**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,DC 20549**

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Form 10-K

**(Mark One)**

**x**                              ANNUALREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIESEXCHANGE ACT OF 1934

**Forthe fiscal year ended June 30, 2005**

**or**

** ̈**                                 TRANSITIONREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIESEXCHANGE ACT OF 1934

**CommissionFile Number 0-22987**

**VALENTIS, INC.**

(Exact name of registrantas specified in its charter)

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

 

**(650) 697-1900**

(Registrant’s telephonenumber, including area code)

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Securities registered pursuantto 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 (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 an accelerated filer (as defined in Rule 12b-2of the Exchange Act). Yes o  No x

Indicate by check markwhether the registrant is a shell company (as defined in Rule 12b-2 of theExchange 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 SmallCap Market on December 31, 2004was $27,267,920.

The number of shares ofregistrant’s common stock outstanding, as of September 23, 2005 was 14,837,831.

**DOCUMENTSINCORPORATED BY REFERENCE**

Portions of the Registrant’s proxy statement, whichwill be filed with the Commission pursuant to Regulation 14A in connectionwith the 2005 meeting of stockholders within 120 days after the Registrant’sfiscal year ended June 30, 2005 are incorporated herein by referencein Part III of this Report.

 

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**VALENTIS, INC.**

**FORM 10-K—ANNUAL REPORTFOR THE YEAR ENDED JUNE 30, 2005**

**TABLEOF CONTENTS**
|               |                                                                                                                    | **Page** |
|---------------|--------------------------------------------------------------------------------------------------------------------|----------|
| PART I   |                                                                                                               |     |   |
| Item 1        | Business                                                                                                           | 1        |   |
| Item 2        | Properties                                                                                                         | 28       |   |
| Item 3        | Legal  Proceedings                                                                                                 | 28       |   |
| Item 4        | Submission  of Matters to a Vote of Security Holders                                                               | 28       |   |
| PART II  |                                                                                                               |     |   |
| Item 5        | Market  for Registrant’s Common Stock, Related Stockholder Matters and Issuer  Purchases of Equity Securities | 29       |   |
| Item 6        | Selected  Financial Data                                                                                           | 30       |   |
| Item 7        | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                   | 31       |   |
| Item 7A       | Quantitative  and Qualitative Disclosures About Market Risk                                                        | 40       |   |
| Item 8        | Financial  Statements and Supplementary Data                                                                       | 40       |   |
| Item 9        | Changes  in and Disagreements With Accountants on Accounting and Financial Disclosure                         | 40       |   |
| Item 9A       | Controls  and Procedures                                                                                           | 40       |   |
| Item 9B       | Other  Information                                                                                                 | 41       |   |
| PART III |                                                                                                               |     |   |
| Item 10       | Directors  and Executive Officers of the Registrant                                                                | 41       |   |
| Item 11       | Executive  Compensation                                                                                            | 41       |   |
| Item 12       | Security  Ownership of Certain Beneficial Owners and Management and Related Stockholder  Matters                   | 41       |   |
| Item 13       | Certain  Relationships and Related Transactions                                                                    | 41       |   |
| Item 14       | Principal  Accountant Fees and Services                                                                            | 41       |   |
| PART IV  |                                                                                                               |     |   |
| Item 15       | Exhibits,  Financial Statement Schedules and Reports on Form 8-K                                              | 42       |   |
| SIGNATURES    | 45                                                                                                                 |     |
|               |                                                                                                                    |          |  |  |

 

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**PART I**

**ITEM 1.**                BUSINESS

*This Annual Report on Form 10-K contains certainforward-looking statements within the meaning of Section 27A of theSecurities Act of 1933, as amended, and Section 21E of the SecuritiesExchange Act of 1934, as amended. These forward-looking statementsinclude, without limitation, statements containing the words “believes,” “anticipates,”“expects,” “intends,” “projects,” “estimates” and other words of similar importor the negative of those terms or expressions. Forward-looking statementsin this section include, but are not limited to, expectations of future levelsof research and development spending, general and administrative spending,levels of capital expenditures and operating results, our intention to licenseVLTS 934 to a pharmaceutical company that will assume responsibility forlate-stage development and commercialization and our intention to seek revenuefrom the licensing of our proprietary manufacturing technologies. Forward-lookingstatements subject to certain known and unknown risks, uncertainties and otherfactors that may cause our actual results, performance or achievements to bematerially different from any future results, performance or achievementsexpressed or implied by such forward-looking statements. Factors thatcould affect our actual results include the early stage of development for ourproducts, uncertainties related to the timing of completing clinical trials,the need for additional capital and whether clinical trial results willvalidate and support the safety and efficacy of our VLTS 934 and DeltavascTMproducts. Further, there can be no assurance that the necessary regulatoryapprovals will be obtained, that we will be able to develop commercially our peripheralarterial disease therapeutics or that any of our programs will be partneredwith pharmaceutical partners. We undertake no obligation to revise or updateany such forward-looking statements. The reader is strongly urged to readthe information set forth under the caption “Part I, Item 1.Business—Additional Factors That May Affect Future Results,” for adetailed description of these significant risks, uncertainties and otherfactors.*

**COMPANY OVERVIEW**

Valentis is a clinical-stage biotechnology companyengaged in the development of innovative products for peripheral arterialdisease, or PAD, a large and unsatisfied market. PAD is due to chronicinflammation of the blood vessels of the legs leading to the formation ofplaque which obstructs blood flow. VLTS 934, our lead product, is ananti-inflammatory drug in Phase IIb testing. Our second product for thetreatment of PAD is the DEL-1 angiogenic protein, a product, which we believepromotes the formation of new blood vessels.

Valentis has developed a series of technologiesincluding gene delivery and expression technologies, and proprietaryformulation and manufacturing technologies that allow the generation of noveltherapeutics to treat a wide range of diseases. While Valentis is focusing itsefforts on the development of novel peripheral arterial disease therapeutics,its technologies are being applied by its collaborators for the development oftherapeutics to treat a variety of indications including infectious diseasesand cancer.

The merger ofMegabios Corp. and GeneMedicine, Inc. in March 1999 formedValentis Inc., a Delaware corporation. In August 1999, Valentisacquired U.K.-based PolyMASC Pharmaceuticals plc. Valentis is located inBurlingame, California, where our headquarters, as well as our center forpreclinical and clinical development and manufacturing is located.

**PRODUCTS,TECHNOLOGIES, SERVICES AND LICENSES**

We continue to invest inresearch and development activities to further the development of ourtechnologies and products. Research and development expenses were $9.2 million,$10.1 million and $10.0 million for the fiscal years ended June 30, 2005,2004 and 2003, respectively.

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***VLTS 934 Product***

VLTS 934, our lead product, is a nonionic blockcopolymer. VLTS 934 appears to have a direct effect of repairingcompromised cell membranes and improving cell function, which may have atherapeutic benefit in ischemic tissue due to its anti-inflammatory effects.Peripheral arterial disease is a result of atherosclerosis in the legs ofpatients. Atherosclerosis is a chronic inflammatory disorder of blood vesselsthat ultimately leads to the formation of atheroma or plaque in large bloodvessels. This plaque impedes blood flow to tissues including the legs.VLTS 934 is believed to reduce levels of specific mediators of inflammation,which drives progression of the disease. By suppressing the local inflammatoryresponse in the blood vessels and muscle tissue, it would explain theimprovement in blood flow and exercise tolerance seen in the prior clinicaltrial that included VLTS 934

We recently completed a Phase IIa clinical trialcomparing VLTS 934 to DeltavascTM, an angiogenic agent, in patients withperipheral arterial disease. The primary endpoint of the Phase IIa clinicaltrial was the improvement in exercise tolerance of patients treated withDeltavascTM. In September 2004, we reported that our DeltavascTM product didnot meet its primary endpoint in the clinical trial. Both the DeltavascTM andthe VLTS 934 treatment groups demonstrated statistically significantimprovements compared to baseline with no significant differences betweentreatment groups. In that trial, VLTS 934 demonstrated statisticallysignificant improvements in exercise tolerance (38 percent, p<0.00001),ankle brachial index (p=0.00072) and quality of life over baseline. Patientstreated with VLTS 934 experienced an increase in work capacity of 74percent compared to baseline measurements.

In order to assess the potential efficacy ofVLTS 934 in peripheral arterial disease, we have initiated aPhase IIb trial comparing VLTS 934 versus saline in patients withPAD. The results of this clinical trial are expected in mid-calendar 2006. Apositive outcome for the clinical trial demonstrating a statisticallysignificant drug effect and safety for use in the targeted population iscritical to the continued development of VLTS 934. A negative trialoutcome could have a material and adverse effect on the further development ofVLTS 934, negatively affect our ability to raise additional financing onacceptable terms, if at all, negatively impact our business and prospects andcause the price of our common stock to fall. See “*—Additional Factors That May Affect Future Results*” fora description of the risks related to our product development efforts,including risks with regard to the VLTS 934 PAD Phase IIb clinicaltrial. If results of the Phase IIb clinical trial justify proceeding to aPhase III clinical trial of VLTS 934, we expect to licenseVLTS 934 to a pharmaceutical company that will assume responsibility forlate-stage development and commercialization.

Additionally, we expect toperform an interim analysis of a portion of the placebo patients at the end ofcalendar 2005. Change in peak walking time after 90 days will becalculated on a representative sample of placebo patients to assess thevalidity of the statistical assumptions in the Phase IIb trial. Followingthe analysis, the sample size for the trial may be recalculated based on theseplacebo data and the number of subjects to be enrolled may be reduced or increasedby the sponsor. The calculations will be performed by a separate statisticalteam, and no study personnel will have access to unblinded data. Since noresults of the active treatment arm will be available and no treatmentcomparisons will be made, there will be no impact on the type I error rate andno adjustments to the alpha-level for the final analysis will be necessary.

***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-1 proteinenhances the angiogenic response to ischemia. DEL-1 has a distinct mechanism ofaction from other known angiogenic factors, such as members of the VEGF and FGFfamilies. The angiogenic effect of DEL-1 is mediated in part by activation ofintegrin-mediated 

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signalingand requires an RGD motif and a discoidin-I—like domain. The affinity of theDEL-1 protein for the extracellular matrix is unlike that of any of theangiogenic proteins.

***DeltavascTM Product***

DeltavascTM is aninvestigational product that incorporates the DEL-1 gene to stimulate new bloodvessel growth, as known as angiogenesis. The DEL-1 protein from this gene isinvolved in the embryonic growth of blood vessels. In September 2004, wecompleted a Phase IIa clinical trial of DeltavascTM and VLTS 934 inperipheral arterial disease. In this trial, DeltavascTM was well tolerated;however, it did not meet its primary endpoint of improvement in exercisetolerance versus VLTS 934. Based on the preclinical studies completed todate, DEL-1 has clearly demonstrated angiogenic activity. However, we believethe formulation of this product requires further optimization and plan to completeadditional preclinical studies to understand the contribution of eachformulation component prior to further human trials.

***DEL-1 Antibody Product***

Recently, we acquired therights to the DEL-1 antibody. We intend to complete preclinical work on thisproduct and license it to another company for development in oncologyapplications. It is well established that tumors need an ever-increasing supplyof blood to maintain their growth. They achieve this through stimulation ofangiogenesis or new blood vessel formation. Inhibition of new blood vesselformation, or anti-angiogenesis, has been the strategy behind many new oncologyproducts. The commercial success of Genentech’s Avastin has increased interestin the inhibition of angiogenesis through an antibody to a well-establishedangiogenic protein as a route for new product development. Published findingsreport that some tumor cell lines, when propogated *in vitro*,produce DEL-1 as an angiogenic agent for new vessel growth into the tumor. Forthis reason, in combination with the commercial success of Avastin, we believethat we will find considerable interest in licensing the rights to the DEL-1antibody.

***Technologies for Gene-Based Products***

Our gene-based technologies seek to producetherapeutic proteins in their most natural and active forms at specific siteswithin the body. These products contain genes formulated with syntheticdelivery systems that are administered to specific tissues where they seek toenter targeted cells. These cells then produce the therapeutic protein orvaccine antigen.

Genes provide the “instructions” for the production ofproteins in the body. Specifically, a gene produces the message that a cellwill then use to make a protein. For gene-based products to produce atherapeutic effect, the genes for the therapeutic protein of interest must be “delivered”into the nucleus of cells.

We have developed novel,chemical-based technologies for the delivery of genes. Contrary to othergene delivery approaches, our technologies do not use a live, geneticallyaltered virus to deliver the gene. Also, our technologies have clear advantagesover other gene delivery technologies in delivery efficiency, cost and abilityto repeat dosing.

**PINCTM Polymers**

We have developedsynthetic gene delivery systems based on several classes of polymers. Our PINCTM(Polymeric Non-Condensing) polymers are designed to provide efficient deliveryto a variety of tissues including muscle and solid tumors. Also, our polymerdelivery systems seek to enhance cellular distribution and uptake of genes *in vivo* and result in the production of therapeutic levelsof proteins.

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**CLICTM Lipids**

We have developedproprietary cationic lipid delivery systems to provide efficient delivery afterintravenous, aerosol or intra-tumoral administration. These deliverysystems have been used in clinical trials by third parties for each of theseapplications.

**DNAVaxTM**

We have developedsynthetic vaccine delivery systems based on several classes of polymers. Ourproprietary DNAVaxTM polymer-based delivery systems for intramuscularadministration of vaccines provide for higher and more consistent levels ofantigen production.

***Hermes***TM Gene Expression Technology

We have developed the HermesTM expression systems,which are proprietary plasmids. A plasmid is a circle of DNA that includes thegene for a therapeutic protein. Also included in plasmids are elements thatcontrol the production of the message from that gene. This message serves asthe code or “blueprint” for the production of the therapeutic protein by cells.Once plasmids are delivered into cells, they operate “episomally” which meansthey are not incorporated in the DNA of the cell.

