**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, DC 20549**

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**Form 10-K**

| **(Mark One)**                                         |   |                                                                                                         |
|--------------------------------------------------------|--------|--------------------------------------------------------------------------------------------------------------|
| **x**                                                  |   | **ANNUAL REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**     |
| **For the  fiscal year ended June 30, 2006** |
| **or**                                                 |
| **o**                                                  |   | **TRANSITION REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |

 

**CommissionFile Number 0-22987**

**VALENTIS, INC.**

(Exact name of registrantas specified in its charter)

| **Delaware**                        |   | **94-3156660**       |
|-------------------------------------|--------|----------------------|
| (State or other  jurisdiction       |   | (IRS Employer        |
| of incorporation  or organization)  |   | Identification  No.) |
| **863A Mitten Rd., Burlingame, CA** |   | **94010**            |
| (Address of  principal offices)     |   | (Zip Code)           |

 

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

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Securities registeredpursuant to Section 12(b) of the Act: **None**

Securities registeredpursuant to Section 12(g) of the Act: **CommonStock, Par Value $.001**

Indicate by check markwhether the registrant is a well-known seasoned issuer, as defined in Rule 405of the Securities Act. Yes **o**  No **x**

Indicate by check mark ifthe registrant is not required to file reports pursuant to Section 13 or Section 15(d) ofthe Exchange Act. Yes **o**  No **x**

Indicate by check markwhether the registrant (1) has filed all reports required by Section 13or 15(d) of the Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the registrant was required tofile such reports), and (2) has been subject to such filing requirementsfor the past 90 days. Yes **x**  No **o**

Indicate by check mark ifdisclosure of delinquent filers pursuant to Item 405 of Regulation S-K isnot contained herein, and will not be contained, to the best of registrant’sknowledge, in definitive proxy or information statements incorporated by referencein Part III of this Form 10-K or any amendment to this Form 10-K. **o**

Indicate by check markwhether the registrant is a large accelerated filer, an accelerated filer or anon-accelerated filer. See definition of “accelerated filer and largeaccelerated filer” in Rule 12b-2 of the Exchange Act.

| Large Accelerated Filer **o** |   | Accelerated Filer **o** |   | Non-accelerated Filer **x** |
|-------------------------------|--------|-------------------------|--------|-----------------------------|

Indicate by check markwhether the registrant is a shell company (as defined in Rule 12b-2of the Exchange Act). Yes **o**  No **x**

The aggregate market valueof the common stock held by non-affiliates of the registrant, based upon thelast sale price of the common stock reported on the Nasdaq Capital Market on December 31, 2005was $26,984,764.

The number of shares ofregistrant’s common stock outstanding, as of September 26, 2006 was17,082,965.

**DOCUMENTS INCORPORATED BYREFERENCE**

None.

 

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**VALENTIS, INC.**

**FORM 10-K—ANNUALREPORTFOR THE YEAR ENDED JUNE 30, 2006**

**TABLE OF CONTENTS**
|               | ** ** |                                                                                                                                 | ** ** | **Page** |
|---------------|------------|---------------------------------------------------------------------------------------------------------------------------------|------------|----------|
| PART I   |       |                                                                                                                            |       |     |
| Item  1       |       | Business                                                                                                                        |       | 1        |
| Item  1A      |       | Risk Factors                                                                                                                    |       | 14       |
| Item 1B       |       | Unresolved Staff Comments                                                                                                       |       | 26       |
| Item 2        |       | Properties                                                                                                                      |       | 27       |
| Item  3       |       | Legal  Proceedings                                                                                                              |       | 27       |
| Item 4        |       | Submission of Matters to a Vote of Security Holders                                                                             |       | 27       |
| PART II  |       |                                                                                                                            |       |     |
| Item 5        |       | Market for Registrant’s Common Equity, Related  Stockholder Matters and Issuer Purchases of Equity Securities              |       | 28       |
| Item 6        |       | Selected Financial Data                                                                                                         |       | 29       |
| Item 7        |       | Management’s Discussion and Analysis of Financial  Condition and Results of Operations       |       | 30       |
| Item 7A       |       | Quantitative and Qualitative Disclosures About Market  Risk                                                                     |       | 39       |
| Item 8        |       | Financial Statements and Supplementary Data                                                                                     |       | 39       |
| Item 9        |       | Changes in and Disagreements With Accountants on  Accounting and Financial Disclosure                  |       | 40       |
| Item 9A       |       | Controls and Procedures                                                                                                         |       | 40       |
| Item  9B      |       | Other  Information                                                                                                              |       | 40       |
| PART III |       |                                                                                                                            |       |     |
| Item 10       |       | Directors and Executive Officers of the Registrant                                                                              |       | 41       |
| Item 11       |       | Executive Compensation                                                                                                          |       | 47       |
| Item 12       |       | Security Ownership of Certain Beneficial Owners and  Management and Related Stockholder Matters                  |       | 49       |
| Item 13       |       | Certain Relationships and Related Transactions                                                                                  |       | 53       |
| Item 14       |       | Principal Accountant Fees and Services                                                                                          |       | 54       |
| PART IV  |       |                                                                                                                            |       |     |
| Item 15       |       | Exhibits and Financial Statement Schedules                                                                                      |       | 58       |
| SIGNATURES    |       | 61                                                                                                                              |

 

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**PART I**

**ITEM1.**                BUSINESS

*This Annual Report on Form 10-K containscertain forward-looking statements within the meaning of Section 27Aof the Securities Act of 1933, as amended, and Section 21E of theSecurities Exchange Act of 1934, as amended. These forward-lookingstatements include, without limitation, statements containing the words “believes,”“anticipates,” “expects,” “intends,” “projects,” “estimates” and other words ofsimilar import or the negative of those terms or expressions. Forward-lookingstatements in this section include, but are not limited to, expectationsregarding any strategic opportunities that may be available to us, expectationsof future levels of research and development spending, general andadministrative spending, levels of capital expenditures and operating results,our intention to license potential products and technologies to apharmaceutical company that may assume responsibility for late-stagedevelopment and commercialization and our intention to seek revenue from the licensingof our proprietary manufacturing technologies. Forward-looking statementssubject to certain known and unknown risks, uncertainties and other factorsthat may cause our actual results, performance or achievements to be materiallydifferent from any future results, performance or achievements expressed orimplied by such forward-looking statements. Factors that could affect ouractual results include the outcomes of our clinical trials in patients withperipheral arterial disease, uncertainties related our financial condition,uncertainties related to the strategic opportunities that may be available tous, our need for additional capital, our going concern report from ourindependent registered public accounting firm and the other risk factors set forthin this Annual Report on Form 10-K. Further, there can be noassurance that necessary regulatory approvals for any of our potential productsmay be obtained. We undertake no obligation to revise or update any suchforward-looking statements. The reader is strongly urged to read theinformation set forth under the caption “Part I, Item 1A. Risk Factors,for a detailed description of these significant risks, uncertainties and otherfactors.*

**COMPANY OVERVIEW**

Valentis is abiotechnology company that was previously engaged in the development ofinnovative products for peripheral artery disease, or PAD. PAD is due tochronic inflammation of the blood vessels of the legs leading to the formationof plaque, which obstructs blood flow.

On July 11, 2006Valentis announced that no statistically significant difference was seen in theprimary endpoint or any of the secondary endpoints in its Phase IIbclinical trial of VLTS 934 in PAD. The primary efficacy endpoint in thestudy was improvement in exercise tolerance on an escalating grade treadmillafter 90 days in patients receiving VLTS 934 versus patientsreceiving placebo. The trial was a randomized, double-blind, placebo-controlledPhase IIb trial of VLTS 934 versus a saline placebo in 157 patientswith the intermittent claudication form of PAD.

After 90 days, therewas no statistically significant change in exercise in the 78 patientsreceiving VLTS 934 versus the 79 patients receiving placebo. Therewere also no significant differences in any of the secondary endpoints ofexercise tolerance at 30 days, ankle-brachial index at 30 and90 days, total work capacity at 30 and 90 days and quality of life at90 days. VLTS 934 was well tolerated in the trial with no definitelyrelated severe adverse effects.

Valentis has no plans forfurther development of VLTS 934, has ceased research and developmentactivities on all of its remaining potential products and technologies and isassessing strategic opportunities, which include the sale or merger of thebusiness, the sale of certain assets or other actions.

In conjunction with theassessment of strategic opportunities, Valentis reduced its workforce byeliminating 55% of its employees on August 18, 2006. Furtherreductions in workforce of approximately 66% are anticipated by the end of October 2006.The total costs associated with the reduction in workforce on August 18, 2006and anticipated further reductions are estimated to be between $525,000 and$1.4 million, primarily related to severance benefits, which will berecorded in the fiscal first quarter of 2007, and paid in the fiscal first andsecond quarters of 2007.

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Additional actionsValentis has taken following its July 2006 announcement regarding negativeresults in its Phase IIb clinical trial of VLTS 934 in patients with PADinclude (i) ceasing all research and development activities on all of itspotential products and technologies, including activities under itscollaboration and contract research agreements and activities relating toclinical trials and (ii) terminating its 401(k) plan in August 2006.

Valentishas several remaining potential products and technologies, including itsproprietary products VLTS 934, and DEL-1 and gene delivery andexpression technologies, and proprietary formulation and manufacturingtechnologies that allow the generation of novel therapeutics to treat a widerange of diseases. While Valentis focused its efforts on the development ofnovel PAD therapeutics, its technologies are being applied by its collaboratorsfor the development of therapeutics to treat a variety of indications,including infectious diseases and cancer. Valentis is assessing strategicopportunities that may be available to it, including the sale or license of theseremaining potential products and technologies. Valentis’ remaining potentialproducts and technologies include:

·       VLTS 934product candidate for compromised cell membranes;

·       DeltavascTMproduct candidate for angiogenesis or stimulation of new blood vessel growth;

·       Del-1Protein product candidate for promotion of vascular growth and inhibition ofendothelial cell death;

·       DEL-1antibody for anti-angiogenesis or the inhibition of new blood vessel formation;

·       PINCTMpolymer, synthetic gene delivery system;

·       CLICTMlipids delivery system;

·       DNAVaxTMpolymer-based delivery system;

·       Hermes*TM* gene expression technology;

·       GeneSwitch® gene regulation technology;

·       OptiPEG*TM* PEGylation technology;

·       Plasmidbackbone technology;

·       Scalableprocesses to manufacture plasmid DNA formulated products; and

·       Tenother early-stage potential products in development through partners, whichutilize Valentis’ licensed technologies.

In August 2006,Valentis received a letter from the Listing Qualifications Department of TheNasdaq Stock Market indicating that Valentis is not in compliance with NasdaqMarketplace Rule 4310(c)(4) (the “Minimum Bid Price Rule”) becausethe closing bid price per share for Valentis common stock has been below $1.00per share for 30 consecutive trading days. In accordance with NasdaqMarketplace Rules, Valentis will be provided 180 calendar days, or until February 20,2007, to regain compliance with the Minimum Bid Price Rule. Should Valentisfail to regain compliance with the Minimum Bid Price Rule by February 20,2007, Nasdaq will determine whether Valentis meets The Nasdaq Capital Marketinitial listing criteria set forth in Marketplace Rule 4310(c), except forthe bid price requirement. If Valentis meets the initial listing criteria,Nasdaq will notify Valentis that it has been granted an additional 180 calendarday compliance period. If Valentis is not eligible for an additional complianceperiod, Nasdaq will provide Valentis with written notification that its commonstock will be delisted.

Valentis, Inc. wasformed as the result of the merger of Megabios Corp. and GeneMedicine, Inc.in March 1999. Valentis is incorporated in Delaware. In August 1999,Valentis acquired U.K.-based PolyMASC Pharmaceuticals plc. Valentis islocated in Burlingame, California, where its headquarters and remainingbusiness operations are located.

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**POTENTIAL PRODUCTS, TECHNOLOGIES AND SERVICES**

Research and developmentexpenses to further the development of Valentis’ potential products andtechnologies were $11.2 million, $9.2 million and $10.1 millionfor the fiscal years ended June 30, 2006, 2005 and 2004,respectively.

Valentis has no plans forfurther development of any of its potential products and technologies. Followingis a summary of Valentis’ remaining potential products and technologies.Valentis is currently exploring strategic opportunities that may be open to itwith respect to each of these potential products and technologies, includingthe license or sale of such potential products and technologies.

***Proprietary ProductCandidates***

**VLTS 934 Product Candidate**

VLTS 934 was Valentis’lead product candidate. It is a non-ionic, block copolymer surfactant withhemorheologic, anti-thromobotic, cytoprotective and anti-inflammatoryproperties. VLTS 934 appeared to have the effect of repairing compromised cellmembranes and improving cell function, which Valentis tested in clinical trialsin PAD for potential therapeutic benefit in ischemic tissue. PAD is a result ofatherosclerosis in the legs of patients. Atherosclerosis is a chronicinflammatory disorder of blood vessels that ultimately leads to the formationof atheroma or plaque in large blood vessels. This plaque impedes blood flow totissues including the legs. VLTS 934 was believed to reduce levels ofspecific mediators of inflammation, which drives progression of the disease. Bysuppressing the local inflammatory response in the blood vessels and muscletissue, it was believed  to explain theimprovement in blood flow and exercise tolerance seen in the prior clinical trialthat included VLTS 934.

On July 11, 2006Valentis announced that no statistically significant difference was seen in theprimary endpoint or any of the secondary endpoints in its Phase IIbclinical trial of VLTS 934 in PAD.. The primary efficacy endpoint in thestudy was improvement in exercise tolerance on an escalating grade treadmillafter 90 days in patients receiving VLTS 934 versus patientsreceiving placebo. The trial was a randomized, double-blind, placebo-controlledPhase IIb trial of VLTS 934 versus a saline placebo in 157 patientswith the intermittent claudication form of PAD.

Valentis has no plans forfurther development of VLTS 934. Valentis is assessing strategicopportunities related to VLTS 934, which may include the sale or license of thisasset.

**DEL-1 Protein Product**

DEL-1 is a uniqueangiogenic protein that promotes vascular growth and inhibits endothelial celldeath. It is expressed during embryonic vasculature development and isre-expressed in the setting of ischemia. Administration of the DEL-1protein enhances the angiogenic response to ischemia. DEL-1 has adistinct mechanism of action from other known angiogenic factors, such asmembers of the VEGF and FGF families. The angiogenic effect of DEL-1 ismediated in part by activation of integrin-mediated signaling and requires anRGD motif and a discoidin-I—like domain. The affinity of the DEL-1protein for the extracellular matrix is unlike that of any of the angiogenicproteins. Valentis is assessing strategic opportunities related to the DEL-1protein, which may include the sale or license of this asset.

**DeltavascTM Product Candidate**

DeltavascTM is aninvestigational product that incorporates the DEL-1 gene to stimulate newblood vessel growth, as known as angiogenesis. The DEL-1 protein fromthis gene is involved in the embryonic growth of blood vessels. In September 2004,we completed a Phase IIa clinical trial of DeltavascTM and VLTS 934 inPAD. In this trial, DeltavascTM was well tolerated; however, it did not meet itsprimary endpoint of improvement in exercise tolerance versus VLTS 934.Based on the preclinical studies 

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completedto date, DEL-1 has demonstrated angiogenic activity. Valentis isassessing strategic opportunities related to DeltavascTM, which may include thesale or license of this asset.

**DEL-1 Antibody Product Candidate**

Valentis acquired the rightsto the DEL-1 antibody in March 2006. Valentis’ preclinical work todate has demonstrated that several of its proprietary hybridoma cell linesproduce monoclonal antibodies that neutralize DEL-1 in in vitrointegrin binding and adherence assays. It is well established that tumors needan ever-increasing supply of blood to maintain their growth. They achieve thisthrough stimulation of angiogenesis or new blood vessel formation. Inhibitionof new blood vessel formation, or anti-angiogenesis, has been the strategybehind many new oncology products. The commercial success of Genentech’sAvastin has increased interest in the inhibition of angiogenesis through anantibody to a well-established angiogenic protein as a route for new productdevelopment. Published findings report that some tumor cell lines, whenpropogated in vitro, produce DEL-1 as an angiogenic agent for newvessel growth into the tumor. Valentis is assessing strategic opportunitiesrelating to the DEL-1 antibodyTM, which may include the sale or license ofthis asset.

***Technologies forGene-Based Therapeutics***

Gene-based therapeutics isan approach to the treatment or prevention of certain diseases in whichtherapeutic genes are introduced into the body to cause the production ofspecific proteins needed to bring about a therapeutic effect. For gene-basedtherapeutics to be effective, the therapeutic gene must be delivered to, andtransported across, the outer membrane of a targeted cell and into the nucleus whereit can be expressed. The expressed protein may remain within the cell for anintracellular effect, be transported to the cell membrane to exert acell-surface effect, or be secreted into the bloodstream to have a systemiceffect. Most gene-based therapeutics utilize a delivery system, or vector, intowhich the therapeutic gene is incorporated to facilitate its delivery to,uptake by and expression in the target cell.

Genes provide the “instructions”for the production of proteins in the body. Specifically, a gene produces themessage that a cell will then use to make a protein. For gene-based products toproduce a therapeutic effect, the genes for the therapeutic protein of interestmust be “delivered” into the nucleus of cells.

To date, a limiting factorin gene-based therapeutics has been the lack of safe, effective gene deliverysystems. A number of gene delivery approaches are being developed. Theseapproaches may be categorized by their mode of administration as ex vivo(outside the body) or in vivo (inside the body) and by the nature of thegene delivery system (viral or plasmid-based (synthetic)).

Valentis has developednovel, chemical-based technologies for the delivery of genes. Contrary toother gene delivery approaches, Valentis’ technologies do not use a live,genetically altered virus to deliver the gene. Also, we believe Valentis’technologies have advantages over other gene delivery technologies in deliveryefficiency, cost and ability to repeat dosing. Valentis is assessing strategicopportunities relating to each of its gene delivery technologies, which mayinclude the sale or license of these assets.

**PINCTM Polymers**

Valentis developed itsPINCTM delivery technologies consisting of synthetic, non-toxic, poloxamer(symmetrical block copolymer) delivery systems. Each PINCTM product consistsprimarily of two components: (i) a plasmid DNA (a circular segment of DNAthat contains a therapeutic gene and components that regulate its expression inthe cell), and (ii) polymers, which are synthetic, non-viral agents tofacilitate the delivery of the plasmid DNA into target cells followingintramuscular administration. This traditional mode of administration isfamiliar to physicians and may be more convenient and cost effective thanex vivo approaches.

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DNA formulated withValentis’ PINCTM formulations have been shown to produce high protein levelswith decreased variability as compared to protein levels obtained after nakedDNA administration. In addition, Valentis’ PINCTM gene delivery systems can behandled and administered like traditional pharmaceuticals. Valentis hasdemonstrated that it can produce clinical-grade plasmid DNA and plasmid-basedDNA formulations under controlled conditions, and Valentis has developedproprietary manufacturing and production methods designed to be scaled to meetcommercial requirements.

**CLICTM Lipids**

Valentis has developedproprietary cationic lipid delivery systems to provide efficient delivery afterintravenous, aerosol or intra-tumoral administration. Valentis has shownthat gene delivery systems containing cationic lipids combined with neutrallipids enhance the cellular uptake of plasmid-based gene expressionsystems. These lipid-based gene delivery systems have been demonstratedto enhance the entry of genes into tumor cells after intratumoraladministration, and to deliver genes to the endothelium and epithelium of thelung after intravenous administration and inhalation, respectively. Although weare not actively pursuing their use internally, the technologies are beingout-licensed for development by corporate partners.

**DNAVaxTM**

Valentis has developedsynthetic vaccine delivery systems based on several classes of polymers.Valentis’ proprietary DNAVaxTM polymer-based delivery systems forintramuscular administration of vaccines provide for higher and more consistentlevels of antigen production.

***HermesTM Gene Expression Technology***

Valentis has developed theHermesTM expression systems, which are proprietary plasmids. A plasmid is acircle of DNA that includes the gene for a therapeutic protein. Also includedin plasmids are elements that control the production of the message from thatgene. This message serves as the code or “blueprint” for the production of thetherapeutic protein by cells. Once plasmids are delivered into cells, theyoperate “episomally” which means they are not incorporated in the DNA of thecell.

Our plasmids have beenengineered to provide increased gene expression, which is the production of themessage for protein production, and allow cost efficient manufacturing. In ourplasmids, we incorporate high expression promoters into proprietary expressioncassettes. These proprietary cassettes contain novel untranslated regions withsynthetically designed introns. Our plasmids have been selected for increasedyield to allow cost efficient manufacturing. Included in our library ofplasmids are those with tissue specific promoters. Valentis is assessingstrategic opportunities relating to its HermesTM gene expression technology,which may include the sale or license of this asset.

***GeneSwitch® GeneRegulation Technology***

To control the level andduration of selected genes in transgenic animals and cell cultures, ourresearchers have developed the GeneSwitch® gene regulation system. Our GeneSwitch® permits therapeutic protein production that iscontrolled via an orally administered drug. Products incorporating ourGeneSwitch® technology are delivered with a polymerdelivery system along with electroporation. This results in controlled geneexpression and the production of therapeutic proteins from muscle tissue forprolonged periods. GeneSwitch® technology may accelerate the throughput ofgenomics research and assist in the identification and characterization of thefunction of selected genes due to its unique ability to control geneexpression. This gene expression regulatory system has been licensed to anumber of corporate partners who are successfully developing the technology ina variety of applications. Valentis is assessing strategic opportunitiesrelating to its GeneSwitch® gene regulation system technology, which mayinclude the sale or license of this asset.

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***OptiPEGTM PEGylation Technology***

Our OptiPEGTM family oftechnologies is based on polymer modification using polyethylene glycol, orPEG, a compound with a long and safe clinical history. We have developedbreakthrough methods to directly couple our proprietary OptiPEGTM with proteins,peptides, antibodies and antibody fragments, viruses and liposomes to retainhigh levels of biological activity of the material and potentially protect thebiopharmaceutical from inactivation by the immune system. OptiPEGTM technologiesprovide the potential to deliver products with improved safety, efficacy anddosing regimens. OptiPEGTM is being developed through licensing to corporatepartners. Valentis is assessing strategic opportunities relating to itsOptiPEGTM technology, which may include the sale or license of this asset.

***Plasmid BackboneTechnology***

Valentis’ plasmid backbonetechnology is a robust manufacturing and expression system that allows for costeffective production of gene expression products. Valentis is assessing strategicopportunities relating to its plasmid backbone technology, which may includethe sale or license of this asset.

***Current GoodManufacturing Practices Manufacturing (cGMP Manufacturing)***

We have developedproprietary scalable processes to manufacture plasmid DNA formulated products.Through a strategy of using contract manufacturing organizations, or CMOs, forplasmid DNA production, we have the technology to produce products from lab tocommercial scale using the same process. Valentis is assessing strategicopportunities relating to its plasmid manufacturing technology, which mayinclude the sale or license of this asset.

**CORPORATE COLLABORATIONS**

Valentis maintains certaincollaborations with pharmaceutical and biotechnology companies. In enteringinto its remaining corporate collaborations, Valentis sought license fees,funding for research and development, milestone payments and royalties onproduct sales in exchange for worldwide commercial licenses to specifictherapeutics and access to Valentis development expertise. Valentis has noplans for further development of any of its potential products and technologiesand its sole current focus is on assessing its strategic opportunities. As aresult, Valentis’ collaborators may exercise contractual their rights toterminate their collaboration arrangements with Valentis.  Valentis expects that each of its corporatecollaborations below will be terminated according to the terms of therespective contracts underlying such collaborations moving forward.

***Cangene Corporation(“Cangene”)***

Since June 2001,Valentis has utilized Cangene Corporation, an established contractmanufacturing organization (CMO), for the manufacture of its DeltavascTMproduct. Also, since October 1999, Valentis has utilized Cangene for finaldrug product formulation and filling for DeltavascTM and other products.Valentis has developed proprietary scalable processes to manufacture plasmidDNA formulated products. Through a strategy of using a contract manufacturingorganization for plasmid DNA production of our products, we are able to producedrug material from lab to commercial scale using the same process.

***DSM Biologics (“DSM”)***

In June 2003,Valentis announced that it completed an agreement with DSM Biologics underwhich the license granted by Valentis to DSM Biologics for Valentis’ plasmidDNA manufacturing technology was affirmed on revised financial terms. Theagreement further resolved outstanding disputes between Valentis and DSMBiologics regarding prior plasmid DNA manufacturing services performed byDSM Biologics for Valentis.

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Under this agreement, thepAllianceTM plasmid DNA contract manufacturing alliance that had included Valentis,DSM Biologics and Qiagen GmbH was dissolved. The new agreement reinstated thelicense to DSM Biologics under the terms of the original agreement betweenValentis and DSM Biologics, modified to add a royalty to Valentis (in additionto the previously-agreed profit-sharing arrangement).

**TECHNOLOGY LICENSES**

Valentis has technologylicense agreements and is actively seeking additional licensing agreements withpharmaceutical and biotechnology companies. Valentis has no plans for furtherdevelopment of any of its potential products and technologies and is assessingits strategic opportunities, which include the sale or merger of the business,the sale or license of certain assets or other actions. Valentis does notexpect that any of its technology licenses will be terminated by its corporatepartners in the near term.

***Biolitec A.G. (“Biolitec”)***

In June 2005,Valentis granted Biolitec an exclusive worldwide license to Valentis’ PEGylatedliposome technology to develop a PEGylated formulation of Foscan temoporfin totreat cancer, rheumatoid arthritis and atherosclerotic plaque. Valentis wouldreceive an upfront payment and is eligible for milestones and royalties.Foscan, a photosensitizing drug used with photodynamic therapy, is marketed inEurope to treat head and neck cancer.

***Genzyme Corporation(“Genzyme”)***

In January 2002,Valentis entered into a non-exclusive cross-license agreement withGenzyme Corporation in which Genzyme receives non-exclusive rights to Valentis’GeneSwitch® gene regulation technology for research use, and Valentis receivescertain rights to Genzyme’s plasmid DNA manufacturing technology.

In September 2004,Valentis expanded its existing license agreement with Genzyme Corp. by grantingGenzyme increased use of Valentis’ GeneSwitch® generegulation technology. In return, Valentis received certain rights to Genzyme’sstatic mixer technologies that are useful in plasmid DNA manufacturing.

Valentis’ GeneSwitch® system allows researchers to control the leveland duration of expression of selected genes by oral administration of a smallmolecule drug. Genzyme plans to use the GeneSwitch® technology for its internalproduct research. Genzyme’s manufacturing technology allows Valentis to improvethe yield of large-scale produced plasmid DNA. The technology is usefulfor Valentis’ internal manufacturing requirements and potentially forcommercial manufacturing.

***IDM Pharma, Inc.(“IDM”)***

In December 2000, IDMlicensed Valentis’ proprietary PINCTM gene delivery technology for IDM’spreventive and therapeutic DNA vaccines that are in development for thetreatment of human immunodeficiency virus (HIV) and the hepatitis C virus (HCV)in exchange for up-front, milestone and royalty payments.

In October 2002, IDMsigned a non-exclusive license for Valentis’ proprietary DNA vaccine deliverytechnology for use in developing treatments for cancer. Under the terms of theagreement, IDM has rights to use Valentis’ proprietary PINCTM polymer DNAdelivery technology for use in up to four preventive and therapeutic DNA cancervaccine products. In return, Valentis received an upfront license fee and willbe eligible to receive product development milestones and royalties on futureproduct sales. IDM and its collaborators will fund product development.

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***Innogenetics N.V. (“Innogenetics”)***

In June 2002,Valentis’ provided Innogenetics N.V. with an option to a license for the use ofour proprietary DNAVaxTM gene delivery technology for Innogenetics’ preventiveand therapeutic DNA vaccines in development for the treatment ofhepatitis B virus (HBV) and the human papilloma virus (HPV) in exchangefor up-front, milestone and royalty payments.

Innogenetics’ geneticvaccines contain DNA sequences from HBV or HPV, which code for proteinfragments (epitopes) that stimulate cytotoxic and helper T cell responses.These immune responses are important defenses against infection.

In March 2004,Genencor International, Inc. agreed to sell its therapeutic vaccineprogram to Innogenetics N.V., which may enhance Innogenetics’ capabilitiesin its preventive and therapeutic DNA development program.

***InvitrogenCorporation (“Invitrogen”)***

In November 1999,Valentis and Invitrogen Corporation announced the commercial launch of Valentis’proprietary GeneSwitch® gene regulation system to the life sciencesresearch market. The GeneSwitch® gene regulation system is a technology thatallows researchers to control the level and duration of expression of selectedgenes by oral administration of a small molecule drug. Valentis recordedminimal royalties from the license agreement with Invitrogen.

***JuvarisBioTherapeutics (“Juvaris”)***

In June 2004,Valentis and Juvaris BioTherapeutics entered into a broad, exclusive licensingagreement in which Juvaris will use Valentis’ proprietary plasmid backbone andcationic lipid delivery technologies for the development and commercializationof therapeutic vaccine products. Juvaris is responsible for the development,manufacturing and commercialization of products and bears all related programexpenses.

***Pharmexa***

In December 2000,Pharmexa (formerly Epimmune) licensed Valentis’ proprietary PINCÔgene delivery technology for Pharmexa’s preventive and therapeutic DNA vaccinesthat are in development against the human immunodeficiency virus (HIV) and thehepatitis C virus (HCV) in exchange for up-front, milestone and royaltypayments.

In October 2002,Pharmexa signed a non-exclusive license for Valentis’ proprietary DNA vaccinedelivery technology for use in developing treatments for cancer. Under theterms of the agreement, Epimmune has rights to use Valentis’ proprietary PINCÔpolymer DNA delivery technology for use in up to four preventive andtherapeutic DNA cancer vaccine products. In return, Valentis received anupfront license fee and will be eligible to receive product developmentmilestones and royalties on future product sales. Pharmexa and itscollaborators will fund product development.

***Valentis’ GeneSwitch®Gene Regulation System***

Valentis has licensed itsproprietary GeneSwitch® gene regulation technology to GenzymeCorporation, LARNAX GmbH, Organon Laboratories Ltd, Senomyx, Inc.,Schering AG and Wyeth-Ayerst Laboratories. All licenses are non-exclusivelicenses for research purposes only, and Valentis maintains all rights toclinical gene therapy applications of the GeneSwitch® technology.

Also, in December 2002and August 2004, Valentis licensed to Schering AG its proprietaryGeneSwitch® gene regulation and PINCTM polymer basedsynthetic gene delivery technologies. Under the 

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agreementSchering AG obtained exclusive, world-wide rights to develop and commercializetwo gene-based therapeutic products.

***Inovio BiomedicalCorporation (formerly Genetronics Biomedical Corp. (“Inovio”)***

In November 2001,Valentis obtained a non-exclusive license to in vivo electroporation technologyfrom Inovio for use in the development of certain products. Electroporationseeks to enhance the ability of cells to take up large molecules such as DNA.When combined with Valentis’ GeneSwitch® gene regulation system, electroporation mayallow researchers to control the level and duration of gene expression for upto several months.

**ACADEMIC LICENSES**

Valentis activelymonitored, investigated and licensed technologies under development at academicand other research institutions. We believe that such institutions are animportant source of breakthrough technologies. Valentis does not expect thatany of its academic licenses will be terminated by its academic partners in thenear term.

***Baylor College ofMedicine (“Baylor”)***

Valentis has three licenseagreements with Baylor pursuant to which Valentis has exclusive and non-exclusiverights to certain current and future gene therapy technologies related to geneexpression, gene delivery and gene regulation, including the GeneSwitch® gene regulation system, and gene delivery tofluid spaces including the vitreous of the eye and the synovium of the joint.Baylor and Valentis co-developed certain synthetic promoters useful inmuscle specific expression. We are required to pay Baylor a royalty based onamounts received by Valentis for the commercialization of the patentedtechnology. Baylor has the ability to terminate the license for a materialviolation or material failure to perform any covenant under the license.

***VanderbiltUniversity (“Vanderbilt”)***

Valentis has an exclusivelicense from Vanderbilt covering Vanderbilt’s interest in the DEL-1 gene,protein, and antibodies thereto. Valentis acquired the Vanderbilt License inconjunction with the purchase in April 1999 by Valentis of DEL-1rights held by Progenitor Inc. Rights to patents covering the DEL-1 geneand protein are co-owned by Valentis and Vanderbilt. Under the terms of thislicense, Valentis is obligated to make payments upon the achievement of certainmilestones, to share revenue received from sublicensing at a specified rate,and to make royalty payments on sales of products, if any. Vanderbilt mayterminate the license if we fail to satisfy certain requirements for diligentdevelopment of licensed products. In addition, Vanderbilt may terminate thelicense upon 60 days notice for a material violation or material failureto perform any covenant under the license.

**PATENTS AND PROPRIETARY TECHNOLOGIES**

Patents and otherproprietary rights are important to Valentis’ business. Valentis’ policy is tofile patent applications and protect inventions and improvements to inventionsthat are commercially important to the development of its business. Valentis alsorelies on trade secrets, know-how, confidentiality agreements, continuingtechnology innovations and licensing opportunities to protect its technologyand develop and maintain its competitive position. To date, Valentis has filed,or participated as a licensee in the filing of, numerous patent applications inthe United States relating to our technology, as well as counterparts ofcertain of these applications in many foreign countries. Our failure to obtainpatent protection or otherwise protect our proprietary technology or proposedproducts may have a material adverse effect on Valentis’ competitive positionand business prospects. The patent application process takes several years andentails considerable expense. There is no assurance that additional patents 

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willissue from these applications or, if patents do issue, that the claims allowedwill be sufficient to protect our technology.

Valentis has numerouspatents and patent applications worldwide covering its poloxamer therapy, geneexpression and delivery technology, and PEGylation technology, as well as usepatents for various therapeutic applications, and patents and patentapplications on its manufacturing technologies. In addition to patents andpatent applications filed and owned by Valentis, we have exclusive rights underour licenses with Baylor College of Medicine including rights to certain geneexpression, gene delivery and gene regulation, the GeneSwitch® gene regulation system, and gene delivery, andVanderbilt University to patents and patent applications worldwide includingthe DEL-1 gene, protein and antibody. Valentis has an exclusive licensefrom Roche Biosciences for rights under certain U.S. and foreign patentsclaiming the use of the cationic lipid, DOTMA, for *in vivo* gene delivery. Valentis is also licensedexclusively by Roche Biosciences under a single related U.S. patent claimingthe use of cationic lipids for *in vivo*gene delivery without limitations to DOTMA.

