, or we breach any of our covenants to the
holders.

Beginning
December 5, 2002, we may redeem all, but not less than all, of the outstanding shares of Series A preferred stock if a certain triggering event occurs. The
triggering event occurs when the closing bid price of our common stock exceeds $24.83 (subject to adjustment upon the occurrence of certain events such as stock split) for twenty consecutive trading
days.

Other
than as required by law, the holders of the Series A preferred stock shall have no voting rights, except that the consent of the holders of a majority of the preferred
stock shall be required to effect any change in our certificate of corporation that would materially and adversely affect any rights of the Series A preferred stock or would create any series
of preferred stock with rights senior to those of the Series A preferred stock.

Class A Warrants

We issued common stock purchase warrants, Class A, exercisable for an aggregate of 959,512 shares of common stock to the purchasers of the
Series A preferred stock and to the placement agents. The Class A Warrants are immediately exercisable and remain exercisable for four years at an exercise price of $10.25 per share,
subject to adjustment. In the event that the average closing bid price of the common stock during any ten consecutive trading days exceeds 275% of the exercise price, we may cancel the Class A
warrants or require that the holders exercise the warrants.

Class B Warrants

We issued common stock purchase warrants, Class B, to the purchasers of the Series A preferred stock, exercisable for an aggregate of 307,316
shares of common stock. The Class B Warrants become exercisable one year after issuance and remain exercisable for three years at an exercise price of $10.25 per share, subject to adjustment.
If, at any time before the one-year anniversary of the issuance of the warrants, the closing bid price of our common stock exceeds $23.99 per share for twenty consecutive trading days,
these warrants shall be cancelled.

Summary of Certain Preferred Stock and Warrant Accounting

The total cash proceeds of $31.5 million were discounted by approximately $6.0 million, representing the value assigned to the Class A and
B warrants exercisable for an aggregate of 1,266,820 shares of common stock issued in the private placement. The $6.0 million value of the warrants is subject to accretion over the
3.5-year redemption period. After reducing the proceeds by the value of the warrants, the remaining proceeds are used to compute a discounted conversion price in accordance with EITF
00-27, "Application of EITF Issue No. 98-5, Accounting for Convertible Securities with Beneficial Conversion Features or Contingently Adjustable Conversion Ratios to
Certain Convertible Instruments". The discounted conversion price is compared to the fair market value of the Valentis common stock on December 5, 2000 (the date of issuance of the
Series A preferred stock) resulting in a beneficial conversion feature of approximately $1.1 million which represents the difference between the fair market value of Valentis' common
stock and the discounted conversion price, and is subject to accretion over the 3.5-years redemption period.

The
accretion of Class A and B warrants for the year ended June 30, 2001 was approximately $984,000. The accretion of the beneficial conversion feature for the year
ended June 30, 2001 was approximately $179,000. The aggregate accretion value associated with the warrants and beneficial conversion feature were included in the calculation of net loss
applicable to common stockholders.

72

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Dividends on the preferred stock, calculated at value at the rate of 5% per annum, were approximately $898,000 for the year ended June 30, 2001 and were charged against
additional-paid-in-capital and included in the calculation of net loss applicable to common stockholders.

Issuance
costs of approximately $1.9 million were accounted for as a discount on the redeemable preferred stock and are accreted over the 3.5-year redemption
period. Accretion of approximately $316,000 for the year ended June 30, 2001 was included in the calculation of net loss applicable to common stockholders.

Additional
details associated with our December 5, 2000 Private Placement of Series A Preferred Stock and Warrants can be obtained from the Registration Statement on
Form S-3 (File No. 333-54066) filed with the Securities and Exchange Commission on January 19, 2001.

Common Stock

On July 30, 1999, the Company's stockholders approved an amendment to Valentis' Amended and Restated Certificate of Incorporation to increase the
authorized number of shares of our common stock from 30,000,000 to 45,000,000.

In
April 2000, Valentis completed a private placement of 1,915,000 shares of newly issued common stock at $10.00 per share, resulting in net proceeds to the Company of
approximately $18.8 million.