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.

***GeneSwitch® Gene Regulation Technology***

To control the level andduration of selected genes in transgenic animals and cell cultures, ourresearchers have developed the GeneSwitch® gene regulation system. OurGeneSwitch® permits therapeutic protein production that is controlled via anorally administered drug. Products incorporating our GeneSwitch® technology aredelivered with a polymer delivery system along with electroporation. Thisresults in controlled gene expression and the production of therapeuticproteins from muscle tissue for prolonged periods. GeneSwitch® technology mayaccelerate the throughput of genomics research and assist in the identificationand characterization of the function of selected genes due to its uniqueability to control gene expression. This gene expression regulatory system hasbeen licensed to a number of corporate partners who are successfully developingthe technology in a variety of applications.

***OptiPEG***TM 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.

***Plasmid Backbone Technology***

Valentis’ plasmid backbonetechnology is a robust manufacturing and expression system that allows for costeffective production of gene expression products.

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***Current Good Manufacturing 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 are able to produce products from lab to commercialscale using the same process. We have utilized Cangene Corporation and DSMBiologics as contract manufacturing organizations.

***Bioprocessing Contract Services***

We provide contractservices for bioprocessing process development and small-scale, non-GMPmanufacturing. We have expertise in all areas of process development, scale-up,technology transfer, and production of R&D and safety/toxicology material.Also, we can assist with CMC documentation for regulatory filings, provideconsultation for cGMP manufacturing, develop project plans to specifications,and project management.

***Technology Licenses***

We currentlylicense technology to:

·       BiolitecAG for the use of our OptiPEGTM PEGylated liposomes technology to be utilized incertain photosensitizing products.

·       IDMPharma, Inc. for the use of our proprietary PINCTM gene delivery technologyfor human immunodeficiency virus (HIV) and hepatitis C virus (HCV) vaccines,and cancer immunotherapies.

·       InnogeneticsN.V. for the use of our proprietary DNAVaxTM gene delivery technology forhepatitis B virus (HBV) and human papilloma virus (HPV) vaccines.

·       InvitrogenCorporation to sell our proprietary GeneSwitch® gene regulation system to theresearch market.

·       JuvarisBioTherapeutics, Inc. for our proprietary plasmid backbone and cationiclipid delivery technologies for the development and commercialization of therapeuticvaccine products.

·       ProlongPharmaceuticals for use of our proprietary OptiPEGTM PEGylation platform in thedevelopment and commercialization of PEGylated protein therapeutics.

·       ScheringAG for the exclusive, worldwide rights to our GeneSwitch® gene regulation andPINCTM polymer based synthetic gene delivery technologies to develop andcommercialize two gene-based therapeutic products.

Also, Valentis has licensed its proprietaryGeneSwitch® gene regulation technology on a non-exclusive basis to GlaxoSmithKline,LARNAX GmbH, Lexicon Genetics, Organon Laboratories Ltd, Pfizer Inc.,Senomyx, Inc., Schering AG, and Wyeth-Ayerst Laboratories, in eachcase, for research. Further, 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.

Valentis also has licensedtechnology from Genetronics Biomedical Corp. for *in vivo* electroporation technology for use in thedevelopment of certain gene-based products. Electroporation is a method forincreasing DNA uptake by protoplasts through prior exposure to a high voltage,which results in the temporary formation of small pores in the cell membrane.

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**VALENTIS’PRODUCTS IN DEVELOPMENT AND PARTNERED PROGRAMS**

Valentis is focusing onthe development of therapies for peripheral arterial disease as well aslicensing opportunities for its technologies. We seek corporate partnershipswith pharmaceutical and biotechnology companies that assume responsibility fordevelopment, marketing, and commercialization of products incorporating ourtechnologies. The table below summarizes our current products and technologylicensed to third parties for development as products, potential therapeuticindications, stage of development and corporate partner or licensee:

**VALENTIS PIPELINE**
| Product/Indication                           | **Research** | **Preclinical** | **Phase I** | **Phase II** | **Phase III** |
|----------------------------------------------|--------------|-----------------|------------------|-------------------|--------------------|
| **PROPRIETARY PRODUCTS**                     | ** **   | ** **      | ** **       | ** **        | ** **         |
| **VLTS 934**                                 | ** **   | ** **      | ** **       | ** **        | ** **         |
| Intermittent Claudication                    |         |            |             |              |               |
| **DEL-1**                                    | ** **   | ** **      | ** **       | ** **        | ** **         |
| Protein: Critical Limb Ischemia              | ** **   | ** **      | ** **       | ** **        | ** **         |
| Gene: Intermittent Claudication              | ** **   | ** **      | ** **       | ** **        | ** **         |
| Antibody: Oncology                           | ** **   | ** **      | ** **       | ** **        | ** **         |
| **PARTNERED PROGRAMS**                       | ** **   | ** **      | ** **       | ** **        | ** **         |
| GeneSwitch® / PINCTM: Schering A.G. |         |            |             |              |               |
| Two Undisclosed Products                     |         |            |             |              |               |
| DNAVaxTM / DNA Vaccines:                 |         |            |             |              |               |
| IDM Pharma                                   |         |            |             |              |               |
| HIV                                          |         |            |             |              |               |
| Hepatitis C                                  |         |            |             |              |               |
| Cancer                                       |         |            |             |              |               |
| DNAVaxTM / DNA Vaccines:                 | ** **   |            |             |              |               |
| Innogenetics                                 |         |            |             |              |               |
| Hepatitis B                                  |         |            |             |              |               |
| Human Papilloma Virus                        |         |            |             |              |               |
| Cationic Lipid Delivery / Plasmid Backbone   |         |            |             |              |               |
| Juvaris BioTherapeutics, Inc.           |         |            |             |              |               |
| OptiPEGTM / PEG liposomes                |         |            |             |              |               |
| Biolitec                                     |         |            |             |              |               |
| Prolong Pharmaceuticals                      |         |            |             |              |               |

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Notes:              “Phase I”              means that the compound is beingtested in humans for safety in a limited patient population.

“Phase II”                                    meansthat the compound is being tested in humans for indications of efficacy in alimited patient population.

“Phase III”                               meansthat the compound is being tested in humans for indications of efficacy in anexpanded patient population.

“Preclinical”                     meansthat Valentis is conducting efficacy, pharmacology and/or toxicology testing ofa gene delivery system in animal models or biochemical or cell culture assays.

“Research”                              includesthe development of animal models and assay systems, discovery of prototype genedelivery systems and evaluation and refinement of prototype gene deliverysystems in in vitro and in vivo testing.

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**SCIENTIFIC AND INDUSTRY BACKGROUND**

**VLTS 934**

***Overview***

VLTS 934(Poloxamer 188) is a non-ionic, block copolymer surfactant withhemorheologic, anti-thromobotic, cytoprotective and, importantly,anti-inflammatory properties. Preclinical studies in models of vascularocclusive disorders, including circulatory shock, acute stroke and myocardialinfarction, suggest that intravenous administration of Poloxamer 188improves microvascular blood flow by reducing blood viscosity, especially underlow shear conditions (low flow) by reducing frictional forces. In clinicalstudies conducted by others utilizing high intravenous doses,Poloxamer 188 demonstrated benefits in patients with acute myocardialinfarction and acute vaso-occlusive crisis of sickle cell disease. Recently,Poloxamer 188 has been shown to have anti-inflammatory effects.Because chronic inflammation is an important factor in the pathogenesis ofatherosclerosis, this anti-inflammatory attribute might be crucial inproviding symptomatic relief or even slowing the progression of disease. Localintramuscular delivery of VLTS 934 offers the potential for improvedtissue perfusion, improved microvascular flow and a decrease in theinflammatory mediators inherent in the underlying atherosclerotic process whileminimizing systemic adverse reactions.

***Development History of Poloxamer 188 andVLTS 934***

Poloxamer 188 has been studied extensively inmyocardial infarction and sickle cell anemia. Over 3,700 subjects had exposureto very high intravenous doses of Poloxamer 188 as a part of a program byBurroughs Wellcome to evaluate its effect in reducing the sequelae ofmyocardial infarction. In this program, doses of up 140 grams ofPoloxamer 188 were given intravenously over a 48 hour period. Afterpositive Phase II data, Burroughs Wellcome ran a Phase III study butexecuted the trial differently from the Phase II trial in several criticalways.

The Phase II trial was blinded and thePhase III trial was not. Also, in the Phase III trial the controlgroup did not receive the very high volume of fluid given to the patientsreceiving Poloxamer 188. The Phase II trial was a U.S. trial and thePhase III trial was an international trial conducted using some siteswhere medical care would not meet U.S. standards. In the Phase III trial,drug intervention after the onset of myocardial infarction was later than inthe Phase II trial. In the Phase III trial, there were a greaternumber of treatment interruptions than in the Phase II trial. ThePhase III trial did not show the expected improvements in mortality,reinfarction and cardiogenic shock that were expected based on thePhase II results. Soon thereafter, Burroughs Wellcome was bought byGlaxo and the program was discontinued. During development, Burroughs Wellcomehad completed a promising Phase II program in sickle cell anemia crisis.Following discontinuation of the Burroughs Wellcome program, CytRx conducted aPhase III trial in sickle cell crisis with negative results. Very highintravenous doses of Poloxamer 188 were used in all of these programs.

Valentis utilized Poloxamer 188 at much lowerdoses (4.2 grams) in its Phase IIa clinical trial of DeltavascTM andVLTS 934 in patients with peripheral arterial disease and administered bythe intramuscular route. For this application, Poloxamer 188 was used as aspreading agent for the delivery of an investigational angiogenesis productknown as “DEL-1 Plasmid DNA Therapeutic” or “VLTS-589,” which isalso referred to as “DeltavascTM.” VLTS-589 is a combination of theangiogenic gene DEL-1 plus Poloxamer 188. Poloxamer 188 wascombined with the DEL-1 gene because it caused the gene to be spread overa greater area of tissue thus increasing the contact of the DEL-1 genewith more cells which allowed the gene to be taken up by a larger number ofcells resulting in higher levels of protein expression.

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In thePhase IIa trial, VLTS 934 demonstrated statistically significantimprovements in the primary and secondary measures of efficacy compared tobaseline. More specifically, data from 52 subjects in the VLTS 934group showed:

·       Asignificant increase in exercise tolerance from baseline of 38 percent(p=0.00005).

·       Animprovement in ankle branchial index, or ABI, of +0.059 (p=0.00072).

·       Improvementsin quality of life using two validated instruments, which were alsostatistically significant.

VLTS 934 was well tolerated. The confluence ofstatistically significant changes from baseline in exercise tolerance,ankle-brachial index and quality of life assessments with VLTS 934 appearto indicate an active agent. A compilation of results from 1,164 patientsreceiving placebo and 441 patients receiving Cilostazol in prior trials of peripheralarterial disease (PAD) conducted by others also appear to indicate thatVLTS 934 may have a direct effect of repairing compromised cell membranesand improving cell function, which may have a therapeutic benefit in ischemictissue due to its anti-inflammatory effects.

Following the Phase IIa clinical results, we conductedadditional *in vitro* pharmacology studies withVLTS 934. The studies appear to indicate that in addition tocytoprotective effects, VLTS 934 specifically down-regulates theproduction of IL-6 and IL-8 in human endothelial cells, and MCP-1in human skeletal muscle cells. These findings appear to be important in lightof pathogenesis of atherosclerosis. Anti-inflammatory effects areconceivably integral to breaking the chronic release of those pro-inflammatorycytokines that have been implicated in driving the progression of the disease. Thehistorically described cytoprotective effects are also potentially important inimproving cell function in ischemic tissue by restoring membrane function.Based on this data, combined with the human data from the VLTS-589 PhaseI and IIa studies, we believe that VLTS 934 is active in ameliorating theclinical manifestations of PAD.

Lower extremity PAD is a common disorder that occurswhen the arteries that carry oxygen rich blood from the heart to the legsbecome severely narrowed and sometimes blocked through the accumulation ofplaque (atherosclerosis).

The incidence of PAD and the number of patients withPAD is high and growing in the aging population. PAD is estimated to affectabout 63 million people in the U.S., Europe and Japan. PAD becomes morecommon as one gets older. It is estimated that five percent of adults over theage of 55 have PAD and that nearly 20 percent of Americans over the age of70 have PAD. Diagnosis is critical, as people with PAD face a six to seventimes higher risk of heart attack or stroke. The risk factors for PAD aresimilar to those of other cardiovascular and cerebrovascular diseases, such assmoking, obesity, genetic predisposition, lack of regular exercise and ahigh-fat diet.

Approximately one-third to one-half, or an estimated30 million PAD patients, suffer from PAD disease that is severe enough toresult in intermittent claudication, or IC. The leg pain associated with IC canbe severe enough to hinder a person from normal walking. Typically, whenpatients rest, the leg muscles require less blood flow and the pain goes away.However, once walking is resumed, the pain returns. Often, patients with ICwill feel numbness, weakness or heaviness in their legs that affects theirability to exercise. Estimates show that up to 25 percent of patients withIC will progress to critical limb ischemia, which increases the risk of limbloss and mortality.

Treatment options for PADare scant and currently approved products to treat PAD such as Pletal® orTrental® are limited in their ability to effectively treat PAD due to either alack of effectiveness or undesirable side effects. VLTS 934 is beingevaluated to show improved effectiveness in treating PAD without the sideeffects seen with currently available treatments.