A number of thebiopharmaceuticals that Valentis and/or its corporate partners areinvestigating, or may use in its products are, or, may become patented byothers. As a result, Valentis or its corporate partners may be required toobtain licenses to gene sequences, proteins, or other technology to which itcurrently has no proprietary rights in order to use or market such potentialproducts. In addition, some of the potential products based on our deliverysystems may require the use of multiple proprietary technologies. Consequently,Valentis or its corporate partners may be required to make cumulative royaltypayments to several third parties. Such cumulative royalties could reduceamounts paid to Valentis or be commercially prohibitive. In connection with ourefforts to obtain rights to gene sequences, proteins, or other proprietarytechnology, Valentis may find it necessary to convey rights to its technologyto others. There can be no assurance that Valentis or its corporate partnerswill be able to obtain any required licenses on commercially reasonable termsor at all. If required licenses are not available to Valentis, it may not beable to develop or market certain potential products and technologies.

The patent positions ofpharmaceutical and biotechnology firms are often uncertain and involve complexlegal and factual questions. Furthermore, the breadth of claims allowed inbiotechnology patents is unpredictable. Valentis cannot be certain that othershave not filed patent applications for technology covered by our pendingapplications or that we were the first to invent the technology that is thesubject of such patent applications. Competitors may have filed applicationsfor, or may have received patents and may obtain additional patents andproprietary rights relating to compounds, products or processes that block orcompete with those of Valentis. Valentis is aware of patent applications filedand patents issued to third parties relating to genes, gene deliverytechnologies and gene therapeutics, and there can be no assurance that anypatent applications or patents will not have a material adverse effect onpotential products Valentis or its corporate partners are developing or mayseek to develop in the future.

Patent litigation is widespread in the biotechnologyindustry. Litigation may be necessary to defend against or assert claims ofinfringement, to enforce patents issued to Valentis, to protect trade secretsor know-how owned or licensed by Valentis, or to determine the scope andvalidity of the proprietary rights of third parties. Although no third party hasasserted that Valentis is infringing such third party’s patent rights or otherintellectual property, there can be no assurance that litigation asserting suchclaims will not be initiated, that Valentis would prevail in any suchlitigation or that Valentis would be able to obtain any necessary licenses onreasonable terms, if at all. Any such claims against Valentis, with or withoutmerit, as well as claims initiated by Valentis against third parties, can betime-consuming and expensive to defend or prosecute and to resolve. If othercompanies prepare and file patent applications in the United States that claimtechnology also claimed by Valentis, we may have to participate in interferenceproceedings to determine priority of invention which could result insubstantial cost to Valentis even if the outcome is favorable to us.

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There can be no assurancethat third parties will not independently develop equivalent proprietaryinformation or techniques, will not gain access to Valentis’ trade secrets ordisclose such technology to the public or that we can maintain and protect unpatentedproprietary technology. Valentis typically requires its employees, consultants,collaborators, advisors and corporate partners to execute confidentialityagreements upon commencement of employment or other relationships withValentis. There can be no assurance, however, that these agreements willprovide meaningful protection or adequate remedies for Valentis technology inthe event of unauthorized use or disclosure of such information, that theparties to such agreements will not breach such agreements or that Valentis’trade secrets will not otherwise become known or be discovered independently byits competitors.

**GOVERNMENTREGULATION**

While Valentis is no longer developing any of itsremaining potential products or technologies, the production and marketing ofany of Valentis’ potential products will be subject to extensive regulation forsafety, efficacy and quality by numerous governmental authorities in the UnitedStates and other countries. In the United States, pharmaceutical products aresubject to rigorous regulation by the United States Food and DrugAdministration (FDA). We believe that the FDA and comparable foreign regulatorybodies will regulate the commercial uses of our potential products asbiologics. Biologics are regulated under certain provisions of the PublicHealth Service Act and the Federal Food, Drug, and Cosmetic Act. These laws andthe 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 forBiologics Evaluation and Research is responsible for the regulation ofbiological products and has handled the FDA’s regulation of most genetherapeutics to date. Gene therapy, however, is a relatively new technology,and it is uncertain whether any unique regulatory requirements may be imposedupon gene therapeutics. We are not aware of any gene therapeutics that havereceived marketing approval from the FDA or any comparable foreign authorities.

The necessary steps to take before a new drug may bemarketed in the United States include the following: (i) laboratory testsand animal studies; (ii) the submission to the FDA of an InvestigationalNew Drug (IND) application for clinical testing, which must become effectivebefore clinical trials commence; (iii) under certain circumstances,approval by a special advisory committee convened to review clinical trialprotocols involving gene therapeutics; (iv) adequate and well-controlledclinical trials to establish the safety and efficacy of the product; (v) thesubmission to the FDA of a New Drug Application (NDA); and (vi) FDAapproval of the NDA prior to any commercial sale or shipment of the biologic.

Facilities used for the manufacture of biologics aresubject to periodic inspection by the FDA and other authorities, whereapplicable, and must comply with the FDA’s Good Manufacturing Practice (GMP)regulations. Manufacturers of biologics also must comply with the FDA’s generalbiological product standards and may also be subject to state regulation.Failure to comply with GMP or other applicable regulatory requirements mayresult in withdrawal of marketing approval, criminal prosecution, civilpenalties, recall or seizure of products, warning letters, total or partialsuspension of production, suspension of clinical trials, FDA refusal to reviewpending marketing approval applications or supplements to approvedapplications, or injunctions, as well as other legal or regulatory actionagainst Valentis or its corporate partners.

Clinical trials are conducted in three sequentialphases, but the phases may overlap. In Phase I (the initial introductionof the product into human subjects or patients), the drug is tested to assesssafety, metabolism, pharmacokinetics and pharmacological actions associatedwith increasing doses. Phase II usually involves studies in a limitedpatient population to (i) determine the efficacy of the potential productfor specific, targeted indications, (ii) determine dosage tolerance andoptimal dosage, and (iii) further identify possible adverse effects andsafety risks. If a compound is found to be effective and to have an acceptablesafety profile in Phase II evaluations, Phase III trials areundertaken to further evaluate 

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clinical efficacy and testfor safety within a broader patient population at geographically dispersedclinical sites. There can be no assurance that Phase I, Phase II orPhase III testing will be completed successfully within any specific timeperiod, if at all, with respect to any of Valentis’ or its corporate partners’potential products subject to such testing. In addition, after marketingapproval is granted, the FDA may require post-marketing clinical studiesthat typically entail extensive patient monitoring and may result in restrictedmarketing of the product for an extended period of time.

The results of product development, preclinical animalstudies, and human studies are submitted to the FDA as part of the NDA. The NDAmust also contain extensive manufacturing information, and each manufacturingfacility must be inspected and approved by the FDA before the NDA will beapproved. Similar regulatory approval requirements exist for the marketing ofthese products outside the United States (e.g., Europe and Japan). The testingand approval process is likely to require substantial time, effort andfinancial and human resources, and there can be no assurance that any approvalwill be granted on a timely basis, if at all, or that any potential productdeveloped by Valentis and/or its corporate partners will prove safe andeffective in clinical trials or will meet all the applicable regulatoryrequirements necessary to receive marketing approval from the FDA or thecomparable regulatory body of other countries. Data obtained from preclinicalstudies and clinical trials are subject to interpretations that could delay,limit or prevent regulatory approval. The FDA may deny the NDA if applicableregulatory criteria are not satisfied, require additional testing orinformation, or require post-marketing testing and surveillance to monitor thesafety or efficacy of a product. Moreover, if regulatory approval of abiological product candidate is granted, such approval may entail limitationson the indicated uses for which it may be marketed. Finally, product approvalsmay be withdrawn if compliance with regulatory standards is not maintained orif problems occur following initial marketing. Among the conditions for NDAapproval is the requirement that the prospective manufacturer’s quality controland manufacturing procedures conform to the appropriate GMP regulations, whichmust be followed at all times. In complying with standards set forth in theseregulations, manufacturers must continue to expend time, financial resourcesand effort in the area of production and quality control to ensure fullcompliance.

For clinical investigation and marketing outside theUnited States, Valentis and our corporate partners may be subject to FDA aswell as regulatory requirements of other countries. The FDA regulates theexport of biological products, whether for clinical investigation or commercialsale. In Europe, the approval process for the commencement of clinical trialsvaries from country to country. The regulatory approval process in othercountries includes requirements similar to those associated with FDA approvalset forth above. Approval by the FDA does not ensure approval by the regulatoryauthorities of other countries.

Valentis’ previousresearch and development activities involved the controlled use of hazardousmaterials, chemicals and radioactive materials and produce waste products.Valentis remains subject to federal, state and local laws and regulationsgoverning the use, manufacture, storage, handling and disposal of suchmaterials and waste products. Although we believe that our safety proceduresfor handling and disposing of such materials complied and continue to complywith the standards prescribed by such laws and regulations, the risk of accidentalcontamination or injury from these materials cannot be eliminated completely.In the event of such an accident, Valentis could be held liable for any damagesthat result, and any such liability could exceed our resources. Although webelieve that we are in compliance in all material respects with applicableenvironmental laws and regulations, there can be no assurance that we will notbe required to incur significant costs to comply with environmental laws andregulations in the future or that any of the operations, business or assets ofValentis will not be materially adversely affected by current or futureenvironmental laws or regulations.

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**COMPETITION**

As a result of Valentis’ July 2006 announcementof negative results in its Phase IIb clinical trial of VLTS 934 inPAD and its sole current focus on assessing strategic opportunities, includingthe sale or merger of the business and the sale of certain assets, competitiveconsiderations are less keen at this time. However, overall the pharmaceuticaland biotechnology industries are highly competitive and strong competition, orthe perception of strong competition, may dilute the value of our remainingpotential products and technologies. Several pharmaceutical and biotechnologycompanies that are pursuing peripheral arterial disease therapeutics. Forexample, AnGes MG, Centelion/Gencell SAS, NicOx, Sigma Tau, Inc., NissanChemical, Mitsubishi Pharmaceuticals, Kos Pharmaceuticals, Endovasc, SangamoBioSciences, Inc. and Otsuka Pharmaceutical Co., Ltd. have engaged or areengaged in developing biotechnology or pharmaceutical therapies that competewith or could compete with our potential products and technologies. Suchcompetitors may develop safer, more effective or less costly cardiovascular orgene-based therapeutics. Moreover, Valentis faces competition from suchcompanies, as well as the competitors described above, in establishingcorporate collaborations with pharmaceutical and biotechnology companies,relationships with academic and research institutions and in negotiatinglicenses to proprietary technology, including intellectual property.

Many competitors andpotential competitors have substantially greater product developmentcapabilities and financial, scientific, manufacturing, managerial and human resourcesthan Valentis. There is no assurance that research and development by suchcompetitors would not render Valentis’ potential products and technologies, orthe potential products and technologies developed by its corporate partners,obsolete or non-competitive, or that any potential product and technologiesValentis or its corporate partners develop would be preferred to any existingor newly developed products and technologies. In addition, there is noassurance that competitors will not develop safer, more effective or lesscostly cardiovascular therapies, gene delivery systems, gene therapeutics,non-gene therapies, or other therapies, achieve superior patent protection orobtain regulatory approval or product commercialization earlier than Valentisor its corporate partners, any of which could have a material adverse effect onthe business, financial condition or results of operations of Valentis.

**PRODUCT LIABILITYINSURANCE**

The manufacture and saleof human therapeutic products involve an inherent risk of product liabilityclaims and associated adverse publicity. Valentis currently has only limitedproduct liability insurance, and there can be no assurance that we will be ableto maintain existing or obtain additional product liability insurance onacceptable terms or with adequate coverage against potential liabilities. Suchinsurance is expensive, difficult to obtain and may not be available in thefuture on acceptable terms, or at all. An inability to obtain sufficientinsurance coverage on reasonable terms or to otherwise protect againstpotential product liability claims could inhibit Valentis’ business. A productliability claim brought against Valentis in excess of its insurance coverage,if any, could have a material adverse effect upon its business, financialcondition and results of operations.

**EMPLOYEES**

As of September 20, 2006, Valentis employedeight individuals full-time, including two who hold doctoral degrees. Currentemployees are engaged in finance and administrative activities, includingassessing strategic opportunities that may be available to Valentis, includingthe sale or merger of the business and the sale of certain assets or otheractions. Valentis expects to further reduce its current workforce byapproximately 66% by the end of October 2006. Valentis employees are notrepresented by a collective bargaining agreement. We believe our relationshipswith our remaining employees are good.

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**ITEM1A. RISK FACTORS**

The following risk factorsoutline certain risks and uncertainties concerning future results and should beread in conjunction with the information contained in this Annual Report on Form 10-K.Any of these risk factors could materially and adversely affect our business,operating results and financial condition. Additional risks and uncertaintiesnot presently known to us, or those we currently deem immaterial, may alsomaterially harm our business, operating results and financial condition.

***Our business todate has been largely dependent on the success of VLTS 934. In July 2006,we announced that our Phase IIb clinical trial of VLTS 934 failed tomeet any of its primary or secondary endpoints and that we had no further plansfor the development of VLTS 934. We have undertaken restructuringactivities since our announcement, but we may be unable to successfully manageour remaining resources, including available cash, which would adversely affectour business and may require us to seek bankruptcy protection.***

In July 2006, weannounced that our Phase IIb clinical trial for VLTS 934 in patientswith peripheral arterial disease failed to meet its primary or any of itssecondary endpoints. We have no plans for further development of VLTS 934and we have terminated our Phase IIb clinical trial. We had previouslydevoted substantially all of our research, development and clinical efforts andfinancial resources toward the development VLTS 934.

Following our announcementregarding the results of our clinical trial for VLTS 934, we announcedrestructuring activities, including a workforce reduction of approximately 55%of our employees on August 18, 2006. Further reductions of approximately66% of our remaining workforce are anticipated by the end of October 2006.The total costs associated with the reduction in workforce on August 18, 2006and anticipated further reductions are estimated to be between $525,000 and$1.4 million, primarily related to severance benefits, which will berecorded in the fiscal first quarter of 2007, and paid in the fiscal first andsecond quarters of 2007. As a result of the July 2006 announcementregarding negative results in our Phase IIb clinical trial ofVLTS 934, Valentis is currently assessing its strategic opportunitiesincluding the sale or merger of the business, the sale or license of certainassets and the resolution of property leases. We are exploring alternatives toterminate our current facilities lease and divest related equipment and tenantimprovements. We are also exploring strategic opportunities that may beavailable to us, including the sale or merger of our business, the sale ofcertain of our assets or other options. Despite these efforts, we may be unableto adequately reduce expenses associated with our existing agreements andcommitments, including agreements related to our facilities, VLTS 934, ourother potential products and technologies or otherwise related to our business.If we fail to reduce our current expenses or generate additional cash resourcesthrough sales of our assets or otherwise, we will be unsuccessful in managingour remaining resources, which would adversely affect our business and reducethe value of an investment in, and trading price of, our common stock and mayrequire us to seek bankruptcy protection.

***We have received a “goingconcern” opinion from our independent registered public accounting firm, whichmay negatively impact our business.***

We have received a reportfrom Ernst & Young LLP, our independent registered public accountingfirm, regarding our consolidated financial statements for the fiscal year endedJune 30, 2006, which included an explanatory paragraph stating thatthe financial statements were prepared assuming we will continue as a goingconcern. The report also stated that our recurring operating losses and needfor additional financing have raised substantial doubt about our ability tocontinue as a going concern. Given our July 2006 announcement that ourPhase IIb clinical trial for VLTS 934 in patients with peripheralarterial disease failed to meet its primary or any of its secondary endpoints,we are focusing our business efforts on pursuing strategic opportunities that maybe open to us, including the sale or merger of our business, the sale ofcertain of our assets or other actions. If we fail to show progress toward asuitable strategic alternative, we will be unable to dispel any continuingdoubts about our ability to continue as a 

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goingconcern, which would adversely affect our ability to consummate any suchstrategic alternative, enter into collaborative relationships with businesspartners, raise additional capital or further develop our remaining potentialproducts and technologies, which would have a material adverse effect on ourbusiness, financial condition and results of operations.

***We may engage instrategic alternatives, which could materially adversely affect our business. Ifwe are unsuccessful in consummating a suitable strategic alternative, we may berequired to seek bankruptcy protection.***

Following our July 2006announcement regarding the negative results of our clinical trial forVLTS 934, we are actively considering strategic alternatives that may beavailable to us with the goal of maximizing stockholder value. These strategicalternatives may include a variety of different business arrangements, such asthe sale of certain of our assets, business combinations, strategicpartnerships, joint ventures, restructurings, divestitures, investments andother alternatives. Our strategic measures implemented to date and anystrategic opportunity we may pursue could disappoint investors and furtherdepress the price of our common stock and the value of an investment in our commonstock. Any strategic alternative we pursue may require us to incurnon-recurring or other charges and may pose significant integration challengesand/or management and business disruptions, any of which could materially andadversely affect our business and financial results. Moreover, given ourfinancial condition and recent and anticipated workforce reductions, we may notbe able to successfully implement any strategic alternative we pursue, and evenif we determine to pursue one or more of the strategic alternatives describedabove, we may be unable to do so on acceptable financial terms and suchalternatives may not enhance stockholder value or improve the trading price ofour common stock. Although pursuing a strategic opportunity is subject to therisks outlined herein, if we are unsuccessful in consummating a suitablestrategic alternative, our business would be materially adversely affected andwe may be required to seek bankruptcy protection.

***Our remainingpotential products and technologies are in early stages of development. We haveno current plans to continue the development of any of these potential productsor technologies and any efforts to develop and commercialize these potentialproducts or technologies would be subject to a high risk of failure. Inaddition, we do not have sufficient resources to pursue the development of anyof these potential products or technologies.***

The process ofsuccessfully developing potential products or technologies is verytime-consuming, expensive and unpredictable, there is a high rate of attritionfor product candidates in preclinical and clinical trials and it may bedifficult or impossible for us to develop, commercialize or license any novelor existing technologies. Until our recent July 2006 announcementregarding VLTS 934, our business strategy depended upon the successfulclinical development of VLTS 934 and the subsequent development ofadditional potential products and technologies in our pipeline. Shortly following thisannouncement, we announced a workforce reduction of 55% of our employees, which includedthe elimination of scientific staff and advisors necessary to further developour potential product candidates and technologies. We anticipate a furtherworkforce reduction of approximately 66% of our employees by the end of October 2006.Consequently, we have no current plans to pursue the development of anyof our remaining potential products and, in any event, such potential productsand technologies currently are in research, preclinical development or theearly stages of clinical testing, and commercialization of those potentialproducts will not occur for at least the next several years, if at all. Thedevelopment of new drugs is a highly risky undertaking and there can be noassurance that any future research and development efforts we might undertakewill be successful. In September 2004, we reported that our DeltavascTMproduct did not meet its primary endpoint in its Phase IIa clinical trialin patients with the intermittent claudication form of peripheral arterialdisease. In July 2006, we reported that our VLTS 934 product did notmeet its primary or any of its secondary endpoints in its Phase IIbclinical trial in patients with peripheral arterial disease. All of ourremaining potential products and technologies will require extensive additionalresearch and 

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developmentprior to any commercial introduction. There can be no assurance that any futureresearch and development and clinical trial efforts will result in viableproducts or technologies.

Our remaining potentialproducts and technologies include DEL-1, DeltavascTM, DEL-1antibody, certain technologies for gene-based synthetic delivery systems,including PINC polymers, CLIC lipids and DNA Vax, Hermes gene expressiontechnology, GeneSwitch regulation technology, OptiPEG PEGylation technology andplasmid backbone technology, all of which are described in more detail in “Business”in this Annual Report on Form 10-K. We are considering strategicopportunities that may be available to us with respect to our potentialproducts and technologies, given the substantial reduction in our research anddevelopment and clinical resources in connection with the termination of ourVLTS 934 development activities. We will be unable to successfully developthese potential products and technologies ourselves, and we also may be unableto enter into strategic collaborations with third parties to pursue thedevelopment of these potential products and technologies. Even if we are ableto identify potential strategic collaborators or licensees for these potentialproducts and technologies, we may be unable to negotiate relationships withthese parties on favorable terms, or at all. Moreover, any failure to obtain anadequate and timely amount of additional capital on commercially reasonableterms may limit our ability to carry out any further research anddevelopment activities or strategic opportunities we may opt to pursue withrespect to our remaining potential products and technologies, which would havea material adverse effect on our business and financial condition, includingour viability as an enterprise.

***We have a historyof losses and may never be profitable.***

We have engaged inresearch and development activities since our inception. We incurred lossesfrom operations of approximately $15.6 million, $11.3 million and$6.5 million, for our fiscal years ended June 30, 2006, 2005 and2004, respectively. As of June 30, 2006, we had an accumulateddeficit totaling approximately $240.0 million. In addition, following our July 2006announcement regarding the negative results of our clinical trial for VLTS 934,we announced restructuring activities, including a workforce reduction ofapproximately 55% of our employees on August 18, 2006. Furtherworkforce reductions of approximately 66% are anticipated by the end of October 2006.The total costs associated with the reduction in workforce on August 18, 2006and anticipated further reductions are estimated to be between $525,000 and$1.4 million, primarily related to severance benefits, which will berecorded in the fiscal first quarter of 2007 and paid in the fiscal first andsecond quarters of 2007. We have no current plans to develop or commercializeany of our remaining potential products or technologies and, in any event, thedevelopment and commercialization of potential products and technologies willrequire completion of additional clinical trials and significant research anddevelopment activities. We expect to incur net losses for the foreseeable futureas we evaluate the strategic opportunities that may be available to us, whichmay include the sale or merger of our business, the sale of certain assets orother actions. Our ability to achieve profitability depends on the outcome ofour efforts with respect to these strategic alternatives and the other riskfactors set forth in this Annual Report on Form 10-K. Because of thenumerous risks and uncertainties associated with our restructuring andstrategic activities and our product development efforts, we are unable topredict the extent of any future losses or when we will become profitable, ifat all. Even if we do achieve profitability, we may not be able to sustainor increase profitability on a quarterly or annual basis.

***We announced a significant reduction in our workforcein August 2006 and we anticipate further substantial reductions in ourworkforce will occur. As a result of our financial condition and actual andanticipated workforce reductions, we may not be successful in retaining keyemployees or in attracting additional qualified personnel, which couldadversely affect our efforts to effectively manage our remaining resources andexplore or consummate any strategic opportunities that may be available to us.***

In July 2006, we announced that ourPhase IIb clinical trial for VLTS 934 in patients with peripheralarterial disease failed to meet its primary or any of its secondary endpoints.Shortly thereafter, in 

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August 2006, weannounced that our Board of Directors had approved a plan to reduce our staffby eliminating approximately 55% of our employees on August 18, 2006.Further workforce reductions of approximately 66% are anticipated by the end ofOctober 2006. The total costs associated with the reduction in workforceon August 18, 2006 and anticipated further reductions are estimatedto be between $525,000 and $1.4 million, primarily related to severancebenefits, which will be recorded in the fiscal first quarter of 2007, and paidin the fiscal first and second quarters of 2007.

We anticipate that severalmembers of our principal management may not remain with us over the long term.Moreover, given our current financial condition, we expect that it will bedifficult to attract and retain the services of any additional personnel we mayneed to operate our business or consummate any strategic opportunity that maybe available to us. While a further reduced workforce will assist us inconserving our remaining resources, the loss of the services of any principalmember of our management could significantly delay or prevent the achievementof any strategic alternatives that may be available to us, which wouldadversely affect our future business prospects and the value of an investmentin our common stock.

***There are no assurances that we can maintain ourlisting on The Nasdaq Capital Market, and the failure to maintain this listingcould adversely affect the liquidity and price of our common stock.***

On January 31, 2003, our common stock begantrading on The Nasdaq Capital Market pursuant to an exception from delisting.In the event we fail to demonstrate compliance, as well as an ability tosustain compliance, with all requirements for continued listing on The NasdaqCapital Market, including Nasdaq’s corporate governance criteria, our securitieswill be delisted from The Nasdaq Capital Market.

In August 2006, we received a letter from theListing Qualifications Department of The Nasdaq Stock Market indicating that weare not in compliance with Nasdaq Marketplace Rule 4310(c)(4) (the “MinimumBid Price Rule”) because the closing bid price per share for our common stockhas been below $1.00 per share for 30 consecutive trading days. Inaccordance with Nasdaq Marketplace Rules, we will be provided 180 calendardays, or until February 20, 2007, to regain compliance with theMinimum Bid Price Rule. Should we fail to regain compliance with the MinimumBid Price Rule by February 20, 2007, Nasdaq will determinewhether we meet The Nasdaq Capital Market initial listing criteria set forth inMarketplace Rule 4310(c), except for the bid price requirement. If we meetthe initial listing criteria, Nasdaq will notify us that we have been grantedan additional 180 calendar day compliance period. If we are not eligiblefor an additional compliance period, Nasdaq will provide us with writtennotification that our common stock will be delisted.

If our securities aredelisted from The Nasdaq Capital Market, the trading of our common stock islikely to be conducted on the OTC Bulletin Board. The delisting of our commonstock from The Nasdaq Capital Market will result in decreased liquidity of ouroutstanding shares of common stock and a resulting inability of ourstockholders to sell our common stock or obtain accurate quotations as to theirmarket value, which would reduce the price at which our shares trade. Thedelisting of our common stock could also deter broker-dealers from making amarket in or otherwise generating interest in our common stock and wouldadversely affect our ability to attract investors in our common stock.Furthermore, our ability to raise additional capital would be severelyimpaired. As a result of these factors, the value of the common stock woulddecline significantly, and our stockholders could lose some or all of theirinvestment.

***Our stock price has been and may continue to bevolatile, and an investment in our common stock could suffer a decline invalue.***

The trading priceof our common stock has dropped significantly as a result of our recentannouncements regarding our product candidate VLTS 934 andmay continue to be highly volatile. Our common stock has traded below$1.00 per share since these announcements and closed at $.3802 on 

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September 26, 2006.We receive only limited attention by securities analysts andmay experience an imbalance between supply and demand for our common stockresulting from low trading volumes. The market price of our common stockmay fluctuate significantly in response to a variety of factors, most ofwhich are beyond our control, including the following:

·       announcementsregarding any strategic alternative we may choose to pursue or the lack of suchannouncement;

·       announcementsregarding future reductions in our remaining staff;

·       announcementsregarding our financial condition;

·       developmentsrelated to our collaboration agreements, license agreements, academic licensesand other material agreements;

·       changesin our eligibility for continued listing of our common stock on The NasdaqCapital Market;

·       ourability to attract and retain corporate partners;

·       developmentsrelated to our patents or other proprietary rights or those of our competitors;

·       announcementsby us or our competitors of new products or product candidates, technologicalinnovations, contracts, acquisitions, corporate partnerships or joint ventures;and

·       marketconditions for biopharmaceutical or biotechnology stocks in general.

The stock market has, fromtime to time, experienced extreme price and volume fluctuations, which haveparticularly affected the market prices for emerging biotechnology andbiopharmaceutical companies and which have often been unrelated to theiroperating performance. These broad market fluctuations may adverselyaffect the market price of our common stock. In addition, sales of substantialamounts of our common stock in the public market could lower the market priceof our common stock.

***We may engage in strategic alternatives, which couldresult in changes to our management and Board of Directors, which could resultin material changes to our business operations, strategies and focus movingforward.***

Following our July 2006announcement regarding the negative results of our clinical trial forVLTS 934, we are actively considering strategic alternatives that may beavailable to us with the goal of maximizing stockholder value. These strategicalternatives may include a variety of different business arrangements,including business combinations. If we pursue any business combinationopportunities available to us, any resulting entity may have a substantially,or completely, different management group and board of directors. There can beno guarantee that any such different management group and board of directorswould operate Valentis consistent with our past business operations, strategiesand focus. Moreover, even if we are able to pursue a business combination,there can be no assurance that any resulting entity and material changes in ourbusiness operations, strategies or focus would be successful, and suchtransactions could disappoint investors and further depress the price of ourcommon stock and the value of an investment in our common stock. Any strategicalternative we pursue may require us to incur non-recurring or other chargesand may pose significant integration challenges and/or management and businessdisruptions, any of which could materially and adversely affect our businessand financial results.

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***Certain of our collaboration, contract research,license and other agreements may be affected as a result of our currentbusiness focus on strategic alternatives. The parties to such agreements may beable to terminate such agreements if we are unable to perform our obligationsunder such agreements or if we pursue certain types of strategic alternatives,which could prevent or delay us from consummating certain strategicalternatives and reduce the value of our remaining potential products andtechnologies.***

Following our July 2006 announcement regardingnegative results in our Phase IIb clinical trial of VLTS 934 in parties withPAD, we have ceased all research and development activities on all of ourpotential products and technologies, including activities under ourcollaboration and contract research agreements and activities relating to ourclinical trials. Certain of our collaboration, contract research, license andother agreements may give our partners the right to terminate such agreementsif we fail to perform our obligations under such agreements. For example, weexpect that each of our corporate collaborations described under the caption “Item1. Business—Corporate Collaboration” will be terminated according to the termsof the respective agreement underlying such collaborations. Although we do notexpect that any of our technology licenses or academic licenses will beterminated in the near term, we cannot guarantee that our partners to suchagreements will not seek to terminate their agreements with us. The loss of anyof these agreements, or the rights we receive under such agreements, maymaterially adversely affect the aggregate value of our remaining potentialproducts and technologies and may prevent us from carrying our any strategicopportunity that may be available to us, which would materially adverselyaffect our business results of operations and financial condition.

Moreover, certain of ourcollaboration, contract research, license and other agreements are silent withrespect to, or contain prohibitions on, our ability to assign such agreementsin the event of certain business combinations and assets sales. Although wegenerally believe that we have the right to assign a substantial majority ofour agreements if we determine to pursue certain types of business combinations,we cannot assure you that our partners to such agreements would not seek toprevent or delay the assignment of such agreements, which might renderpotential strategic partners less willing to negotiate with us and decrease thevalue of our remaining potential products and technologies.

***Our stock price could be adversely affected bydispositions of our shares pursuant to registration statements currently ineffect.***

Some of our current stockholders hold a substantialnumber of shares, which they are currently able to sell in the public marketunder certain registration statements currently in effect, or otherwise. Salesof a substantial number of our shares or the perception that these salesmay occur, could cause the trading price of our common stock to fall andcould impair our ability to raise capital through the sale of additional equitysecurities.

As of June 30, 2006,we had issued and outstanding 17,087,737 shares of our common stock. Thisamount does not include, as of June 30, 2006:

·       approximately3.7 million shares of our common stock issuable upon the exercise of allof our outstanding options and the release of restricted stock awards; and

·       approximately4.7 million shares of our common stock issuable upon the exercise of allof our outstanding warrants.

These shares of commonstock, if and when issued, may be sold in the public market assuming theapplicable registration statements continue to remain effective and subject inany case to trading restrictions to which our insiders holding such sharesmay be subject from time to time. If these options or warrants areexercised and sold, our stockholders may experience additional dilutionand the market price of our common stock could fall.

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***We must be able to continue to secure additionalfinancing in order to continue our operations, which might not be available orwhich, if available, may be on terms that are not favorable to us.***

Our ability to pursue any strategic alternative thatmay be available to us or to engage in any future development and clinicaltesting of our potential products will require substantial additional financialresources. Our future funding requirements will depend on many factors,including:

Our ability topursue any strategic opportunity that may be available to us or to engage inany future development and clinical testing of our potential products willrequire substantial additional financial resources. Our future fundingrequirements will depend on many factors, including:

·       anystrategic alternative we may choose to pursue;

·       futurereductions in our remaining staff;

·       ourfinancial condition;

·       developmentsrelated to our collaboration agreements, license agreements, academic licensesand other material agreements;

·       changesin our eligibility for continued listing of our common stock on The NasdaqCapital Market;

·       progressand results of our clinical trials and preclinical studies;

·       timeand costs involved in obtaining FDA and other regulatory approvals;

·       scientificprogress in our research and development programs;

·       sizeand complexity of such programs;

·       ourability to establish and maintain corporate collaborations;

·       thetime and costs involved in filing, prosecuting and enforcing patent claims;

·       competingtechnological and market developments; and

·       thecost of manufacturing material for preclinical, clinical and commercialpurposes.

We may have insufficient working capital to fundour cash needs unless we are able to raise additional capital in the future. Wehave financed our operations to date primarily through the sale of equitysecurities and through corporate collaborations. We do not anticipategenerating revenues for the foreseeable future and may fund our operationsthrough additional third party financing or other means. If we raise additionalfunds by issuing equity securities, substantial dilution to existingstockholders may result. We may not be able to obtain additionalfinancing on acceptable terms, or at all. Any failure to obtain an adequate andtimely amount of additional capital on commercially reasonable terms will havea material adverse effect on our business and financial condition, includingour viability as an enterprise. As a result of these concerns, management isassessing, and may pursue, strategic alternatives, including the sale ormerger of the business, the sale of certain assets or other actions.

We may also takeactions to conserve our cash resources through further reductions in ourpersonnel or by relinquishing greater or all rights to our potential productsat an earlier stage of development or on less favorable terms than we otherwisewould. Any or all of these actions could have a material adverse affect on ourbusiness.

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***We may become involved in securities class actionlitigation that could divert management’s attention and harm our business.***

The market price ofdevelopment stage companies is typically volatile. When there is a sharp dropin the stock price of a development stage company, stockholder class actionsmay be filed against the company. Our stock price dropped substantiallyfollowing our July 2006 announcement regarding the negative results of ourclinical trial for VLTS 934 and has traded below $1.00 per share since ourannouncement. We do not anticipate that the price of our common stock willsignificantly increase in the short term. As a result, we may become involvedin securities litigation in the future. Litigation often is expensive anddiverts management’s attention and resources, which could adversely affect ourbusiness.