Warrants

In June 1995, Valentis issued a warrant to purchase 28,969 shares of common stock at $3.88 per share to the commercial bank providing a line of credit
to us. In accordance with the terms of the warrant, the number of shares subject to the warrant was reduced from 28,969 to 24,140 in July 1995. The warrant was exercised in May 2000 for
a net issuance of 12,606 shares.

In
connection with an equipment financing agreement in May 1996, we issued a warrant to purchase 38,238 shares of common stock at $3.88 per share. The warrant was exercised in
January 2000 for a net issuance of 25,600 shares.

Equity Incentive Plan

In July 1997, the Board of Directors amended and restated the 1993 Stock Option Plan, renamed it as the 1997 Equity Incentive Plan (the "Incentive
Plan") and reserved 2,100,000 shares of Valentis'
common stock for issuance under the Incentive Plan. Shareholders approved the Incentive Plan in September 1997. An additional 1,000,000 shares was added to the plan as approved by the
stockholders in December 1998. The Incentive Plan provides for grants to employees, directors and consultants of Valentis. The exercise price of options granted under the Incentive Plan is
determined by the Board of Directors but cannot be less than 100% of the fair market value of the common stock on the date of the grant. Options under the Incentive Plan generally vest 25% one year
after the date of grant and on a pro rata basis over the following 36 months and expire ten years after the date of grant or 90 days after termination of employment. Options granted
under the plan cannot be repriced without the prior approval of Valentis' stockholders.

In
December 1998, the Board of Directors adopted and stockholders approved the 1998 Non-Employee Directors' Stock Option Plan (the "Directors' Plan") covering
200,000 shares of common stock of Valentis. Option grants under the Directors' Plan are non-discretionary. Pursuant to the terms of the Directors' Plan, each non-employee
director, other than a non-employee director who currently serves on the Board, automatically shall be granted, upon his or her initial election or appointment as a

73

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non-employee director, an option to purchase 25,000 shares of common stock, and commencing with the annual meeting of stockholders in 1998, each person who is serving as a
non-employee director on the day following each Annual Meeting of Stockholders automatically shall be granted an option to purchase 10,000 shares of common stock. As of June 30,
2001, options for 275,000 shares had been issued to non-employee directors under this plan.

The
merger with GeneMedicine included the conversion of outstanding GeneMedicine stock options into options to purchase 1.5 million shares of Valentis common stock. These
options relate to Valentis' assumption of GeneMedicine's 1993 Stock Option Plan referred to as the "GeneMedicine Plan." Under the terms of the GeneMedicine Plan, eligible key employees, directors and
consultants received options to purchase shares of GeneMedicine's previously outstanding common stock at prices not less than 100% and 85% for incentive stock and nonqualified options, respectively,
of the fair value on the date of grant as determined by GeneMedicine's Board of Directors. Options under the GeneMedicine Plan typically vest over a four-year period and expire ten years
after the date of grant or 90 days after termination of employment.

In
May 2001, the Board of Directors adopted the 2001 Nonstatutory Incentive Plan (the "NQ Plan") covering 3,000,000 shares of common stock of Valentis. The NQ Plan provides for
grants of Nonstatutory stock options to employees, directors and consultants of Valentis. The exercise price of options granted under the NQ Plan is determined by the Board of Directors but cannot be
less than 100% of the fair market value of the common stock on the date of the grant. Options under the NQ Plan generally vest 25% one year after the date of grant and on a pro rata basis over the
following 36 months and expire ten years after the date of grant or 90 days after termination of employment. Options granted under the plan cannot be repriced without the prior approval
of Valentis' stockholders. As of June 30, 2001, options for no shares had been granted under this plan.

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Activity under all option plans was as follows:

|                                                |  | Outstanding Stock Options
|----------------------------------------------- |  | -------------------------
|
|Balance at June 30, 1998                        |  | 412,909                  
|                                                |  |                          
|Additional authorization                        |  | 1,200,000                
|Options granted                                 |  | (572,460                 
|Options exercised                               |  |                         
|Options canceled                                |  | 351,411                  
|Options assumed in the merger with GeneMedicine |  | 251,346                  
|Shares repurchased                              |  | 42,936                   
|                                                |  |                          
|Balance at June 30, 1999                        |  | 1,686,142                
|                                                |  |                          
|Options granted                                 |  | (1,066,497               
|Options exercised                               |  |                         
|Options canceled                                |  | 615,578                  
|Shares repurchased                              |  | 1,373                    
|                                                |  |                          
|Balance at June 30, 2000                        |  | 1,236,596                
|                                                |  |                          
|Additional authorization                        |  | 5,200,000                
|Options granted                                 |  | (1,330,743               
|Options exercised                               |  |                         
|Options canceled                                |  | 169,867                  
|                                                |  |                          
|Balance at June 30, 2001                        |  | 5,275,720                
|                                                |  |                          