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***DEL-1 Protein***

DEL-1 is a uniqueangiogenic protein that promotes vascular growth and inhibits endothelial celldeath. It is expressed during embryonic vasculature development and is re-expressedin the setting of ischemia. Administration of the DEL-1 protein enhancesthe angiogenic response to ischemia. DEL-1 has a distinct mechanism ofaction from other known angiogenic factors, such as members of the VEGF and FGFfamilies. The angiogenic effect of DEL-1 is mediated in part byactivation of integrin-mediated signaling and requires an RGD motif and adiscoidin-I—like domain. The affinity of the DEL-1 protein for theextracellular matrix is unlike that of any of the angiogenic proteins.

***DEL-1 Antibody***

Valentis recently acquiredthe rights to the DEL-1 antibody. Our preclinical work to date hasdemonstrated that several of its proprietary hybridoma cell lines producemonoclonal antibodies that neutralize DEL-1 in *in vitro*integrin 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 anangiogenic agent for new vessel growth into the tumor.

**Gene-based Therapeutics**

***Overview***

Gene-based therapeutics is an approach to the treatmentor prevention of certain diseases in which therapeutic genes are introducedinto the body to cause the production of specific proteins needed to bringabout a therapeutic effect. For gene-based therapeutics to be effective, thetherapeutic gene must be delivered to, and transported across, the outermembrane of a targeted cell and into the nucleus where it can be expressed. Theexpressed protein may remain within the cell for an intracellular effect, betransported to the cell membrane to exert a cell-surface effect, or be secretedinto the bloodstream to have a systemic effect. Most gene-based therapeuticsutilize a delivery system, or vector, into which the therapeutic gene isincorporated to facilitate its delivery to, uptake by and expression in, thetarget cell.

Genes provide theinstructions or “code” for the productions of proteins, which determine thenature and function of cells and tissues in all living organisms. The study ofgenes and their function (“genomics”) provides the fundamental basis forunderstanding human health and disease and has led to the identification ofmany genes with potential therapeutic utility (“therapeutic genes”).

***Gene Delivery Approaches***

To date, a limiting factor in gene-based therapeuticshas been the lack of safe, effective gene delivery systems. A number of genedelivery approaches are being developed. These approaches may be categorized bytheir mode of administration as *ex vivo*(outside the body) or *in vivo*(inside the body) and by the nature of the gene delivery system (viral orplasmid-based (synthetic)).

Valentis is developing its PINCTM delivery technologiesconsisting of synthetic, non-toxic, poloxamer (symmetrical block copolymer)delivery systems. Each product consists primarily of two components: (i) aplasmid DNA (a circular segment of DNA that contains a therapeutic gene andcomponents that regulate its expression in the cell), and (ii) polymers,which are synthetic, non-viral agents to facilitate the delivery of the plasmidDNA into target cells following intramuscular administration. This traditionalmode of 

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administration is familiarto physicians and may be more convenient and cost effective than *ex vivo* approaches.

We believe our proprietarygene delivery systems have advantages over other gene delivery systems. DNAformulated with our PINCTM formulations have been shown to produce high proteinlevels with decreased variability as compared to protein levels obtained afternaked DNA administration. In addition, Valentis’ PINCTM gene delivery systemscan be handled and administered like traditional pharmaceuticals. We havedemonstrated that we can produce clinical-grade plasmid DNA and plasmid-basedDNA formulations under controlled conditions, and we have developed proprietarymanufacturing and production methods designed to be scaled to meet commercialrequirements.

***Additional Technologies***

Valentis has shown thatgene delivery systems containing cationic lipids combined with neutral lipidsenhance the cellular uptake of plasmid-based gene expression systems.These lipid-based gene delivery systems have been demonstrated to enhancethe entry of genes into tumor cells after intratumoral administration, and todeliver genes to the endothelium and epithelium of the lung after intravenousadministration and inhalation, respectively. Although we are not activelypursuing their use internally, the technologies are being out-licensed fordevelopment by corporate partners.

**CORPORATE COLLABORATIONS**

We are actively seeking collaborations with pharmaceuticaland biotechnology companies. In entering corporate collaborations, we seeklicense fees, funding for research and development, milestone payments androyalties on product sales in exchange for worldwide commercial licenses tospecific therapeutics and access to our development expertise. We anticipateentering into licenses for our products, delivery and plasmid expressionsystems as well as licensing opportunities for our proprietary manufacturingtechnologies.

Since 1994, Valentis hasexperience with corporate research and development collaborations includingRoche Holdings Ltd., Boehringer Ingelheim International GmbH, Eli Lilly &Company and Glaxo Wellcome plc. Also, we have experience with a manufacturingcollaborative license agreement with DSM Biologics and cGMP contractmanufacturing at Cangene Corporation and DSM Biologics.

***Cangene Corporation (“Cangene”)***

Since June 2001,Valentis has utilized Cangene Corporation, an established contractmanufacturing organization (CMO) for the manufacture of its DeltavascTM product.Also, since October 1999, Valentis has utilized Cangene for final drugproduct formulation and filling for DeltavascTM and other products. Valentis hasdeveloped proprietary scalable processes to manufacture plasmid DNA formulatedproducts. Through a strategy of using a contract manufacturing organization forplasmid DNA production of our products, we are able to produce drug materialfrom lab to commercial scale using the same process.

***DSM Biologics (“DSM”)***

In June 2003, Valentis announced that itcompleted an agreement with DSM Biologics under which the license granted byValentis to DSM Biologics for Valentis’ plasmid DNA manufacturing technologywas affirmed on revised financial terms. The agreement further resolvedoutstanding disputes between Valentis and DSM Biologics regarding prior plasmidDNA manufacturing services performed by DSM Biologics for Valentis.

Under this agreement, thepAllianceTM plasmid DNA contract manufacturing alliance that had included Valentis,DSM Biologics and Qiagen GmbH was dissolved. The new agreement reinstated the 

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licenseto DSM Biologics under the terms of the original agreement between Valentis andDSM Biologics, modified to add a royalty to Valentis (in addition to thepreviously-agreed profit-sharing arrangement). In consideration forthe license reinstatement, DSM Biologics paid a $1.3 million milestonepayment. The milestone payment, net of approximately $0.6 million ofoutstanding debt owed to DSM Biologics by Valentis, which had been accrued byValentis as of June 30, 2002, was received in cash duringfiscal 2003. We recorded an expense reversal of approximately$0.5 million during fiscal 2003 for the remaining amount accrued byValentis as of June 30, 2002, which we are no longer obligated to payto DSM Biologics as a result of the new agreement.

**TECHNOLOGY LICENSES**

Valentis has technologylicense agreements and is actively seeking additional licensing agreements withpharmaceutical and biotechnology companies.

***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 anon-exclusive cross-license agreement with Genzyme Corporation in whichGenzyme receives non-exclusive rights to Valentis’ GeneSwitch® gene regulationtechnology for research use, and Valentis receives certain rights to Genzyme’splasmid DNA manufacturing technology.

In September 2004, Valentis expanded its existinglicense agreement with Genzyme Corp. by granting Genzyme increased use ofValentis’ GeneSwitch® gene regulation technology. In return, Valentis receivedcertain rights to Genzyme’s static mixer technologies that are useful inplasmid DNA manufacturing.

Valentis’ GeneSwitch®system allows researchers to control the level and duration of expression ofselected genes by oral administration of a small molecule drug. Genzyme plansto use the GeneSwitch® technology for its internal product research. Genzyme’smanufacturing technology allows Valentis to improve the yield of large-scaleproduced plasmid DNA. The technology is useful for Valentis’ internalmanufacturing requirements and potentially for commercial manufacturing.

***IDM Pharma, Inc. (“IDM”)***

In December 2000, IDM licensed Valentis’proprietary PINCTM gene delivery technology for IDM’s preventive and therapeuticDNA vaccines that are in development for the treatment of human immunodeficiencyvirus (HIV) and the hepatitis C virus (HCV) in exchange for up-front, milestoneand 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 InnogeneticsN.V. with an option to a license for the use of our proprietary DNAVaxTM genedelivery technology for Innogenetics’ preventive and therapeutic DNA vaccinesin development for the treatment of hepatitis B virus (HBV) and the humanpapilloma virus (HPV) in exchange for up-front, milestone and royalty payments.

Innogenetics’ genetic vaccines contain DNA sequencesfrom HBV or HPV, which code for protein fragments (epitopes) that stimulatecytotoxic and helper T cell responses. These immune responses are importantdefenses against infection.

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

***Invitrogen Corporation (“Invitrogen”)***

In November 1999,Valentis and Invitrogen Corporation announced the commercial launch of Valentis’proprietary GeneSwitch® gene regulation system to the life sciences researchmarket. The GeneSwitch® gene regulation system is a technology that allowsresearchers to control the level and duration of expression of selected genesby oral administration of a small molecule drug. Valentis recorded minimalroyalties from the license agreement with Invitrogen.

***Juvaris BioTherapeutics (“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.

***Prolong Pharmaceuticals (“Prolong”)***

In February 2003,Valentis entered into a broad licensing agreement with Prolong for use of ourproprietary OptiPEGTM PEGylation technology in the development andcommercialization of PEGylated protein therapeutics. Prolong is responsible forthe development, manufacturing and commercialization of products and bears allrelated program expenses.

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

Valentis has licensed its proprietary GeneSwitch® generegulation technology to Genzyme Corporation, Lexicon Genetics, LARNAX GmbH, OrganonLaboratories Ltd, Pfizer Inc., Senomyx, Inc., Schering AG andWyeth-Ayerst Laboratories. All licenses are non-exclusive licenses for researchpurposes only, and Valentis maintains all rights to clinical gene therapyapplications of the GeneSwitch® technology.

Also, in December 2002and August 2004, Valentis has licensed Schering AG its proprietaryGeneSwitch® gene regulation and PINCTM polymer based synthetic gene deliverytechnologies. Under the agreement Schering AG obtained exclusive, world-widerights to develop and commercialize two gene-based therapeutic products.

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***Genetronics Biomedical Corp. (“Genetronics”)***

In November 2001, Valentisobtained a non-exclusive license to *in vivo*electroporation technology from Genetronics for use in the development ofcertain products. Electroporation seeks to enhance the ability of cells to takeup large molecules such as DNA. When combined with Valentis’ GeneSwitch® generegulation system, electroporation may allow researchers to control the leveland duration of gene expression for up to several months.

**ACADEMIC LICENSES**

Valentis activelymonitors, investigates and licenses technologies under development at academicand other research institutions. We believe that such institutions are animportant source of breakthrough technologies, and we intend to enter intoadditional licensing arrangements to expand our core technologies if suitableresources are available.

***Baylor College of Medicine (“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® generegulation system, and gene delivery to fluid spaces including the vitreous ofthe eye and the synovium of the joint. Baylor and Valentis co-developedcertain synthetic promoters useful in muscle specific expression. We arerequired to pay Baylor a royalty based on amounts received by Valentis for thecommercialization of the patented technology. Baylor has the ability toterminate the license for a material violation or material failure to performany covenant under the license.

***Vanderbilt University (“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.

**PATENTSAND PROPRIETARY TECHNOLOGIES**

Patents and other proprietary rights are important toValentis’ business. Our policy is to file patent applications and protectinventions and improvements to inventions that are commercially important tothe development of our business. Valentis also relies on trade secrets,know-how, confidentiality agreements, continuing technology innovations andlicensing opportunities to protect its technology and develop and maintain itscompetitive position. To date, Valentis has filed, or participated as alicensee in the filing of, numerous patent applications in the United Statesrelating to our technology, as well as counterparts of certain of theseapplications in many foreign countries. Our failure to obtain patent protectionor otherwise protect our proprietary technology or proposed products may have amaterial adverse effect on Valentis’ competitive position and businessprospects. The patent application process takes several years and entailsconsiderable expense. There is no assurance that additional patents will issuefrom these applications or, if patents do issue, that the claims allowed willbe sufficient to protect our technology.

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Valentis has numerous patents and patent applicationsworldwide covering its poloxamer therapy, gene expression and deliverytechnology, and PEGylation technology, as well as use patents for varioustherapeutic applications, and patents and patent applications on itsmanufacturing technologies. In addition to patents and patent applicationsfiled and owned by Valentis, we have exclusive rights under our licenses withBaylor College of Medicine including rights to certain gene expression, genedelivery and gene regulation, the GeneSwitch® gene regulation system, and genedelivery, and Vanderbilt University to patents and patent applications worldwideincluding the DEL-1 gene, protein and antibody. Valentis has an exclusivelicense from Roche Biosciences for rights under certain U.S. and foreignpatents claiming the use of the cationic lipid, DOTMA, for *in vivo* gene delivery. Valentis isalso licensed exclusively by Roche Biosciences under a single related U.S.patent claiming the use of cationic lipids for *in vivo*gene delivery without limitations to DOTMA.

A number of the biopharmaceuticals that Valentis andits corporate partners are investigating, or may use in its products are, or,may become patented by others. As a result, Valentis or its corporate partnersmay be required to obtain licenses to gene sequences, proteins, or othertechnology to which it currently has no proprietary rights in order to use ormarket such products. In addition, some of the 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, we may not beable to develop or market certain products.