***Due to our financial condition, we may be unable toattract and retain corporate or academic partners to develop, introduce andmarket our remaining potential products and technologies.***

Our business strategy has been to attract businesspartners to fund or conduct research and development, clinical trials,manufacturing, marketing and sales of our potential products and technologies.We face intense competition from many other companies in the pharmaceutical andbiotechnology industries for corporate collaborations, as well as forestablishing relationships with academic and research institutions and forobtaining licenses to proprietary technology. Our financial condition willsubstantially reduce our ability to attract and retain current and potentialcorporate and academic partners, which will reduce our ability to develop,introduce and market our potential products and could adversely affect ourbusiness.

In addition, as a resultof our recent announcements concerning VLTS 934 and our recentrestructuring activities, our existing partners may not devote sufficientresources to the development, introduction and marketing of our remainingpotential products or technologies or may elect to cease pursuing furtherdevelopment and commercialization of potential products or technologies resultingfrom collaborations with us. If any of our corporate or academic partnerselects to terminate its relationship with us, the value of our remaining assetsmay be materially adversely affected. We may not be able to negotiatealternative corporate or academic partnership agreements on acceptable terms,or at all.

***Our potential products are subject to extensiveregulatory approval by the FDA and others, including with regard to completionof clinical trials, which is expensive, time consuming and uncertain. We cannotassure you that any of our remaining potential products or technologies will beapproved.***

We are subject to significant regulatory requirements,including the successful completion of clinical trials, prior to thecommercialization of our potential products. Under the Federal Food, Drug andCosmetic Act, the Public Health Services Act, and related regulations, the Foodand Drug Administration, or FDA, regulates the development, clinical testing,manufacture, labeling, sale, distribution and promotion of drugs and biologicsin the United States. Prior to market introduction in the United States, apotential drug or biological product must undergo rigorous clinical trials thatmeet the requirements of the FDA in order to demonstrate safety and efficacy inhumans. Depending upon the type, novelty and effects of the drug and the natureof the disease or disorder to be treated, the FDA approval process can takeseveral years, require extensive clinical testing and result in significantexpenditures.

Clinical trials and the FDA approval process are long,expensive and uncertain processes, which require substantial time, effort andfinancial and human resources. We have limited experience in conductingclinical trials, and we may encounter problems or fail to demonstrate theefficacy or safety that cause us, or the FDA, to delay, suspend or terminatethe development of any potential products. For example, in July 2006, weannounced that our Phase IIb clinical trial for VLTS 934 in patientswith peripheral arterial disease failed to meet its primary or any of itssecondary endpoints. We have no plans for further development of VLTS 934and we have terminated our Phase IIb clinical trial. We had 

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previously devotedsubstantially all of our research, development and clinical efforts andfinancial resources toward the development VLTS 934.

Although we have a pipeline of remaining potentialproducts and technologies, we have no current plans for the further commercialdevelopment of any of our potential products or technologies. Even were we ableto continue development of any of our potential products, clinical trials arelong, expensive and uncertain processes during which we may encounterdifficulties completing the trial. Problems we may encounter include theunavailability of preferred sites for conducting the trials, an insufficientnumber of eligible subjects, changes in the number of subjects based on theperformance of interim analyses, changes in protocol and other factors, whichmay delay the advancement of our clinical trials, lead to increased costsor result in the termination of the clinical trials altogether. Furthermore,the FDA may suspend clinical trials at any time if it believes thesubjects participating in the trials are being exposed to unacceptable healthrisks or if it finds deficiencies in the clinical trial process or the conductof the investigation.

We cannot assure you that clinical testing for any ofour remaining potential products will be completed within any specific timeperiod, if at all. There can be no assurance that any FDA approval will begranted on a timely basis, if at all, or that any of our potential productswill prove safe and effective in all required clinical trials or will meet allapplicable regulatory requirements necessary to receive marketing approval fromthe FDA. In addition, should any other future clinical trials for our potentialproducts fail to demonstrate a statistically significant therapeutic drugeffect and/or show that our potential products are safe for the targetedpatient population, our business and prospects could be harmed, the marketprice of our common stock could fall, our ability to generate revenues fromthose potential products could be adversely affected, delayed or preventedentirely, and we may not be able to obtain additional financing onacceptable terms, or at all.

Even if we successfullyobtain FDA approval for our potential products, we may not be able toobtain the regulatory approvals necessary to market our potential productsoutside the United States since the commercialization of our potential productsoutside the United States will be subject to separate regulations imposed byforeign government agencies. The approval procedures for marketing outside theUnited States vary among countries and can involve additional testing.Accordingly, we cannot predict with any certainty how long it will take or howmuch it will cost to obtain regulatory approvals for manufacturing andmarketing our potential products within and outside the United States orwhether we will be able to obtain those regulatory approvals at all. Ourfailure to successfully complete any necessary clinical trials, and obtain FDAand any applicable foreign government approvals, or any delays in receipt ofsuch approvals, could have a material effect on our business, results ofoperations and financial condition.

***We face strong competition in the markets we havetargeted from other companies with substantially greater experience, financialresources and name recognition than us, and competition from alternativetreatments in the biopharmaceuticals market. If our potential products andtechnologies do not remain competitive, their value may be materiallydiminished.***

The pharmaceutical and biotechnology industries arehighly competitive. We are aware of several pharmaceutical and biotechnologycompanies that are pursuing peripheral arterial disease therapeutics thatcompete with our remaining potential products and technologies. For example, weare aware that AnGes MG, Centelion/Gencell SAS, NicOx, Sigma Tau, Inc.,Nissan Chemical, Mitsubishi Pharmaceuticals, Kos Pharmaceuticals, Endovasc,Sangamo BioSciences, Inc. and Otsuka Pharmaceutical Co., Ltd. have engagedor are engaged in developing biotechnology or pharmaceutical therapies. Many ofthese companies are addressing diseases that have been targeted by us directlyor through our corporate partners, and many of them may have moreexperience in these areas and substantially greater financial, research,product development, manufacturing, marketing and technical resources than wehave. Some companies also have greater name recognition than us andlong-standing collaborative relationships. Our 

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competitive positiondepends on a number of factors, including safety, efficacy, reliability, marketingand sales efforts, and existence of competing products, and treatments andgeneral economic conditions. If our remaining potential products andtechnologies do not remain competitive in light of these factors, their valuemay be materially diminished, which would adversely affect our businessprospects.

Our competitors, academicand research institutions or others may develop safer, more effective orless costly cardiovascular therapies, biologic delivery systems, gene-basedtherapeutics or chemical-based therapies. In addition, competitorsmay achieve superior patent protection or obtain regulatory approval orproduct commercialization earlier than we do. Any such developments couldseriously harm our business, financial condition and results of operations.

***Adverse events in the field of cardiovasculartherapies may negatively impact regulatory approval or public perceptionof our potential products and technologies.***

The FDA may becomemore restrictive regarding the conduct of clinical trials includingcardiovascular therapies. This approach by the FDA could lead to delays in thetimelines for regulatory review, as well as potential delays in the conduct ofclinical trials. In addition, negative publicity may affect patients’willingness to participate in clinical trials. If fewer patients are willing toparticipate in clinical trials, the timelines for recruiting patients andconducting such trials will be delayed. The commercial success of our potentialproducts and technologies will depend in part on public acceptance of theuse of our therapies for the prevention or treatment of human diseases.Negative public reaction to our therapies in general could result in stricterlabeling requirements of products, including any of our potential products, andcould cause a decrease in the demand for products we may develop, if any.

***If we are unable to obtain rights to requiredtechnologies including poloxamer, proprietary gene sequences, proteins or othertechnologies, we will be unable to operate our business.***

Our remaining potentialproducts involve multiple component technologies, many of which may bepatented by others. For example, our potential products can use poloxamers,proprietary gene sequences, proteins or other technologies some of which have been,or may be, patented by others. As a result, we may be required toobtain licenses or acquire rights to those poloxamers, gene sequences, proteinsor other technologies. We may not be able to obtain a license or acquirerights to those technologies on reasonable terms, or at all. As a consequence,we may be prevented from developing potential products or we may have to makecumulative royalty payments to several companies. These cumulative royaltieswould reduce amounts paid to us or could make our potential products tooexpensive to develop or market. From time to time, we may engage inpreliminary discussions with third parties concerning potential acquisitions oftechnologies, products or product candidates. Even if we are successful inacquiring technologies, products or product candidates, we may experiencedifficulties in and costs associated with the assimilation of technologies,products, product candidates, operations and personnel acquired, diversion ofmanagement’s attention from other business concerns, inability to maintainuniform standards, controls, procedures and policies and the subsequentloss of key personnel. If we are unable to acquire or obtain rights totechnologies, products or product candidates necessary for our business, ourbusiness would be harmed.

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***We rely on patents and other proprietary rights toprotect our intellectual property and any inability to protect our intellectualproperty rights would adversely impact our business.***

We relyon a combination of patents, trade secrets, trademarks, proprietary know-how,and nondisclosure and other contractual agreements and technical measures toprotect our intellectual property rights. We file patent applications toprotect processes, practices and techniques related to our potential productsthat are significant to the development of our business. We own or haveexclusive rights to 39 issued United States patents and 45 granted foreignpatents. We own or have exclusive rights to approximately 12 pending patentapplications in the United States and 34 foreign pending patent applications.Our patent applications may not be approved. Any patents granted now or inthe future may be invalidated or offer only limited protection againstpotential infringement and development by our competitors of competing products.Moreover, our competitors, many of which have substantial resources and havemade substantial investments in competing technologies, may seek to applyfor and obtain patents that will prevent, limit or interfere with our abilityto make, use or sell our potential products either in the United States or ininternational markets. In addition to patents, we rely on trade secrets andproprietary know-how, which we seek to protect, in part, through proprietaryinformation agreements with employees, consultants and other parties. Ourproprietary information agreements with our employees and consultants containindustry standard provisions requiring such individuals to assign to us,without additional consideration, any intellectual property conceived or reducedto practice by them while employed or retained by us, subject to customaryexceptions. Proprietary information agreements with employees, consultants andothers may be breached, and we may not have adequate remedies for anybreach. Also, our trade secrets may become known to, or independentlydeveloped by, competitors. Any failure to protect our intellectual propertywould significantly impair our competitive position and adversely affect ourresults of operations and business.

***We could become subject to litigation regarding ourintellectual property rights, which could seriously harm our business.***

In previous years, there has been significantlitigation in the United States involving patents and other intellectualproperty rights. Competitors in the biotechnology industry may useintellectual property litigation against us to gain advantage. In the future,we may be a party to litigation to protect our intellectual property or asa result of an alleged infringement of others’ intellectual property. These claimsand any resulting lawsuit, if successful, could subject us to significantliability for damages and invalidation of our proprietary rights. Any potentialintellectual property litigation, if successful, also could force us to stopselling, incorporating or using our potential products that use the challengedintellectual property; obtain from the owner of the infringed intellectualproperty right a license to sell or use the relevant technology, which licensemay not be available on reasonable terms, or at all; or redesign ourpotential products that use the technology. We may also be required in thefuture to initiate claims or litigation against third parties for infringementof our intellectual property rights to protect such rights or determine the scopeor validity of our intellectual property or the rights of our competitors. Thepursuit of these claims could result in significant expenditures and thediversion of our technical and management personnel and we may not havesufficient cash and manpower resources to pursue any such claims. If we areforced to take any of these actions, our business may be seriously harmed.

Any claims, with orwithout merit, and regardless of whether we prevail in the dispute, would betime-consuming, could result in costly litigation and the diversion oftechnical and management personnel and could require us to developnon-infringing technology or to enter into royalty or licensing agreements. Anadverse determination in a judicial or administrative proceeding and failure toobtain necessary licenses or develop alternate technologies could prevent usfrom developing and selling our potential products, which would have a materialadverse effect on our business, results of operations and financial condition.

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***We may experience delays in the commercialintroduction, manufacture or regulatory approval of our potential products as aresult of failure to comply with FDA manufacturing practices and requirements.***

Drug-manufacturing facilities regulated by the FDAmust comply with the FDA’s current good manufacturing practice (cGMP)regulations, which include quality control and quality assurance requirements,as well as maintenance of records and documentation. Manufacturers of biologicsalso must comply with the FDA’s general biological product standards andmay be subject to state regulation as well. Such manufacturing facilitiesare subject to ongoing periodic inspections by the FDA and corresponding stateagencies, including unannounced inspections, and must be licensed as part ofthe product approval process before being utilized for commercialmanufacturing. Noncompliance with the applicable requirements can result in,among other things, fines, injunctions, civil penalties, recall or seizure ofproducts, total or partial suspension of production, withdrawal of marketingapprovals, and criminal prosecution. Any of these actions by the FDA wouldmaterially and adversely affect our ability to continue clinical trials,commercialize our potential products and adversely affect our business. Wecannot assure you that we or any of our existing or future contractmanufacturers will attain or maintain compliance with current or future goodmanufacturing practice requirements and the FDA could suspend or further delayour clinical trials, the commercial introduction and manufacture of ourpotential products or place restrictions on our ability to conduct clinicaltrials or commercialize our potential products, including the mandatorywithdrawal of the potential product from the clinical trials.

Our research anddevelopment processes involved the controlled use of hazardous materials,chemicals and radioactive materials and produce waste products that couldsubject us to unanticipated environmental liability and would adversely affectour results of operations. We are subject to federal, state and localenvironmental laws and regulations governing the use, manufacture, storage,handling and disposal of such materials and waste products. Although we believethat our safety procedures for handling and disposing of such materialscomplied with the standards prescribed by such laws and regulations, the riskof accidental contamination or injury from these materials cannot be eliminatedcompletely. In the event of such an accident, we could be held liable for anydamages that result, and any such liability could exceed our resources.Although we believe that we are in compliance in all material respects withapplicable environmental laws and regulations, there can be no assurance thatwe will not be required to incur significant costs to comply with environmentallaws and regulations in the future or that any of our operations, business orassets will not be materially adversely affected by current or futureenvironmental laws or regulations.

***If we are unable to complete our assessment as to theadequacy of our internal control over financial reporting within the requiredtime periods as required by Section 404 of the Sarbanes-Oxley Act of 2002,or in the course of such assessments identify and report material weaknesses inour controls, investors could lose confidence in the reliability of ourfinancial statements, which could result in a decrease in the value of ourcommon stock.***

As directed by Section 404of the Sarbanes-Oxley Act of 2002, the Securities and Exchange Commissionadopted rules requiring public companies to include a report of managementon internal control over financial reporting in their Annual Reports on Form 10-K.This report is required to contain an assessment by management of theeffectiveness of a company’s internal control over financial reporting. Inaddition, the independent registered public accounting firm auditing a publiccompany’s financial statements must attest to and report on management’sassessment of the effectiveness of the company’s internal control overfinancial reporting. Our current non-affiliated market capitalization qualifiesus as a non-accelerated filer. As such, we are required to comply with the Section 404requirements beginning with the fiscal year that ends June 30, 2008.We intend to diligently and vigorously assess (and enhance as may beappropriate) our internal control over financial reporting in order to ensurecompliance with the Section 404 requirements. We anticipate expendingsignificant resources in developing the necessary documentation and testingprocedures required by Section 404, however, there is a risk that we willnot 

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complywith all of the requirements imposed by Section 404. In addition, the verylimited size of our organization could lead to conditions that could beconsidered material weaknesses, such as those related to segregation of duties,that is possible in larger organizations but significantly more difficult insmaller organizations. Also, controls related to our general informationtechnology infrastructure may not be as comprehensive as in the case of alarger organization with more sophisticated capabilities and more extensiveresources. It is not clear how such circumstances should be interpreted in thecontext of an assessment of internal control over financial reporting. If wefail to implement required new or improved controls, we may be unable tocomply with the requirements of Section 404 in a timely manner, whichmay result in our independent registered public accounting firm issuing aqualified or adverse report on our internal control and/or management’sassessment thereof. This could result in an adverse reaction in the financialmarkets due to a loss of confidence in the reliability of our financialstatements, which could cause the market price of our common stock to decline.

***Our certificate of incorporation and by-laws includeanti-takeover provisions that may enable our management to resist anunwelcome takeover attempt by a third party.***

Our basic corporate documentsand Delaware law contain provisions that enable our management to attempt toresist a takeover unless it is deemed by management and our Board of Directorsto be in the best interests of our stockholders. Those provisions mightdiscourage, delay or prevent a change in the control of our company or a changein our management. Our Board of Directors may also choose to adopt furtheranti-takeover measures without stockholder approval. The existence and adoptionof these provisions could adversely affect the voting power of holders ofcommon stock and limit the price that investors might be willing to pay in thefuture for shares of our common stock.

***The concentration of ownership among our executiveofficers, directors and their affiliates may delay or prevent a change inour corporate control.***

Our executive officers,directors and their affiliates beneficially own or control in excess ofapproximately 22% of outstanding common shares, warrants or options to purchasecommon stock, with approximately 15% of outstanding common shares, warrants andoptions to purchase common stock held by Perseus-Soros BioPharmaceutical Fund,L.P. As a result, our executive officers, directors and their affiliates willbe able to exercise significant control over all matters requiring stockholderapproval, including the election of directors and approval of significantcorporate transactions, which could delay or prevent an outside party fromacquiring or merging with us, which could in turn reduce our stock price.

***If our facilities were to experience an earthquake orother catastrophic loss, our operations would be seriously harmed.***

Our facilities could besubject to a catastrophic loss such as fire, flood or earthquake. Our corporateheadquarters and remaining business operations are located near majorearthquake faults in Burlingame, California. Any such loss at any of ourfacilities could disrupt our operations, delay development of our potentialproducts and result in large expense to repair and replace our facilities. We currentlydo not maintain insurance policies protecting against catastrophic loss, exceptfor fire insurance with coverage amounts normally obtained in our industry.

**ITEM 1B.**       UNRESOLVEDSTAFF COMMENTS

None.

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**ITEM 2.**                PROPERTIES

Valentis leases approximately 45,000 square feetin Burlingame, California, which was fully occupied as of June 30, 2006.The facilities were built to Valentis’ specifications to accommodate ourlaboratory, support and administrative needs and include manufacturingfacilities designed to supply material required for preclinical research anddevelopment and initial clinical trials. These leases expire in October 2007with renewal options at the end of the initial terms to extend the leases foran additional five years.

As a result of the July 2006announcement regarding negative results in our Phase IIb clinical trial ofVLTS 934, Valentis is currently assessing its strategic opportunitiesincluding the sale or merger of the business, the sale or license of certainassets and the resolution of property leases, which the Company believes willbe resolved without material adverse effect.

**ITEM 3.**                LEGALPROCEEDINGS

None.

**ITEM 4.**                SUBMISSIONOF MATTERS TO A VOTE OF SECURITY HOLDERS

None.

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**PART II**

**ITEM 5.**                MARKETFOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUERPURCHASES OF EQUITY SECURITIES

**Market Information**

Ourcommon stock trades on the Nasdaq Capital Market under the symbol “VLTS.” Thefollowing table sets forth, for the calendar periods indicated, the high andlow sales prices of the common stock reported by Nasdaq.

| ** **                                            | ** ** | **High**   | ** ** | **Low**    | ** ** |
|-------------------------------------------------------|------------|------------|------------|------------|------------|
| **2004**                                              | ** ** | ** ** | ** ** | ** ** | ** ** |
| First Quarter                                         |       | $          | 8.44       |       | $          | 2.60 |   |
| Second Quarter                                        |       | 7.95       |       | 3.75       |       |
| Third Quarter                                         |       | 10.43      |       | 1.90       |       |
| Fourth Quarter                                        |       | 2.69       |       | 1.88       |       |
| **2005**                                              | ** ** | ** ** | ** ** | ** ** | ** ** |
| First Quarter                                         |       | $          | 3.90       |       | $          | 2.20 |   |
| Second Quarter                                        |       | 3.19       |       | 2.26       |       |
| Third Quarter                                         |       | 2.90       |       | 2.11       |       |
| Fourth Quarter                                        |       | 2.60       |       | 1.48       |       |
| **2006**                                              | ** ** | ** ** | ** ** | ** ** | ** ** |
| First Quarter                                         |       | $          | 3.95       |       | $          | 2.12 |   |
| Second Quarter                                        |       | 4.06       |       | 2.64       |       |
| Third Quarter (through  September 26, 2006) |       | 3.50       |       | 0.15       |       |

 

On September 26, 2006the last sale price reported on the Nasdaq Capital Market for Valentis’ commonstock was $0.38 per share. As of that date, there were approximately 318stockholders of record of our common stock.

**Sales andRepurchases of Securities**

During the period covered by this Annual Report on Form 10-K,we sold and issued the following securities, which were not registered underthe Securities Act of 1933:

In March 2006, the Company completed a privateplacement, in which the Company issued and sold 2,100,000 shares of the Company’scommon stock and warrants, exercisable for a five-year period, to purchase upto 1,050,000 additional shares of the Company’s common stock at $2.50 per unit,for net proceeds of approximately $5.0 million. The warrants areexercisable at $3.00 per share. In addition, the Company issued to thedesignees of Griffin Securities, Inc., the placement agent of the privateplacement, warrants to purchase 22,500 shares of common stock at $3.00 pershare, exercisable for a five-year period. The issuance of our commonstock and warrants in the private placement was exempt from the registrationrequirements under the Securities Act because all of the securities were issuedsolely to accredited investors, as defined in Rule 501 ofRegulation D of the Securities Act.

We did not repurchase anyof our equity securities during the fourth quarter of the fiscal year ended June 30,2006.

**Dividends**

Valentis has never paidany cash dividends on its common stock.

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**ITEM 6.**                SELECTEDFINANCIAL DATA

Thedata set forth below should be read in conjunction with “Management’sDiscussion and Analysis of Financial Condition and Results of Operations” andthe Consolidated Financial Statements and related Notes included elsewhere inthis report.

| ** **                                                                                      | ** ** | **Year Ended June 30,**                             | ** ** |
|-------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                                                                                      | ** ** | **2006**                                                           | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
| ** **                                                                                      | ** ** | **(in thousands, except per share data)** | ** ** |
| **Consolidated Statement of  Operations Data:**                                                 | ** ** | ** **                                                         | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Collaborative  research and development revenue                                                 |       | $                                                                  | —     |   | $ | — |   | $ | — |   | $ | — |   | $ | 3,333 |   |
| License and  milestone revenue                                                                  |       | 627                                                                |       | 1,640 |   | 7,284 |   | 3,958 |   | 487 |   |
| Contract research  revenue                                                                      |       | 100                                                                |       | 476 |   | — |   | — |   | — |   |
| Other revenue                                                                                   |       | —                                                             |       | 61 |   | 194 |   | — |   | 17 |   |
| Total revenue                                                                                   |       | 727                                                                |       | 2,177 |   | 7,478 |   | 3,958 |   | 3,837 |   |
| Costs and Operating  expenses:                                                                  |       |                                                               |       |   |   |   |   |   |   |   |   |
| Cost of contract research revenue                                                               |       | 93                                                                 |       | 521 |   | — |   | — |   | — |   |
| Research and development                                                                        |       | 11,228                                                             |       | 9,169 |   | 10,054 |   | 9,965 |   | 23,738 |   |
| General and administrative                                                                      |       | 4,987                                                              |       | 3,763 |   | 3,912 |   | 8,859 |   | 7,853 |   |
| Restructuring charges                                                                           |       | —                                                             |       | — |   | — |   | 832 |   | 1,812 |   |
| Amortization of goodwill and other acquired  intangible assets                                  |       | —                                                             |       | — |   | — |   | — |   | 4,914 |   |
| Total operating expenses                                                                        |       | 16,308                                                             |       | 13,453 |   | 13,966 |   | 19,656 |   | 38,317 |   |
| Loss from operations                                                                            |       | (15,581                                                            | )          | (11,276 | ) | (6,488 | ) | (15,698 | ) | (34,480 | ) |
| Other income and  expense, net                                                                  |       | 244                                                                |       | 193 |   | 4 |   | 838 |   | 1,390 |   |
| Net loss                                                                                        |       | (15,337                                                            | )          | (11,083 | ) | (6,484 | ) | (14,860 | ) | (33,090 | ) |
| Deemed dividend                                                                                 |       | —                                                             |       | — |   | — |   | (4,972 | ) | (2,590 | ) |
| Adjustment  resulting from the reduction in the Series A Preferred stock conversion  price |       | —                                                             |       | — |   | — |   | (22,293 | ) | — |   |
| Dividends on  convertible preferred stock                                                       |       | —                                                             |       | — |   | — |   | (882 | ) | (1,557 | ) |
| Net loss  applicable to common stockholders                                                     |       | $                                                                  | (15,337    | ) | $ | (11,083 | ) | $ | (6,484 | ) | $ | (43,007 | ) | $ | (37,237 | ) |
| Basic and diluted  net loss per share applicable to common stockholders                         |       | $                                                                  | (0.99      | ) | $ | (0.85 | ) | $ | (0.81 | ) | $ | (13.86 | ) | $ | (33.61 | ) |
| Shares used in  computing basic and diluted net loss per common share                           |       | 15,453                                                             |       | 13,028 |   | 8,024 |   | 3,103 |   | 1,108 |   |

 

| ** **                                                | ** ** | **June 30,**       | ** ** |
|-----------------------------------------------------------|------------|-------------------------|------------|
| ** **                                                | ** ** | **2006**                | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
| ** **                                                | ** ** | **(in thousands)** | ** ** |
| **Consolidated  Balance Sheet Data:**                     | ** ** | ** **              | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Cash, cash equivalents and short-term investments         |       | $                       | 4,348      |   | $ | 12,513 |   | $ | 20,450 |   | $ | 3,290 |   | $ | 19,104 |   |
| Working capital                                           |       | 2,300                   |       | 10,624 |   | 16,905 |   | 230 |   | 14,137 |   |
| Total assets                                              |       | 5,258                   |       | 14,152 |   | 21,891 |   | 6,078 |   | 24,044 |   |
| Convertible redeemable preferred stock                    |       | —                  |       | — |   | — |   | — |   | 25,828 |   |
| Accumulated deficit                                       |       | (239,974                | )          | (224,637 | ) | (213,554 | ) | (207,070 | ) | (192,210 | ) |
| Total  stockholders’ equity (net capital deficiency) |       | 2,843                   |       | 11,569 |   | 17,890 |   | 2,589 |   | (7,701 | ) |
|                                                           |            |                         |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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**ITEM 7.**                MANAGEMENT’SDISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

*The discussion in “Management’s Discussion andAnalysis of Financial Condition and Results of Operations” contains forward-lookingstatements within the meaning of Section 27A of the Securities Act of1933, 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,” “intends,”“projects,” “estimates,” and other words of similar import or the negative ofthose terms or expressions. Forward-looking statements in this sectioninclude, but are not limited to, expectations regarding any strategicopportunities that may be available to us, expectations of future levels ofresearch and development spending, general and administrative spending, levelsof capital expenditures and operating results, our intention to licensepotential products and technologies to a pharmaceutical company that willassume responsibility for late-stage development and commercialization and ourintention to seek revenue from the licensing of our proprietary manufacturingtechnologies. Forward-looking statements subject to certain known andunknown risks, uncertainties and other factors that may cause our actualresults, performance or achievements to be materially different from any futureresults, performance or achievements expressed or implied by such forward-lookingstatements. Factors that could affect our actual results include the outcomesof our clinical trials in patients with peripheral arterial disease,uncertainties related to our financial condition, uncertainties related to thestrategic opportunities that may be available to us, our need for additionalcapital, our going concern report from our independent registered publicaccounting firm and the other risk factors set forth in this Annual Report on Form 10-K.Further, there can be no assurance that necessary regulatory approvals for anyof our potential products will be obtained. Actual results may differmaterially from those projected in such forward-looking statements as aresult of the “Risk Factors” described previously and other risks detailed inour reports filed with the Securities and Exchange Commission. We undertake noobligation to revise or update any such forward-looking statements.*

**COMPANY OVERVIEW**

Valentis is a biotechnology company that waspreviously engaged in the development of innovative products for peripheralartery disease, or PAD. PAD is due to chronic inflammation of the blood vesselsof the legs leading to the formation of plaque, which obstructs blood flow.

On July 11, 2006 Valentis announced that nostatistically significant difference was seen in the primary endpoint or any ofthe secondary endpoints in its Phase IIb clinical trial of VLTS 934in PAD. The primary efficacy endpoint in the study was improvement in exercisetolerance on an escalating grade treadmill after 90 days in patientsreceiving VLTS 934 versus patients receiving placebo. The trial was arandomized, double-blind, placebo-controlled Phase IIb trial ofVLTS 934 versus a saline placebo in 157 patients with the intermittentclaudication form of PAD.

After 90 days, there was no statisticallysignificant change in exercise in the 78 patients receiving VLTS 934versus the 79 patients receiving placebo. There were also no significantdifferences in any of the secondary endpoints of exercise tolerance at30 days, ankle-brachial index at 30 and 90 days, total work capacityat 30 and 90 days and quality of life at 90 days. VLTS 934 waswell tolerated in the trial with no definitely related severe adverse effects.

Valentis has no plans for further development of VLTS934, has ceased research and development activities on all of its remainingpotential products and technologies and is assessing strategic opportunities,which include the sale or merger of the business, the sale of certain assets orother actions.

In conjunction with the assessment of strategicopportunities, Valentis reduced its workforce by eliminating 55% of its employeeson August 18, 2006. Further reductions in workforce of approximately 66%are anticipated by the end of October 2006. The total costs associatedwith the reduction in workforce on August 18, 2006 and anticipatedfurther reductions are estimated to be between $525,000 and 

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$1.4 million,primarily related to severance benefits, which will be recorded in the fiscalfirst quarter of 2007, and paid in the fiscal first and second quarters of2007.

Additional actions Valentis has taken following its July 2006announcement regarding negative results in its Phase IIb clinical trial ofVLTS 934 in patients with PAD include (i) ceasing all research anddevelopment activities on all of its potential products and technologies,including activities under its collaboration and contract research agreementsand activities relating to clinical trials and (ii) terminating its401(k) plan in August 2006.

Valentis hasseveral remaining potential products and technologies, including itsproprietary products VLTS 934, and DEL-1 and gene delivery andexpression technologies, and proprietary formulation and manufacturingtechnologies that allow the generation of novel therapeutics to treat a widerange of diseases. While Valentis focused its efforts on the development of novelPAD therapeutics, its technologies are being applied by its collaborators forthe development of therapeutics to treat a variety of indications includinginfectious diseases and cancer. Valentis is assessing strategic opportunitiesthat may be available to it, including the sale or license of these remainingpotential products and technologies. Valentis’ remaining potential products andtechnologies includes:

·       VLTS 934product candidate for compromised cell membranes;

·       DeltavascTMproduct candidate for angiogenesis or stimulation of new blood vessel growth;

·       Del-1Protein product candidate for promotion of vascular growth and inhibition ofendothelial cell death;

·       DEL-1antibody for anti-angiogenesis or the inhibition of new blood vessel formation;

·       PINCTMpolymer, synthetic gene delivery system;

·       CLICTMlipids delivery system;

·       DNAVaxTMpolymer-based delivery system;

·       Hermes*TM* gene expression technology;

·       GeneSwitch®gene regulation technology;

·       OptiPEG*TM* PEGylation technology;

·       Plasmidbackbone technology;

·       Scalableprocesses to manufacture plasmid DNA formulated products; and

·       Tenother early-stage potential products in development through partners, whichutilizing Valentis’ licensed technologies.

In August 2006, Valentisreceived a letter from the Listing Qualifications Department of The NasdaqStock Market indicating that Valentis is not in compliance with NasdaqMarketplace Rule 4310(c)(4) (the “Minimum Bid Price Rule”) becausethe closing bid price per share for Valentis common stock has been below $1.00per share for 30 consecutive trading days. In accordance with NasdaqMarketplace Rules, Valentis will be provided 180 calendar days, or until February 20, 2007,to regain compliance with the Minimum Bid Price Rule. Should Valentis fail toregain compliance with the Minimum Bid Price Rule by February 20, 2007,Nasdaq will determine whether Valentis meets The Nasdaq Capital Market initiallisting criteria set forth in Marketplace Rule 4310(c), except for the bidprice requirement. If Valentis meets the initial listing criteria, Nasdaq willnotify Valentis that it has been granted an additional 180 calendar daycompliance period. If Valentis is not eligible for an additional complianceperiod, Nasdaq will provide Valentis with written notification that its commonstock will be delisted.

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**Results ofOperations**

***Fiscal Years Ended June 30, 2006, 2005 and2004***

***Revenue***

Revenuerecognized in the fiscal years ended June 30, 2006, 2005 and 2004 isas follows (in thousands):

| ** **                                                   | ** ** | **Year ended June 30,** | ** ** |
|--------------------------------------------------------------|------------|----------------------------------------|------------|
| ** **                                                   | ** ** | **2006**                               | ** ** | **2005** | ** ** | **2004** | ** ** |
| License and  milestone revenue:                              |       |                                   |       |   |   |   |   |
| GeneSwitch® licenses                                    |       | $                                      | 393        |   | $ | 1,021 |   | $ | 284 |   |
| DNAVaxTM gene delivery technology license and  milestone |       | —                                 |       | — |   | 500 |   |
| PINCTM gene delivery technology licenses                 |       | 114                                    |       | 619 |   | — |   |
| PEGylation technology licenses                               |       | 120                                    |       | — |   | 6,500 |   |
|                                                         |       | 627                                    |       | 1,640 |   | 7,284 |   |
| Contract research  revenue                                   |       | 100                                    |       | 476 |   | — |   |
| Other revenue                                                |       | —                                 |       | 61 |   | 194 |   |
| Total                                                        |       | $                                      | 727        |   | $ | 2,177 |   | $ | 7,478 |   |

 

Changesin revenue for each of the fiscal years ended June 30, 2006, 2005 and2004 are explained below:

·       TheGeneSwitch® revenue recognized in fiscal 2006, 2005 and 2004 resultedprimarily from license and annual license maintenance fees received underseveral agreements for our GeneSwitch® technology. The GeneSwitch® revenuerecognized in fiscal 2005 included approximately $500,000 of license feesreceived from Schering AG that was non-recurring.