The
options outstanding at June 30, 2001 have been segregated into ranges for additional disclosure as follows:

Exercise
Price
Per Share

Options
Outstanding
at
June 30, 2001

Weighted
Average
Remaining
Contractual Life
(in years)

Options
Vested
At
June 30, 2001

Weighted
Average
Exercise
Price$
0.30-$ 3.75

323,803

6.43

233,414

$
2.24$
4.05-$ 4.94

279,802

8.08

162,941

$
4.46$
5.00-$ 5.88

569,693

7.82

328,517

$
5.58$
6.06-$ 9.75

1,287.937

8.01

376,549

$
7.10$
10.07-$15.56

619,697

7.93

273,907

$
12.573,080,932

7.80

1,375,328

$
6.69


The
weighted average fair value of options granted in fiscal 2001, 2000 and 1999 was $5.11, $3.58 and $3.04, respectively.

At
June 30, 2001, no shares of common stock were subject to repurchase.

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1997 Stock Purchase Plan

In July 1997, the Board of Directors adopted the 1997 Employee Stock Purchase Plan (the "Purchase Plan") covering an aggregate of 200,000 shares of
common stock. An additional 200,000 shares was added to the plan as approved by the stockholders in December 2000. The Purchase Plan was approved by stockholders in September 1997 and is
qualified under Section 423 of the Internal Revenue Code. The Purchase Plan is designed to allow eligible employees of Valentis to purchase shares of common stock through periodic payroll
deductions. The price of common stock purchased under the Purchase Plan must be equal to at least 85% of the lower of the fair market value of the common stock on the commencement date of each
offering period or the specified purchase date. Of the 400,000 shares reserved under the plan, 166,670 shares were available for issuance at June 30, 2001 and 233,330 shares had been issued
under the Purchase Plan at an average purchase price of $4.83 per share.

Stocks Issued Under the Valentis Inc. 401(k) Plan

In April 1997, the Board of Directors adopted the 1997 Valentis, Inc. 401(k) Plan (the "401(k) Plan") in accordance with Section 401(k) of
the Internal Revenue Code. All employees who complete at least 1,000 hours of service during the year are eligible to participate in the 401(k) Plan. Participants may
elect to have up to 20% of their annual salary deferred and contributed to the 401(k) Plan. Valentis has the discretion to make a matching 25% contribution in common stock each year for every dollar
contributed to the 401(k) Plan. The stock match is priced at the closing price on December 31st of each year and vests according to the employee's years of employment with the
Company. In fiscal 2001, the Company contributed 15,493 shares of common stock to the 401(k) Plan.

Deferred Compensation Expense

Valentis has recorded deferred compensation expense for the difference between the exercise price and the deemed fair value for financial statement
presentation purposes of our common stock, as determined by the Board of Directors, for options granted through the year ended June 30, 1997. The deferred compensation is being amortized to
expense over the vesting period of the options, generally four years. Amortization of $94,000, $216,000 and $513,000 were recorded in fiscal 2001, 2000 and 1999, respectively.

Pro Forma Information

Valentis has elected to follow APB 25, "Accounting for Stock Issued to Employees" and related interpretations in accounting for its employee stock options
because, as discussed below, the alternative fair value accounting provided for under SFAS 123 requires use of valuation models that were not developed for use in valuing employee stock
options. Under APB 25, if the exercise price of Valentis' employee stock options equals the market price of the underlying stock on the date of grant, no compensation expense is recognized.