The patent positions of pharmaceutical andbiotechnology firms are often uncertain and involve complex legal and factualquestions. Furthermore, the breadth of claims allowed in biotechnology patentsis unpredictable. Valentis cannot be certain that others have not filed patentapplications for technology covered by our pending applications or that we werethe first to invent the technology that is the subject of such patentapplications. Competitors may have filed applications for, or may have receivedpatents and may obtain additional patents and proprietary rights relating tocompounds, products or processes that block or compete with those of Valentis.Valentis is aware of patent applications filed and patents issued to thirdparties relating to genes, gene delivery technologies and gene therapeutics,and there can be no assurance that any patent applications or patents will nothave a material adverse effect on products Valentis or its corporate partnersare developing or may seek 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 partyhas asserted that Valentis is infringing such third party’s patent rights orother intellectual property, there can be no assurance that litigationasserting such claims will not be initiated, that Valentis would prevail in anysuch litigation or that Valentis would be able to obtain any necessary licenseson reasonable terms, if at all. Any such claims against Valentis, with orwithout merit, as well as claims initiated by Valentis against third parties,can be time-consuming and expensive to defend or prosecute and to resolve. Ifother companies prepare and file patent applications in the United States thatclaim technology also claimed by Valentis, we may have to participate ininterference proceedings to determine priority of invention which could resultin substantial cost to Valentis even if the outcome is favorable to us.

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 protectunpatented proprietary technology. Valentis typically requires 

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itsemployees, consultants, collaborators, advisors and corporate partners toexecute confidentiality agreements upon commencement of employment or otherrelationships with Valentis. There can be no assurance, however, that theseagreements will provide meaningful protection or adequate remedies for Valentistechnology in the event of unauthorized use or disclosure of such information,that the parties to such agreements will not breach such agreements or that Valentis’trade secrets will not otherwise become known or be discovered independently byits competitors.

**MANUFACTURINGAND COMMERCIALIZATION**

Valentis’ commercialization strategy is based onestablishing corporate collaborations with pharmaceutical and biotechnologycompanies whereby we will primarily pursue development up through Phase IIclinical trials, while our partners will be responsible for late stage clinicaltrials, sales, marketing and large-scale clinical and commercialmanufacturing.

Valentis intends that its large scale manufacturing ofproducts will be conducted either through contract manufacturing organizationsor at our corporate partners’ site after technology transfer.

Valentis itself does notcurrently operate manufacturing facilities for commercial production of itsproducts. We have limited experience in, and currently lack the resources andcapability needed for, the manufacture or marketing of any of our products on acommercial scale. Although VLTS 934 can be synthesized using readily scalable,organic synthesis procedures, Valentis will be dependent initially on corporatepartners, licensees or other third parties for commercial-scalemanufacturing and commercialization of our products. There can be no assurancethat our corporate partners will be able to develop adequate manufacturingcapabilities for production of commercial-scale quantities of ourproducts or successfully commercialize our products.

**GOVERNMENT REGULATION**

The production and marketing of Valentis’ products andour research and development activities are 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 products as biologics.Biologics are regulated under certain provisions of the Public Health ServiceAct and the Federal Food, Drug, and Cosmetic Act. These laws and the relatedregulations govern, among other things, the testing, manufacturing, safety,efficacy, labeling, storage, record keeping, and the promotion, marketing anddistribution of biological products. At the FDA, the Center for BiologicsEvaluation and Research is responsible for the regulation of biologicalproducts and has handled the FDA’s regulation of most gene therapeutics todate. Gene therapy, however, is a relatively new technology, and it isuncertain whether any unique regulatory requirements may be imposed upon genetherapeutics. We are not aware of any gene therapeutics that have receivedmarketing 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 

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product standards and may alsobe subject to state regulation. Failure to comply with GMP or other applicableregulatory requirements may result in withdrawal of marketing approval,criminal prosecution, civil penalties, recall or seizure of products, warningletters, total or partial suspension of production, suspension of clinicaltrials, FDA refusal to review pending marketing approval applications orsupplements to approved applications, or injunctions, as well as other legal orregulatory action against 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 clinical efficacy and test for safety within abroader patient population at geographically dispersed clinical sites. Therecan be no assurance that Phase I, Phase II or Phase III testingwill be completed successfully within any specific time period, if at all, withrespect to any of Valentis’ or its corporate partners’ products subject to suchtesting. In addition, after marketing approval is granted, the FDA may requirepost-marketing clinical studies that typically entail extensive patientmonitoring and may result in restricted marketing of the product for anextended 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 product developed byValentis and its corporate partners will prove safe and effective in clinicaltrials or will meet all the applicable regulatory requirements necessary toreceive marketing approval from the FDA or the comparable regulatory body ofother countries. Data obtained from preclinical studies and clinical trials aresubject to interpretations that could delay, limit or prevent regulatoryapproval. The FDA may deny the NDA if applicable regulatory criteria are notsatisfied, require additional testing or information, or require post-marketingtesting and surveillance to monitor the safety or efficacy of a product.Moreover, if regulatory approval of a biological product is granted, suchapproval may entail limitations on the indicated uses for which it may bemarketed. Finally, product approvals may be withdrawn if compliance withregulatory standards is not maintained or if problems occur following initialmarketing. Among the conditions for NDA approval is the requirement that theprospective manufacturer’s quality control and manufacturing procedures conformto the appropriate GMP regulations, which must be followed at all times. Incomplying with standards set forth in these regulations, manufacturers mustcontinue to expend time, financial resources and effort in the area ofproduction and quality control to ensure full compliance.

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’ research anddevelopment processes involve the controlled use of hazardous materials,chemicals and radioactive materials and produce waste products. We are subjectto federal, state and local 

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laws andregulations governing the use, manufacture, storage, handling and disposal ofsuch materials and waste products. Although we believe that our safetyprocedures for handling and disposing of such materials comply with thestandards 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.

**COMPETITION**

The pharmaceutical and biotechnology industries arehighly competitive. We are aware of several pharmaceutical and biotechnologycompanies that are pursuing peripheral arterial disease therapeutics Forexample, we are 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.

We also face competition from biotechnology andpharmaceutical companies using more traditional approaches to treating humandiseases. Our competitors may develop safer, more effective or less costlycardiovascular or gene-based therapeutics. In addition, we face and willcontinue to face competition from other companies for corporate collaborationswith pharmaceutical and biotechnology companies, for establishing relationshipswith academic and research institutions and for licenses to proprietarytechnology, including intellectual property.

Many of our competitorsand potential competitors have substantially greater product developmentcapabilities and financial, scientific, manufacturing, managerial and humanresources than Valentis. There can be no assurance that research anddevelopment by others will not render our products, or the products developedby corporate partners using our licensed technologies obsolete, ornon-competitive, or that any product we or our corporate partners develop willbe preferred to any existing or newly developed technologies. In addition,there can be no assurance that our competitors will not develop safer, moreeffective or less costly cardiovascular therapies, gene delivery systems, genetherapeutics, non-gene therapies, or other therapies, achieve superior patentprotection or obtain regulatory approval or product commercialization earlierthan Valentis, any of which could have a material adverse effect on ourbusiness, financial condition or results of operations.

**PRODUCT LIABILITY INSURANCE**

The manufacture and sale of human therapeutic productsinvolve an inherent risk of product liability claims and associated adversepublicity. Valentis currently has only limited product liability insurance, andthere can be no assurance that we will be able to maintain existing or obtainadditional product liability insurance on acceptable terms or with adequatecoverage against potential liabilities. Such insurance is expensive, difficultto obtain and may not be available in the future on acceptable terms, or atall. An inability to obtain sufficient insurance coverage on reasonable termsor to otherwise protect against potential product liability claims couldprevent or inhibit the commercialization of products by Valentis. A productliability claim brought against us in excess of our insurance coverage, if any,or a product withdrawal, could have a material adverse effect upon ourbusiness, financial condition and results of operations.

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**EMPLOYEES**

As of September 2, 2005,Valentis employed 19 individuals full-time, including 5 who hold doctoraldegrees. Of our total work force, 13 employees are engaged in or directlysupport research and development activities, and 6 are engaged in businessdevelopment, finance and administrative activities. Valentis employees are notrepresented by a collective bargaining agreement. We believe our relationshipswith our employees are good.

**ADDITIONAL FACTORS THAT MAY AFFECT FUTURE RESULTS**

***We have a history of losses and may never beprofitable.***

We have engaged inresearch and development activities since our inception. We incurred lossesfrom operations of approximately $11.3 million, $6.5 million and$15.7 million, for our fiscal years ended June 30, 2005, 2004and 2003, respectively. As of June 30, 2005, we had an accumulateddeficit totaling approximately $224.6 million. The development and sale ofour products will require completion of additional clinical trials andsignificant research and development activities. We expect to incur net lossesfor the foreseeable future as we continue with the research, development andcommercialization of our products. Our ability to achieve profitability dependson the successful completion of our clinical trials especially our ongoingVLTS 934 Phase IIb clinical trial, our additional research anddevelopment efforts, our ability to successfully commercially introduce ourproducts, market acceptance of our products, the competitive position of ourproducts and the other risk factors set forth herein. Even if we do achieveprofitability, we may not be able to sustain or increase profitability on aquarterly or annual basis.

***Our ability toachieve profitability depends upon our research and development efforts andwhether we can successfully develop and commercially introduce new products.***

Our future success isdependent upon, among other factors, our ability to develop working productsand our ability to successfully complete clinical trials. All of our potentialproducts currently are in research, preclinical development or the early stagesof clinical testing, and commercialization of those products will not occur forat least the next several years, if at all. The development of new drugs is ahighly risky undertaking and there can be no assurance that our research anddevelopment efforts will be successful. In September 2004, we reportedthat our DeltavascTM product did not meet its primary endpoint in itsPhase IIa clinical trial in patients with the intermittent claudicationform of peripheral arterial disease. Both the DeltavascTM and the VLTS 934groups demonstrated statistically significant improvements compared to baselinewith no significant differences between treatment groups. The unforeseenresults observed in both groups led to the initiation of a Phase IIbclinical trial of VLTS 934. All of our products will require extensiveadditional research and development prior to any commercial introduction. Therecan be no assurance that any of our research and development and clinical trialefforts will result in viable products. If our product and development effortsare unsuccessful, we will not achieve profitability and our business andresults of operations would be adversely affected.

***Our products aresubject to extensive regulatory approval by the FDA and others, including withregard to completion of our clinical trials, which is expensive, time consumingand uncertain, and failure to obtain regulatory approval or successfullycomplete clinical trials may cause us to delay or withdraw the introduction ofour products and could materially adversely affect our business and prospects.***

We are subject to significant regulatory requirements,including the successful completion of clinical trials, prior to thecommercialization of our products. Under the Federal Food, Drug and CosmeticAct, the Public Health Services Act, and related regulations, the Food and DrugAdministration, 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 

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drug or biological productmust undergo rigorous clinical trials that meet the requirements of the FDA inorder to demonstrate safety and efficacy in humans. Depending upon the type,novelty and effects of the drug and the nature of the disease or disorder to betreated, the FDA approval process can take several years, require extensiveclinical testing and result in significant expenditures.

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 our products. We initiated a follow-on Phase IIbclinical trial using our VLTS 934 product compared to a saline placebo in March 2005.In addition to this Phase IIb clinical trial, VLTS 934 will requiresignificant additional clinical testing. This process may take a number ofyears. We cannot assure you that our clinical testing will be completed withinany specific time period, if at all. There can be no assurance that any FDAapproval will be granted on a timely basis, if at all, or that any of ourproducts will prove safe and effective in all required clinical trials or willmeet all applicable regulatory requirements necessary to receive marketingapproval from the FDA.

Even if we successfullyobtain FDA approval for our products, we may not be able to obtain theregulatory approvals necessary to market our products outside the United Statessince the commercialization of our products outside the United States will besubject to separate regulations imposed by foreign government agencies. Theapproval procedures for marketing outside the United States vary amongcountries and can involve additional testing. Accordingly, we cannot predictwith any certainty how long it will take or how much it will cost to obtainregulatory approvals for manufacturing and marketing our products within andoutside the United States or whether we will be able to obtain those regulatoryapprovals at all. Our failure to successfully complete our clinical trials,obtain FDA and any applicable foreign government approvals or any delays inreceipt of such approvals could have a material effect on our business, resultsof operations and financial condition.

***We are dependent onthe successful outcomes of clinical trials of our products, includingVLTS 934, and we cannot assure you that any clinical testing willdemonstrate the safety and efficacy of our products.***

In order to introduce and market our products, we mustbe able to, among other things, demonstrate safety and efficacy withsubstantial evidence from well-controlled clinical trials. In September 2004,we announced that DeltavascTM did not meet the primary endpoint in aPhase IIa clinical trial in patients with intermittent claudication formof peripheral arterial disease. Accordingly, further DeltavascTM clinical trialsare on-hold. This had been our most advanced clinical program and representedthe substantial portion of our clinical development activities. The DeltavascTMPhase IIa clinical trial results led to the initiation of a Phase IIbclinical trial of VLTS 934.

VLTS 934 is an investigational product that is anon-ionic polyoxyethylene-polyoxypropylene block copolymer. Although, we haveinvestigated the poloxamer’s possible mechanism of action in preclinical study,there can be no assurance that VLTS 934 improves microvascular blood flow,results in a pharmacologic effect or will demonstrate efficacy. We initiated afollow-on Phase IIb clinical trial using our VLTS 934 productcompared to a saline placebo in March 2005. This clinical trial is a studyperformed within the FDA guidelines regarding whether patients suffering fromperipheral arterial disease can achieve better cardiovascular blood flow afterbeing treated with VLTS 934 compared to patients given a saline placebo.Clinical trials are long, expensive and uncertain processes during which we mayencounter difficulties completing the trial. Problems we may encounter includethe unavailability of preferred sites for conducting the trials, aninsufficient number of eligible subjects, changes in the number of subjectsbased-on the performance of interim analyses, changes in protocol and otherfactors, which may delay the advancement of our clinical trials, lead toincreased costs or result in the termination of the clinical trials altogether.Furthermore, the FDA may suspend clinical trials at any time if it believes thesubjects 

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participating in thetrials are being exposed to unacceptable health risks or if it findsdeficiencies in the clinical trial process or the conduct of the investigation.