·       TheDNAVaxTM gene delivery technology license and milestone revenue of $500,000recognized in fiscal 2004 consists of a milestone payment of $250,000 anda license fee of $250,000 received during fiscal 2004 under a license agreementrelated to our DNAVaxTM delivery technology.

·       ThePINCTM gene delivery technology revenue recognized in fiscal 2006 and 2005resulted primarily from license and annual license maintenance fees receivedunder several agreements for our PINCTM gene delivery technology. The PINCTM genedelivery technology revenue recognized in fiscal 2005 includedapproximately $500,000 of license fees received from Schering AG that was non-recurring.

·       ThePEGylation revenue recognized in fiscal 2006 primarily reflected anexclusive worldwide license of our pegylated liposome technology. In July 2003,PolyMASC Pharmaceuticals plc, our wholly owed subsidiary, entered into alicense and settlement agreement with ALZA Corporation, a unit of Johnson &Johnson. Under the agreement, PolyMASC settled its patent infringementlitigation against ALZA and granted a worldwide, irrevocable and non-exclusivelicense to ALZA under its PEG-liposome patents. Non-recurring license revenueof $6.5 million was recognized from this agreement in fiscal 2004.

·       Infiscal 2006 and 2005, we recognized $100,000 and $476,000 of contractresearch revenue under agreements with other companies, respectively. Under theagreements, we are required to conduct research on the manufacturing of certainbiological materials for other companies. The revenue was recognized based onresearch performed during the periods.

·       Otherrevenue of $61,000 and $194,000 recognized in fiscal 2005 and 2004,respectively, consisted primarily of profit sharing and royalties receivedunder a plasmid DNA manufacturing agreement.

Revenue derived fromcorporate collaborations and licenses helps Valentis fund its operations andmay increase in the future if Valentis is successful in establishing newcollaborations and additional 

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licensingof its technology. If Valentis is unsuccessful in establishing newcollaborations, additional licensing and grants, revenues may decline.Therefore, a reduction in funds for conducting research and development,clinical trial, manufacturing, marketing and sales efforts may occur.

Valentis has no plans forfurther development of any of its potential products and technologies and itssole current focus is on assessing its strategic opportunities. As a result,Valentis’ collaborators may exercise their contractual rights to terminatetheir collaboration arrangements with Valentis. Valentis expects that each ofits corporate collaborations will be terminated according to the terms of therespective contracts underlying such collaborations moving forward.

***Costs and Expenses***

Costs of contract researchwere $93,000 and $521,000 for fiscal years ended June 30, 2006 and2005, respectively, which consisted of costs incurred for contract research onthe manufacturing of biological materials for other companies and includeddirect and related overhead expenses and costs of general and administrativesupport. We did not have contract research arrangements with other companiesprior to the fiscal year ended June 30, 2005.

Research and developmentexpenses were $11.2 million, $9.2 million and $10.1 million for thefiscal years ended June 30, 2006, 2005 and 2004, respectively. Theincrease in expenses in fiscal 2006 compared to 2005 primarily reflectsincreased expenses related to VLTS 934 Phase IIb clinical trial andstock-based compensation expenses recorded in the year ended June 30, 2006.The decrease in expenses in fiscal 2005 compared to 2004 primarilyreflects decreased expenses for the DeltavascTM PAD Phase IIa clinicaltrial, which completed the dosing of patients in June 2004 and resulted ina fall off in clinical trial expenses. The decrease was partially offset byexpenses incurred for the commencement of the VLTS 934 Phase IIbclinical trial in March 2005. In light of the July 2006 announcementof negative results in the VLTS 934 Phase IIb clinical trial, we haveno plans for further development of VLTS 934 or any of or other remainingproduct candidates and technologies. We are currently assessing our strategicopportunities, which include the sale or merger of the business, the sale orlicense of certain assets or other actions.

All of our research anddevelopment expenses for the fiscal years ended June 30, 2006, 2005and 2004 were incurred in connection with the development of novel peripheralarterial disease therapeutics.

General and administrativeexpenses were $5.0 million, $3.8 million and $3.9 million for thefiscal years ended June 30, 2006, 2005 and 2004, respectively. Theincrease in expenses in fiscal 2006 compared to 2005 was primarilyattributable to stock-based compensation expenses recorded in fiscal 2006. Thedecrease in expenses in fiscal 2005 compared to 2004 was primarilyattributable to lower depreciation and clinical support expenses in fiscal2005, partially offset by expenses recorded in fiscal 2005 for the issuance ofwarrants to non-employees for services provided. In light of the July 2006announcement of negative results in the VLTS 934 Phase IIb clinicaltrial, we have no plans for further development of VLTS 934 or any of or otherremaining product candidates and technologies. Our general and administrativestaff are assessing our strategic opportunities, which include the sale ormerger of the business, the sale or license of certain assets or other actions.We expect general and administrative expenses to decline going forward as wedetermine to pursue, and complete, any of the strategic opportunities that maybe available to us.

***Interest Income andOther Income and Expense, net***

Interest income and otherincome and expense, net was approximately $244,000, $193,000 and $4,000 infiscal 2006, 2005 and 2004, respectively. The increase in interest incomeand other income and expense, net in fiscal 2006 compared to 2005 wasprimarily attributable to lower state franchise tax expenses incurred infiscal 2006. The increase in interest income and other income and expense,net in fiscal 2005 compared to 2004 was primarily attributable to higherinterest income derived from higher investment balances in fiscal 2005. Wedid not incur any interest expenses for fiscal 2006, 2005 and 2004.

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**New Accounting Pronouncements**

In June 2005, theFASB issued SFAS No. 154, Accounting Changes and Error Corrections (SFAS No. 154),a replacement of APB Opinion No. 20, Accounting Changes, and FASB No. 3,Reporting Accounting Changes in Interim Financial Statements SFAS No. 154applies to all voluntary changes in accounting principle, and changes therequirements for accounting for and reporting of a change in accountingprinciple. SFAS No. 154 requires retrospective application to priorperiods’ financial statements of a voluntary change in accounting principleunless it is impracticable. It is effective for accounting changes andcorrections of errors made in fiscal years beginning after December 15, 2005.The Company does not expect the adoption of SFAS No. 154 will havematerial impact on our consolidated results of operations and financialcondition.

In December 2004, theFinancial Accounting Standards Board (FASB) issued Statement of FinancialAccounting Standards (FAS) No. 123 (revised 2004, or FAS 123R), “Share-BasedPayment”. FAS 123R supersedes Accounting Principles Board (APB) Opinion No. 25,“Accounting for Stock Issued to Employees,” and requires companies to recognizecompensation expense, using a fair-value based method, for costs related toshare-based payments, including stock options and employee stock purchaseplans. FAS 123R permits public companies to adopt its requirements usingeither the modified prospective or modified retrospective transition method.

The Company adoptedFAS 123R on July 1, 2005 using the modified prospectivetransition method, which requires that stock-based compensation cost is recognizedfor all awards granted, modified or settled after the effective date as well asfor all awards granted to employees prior to the effective date that remainunvested as of the effective date (see Note 2 for more information).

**Liquidity and Capital Resources**

As discussed elsewhere inthis report, including further below, we have received a report from ourindependent registered public accounting firm regarding the consolidatedfinancial statements for the fiscal year ended June 30, 2006 thatincludes an explanatory paragraph stating that the financial statements havebeen prepared assuming Valentis will continue as a going concern. Theexplanatory paragraph states the following conditions, which raise substantialdoubt about our ability to continue as a going concern: (i) we haveincurred operating losses since inception, including a net loss of$15.3 million for the fiscal year ended June 30, 2006, and ouraccumulated deficit was $240.0 million at June 30, 2006 and (ii) weanticipate requiring additional financial resources to enable us to fund thecompletion of any strategic opportunity that may be available to us, includinga potential merger or sale of the business. These funds may be derived from thesale or license of assets or other actions. We expect these funds to allowValentis to carry-on operations until fiscal second or third quarter 2007.Management’s plans as to these matters are also described in Note 1 to theconsolidated financial statements.

If we are unable to obtainthe required additional financial resources to enable us to fund the completionof the strategic opportunities that may be available to us, or if we areotherwise unsuccessful in completing any strategic alternative, our business,results of operation and financial condition would be materially adverselyaffected and we may be required to seek bankruptcy protection.

Subsequent to the fiscalyear ended June 30, 2006, on July 11, 2006, we announcedthat no statistically significant difference was seen in the primary endpoint orany of the secondary endpoints in our Phase IIb clinical trial ofVLTS 934 in PAD. We have no plans for further development of VLTS 934 orany of our other remaining potential products and technologies and areassessing strategic opportunities, which include the sale or merger of ourbusiness, the sale of certain assets or other actions.

In conjunction with ourassessment of strategic opportunities, we reduced our workforce by eliminating55% of our employees on August 18, 2006. Further reductions in workforceof approximately 66% are anticipated by the end of October 2006. The totalcosts associated with the reduction in workforce 

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on August 18, 2006and anticipated further reductions are estimated to be between $525,000 and$1.4 million, primarily related to severance benefits, which will berecorded in the fiscal first quarter of 2007, and paid in the fiscal first andsecond quarters of 2007.

In August 2006, wereceived a letter from the Listing Qualifications Department of The StockMarket indicating that we are not in compliance with Nasdaq Marketplace Rule 4310(c)(4) (the“Minimum Bid Price Rule”) because the closing bid price per share for ourcommon stock has been below $1.00 per share for 30 consecutive trading days. Inaccordance with Nasdaq Marketplace Rules, we will be provided 180 calendardays, or until February 20, 2007, to regain compliance with theMinimum Bid Price Rule. Should we fail to regain compliance with the MinimumBid Price Rule by February 20, 2007, Nasdaq will determinewhether we meet The Nasdaq Capital Market initial listing criteria set forth inMarketplace Rule 4310(c), except for the bid price requirement. If we meetthe initial listing criteria, Nasdaq will notify us that we have been grantedan additional 180 calendar day compliance period. If we are not eligiblefor an additional compliance period, Nasdaq will provide us with writtennotification that our common stock will be delisted.

Since our inception, wehave financed our operations principally through public and private issuancesof our common and preferred stock and funding from collaborative arrangements.We have used the net proceeds from the sale of the common and preferred stockfor general corporate purposes, which has included funding research, developmentand product manufacturing, increasing our working capital, reducingindebtedness, pursuing and completing acquisitions or investments inbusinesses, products or technologies that are complementary to our own, andcapital expenditures. We expect that proceeds received from any future issuanceof stock, if any, will be used to fund our efforts to pursue and consummatestrategic opportunities that may be available to us.

In March 2006, theCompany completed a private placement, in which the Company issued and sold2,100,000 shares of the Company’s common stock and warrants, exercisable for afive-year period, to purchase up to 1,072,500 additional shares of the Company’scommon stock at $2.50 per unit, for net proceeds of approximately$5.0 million. The warrants are exercisable at $3.00 per share (the “March 2006Private Placement”).

We entered intoregistration rights agreements with the purchasers in the March 2006Private Placement. Pursuant to the registration rights agreements, we filedwith the Securities and Exchange Commission registration statements related tothe shares issued to the purchasers and shares issuable upon the exercise ofthe warrants in the March 2006 Private Placement. In the event we mustsuspend use of the registration statements for greater than 20 consecutive daysor a total of 40 days in the aggregate during the time we are required tokeep the registration statement effective under the registration rightsagreements, then we must pay to each purchaser in cash 1.0% of the purchaser’saggregate purchase price of the shares for the first month, as well as anadditional 1.5% of the purchaser’s aggregate purchase price for each additionalmonth thereafter, while the use of the registration statements has beensuspended. We currently expect to be required to maintain availability of theregistration statement for at least two years following the applicable closing.

In addition, under thesecurities purchase agreement entered into in connection with the March 2006Private Placement, while there is an effective registration statement and if wefail to deliver a stock certificate that is free of restrictive legends withinthree trading days upon delivery of such a request by a purchaser of the March 2006Private Placement, we are required to pay to the purchaser, for each $1,000 ofshares of stock or shares issuable upon exercise of warrants requested,$10 per trading day for each trading day beginning five trading days afterthe delivery of the request, increasing to $20 per trading day after the firstfive trading days for which such damages have begun to accrue, until suchcertificate is delivered without restrictive legends.

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We lease our facilitiesunder operating leases. These leases expire in October 2007 with renewaloptions at the end of the initial terms to extend the leases for an additionalfive years.

Minimalannual rental commitments under the operating leases at June 30, 2006 areas follows (in thousands):

| **Year ended June 30,** | ** ** | ** ** | ** ** | ** ** | ** ** |
|----------------------------------------|------------|------------|------------|------------|------------|
| 2007                                   |       | $          | 1,201      |       |
| 2008                                   |       | 458        |       |
|                                   |       | $          | 1,659      |       |

 

As a result of the July 2006announcement regarding negative results in our Phase IIb clinical trial ofVLTS 934, Valentis is currently assessing its strategic opportunitiesincluding the sale or merger of the business, the sale or license of certainassets and the resolution of property leases, which the Company believes willbe resolved without material adverse effect.

Our capital expenditureswere $33,000, $8,000 and $7,000 in fiscal 2006, 2005 and 2004, respectively. Wedo not expect additional capital expenditures going forward as we determine topursue, and complete, any of the strategic opportunities that may be availableto us, including the sale or merger of the business or sale of certain assets.

Net cash used in operatingactivities for the year ended June 30, 2006 was approximately$13.2 million, which primarily reflected the net loss of$15.3 million, adjusted for non-cash stock-based compensation expenses of$1.5 million and the decreases in receivable, deposits and other assets of$700,000. Net cash used in operating activities for the year endedJune 30, 2005 was approximately $12.1 million, which primarilyreflected the net loss of $11.1 million and the decreases in accruedliabilities of $1.2 million related to compensation and clinical trial expenses.Net cash used in operating activities for the year endedJune 30, 2004 was approximately $3.9 million, which primarilyconsisted of a net loss of approximately $6.5 million, an increase inaccrued clinical trial expenses of approximately $1.1 million and non-cashdepreciation expenses of approximately $1.4 million. We expect net cashused in operating activities to decrease going forward as additional personneldepart and we determine to pursue, and complete, any of the strategicopportunities that may be available to us, including the sale or merger of thebusiness or sale of certain assets.

Net cash provided byinvesting activities was approximately $2.9 million and $7.3 millionfor the fiscal years ended June 30, 2006 and 2005, respectively,which primarily reflected the maturities of available-for-saleinvestments. Net cash used in investing activities for the fiscal years endedJune 30, 2004 was approximately $10.9 million, which wasprimarily attributable to the purchases of marketable securities.

Net cash provided byfinancing activities was approximately $5.0 million, $4.1 million and$21.1 million for the fiscal years ended June 30, 2006, 2005 and2004, respectively, which consisted primarily of net proceeds received fromprivate placements of our common stock and warrants.

Except for the quarterended September 30, 2003, in which we reported net income ofapproximately $3.4 million resulting principally from the$6.5 million non-recurring license revenue recognized under the licenseand settlement agreement with ALZA Corporation (see Note 13 “ALZA Licenseand Settlement Agreement” in our Notes to Consolidated Financial Statements),we have experienced net losses since our inception throughJune 30, 2006, and reported a net loss of $15.3 million for thefiscal year ended June 30, 2006. Our accumulated deficit was$240.0 million at June 30, 2006. At June 30, 2006, wehad $4.3 million in cash, cash equivalents and investments, and weanticipate requiring additional financial resources to enable us to fund thecompletion of any strategic opportunities we may pursue, including a potentialmerger or sale of the business. These funds may be derived from the sale orlicense of assets or other actions. We expect these funds to allow Valentis tocarry-on operations until fiscal second or third quarter 2007.

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The accompanyingconsolidated financial statements have been prepared assuming that we willcontinue as a going concern. The financial statements do not include anyadjustments to reflect the possible future effects on the recoverability andclassification of assets or the amounts and classification of liabilities thatmay result from the matters discussed above.

***Critical Accounting Policies***

**Clinical trialexpenses**

Valentis believes theaccrual for clinical trial expense represents its most significant estimateused in the preparation of the consolidated financial statements. Valentis’accruals for clinical trial expenses are based in part on estimates of servicesreceived and efforts expended pursuant to agreements established with clinicalresearch organizations and clinical trial sites. We have a history ofcontracting with third parties that perform various clinical trial activitieson our behalf in the ongoing development of our biopharmaceutical drugs. Thefinancial terms of these contracts are subject to negotiations and may varyfrom contract to contract and may result in uneven payment flows. We determineour estimates through discussion with internal clinical personnel and outsideservice providers as to progress or stage of completion of trials or servicesand the agreed upon fee to be paid for such services. The objective of Valentis’clinical trial accrual policy is to reflect the appropriate trial expenses inour financial statements by matching period expenses with period services andefforts expended. In the event of early termination of a clinical trial, weaccrue expenses associated with an estimate of the remaining, non-cancelableobligations associated with the winding down of the trial. Our estimates andassumptions for clinical trial expenses have been materially accurate in thepast. Following Valentis’ July 2006 announcement regarding the negativeresults of its Phase IIb clinical trial of VLTS 934 in patients withPAD, Valentis has ceased all research and development activities on all of itspotential products and technologies.

**Revenue Recognition**

Revenue arrangements with multiple elements aredivided into separate units of accounting if certain criteria are met,including whether the delivered item has value to the customer on a stand-alonebasis and whether there is objective and reliable evidence of the fair value ofthe undelivered items. Consideration received is allocated among the separateunits of accounting based on their respective fair values, and the applicablerevenue recognition criteria are considered separately for each of the separateunits.

Non-refundable up-front payments received inconnection with research and development collaboration agreements, includingtechnology advancement funding that is intended for the development of our coretechnology, are deferred and recognized on a straight-line basis over therelevant period specified in the agreement, generally the research term.

Revenue related to research with our corporatecollaborators is recognized as research services are performed over the relatedfunding periods for each contract. Under these agreements, we are required toperform research and development activities as specified in each respectiveagreement. The payments received under each respective agreement are notrefundable and are generally based on a contractual cost per full-timeequivalent employee working on the project. Research and development expensesunder the collaborative research agreements approximate or exceed the revenuerecognized under such agreements over the terms of the respective agreements.Deferred revenue may result when we do not incur the required level of effortduring a specific period in comparison to funds received under the respectivecontracts. Payments received relative to substantive, at-risk incentivemilestones, if any, are recognized as revenue upon achievement of the incentivemilestone event because we have no future performance obligations related tothe payment. Incentive milestone payments are triggered either by results ofour research efforts or by events external to us, such as regulatory approvalto market a product. Following Valentis’ July 2006 announcement regardingthe negative results in its Phase IIb clinical trial of VLTS 934 

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in patients with PAD,Valentis has ceased all research and development activities on all of itspotential products and technologies, including under its agreements withcorporate collaborators.

We also have licensedtechnology to various biotechnology, pharmaceutical and contract manufacturingcompanies. Under these arrangements, we receive nonrefundable license paymentsin cash. These payments are recognized as revenue when received, provided wehave no future performance or delivery obligations under these agreements.Otherwise, revenue is deferred until performance or delivery is satisfied.Certain of these license agreements also provide the licensee an option toacquire additional licenses or technology rights for a fixed period of time.Fees received for such options are deferred and recognized at the time theoption is exercised or expires unexercised. Additionally, certain of theselicense agreements involve technology that we have licensed or otherwiseacquired through arrangements with third parties pursuant to which we arerequired to pay a royalty equal to a fixed percentage of amounts received by usas a result of licensing this technology to others. Such royalty obligationsare recorded as a reduction of the related revenue. Furthermore, we receiveroyalty and profit sharing payments under a licensing agreement with a contractmanufacturing company. Royalty and profit sharing payments are recognized asrevenue when received. We are not currently providing contract researchservices for research and development manufacturing of biological materials forother companies. Under our existing service contracts, we generally receivepayments based on a contractual cost per full-time equivalent employee workingon the project. Revenue is recognized for actual research work performed duringthe period.

**Stock-BasedCompensation**

In December 2004, the FASB issued FAS 123R, “Share-BasedPayment.” FAS 123R supersedes APB Opinion No. 25, “Accounting forStock Issued to Employees,” and requires companies to recognize compensationexpense, using a fair-value based method, for costs related to share-basedpayments including stock options and employee stock purchase plans. We adoptedFAS 123(R) on July 1, 2005. Prior to the adoption, wedisclosed such expenses on a pro forma basis in the notes to our financialstatements. For the year ended June 30, 2006, the Company recordedapproximately $1.45 million of stock-based compensation expenses, of which$503,000 was included in research and development expense and $944,000 wasincluded in general and administrative expense.

We estimated the fairvalue of stock options granted during the year ended June 30, 2006using the Black-Scholes-Merton option pricing model. The weighted-averageassumptions used under this model were as follows: 1) Due to insufficient relevanthistorical option exercise data, the expected term of the options was estimatedto be 6.1 years using the “simplified” method suggested in the Securitiesand Exchange Commission’s Staff Accounting Bulletin No. 107; 2) Expectedvolatility was estimated to be 143% based on the Company’s historicalvolatility that matched the expected term; 3) Risk-free interest rate of 4.5%is based on the U.S. Treasury yield curve in effect at the time of grant forperiods corresponding with the expected term of the option; 4) The Companyassumed a zero percent dividend yield. In addition, under FAS 123R, fairvalue of stock options granted is recognized as expense over the vestingperiod, net of estimated forfeitures. Estimated annual forfeiture rate wasbased on historical data and anticipated future conditions. The estimation offorfeitures requires significant judgment, and to the extent actual results orupdated estimates differ from our current estimates, such amounts will berecorded as a cumulative adjustment in the period estimates are revised (SeeNote 2 “Stock-Based Compensation” in our Notes to the Consolidated FinancialStatements for more information).

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**ContractualObligations**

Ourcontractual obligations as of June 30,  2006 were as follows:

| ** **                     | ** ** | **Payments due by period (in thousands)** | ** ** |
|--------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                     | ** ** | **Total**                                                          | ** ** | **Less than  1 year** | ** ** | **1-3  years** | ** ** | **3-5  years** | ** ** | **More than 5  years** | ** ** |
| Facility lease  obligations(1) |       | $                                                                  | 1,659      |   |   | $ | 1,201 |   |   | $ | 458 |   |   | $ | — |   |   |   | $ | — |   |   |
| Purchase  obligations(2)       |       | —                                                             |       |   | — |   |   | — |   |   | — |   |   |   | — |   |   |
| Total                          |       | $                                                                  | 1,659      |   |   | $ | 1,201 |   |   | $ | 458 |   |   | — |   |   |   | — |   |   |

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1)               Welease office facilities under noncancelabe operating leases that expire throughOctober 2007. In connection withthe leases, we have security deposits for$39,000.

2)               Outstandingpurchase orders for ongoing operations. Payments of these obligation aresubject to the provision of services or products.

As a result of the July 2006announcement regarding negative results in our Phase IIb clinical trial ofVLTS 934, Valentis is currently assessing its strategic opportunitiesincluding the sale or merger of the business, the sale or license of certainassets and the resolution property leases, which the Company believes will beresolved without material adverse effect.

**Off Balance SheetArrangements**

At June 30, 2006and 2005, we did not have any off balance sheet arrangements.

**ITEM 7A.**        QUANTITATIVEAND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Valentis’exposure to market risk for changes in interest rates relates primarily to ourinvestment portfolio. We maintain a strict investment policy that is designedto limit default risk, market risk, and reinvestment risk. Our cash and cashequivalents consist of cash and money market accounts. Our investments consistprimarily of commercial paper, medium term notes, U.S. Treasury notes andobligations of U.S. Government agencies and corporate bonds. The table belowpresents notional amounts and related weighted-average interest rates forour investment portfolio (in thousands, except percentages) as of June 30,2006 and 2005. All of our market risk sensitive instruments mature within ayear from the balance sheet date.

| ** **                                        | ** ** | **As of June 30,** | ** ** |
|---------------------------------------------------|------------|-----------------------------------|------------|
| ** **                                        | ** ** | **2006**                          | ** ** | **2005** | ** ** |
| Cash equivalents                                  |       |                              |       |   |   |
| Estimated market value                            |       | $                                 | 3,635      |   | $ | 8,163 |   |
| Average interest rate                             |       | 4.96                              | %          | 2.95 | % |
| Short-term  investments                           |       |                              |       |   |   |
| Estimated market value                            |       | $                                 | 750        |   | $ | 3,648 |   |
| Average interest rate                             |       | 4.97                              | %          | 2.73 | % |
| Total cash  equivalents and investment securities |       | $                                 | 4,385      |   | $ | 11,811 |   |
| Average rate                                      |       | 4.97                              | %          | 2.88 | % |

 

**ITEM 8.**                FINANCIALSTATEMENTS AND SUPPLEMENTARY DATA

Valentis’ FinancialStatements and notes thereto appear on pages 62 to 82 of this AnnualReport on Form 10-K.

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**ITEM 9.**                CHANGESIN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE

Not applicable.

**ITEM 9A.**        CONTROLSAND PROCEDURES

We maintain disclosure controls and procedures thatare designed to ensure that information required to be disclosed in reportsthat we file or submit under the Securities Exchange Act of 1934, as amended,is recorded, processed, summarized and reported within the time periodsspecified in the Securities and Exchange Commission’s rules and forms, andthat such information is accumulated and communicated to our management,including our principal executive officer and principal finance and accountingofficer, as appropriate, to allow timely decisions regarding requireddisclosure. In designing and evaluating the disclosure controls and procedures,management recognizes that any controls and procedures, no matter how welldesigned and operated, can provide only reasonable assurance of achieving the desiredcontrol objectives, and management necessarily was required to apply itsjudgment in evaluating the cost-benefit relationship of possible controls andprocedures.

Our management has evaluated, with the participationof our President and Chief Executive Officer, who is our principal executiveofficer, and our Vice President of Finance and Administration, who is ourprincipal financial and accounting officer, the effectiveness of our “disclosurecontrols and procedures” (as defined in Rules 13a-15(e) and15(d)-15(e) of the Securities Exchange Act of 1934, as amended) asof the end of the period covered by this Annual Report on Form 10-K.Based on that evaluation, our President and Chief Executive Officer and ourVice President of Finance and Administration concluded that our disclosurecontrols and procedures are effective to ensure that information we arerequired to disclose in reports that we file or submit under the Exchange Act,as amended, is recorded, processed, summarized and reported within the timeperiods specified in the Securities Exchange Commission rules and forms.

There have been no changesin our internal controls over financial reporting during our most recent fiscalquarter that has materially affected, or is reasonably likely to materiallyaffect, our internal control over financial reporting.

**ITEM 9B.**       OTHERINFORMATION

None.

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**PART III**

**ITEM 10.**         DIRECTORSAND EXECUTIVE OFFICERS OF THE REGISTRANT

**Executive Officers**

Theexecutive officers of Valentis as of  September 15, 2006are as follows:

| **Name**                                | ** ** | ** ** | ** ** | **Age**                                          | ** ** | **Position** |
|-----------------------------------------|------------|------------|------------|--------------------------------------------------|------------|--------------|
| Benjamin F.  McGraw, III, Pharm.D. |       | 57         |       | President, Chief  Executive Officer and Chairman |
| John J. Reddington,  Ph.D., DVM         |       | 52         |       | Chief Operating Officer                          |
| Joseph A. Markey                        |       | 52         |       | Vice President of Finance and Administration     |

 

The principal occupationsand positions for the past five years, and in some cases prior years, of theexecutive officers named above, are as follows unless set forth elsewhere inthis report:

**Benjamin F. McGraw, III,Pharm.D.**

Benjamin F. McGraw, III,Pharm.D., 57, has served as the President and Chief Executive Officer ofValentis since September 1994, when he joined Megabios Corp., and asChairman since May 1997. In March 1999, Megabios merged withGeneMedicine, Inc. to form Valentis. Prior to Megabios, Dr. McGraw gainedexperience in R&D as Vice President, Development for Marion and Marion,Merrell Dow; in business development as Corporate Vice President, CorporateDevelopment at Allergan, Inc.; and in finance as President of CarerraCapital Management. Dr. McGraw currently serves on the board of directorsof ISTA Pharmaceuticals, Inc. Dr. McGraw received his Doctor ofPharmacy from the University of Tennessee Center for the Health Sciences, wherehe also completed a clinical practice residency.

**John J. Reddington,Ph.D., DVM**

John J. Reddington, 52,became Valentis’ Chief Operating Officer on July 1, 2005. Dr. Reddington’sresponsibilities include Research and Development, Intellectual Property andValentis Bioprocessing, the contract process development and manufacturingbusiness. Dr. Reddington served as Valentis’ Senior Vice President from May 2003to June 2005, although he periodically provided consulting services toValentis prior to that time. Prior to joining Valentis, Dr. Reddingtonserved as President and Chief Executive Officer for DiagXotics, Inc., aprivately held veterinary biotechnology company for 15 years. From January 1998through June 2000, Dr. Reddington also served as interim ChiefExecutive Officer for a fledgling functional genomics company, XeneX LLC.Before founding DiagXotics, Dr. Reddington was the Director of GreenwichBiotherapeutics, Inc., a biotechnology company working in human cancerbiotherapy from May 1988 to December 1989. Dr. Reddingtonreceived D.V.M. and Ph.D. degrees from Washington State University, a Mastersdegree from the University of Texas, Arlington, and a B.A. from Rice Universityin Houston, Texas.

**Joseph A. Markey**

Joseph A. Markey, 52, hasserved as Valentis’ Vice President of Finance and Administration since December 2004.Prior to that, Mr. Markey served as Senior Director of Finance andController of Valentis since February 2002. From April 2000 to February 2002,Mr. Markey served as Valentis’ Director of Finance. From July 1979 toApril 2000, Mr. Markey held various domestic and internationalfinancial positions with International Business Machines Corporation. Mr. Markeyreceived an M.B.A. and a B.S. in finance from the University of Scranton.

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**Directors**

Thedirectors of Valentis as of  September 15, 2006are as follows:

| **Name**                                | ** ** | ** ** | ** ** | **Age**                                          | ** ** | **Position** |
|-----------------------------------------|------------|------------|------------|--------------------------------------------------|------------|--------------|
| Benjamin F.  McGraw, III, Pharm.D. |       | 57         |       | President, Chief  Executive Officer and Chairman |
| Reinaldo M. Diaz                        |       | 52         |       | Director                                         |
| Patrick G. Enright                      |       | 44         |       | Director                                         |
| George M. Lasezkay,  Pharm.D.           |       | 54         |       | Director                                         |
| Mark McDade                             |       | 51         |       | Director                                         |
| Dennis J. Purcell                       |       | 50         |       | Director                                         |
| John S. Schroeder, M.D.                 |       | 68         |       | Director                                         |

 

The principal occupationsand positions for the past five years, and in some cases prior years, of theexecutive officers named above, are as follows unless set forth elsewhere in thisreport:

**Benjamin F. McGraw, III,Pharm.D.**

Benjamin F. McGraw, III,Pharm.D., 57, has served as the President and Chief Executive Officer ofValentis since September 1994, when he joined Megabios Corp., and asChairman since May 1997. In March 1999, Megabios merged withGeneMedicine, Inc. to form Valentis. Prior to Megabios, Dr. McGrawgained experience in R&D as Vice President, Development for Marion andMarion, Merrell Dow; in business development as Corporate Vice President,Corporate Development at Allergan, Inc.; and in finance as President ofCarerra Capital Management. Dr. McGraw currently serves on the board ofdirectors of ISTA Pharmaceuticals, Inc. Dr. McGraw received hisDoctor of Pharmacy from the University of Tennessee Center for the Health Sciences,where he also completed a clinical practice residency.

**Reinaldo Diaz**

Reinaldo M. Diaz, 52, hasserved as a director of Valentis since January 2003. Mr. Diazco-founded Diaz & Altschul Capital Management in 1996 and has servedas its Chief Investment Officer since then. Diaz & Altschul CapitalManagement is an asset management firm that focuses on healthcare companies. Mr. Diazhas been active in the investment banking industry for over 24 years. From1993 to 1996, Mr. Diaz was Managing Director and Head of the HealthcareGroup at Schroder Wertheim & Co., Inc., where he was responsiblefor establishing and developing the firm’s investment banking presence in thehealthcare sector. From 1981 to 1993, Mr. Diaz was with PaineWebberIncorporated. From 1981 to 1985, he was a member of the Investment BankingDepartment, where he focused on Healthcare and Technology clients. In 1985, Mr. Diazco-founded PaineWebber Development Corporation and was its President from 1990to 1993. Mr. Diaz currently serves on the board of directors of Medrium, Inc.,Berkeley Heart Labs, Inc., and Tenex Greenhouse Ventures LLC. Mr. Diazhas also served on the board of directors of Alkermes, Inc., AmgenDevelopment Corporation, Genentech Development Corporation III, Genzyme DevelopmentCorporation and several private companies. Mr. Diaz is Co-Chairman ofMedrium, Inc., a company focused on claims submission software andmanagement practice tools for physicians. He is a graduate of Harvard Collegeand of Harvard University Graduate School of Business.

**Patrick G. Enright**

Patrick G. Enright, 44,has served as a director of Valentis since March 1998 and performedconsulting services for Valentis from December 2001 to June 2002.Since June 2002, Mr. Enright has been a general partner of PequotVentures, where he specializes in healthcare venture capital investments. From March 1998to December 2001, Mr. Enright was a managing member of Diaz &Altschul Group, LLC, a principal investment group specializing in investmentsin biopharmaceutical and medical device 

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companies.From March 1995 to February 1998, Mr. Enright served in variousexecutive positions at Valentis, including Senior Vice President, CorporateDevelopment and Chief Financial Officer. From September 1993 to June 1994,Mr. Enright was Senior Vice President of Finance and Business Developmentfor Boehringer Mannheim Therapeutics, a pharmaceutical company and a subsidiaryof Corange Ltd. From September 1989 to September 1993, Mr. Enrightwas employed at PaineWebber Incorporated, an investment banking firm, where hebecame a Vice President in January 1992. Mr. Enright currently serveson the board of directors of Threshold Pharmaceuticals, Inc., Sequenom, Inc.and several privately-held companies. Mr. Enright received his M.B.A. fromthe Wharton School of Business at the University of Pennsylvania and his B.S.in Biological Sciences from Stanford University.