Pro
forma net loss and net loss per share information is required by SFAS 123, which also requires that the information be determined as if Valentis has accounted for its
employee stock options granted subsequent to December 31, 1994 under the fair market value method of that statement. The fair value for

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these options was estimated at the date of grant using a Black-Scholes option-pricing model with the following weighted-average assumptions:

Employee Stock Options

Stock Purchase Plan SharesYears ended June 30,2001

2000

1999

2001

2000

1999Expected life (in years)

2.4

2.3

2.3

0.5

0.5

0.5Risk-free interest rate

4.95
%
6.02
%
4.58
%
4.95
%
6.06
%
4.83
%Volatility

0.97

0.97

0.93

0.97

0.97

0.93Dividend yield














The
Black-Scholes option valuation model was developed for use in estimating the fair value of traded options that have no vesting restrictions and are fully transferable. In
addition, option valuation models require the input of highly subjective assumptions including the expected stock price volatility. Because
Valentis' employee stock options and employee stock purchase plans have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions
can materially affect the fair market value estimate, in management's opinion, the existing models do not necessarily provide a reliable single measure of the fair value of its employee stock options
and shares issued pursuant to the employee stock purchase plan.

For
purposes of pro forma disclosures, the estimated fair value of the options is amortized to expense over the options' vesting periods. Valentis' pro forma information follows (in
thousands except for net loss per share information):

Year ended June 30,2001

2000

1999Net lossas reported

$
(40,576
)
$
(47,655
)
$
(44,680
)Net losspro forma

$
(44,332
)
$
(50,174
)
$
(45,837
)Net loss per shareas reported

$
(1.37
)
$
(1.80
)
$
(2.90
)Net loss per sharepro forma

$
(1.50
)
$
(1.90
)
$
(2.97
)


Stock-Based Awards to Non-Employees

In fiscal years 2001, 2000 and 1999, Valentis granted 65,000, 65,000 and 5,000 common stock options to consultants, respectively. Options granted to
consultants are periodically revalued as they vest in accordance with SFAS 123 and EITF 96-18 using a Black-Scholes model. Assumptions used for valuing the options for 2001 were an
estimated volatility of 0.97, risk free interest rate of 4.95%, no dividend yield and an expected life of the option of 2.4 years. Assumptions used for valuing the options for 2000 were an
estimated volatility of 0.97, risk free interest rate of 6.02%, no dividend yield and an expected life of the option of 2.3 years. Expenses of $783,836 and $696,000 were recognized in fiscal
2001 and 2000, respectively, related to these grants. Expenses associated with non-employee option grants in prior periods were not material.

13. INCOME TAXES

As of June 30, 2001, Valentis had federal net operating loss carryforwards and federal research credit carryforwards of approximately
$14.6 million and $3.5 million, respectively. The net operating loss and credit carryforwards will expire at various dates beginning in 2007 through 2020, if not utilized.

77

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Utilization of the net operating losses and credits may be subject to a substantial annual limitation due to the "change in ownership" provisions of the Internal Revenue Code of 1986.
The annual limitation may result in the expiration of net operating losses and credits before utilization.

Significant
components of our deferred tax assets and liabilities for federal income taxes as of June 30 are as follows (in thousands):

2001

2000Net operating loss carryforwards

$
51,800

$
40,400Research and development credits


4,100


3,700Capitalized research and development


5,000


3,700Other, net


3,600


2,600Net deferred tax assets


64,500


50,400Valuation allowance


(64,500
)

(50,400
)$


$



The
net valuation allowance increased by $14.1 million, $11.8 million and $27.2 million during the years ended June 30, 2001, 2000 and 1999, respectively.

14. QUARTERLY FINANCIAL INFORMATION (UNAUDITED)

|                                                                       |  | Quarter |        
|---------------------------------------------------------------------- |  | ------- | -------
|
|
|2001                                                                   |  |         |        
|Revenue                                                                |  | $       | 986    
|Operating expenses                                                     |  |         | 10,245 
|Net loss                                                               |  |         | (9,027 
|Deemed dividend                                                        |  |         |       
|Dividends on redeemable, convertible preferred stock                   |  |         |       
|Net loss applicable to common stockholders                             |  |         | (9,027 
|Basic and diluted net loss per share applicable to common stockholders |  |         | (0.31  
|2000                                                                   |  |         |        
|Revenue                                                                |  | $       | 1,185  
|Operating expenses                                                     |  |         | 22,488 
|Net loss                                                               |  |         | (21,030
|Basic and diluted net loss per share                                   |  |         | (0.89  

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