In addition, should eitherour follow-on Phase IIb clinical trial of our VLTS 934 product or anyother future clinical trials fail to demonstrate a statistically significantdrug effect and show safety for the targeted patient population, our ability toraise additional financing on acceptable terms, if at all, our business andprospects could be harmed and the market price of our common stock could fall. Ifthe future results of clinical trials regarding our products fail to validatethe safety and effectiveness of treatments using our products, our ability togenerate revenues from those products would also be adversely affected, delayedor prevented entirely.

***There are noassurances that our clinical trial interim analysis will validate ourstatistical assumptions in the VLTS 934 Phase IIb trial.***

We expect to perform aninterim analysis of a portion of the placebo subjects at the end ofcalendar 2005. Change in peak walking time after 90 days will becalculated on a representative sample of placebo subjects to assess thevalidity of the statistical assumptions in the Phase IIb trial. Followingthe analysis, the sample size will be recalculated based on these placebo dataand the number of subjects to be enrolled may be reduced or increased by thesponsor. The calculations will be performed by a separate statistical team, andno study personnel will have access to unblinded data. Since no results of theactive treatment arm will be available and no treatment comparisons will bemade, there will be no impact on the type I error rate and no adjustments tothe alpha-level for the final analysis will be necessary. There are noassurances that our clinical trial interim analysis will validate ourstatistical assumptions in the Phase IIb trial.

***The results ofearly Phase I and Phase II clinical trials are based on a smallnumber of patients over a short period of time, and our success may not beindicative of results in a large number of patients or long-term efficacy.***

The results in earlyphases of clinical testing are based upon limited numbers of patients and alimited follow-up period. Typically, our Phase I clinical trials forindications of safety enroll less than 50 patients. Our Phase IIaclinical trial of DeltavascTM enrolled 105 patients and our Phase IIbclinical trial of VLTS 934 is expected to enroll approximately 148patients. Actual results with more data points may not confirm favorableresults from our earlier stage trials. A number of companies in thepharmaceutical and biotechnology industries have suffered significant setbacksin late stage Phase III clinical trials even after achieving promisingresults in earlier stage clinical trials. In addition, we do not yet know ifearly results will have a lasting effect. If a sufficiently large population ofpatients necessary to demonstrate efficacy does not experience positive results,or if these results do not have a lasting effect, our products may not receiveapproval from the FDA. Failure to demonstrate the safety and effectiveness ofour products in larger patient populations could have a material adverse effecton our business that would cause our stock price to decline significantly.

***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, 2005 that included an explanatory paragraph which statedthat the financial statements have been prepared assuming we will continue as agoing concern. The explanatory paragraph stated that our recurring operatinglosses and need for additional financing have raised substantial doubt aboutour ability to continue as a going concern. Any failure to dispel anycontinuing doubts about our ability to continue as a going concern couldadversely affect our ability to enter into collaborative relationships withbusiness partners, to raise 

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additionalcapital and our ability to sell our products, and could have a material adverseeffect on our business, financial condition and results of operations.

***Our stock price hasbeen and may continue to be volatile and an investment in our common stockcould suffer a decline in value.***

The trading priceof the shares of our common stock has been and may continue to be highlyvolatile. We receive only limited attention by securities analysts and mayexperience an imbalance between supply and demand for our common stockresulting from low trading volumes. The market price of our common stock mayfluctuate significantly in response to a variety of factors, most of which arebeyond our control, including the following:

·       resultsof our clinical trials and preclinical studies, or those of our competitors;

·       ourability to attract and retain corporate partners;

·       negativeregulatory action or regulatory approval with respect to our products or ourcompetitors’ products;

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

·       announcementsby us or our competitors of new products, technological innovations, contracts,acquisitions, corporate partnerships or joint ventures;

·       changesin our eligibility for continued listing of our common stock on The NasdaqSmallCap Market; 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 adversely affect themarket price of our common stock. In addition, sales of substantial amounts ofour common stock in the public market could lower the market price of our commonstock.

***Our stock pricecould be adversely affected by dispositions of our shares pursuant toregistration statements currently in effect.***

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 sales mayoccur, could cause the trading price of our common stock to fall and couldimpair our ability to raise capital through the sale of additional equitysecurities.

As of September 23, 2005,we had issued and outstanding 14,837,831 shares of our common stock. Thisamount does not include, as of September 23, 2005:

·       approximately2.9 million shares of our common stock issuable upon the exercise of allof our outstanding options and the release of restricted stock awards; and

·       approximately3.7 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 shares maybe subject from time to time. If these options or 

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warrantsare exercised and sold, our stockholders may experience additional dilution andthe market price of our common stock could fall.

***We must be able tocontinue to secure additional financing in order to continue our operations,which might not be available or which, if available, may be on terms that arenot favorable to us.***

The continueddevelopment and clinical testing of our potential products will requiresubstantial additional financial resources. Our future funding requirementswill depend on many factors, including:

·       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;

·       abilityto establish and maintain corporate collaborations;

·       timeand 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 fund ourcash 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. If we raise additional funds byissuing equity securities, substantial dilution to existing stockholders mayresult. We may not be able to obtain additional financing on acceptable terms,or at all. Any failure to obtain an adequate and timely amount of additionalcapital on commercially reasonable terms will have a material adverse effect onour business, financial condition, including our viability as an enterprise. Asa result of these concerns, management may pursue strategic alternatives, whichmay include the sale or merger of the business, the sale of certain assets orother actions.

We may also take actionsto conserve our cash resources through reductions in our personnel, delaying orscaling back our development programs or relinquishing greater or all rights toproducts at an earlier stage of development or on less favorable terms than weotherwise would. Any or all of these actions could have a material adverseaffect on our business.

***The future successof our business depends on our ability to attract and retain corporate partnersto develop, introduce and market our peripheral arterial disease productcandidate and other product candidates.***

Our business strategy is to attract business partnersto fund or conduct research and development, clinical trials, manufacturing,marketing and sales of our peripheral arterial disease product candidate andother product candidates. We face intense competition from many other companiesin the pharmaceutical and biotechnology industry for corporate collaborations,as well as for establishing relationships with academic and researchinstitutions and for obtaining licenses to proprietary technology. If we areunable to attract and retain corporate partners to develop, introduce andmarket our products, our business may be materially and adversely affected.

Our strategy and anyreliance on corporate partners, if we are able to establish such collaborativerelationships, are subject to additional risks. Our partners may not devotesufficient resources to the development, introduction and marketing of ourproducts or may not pursue further development and commercialization ofproducts resulting from collaborations with us. If a corporate partner electsto 

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terminateits relationship with us, our ability to develop, introduce and market ourproducts may be significantly impaired and we may be forced to discontinue theproduct altogether. We may not be able to negotiate alternative corporatepartnership agreements on acceptable terms, if at all. The failure of anyfuture collaboration efforts could have a material adverse effect on ourability to develop, introduce and market our products and, consequently, couldhave a material adverse effect on our business, results of operations andfinancial condition.

***We face strongcompetition in our market and competition from alternative treatments in thebiopharmaceuticals market.***

The pharmaceutical and biotechnology industries arehighly competitive. We are aware of several pharmaceutical and biotechnologycompanies that are pursuing peripheral arterial disease therapeutics Forexample, we are 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 more experience inthese areas. Our competitive position depends on a number of factors, includingsafety, efficacy, reliability, marketing and sales efforts, and existence ofcompeting products, and treatments and general economic conditions. Many of ourcompetitors have substantially greater financial, research, productdevelopment, manufacturing, marketing and technical resources than we do. Somecompanies also have greater name recognition than us and long-standingcollaborative relationships.

We also face competitionfrom biotechnology and pharmaceutical companies using more traditionalapproaches to treating human diseases and existing treatments. Our competitors,academic and research institutions or others may develop safer, more effectiveor less costly cardiovascular therapies, biologic delivery systems, gene-basedtherapeutics or chemical-based therapies. In addition, competitors may achievesuperior patent protection or obtain regulatory approval or product commercializationearlier than we do. Any such developments could seriously harm our business,financial condition and results of operations.

***Adverse events inthe field of cardiovascular therapies may negatively impact regulatory approvalor public perception of our potential products.***

The FDA may become morerestrictive regarding the conduct of clinical trials including cardiovasculartherapies. This approach by the FDA can lead to delays in the timelines forregulatory review, as well as potential delays in the conduct of our clinicaltrials. In addition, negative publicity may affected patients’ willingness toparticipate in our clinical trials. If fewer patients are willing toparticipate in our clinical trials, the timelines for recruiting patients andconducting the trials will be delayed. The commercial success of our potentialproducts will depend in part on public acceptance of the use of our therapiesfor the prevention or treatment of human diseases. Negative public reaction toour therapies in general could result in stricter labeling requirements of products,including any of our products, and could cause a decrease in the demand forproducts we may develop.

***If we are unable toobtain rights to required technologies including poloxamer, proprietary genesequences, proteins or other technologies, we will be unable to operate ourbusiness.***

Our VLTS 934 productand other therapies involve multiple component technologies, many of which maybe patented by others. For example, our products can use poloxamers,proprietary gene sequences, proteins or other technologies some of which havebeen, or may be, patented by others. As a result, we may be required to obtainlicenses or acquire rights to those poloxamers, gene sequences, proteins orother technologies. We may not be able to obtain a license or acquire rights tothose technologies on reasonable 

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terms,if at all. As a consequence, we might be prohibited from developing potentialproducts or we might have to make cumulative royalty payments to severalcompanies. These cumulative royalties would reduce amounts paid to us or couldmake our products too expensive to develop or market. From time to time, we mayengage in preliminary discussions with third parties concerning potentialacquisitions of technologies or products. Even if we are successful inacquiring technologies or products, we may experience difficulties in and costsassociated with the assimilation of technologies, products, operations andpersonnel acquired, diversion of management’s attention from other businessconcerns, inability to maintain uniform standards, controls, procedures andpolicies and the subsequent loss of key personnel. If we are unable to acquireor obtain rights to technologies or products necessary for our business, ourbusiness would be harmed.

***We rely on patentsand other proprietary rights to protect our intellectual property and anyinability to protect our intellectual property rights would adversely impactour business.***

We rely on a combinationof patents, trade secrets, trademarks, proprietary know-how, and nondisclosureand other contractual agreements and technical measures to protect ourintellectual property rights. We file patent applications to protect processes,practices and techniques related to our products that are significant to thedevelopment of our business. We own or have exclusive rights to 46 issuedUnited States patents and 62 granted foreign patents on the technologies relatedto our products and processes. We own or have exclusive rights to approximately14 pending patent applications in the United States and 39 foreign pendingpatent applications. Our patent applications may not be approved. Any patentsgranted now or in the future may be invalidated or offer only limitedprotection against potential infringement and development by our competitors ofcompeting products. Moreover, our competitors, many of which have substantialresources and have made substantial investments in competing technologies, mayseek to apply for and obtain patents that will prevent, limit or interfere withour ability to make, use or sell our 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 orreduced to practice by them while employed or retained by us, subject tocustomary exceptions. Proprietary information agreements with employees,consultants and others may be breached, and we may not have adequate remediesfor any breach. Also, our trade secrets may become known to, or independentlydeveloped by, competitors. Any failure to protect our intellectual property wouldsignificantly impair our competitive position and adversely affect our resultsof operations and business.

***We could becomesubject to litigation regarding our intellectual property rights, which couldseriously 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 use intellectualproperty litigation against us to gain advantage. In the future, we may be aparty to litigation to protect our intellectual property or as a result of analleged infringement of others’ intellectual property. These claims and anyresulting lawsuit, if successful, could subject us to significant liability fordamages and invalidation of our proprietary rights. Any potential intellectualproperty litigation, if successful, also could force us to stop selling,incorporating or using our products that use the challenged intellectualproperty; obtain from the owner of the infringed intellectual property right alicense to sell or use the relevant technology, which license may not beavailable on reasonable terms, or at all; or redesign our products that use thetechnology. We may also be required in the future to initiate claims orlitigation against third parties for infringement of our intellectual propertyrights to protect these rights or determine the scope or validity of ourintellectual property or the rights of our competitors. The pursuit of theseclaims could result in 

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significant expendituresand the diversion of our technical and management personnel. If we are forcedto 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 be time-consuming,could result in costly litigation and the diversion of technical and managementpersonnel and could require us to develop non-infringing technology or to enterinto royalty or licensing agreements. An adverse determination in a judicial oradministrative proceeding and failure to obtain necessary licenses or developalternate technologies could prevent us from developing and selling ourproducts, which would have a material adverse effect on our business, resultsof operations and financial condition.

***We may experiencedelays in the commercial introduction, manufacture or regulatory approval ofour products as a result of failure to comply with FDA manufacturing practicesand 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 and may besubject to state regulation as well. Such manufacturing facilities are subjectto ongoing periodic inspections by the FDA and corresponding state agencies,including unannounced inspections, and must be licensed as part of the productapproval process before being utilized for commercial manufacturing.Noncompliance with the applicable requirements can result in, among otherthings, fines, injunctions, civil penalties, recall or seizure of products,total or partial suspension of production, withdrawal of marketing approvals,and criminal prosecution. Any of these actions by the FDA would materially andadversely affect our ability to continue clinical trials, commercialize ourproducts and adversely affect our business. We cannot assure you that we or ourcontract manufacturers will attain or maintain compliance with current orfuture good manufacturing practice requirements and the FDA could suspend orfurther delay our clinical trials, the commercial introduction and manufactureof our products or place restrictions on our ability to conduct clinical trialsor commercialize our products, including the mandatory withdrawal of theproduct from the clinical trials.