**George M. Lasezkay,Pharm.D.**

George M. Lasezkay,Pharm.D., 54, has served as a director of Valentis since May 2004. Since September 2003,Dr. Lasezkay has provided business development and strategic advisoryservices to biotechnology and emerging pharmaceutical companies through hisconsulting firm, Turning Point Consultants . From 1989 to 2002, Dr. Lasezkayserved in various positions at Allegan, Inc., including Assistant GeneralCounsel from 1994 to 1996, Vice President, Corporate Development from 1996 to1998, and Corporate Vice President, Corporate Development from 1998 to 2002. Dr. Lasezkaycurrently serves on the board of directors of Collagenex Pharmaceuticals, Inc.and a number of privately-held companies. Dr. Lasezkay received his J.D.from the University of Southern California Law Center and his Doctor ofPharmacy and Bachelor of Science in Pharmacy from the State University of NewYork at Buffalo.

**Mark D. McDade**

Mark D. McDade, 51, hasserved as a director of Valentis since May 2000. Since December 2002,Mr. McDade has served as Chief Executive Officer and a director of PDLBioPharma. From January 2001 to December 2002, Mr. McDade hadbeen the Chief Executive Officer of Signature BioScience, Inc., aprivately-held company focused on drug discovery. Mr. McDade was thePresident and Chief Operating Officer of Corixa Corporation, a developer ofimmunotherapeutic products through 2000. As a cofounder of Corixa in September 1994,he served as its Chief Operating Officer since that company’s inception. Priorto Corixa, Mr. McDade held various management positions at BoehringerMannheim, and Sandoz Ltd. Mr. McDade currently serves on the board ofdirectors of LigoCyte Pharmaceuticals, Inc. and Cytokinetics,Incorporated. Mr. McDade earned an M.B.A. from the Harvard UniversityGraduate School of Business and a B.A. in History from Dartmouth College.

**Dennis J. Purcell**

Dennis J. Purcell, 50, hasserved as a director of Valentis since January 2003. Since April 2000,Mr. Purcell has been senior managing partner of Aisling Capital (formerlythe Perseus-Soros BioPharmaceutical Fund, L.P.). Mr. Purcell isresponsible for the overall management of the fund, which is dedicated tomaking private equity investments in the life sciences industry and is also asignificant investor in Valentis. Prior to joining Perseus-Soros, Mr. Purcellserved as Managing Director of Life Sciences Investment Banking at ChaseH&Q, formerly Hambrecht & Quist, from 1994 to 2000. Mr. Purcellhas often been cited as one of the life sciences sector’s leaders. He washonored in the “Biotech Hall of Fame” by Genetic Engineering News in June 1998and named to the Biotechnology All-Stars list by Forbes ASAP in May 1999.Prior to joining Chase H&Q, Mr. Purcell was a Managing Director in theHealthcare Group at PaineWebber, Inc. Mr. Purcell currently serves onthe board of directors of Auxilium Pharmaceuticals, Inc. and several privately-heldcompanies. Mr. Purcell also serves on the Bioethics Committee of TheBiotechnology Industry Organization. Mr. Purcell received an M.B.A. fromHarvard University and a Bachelor of Science in Economics and Accounting fromthe University of Delaware.

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**John S. Schroeder,M.D.**

John S. Schroeder, M.D.,68, has served as a director of Valentis since April 2003 and hadpreviously served as a director from June 2002 to January 2003. Dr. Schroederis a Professor of Medicine at the Stanford University School of Medicine, wherehe was an intern and resident from 1962 to 1967, a postdoctoral fellow from1967 to 1969 and became Chief of the Cardiovascular Medicine Clinic at Stanfordafter an Assistant and Associate Professorship of Medicine there. Dr. Schroederis nationally and internationally known for his research in hearttransplantation, coronary artery spasm and coronary artery disease, with overtwelve books and 270 scientific publications to his credit. Dr. Schroederreceived his B.A. from the University of Michigan, Ann Arbor and his M.D. fromthe University of Michigan Medical School.

**Former Director**

Effective August 14, 2006,Alan C. Mendelson tendered his resignation from the Valentis Board ofDirectors in light of Valentis’ announced plans that it is assessing strategicopportunities, including the sale or merger of the business and the sale ofcertain assets. Mr. Mendelson’s law firm, Latham & Watkins LLPcontinues to advise Valentis with respect to such efforts, and Valentis and Mr. Mendelsonfelt that he could be more helpful as counsel as Valentis moves forward.

**Alan C. Mendelson**

Alan C. Mendelson, 58, served as a director ofValentis from February 2001 to August 2006 and as Secretary ofValentis from March 2000 to July 2003. Mr. Mendelson is a seniorpartner of Latham & Watkins LLP, a private law firm, and has been withthat firm since May 2000. Previously, Mr. Mendelson was with CooleyGodward LLP, a private law firm, for 27 years and served as the managingpartner of its Palo Alto office from May 1990 to March 1995 and from November 1996to October 1997. Mr. Mendelson served as Acting General Counsel ofCadence Design Systems, Inc., an electronic design automation softwarecompany, from November 1995 to June 1996. Mr. Mendelsonpreviously served as Secretary and Acting General Counsel of Amgen, Inc.,a biopharmaceutical company, from April 1990 to April 1991. Mr. Mendelsoncurrently serves on the board of directors of QLT, Inc. Mr. Mendelsonreceived his J.D. from Harvard Law School and his A.B. in Political Sciencefrom the University of California, Berkeley.

**Committees of theBoard of Directors**

The Valentis Board ofDirectors has a standing Audit Committee, Compensation Committee and NominatingCommittee.

**Audit Committee**

The Audit Committee meets with the independentauditors at least annually to review the results of the annual audit anddiscuss the financial statements, recommends to the Board of Directors theindependent auditors to be retained and receives and considers the accountants’comments as to controls, adequacy of staff and management performance andprocedures in connection with audit and financial controls. The Audit Committeealso meets with the independent auditors to review the quarterly financialresults and to discuss the results of the independent auditors’ quarterlyreview and any other matters required to be communicated to the Audit Committeeby the independent auditors under generally accepted accounting procedures.During the fiscal year ended June 30, 2006, the Audit Committee wascomposed of three independent non-employee directors: Messrs. Enright andMcDade and Dr. Lasezkay.

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The Board of Directors hasdetermined that Valentis has at least one audit committee financial expertserving on its audit committee and that Mr. McDade is an “audit committeefinancial expert” as that term is defined in Item 401(h) of Regulation S-K.The Board of Directors has determined that each member of the Audit Committeeis independent within the meaning of the Nasdaq Stock Market’s directorindependence standards and meets the requirements for audit committee membersunder applicable Nasdaq listing standards. The Audit Committee has adopted awritten charter, a copy of which was included as an appendix to the proxystatement filed with the Securities and Exchange Commission for the 2004 AnnualMeeting of Stockholders.

**CompensationCommittee**

The Compensation Committeemakes recommendations concerning salaries and incentive compensation, awardsstock options to employees and consultants under Valentis’ stock option plansand otherwise determines compensation levels and performs such other functionsregarding compensation as the Board of Directors may delegate. During thefiscal year ended June 30, 2006, the Compensation Committee wascomposed of three independent non-employee directors: Messrs. McDade andDiaz and Dr. Lasezkay. The Board of Directors has determined that eachmember of the Compensation Committee is independent within the meaning of theNasdaq Stock Market’s director independence standards. The CompensationCommittee has adopted a written charter, a copy of which was included as anappendix to the proxy statement filed with the Securities and ExchangeCommission for the 2004 Annual Meeting of Stockholders.

**Nominating andGovernance Committee**

The Nominating and Governance Committee assists theBoard of Directors in discharging the Board of Directors’ responsibilitiesregarding identifying qualified candidates to become members of the Board ofDirectors, selecting candidates to fill any vacancies on the Board ofDirectors, ensuring that Valentis has and follows the appropriate governancestandards and overseeing the evaluation of the Board of Directors. During thefiscal year ended June 30, 2006, the Nominating Committee is composedof three independent non-employee directors: Messrs. Mendelson, Schroeder,M.D. and Purcell. Mr. Mendelson resigned from the Board of Directorseffective August 14, 2006. The Board of Directors has determined thateach member of the Nominating Committee is independent within the meaning ofthe Nasdaq Stock Market’s director independence standards. The Nominating and GovernanceCommittee has adopted a written charter, a copy of which was included as anappendix to the proxy statement filed with the Securities and ExchangeCommission for the 2004 Annual Meeting of Stockholders.

The Nominating Committeewill consider and has adopted a policy with regard to the consideration of anydirector candidates recommended by security holders. The Nominating Committeeuses a process similar to that contained in the Nominating Committee Charterfor identifying and evaluating director nominees recommended by ourstockholders. In the fiscal year ended June 30, 2006, there have beenno material changes to the procedures by which security holders may recommendnominees to Valentis’ Board of Directors.

**Compensation ofDirectors**

Each non-employee director of Valentis receives anannual retainer of $12,000 and a per meeting fee of $1,000. The chairman of theAudit Committee receives an annual retainer of $6,000 and a per meeting fee of$800 and the other members of the Audit Committee receive an annual retainer of$4,000 and a per meeting fee of $500. The chairman of the CompensationCommittee receives an annual retainer of $3,500 and a per meeting fee of $800and the other members of the Compensation Committee receive an annual retainerof $2,500 and a per meeting fee of $500. The chairman of the NominatingCommittee receives an annual retainer of $2,000 and a per meeting fee of $500and the other members of the Nominating 

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Committee receive anannual retainer of $1,500 and a per meeting fee of $500. The members of theBoard of Directors are also eligible for reimbursement for their expensesincurred in connection with attendance at Board of Directors and committeemeetings.

Under the 1998Non-Employee Directors’ Stock Option Plan as amended and restated, on the datefollowing the date of the annual stockholders’ meeting of each year, eachnon-employee director will automatically be granted, without further action byValentis, its stockholders or the Board of Directors, an option to purchase10,000 shares of common stock. In addition, each new non-employee director willreceive a one time grant to purchase 26,000 shares of common stock on the dateof the annual stockholders’ meeting at which such new director is first electedto the Board of Directors. The exercise price of the options granted to thenon-employee directors is 100% of the fair market value of the common stock onthe date of the option grant.

**Compliance with Section 16(a) ofthe Exchange Act**

Section 16(a) of the Securities Exchange Actof 1934, as amended, (the “Exchange Act”) requires that our directors,executive officers and persons who own more than ten percent of a registeredclass of our equity securities, file reports of ownership and changes inownership (Forms 3, 4 and 5) with the Securities and Exchange Commission.Our directors, executive officers and, beneficial owners of more than tenperfect of our common stock are required to furnish us with copies of all ofthese forms, which they file.

Based solely upon ourreview of these reports, any amendments thereto or written representations fromcertain reporting persons, we believe that during the fiscal year ended June 30, 2006,all filing requirements applicable to our directors, executive officers,beneficial owners of more than ten percent of our common stock and otherpersons subject to Section 16(a) of the Exchange Act were met, exceptReindalo Diaz, a Valentis director, filed a Form 4 on January 9, 2006for an option to purchase 10,000 shares of our common stock granted on December 2, 2005.

**Code of BusinessConduct and Ethics**

The Board of Directors hasadopted a Code of Business Conduct and Ethics that applies to all Valentisdirectors, officers and employees, including our Chief Executive Officer, whois our principal executive officer, our Vice President of Finance andAdministration, who is our principal financial officer and principal accountingofficer. Our Code of Business Conduct and Ethics is posted on our website *www.valentis.com*. We will also provide acopy of our Code of Business Conduct and Ethics to any person without chargeupon request made in writing to Valentis, Inc., Attention: InvestorRelations, 863A Mitten Road, Burlingame, California 94010. Valentisintends to disclose any amendment to, or a waiver from, a provision of its Codeof Business Conduct and Ethics that applies to its principal executive officer,principal financial officer, principal accounting officer or controller, orpersons performing similar functions and that relates to any element of its Codeof Business Conduct and Ethics by posting such information on its website *www.valentis.com.*

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**ITEM 11.**         EXECUTIVECOMPENSATION

**SummaryCompensation Table**

Thefollowing table shows for the fiscal years ended June 30, 2006, 2005 and2004, compensation awarded or paid to, or earned by, Valentis’ Chief ExecutiveOfficer and its executive officers, other than the Chief Executive Officer,whose total annual salary and bonus exceeded $100,000 for the fiscal year endedJune 30, 2006, referred to as our named executive officers:

| ** **                                     | ** ** | ** ** | ** ** | **Annual Compensation** | ** ** | **Long-Term Compensation** | ** ** | ** **   | ** ** |
|------------------------------------------------|------------|------------|------------|------------------------------|------------|---------------------------------|------------|--------------|------------|
| **Name and Principal Position** | ** ** | ** ** | ** ** | **Year**                     | ** ** | **Salary**                      | ** ** | **Bonus(1)** | ** ** | **Other  Annual  Compensation(2)** | ** ** | **Securities  Underlying  Options/SARs** | ** ** | **Restricted  Stock  Award(s) $** | ** ** | **All Other  Compensation** | ** ** |
| Benjamin F. McGraw, III,                  |       |       | 2006       |                         |       | $                               | 370,000    |         |       | $ | — |   |   |   | — |   |   |   | 438,000 |   |   |   | 59,464 |   |   |   | $ | 1,598 | (3) |   |
| Pharm.D., President, Chief                     |       |       | 2005       |                         |       | 370,000                         |       |         | 177,500    |   |   |   | — |   |   |   | 221,000 |   |   |   | — |   |   |   | 3,483 | (4) |   |
| Executive Officer and Chairman                 |       |       | 2004       |                         |       | 355,000                         |       |         | —     |   |   |   | — |   |   |   | 250,000 |   |   |   | — |   |   |   | 76,725 | (5) |   |
| John J. Reddington, Ph.D., DVM                 |       |       | 2006       |                         |       | $                               | 275,000    |         |       | $ | 22,950 |   |   |   | — |   |   |   | 257,000 |   |   |   | 29,507 |   |   |   | $ | 1,102 | (6) |   |
| Chief Operating Officer                        |       |       | 2005       |                         |       | 255,000                         |       |         | 73,498     |   |   |   | — |   |   |   | 75,000 |   |   |   | — |   |   |   | 47,772 | (7) |   |
|                                           |       |       | 2004       |                         |       | 244,992                         |       |         | —     |   |   |   | — |   |   |   | 90,000 |   |   |   | — |   |   |   | 18,019 | (8) |   |
| Joseph A. Markey                               |       |       | 2006       |                         |       | $                               | 206,000    |         |       | $ | 13,875 |   |   |   | — |   |   |   | 122,000 |   |   |   | 17,839 |   |   |   | $ | 845 | (9) |   |
| Vice President of Finance and                  |       |       | 2005       |                         |       | 185,000                         |       |         | 43,750     |   |   |   | — |   |   |   | 65,000 |   |   |   | — |   |   |   | 856 | (10) |   |
| Administration                                 |       |       | 2004       |                         |       | 175,000                         |       |         | —     |   |   |   | — |   |   |   | 93,000 |   |   |   | — |   |   |   | 20,636 | (11) |   |
|                                                |            |            |            |                              |            |                                 |            |              |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

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(1)             Bonuses reflect payment by Valentis to thenamed executive officer during the fiscal year for such officer’s performancein the prior fiscal year.

(2)             As permitted by rules promulgated bythe Securities and Exchange Commission, no amounts are shown where the amountsconstitute perquisites and do not exceed the higher of 10% of the sum of thesalary and bonus column or $50,000.

(3)             Represents insurance premiums of $1,598paid by Valentis with respect to group life insurance for the benefit of Dr. McGraw.

(4)             Represents insurance premiums of $3,483paid by Valentis with respect to group life insurance for the benefit of Dr. McGraw.

(5)             Represents (i) payment that had beendeferred to a future date for compensation of $75,000 earned by Dr. McGrawduring fiscal year ended June 30, 2004 for the achievement of Companyfinancing objectives, which amount was paid during fiscal year ended June 30,2005; and (ii) $1,725 in insurance premiums paid by Valentis with respectto group life insurance for the benefit of Dr. McGraw.

(6)             Represents insurance premiums of $1,102paid by Valentis with respect to group life insurance for the benefit of Dr. Reddington.Excludes approximately $59,000 of used lab equipment that Valentis purchasedfrom DiagXotics, Inc. where Dr. Reddington had served as Chief ExecutiveOfficer for over 15 years until July 2005.

(7)             Represents (i) payment of $46,530 formoving expenses during fiscal year ended June 30, 2005; and (ii) insurancepremiums of $1,242 paid by Valentis with respect to group life insurance forthe benefit of Dr. Reddington.

(8)             Represents (i) payment of $17,226 formoving allowances during fiscal year ended June 30, 2004, and (ii) paymentof $792 in insurance premiums paid by Valentis with respect to group lifeinsurance for the benefit of Dr. Reddington.

(9)             Represents insurance premiums of $845 paidby Valentis with respect to group life insurance for the benefit of Mr. Markey.

(10)       Represents insurance premiums of $856 paidby Valentis with respect to group life insurance for the benefit of Mr. Markey.

(11)       Represents (i) payment of $20,000 forcompensation earned by Mr. Markey during fiscal year ended June 30, 2004for the achievement of Company financing objectives, and (ii) payment of$636 in insurance premiums paid by Valentis with respect to group lifeinsurance for the benefit of Mr. Markey.

**Stock Option Grantsand Exercises**

Valentis grants options to its executive officersunder its 1997 Equity Incentive Plan and its 2001 Nonstatutory Incentive Plan.As of June 30, 2006, options to purchase a total of 3,396,811 shareswere outstanding under the 1997 Equity Incentive Plan and the 2001 NonstatutoryIncentive Plan and options to purchase 842,984 shares remained available forgrant thereunder.

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The following tables showfor the fiscal year ended June 30, 2006, certain information regardingoptions granted to, exercised by, and held at year end by, the named executiveofficers:

**OptionGrants in Fiscal Year Ended June 30, 2006**

| ** **                    | ** ** | ** ** | ** ** | **Individual Grants**                         | ** ** | ** **                                                            | ** ** | ** **              | ** ** | **Potential Realizable  Value at Assumed** | ** ** |
|-------------------------------|------------|------------|------------|----------------------------------------------------|------------|-----------------------------------------------------------------------|------------|-------------------------|------------|-----------------------------------------------------------|------------|
| ** **                    | ** ** | ** ** | ** ** | **Number of  Securities  Underlying  Option** | ** ** | **% of Total  Options  Granted to  Employees in** | ** ** | **Exercise Price** | ** ** | **Expiration**                                            | ** ** | **Annual Rates of  Stock Price  Appreciation for  Option Term(1)** | ** ** |
| **Name**                      | ** ** | ** ** | ** ** | **Granted (#)**                               | ** ** | **Fiscal Year(2)**                                               | ** ** | **($/sh)(3)**           | ** ** | **Date**                                                  | ** ** | **   5% ($)   ** | ** ** | **   10% ($)   ** | ** ** |
| Benjamin F. McGraw, III, |       |       | 29,896     |                                               |       |                                                                  | 2.17       | %                       |       |                                                      | $          | 2.80 |   |   |   | 7/1/2015 |   |   |   | $ | 52,644 |   |   |   | $ | 133,410 |   |   |
| Pharm.D.                      |       |       | 175,104    |                                               |       |                                                                  | 12.70      | %                       |       |                                                      | 2.80       |   |   |   | 7/1/2015 |   |   |   | 308,342 |   |   |   | 781,398 |   |   |
|                          |       |       | 34,313     |                                               |       |                                                                  | 2.49       | %                       |       |                                                      | 3.14       |   |   |   | 6/15/2016 |   |   |   | 67,759 |   |   |   | 171,714 |   |   |
|                          |       |       | 198,687    |                                               |       |                                                                  | 14.41      | %                       |       |                                                      | 3.14       |   |   |   | 6/15/2016 |   |   |   | 392,353 |   |   |   | 994,300 |   |   |
| John J. Reddington,           |       |       | 16,334     |                                               |       |                                                                  | 1.18       | %                       |       |                                                      | $          | 2.80 |   |   |   | 7/1/2015 |   |   |   | $ | 28,763 |   |   |   | $ | 72,890 |   |   |
| Ph.D., DVM                    |       |       | 65,666     |                                               |       |                                                                  | 4.76       | %                       |       |                                                      | 2.80       |   |   |   | 7/1/2015 |   |   |   | 115,632 |   |   |   | 293,033 |   |   |
|                          |       |       | 75,000     |                                               |       |                                                                  | 5.44       | %                       |       |                                                      | 2.22       |   |   |   | 1/9/2016 |   |   |   | 104,711 |   |   |   | 265,358 |   |   |
|                          |       |       | 33,683     |                                               |       |                                                                  | 2.44       | %                       |       |                                                      | 3.14       |   |   |   | 6/15/2016 |   |   |   | 66,515 |   |   |   | 168,562 |   |   |
|                          |       |       | 66,317     |                                               |       |                                                                  | 4.81       | %                       |       |                                                      | 3.14       |   |   |   | 6/15/2016 |   |   |   | 130,958 |   |   |   | 331,874 |   |   |
| Joseph A. Markey              |       |       | 16,135     |                                               |       |                                                                  | 1.17       | %                       |       |                                                      | $          | 2.80 |   |   |   | 7/1/2015 |   |   |   | $ | 28,412 |   |   |   | $ | 72,002 |   |   |
|                          |       |       | 35,865     |                                               |       |                                                                  | 2.60       | %                       |       |                                                      | 2.80       |   |   |   | 7/1/2015 |   |   |   | 63,155 |   |   |   | 160,047 |   |   |
|                          |       |       | 26,250     |                                               |       |                                                                  | 1.90       | %                       |       |                                                      | 3.14       |   |   |   | 6/15/2016 |   |   |   | 51,837 |   |   |   | 131,364 |   |   |
|                          |       |       | 43,750     |                                               |       |                                                                  | 3.17       | %                       |       |                                                      | 3.14       |   |   |   | 6/15/2016 |   |   |   | 86,394 |   |   |   | 218,940 |   |   |

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(1)             Reflects the value of the stock option onthe date of grant assuming for the 5% column, a five-percent annual rate ofappreciation in Valentis’ common stock over the ten-year term of the option andfor the 10% column, a ten-percent annual rate of appreciation in Valentis’common stock over the ten-year term of the option, in each case withoutdiscounting to net present value and before income taxes associated with theexercise. The 5% and 10% assumed rates of appreciation are based on the rules ofthe Securities and Exchange Commission and do not represent Valentis’ estimateor projection of the future common stock price. The amounts in this table maynot necessarily be achieved.

(2)             Based on options to purchase 1,378,868shares of Valentis’ common stock granted in fiscal year ended June 30, 2006.

(3)             All options were granted at the fairmarket value at the date of grant.

**AggregatedOption Exercises in Last Fiscal Year and Fiscal Year End Option Values**

| **Name**                          | ** ** | ** ** | ** ** | **Shares  Acquired  on Exercise  (#)(1)** | ** ** | **Value  Realized  ($)** | ** ** | **Number of Securities  Underlying  Unexercised  Options at  June 30, 2006  (#) Exercisable/  Unexercisable** | ** ** | **Value of Unexercised  In-the-Money  Options at  June 30, 2006(2)  ($) Exercisable/  Unexercisable** | ** **      |
|-----------------------------------|------------|------------|------------|------------------------------------------------|------------|--------------------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------------------------------------------------|-----------------|
| Benjamin F.  McGraw III, Pharm.D. |       |       | —     |                                           |       |                     | —     |                                                                                                                                        |       |                                                                                                                                | 644,650/649,529 |   |   |   | $ | 0/144,160 |   |   |
| Joseph A. Markey                  |       |       | —     |                                           |       |                     | —     |                                                                                                                                        |       |                                                                                                                                | 160,092/168,245 |   |   |   | $ | 0/38,420 |   |   |
| John J. Reddington,  Ph.D., DVM   |       |       | —     |                                           |       |                     | —     |                                                                                                                                        |       |                                                                                                                                | 184,375/317,625 |   |   |   | $ | 0/140,570 |   |   |

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(1)          Noneof the executive officers exercised any options in the last fiscal year.

(2)          Calculatedon the fair market value of Valentis’ common stock on June 30, 2006,which was $3.31, minus the exercise price of the options.

**Change of Controland Severance Agreements**

In May 2006, Valentis entered into Severance andChange of Control agreements with each ofBenjamin F. McGraw III, the President and Chief ExecutiveOfficer of the Company, John J. Reddington, the Chief OperatingOfficer of the Company, and Joseph A. Markey, the Vice President ofFinance and 

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Administration of theCompany. The term of the each such agreement is for two years from May 12, 2006,unless extended by mutual agreement by the Company and such executive officeror unless earlier terminated, as described below.

Each agreement provides that, if Valentis terminatessuch executive officer’s employment during the term for any reason other thanfor cause, disability or death, then the executive officer shall be entitled to,among other things, the following: (i) the payment of all earned butunpaid base salary and any other benefit due through the date of termination, (ii) alump sum cash payment in an amount equal to such executive officer’s thencurrent annual base salary, and (iii) notwithstanding any provision to thecontrary in any equity award agreement or equity compensation plan, alloutstanding equity awards then held by such executive officer shall becomefully vested and, if applicable, exercisable with respect to all shares subjectthereto immediately prior to the date of termination.

Each agreement also provides that, if such executiveofficer terminates his employment with Valentis for good reason or Valentisterminates such executive officer’s employment for any reason other than forcause during the period commencing three months prior to and ending 12 monthsafter a change in control of Valentis, such executive officer shall be entitledto, among other things, the following in lieu of the payments described above: (i) thepayment of all earned but unpaid base salary and any other benefit due throughthe date of termination, (ii) a lump sum cash payment in an amount equalto three times such executive officer’s then current base salary, in the caseof the agreement with Dr. McGraw, or two times such executive officer’sthen current base salary, in the case of the agreements with Mr. Reddingtonand Mr. Markey, and (iii) notwithstanding any provision to thecontrary in any equity award agreement or equity compensation plan, alloutstanding equity awards then held by such executive officer shall becomefully vested and, if applicable, exercisable with respect to all shares subjectthereto immediately prior to the date of termination.

Each agreement further provides that, if suchexecutive officer terminates his employment with Valentis without good reasonor Valentis terminates such executive officer’s employment for cause, then suchexecutive officer will (i) receive his earned but unpaid salary throughthe date of termination, (ii) all accrued vacation, expense reimbursementsand any other benefits due through the date of termination and (iii) notbe entitled to any other compensation or benefits from the Company, except asrequired by law or to the extent provided under any agreement(s) relatingto any equity awards.

Each agreement alsoprovides that, for a period commencing on May 12, 2006 and ending24 months following the date of any termination, such executive officershall not, directly or indirectly, (i) induce, solicit or encourage anyemployee of Valentis to leave Valentis or in any way interfere with therelationship between Valentis and any employee thereof or (ii) induce,solicit or encourage any customer, supplier, licensee, licensor, franchisee orother business relation of Valentis to cease doing business with Valentis or inany way interfere with such relationship.

**CompensationCommittee Interlocks and Insider Participation**

During the fiscal year ended June 30, 2006,none of Valentis’ executive officers served on the board of directors of anyentities whose directors or officers serve on Valentis’ Compensation Committee.No current or former executive officer or employee of Valentis serves on theCompensation Committee.

**ITEM 12.**         SECURITYOWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDERMATTERS

Thefollowing table sets forth certain information regarding the beneficialownership of Valentis’ common stock as of September 15, 2006 by: (i) eachdirector and nominee for director; (ii) each of the executive officersnamed in the Summary Compensation Table; (iii) all executive officers ofValentis as a group; and (iv) all those known by Valentis to be beneficialowners of more than five percent of its 

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common stock. Unless indicated otherwise below, theaddress of each officer or director listed below is c /o Valentis, Inc.,863A Mitten Road, Burlingame, California 94010.

| ** **                                                                                                                                 | ** ** | **Beneficial Ownership(1)** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|
| **Name and Address of Beneficial Owner**                                                                          | ** ** | ** **                       | ** ** | **Number of  Shares** | ** ** | **Percent of  Total** | ** ** |
| Reinaldo M. Diaz(2)                                                                                                                        |       | 97,659                           |       |   | * |   |   |
| Patrick G. Enright(3)                                                                                                                      |       | 46,104                           |       |   | * |   |   |
| George M. Lasezkay, Pharm.D.(4)                                                                                                            |       | 26,956                           |       |   | * |   |   |
| Joseph A. Markey(5)                                                                                                                        |       | 216,894                          |       |   | 1.26 | % |   |
| Mark D. McDade(6)                                                                                                                          |       | 34,955                           |       |   | * |   |   |
| Benjamin F. McGraw, III, Pharm.D.(7)                                                                                                  |       | 846,209                          |       |   | 4.74 | % |   |
| Alan C. Mendelson(8)                                                                                                                       |       | 37,118                           |       |   | * |   |   |
| Dennis J. Purcell(9)                                                                                                                       |       | 2,504,978                        |       |   | 14.64 | % |   |
| John J. Reddington, Ph.D., DVM(10)                                                                                                         |       | 266,496                          |       |   | 1.54 | % |   |
| John S. Schroeder, M.D.(11)                                                                                                                |       | 34,289                           |       |   | * |   |   |
| All executive officers and directors as a group (10  persons)                                                                              |       | 4,111,658                        |       |   | 22.22 | % |   |
| Entities Affiliated with Perseus-Soros  BioPharmaceutical Fund, LP(9)  888 Seventh Avenue, 29th Floor  New York, NY 10106                  |       | 2,504,978                        |       |   | 14.64 | % |   |
| Xmark Asset Management, LLC(12)  152 West 57th Street, 21st Floor  New York, NY 10019                                            |       | 2,429,546                        |       |   | 14.22 | % |   |
| Brantrock Advisors, Inc.(13)  9465 Wilshire Boulevard, Suite 900  Beverly Hills, CA 90212                                        |       | 1,404,367                        |       |   | 8.22 | % |   |
| Biotechnology  Value Fund (14)  BVF Partners, L.P. and BVF, Inc.  900 North Michigan Avenue, Suite 1100  Chicago, Illinois 60611 |       | 1,360,000                        |       |   | 7.96 | % |   |
|                                                                                                                                            |            |                                  |            |  |  |  |  |  |  |

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*                    Lessthan one percent.

(1)          Thistable is based upon information supplied to Valentis by officers, directors andprincipal stockholders and Schedules 13D and 13G, if any, filed with theSecurities and Exchange Commission. Unless otherwise indicated in the footnotesto this table and subject to community property laws where applicable, Valentisbelieves that each of the stockholders named in this table has sole voting andinvestment power with respect to the shares indicated as beneficially owned.Applicable percentages are based on17,082,965 shares outstanding on September 15,2006, plus securities deemed outstanding pursuant to Rule 13d-3(d)(1).

(2)          Represents(i) 56,292 shares issuable upon the exercise of immediatelyexercisable warrants owned by Delta Opportunity Fund, Ltd. (“Delta Ltd.”);(ii) 4,411 shares issuable upon the exercise of immediatelyexercisable warrants owned by Delta Opportunity Fund (Institutional), LLC (“DeltaInstitutional”); and (iii) 3,500 shares issuable upon the exercise ofan immediately exercisable warrant 

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owned by Diaz &Altschul Capital Management, LLC. Diaz & Altschul Advisors, LLC, anaffiliate of Diaz & Altschul Capital Management, LLC, providesportfolio management services to Delta Ltd. and Delta Institutional andtherefore may be deemed the beneficial owner of the shares held byDelta Ltd. and Delta Institutional. Mr. Diaz is a managing member ofDiaz & Altschul Capital Management, LLC. Mr. Diaz disclaimsbeneficial ownership of these securities except to the extent of his pecuniaryinterest therein. Also, represents 33,456 shares issuable upon the exercise ofstock options granted to Mr. Diaz that are currently exercisable orexercisable within 60 days of September 15, 2006 . Excludes22,544 shares issuable upon the exercise of stock options granted to Mr. Diazthat are not currently exercisable and will not be exercisable within60 days of September 15, 2006.

(3)          Represents(i) 5,555 shares owned by Mr. Enright; (ii) 283 shares held intrust for the benefit of one Mr. Enright’s children for which Mr. Enrightand his spouse serve as co-trustees; (iii) 246 shares held in trust forthe benefit of one of Mr. Enright’s children for which Mr. Enrightand his spouse serve as co-trustees; (iv) 66 shares held in a partnershipof which Mr. Enright is a general partner; (v) 3,500 shares issuableupon the exercise of an immediately exercisable warrant issued to Mr. Enright;and (vi) 36,454 shares issuable upon the exercise of stock options grantedto Mr. Enright that are currently exercisable or exercisable within60 days of September 15, 2006. Excludes 22,544 shares issuableupon the exercise of stock options granted to Mr. Enright that are notcurrently exercisable and will not be exercisable within 60 days of September 15, 2006.

(4)          Represents26,956 shares issuable upon the exercise of stock options granted to Dr. Lasezkaythat are currently exercisable or exercisable within 60 days of  September 15, 2006 Excludes 29,044shares issuable upon the exercise of stock options granted to Dr. Lasezkaythat are not currently exercisable and will not be exercisable within60 days of September 15, 2006.

(5)          Represents(i) 10,243 shares owned by Mr. Markey; (ii) 17,839 sharessubject to forfeiture in the event that Mr. Markey’s employment is terminated,of which 11,894 shares have been released, or will be released within 60 daysof September 15, 2006, from forfeiture; and (iii) 188,812 sharesissuable upon the exercise of stock options granted to Mr. Markey that arecurrently exercisable or exercisable within 60 days of September 15, 2006.Excludes 139,525 shares issuable upon the exercise of stock options granted to Mr. Markeythat are not currently exercisable and will not be exercisable within60 days of September 15, 2006.

(6)          Represents34,955 shares issuable upon the exercise of stock options granted to Mr. McDadethat are currently exercisable or exercisable within 60 days of September 15, 2006.Excludes 22,544 shares issuable upon the exercise of stock options granted to Mr. McDadethat are not currently exercisable and will not be exercisable within60 days of September 15, 2006.

(7)          Represents(i)1,535 shares owned by Dr. McGraw; (ii) 59,464 shares subject toforfeiture in the event that Dr. McGraw’s employment is terminated, ofwhich 39,643shares have been released, or will be released within 60 daysof September 15, 2006 from forfeiture; (iii) 10,505 shares and403 shares held in an irrevocable trust and in a children’s trust,respectively, for the benefit of Dr. McGraw’s children for which Dr. McGrawand his spouse serve as co-trustees; and (iv) 774,302 shares issuable uponthe exercise of stock options granted to Dr. McGraw that are currentlyexercisable or exercisable within 60 days of September 15, 2006.Excludes 519,877 shares issuable upon the exercise of stock options granted to Dr. McGrawthat are not currently exercisable and will not be exercisable within60 days of September 15, 2006.

(8)          Represents(i) 6,204 shares owned by Mr. Mendelson; and (ii) 30,914 sharesissuable upon the exercise of stock options granted to Mr. Mendelson thatare currently exercisable or will be exercisable within 60 days of September 15, 2006.Mr. Mendelson resigned as a member of Valentis’ Board of Directors,effective August 14, 2006. Mr. Mendelson’s law firm, Latham &Watkins LLP 

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continues to adviseValentis with respect to its efforts to assess strategic opportunities that maybe available to it, and Valentis and Mr. Mendelson felt that he could bemore helpful as counsel as Valentis moves forward. In accordance with therestructuring plan approved by Valentis’ Board of Directors in connection withits recent August 2006 reduction in workforce, upon Mr. Mendelson’sresignation, his unvested options to purchase common stock were cancelled andhe received an additional 18 months to exercise his remaining vestedoptions to purchase common stock.

(9)          Represents(i) 2,504,305 shares (including 313,833 shares subject to immediatelyexercisable warrants and 31,165shares issuable upon the exercise of stock optionsgranted to Mr. Purcell that are currently exercisable or exercisablewithin 60 days of September 15, 2006) beneficially owned byPerseus-Soros BioPharmaceutical Fund, LP, and (ii) 673 shares owned by Mr. Purcell.Mr. Purcell is a senior managing partner of Perseus-SorosBioPharmaceutical Fund, LP. Mr. Purcell disclaims beneficial ownership ofthese securities except to the extent of his pecuniary interest therein.Excludes 14,835 shares issuable upon the exercise of stock options granted to Mr. Purcellthat are not currently exercisable and will not be exercisable within60 days of September 15, 2006.

(10)   Represents(i) 9,139 shares owned by Dr. Reddington; (ii) 29,507 sharessubject to forfeiture in the event that Dr. Reddington’s employment isterminated, of which 19,673shares have been released, or will be releasedwithin 60 days of September 15, 2006, from forfeiture; and (iii) 227,850shares issuable upon the exercise of stock options granted to Dr. Reddingtonthat are currently exercisable or exercisable within 60 days of September 15, 2006.Excludes 274,150 shares issuable upon the exercise of stock options granted to Dr. Reddingtonthat are not currently exercisable and will not be exercisable within60 days of September 15, 2006.

(11)   Represents34,289 shares issuable upon the exercise of stock options granted to Dr. Schroederthat are currently exercisable or exercisable within 60 days of September 15, 2006.Excludes 22,544 shares issuable upon the exercise of stock options granted to Dr. Schroederthat are not currently exercisable and will not be exercisable within60 days of September 15, 2006.

(12)   Basedsolely on a Form 4/A filed on April 28, 2006 and Form 3filed on April 14, 2006  withthe Securities and Exchange Commission. Represents 1,664,354 shares ofcommon stock and warrants to purchase an aggregate of up to 765,192 sharesof common stock.

(13)   Basedsolely on a Schedule 13G/A filed on February 14, 2006 with theSecurities and Exchange Commission.

(14)   Basedsolely on a Schedule 13G filed on March 28, 2006 with the Securitiesand Exchange Commission. Represents 910,000 shares of common stock and warrantsto purchase an aggregate of up to 450,000 shares of common stock.

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**Equity CompensationPlan Information**

The following table sets forth information as of June 30, 2006with respect to Valentis’ compensation plans under which equity securities ofValentis are authorized for issuance:

| **Plan category**                                         | ** ** | ** ** | ** ** | **Number of securitiesto be  issued upon exercise of  outstanding options,  warrants and rights** | ** ** | **Weighted-average exercise  price of outstanding  options, warrants and rights** | ** ** | **Number of securities remaining  available for future issuance  under equity compensation plans  (excluding securities  reflected in column (a))** | ** ** |
|----------------------------------------------------------------|------------|------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| ** **                                                     | ** ** | **(a)**    | ** ** | **(b)**                                                                                                                                        | ** ** | **(c)**                                                                                                         | ** ** |
| Equity compensation  plans approved by security holders(1)     |       |       | 3,265,575  |                                                                                                                                           |       |                                                                                                            | $          | 6.30                                                                                                                                                                                                                 |       |   |   | 861,534 |   |   |
| Equity  compensation plans not approved by security holders(2) |       |       | 452,212    |                                                                                                                                           |       |                                                                                                            | $          | 5.01                                                                                                                                                                                                                 |       |   |   | 237,788 |   |   |
| Total                                                          |       |       | 3,717,787  |                                                                                                                                           |       |                                                                                                            | $          | 6.14                                                                                                                                                                                                                 |       |   |   | 1,099,322 |   |   |

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(1)          Consistsof the 1997 Equity Incentive Plan, the 1998 Non-Employee Directors’ StockOption Plan and the GeneMedicine 1993 Stock Option Plan. These equitycompensation plans are more fully described in Note 2 to ConsolidatedFinancial Statements included in Valentis’ Annual Report on Form 10-K.

(2)          InMay 2001, the Board of Directors adopted the 2001 Nonstatutory IncentivePlan covering 100,000 shares of common stock of Valentis. An additional 590,000shares were added to the plan as approved by the Board of Directors in May 2003,when the plan was amended and restated. The 2001 Plan provides for grants ofnonstatutory stock options, stock bonuses, rights to purchase restricted stock,or a combination of the foregoing, referred to as stock awards, to employeesand consultants of Valentis who are not officers and directors. The exerciseprice of options granted under the 2001 Plan is determined by the Board ofDirectors but cannot be less than 100% of the fair market value of the commonstock on the date of the grant. Options under the 2001 Plan generally vest 25%one year after the date of grant and on a pro rata basis over the following36 months and expire ten years after the date of grant or 90 daysafter termination of employment. Stock awards granted under the plan cannot berepriced without the prior approval of Valentis’ stockholders. Upon a change incontrol of Valentis, the surviving corporation or acquiring corporation isrequired to assume any stock awards outstanding under the 2001 Plan orsubstitute similar stock awards for any stock awards outstanding. If anysurviving or acquiring corporation refuses to assume such Stock Awards orsubstitute similar stock awards, then such stock awards shall be terminated ifnot exercised prior to the change of control. Upon a change in control notapproved by the Board of Directors, each outstanding stock award shall becomefully vested immediately prior to the consummation of such change in control.As of June 30, 2006, options for 452,212 shares had been granted underthis plan.

The foregoing summary isqualified in its entirety by reference to the full text of the 2001 Plan.Valentis will provide, without charge, to each person to whom this proxystatement is delivered, upon request of such person and by first class mailwithin one business day of receipt of such request, a copy of the 2001 Plan.Any such request should be directed as follows: Investor Relations, Valentis, Inc.,863A Mitten Road, Burlingame, California 94010; telephone number: (650) 697-1900.

**ITEM 13.CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS**

For the fiscal year ended June 30, 2006,Valentis paid an aggregate of approximately $454,000******tothe law firm of Latham & Watkins LLP for the provision of legalservices during that period. Mr. Mendelson, a former director of Valentis,is a partner of Latham & Watkins LLP.

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During the fiscal yearended June 30, 2006, the spouse of Joseph A. Markeyprovided services to Valentis for which she was paid approximately $127,000.

Valentis has entered intoindemnity agreements with each of its executive officers and directors whichprovide, among other things, that Valentis will indemnify such officer ordirector, under the circumstances and to the extent provided for therein, forexpenses, damages, judgments, fines and settlements he may be required to payin actions or proceedings, which he is or may be made a party by reason of hisposition as a director, officer or other agent of Valentis, and otherwise tothe full extent permitted under Delaware law and Valentis’ Bylaws.

**ITEM 14.   PRINCIPAL ACCOUNTANT FEES AND SERVICES**

Fees paid or accrued byValentis, Inc. for services provided by our auditor, Ernst &Young LLP, for fiscal year 2006 and 2005 are as follows:

*Audit Fees:*   Theaggregate fees billed for professional services rendered for the audit ofValentis’ annual financial statements for the fiscal year ended June 30,2006 and the reviews of the financial statements included in Valentis’ Forms 10-Q,issuance of consents and other services in connection with statutory andregulatory filings and accounting consultations in connection with or arisingas a result of the audits and quarterly review of the financial statements forthat fiscal year were $336,130.The aggregate fees billed for professionalservices rendered for the audit of Valentis’ annual financial statements forthe fiscal year ended June 30, 2005 and the reviews of the financialstatements included in Valentis’ Forms 10-Q, issuance of consents andother services in connection with statutory and regulatory filings andaccounting consultations in connection with or arising as a result of theaudits and quarterly review of the financial statements for that fiscal yearwere $286,600.

*Audit-Related Fees:**  *The aggregate fees billed foraudit-related services was $27,000 for the fiscal year ended June 30, 2006.The aggregate fees billed for audit-related services was $23,700 for the fiscalyear ended June 30, 2005. Audit-related fees consist of fees for servicesrendered for assurance and related services that are reasonably related to theperformance of the audit or review of Valentis’ financial statements and arenot reported under “Audit Fees.” All of the audit-related fees in fiscal 2006and 2005 relate to services rendered for the audit of Valentis’ employeebenefit plans.

*Tax Fees:*   Theaggregate fees billed for services for tax compliance was $28,100 for thefiscal year ended June 30, 2006. The aggregate fees billed for taxcompliance services for the fiscal year ended June 30, 2005 was $25,500.

During Fiscal 2006 and2005, all services provided by Ernst & Young were pre-approved by theAudit Committee.

Pursuant to our AuditCommittee Charter, before the independent auditor is engaged by Valentis torender audit or non-audit services, the Audit Committee pre-approves theengagement. Audit Committee pre-approval of audit and non-audit services is notrequired if the engagement for the services is entered into pursuant topre-approval policies and procedures established by the Audit Committeeregarding Valentis’ engagement of the independent auditor. The Audit Committeehas established a pre-approved policy and procedure where pre-approval ofspecific audit and non-audit services that equal or are not expected to exceed$30,000 is not required so long as the Audit Committee is informed of eachservice provided by the independent auditor and such policies and procedures donot result in the delegation of the Audit Committee’s responsibilities underthe Securities Exchange Act of 1934, as amended. Audit and non-audit servicesexpected to exceed $30,000 require pre-approval of such audit and non-auditservices by the Audit Committee. The Audit Committee may delegate to one or moredesignated members of the Audit Committee the authority to grant pre-approvals,provided such approvals are presented to the Audit Committee at a subsequentmeeting. Audit Committee pre-approval of non-audit services other than reviewand attest services also is not required if such services fall within availableexceptions established by the Securities and Exchange Commission.

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*The following Compensation Committee Report is notdeemed “filed” with the Securities and Exchange Commission and is not to beincorporated by reference in any filing of Valentis under the Securities Act of1933, as amended, or the Securities Exchange Act of 1934, as amended, whethermade before or after the date hereof and irrespective of any generalincorporation language in any such filing.*

**REPORT OF THECOMPENSATION COMMITTEE OF THE BOARD OF DIRECTORSON EXECUTIVE COMPENSATION**

**CompensationCommittee Report**

During the fiscal yearended June 30, 2006, the Compensation Committee was composed of threeindependent, non-employee directors: Messrs. McDade and Diaz and Dr. Lasezkay.The Compensation Committee is responsible for establishing Valentis’compensation programs for all employees, including executives. For executiveofficers, the Compensation Committee evaluates performance and determinescompensation policies and levels, as the Board of Directors requests.

**ExecutiveCompensation**

We design our executive compensation programs toattract and retain executives who can lead Valentis to meet its businessobjectives and to motivate them to enhance long-term stockholder value. Ourexecutive officers’ annual compensation has consisted of cash salary, a cashincentive bonus, restricted stock and stock option grants.

To determine fair compensation, the CompensationCommittee reviews historical and current salary, bonus and stock awardinformation for other comparable companies in similar geographic areas and atsimilar stages of growth and development gathered by an industry compensationconsultant and others. The group of comparable companies is not necessarily thesame as the companies included in the market indices included in theperformance graph on page 57. The Compensation Committee also reviews avariety of industry surveys throughout the year, which provide additionalinformation about short- and long-term executive compensation. Based in part onthis information, the Compensation Committee generally sets salaries, includingthat of the Chief Executive Officer, at levels comparable to competitivecompanies of comparable size in similar industries. We structure our managementbonus program around both individual and company performance. We base the totalsize of the bonus pool on our success in meeting performance goals for theyear, accounting for changes the Compensation Committee discussed and agreed toduring the course of the year.

We use the stock optionprogram to give management employees a substantial economic interest in thelong-term appreciation of our common stock. We grant existing members ofmanagement new options on an annual basis to provide a continuing financialincentive. The size of the option grant is related to the executive’s positionand performance in the previous year.

**Chief ExecutiveOfficer Compensation**

Dr.   McGraw’s salary during fiscal year ended June 30, 2006as President, Chief Executive Officer and Chairman was $370,000. Following theCompensation Committee’s review of Dr. McGraw’s performance and Valentis’performance during fiscal year ended June 30, 2006, the CompensationCommittee set Dr. McGraw’s annual salary for fiscal year ending June 30, 2007at $370,000. In addition, if Valentis achieves certain milestones, Dr. McGrawwill receive a bonus of $185,000 for performance during the fiscal year ended June 30, 2007.The Compensation Committee granted options for 438,000 shares of common stockto Dr. McGraw on June 14, 2006, which is within the guidelinesfor the Chief Executive Officer under our annual stock options grant program.In approving Dr. McGraw’s compensation, the Compensation Committee tookinto account Dr. McGraw’s past performance as President, Chief ExecutiveOfficer and 

55

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Chairmanof the Board of Directors of Valentis, the scope of Dr. McGraw’sresponsibilities and the Board of Directors’ assessment of Valentis’achievement of its performance objectives.

**Federal TaxConsiderations**

Section 162(m) of the Internal Revenue Code,as amended, limits Valentis to a deduction for federal income tax purposes ofno more than $1 million of compensation paid to our named executiveofficers in a taxable year. None of our named executive officers receivedcompensation in excess of this limit during the fiscal year ended June 30, 2006.

The statute containingthis law and the applicable Treasury regulations offer a number of transitionalexceptions to this deduction limit for pre-existing compensation plans,arrangements and binding contracts. Compensation above $1 million may be deductedif it is “performance-based compensation” within the meaning of the InternalRevenue Code, as amended. The Compensation Committee believes that at thepresent time it is quite unlikely that the compensation paid to any namedexecutive officer in a taxable year, which is subject to the deduction limit,will exceed $1 million. The Compensation Committee intends to continue toevaluate the effects of the statute and applicable Treasury regulations and tocomply with Section 162(m) of the Internal Revenue Code, as amended,in the future to the extent consistent with the best interests of Valentis.

**Conclusion**

A significant portion ofValentis’ compensation program and Dr. McGraw’s compensation arecontingent on Valentis’ performance, and the realization of such compensationis closely linked to increases in long-term stockholder value. Valentis remainscommitted to this philosophy of pay for performance, recognizing that thecompetitive market for talented executives and the volatility of Valentis’business may result in highly variable compensation for a particular timeperiod.

**COMPENSATION COMMITTEE**

Mark D. McDadeReinaldo M. DiazGeorge M. Lasezkay

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*The following Performance Graph is not deemed “filed”with the Securities and Exchange Commission and is not to be incorporated byreference in any filing of Valentis under the Securities Act of 1933, asamended, or the Securities Exchange Act of 1934, as amended, whether madebefore or after the date hereof and irrespective of any general incorporationlanguage in any such filing.*

**PERFORMANCEMEASUREMENT COMPARISON**

The following graph showsthe total stockholder return of an investment of $100 in cash on June 30, 2001for (i) Valentis’ common stock, (ii) the Nasdaq Composite Index and (iii) theNasdaq Biotechnology Index. All values assume reinvestment of the full amountof all dividends, if any.

**Comparison ofCumulative Total Return on Investment**

****

| ** **                  | ** ** | **6/30/01** | ** ** | **6/30/02** | ** ** | **6/30/03** | ** ** | **6/30/04** | ** ** | **6/30/05** | ** ** | **6/30/06** | ** ** |   |
|-----------------------------|------------|-------------|------------|-------------|------------|-------------|------------|-------------|------------|-------------|------------|-------------|------------|--------|
| Valentis                    |       |        | 100.0      |        |       |        | 21.4       |        |       |        | 2.1        |        |       |   | 3.7 |   |   |   | 1.5 |   |   |   | 1.8 |   |   |
| Nasdaq Composite  Index     |       |        | 100.0      |        |       |        | 67.7       |        |       |        | 75.1       |        |       |   | 94.8 |   |   |   | 95.2 |   |   |   | 100.5 |   |   |
| Nasdaq Biotechnology  Index |       |        | 100.0      |        |       |        | 50.3       |        |       |        | 66.3       |        |       |   | 74.9 |   |   |   | 68.1 |   |   |   | 73.3 |   |   |

 

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**PART IV**

**ITEM 15. EXHIBITS and FINANCIAL STATEMENT SCHEDULES**

(a)(1)            Indexto Financial Statements

TheFinancial Statements and report of independent auditors required by this itemare submitted in a separate section beginning on page 62 of this Report.

|                                                                                      | ** ** | **Page No.** | ** ** |
|--------------------------------------------------------------------------------------|------------|-------------------|------------|
| Report of Ernst & Young  LLP, Independent Registered Public Accounting Firm |       |              | 62         |   |   |
| Consolidated Balance Sheets                                                          |       |              | 63         |   |   |
| Consolidated Statements of  Operations                                               |       |              | 64         |   |   |
| Consolidated Statement of Stockholders’  Equity                                 |       |              | 65         |   |   |
| Consolidated Statements of  Cash Flows                                               |       |              | 66         |   |   |
| Notes to Consolidated  Financial Statements                                          |       |              | 67         |   |   |

 

(a)(2)            Noschedules have been filed, as they were not required or are inapplicable andtherefore have been omitted.

(a)(3)            Exhibits  

| Exhibit  Footnote | ** ** | **Exhibit  Number** | ** ** | **Description of Document** |
|-------------------|------------|---------------------|------------|-----------------------------|
|              | (10        | )                   |       | 3.1                         |   | Amended and Restated Certificate of Incorporation of  the Registrant. |
|              | (1         | )                   |       | 3.2                         |   | Bylaws of the Registrant. |
|              | (3         | )                   |       | 3.3                         |   | Certificate of Designations of Series A  Convertible Redeemable Preferred Stock. |
|              | (4         | )                   |       | 3.4                         |   | Certificate of Amendment to the Bylaws of the  Registrant. |
|              |       |                |       | 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, between the Registrant and the investors named  therein. |
|              | (3         | )                   |       | 4.4                         |   | Form of Common Stock Purchase Warrant,  Class A. |
|              | (3         | )                   |       | 4.5                         |   | Form of Common Stock Purchase Warrant,  Class B. |
|              | (10        | )                   |       | 4.6                         |   | Stock Issuance and Restriction Agreement between the  Registrant and The Woodlands, dated September 4, 2003. |
|              | (4         | )                   |       | 10.1                        |   | Amended and Restated 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. |
|              | (1         | )                   |       | 10.7                        |   | Lease Agreement between the Registrant and Provident  Life and Accident Insurance Company (Provident), dated  December 21, 1993. |
|              | (1         | )                   |       | 10.8                        |   | Lease Agreement between the Registrant and SFO  Associates LLC (SFO Associates), dated March 18, 1997. |
|              | (14        | )                   |       | 10.9                        |   | Fourth Amendment to Lease between the Registrant and  ARE-819/863 Mitten Road, LLC (successor in interest to Provident and  SFO Associates), dated March 31, 2004. |
|              | (2         | )*                  |       | 10.10                       |   | First Amendment and Restatement of License Agreement  between Registrant and Baylor College of Medicine dated  March 7, 1994. |

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|        | (2     | )*   |   | 10.11                                                                                                                                                                           |   | First Amendment and Restatement of License  Agreement—Woo between Registrant and Baylor College of Medicine dated  March 7, 1994.                                                                                                                                   |
|--------|--------|------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   | (2     | )*   |   | 10.12                                                                                                                                                                           |   | First Amendment and Restatement of License  Agreement—GeneSwitch® between Registrant and Baylor College of Medicine dated  March 7, 1994.                                                                                                                      |
|   | (3     | )    |   | 10.13                                                                                                                                                                           |   | Form of Subscription Agreement between the  Registrant and each of the selling security holders, dated as of  November 20, 2000.                                                                                                                                    |
|   | (6     | )    |   | 10.14                                                                                                                                                                           |   | Amended and Restated 1998 Non-Employee  Directors’ Stock Option Plan.                                                                                                                                                                                                    |
|   | (4     | )    |   | 10.15                                                                                                                                                                           |   | Amended and Restated 2001 Nonstatutory Incentive  Plan.                                                                                                                                                                                                                       |
|   | (5     | )    |   | 10.16                                                                                                                                                                           |   | Form of Amendment, Consent and Waiver Regarding  the Subscription Agreement and Certificate of Designations for the  Series A Preferred Stock by and among the Company and each holder of the  Company’s Series A Convertible Redeemable Preferred Stock. |
|   | (7     | )*   |   | 10.17                                                                                                                                                                           |   | Form of License and Option Agreement, effective  as of December 19, 2002, by and between the Company and Schering AG.                                                                                                                                               |
|   | (10    | )    |   | 10.18                                                                                                                                                                           |   | Lease Termination Agreement between the Company and  The Woodlands, dated September 4, 2003.                                                                                                                                                                             |
|   | (6     | )    |   | 10.19                                                                                                                                                                           |   | Amendment to the Amended and Restated 1997 Equity  Incentive Plan.                                                                                                                                                                                                            |
|   | (6     | )    |   | 10.20                                                                                                                                                                           |   | 2003 Employee Stock Purchase Plan.                                                                                                                                                                                                                                            |
|   | (8     | )    |   | 10.21                                                                                                                                                                           |   | Securities Purchase Agreement, dated as of  December 2, 2003, by and among Valentis, Inc. and the  purchasers identified on the signature pages thereto.                                                                                                  |
|   | (8     | )    |   | 10.22                                                                                                                                                                           |   | Form of Warrant to purchase Common Stock.                                                                                                                                                                                                                                |
|   | (8     | )    |   | 10.23                                                                                                                                                                           |   | Registration Rights Agreement, dated as of  December 2, 2003, by and among Valentis, Inc. and the  Purchasers signatory thereto.                                                                                                                               |
|   | (9     | )    |   | 10.24                                                                                                                                                                           |   | Securities Purchase Agreement, dated as of  June 7, 2004, by and among Valentis, Inc. and the Purchasers  signatory thereto.                                                                                                                                   |
|   | (9     | )    |   | 10.25                                                                                                                                                                           |   | Form of Warrant to purchase Common Stock.                                                                                                                                                                                                                                |
|   | (9     | )    |   | 10.26                                                                                                                                                                           |   | Registration Rights Agreement, made and entered into  as of June 7, 2004, by and among Valentis, Inc. and the  Purchasers signatory thereto.                                                                                                                   |
|   | (11    | )    |   | 10.27                                                                                                                                                                           |   | Securities Purchase Agreement, dated as of  June 24, 2005, by and among Valentis, Inc. and the Purchasers  signatory thereto.                                                                                                                                  |
|   | (11    | )    |   | 10.28                                                                                                                                                                           |   | Form of Warrant to purchase Common Stock.                                                                                                                                                                                                                                |
|   | (11    | )    |   | 10.29                                                                                                                                                                           |   | Registration Rights Agreement, made and entered into  as of June 24, 2005, by and among Valentis, Inc. and the  Purchasers signatory thereto.                                                                                                                  |
|   | (12    | )    |   | 10.30                                                                                                                                                                           |   | Securities Purchase Agreement, dated  March 21, 2006, by and among Valentis, Inc. and the Purchasers  signatory thereto.                                                                                                                                       |
|   | (12    | )    |   | 10.31                                                                                                                                                                           |   | Form of Warrant to purchase Common Stock.                                                                                                                                                                                                                                |
|   | (12    | )    |   | 10.32                                                                                                                                                                           |   | Registration Rights Agreement, dated  March 21, 2006, by and among Valentis, Inc. and the Purchasers  signatory thereto.                                                                                                                                       |
|   | (13    | )    |   | 10.33                                                                                                                                                                           |   | Severance and Change of Control Agreement, dated  May 12, 2006, between Valentis, Inc. and Benjamin F. McGraw  III.                                                                                                                                            |
|   | (13    | )    |   | 10.34                                                                                                                                                                           |   | Severance and Change of Control Agreement, dated  May 12, 2006, between Valentis, Inc. and John J. Reddington.                                                                                                                                                 |
|   | (13    | )    |   | 10.35                                                                                                                                                                           |   | Severance and Change of Control Agreement, dated  May 12, 2006, between Valentis, Inc. and Joseph A. Markey.                                                                                                                                                   |
|   |   | 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 Independent Registered Public Accounting  Firm.                                                                                                                      |
|   |   | 24.1 |   | Power of Attorney (included on signature  page herewith).                                                                                                                  |
|   |   | 31.1 |   | Certification of Principal Executive Officer  Section 302.                                                                                                                 |

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|        |   | 31.2 |   | Certification of Principal Financial Officer  Section 302. |
|--------|--------|------|--------|-----------------------------------------------------------------|
|   |   | 32.1 |   | Certification of Principal Executive Officer  Section 906. |
|   |   | 32.2 |   | Certification of Principal Financial Officer  Section 906. |

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(1)          Filed as an exhibit tothe Registrant’s Registration Statement on Form S-1 (No. 333-32593)or amendments thereto and incorporated herein by reference.

(2)          Filed as an exhibit toGeneMedicine’s Registration Statement on Form S-1 (No. 33-77126)or amendments thereto and incorporated herein by reference.

(3)          Filed as an exhibit tothe Registrant’s Registration Statement on Form S-3 (No. 333-54066)filed with the SEC on January 19, 2001 and incorporated herein byreference.

(4)          Filed as an exhibit toRegistrant’s Annual Report on Form 10-K (No. 0-22987) forfiscal year ended June 30, 2002 and incorporated herein by reference.

(5)          Incorporated byreference to the Company’s Definitive Proxy Statement on Form DEF 14A(SEC File No. 000-22987), filed with the Securities andExchange Commission on December 12, 2002.

(6)          Incorporated byreference to the Company’s Definitive Proxy Statement on Form DEF 14A(SEC File No. 000-22987), filed with the Securities andExchange Commission on May 5, 2003.

(7)          Filed as Exhibit 10.1to the Registrant’s Quarterly Report on Form 10-Q for the quarterended December 31, 2002 and incorporated herein by reference.

(8)          Filed as an exhibit tothe Report on Form 8-K, filed with the Securities and ExchangeCommission on December 31, 2003 and incorporated herein by reference.

(9)          Filed as an exhibit tothe Report on Form 8-K, filed with the Securities and ExchangeCommission on June 14, 2004 and incorporated herein by reference.

(10)   Filed as an exhibit toRegistrant’s Annual Report on Form 10-K (No. 000-22987)for fiscal year ended June 30, 2003 and incorporated herein by reference.

(11)   Filed as an exhibit to theReport on Form 8-K, filed with the Securities and ExchangeCommission on June 27, 2005 and incorporated herein by reference.

(12)   Filed as an exhibit to theReport on Form 8-K, filed with the Securities and ExchangeCommission on March 22, 2006 and incorporated herein by reference.

(13)   Filed as an exhibit to theReport on Form 8-K, filed with the Securities and ExchangeCommission on May 12, 2006 and incorporated herein by reference.

(14) Filed as anexhibit to the Annual Report on Form 10-K, filed with the Securities andExchange Commission September 26, 2005 and incorporated herein by reference.

*                    Confidentialtreatment granted pursuant to a Confidential Treatment Order for portions ofthis document.

†                     Confidentialtreatment has been requested with respect to certain portions of this Exhibit.The omitted portions have been separately filed with the Securities andExchange Commission.

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**SIGNATURES**

Pursuant to therequirements 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 besigned on its behalf by the undersigned, thereunto duly authorized, on September 28, 2006.

|        | VALENTIS, INC. |
|--------|---------------------|
|   | By:                 | /s/  BENJAMIN F. MCGRAW |
|   |                | Benjamin F.  McGraw III, Pharm.D. |
|   | * *            | *President  and Chief Executive Officer* |

 

**POWER OF ATTORNEY**

KNOW ALL PERSONS BY THESE PRESENTS, that each personwhose signature appears below constitutes and appoints Benjamin F. McGraw IIIand Joseph A. Markey, and each or any one of them, his true and lawfulattorney-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 signany and all amendments (including post-effective amendments) to thisAnnual Report, and to file the same, with all exhibits thereto, and otherdocuments in connection therewith, with the Securities and Exchange Commission,granting unto said attorneys-in-fact and agents, and each of them, full powerand authority to do and perform each and every act and thing requisite andnecessary to be done in connection therewith, as fully to all intents andpurposes as he might or could do in person, hereby ratifying and confirming allthat said attorneys-in-fact and agents, or any of them, or their or hissubstitutes or substitute, may lawfully do or cause to be done by virtuehereof.

Pursuantto the requirements of the Securities Exchange Act of 1934, this report hasbeen signed below by the following persons on behalf of the registrant and inthe capacities and on the dates indicated.
|                                         | **Signature** | ** **                                                           | ** ** | ** **              | **Title** | ** ** | ** ** | ** ** | **Date** | ** ** |
|-----------------------------------------|---------------|----------------------------------------------------------------------|------------|-------------------------|-----------|------------|------------|------------|----------|------------|
| /s/  BENJAMIN F. MCGRAW                 |          | Chairman of the Board of  Directors,                                 |       | September 26, 2006 |
| Benjamin F.  McGraw, III, Pharm.D. |          | President and Chief  Executive Officer (Principal Executive Officer) |       |                    |
| /s/  JOSEPH A. MARKEY                   |          | Vice President of  Finance and                                       |       | September 26, 2006 |
| Joseph A. Markey                        |          | Administration (Principal  Financial and Accounting Officer)    |       |                    |
| /s/  PATRICK G. ENRIGHT                 |          | Director                                                             |       | September 26, 2006 |
| Patrick G.  Enright                     |          |                                                                 |       |                    |
| /s/  REINALDO M. DIAZ                   |          | Director                                                             |       | September 28, 2006 |
| Reinaldo M. Diaz                        |          |                                                                 |       |                    |
| /s/  GEORGE M. LASEZKAY                 |          | Director                                                             |       | September 28, 2006 |
| George M.  Lasezkay                     |          |                                                                 |       |                    |
| /s/  MARK MCDADE                        |          | Director                                                             |       | September 26, 2006 |
| Mark McDade                             |          |                                                                 |       |                    |
| /s/  DENNIS J. PURCELL                  |          | Director                                                             |       | September 27, 2006 |
| Dennis J. Purcell                       |          |                                                                 |       |                    |
| /s/  JOHN S. SCHROEDER                  |          | Director                                                             |       | September 26, 2006 |
| John S.  Schroeder, M.D.                |          |                                                                 |       |                    |

 

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**REPORTOF INDEPENDENT REGISTEREDPUBLIC ACCOUNTING FIRM**

The Board of Directors andStockholdersValentis, Inc.

We have audited the accompanying consolidated balancesheets of Valentis, Inc. as of June 30, 2006 and 2005, and therelated consolidated statements of operations, stockholders’ equity and cashflows for each of the three years in the period ended June 30, 2006.These financial statements are the responsibility of the Company’s management.Our responsibility is to express an opinion on these financial statements basedon our audits.

We conducted our audits in accordance with thestandards of the Public Company Accounting Oversight Board (United States).Those standards require that we plan and perform the audit to obtain reasonableassurance about whether the financial statements are free of materialmisstatement. We were not engaged to perform an audit of the Company’s internalcontrol over financial reporting. Our audits included consideration of internalcontrol over financial reporting as a basis for designing audit procedures thatare appropriate in the circumstances, but not for the purpose of expressing anopinion on the effectiveness of the Company’s internal control over financialreporting. Accordingly, we express no such opinion. An audit includesexamining, on a test basis, evidence supporting the amounts and disclosures inthe financial statements. An audit also includes assessing the accountingprinciples used and significant estimates made by management, as well asevaluating the overall financial statement presentation. We believe that ouraudits provide a reasonable basis for our opinion.

In our opinion, the financial statements referred toabove present fairly, in all material respects, the consolidated financialposition of Valentis, Inc. as of June 30, 2006 and 2005, and theconsolidated results of its operations and its cash flows for each of the threeyears in the period ended June 30, 2006, in conformity with U.S.generally accepted accounting principles.

The accompanying consolidated financial statementshave been prepared assuming that Valentis, Inc. will continue as a goingconcern. As more fully described in Note 1, the Company has incurredlosses since inception, including a net loss of $15.3 million for the yearended June 30, 2006 and its accumulated deficit was $240 million at June 30, 2006.Additionally, the Company anticipates requiring additional financial resourcesto fund its operations at least through June 30, 2007. Theseconditions raise substantial doubt about the Company’s ability to continue as agoing concern. Management’s plans as to these matters are also described inNote 1. The financial statements do not include any adjustments to reflectthe possible future effects on the recoverability and classification of assetsor the amounts and classification of liabilities that may result from theoutcome of this uncertainty.