Our research anddevelopment processes involve 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 materials complywith the standards prescribed by such laws and regulations, the risk ofaccidental 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.

***We depend on keypersonnel to develop our products and, if we are unable to hire additionalpersonnel due to the intense competition in the Bay Area and other obstacles inrecruiting qualified personnel for key management, scientific and technicalpositions, our business may suffer.***

Our ability to attract and retain management,scientific and technical staff to develop our potential products and formulateour research and development strategy is a critical factor in determiningwhether we will be successful in the future. The San Francisco Bay Area, whereour corporate headquarters and clinical development center is located, is hometo a large number of biotechnology and pharmaceutical 

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companies, and there is alimited number of qualified individuals to fill key scientific and technicalpositions. Competition for highly skilled personnel is intense and we may notbe successful in attracting and hiring qualified personnel to fulfill our currentor future needs.

Although we have programsin place to retain personnel, including programs to create a positive workenvironment and competitive compensation packages, none of our officers or keyemployees are bound by an employment agreement for any specific term and theseindividuals may terminate their employment at any time. Our future successdepends upon the continued services of our executive officers and other keyscientific, marketing, manufacturing and support personnel. As of September 2, 2005,we had a total of 19 full-time employees, including 13 employeessupporting our research and development efforts. We do not have “key person”life insurance policies covering any of our employees and the loss of servicesof any of our key employees would adversely affect our business. If we do notattract and retain qualified personnel, our research and development programscould be delayed, which could materially and adversely affect the developmentof our products and our business.

***If we fail to manage growth effectively, our businesscould be disrupted, which could harm our operating results.***

If any of our productssuccessfully complete clinical trials and receive FDA approval, we mayexperience growth in our business. We must be prepared to expand our workforceand to train, motivate and manage additional employees as the need foradditional personnel arises. Failure to attract and retain sufficient numbersof additional employees could impede our growth. In addition, our ability tomanage our growth effectively could require us to make significant investmentsand expenditures to enhance our operational, management and financialinfrastructure, information systems and procedures. Any failure to effectivelymanage future growth could have a material adverse effect on our business,results of operations and financial condition.

***There are noassurances that we can maintain our listing on The Nasdaq SmallCap Market andthe failure to maintain listing could adversely affect the liquidity and priceof our common stock.***

On January 31, 2003,our common stock began trading on The Nasdaq SmallCap Market pursuant to anexception from delisting. In the event we fail to demonstrate compliance, aswell as an ability to sustain compliance, with all requirements for continuedlisting on The Nasdaq SmallCap Market, including Nasdaq’s corporate governancecriteria, our securities will be delisted from The Nasdaq Stock Market. If oursecurities are delisted from The Nasdaq Stock Market, the trading of our commonstock is likely to be conducted on the OTC Bulletin Board. The delisting of ourcommon stock from The Nasdaq SmallCap Market will result in decreased liquidityof our outstanding 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.

***If we are unable tocomplete our assessment as to the adequacy of our internal control overfinancial reporting within the required time periods as required by Section 404of the Sarbanes-Oxley Act of 2002, or in the course of such assessmentsidentify and report material weaknesses in our controls, investors could loseconfidence in the reliability of our financial statements, which could resultin a decrease in the value of our common 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 the company’s internal control over financial reporting in their Annual Reportson Form 10-K. This report is required to contain an assessment bymanagement of the effectiveness of a company’s internal control over 

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financialreporting. In addition, the independent registered public accounting firmauditing a public company’s financial statements must attest to and report onmanagement’s assessment of the effectiveness of the company’s internal controlover financial reporting. Our current non-affiliated market capitalizationqualifies us as a non-accelerated filer. As such, we are required to be incompliance with the Section 404 requirements beginning with the fiscalyear that ends June 30, 2007. If we achieved a non-affiliated marketcapitalization of $75 million or more by December 31, 2005, wewould be classified as an accelerated filer. As such, we would be required tobe in compliance with the Section 404 requirements beginning with thefiscal year that ends June 30, 2006. We intend to diligently andvigorously assess (and enhance as may be appropriate) our internal control overfinancial reporting in order to ensure compliance with the Section 404requirements. We anticipate expending significant resources in developing thenecessary documentation and testing procedures required by Section 404,however, there is a risk that we will not comply with all of the requirementsimposed by Section 404. In addition, the very limited size of ourorganization could lead to conditions that could be considered materialweaknesses, such as those related to segregation of duties that is possible inlarger organizations but significantly more difficult in smaller organizations.Also, controls related to our general information technology infrastructure maynot be as comprehensive as in the case of a larger organization with moresophisticated capabilities and more extensive resources. It is not clear howsuch circumstances should be interpreted in the context of an assessment ofinternal control over financial reporting. If we fail to implement required newor improved controls, we may be unable to comply with the requirements of Section 404in a timely manner, and the may result in our independent registered publicaccounting firm issuing a qualified or adverse report on our internal controland/or management’s assessment thereof. This could result in an adversereaction in the financial markets due to a loss of confidence in thereliability of our financial statements, which could cause the market price ofour common stock to decline.

***Our certificate ofincorporation and by-laws include anti-takeover provisions that may enable ourmanagement to resist an unwelcome takeover attempt by a third party.***

Our basic corporatedocuments and Delaware law contain provisions that enable our management toattempt to resist a takeover unless it is deemed by management and our Board ofDirectors to be in the best interests of our stockholders. Those provisionsmight discourage, delay or prevent a change in the control of our company or achange in 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 concentrationof ownership among our executive officers, directors and their affiliates maydelay or prevent a change in our corporate control.***

Our executive officers,directors and their affiliates beneficially own or control in excess ofapproximately 27% of outstanding common shares, warrants or options to purchasecommon stock, with approximately 17% 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 facilitieswere to experience an earthquake or other catastrophic loss, our operationswould be seriously harmed.***

Our facilities could besubject to a catastrophic loss such as fire, flood or earthquake. All of ourresearch and development activities, our corporate headquarters and othercritical business operations are 

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locatednear major earthquake faults in Burlingame, California. Any such loss at any ofour facilities could disrupt our operations, delay development of our productsand 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.

***Recent changes inthe required accounting treatment for stock options will have a materialnegative impact on our financial statements and may affect our stock price.***

In December 2004, theFinancial Accounting Standards Board issued SFAS No. 123(R), pursuant towhich we must measure all stock-based compensation awards, including grants ofemployee stock options, using a fair value method and record such expense inour consolidated financial statements. This requirement to expense stock-basedcompensation awards is set to take effect for public companies for interim andannual periods beginning after June 15, 2005. We adopted SFAS No. 123(R) onJuly 1, 2005. Prior to the adoption, we disclosed such expenses on apro forma basis in the notes to our financial statements, but did not record acharge for employee stock option expense in the reported financial statements.Beginning with the first quarter of fiscal year 2006, our reported losseswill increase as a requirement of including stock-based compensation expense inour financial statements, which may affect our stock price.

**ITEM 2.**                PROPERTIES

Valentis leases approximately 45,000 square feet inBurlingame, California, which was fully occupied as of June 30, 2005.The facilities have been 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.

The term of the lease for approximately 35,000 squarefeet of the facilities expires in November 2006, at which time Valentishas options to renew the lease for up to an additional period of six years. Anadditional approximately 10,000 square feet of the facilities has beenbuilt-out for use as a pilot manufacturing facility. The term of the lease forthis portion of the facilities expires in October 2007, at which timeValentis has the option to renew the lease for an additional period of fiveyears.

Valentis believes that itsfacilities are adequate to meet its needs for the foreseeable future. Should itneed additional space, management believes it will be able to secure such spaceon reasonable terms.

**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 STOCK AND RELATED STOCKHOLDER MATTERS

Ourcommon stock trades on the Nasdaq SmallCap 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** | ** ** |
|-------------------------------------------------------|------------|----------|------------|---------|------------|
| **2003**                                              |       |     |       |    |       |
| First Quarter                                         |       | $        | 7.20       |    | $          | 3.15 |   |
| Second Quarter                                        |       | 5.40     |       | 2.45    |       |
| Third Quarter                                         |       | 4.05     |       | 2.00    |       |
| Fourth Quarter                                        |       | 2.25     |       | 3.45    |       |
| **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 (through  September 23, 2005) |       | 2.18     |       | 2.80    |       |

 

On September 23, 2005 the last sale pricereported on the Nasdaq SmallCap Market for Valentis’ common stock was $2.31 pershare. As of that date, there were approximately 508 stockholders of record ofour common stock.

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 June 2005, we completed a private placement,in which we issued and sold 1,680,840 shares of common stock and warrants,exercisable for a five-year period, to purchase 840,420 shares of common stockat $2.50 per unit, resulting in net proceeds of approximately$3.9 million. The warrants are exercisable at $3.51 per share. If thewarrants are fully exercised, we will receive additional aggregate grossproceeds of approximately $3.2 million. The issuance of our common stock andwarrants in the June 2005 Private Placement was exempt from theregistration requirements under the Securities Act because all of thesecurities were issued solely to accredited investors, as defined in Rule 501of Regulation D of the Securities Act.

In April and June 2005, we issued a total of18,796 shares of our common stock to a company performing investor relationsconsulting services, as partial compensation for the services provided,pursuant to the terms of a stock grant agreement. The issuance of the shares ofcommon stock was exempt from the registration requirements under Section 4(2) ofthe Securities Act as a transaction not involving a public offering.

Valentis has never paid any cash dividends on itscommon stock.

Information regardingsecurities authorized for issuance under our equity compensation plans will beincluded in our definitive Proxy Statement with respect to our 2005 AnnualMeeting of Stockholders, under the caption “Equity Compensation PlanInformation”, and is hereby incorporated by reference.

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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” and theConsolidated Financial Statements and related Notes included elsewhere in thisreport.

| ** **                                                                                      | ** ** | **Year Ended June 30,**                             | ** ** |
|-------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                                                                                      | ** ** | **2005**                                                           | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** |
| ** **                                                                                      | ** ** | **(in thousands, except per share data)** | ** ** |
| **Consolidated Statement of  Operations Data:**                                                 |       |                                                               |       |   |   |   |   |   |   |   |   |
| Collaborative  research and development revenue                                            |       | $                                                                  | —     |   | $ | — |   | $ | — |   | $ | 3,333 |   | $ | 3,226 |   |
| License and  milestone revenue                                                                  |       | 1,640                                                              |       | 7,284 |   | 3,958 |   | 487 |   | 1,071 |   |
| Contract research  revenue                                                                      |       | 476                                                                |       | — |   | — |   | — |   | — |   |
| Other revenue                                                                                   |       | 61                                                                 |       | 194 |   | — |   | 17 |   | 349 |   |
| Total revenue                                                                                   |       | 2,177                                                              |       | 7,478 |   | 3,958 |   | 3,837 |   | 4,646 |   |
| Costs and Operating  expenses:                                                                  |       |                                                               |       |   |   |   |   |   |   |   |   |
| Cost of contract research revenue                                                               |       | 521                                                                |       | — |   | — |   | — |   | — |   |
| Research and development                                                                        |       | 9,169                                                              |       | 10,054 |   | 9,965 |   | 23,738 |   | 30,177 |   |
| General and administrative                                                                      |       | 3,763                                                              |       | 3,912 |   | 8,859 |   | 7,853 |   | 8,231 |   |
| Restructuring charges                                                                           |       | —                                                             |       | — |   | 832 |   | 1,812 |   | — |   |
| Amortization of goodwill and other acquired  intangible assets                                  |       | —                                                             |       | — |   | — |   | 4,914 |   | 5,733 |   |
| Total operating expenses                                                                        |       | 13,453                                                             |       | 13,966 |   | 19,656 |   | 38,317 |   | 44,141 |   |
| Loss from operations                                                                            |       | (11,276                                                            | )          | (6,488 | ) | (15,698 | ) | (34,480 | ) | (39,495 | ) |
| Other income and  expense, net                                                                  |       | 193                                                                |       | 4 |   | 838 |   | 1,390 |   | 1,296 |   |
| Net loss                                                                                        |       | (11,083                                                            | )          | (6,484 | ) | (14,860 | ) | (33,090 | ) | (38,199 | ) |
| Deemed dividend                                                                                 |       | —                                                             |       | — |   | (4,972 | ) | (2,590 | ) | (1,479 | ) |
| Adjustment  resulting from the reduction in the Series A Preferred stock conversion  price |       | —                                                             |       | — |   | (22,293 | ) | — |   | — |   |
| Dividends on  convertible preferred stock                                                       |       | —                                                             |       | — |   | (882 | ) | (1,557 | ) | (898 | ) |
| Net loss  applicable to common stockholders                                                     |       | $                                                                  | (11,083    | ) | $ | (6,484 | ) | $ | (43,007 | ) | $ | (37,237 | ) | $ | (40,576 | ) |
| Basic and diluted  net loss per share applicable to common stockholders                         |       | $                                                                  | (0.85      | ) | $ | (0.81 | ) | $ | (13.86 | ) | $ | (33.61 | ) | $ | (41.28 | ) |
| Shares used in  computing basic and diluted net loss per common share                           |       | 13,028                                                             |       | 8,024 |   | 3,103 |   | 1,108 |   | 983 |   |

 

| ** **                                                | ** ** | **June 30,**       | ** ** |
|-----------------------------------------------------------|------------|-------------------------|------------|
| ** **                                                | ** ** | **2005**                | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** |
| ** **                                                | ** ** | **(in thousands)** | ** ** |
| **Consolidated  Balance Sheet Data:**                     |       |                    |       |   |   |   |   |   |   |   |   |
| Cash, cash equivalents and short-term investments         |       | $                       | 12,513     |   | $ | 20,450 |   | $ | 3,290 |   | $ | 19,104 |   | $ | 35,833 |   |
| Working capital                                           |       | 10,624                  |       | 16,905 |   | 230 |   | 14,137 |   | 25,191 |   |
| Total assets                                              |       | 14,152                  |       | 21,891 |   | 6,078 |   | 24,044 |   | 50,249 |   |
| Long-term debt                                            |       | —                  |       | — |   | — |   | — |   | 138 |   |
| Convertible redeemable preferred stock               |       | —                  |       | — |   | — |   | 25,828 |   | 23,895 |   |
| Accumulated deficit                                       |       | (224,637                | )          | (213,554 | ) | (207,070 | ) | (192,210 | ) | (159,120 | ) |
| Total  stockholders’ equity (net capital deficiency) |       | 11,569                  |       | 17,890 |   | 2,589 |   | (7,701 | ) | 14,512 |   |
|                                                           |            |                         |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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**ITEM7.**                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 of future levels of research anddevelopment spending, general and administrative spending, levels of capitalexpenditures and operating results, our intention to license VLTS 934 to apharmaceutical company that will assume responsibility for late-stagedevelopment and commercialization and our intention to seek revenue from thelicensing of our proprietary manufacturing technologies. Forward-lookingstatements subject to certain known and unknown risks, uncertainties and otherfactors that 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 early stage of development for our products,development, uncertainties related to the timing of completing clinical trials,the need for additional capital and whether clinical trial results willvalidate and support the safety and efficacy of our VLTS 934 and DeltavascTMproducts. Further, there can be no assurance that the necessary regulatoryapprovals will be obtained, that we will be able to develop commercially our peripheralarterial disease therapeutics or that any of our programs will be partneredwith pharmaceutical partners. Actual results may differ materially from thoseprojected in such forward-looking statements as a result of the “AdditionalFactors That May Affect Future Results” described previously and otherrisks detailed in our reports filed with the Securities and Exchange Commission.We undertake no obligation to revise or update any such forward-lookingstatements.*

**COMPANY OVERVIEW**

Valentis is a clinical-stage biotechnology companyengaged in the development of innovative products for peripheral arterialdisease, or PAD, a large and unsatisfied market. PAD is due to chronicinflammation of the blood vessels of the legs leading to the formation ofplaque which obstructs blood flow. VLTS 934, our lead product, is ananti-inflammatory drug in Phase IIb testing. Our second product for thetreatment of PAD is the DEL-1 angiogenic protein, a product, which we believepromotes the formation of new blood vessels.

Valentis has developed a series of technologiesincluding gene delivery and expression technologies, and proprietary formulationand manufacturing technologies that allow the generation of novel therapeuticsto treat a wide range of diseases. While Valentis is focusing its efforts onthe development of novel peripheral arterial disease therapeutics, itstechnologies are being applied by its collaborators for the development oftherapeutics to treat a variety of indications including infectious diseasesand cancer.

VLTS 934, our lead product, is a nonionic blockcopolymer. VLTS 934 appears to have a direct effect of repairing compromisedcell membranes and improving cell function, which may have a therapeuticbenefit in ischemic tissue due to its anti-inflammatory effects. Peripheralarterial disease is a result of atherosclerosis in the legs of patients.Atherosclerosis is a chronic inflammatory disorder of blood vessels thatultimately leads to the formation of atheroma or plaque in large blood vessels.This plaque impedes blood flow to tissues including the legs. VLTS 934 isbelieved to reduce levels of specific mediators of inflammation, which drivesprogression of the disease. By suppressing the local inflammatory response inthe blood vessels and muscle tissue, it would explain the improvement in bloodflow and exercise tolerance seen in the prior clinical trial that includedVLTS 934.

We recently completed a Phase IIa clinical trialcomparing VLTS 934 to DeltavascTM, an angiogenic agent, in patients withperipheral arterial disease. The primary endpoint of the Phase IIa clinicaltrial was 

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the improvement inexercise tolerance of patients treated with DeltavascTM. In September 2004,we reported that our DeltavascTM product did not meet its primary endpoint in theclinical trial. Both the DeltavascTM and the VLTS 934 treatment groupsdemonstrated statistically significant improvements compared to baseline withno significant differences between treatment groups. In that trial,VLTS 934 demonstrated statistically significant improvements in exercisetolerance (38 percent, p<0.00001), ankle brachial index (p=0.00072) andquality of life over baseline. Patients treated with VLTS 934 experiencedan increase in work capacity of 74 percent compared to baselinemeasurements.

In order to assess the potential efficacy ofVLTS 934 in peripheral arterial disease, we have initiated aPhase IIb trial comparing VLTS 934 versus saline in patients withPAD. The results of this clinical trial are expected in mid-calendar 2006. Apositive outcome for the clinical trial demonstrating a statisticallysignificant drug effect and safety for use in the targeted population iscritical to the continued development of VLTS 934. A negative trialoutcome could have a material and adverse effect on the further development ofVLTS 934, negatively affect our ability to raise additional financing onacceptable terms, if at all, negatively impact our business and prospects andcause the price of our common stock to fall. See “*—Additional Factors That May Affect Future Results*” fora description of the risks related to our product development efforts,including risks with regard to the VLTS 934 PAD Phase IIb clinicaltrial. If results of the Phase IIb clinical trial justify proceeding to aPhase III clinical trial of VLTS 934, we expect to licenseVLTS 934 to a pharmaceutical company that will assume responsibility for late-stagedevelopment and commercialization.

Additionally, we expect toperform an interim analysis of a portion of the placebo patients at the end ofcalendar 2005. Change in peak walking time after 90 days will becalculated on a representative sample of placebo patients to assess thevalidity of the statistical assumptions in the Phase IIb trial. Followingthe analysis, the sample size for the trial may be recalculated based on theseplacebo data and the number of subjects to be enrolled may be reduced orincreased by the sponsor. The calculations will be performed by a separatestatistical team, and no study personnel will have access to unblinded data.Since no results of the active treatment arm will be available and no treatmentcomparisons will be made, there will be no impact on the type I error rate andno adjustments to the alpha-level for the final analysis will be necessary.

**Results ofOperations**

***Fiscal Years Ended June 30, 2005, 2004 and2003***

***Revenue***

Revenuerecognized in the fiscal years ended June 30, 2005, 2004 and 2003 isas follows (in thousands):

| ** **                                                   | ** ** | **Year ended June 30,** | ** ** |
|--------------------------------------------------------------|------------|----------------------------------------|------------|
| ** **                                                   | ** ** | **2005**                               | ** ** | **2004** | ** ** | **2003** | ** ** |
| License and milestone  revenue:                              |       |                                   |       |   |   |   |   |
| GeneSwitch® licenses                                    |       | $                                      | 1,021      |   | $ | 284 |   | $ | 1,888 |   |
| DNAVaxTM gene delivery  technology license and milestone |       | —                                 |       | 500 |   | — |   |
| PINCTM gene delivery  technology licenses                |       | 619                                    |       | — |   | 570 |   |
| Manufacturing technology  milestone                          |       | —                                 |       | — |   | 1,500 |   |
| PEGylation technology  licenses                              |       | —                                 |       | 6,500 |   | — |   |
|                                                         |       | 1,640                                  |       | 7,284 |   | 3,958 |   |
| Contract research  revenue                                   |       | 476                                    |       | — |   | — |   |
| Other revenue                                                |       | 61                                     |       | 194 |   | — |   |
| Total                                                        |       | $                                      | 2,177      |   | $ | 7,478 |   | $ | 3,958 |   |

 

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Changes in revenuefor each of the fiscal years ended June 30, 2005, 2004 and 2003 areexplained below:

·       TheGeneSwitch® revenue recognized in fiscal 2005, 2004 and 2003 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 under a licensing agreement for the use of ourGeneSwitch® technology to develop and commercialize a designated product. TheGeneSwitch® revenue recognized in fiscal 2003 included approximately$500,000 of license fee received under the same agreement with Schering AG thatallows the use of our GeneSwitch® technology to develop and commercialize adifferent designated product. The GeneSwitch® revenue recognized infiscal 2003 also reflected approximately $1.0 million of license feereceived from GlaxoSmithKline under an agreement that allows GlaxoSmithKline topractice the GeneSwitch® technology for research purposes only.

·       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 2005 primarilyreflected $500,000 of license fees received from Schering AG under a licensing agreementfor the use of our PINCTM delivery technology to develop and commercialize adesignated product. The PINCTM gene delivery technology revenue recognized infiscal 2003 included approximately $500,000 of license fee received underthe same agreement with Schering AG that allows the use of our PINCTM deliverytechnology to develop and commercialize a different designated product.

·       Werecognized $1.5 million of manufacturing technology milestone revenue infiscal 2003 under a license agreement for our plasmid DNA manufacturingtechnology.

·       InJuly 2003, PolyMASC Pharmaceuticals plc, our wholly owed subsidiary,entered into a license and settlement agreement with ALZA Corporation, a unitof Johnson & Johnson. Under the agreement, PolyMASC settled its patentinfringement litigation against ALZA and granted a worldwide, irrevocable andnon-exclusive license to ALZA under its PEG-liposome patents. Non-recurringlicense revenue of $6.5 million was recognized from this agreement infiscal 2004.

·       Infiscal 2005, we recognized $476,000 of contract research revenue underagreements with other companies. Under the agreements, we are required toconduct research on the manufacturing of certain biological materials for othercompanies. The revenue was recognized based on research performed during theyear.

·       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 us fund our operations and mayincrease in the future if we are successful in establishing new collaborationsand additional licensing of our technology. If we are unsuccessful inestablishing new collaborations, additional licensing and grants, revenues maydecline. Therefore, a reduction in funds for conducting our research anddevelopment, clinical trial, manufacturing, marketing and sales efforts mayoccur.

***Costs and Expenses***

Costs of contract research were $521,000 for fiscalyear ended June 30, 2005, which consisted of costs incurred forcontract research on the manufacturing of biological materials for othercompanies and 

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included direct andrelated overhead expenses and costs of general and administrative support. Wedid not have contract research arrangements with other companies prior to thefiscal year ended June 30, 2005.

Research and development expenses were$9.2 million, $10.1 million and $10.0 million for the fiscalyears ended June 30, 2005, 2004 and 2003, respectively. The decreasein expenses in fiscal 2005 compared to 2004 primarily reflects decreasedexpenses for the DeltavascTM PAD Phase IIa clinical trial, which completedthe dosing of patients in June 2004 and resulted in a fall off in clinicaltrial expenses. The decrease was partially offset by expenses incurred for thecommencement of the VLTS 934 Phase IIb clinical trial in March 2005.The increase in expenses in fiscal 2004 compared to 2003 was primarilyattributable to increased clinical trial expenses for the DeltavascTM PADPhase IIa clinical trial, which was initiated in July 2003. Theincrease was partially offset by decreased expenses resulting from staffreductions in October 2002. We expect research and development expenses inthe future to remain at current levels. However, research and developmentexpenses may increase or decrease depending on the outcome of the VLTS 934Phase IIb clinical trial and if we are successful in securing additionalnew funding and strategic partnerships to support increased spending levels.The results of the trial are expected mid-calendar 2006.

The scope and magnitude of future research anddevelopment expenses are difficult to predict at this time given the number ofstudies that will need to be conducted for any of our potential products. Ingeneral, biopharmaceutical development involves a series of steps—beginningwith identification of a potential target and including, among others, proof ofconcept in animal studies and Phase I, II, and III clinicalstudies in humans—each of which is typically more expensive than the previousstep. Our research and development expenses currently include costs forscientific personnel, animal studies, supplies, equipment, consultants, patentfilings, overhead allocation, human clinical trials and sponsored research atacademic and research institutions.

All of our research and development expenses for thefiscal years ended June 30, 2005, 2004 and 2003 were incurred inconnection with the development of novel peripheral arterial disease therapeutics.

General and administrativeexpenses were $3.8 million, $3.9 million and $8.9 million forthe fiscal years ended June 30, 2005, 2004 and 2003, respectively.The decrease 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. The decrease in expenses infiscal 2004 compared to 2003 primarily reflected higher professional feesand other expenses incurred in fiscal 2003 related to the Company’scapital restructuring efforts, patent infringement lawsuit with ALZA Corporationand the termination of leases, partially offset by savings resulting from staffreductions in October 2002. We expect our annual general andadministrative expenses to increase in the future reflecting expensesassociated with the requirements of the Sarbanes-Oxley Act including, asdirected by Section 404 of the Sarbanes-Oxley Act, our assessment of andreport on the effectiveness of our internal control over financial reporting.However, general and administrative expenses may increase or decrease dependingon the outcome of the VLTS 934 Phase IIb clinical trial and if we aresuccessful in securing additional new funding and strategic partnerships tosupport increased spending levels. The results of the trial are expectedmid-calendar 2006.

***Corporate Restructuring***

On October 8, 2002,we announced that we had reduced our staff and planned expenditures to allow usto continue the development of our then lead product, DEL-1 for the treatmentof a variety of cardiovascular diseases including peripheral arterial disease(PAD) and ischemic heart disease (IHD). In addition, we continued to advanceour GeneSwitch® gene regulation technology through the licensing to othercompanies. In connection with our corporate restructuring, we reduced staff by34 individuals in 

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order toreduce our cash expenditures. For the year ended June 30, 2003, werecorded restructuring and related charges of approximately $832,000.

***Interest Income and Other Income and Expense, net***

Interest income and otherincome and expense, net was approximately $193,000, $4,000 and $838,000 infiscal 2005, 2004 and 2003, respectively. The increase in interest incomeand other income and expense, net in fiscal 2005 compared to 2004 wasprimarily attributable to higher interest income derived from higher investmentbalances in fiscal 2005. The decrease in interest income and other incomeand expense, net in fiscal 2004 compared to 2003 resulted primarily fromdecreased interest income derived from lower investment balances in fiscal 2004and foreign currency transaction adjustments recorded in fiscal 2003. We didnot incur any interest expenses for fiscal 2005 and 2004. Interest expensefor fiscal 2003 was approximately $9,000.