Asdiscussed in Note 1 to the consolidated financial statements, in fiscal year2006, Valentis, Inc. changed its method of accounting for stock-basedcompensation in accordance with guidance provided in Statement of FinancialAccounting Standards No. 123(R), “Share-Based Payment”.
|                              | /s/  ERNST & YOUNG LLP |   |
|------------------------------|---------------------------------|--------|
| Palo Alto,  California       |                            |   |
| September 27, 2006 |                            |   |

 

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**VALENTIS, INC.**

**CONSOLIDATEDBALANCE SHEETS**

**(inthousands, except share and per share amounts)**

| ** **                                                                                                                                                           | ** ** | **June 30,** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------|------------|
| ** **                                                                                                                                                           | ** ** | **2006**          | ** ** | **2005** | ** ** |
| **ASSETS**                                                                                                                                                           | ** ** | ** **        | ** ** | ** ** | ** ** |
| Current assets:                                                                                                                                                      |       |              |       |   |   |
| Cash and cash equivalents                                                                                                                                            |       | $                 | 3,598      |   | $ | 8,865 |   |
| Short-term investments                                                                                                                                               |       | 750               |       | 3,648 |   |
| Interest and other receivables                                                                                                                                       |       | 87                |       | 357 |   |
| Prepaid expenses and other current assets                                                                                                                            |       | 280               |       | 337 |   |
| Total current assets                                                                                                                                                 |       | 4,715             |       | 13,207 |   |
| Property and equipment, net                                                                                                                                          |       | 37                |       | 39 |   |
| Goodwill                                                                                                                                                             |       | 409               |       | 409 |   |
| Other assets                                                                                                                                                         |       | 97                |       | 497 |   |
| Total assets                                                                                                                                                         |       | $                 | 5,258      |   | $ | 14,152 |   |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                                                       | ** ** | ** **        | ** ** | ** ** | ** ** |
| Current liabilities:                                                                                                                                                 |       |              |       |   |   |
| Accounts payable                                                                                                                                                     |       | $                 | 91         |   | $ | 265 |   |
| Accrued compensation                                                                                                                                                 |       | 889               |       | 496 |   |
| Accrued clinical trial costs                                                                                                                                         |       | 730               |       | 863 |   |
| Other accrued liabilities                                                                                                                                            |       | 705               |       | 959 |   |
| Total current liabilities                                                                                                                                            |       | 2,415             |       | 2,583 |   |
| Stockholders’ equity:                                                                                                                                           |       |              |       |   |   |
| Common stock, $.001 par value, 190,000,000 shares  authorized; 17,087,737 and 14,833,379 shares issued and outstanding at  June 30, 2006 and 2005, respectively |       | 17                |       | 15 |   |
| Additional paid-in capital                                                                                                                                           |       | 243,493           |       | 236,889 |   |
| Accumulated other comprehensive loss                                                                                                                                 |       | (693              | )          | (698 | ) |
| Accumulated deficit                                                                                                                                                  |       | (239,974          | )          | (224,637 | ) |
| Total stockholders’ equity                                                                                                                                      |       | 2,843             |       | 11,569 |   |
| Total liabilities  and stockholders’ equity                                                                                                                     |       | $                 | 5,258      |   | $ | 14,152 |   |

 

See accompanying notes.

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**VALENTIS, INC.**

**CONSOLIDATEDSTATEMENTS OF OPERATIONS**

**(inthousands, except per share amounts)**

| ** **                                                            | ** ** | **Year ended June 30,** | ** ** |
|-----------------------------------------------------------------------|------------|----------------------------------------|------------|
| ** **                                                            | ** ** | **2006**                               | ** ** | **2005** | ** ** | **2004** | ** ** |
| License and  milestone revenue                                        |       | $                                      | 627        |   | $ | 1,640 |   | $ | 7,284 |   |
| Contract research  revenue                                            |       | 100                                    |       | 476 |   | — |   |
| Other revenue                                                         |       | —                                 |       | 61 |   | 194 |   |
| Total revenue                                                         |       | 727                                    |       | 2,177 |   | 7,478 |   |
| Costs and operating  expenses:                                        |       |                                   |       |   |   |   |   |
| Cost of contract research revenue                                     |       | 93                                     |       | 521 |   | — |   |
| Research and development                                              |       | 11,228                                 |       | 9,169 |   | 10,054 |   |
| General and administrative                                            |       | 4,987                                  |       | 3,763 |   | 3,912 |   |
| Total operating expenses                                              |       | 16,308                                 |       | 13,453 |   | 13,966 |   |
| Loss from  operations                                                 |       | (15,581                                | )          | (11,276 | ) | (6,488 | ) |
| Interest income                                                       |       | 279                                    |       | 285 |   | 90 |   |
| Other income and  expense, net                                        |       | (35                                    | )          | (92 | ) | (86 | ) |
| Net loss                                                              |       | $                                      | (15,337    | ) | $ | (11,083 | ) | $ | (6,484 | ) |
| Basic and diluted net loss per share                                  |       | $                                      | (0.99      | ) | $ | (0.85 | ) | $ | (0.81 | ) |
| Shares used in  computing basic and diluted net loss per common share |       | 15,453                                 |       | 13,028 |   | 8,024 |   |

 

See accompanying notes.

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**VALENTIS, INC.**

**CONSOLIDATEDSTATEMENT OF STOCKHOLDERS’ EQUITY**

**(inthousands, except share amounts)**

| ** **                                                                                   | ** ** | ** **            | ** ** | ** **  | ** ** | ** **        | ** ** | **Accumulated** | ** ** | ** **             | ** ** | ** ** | ** ** |
|----------------------------------------------------------------------------------------------|------------|-----------------------|------------|-------------|------------|-------------------|------------|-----------------|------------|------------------------|------------|------------|------------|
| ** **                                                                                   | ** ** | ** **            | ** ** | ** **  | ** ** | **Additional**    | ** ** | **Other**       | ** ** | ** **             | ** ** | **Total**  | ** ** |
| ** **                                                                                   | ** ** | **Common Stock** | ** ** | **Paid-In** | ** ** | **Comprehensive** | ** ** | **Accumulated** | ** ** | **Stockholders’** | ** ** |
| ** **                                                                                   | ** ** | **Shares**            | ** ** | **Amount**  | ** ** | **Capital**       | ** ** | **Loss**        | ** ** | **Deficit**            | ** ** | **Equity** | ** ** |
| Balance at June 30, 2003                                                                |       | 5,555,708             |       |        | $          | 6                 |       |            |       | $                      | 210,399    |       |       |   | $ | (746 | ) |   |   | $ | (207,070 | ) |   |   | $ | 2,589 |   |   |
| Issuance of common stock pursuant to Employee Stock  Purchase Plan and 401(k) Plan |       | 77,351                |       |        | —     |              |       |            | 237        |                   |       |       | —     |   |   |   | — |   |   |   | 237 |   |   |
| Issuance of common stock pursuant to a license  termination agreement                        |       | 185,000               |       |        | —     |              |       |            | 433        |                   |       |       | —     |   |   |   | — |   |   |   | 433 |   |   |
| Stock options granted to non-employees for  services rendered                                |       | —                |       |        | —     |              |       |            | 80         |                   |       |       | —     |   |   |   | — |   |   |   | 80 |   |   |
| Disgorgement of Short-Swing Profits                                                          |       | —                |       |        | —     |              |       |            | 133        |                   |       |       | —     |   |   |   | — |   |   |   | 133 |   |   |
| Exercise of warrants                                                                         |       | 65,722                |       |        | —     |              |       |            | 197        |                   |       |       | —     |   |   |   | — |   |   |   | 197 |   |   |
| Private placement of common stock and warrants, net  of issuance costs of $2,358        |       | 7,112,826             |       |        | 7          |              |       |            | 20,658     |                   |       |       | —     |   |   |   | — |   |   |   | 20,665 |   |   |
| Net loss                                                                                     |       | —                |       |        | —     |              |       |            | —     |                   |       |       | —     |   |   |   | (6,484 | ) |   |   | (6,484 | ) |   |
| Net unrealized loss on available for sale securities                                         |       | —                |       |        | —     |              |       |            | —     |                   |       |       | (13        | ) |   |   | — |   |   |   | (13 | ) |   |
| Foreign currency translation adjustment                                                      |       | —                |       |        | —     |              |       |            | —     |                   |       |       | 53         |   |   |   | — |   |   |   | 53 |   |   |
| Total comprehensive loss                                                                     |       |                  |       |        |       |              |       |            |       |                   |       |       |       |   |   |   |   |   |   |   | (6,444 | ) |   |
| Balance at June 30, 2004                                                                |       | 12,996,607            |       |        | 13         |              |       |            | 232,137    |                   |       |       | (706       | ) |   |   | (213,554 | ) |   |   | 17,890 |   |   |
| Issuance of common stock pursuant to Employee Stock  Purchase Plan and 401(k) Plan |       | 34,981                |       |        | —     |              |       |            | 80         |                   |       |       | —     |   |   |   | — |   |   |   | 80 |   |   |
| Stock options and warrants granted to non-employees  for services rendered                   |       | —                |       |        | —     |              |       |            | 516        |                   |       |       | —     |   |   |   | — |   |   |   | 516 |   |   |
| Stock issued to non-employees for  services rendered                                    |       | 18,796                |       |        | —     |              |       |            | 52         |                   |       |       | —     |   |   |   | — |   |   |   | 52 |   |   |
| Disgorgement of Short-Swing Profits                                                          |       | —                |       |        | —     |              |       |            | 29         |                   |       |       | —     |   |   |   | — |   |   |   | 29 |   |   |
| Exercise of warrants                                                                         |       | 102,155               |       |        | —     |              |       |            | 198        |                   |       |       | —     |   |   |   | — |   |   |   | 198 |   |   |
| Private placement of common stock and warrants, net  of issuance costs of $324          |       | 1,680,840             |       |        | 2          |              |       |            | 3,877      |                   |       |       | —     |   |   |   | — |   |   |   | 3,879 |   |   |
| Net loss                                                                                     |       | —                |       |        | —     |              |       |            | —     |                   |       |       | —     |   |   |   | (11,083 | ) |   |   | (11,083 | ) |   |
| Net unrealized gain on available for sale securities                                         |       | —                |       |        | —     |              |       |            | —     |                   |       |       | 8          |   |   |   | — |   |   |   | 8 |   |   |
| Total comprehensive loss                                                                     |       |                  |       |        |       |              |       |            |       |                   |       |       |       |   |   |   |   |   |   |   | (11,075 | ) |   |
| Balance at June 30, 2005                                                                |       | 14,833,379            |       |        | 15         |              |       |            | 236,889    |                   |       |       | (698       | ) |   |   | (224,637 | ) |   |   | 11,569 |   |   |
| Issuance of common stock pursuant to Stock Plans  and 401(k) Plan, net             |       | 154,358               |       |        | —     |              |       |            | 85         |                   |       |       | —     |   |   |   | — |   |   |   | 85 |   |   |
| Stock-based compensation expenses—non-employees                                         |       | —                |       |        | —     |              |       |            | 63         |                   |       |       | —     |   |   |   | — |   |   |   | 63 |   |   |
| Stock-based compensation expenses—employees                                             |       | —                |       |        | —     |              |       |            | 1,447      |                   |       |       | —     |   |   |   | — |   |   |   | 1,447 |   |   |
| Private placement of common stock and warrants, net  of issuance costs of $239          |       | 2,100,000             |       |        | 2          |              |       |            | 5,009      |                   |       |       | —     |   |   |   | — |   |   |   | 5,011 |   |   |
| Net loss                                                                                     |       | —                |       |        | —     |              |       |            | —     |                   |       |       | —     |   |   |   | (15,337 | ) |   |   | (15,337 | ) |   |
| Net unrealized gain on available for sale securities                                         |       | —                |       |        | —     |              |       |            | —     |                   |       |       | 5          |   |   |   | — |   |   |   | 5 |   |   |
| Total comprehensive loss                                                                     |       |                  |       |        |       |              |       |            |       |                   |       |       |       |   |   |   |   |   |   |   | (15,332 | ) |   |
| Balance at  June 30, 2006                                                               |       | 17,087,737            |       |        | $          | 17                |       |            |       | $                      | 243,493    |       |       |   | $ | (693 | ) |   |   | $ | (239,974 | ) |   |   | $ | 2,843 |   |   |

 

See accompanying notes.

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**VALENTIS, INC.**

**CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

**(inthousands)**

| ** **                                                                           | ** ** | **Year ended June 30,** | ** ** |
|--------------------------------------------------------------------------------------|------------|----------------------------------------|------------|
| ** **                                                                           | ** ** | **2006**                               | ** ** | **2005** | ** ** | **2004** | ** ** |
| Cash flows from  operating activities                                                |       |                                   |       |   |   |   |   |
| Net loss                                                                             |       | $                                      | (15,337    | ) | $ | (11,083 | ) | $ | (6,484 | ) |
| Adjustments to  reconcile net loss to net cash used in operations:                   |       |                                   |       |   |   |   |   |
| Depreciation                                                                         |       | 35                                     |       | 48 |   | 1,439 |   |
| Loss (gain) on disposal of assets                                                    |       | —                                 |       | — |   | (8 | ) |
| Stock options, stock and warrants granted to non-employees  for services rendered    |       | 63                                     |       | 529 |   | 80 |   |
| Employee Stock-based compensation                                                    |       | 1,447                                  |       | — |   | — |   |
| 401(k) stock contribution matching expense                                      |       | 62                                     |       | 55 |   | 55 |   |
| Changes in  operating assets and liabilities:                                        |       |                                   |       |   |   |   |   |
| Interest and other receivables                                                       |       | 270                                    |       | (167 | ) | (3 | ) |
| Prepaid expenses and other assets                                                    |       | 57                                     |       | (32 | ) | (82 | ) |
| Deferred revenue                                                                     |       | —                                 |       | (100 | ) | (75 | ) |
| Deposits and other assets                                                            |       | 400                                    |       | — |   | — |   |
| Accounts payable                                                                     |       | (174                                   | )          | 58 |   | 41 |   |
| Accrued liabilities                                                                  |       | 6                                      |       | (1,376 | ) | 1,101 |   |
| Other                                                                                |       | —                                 |       | — |   | 53 |   |
| Net cash used in operating activities                                                |       | (13,171                                | )          | (12,068 | ) | (3,883 | ) |
| Cash flows from  investing activities                                                |       |                                   |       |   |   |   |   |
| Purchase of property and equipment                                                   |       | (33                                    | )          | (8 | ) | (7 | ) |
| Proceeds from sale of property and equipment                                         |       | —                                 |       | — |   | 8 |   |
| Purchases of available-for-sale  investments                                         |       | (5,522                                 | )          | (10,474 | ) | (12,234 | ) |
| Maturities of available-for-sale  investments                                        |       | 8,425                                  |       | 17,768 |   | 1,287 |   |
| Net cash provided by (used in) investing activities                                  |       | 2,870                                  |       | 7,286 |   | (10,946 | ) |
| Cash flows from  financing activities                                                |       |                                   |       |   |   |   |   |
| Payments on long-term debt                                                           |       | —                                 |       | — |   | (9 | ) |
| Proceeds from issuance of common stock, net of  repurchases                          |       | 5,034                                  |       | 4,131 |   | 21,064 |   |
| Net cash provided by financing activities                                            |       | 5,034                                  |       | 4,131 |   | 21,055 |   |
| Net increase  (decrease) in cash and cash equivalents                                |       | (5,267                                 | )          | (651 | ) | 6,226 |   |
| Cash and cash  equivalents, beginning of year                                        |       | 8,865                                  |       | 9,516 |   | 3,290 |   |
| Cash and cash  equivalents, end of year                                              |       | $                                      | 3,598      |   | $ | 8,865 |   | $ | 9,516 |   |
| *Supplemental disclosure of cash  flow information:*                                 | * *   | * *                               | * *   | * * | * * | * * | * * |
| Income taxes and Interest paid                                                       |       | $                                      | —     |   | $ | — |   | $ | — |   |
| *Schedule of non-cash  transactions:*                                                | * *   | * *                               | * *   | * * | * * | * * | * * |
| Pre-paid expenses recorded for stock issued to a  non-employee for services rendered |       | $                                      | —     |   | $ | 39 |   | $ | — |   |
| Stock issued for prior year accrued  401(k) matching contributions              |       | $                                      | —     |   | $ | — |   | $ | 113 |   |
| Stock issued for  prior year accrued lease termination fees                          |       | $                                      | —     |   | $ | — |   | $ | 433 |   |

 

See accompanying notes.

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**NOTESTO CONSOLIDATED FINANCIAL STATEMENTSJune 30, 2006**

**1.**   ORGANIZATIONSAND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

***Organization and Basis of Presentation***

Valentis, Inc. (“Valentis”, “the Company”, “we”or “us”) was formed from the merger of Megabios Corp. and GeneMedicine, Inc.(“GeneMedicine”) in March 1999. In August 1999, the Company acquiredPolyMASC Pharmaceuticals plc (“PolyMASC”). Valentis is incorporated in theState of Delaware.

Valentis is a biotechnology company that waspreviously engaged in the development of innovative products for peripheralartery disease, or PAD. PAD is due to chronic inflammation of the blood vesselsof the legs leading to the formation of plaque, which obstructs blood flow.

On July 11, 2006 Valentis announced negativeresults for its Phase IIb clinical trial of VLTS 934 in PAD. Valentisalso announced that it has no plans for further development of the product andis assessing strategic opportunities, which include the sale or merger of thebusiness, the sale of certain assets or other actions.

Except for the quarter ended September 30, 2003,in which the Company reported net income of approximately $3.4 millionresulting principally from the $6.5 million non-recurring license revenuerecognized under the license and settlement agreement with ALZA Corporation(see Note 13 “ALZA License and Settlement Agreement” in our Notes toConsolidated Financial Statements), Valentis has experienced net losses sinceits inception through June 30, 2006, and reported a net loss of $15.3 millionfor the fiscal year ended June 30, 2006. The accumulated deficit was$240.0 million at June 30, 2006.

At June 30, 2006, Valentis had$4.3 million in cash, cash equivalents and investments, and the Companyanticipates requiring additional financial resources to enable the Company tofund the completion of a potential merger or sale of the business. These fundsmay be derived from the sale or license of assets or other actions. We expectthese funds to allow Valentis to carry-on operations at least until fiscalsecond or third quarter 2007.

The accompanying consolidated financial statementshave been prepared assuming that we will continue as a going concern. Thefinancial statements do not include any adjustments to reflect the possiblefuture effects on the recoverability and classification of assets or theamounts and classification of liabilities that may result from the mattersdiscussed above.

The consolidated financialstatements include the accounts of Valentis and its wholly owned subsidiary,PolyMASC. The Company translates the assets and liabilities of its foreignsubsidiary stated in local functional currency to U.S. dollars at the rates ofexchange in effect at the end of the period. Revenues and expenses aretranslated using rates of exchange in effect during the period. Gains andlosses from currency translation are included in other comprehensive income(loss).

***Revenue Recognition***

Revenue arrangements with multiple elements aredivided into separate units of accounting if certain criteria are met,including whether the delivered item has value to the customer on a stand-alonebasis and whether there is objective and reliable evidence of the fair value ofthe undelivered items. Consideration received is allocated among the separate unitsof accounting based on their respective fair values, and the applicable revenuerecognition criteria are considered separately for each of the separate units.

Non-refundable up-front payments received inconnection with research and development collaboration agreements, includingtechnology advancement funding that is intended for the development 

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of the Company’s coretechnology, are deferred and recognized on a straight-line basis over therelevant period specified in the agreement, generally the research term.

Revenue related to research with the Company’scorporate collaborators is recognized as research services are performed overthe related funding periods for each contract. Under these agreements, theCompany is required to perform research and development activities as specifiedin each respective agreement. The payments received under each respectiveagreement are not refundable and are generally based on a contractual cost perfull-time equivalent employee working on the project. Research and developmentexpenses under the collaborative research agreements approximate or exceed therevenue recognized under such agreements over the terms of the respectiveagreements. Deferred revenue may result when the Company does not incur therequired level of effort during a specific period in comparison to fundsreceived under the respective contracts. Payments received relative tosubstantive, at-risk incentive milestones, if any, are recognized as revenueupon achievement of the incentive milestone event because the Company has nofuture performance obligations related to the payment. Incentive milestonepayments are triggered either by results of the Company’s research efforts orby events external to the Company, such as regulatory approval to market a product.

The Company also haslicensed technology to various biotechnology, pharmaceutical and contractmanufacturing companies. Under these arrangements, the Company receivesnonrefundable license payments in cash. These payments are recognized asrevenue when received, provided the Company has no future performance ordelivery obligations under these agreements. Otherwise, revenue is deferreduntil performance or delivery is satisfied. Certain of these license agreementsalso provide the licensee an option to acquire additional licenses ortechnology rights for a fixed period of time. Fees received for such optionsare deferred and recognized at the time the option is exercised or expiresunexercised. Additionally, certain of these license agreements involve technologythat the Company has licensed or otherwise acquired through arrangements withthird parties pursuant to which the Company is required to pay a royalty equalto a fixed percentage of amounts received by the Company as a result oflicensing this technology to others. Such royalty obligations are recorded as areduction of the related revenue. Furthermore, the Company receives royalty andprofit sharing payments under a licensing agreement with a contractmanufacturing company. Royalty and profit sharing payments are recognized asrevenue when received. The Company also provides contract research services forresearch and development manufacturing of biological materials for othercompanies. Under these contracts, the Company generally receives payments basedon a contractual cost per full-time equivalent employee working on the project.Revenue is recognized for actual research work performed during the period.

***Critical Accounting Estimates***

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

Valentis believes theaccrual for clinical trial expense represents its most significant estimateused in the preparation of its consolidated financial statements. Valentis’accruals for clinical trial expenses are based in part on estimates of servicesreceived and efforts expended pursuant to agreements established with clinicalresearch organizations and clinical trial sites. The Company has a history ofcontracting with third parties that perform various clinical trial activitieson behalf of Valentis in the ongoing development of its biopharmaceuticaldrugs. The financial terms of these contracts are subject to negotiations andmay vary from contract to contract and may result in uneven payment flows. TheCompany determines its estimates through discussion with internal clinicalpersonnel and outside service providers as to progress or stage of completionof trials or services and the agreed upon fee to be paid for such services. Theobjective of Valentis’ clinical trial accrual policy is to reflect the appropriatetrial expenses in its consolidated 

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financialstatements by matching period expenses with period services and effortsexpended. In the event of early termination of a clinical trial, the Companyaccrues expenses associated with an estimate of the remaining, non-cancelableobligations associated with the winding down of the trial.

***Stock-Based Compensation***

In December 2004, the Financial AccountingStandards Board (FASB) issued Statement of Financial Accounting Standards (FAS)No. 123 (revised 2004, or FAS 123R), “Share-Based Payment”. FAS 123Rsupersedes Accounting Principles Board (APB) Opinion No. 25, “Accountingfor Stock Issued to Employees,” and requires companies to recognizecompensation expense, using a fair-value based method, for costs related toshare-based payments, including stock options and employee stock purchaseplans. FAS 123R permits public companies to adopt its requirements usingeither the modified prospective or modified retrospective transition method.

The Company adoptedFAS 123R on July 1, 2005 using the modified prospectivetransition method, which requires that stock-based compensation cost isrecognized for all awards granted, modified or settled after the effective dateas well as for all awards granted to employees prior to the effective date thatremain unvested as of the effective date (see Note 2  for more information).

***Research and Development Expenses***

Research and developmentexpenses, which consist of costs incurred for independent and collaborativeresearch and development and include direct and research- relatedoverhead expenses and the costs of funding clinical studies, are expensed asincurred.

***Cash, Cash Equivalents and Investments***

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

Valentis classifies its cash equivalents andinvestments as “available-for-sale.” Such investments are recorded at fairvalue, determined based on quoted market prices, and unrealized gains andlosses, which are considered to be temporary, are recorded as othercomprehensive income (loss) in a separate component of stockholders’ equityuntil realized. The cost of securities sold is based on the specificidentification method.

The Company places itscash, cash equivalents, and investments with financial institutions with highcredit quality, in commercial paper and corporate debt with high creditratings, and in U.S. government and government agency securities. Therefore,the Company believes that its exposure due to concentration of credit risk isminimal and has not experienced credit losses on investments in theseinstruments to date.

***Depreciation and Amortization***

Property and equipment arestated at cost, less accumulated depreciation and amortization. Depreciation isprovided using the straight-line method over the estimated useful lives of therespective assets (generally three to seven years). Leasehold improvements areamortized over the shorter of the estimated useful lives of the assets or theapplicable lease term.

***Goodwill and Intangible Assets***

Goodwill consists of thegoodwill related to Valentis’ acquisition of PolyMASC. Prior to July 1, 2002,amortization of goodwill and purchased intangibles was calculated on thestraight-line basis over the estimated useful lives of the intangible assets ofthree years, and amortization of assembled workforce and goodwill was includedas a separate item on the Consolidated Statements of Operations. Effective 

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July 1, 2002,assembled workforce and goodwill are no longer being amortized but are subjectto an impairment analysis on at least an annual basis in accordance with therequirements of Statement of Financial Accounting Standards No. 142, (“SFAS 142”)“Goodwill and Other Intangible Assets”. The Company performed impairmentanalyses in accordance with SFAS 142 at June 30, 2006, 2005 and 2004,and determined that in each case goodwill was not impaired.

***Long-Lived Assets***

Valentis accounts for itslong-lived assets under Statement of Financial Accounting Standards No. 144(“SFAS 144”), “Accounting for the Impairment or Disposal of Long-LivedAssets”. In accordance with SFAS 144, Valentis identifies and recordsimpairment losses, as circumstances dictate, on long-lived assets used inoperations when events and circumstances indicate that the assets might beimpaired and the undiscounted cash flows estimated to be generated by thoseassets are less than the carrying amounts of those assets. The Company’slong-lived assets consist primarily of machinery and equipment and leaseholdimprovements.

***Net Loss Per Share***

Basic earnings per share is computed by dividingincome or loss applicable to common stockholders by the weighted-averagenumber of shares of common stock outstanding during the period, net of certaincommon shares outstanding that are held in escrow or subject to Valentis’ rightof repurchase. Diluted earnings per share include the effect of options andwarrants, if dilutive. Diluted net loss per share has not been presentedseparately as, given our net loss position for all periods presented, theresult would be anti-dilutive.

Areconciliation of shares used in the calculation of basic and diluted net lossper share follows (in thousands, except per share amounts):

| ** **                                                                         | ** ** | **Year ended June 30,** | ** ** |
|------------------------------------------------------------------------------------|------------|----------------------------------------|------------|
| ** **                                                                         | ** ** | **2006**                               | ** ** | **2005** | ** ** | **2004** | ** ** |
| Net loss                                                                           |       | $                                      | (15,337    | ) | $ | (11,083 | ) | $ | (6,484 | ) |
| Basic and  Diluted:                                                                |       |                                   |       |   |   |   |   |
| Weighted average shares of common stock outstanding                                |       | 15,537                                 |       | 13,123 |   | 8,211 |   |
| Less: Shares in escrow, subject to return                                          |       | (2                                     | )          | (2 | ) | (2 | ) |
| Less: Shares subject to repurchase                                                 |       | —                                 |       | (93 | ) | (185 | ) |
| Less: Shares subject to forfeiture                                                 |       | (82                                    | )          | — |   | — |   |
| Weighted-average  shares of common stock used in computing net loss per share |       | 15,453                                 |       | 13,028 |   | 8,024 |   |
| Basic and diluted net loss  per share                                              |       | $                                      | (0.99      | ) | $ | (0.85 | ) | $ | (0.81 | ) |

 

The computation ofbasic net loss per share excludes the following shares of common stock, whichare outstanding but are held in escrow or subject to Valentis’ right torepurchase or forfeiture:

·       Atotal of 2,106 shares of common stock issued in December 2002 in partialconsideration for a license agreement. The 2,106 shares of common stock areheld in escrow and will be released when certain conditions in the licenseagreement are met.

·       92,500and 185,000 weighted average shares of common stock that were subject to arepurchase option of the Company as of June 30, 2005 and 2004,respectively.

·       Aweighted average total of 82,330 shares of common stock that were subject toshares vest based on continued employment during the year ended June 30, 2006.

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The followingoptions and warrants have been excluded from the calculation of diluted netloss per share because the effect of inclusion would be antidilutive.

·       Optionsto purchase 3,717,787 shares of common stock at a weighted average price of$6.14 per share, Options to purchase 2,319,674 shares of common stock at aweighted average price of $8.45 per share and options to purchase 1,744,280 shares of common stock at a weightedaverage price of $11.24 per share at June 30, 2006, 2005 and2004, respectively.

·       Warrantsto purchase 4,749,075 shares of common stock at a weighted average price of$3.85 per share, Warrants to purchase 3,666,575 shares of common stock at aweighted average price of $4.09 per share and warrants to purchase 2,821,625shares of common stock at a weighted average price of $8.69 per share at June 30, 2006,2005 and 2004, respectively.

The options, common stockwarrants, shares of common stock held in escrow and shares of outstandingcommon stock subject to our right of repurchase will be included in thecalculation of income (loss) per share at such time as the effect is no longerantidilutive, as calculated using the treasury stock method for options andwarrants.

***401(k) Plan***

In April 1997, theBoard 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. Allemployees who complete at least 1,000 hours of service during the year areeligible to participate in the 401(k) Plan. Participants may elect to haveup to 75% of their annual salary, not to exceed the annual dollar limit set bylaw, deferred and contributed to the 401(k) Plan. Valentis has thediscretion to make a matching contribution in common stock each year for everydollar contributed to the 401(k) Plan. The stock match vests according tothe employee’s years of employment with the Company (see Note 11).

***Recent Accounting Pronouncements***

In June 2005, the FASB issued SFAS No. 154,Accounting Changes and Error Corrections (SFAS No. 154), a replacement ofAPB Opinion No. 20, Accounting Changes, and FASB No. 3, ReportingAccounting Changes in Interim Financial Statements SFAS No. 154 applies toall voluntary changes in accounting principle, and changes the requirements foraccounting for and reporting of a change in accounting principle. SFAS No. 154requires retrospective application to prior periods’ financial statements of avoluntary change in accounting principle unless it is impracticable. It is effectivefor accounting changes and corrections of errors made in fiscal years beginningafter December 15, 2005. The Company does not expect the adoption ofSFAS No. 154 will have material impact on our consolidated results ofoperations and financial condition.

In December 2004, theFinancial Accounting Standards Board (FASB) issued Statement of FinancialAccounting Standards (FAS) No. 123 (revised 2004, or FAS 123R),“Share-Based Payment”. FAS 123R supersedes Accounting Principles Board(APB) Opinion No. 25, “Accounting for Stock Issued to Employees,” andrequires companies to recognize compensation expense, using a fair-value basedmethod, for costs related to share-based payments, including stock options andemployee stock purchase plans. FAS 123R permits public companies to adoptits requirements using either the modified prospective or modifiedretrospective transition method.

The Company adoptedFAS 123R on July 1, 2005 using the modified prospectivetransition method, which requires that stock-based compensation cost isrecognized for all awards granted, modified or settled after the effective dateas well as for all awards granted to employees prior to the effective date thatremain unvested as of the effective date (see Note 2  for more information).

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***Business Segments***

Valentis has no productrevenue and operates in one business segment, the research and development ofcardiovascular therapeutics and associated delivery systems.

**2.**   STOCK-BASEDCOMPENSATION

In accordance with FAS 123R,  the Company recorded approximately $1.45million of stock-based compensation expenses for the year ended June 30, 2006,of which $503,000 was included in research and development expense and $944,000was included in general and administrative expense. The adoption of FAS 123Rhad the impact of a loss of $0.09 on the Company’s net loss per share for theyear ended June 30, 2006. The adoption of FAS 123R had no impacton cash flow from operations and cash flow from financing activities for theyear ended June 30, 2006. As of June 30, 2006, unamortizedstock-based compensation expenses of approximately $1.3 million remain tobe recognized over a weighted-average period of 1.8 years. The Companyamortizes stock-based compensation expenses on a straight-line basis over thevesting period.

The Company estimated the fair value of stock optionsgranted during the year ended June 30, 2006 using theBlack-Scholes-Merton option pricing model. The weighted-average assumptionsused under this model are as follows: 1) Due to insufficient relevanthistorical option exercise data, the expected term of the options was estimatedto be 6.1 years using the “simplified” method suggested in the Securitiesand Exchange Commission’s Staff Accounting Bulletin No. 107; 2) Expectedvolatility was estimated to be 143% based on the Company’s historicalvolatility that matched the expected term; 3) Risk-free interest rate of 4.5%is based on the U.S. Treasury yield curve in effect at the time of grant forperiods corresponding with the expected term of the option; 4) The Companyassumed a zero percent dividend yield. In addition, under FAS 123R, fairvalue of stock options granted is recognized as expense over the vestingperiod, net of estimated forfeitures. Estimated annual forfeiture rate wasbased on historical data and anticipated future conditions. The estimation offorfeitures requires significant judgment, and to the extent actual results orupdated estimates differ from our current estimates, such amounts will berecorded as a cumulative adjustment in the period estimates are revised.

Priorto the adoption of FAS 123R on July 1, 2005, Valentis accountedfor its stock-based employee compensation expenses under the recognition andmeasurement provision of APB 25, “Accounting for Stock Issued to Employees,”and related interpretations. Under APB 25, if the exercise price ofValentis’ employee stock options equals or exceeds the market price of theunderlying stock on the date of grant, no compensation expense is recognized.The following table illustrates the effect on net loss and net loss per shareif the fair value method of FAS 123 had been applied to the years ended June 30, 2005and 2004.

| ** **                                                                              | ** ** | **Year ended June 30,** | ** ** |
|-----------------------------------------------------------------------------------------|------------|----------------------------------------|------------|
| ** **                                                                              | ** ** | **2005**                               | ** ** | **2004** | ** ** |
| Net loss  applicable to common stockholders—as reported                            |       | $                                      | (11,083    | ) | $ | (6,484 | ) |
| Deduct: Stock-based  employee stock compensation expense determined under SFAS 123 |       | (3,195                                 | )          | (1,880 | ) |
| Net loss  applicable to common stockholders—pro forma                              |       | $                                      | (14,278    | ) | $ | (8,364 | ) |
| Net loss  applicable to common stockholders per share—as reported                  |       | $                                      | (0.85      | ) | $ | (0.81 | ) |
| Net loss applicable to  common stockholders per share—pro forma               |       | $                                      | (1.10      | ) | $ | (1.04 | ) |

 

The weighted-average assumptions used for thevaluation of options granted during the years ended June 30, 2005 and2004 were as follows: expected term of 4.2 years and 2.5 years; risk-freeinterest rate of 4.22% and 4.19%; expected volatility of 120% and 98%; andexpected dividend yield of zero percent and zero percent, respectively.

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At June 30, 2006, the Company has thefollowing stock-based compensation plans:

The 1997 Equity Incentive Plan, as amended andrestated in December 2005 (the “Incentive Plan”), provides for grants ofstock options and awards to employees, directors and consultants of Valentis.The exercise price of options granted under the Incentive Plan is determined bythe Board of Directors but cannot be less than 100% of the fair market value ofthe common stock on the date of the grant. Generally, options under theIncentive Plan vest 25% one year after the date of grant and on a pro ratabasis over the following 36 months and expire upon the earlier of ten yearsafter the date of grant or 90 days after termination of employment. Optionsgranted under the Incentive Plan cannot be repriced without the prior approvalof Valentis’ stockholders. As of June 30, 2006, an aggregate of 3.7million shares have been authorized for issuance and options to purchaseapproximately 3.1 million shares of common stock had been granted under theIncentive Plan.

Pursuant to the terms of the 1998 Non-EmployeeDirectors’ Plan, as amended and restated in December 2004 (the “Director’sPlan”), each non-employee director, other than a non-employee director whocurrently serves on the Board of Directors, automatically shall be granted,upon his or her initial election or appointment as a non-employee director, anoption to purchase 26,000 shares of common stock, and each person who isserving as a non-employee director on the day following each Annual Meeting ofStockholders automatically shall be granted an option to purchase 10,000 sharesof common stock. Generally, options under the 1998 Non-Employee Directors’ Planvest monthly and expire upon the earlier of ten years after the date of grantor 90 days after termination of employment. As of June 30, 2006, an aggregateof 575,000 shares have been authorized for issuance under the Directors’ Plan,and options to purchase approximately 319,000 shares of common stock had beengranted to non-employee directors under the Directors’ Plan.

The 2001 Nonstatutory Incentive Plan, as amended andrestated in May 2003 (the “NQ Plan”), provides for grants of nonstatutorystock options to employees, directors and consultants of Valentis. The exerciseprice of options granted under the NQ Plan is determined by the Board of Directorsbut cannot be less than 100% of the fair market value of the common stock onthe date of the grant. Generally, options under the NQ Plan vest 25% one yearafter the date of grant and on a pro rata basis over the following36 months and expire upon the earlier of ten years after the date of grantor 90 days after termination of employment. Options granted under the NQ Plancannot be repriced without the prior approval of Valentis’ stockholders. As of June 30, 2006,an aggregate of 690,000 shares have been authorized for issuance and options topurchase approximately 452,000 shares had been granted under the NQ Plan.

In May 2003, the Board of Directors adopted the2003 Employee Stock Purchase Plan (the “Purchase Plan”) covering an aggregateof 600,000 shares of common stock. The Purchase Plan was approved bystockholders in May 2003 and is qualified under Section 423 of theInternal Revenue Code. The Purchase Plan is designed to allow eligibleemployees of Valentis to purchase shares of common stock through periodicpayroll deductions. The price of common stock purchased under the Purchase Planmust be equal to at least 85% of the lower of the fair market value of thecommon stock on the commencement date of each offering period or the specifiedpurchase date. 515,500 shares reserved under the Purchase Plan remain availablefor issuance as of June 30, 2006.

In fiscal year 2006 and 2004, Valentis grantedoptions to consultants to purchase 50,000 and 152,000 shares of commonstock, respectively. There were no options granted to consultants in fiscalyear 2005. Options granted to consultants are periodically revalued as theyvest in accordance with SFAS 123 and EITF 96-18 using the Black-Scholesoption-pricing model. Assumptions used for valuing the options forfiscal 2006 were an estimated volatility of 133%, risk free interest rateof 4.61%, no dividend yield and an expected life of each option of7.72 years. Assumptions used for valuing the options for fiscal 2005were an estimated volatility of 115%, risk free interest rate of 4.26%, nodividend yield and an expected life of each option of 8.74 years.Assumptions used for valuing the options for 2004 were an estimated volatilityof 

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90%, risk free interestrate of 4.29%, no dividend yield and an expected life of each option of10 years. Expenses of approximately $63,000, $63,000 and $80,000 wererecognized in fiscal 2006, 2005 and 2004, respectively, related to thesegrants.

In August 2004, the Company issued warrants,exercisable at any time for a five-year period, to purchase a total of 100,000shares of common stock to four individuals who are non-employees of Valentis.These warrants are exercisable at $6.30 per share. The Company estimated thefair value of the warrants using the Black-Scholes option-pricing model andrecorded the resulting general and administrative expense of $454,000 in theyear ended June 30, 2005. Assumptions used for valuing these warrantswere an estimated volatility of 96%, risk free interest rate of 3.64%, nodividend yield and an expected life of 5 years.

In April 2005, the Company obtained theconsulting services of an investor relations company. Pursuant to a servicesagreement, the Company paid a cash fee of $100,000 and issued 18,796 shares ofValentis’ common stock, at an aggregated fair value of approximately $52,000,to the investor relations company. The total compensation of approximately$152,000 for consulting services is being expensed ratably over the term of theagreement of one year. For the year ended June 30, 2006 and 2005, thecompany recorded $14,000 and $38,000 of general and administrative expensesunder this agreement, respectively.

Activityunder all option plans for the year ended June 30, 2006 was asfollows:

| ** **                                      | ** ** | **Number  of  Shares** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Weighted  Average  Remaining  Contractual  Life** | ** ** | **Aggregate  Intrinsic  Value** | ** ** |
|-------------------------------------------------|------------|------------------------|------------|----------------------------------------|------------|-----------------------------------------------------|------------|---------------------------------|------------|
| ** **                                      | ** ** | ** **             | ** ** | ** **                             | ** ** | ** **                                          | ** ** | **(in 000s)**              | ** ** |
| Options  outstanding at June 30, 2003      |       | 1,002,327              |       | $                                      | 22.04      |                                                |       |                            |       |   |   |   |   |   |
| Options granted                                 |       | 779,450                |       | $                                      | 4.46       |                                                |       |                            |       |   |   |   |   |   |
| Options exercised                               |       | —                 |       | —                                 |       |                                                |       |                            |       |   |   |   |   |
| Options forfeited                               |       | (37,497                | )          | $                                      | 165.86     |                                                |       |                            |       |   |   |   |   |   |
| Options  outstanding at June 30, 2004      |       | 1,744,280              |       | $                                      | 11.24      |                                                |       | 9.14                            |       |   |   | $ | 4,832 |   |   |
| Options granted                                 |       | 692,354                |       | $                                      | 6.09       |                                                |       |                            |       |   |   |   |   |   |
| Options exercised                               |       | —                 |       | —                                 |       |                                                |       |                            |       |   |   |   |   |
| Options forfeited                               |       | (116,960               | )          | $                                      | 36.20      |                                                |       |                            |       |   |   |   |   |   |
| Options outstanding  at June 30, 2005 |       | 2,319,674              |       | $                                      | 8.45       |                                                |       | 8.45                            |       |   |   | $ | 66 |   |   |
| Options granted                                 |       | 1,500,250              |       | $                                      | 2.91       |                                                |       |                            |       |   |   |   |   |   |
| Options exercised                               |       | —                 |       | —                                 |       |                                                |       |                            |       |   |   |   |   |
| Options forfeited                               |       | (41,428                | )          | $                                      | 3.91       |                                                |       |                            |       |   |   |   |   |   |
| Options expired                                 |       | (60,709                | )          | $                                      | 15.64      |                                                |       |                            |       |   |   |   |   |   |
| Options  outstanding at June 30, 2006 |       | 3,717,787              |       | $                                      | 6.14       |                                                |       | 8.29                            |       |   |   | $ | 761 |   |   |
| Options exercisable at  June 30, 2006 |       | 1,599,162              |       | $                                      | 9.69       |                                                |       | 7.38                            |       |   |   | $ | 81 |   |   |

 

The weighted average fair value of options grantedduring the years ended June 30, 2006, 2005 and 2004 was $2.69, $4.76and $2.98, respectively. Unrecognized compensation with respect to options thatwill be recognized in future periods was approximately $1.2 million at June 30, 2006.

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Therewas no nonvested share activity under our stock option plans during the yearsended June 30, 2005 and 2004. Nonvested share activity under ourstock option plans for the year ended June 30, 2006 was as follows:

| ** **               | ** ** | **Year Ended  June 30, 2006** | ** ** |
|--------------------------|------------|----------------------------------------------|------------|
| ** **               | ** ** | **Nonvested  Number  of  Shares**            | ** ** | **Weighted  Average  Grant Date  Fair Value** | ** ** |
| Beginning balance        |       |                                         | —     |   |   |   |   |   |   |
| Grants                   |       |                                         | 106,810    |   |   |   | $ | 2.80 |   |   |
| Shares vested            |       |                                         | (44,508    | ) |   |   | $ | 2.80 |   |   |
| Ending nonvested balance |       |                                         | 62,302     |   |   |   | $ | 2.80 |   |   |

 

Unrecognized compensation with respect to nonvestedshares that will be recognized in future periods was approximately $100,000 at June 30, 2006.

During the year ended June 30, 2006,the Company issued 38,613 shares of common stock to employees under the 2003Employee Stock Purchase Plan and recorded approximately $43,000 of compensationexpenses. Unrecognized compensation that will be recognized in future periodswas approximately $111,854 at June 30, 2006.

**3.**   FINANCIALINSTRUMENTS

At June 30, 2006and 2005, financial instruments held by the Company consist of the following(in thousands):

| ** **                                   | ** ** | **Amortized  Cost** | ** ** | **Unrealized  Gain/(Loss)** | ** ** | **Estimated  Fair Value** | ** ** |
|----------------------------------------------|------------|---------------------|------------|-----------------------------|------------|--------------------------------|------------|
| **June 30,  2006**                      |       |                |       |                        |       |                           |       |   |   |   |   |   |   |
| Money market  mutual funds                   |       |                | $          | 2,936                       |       |                           |       | $ | — |   |   |   | $ | 2,936 |   |   |
| Commercial paper                             |       |                | $          | 699                         |       |                           |       | — |   |   |   | $ | 699 |   |   |
| Corporate debt  securities                   |       |                | 750        |                        |       |                           | —     |   |   |   | 750 |   |   |
|                                         |       |                | 4,385      |                        |       |                           | —     |   |   |   | 4,385 |   |   |
| Less amounts  classified as cash equivalents |       |                | (3,635     | )                           |       |                           | —     |   |   |   | (3,635 | ) |   |
| Total short-term  investments                |       |                | $          | 750                         |       |                           |       | $ | — |   |   |   | $ | 750 |   |   |
| **June 30,  2005**                      |       |                |       |                        |       |                           |       |   |   |   |   |   |   |
| Money market  mutual funds                   |       |                | $          | 7,664                       |       |                           |       | $ | — |   |   |   | $ | 7,664 |   |   |
| Commercial paper                             |       |                | $          | 499                         |       |                           |       | — |   |   |   | $ | 499 |   |   |
| Corporate debt  securities                   |       |                | 3,653      |                        |       |                           | (5         | ) |   |   | 3,648 |   |   |
|                                         |       |                | 11,816     |                        |       |                           | (5         | ) |   |   | 11,811 |   |   |
| Less amounts  classified as cash equivalents |       |                | (8,163     | )                           |       |                           | —     |   |   |   | (8,163 | ) |   |
| Total short-term  investments                |       |                | $          | 3,653                       |       |                           |       | $ | (5 | ) |   |   | $ | 3,648 |   |   |

 

Unrealized gains or losseshave not been material and have been presented net. There were no realizedgains or losses in any period presented. The Company’s cash and cashequivalents, interest and other receivables, and accounts payable are carriedat historical cost, which approximates fair value because of the short-termnature of these accounts.

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**4.**   ACCUMULATED OTHERCOMPREHENSIVE LOSS

Comprehensiveloss is comprised of net loss and other comprehensive loss. Other comprehensiveloss includes certain changes to stockholders’ equity of the Company that areexcluded from net loss. The components of accumulated other comprehensive lossare as follows (in thousands):

| ** **                                        | ** ** | **June 30, 2006** | ** ** | **June 30, 2005** | ** ** |
|---------------------------------------------------|------------|-----------------------------|------------|-----------------------------|------------|
| Unrealized loss  on available-for-sale securities |       |                        | $          | —                      |       |   |   | $ | (5 | ) |   |
| Foreign currency  translation adjustments         |       |                        | (693       | )                           |       |   | (693 | ) |   |
| Accumulated other  comprehensive loss             |       |                        | $          | (693                        | )          |   |   | $ | (698 | ) |   |

 

**5.**   COLLABORATIVE,LICENSE AND RESEARCH AGREEMENTS

Revenue recognized in thefiscal years ended June 30, 2006, 2005 and 2004 is as follows (inthousands):

| ** **                                                   | ** ** | **Year ended June 30,** | ** ** |
|--------------------------------------------------------------|------------|----------------------------------------|------------|
| ** **                                                   | ** ** | **2006**                               | ** ** | **2005** | ** ** | **2004** | ** ** |
| License and milestone  revenue:                              |       |                                   |       |   |   |   |   |
| GeneSwitch® licenses                                    |       | $                                      | 393        |   | $ | 1,021 |   | $ | 284 |   |
| DNAVaxTM gene delivery  technology license and milestone |       | —                                 |       | — |   | 500 |   |
| PINCTM gene delivery  technology licenses                |       | 114                                    |       | 619 |   | — |   |
| PEGylation technology  licenses                              |       | 120                                    |       | — |   | 6,500 |   |
|                                                         |       | 627                                    |       | 1,640 |   | 7,284 |   |
| Contract research  revenue                                   |       | 100                                    |       | 476 |   | — |   |
| Other revenue                                                |       | —                                 |       | 61 |   | 194 |   |
| Total                                                        |       | $                                      | 727        |   | $ | 2,177 |   | $ | 7,478 |   |

 

To date, substantially allrevenue has been generated by collaborative research and developmentagreements, from corporate partners, and from licensees, and only minimalrevenue has been generated from royalties on sales of the GeneSwitch® generegulation system to the research market. Under the terms of corporatecollaborations, Valentis historically received research and development fundingon a quarterly basis in advance of associated research and development costs.

***Other license-outagreements***

Valentis has licensed-outits proprietary GeneSwitch® gene regulation technology on a non-exclusive basisto Wyeth-Ayerst Laboratories, GlaxoSmithKline, LARNAX GmbH, Schering AGand Organon Laboratories, LTD for research purposes. In addition, the Companyhas licensed its gene delivery technology on a non-exclusive basis to IDMPharma, Inc and on a exclusive basis to Juvaris BioTherapeutics. Further,the Company has licensed to Schering AG the exclusive, worldwide rights to itsGeneSwitch® gene regulation and gene delivery technologies to develop andcommercialize two gene-based therapeutic products. These agreements generallyinclude (i) up front payments and annual maintenance fees, which arenon-cancelable and recognized at the time of contract signing; and, (ii) milestoneand royalty payments. Revenues, in aggregate, recognized from these agreementswere approximately $627,000, $1.6 million and $784,000 for the fiscal yearended June 30, 2006, 2005 and 2004, respectively. The Company hasalso granted a license to ALZA Corporation under a license and settlementagreement related to its PEGylation technology. Valentis recognized$6.5 million of license revenue in fiscal 2004 under this agreement(See Note 13).

Valentis has established a non-exclusive cross licensewith Genzyme Corporation in which Genzyme receives rights to GeneSwitch® generegulation technology for research use and Valentis receives certain rights toGenzyme’s plasmid DNA manufacturing technology.

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***Contract research agreements***

Valentis has entered intocontract research agreements with other companies. Under the agreements, we arerequired to conduct research on the manufacturing of certain biologicalmaterials for other companies. For the years ended June 30, 2006 and2005, we recognized approximately $100,000 and $476,000 of contract researchrevenue, respectively, based on research performed during the years, andrecorded approximately $93,000 and $521,000 of costs of contract research,respectively, which included direct and related overhead expenses incurred andcosts of general and administrative support.

***Sponsored research agreements***

Valentis has entered intoseveral sponsored research agreements with universities. These agreements aregenerally cancelable by either party upon written notice and may be extended bymutual consent of both parties. Research and development expenses arerecognized as the related services are performed, generally ratably over theperiod of service. Expenses under these agreements were approximately $57,000,$74,000 and $55,000 for the fiscal years ended June 30, 2006, 2005and 2004, respectively.

**6.**   OTHERACQUIRED TECHNOLOGY

In April 1999,Valentis acquired rights to intellectual property related to the DEL-1gene and protein. DEL-1 is a novel extracellular matrix protein involvedin early growth and development of blood vessels and bone that has beendemonstrated to have potential application in the treatment of certain vasculardiseases by stimulating angiogenesis. Valentis is obligated to make payments toVanderbilt University upon the achievement of certain milestones, to sharerevenue received from sublicensing at a specified rate, and to make royaltypayments on sales of products, if any. As of June 30, 2006, no revenueshave been derived from the license of this technology.

**7.**   PROPERTYAND EQUIPMENT

Propertyand equipment consist of the following (in thousands):

| ** **                                      | ** ** | **June 30,** | ** ** |
|-------------------------------------------------|------------|-------------------|------------|
| ** **                                      | ** ** | **2006**          | ** ** | **2005** | ** ** |
| Machinery and  equipment                        |       | $                 | 6,309      |   | $ | 6,287 |   |
| Furniture and  fixtures                         |       | 1,262             |       | 1,251 |   |
| Leasehold  improvements                         |       | 9,868             |       | 9,868 |   |
|                                            |       | 17,439            |       | 17,406 |   |
| Less accumulated  depreciation and amortization |       | (17,402           | )          | (17,367 | ) |
| Property and equipment,  net                    |       | $                 | 37         |   | $ | 39 |   |

 

**8.**   GOODWILL

At June 30, 2006and 2005, goodwill is associated with the acquisitions of PolyMASCPharmaceuticals, plc. in fiscal 2000. The Company performed impairmentanalyses in accordance with SFAS 142 and determined that goodwill was notimpaired during any of the periods presented.

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**9.**   OTHERACCRUED LIABILITIES

Otheraccrued liabilities consist of the following (in thousands):

| ** **                                 | ** ** | **June 30,** | ** ** |
|--------------------------------------------|------------|-------------------|------------|
| ** **                                 | ** ** | **2006**          | ** ** | **2005** | ** ** |
| Accrued research  and development expenses |       | $                 | 172        |   | $ | 208 |   |
| Accrued rent                               |       | 50                |       | 80 |   |
| Accrued property  and use taxes            |       | 98                |       | 378 |   |
| Accrued legal  expenses                    |       | 124               |       | 121 |   |
| Accrued accounting  fees                   |       | 194               |       | 60 |   |
| Other                                      |       | 67                |       | 112 |   |
| Total                                      |       | $                 | 705        |   | $ | 959 |   |

 

**10.**   COMMITMENTS

***Operating Lease***

We lease our facilities under operating leases. Theseleases expire in October 2007 with renewal options at the end of theinitial terms to extend the leases for an additional five years.

Minimalannual rental commitments under the operating leases at June 30, 2006 areas follows (in thousands):

| **Year ended June 30,** | ** ** | ** ** | ** ** | ** ** | ** ** |
|----------------------------------------|------------|------------|------------|------------|------------|
| 2007                                   |       | $          | 1,201      |       |
| 2008                                   |       | 458        |       |
|                                   |       | $          | 1,659      |       |

 

Aggregate future minimum sublease income to bereceived under the Company’s facility subleases as of June 30, 2006totals approximately $526,000, which will offset rent expense in the fiscalyear ended June 30, 2007. Gross rent expense for the fiscal yearsended June 30, 2006, 2005 and 2004 was approximately$1.5 million, $1.2 million and $677,000, respectively. Gross subleaseincome for the fiscal years ended June 30, 2006, 2005 and 2004 wasapproximately $652,000, $517,000 and $502,000, respectively.

As a result of the July 2006announcement regarding negative results in our Phase IIb clinical trial ofVLTS 934, Valentis is currently assessing its strategic opportunitiesincluding the sale or merger of the business, the sale or license of certainassets and the resolution property leases, which the Company believes will beresolved without material adverse effect.

***Restricted Cash***

At June 30, 2006,the Company had approximately $58,000 of restricted cash, which is required byits bank for the establishment of a standby letter of credit related to theCompany’s utility services. The restricted cash of approximately $58,000 isincluded in other assets in the consolidated balance sheet as of June 30, 2006,2005 and 2004.

***Guarantees***

In the ordinary course ofits business, the Company makes certain indemnities, commitments and guaranteesunder which it may be required to make payments in relation to certaintransactions. These include indemnities of clinical investigators and contractresearch organizations involved in the development of the Company’s clinicalstage products, indemnities of contract manufacturers and 

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indemnitiesto directors and officers of the Company to the maximum extent permitted underthe laws of the State of Delaware. The duration of these indemnities,commitments and guarantees varies, and in certain cases, is indefinite. Themajority of these indemnities, commitments and guarantees do not provide forany limitation of the maximum potential future payments the Company could beobligated to make. The Company has not recorded any liability for theseindemnities, commitments and guarantees in the accompanying consolidatedbalance sheets. However, the Company accrues for losses for any knowncontingent liability, including those that may arise from indemnificationprovisions, when future payment is probable and in accordance with SFAS No. 5,Accounting for Contingencies. No such losses have been recorded to date.

***Liquidated Damages Contingencies***

In January and June 2004, June 2005 andMarch 2006, the Company completed four separate private placements ofcommon stock (see Note 11) for gross proceeds of approximately$10.0 million, $12.0 million, $4.2 million and $5.3 million,respectively.

The Company entered into registration rightsagreements with the purchasers in these four private placements of commonstock. Pursuant to the registration rights agreements, the Company filed withthe Securities and Exchange Commission registration statements related to theshares issued to the purchasers and shares issuable upon the exercise of thewarrants under the private placements. In the event the Company must suspenduse of the registration statements for greater than 20 consecutive days ora total of 40 days in the aggregate during the time the Company isrequired to keep the registration statement effective under the registrationrights agreements, then the Company must pay to each purchaser in cash 1.0% ofthe purchaser’s aggregate purchase price of the shares for the first month, aswell as an additional 1.5% of the purchaser’s aggregate purchase price for eachadditional month thereafter, while the use of the registration statements hasbeen suspended. The Company currently expects to be required to maintainavailability of the registration statement for at least two years following theapplicable closing.

In addition, under thesecurities purchase agreement entered into in connection with the privateplacements completed in June 2005 and March 2006, while there is aneffective registration statement and if the Company fails to deliver a stockcertificate that is free of restrictive legends within three trading days upondelivery of such a request by a purchaser, the Company is required to pay tothe purchaser, for each $1,000 of shares of stock or shares issuable uponexercise of warrants requested, $10 per trading day for each trading daybeginning five trading days after the delivery of the request, increasing to$20 per trading day after the first five trading days for which such damageshave begun to accrue, until such certificate is delivered without restrictivelegends.

**11.**   STOCKHOLDERS’EQUITY

***Common Stock***

In January 2004, Valentis completed a privateplacement of 4,878,047 shares of common stock at $2.05 per share along withwarrants, exercisable for a five-year period, to purchase 1,951,220 shares ofcommon stock at $3.00 per share, resulting in net proceeds to the Company ofapproximately $9.4 million.

In June 2004, the Company completed anotherprivate placement, in which the Company issued and sold 2,234,779 shares ofcommon stock and warrants, exercisable for a five-year period, to purchase670,431 shares of common stock at $5.4075 per unit, resulting in net proceedsof approximately $11.2 million. The warrants are exercisable at $6.98 pershare. In addition, the Company issued to Jefferies & company, Inc.,the placement agent of the private placement, warrants to purchase223,478 shares of common stock at $5.4075 per share, exercisable for afive-year period.

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In June 2005, the Company completed an additionalprivate placement, in which the Company issued and sold 1,680,840 shares of theCompany’s common stock and warrants, exercisable for a five-year period, topurchase up to 840,420 additional shares of the Company’s common stock at $2.50per unit, for net proceeds of approximately $3.9 million. The warrants areexercisable at $3.51 per share. In addition, the Company issued to thedesignees of Reedland Capital Partners, the placement agent of the privateplacement, warrants to purchase 63,000 shares of common stock at $3.29 pershare, exercisable for a five-year period.

In March 2006, the Company completed one moreprivate placement, in which the Company issued and sold 2,100,000 shares of theCompany’s common stock and warrants, exercisable for a five-year period, topurchase up to 1,050,000 additional shares of the Company’s common stock at$2.50 per unit, for net proceeds of approximately $5.0 million. Thewarrants are exercisable at $3.00 per share. In addition, the Company issued tothe designees of Griffin Securities, Inc., the placement agent of theprivate placement, warrants to purchase 22,500 shares of common stock at $3.00per share, exercisable for a five-year period.

In August 2004, the Company issued warrants,exercisable at any time for a five-year period, to purchase a total of 100,000shares of common stock to four individuals who are non-employees of Valentis.These warrants are exercisable at $6.30 per share. The Company estimated thefair value of the warrants using the Black-Scholes option-pricing model andrecorded the resulting general and administrative expense of $454,000 in theyear ended June 30, 2005. Assumptions used for valuing these warrantswere an estimated volatility of 96%, risk free interest rate of 3.64%, nodividend yield and an expected life of 5 years.

In April 2005, theCompany obtained the consulting services of an investor relations company.Pursuant to a services agreement, the Company paid a cash fee of $100,000 andissued 18,796 shares of Valentis’ common stock, at an aggregated fair value ofapproximately $52,000, to the investor relations company. The totalcompensation of approximately $152,000 for consulting services is beingexpensed ratably over the term of the agreement of one year. For the year endedJune 30, 2006 and 2005, the company recorded $14,000 and $38,000 ofgeneral and administrative expenses under this agreement, respectively.

***Stock Issued Under the Valentis Inc. 401(k) Plan***

Pursuant to the Valentis, Inc.401(k) Plan (the “401(k) Plan”), the Company made matchingcontributions to all eligible participants who had elective deferrals duringcalendar year 2005, 2004 and 2003, equal to 25% of each such eligibleparticipant’s elective deferrals during such year in the form of shares of theCompany’s Common Stock. In fiscal 2006, Valentis contributed 24,336 sharesof its common stock to the 401(k) Plan as the Company’s fiscal 2006matching contributions. In fiscal 2005, Valentis contributed 20,016 sharesof its common stock to the 401(k) Plan as the Company’s fiscal 2005matching contributions. In fiscal 2004, Valentis contributed 9,927 sharesof its common stock to the 401(k) Plan as the Company’s fiscal 2004matching contributions. Compensation expense related to this match wasapproximately $62,000, $55,000 and $55,000 in fiscal 2006, 2005 and 2004,respectively.

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***Shares of Common Stock Reserved for Issuance***

At June 30, 2006,shares of common stock reserved for future issuance are as follows:

| ** **                                             | ** ** | **Number of  shares** | ** ** |
|--------------------------------------------------------|------------|----------------------------|------------|
| Common stock  warrants                                 |       | 4,749,075                  |       |
| 401(k) Plan—employer  matching contributions |       | 152,219                    |       |
| Employee stock  purchase plan                          |       | 515,500                    |       |
| Stock option  plans                                    |       | 4,858,190                  |       |
| Total                                                  |       | 10,274,984                 |       |

 

**12.**   INCOMETAXES

Forfinancial reporting purposes, income (loss) before taxes includes the followingcomponents (in thousands):

| ** **              | ** ** | **Year ended June 30,** | ** ** |
|-------------------------|------------|----------------------------------------|------------|
| ** **              | ** ** | **2006**                               | ** ** | **2005** | ** ** | **2004** | ** ** |
| Pre-tax  income (loss): |       |                                   |       |   |   |   |   |
| United States           |       | $                                      | (15,337    | ) | $ | (11,083 | ) | $ | (14,596 | ) |
| Foreign                 |       | —                                 |       | — |   | 8,112 |   |
| Total pre-tax loss      |       | $                                      | (15,337    | ) | $ | (11,083 | ) | $ | (6,484 | ) |

 

There is no provision forincome taxes because the Company has incurred operating losses. Deferred incometaxes reflect the net tax effects of operating loss and tax credit carryoversand temporary differences between the carrying amounts of assets andliabilities for financial reporting purposes and the amounts used for incometax purposes. Significant components of the Company’s deferred tax assets areas follows (in thousands):

| ** **                            | ** ** | **June 30,** | ** ** |
|---------------------------------------|------------|-------------------|------------|
| ** **                            | ** ** | **2006**          | ** ** | **2005** | ** ** |
| Deferred tax assets:                  |       |              |       |   |   |
| Net operating  loss                   |       | $                 | 77,855     |   | $ | 72,900 |   |
| Research and  development credits     |       | 3,908             |       | 3,600 |   |
| Capitalized  research and development |       | 23,292            |       | 22,500 |   |
| Other                                 |       | 129               |       | 100 |   |
| Total deferred  tax assets            |       | 105,184           |       | 99,100 |   |
| Valuation  allowance                  |       | (105,184          | )          | (99,100 | ) |
| Net deferred tax assets               |       | $                 | —     |   | $ | — |   |

 

Realization of deferred tax assets is dependent uponfuture earnings, if any, the timing and amount of which are uncertain.Accordingly, the net deferred tax assets have been fully offset by a valuationallowance. The valuation allowance reflected increases of approximately$6.1 million and $4.2 million during 2006 and 2005, respectively.

As of June 30, 2006, the Company had netoperating loss carryforwards for federal income tax purposes of approximately$206.9 million, which expire in the years 2007 through 2026, and federalresearch and development tax credits of approximately $2.9 million, whichexpire in the years 2008 through 2026.

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As of June 30, 2006, the Company had netoperating loss carryforwards for state income tax purposes of approximately$94.8 million, which expire in the years 2007 through 2016, and stateresearch, and development tax credits of approximately $1.5 million, whichdo not expire.

Utilization of the netoperating losses and credit carryforwards may be subject to a substantialannual limitation due to the “change in ownership” provisions of the InternalRevenue Code of 1986. The annual limitation may result in the expiration of netoperating losses and credits before utilization.

**13.**   ALZALICENSE AND SETTLEMENT AGREEMENT

In July 2003, ourwholly owned subsidiary, PolyMASC Pharmaceuticals plc., settled its patentinfringement litigation against ALZA Corporation, a unit of Johnson &Johnson. Under the license and settlement agreement, PolyMASC received$6.5 million, and granted a worldwide license to ALZA under itsPEG-liposome patents. The agreement resolves pending patent infringementlitigation in the United States and Germany, as well as Opposition proceedingsin Japan and before the European Patent Office. The $6.5 million paymentreceived under the license and settlement agreement was recorded as licenserevenue in the first quarter of fiscal 2004.

**14.**   SUBSEQUENTEVENTS

In conjunction with the assessing of our strategicopportunities, we reduced our workforce by eliminating 55% of our employees on August 18, 2006.Further reductions in workforce are anticipated. The total costs associatedwith the reduction in workforce on August 18, 2006 and anticipatedfurther reductions are estimated to be between $525,000 and $1.4 million,primarily related to severance benefits, which will be recorded in the fiscalfirst quarter of 2007, and paid in the fiscal first and second quarters of2007.

In August 2006, wereceived a Nasdaq Staff Deficiency Letter on August 23, 2006indicating that the Company fails to comply with the minimum bid pricerequirement for continued listing set forth in Marketplace Rule 4310(c)(4).Therefore, in accordance with Marketplace Rule 4310(c)(8)(D), the Companyis provided 180 days to regain compliance. If at any time during the next180 days, the bid price of Valentis’ common stock closes at$1.00 per share or more for a minimum of 10 consecutive businessdays, Nasdaq will provide written notification that the Company complies withthe minimum bid price requirements.

**15.**   QUARTERLY FINANCIALINFORMATION

| ** **                            | ** ** | **Quarter**                                                        | ** ** |
|---------------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                            | ** ** | **First**                                                          | ** ** | **Second** | ** ** | **Third** | ** ** | **Fourth** | ** ** |
| ** **                            | ** ** | **(in thousands, except per share data)** | ** ** |
| **2006**                              |       |                                                               |       |   |   |   |   |   |   |
| Revenue                               |       | $                                                                  | 327        |   | $ | 146 |   | $ | 114 |   | $ | 140 |   |
| Costs and  operating expenses         |       | 3,967                                                              |       | 4,119 |   | 5,014 |   | 3,208 |   |
| Net loss                              |       | (3,589                                                             | )          | (3,901 | ) | (4,850 | ) | (2,997 | ) |
| Basic and diluted  net loss per share |       | (0.24                                                              | )          | (0.26 | ) | (0.32 | ) | (0.17 | ) |
| **2005**                              |       |                                                               |       |   |   |   |   |   |   |
| Revenue                               |       | $                                                                  | 1,172      |   | $ | 124 |   | $ | 324 |   | $ | 557 |   |
| Costs and  operating expenses         |       | 4,301                                                              |       | 2,615 |   | 3,358 |   | 3,179 |   |
| Net loss                              |       | (3,099                                                             | )          | (2,416 | ) | (2,977 | ) | (2,591 | ) |
| Basic and diluted net  loss per share |       | (0.24                                                              | )          | (0.19 | ) | (0.23 | ) | (0.19 | ) |

 

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