***Deemed Dividend and Adjustment Related to Series ARedeemable Convertible Preferred Stock***

The deemed dividend related to Series A redeemableconvertible preferred stock (see Note 10 “Redeemable Convertible PreferredStock and Stockholders’ Equity” in our Notes to Consolidated FinancialStatements) includes the accretion of warrants, the accretion of a beneficialconversion feature and the accretion of related issuance costs. Upon conversionof the Series A preferred stock to common stock in January 2003, theremaining amount of unaccreted deemed dividend representing the balance ofamounts attributed to common stock purchase warrants, beneficial conversionfeature and issuance costs related to the Series A preferred stock wasfully accreted and recorded as a deemed dividend.

Additionally, as a resultof the simultaneous conversion of the Series A preferred stock to commonstock and the reduction in the Series A preferred stock conversion price(see Note 10 “Redeemable Convertible Preferred Stock and Stockholders’Equity” in our Notes to Consolidated Financial Statements), the excess of thefair value of the common stock issued to the Series A preferredstockholders over the fair value of the common stock issuable pursuant to theoriginal conversion terms was approximately $22.3 million.

***Dividends on Series A Redeemable ConvertiblePreferred Stock***

Dividends on the Series Apreferred stock (see Note 10 “Redeemable Convertible Preferred Stock andStockholders’ Equity” in our Notes to Consolidated Financial Statements) werecalculated at the rate of 5% per annum, and were approximately $882,000 for thefiscal years ended June 30, 2003 and were charged againstadditional-paid-in-capital. There were no dividends paid on the Series A preferredstock during fiscal 2005 and 2004 because all of the outstanding shares ofSeries A preferred stock were converted into common stock in January 2003.

**New AccountingPronouncements**

In December 2004, theFASB issued Statement No. 123 (revised 2004, or Statement 123R), “Share-BasedPayment”. FAS 123R supersedes APB Opinion No. 25, “Accounting forStock Issued to Employees,” and will require 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 123R on July 1, 2005. Statement 123R permits publiccompanies to adopt its requirements using either the modified prospective ormodified retrospective transition method. We have decided to use the modifiedprospective transition method, which requires that 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. We expect that our adoption ofFAS 123R will have a material adverse impact on our consolidated financial

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statements.However, uncertainties such as stock price volatility, estimated forfeituresand employee stock option exercise behavior, make it difficult to determinewhether future stock-based compensation expenses will be similar to the proforma expenses disclosed in Note 1 to the Consolidated FinancialStatements.

**Liquidity andCapital Resources**

As discussed elsewhere in this report, includingfurther below, we have received a report from our independent registered publicaccounting firm regarding the consolidated financial statements for the fiscalyear ended June 30, 2005 that includes an explanatory paragraphstating that the financial statements have been prepared assuming Valentis willcontinue as a going concern. The explanatory paragraph states the following conditions,which raise substantial doubt about our ability to continue as a going concern:(i) we have incurred operating losses since inception, including a netloss of $11.1 million for the fiscal year ended June 30, 2005,and our accumulated deficit was $224.6 million at June 30, 2005and (ii) we anticipate requiring additional financial resources to enableus to fund our operations at least through June 30, 2006. Management’splans as to these matters are also described in Note 1 to the consolidatedfinancial statements.

We are currently supporting the ongoing VLTS 934Phase IIb clinical trial. The results of this trial are expected inmid-calendar 2006. A positive outcome for the clinical trial demonstrating astatistically significant drug effect and safety for use in the targetedpopulation is critical to the continued development of VLTS 934. Anegative trial outcome could have a material and adverse effect on the furtherdevelopment of VLTS 934, negatively affect Valentis’ ability to raiseadditional financing on acceptable terms, if at all, negatively impact ourbusiness and prospects and cause the price of our common stock to fall. See “AdditionalFactors That May Affect Future Results” for a description of the risksrelated to our product development efforts, including risks with regard to theVLTS 934 PAD Phase IIb clinical trial. If results of thePhase IIb clinical trial justify proceeding to a Phase III clinicaltrial of VLTS 934, because of the size of the potential market for theproduct and the number of possible uses for the product, we expect to licenseVLTS 934 to a pharmaceutical company that will assume responsibility forlate-stage development and commercialization.

Since our inception, we have financed our operationsprincipally through public and private issuances of our common and preferredstock and funding from collaborative arrangements. We have used the netproceeds from the sale of the common and preferred stock for general corporatepurposes, which has included funding research, development and productmanufacturing, increasing our working capital, reducing indebtedness,acquisitions or investments in businesses, products or technologies that arecomplementary to our own, and capital expenditures. We expect that proceedsreceived from any future issuance of stock will be used for similar purposes.

In June 2005, we completed a private placement,in which we issued and sold 1,680,840 shares of common stock and warrants,exercisable for a five-year period, to purchase 840,420 shares of common stockat $2.50 per unit, resulting in net proceeds of approximately$3.9 million. The warrants are exercisable at $3.51 per share (“June 2005Private Placement”).

We entered into registration rights agreements withthe purchasers in the June 2005 Private Placement. Pursuant to theregistration rights agreements, we filed with the Securities and ExchangeCommission registration statements related to the shares issued to thepurchasers and shares issuable upon the exercise of the warrants under the privateplacements. In the event we must suspend use of the registration statements forgreater than 20 consecutive days or a total of 40 days in the aggregateduring the time we are required to keep the registration statement effectiveunder the registration rights agreements, then we must pay to each purchaser incash 1.0% of the purchaser’s aggregate purchase price of the shares for thefirst month, as well as an additional 1.5% of the purchaser’s aggregatepurchase price for each additional month thereafter, while the use of theregistration statements has been suspended. We 

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currently expect to berequired to maintain availability of the registration statement for at leasttwo years following the applicable closing.

In addition, under the securities purchase agreemententered into in connection with the June 2005 Private Placement, whilethere is an effective registration statement and if we fail to deliver a stockcertificate that is free of restrictive legends within three trading days upondelivery of such a request by a purchaser of the June 2005 PrivatePlacement, we are required to pay to the purchaser, for each $1,000 of sharesof stock or shares issuable upon exercise of warrants requested, $10 pertrading day for each trading day beginning five trading days after the deliveryof the request, increasing to $20 per trading day after the first five tradingdays for which such damages have begun to accrue, until such certificate isdelivered without restrictive legends.

The safety and long-term effects of gene-based therapyhas been evaluated and debated extensively in recent years. In 2000, theFood and Drug Administration issued a guidance document that mandated long-termfollow up of patients treated in gene therapy clinical trials. Currently allgene therapy clinical trials are required to include a long-term follow-upprogram to collect patient safety data for selected morbidities in patientsover the course of 15 years. Valentis initiated the long-term follow-up programfor the DeltavascTM Phase IIa clinical trial in January 2005. Weestimated the total expenses for this program to be approximately $700,000 overthe period of fifteen years and the expenses for the first year of the programto be approximately $140,000, of which approximately $70,000 of expenses havebeen incurred and recorded in the year ended June 30, 2005. It isanticipated that annual expenses for this program will decline substantiallyover the 15-year period due to the length of follow up and the age of thepatients. In September 2005, the FDA stated that it generally will notrequire long-term follow-up observations of participants in clinical trials ofgene transfer technology when the risk of delayed adverse events is low,according to draft guidance. Valentis intends to work with the FDA to determineits long-term follow-up requirements.

We lease our facilities under operating leases. Theseleases expire between November 2006 and October 2007 with renewaloptions at the end of the initial terms to extend the leases for an additionalsix and five years, respectively.

Minimalannual rental commitments under the operating leases at June 30, 2004are as follows (in thousands):

| **Year ended June 30,** | ** ** | ** ** | ** ** | ** ** | ** ** |
|----------------------------------------|------------|------------|------------|------------|------------|
| 2006                                   |       | $          | 1,177      |       |
| 2007                                   |       | 650        |       |
| 2008                                   |       | 65         |       |
|                                   |       | $          | 1,892      |       |

 

Our capital expenditures were $8,000, $7,000 and$31,000 in fiscal 2005, 2004 and 2003, respectively. We expect our capitalexpenditures to remain at current levels. However, capital expenditures mayincrease or decrease depending on the outcome of the VLTS 934 Phase IIbclinical trial and if the Company is successful in securing additional newfunding and strategic partnerships to support increased spending levels. Theresults of the trial are expected in mid-calendar 2006.

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 trialexpenses. Net cash used in operating activities for the year ended June 30, 2004was approximately $3.9 million, which primarily consisted of a net loss ofapproximately $6.5 million, an increase in accrued clinical trial expensesof approximately $1.1 million and non-cash depreciation expenses of approximately$1.4 million. For the year ended June 30, 2003, net cash used in

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operating activities wasapproximately $15.6 million, which was primarily attributable to a netloss of approximately $14.9 million, the decreases of $1.6 million ofaccrued clinical trial expenses and non-cash depreciation expenses of$1.8 million.

Net cash provided by investing activities wasapproximately $7.3 million and $8.2 million for the fiscal yearsended June 30, 2005 and 2003, respectively, which primarily reflectedthe maturities of available-for-sale investments. For the year ended June 30, 2004,net cash used in investing activities was approximately $10.9 million,which was primarily attributable to the purchases of marketable securities.

Net cash provided by financing activities wasapproximately $4.1 million and $21.1 million for the fiscal yearsended June 30, 2005 and 2004, respectively, which consisted primarilyof net proceeds received from the private placements of common stock. Net cashused in financing activities was approximately $498,000 for the fiscal yearended June 30, 2003, which related primarily to payments forpreferred stock dividends and long-term debt.

Except for the quarter ended September 30, 2003,in which we reported net income of approximately $3.4 million resultingprincipally from the $6.5 million non-recurring license revenue recognizedunder the license and settlement agreement with ALZA Corporation (seeNote 14 “ALZA License and Settlement Agreement” in our Notes toConsolidated Financial Statements), we have experienced net losses since ourinception through June 30, 2005, and reported a net loss of$11.1 million for the fiscal year ended June 30, 2005. Ouraccumulated deficit was $224.6 million at June 30, 2005. Weexpect such losses to continue into the foreseeable future as we proceed withthe research, development and commercialization of our technologies. Dependingon the outcome of the VLTS 934 Phase IIb clinical trial, which isexpected in mid-calendar 2006, and if we are successful in securing additionalnew funding and strategic partnerships to support increased expenses, spendinglevels for research and development and general and administrative expenses mayincrease above current levels, to reflect increases in clinical trial effortsto advance the VLTS 934 PAD product to Phase III testing. At June 30, 2005,we had $12.5 million in cash, cash equivalents and investments, and weanticipate that we will require additional financial resources to advance theVLTS 934 product and continue our planned operations at least through June 30, 2006.

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 reasonably accurate in thepast.

38

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**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.

We also have licensed technology to variousbiotechnology, pharmaceutical and contract manufacturing companies. Under thesearrangements, we receive nonrefundable license payments in cash. These paymentsare recognized as revenue when received, provided we have no future performanceor delivery 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 involvetechnology that we have licensed or otherwise acquired through arrangementswith third parties pursuant to which we are required to pay a royalty equal toa fixed percentage of amounts received by us as a result of licensing thistechnology to others. Such royalty obligations are recorded as a reduction ofthe related revenue. Furthermore, we receive royalty and profit sharingpayments under a licensing agreement with a contract manufacturing company. Royaltyand profit sharing payments are recognized as revenue when received. We alsoprovide contract research services for research and development manufacturingof biological materials for other companies. Under these contracts, wegenerally receive payments based on a contractual cost per full-time equivalentemployee working on the project. Revenue is recognized for actual research workperformed during the period.

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**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 30,2005 and 2004. All of our market risk sensitive instruments mature within a yearfrom the balance sheet date.
| ** **                                        | ** ** | **As of June 30,** | ** ** |
|---------------------------------------------------|------------|-----------------------------------|------------|
| ** **                                        | ** ** | **2005**                          | ** ** | **2004** | ** ** |
| Cash equivalents                                  |       |                              |       |   |   |
| Fixed rate                                        |       | $                                 | 8,163      |   | $ | 8,798 |   |
| Average rate                                      |       | 2.95                              | %          | 1.40 | % |
| Short-term  investments                           |       |                              |       |   |   |
| Fixed rate                                        |       | $                                 | 3,648      |   | $ | 10,934 |   |
| Average rate                                      |       | 2.73                              | %          | 1.62 | % |
| Total cash equivalents  and investment securities |       | $                                 | 11,811     |   | $ | 19,732 |   |
| Average rate                                      |       | 2.88                              | %          | 1.52 | % |

 

**ITEM 8.**                FINANCIALSTATEMENTS AND SUPPLEMENTARY DATA

Valentis’ FinancialStatements and notes thereto appear on pages 47 to 70 of this AnnualReport on Form 10-K.

**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 thedesired control objectives, and management necessarily was required to applyits judgment in evaluating the cost-benefit relationship of possible controlsand procedures.

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 

40

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reports that we file orsubmit under the Exchange Act, as amended, is recorded, processed, summarizedand reported within the time periods specified in the Securities ExchangeCommission rules and forms.

There have been nosignificant changes in our internal controls over financial reporting duringour most recent fiscal quarter that has materially affected, or is reasonablylikely to materially affect, our internal controls over financial reporting.

**ITEM 9B.**       OTHERINFORMATION

None.

**PART III**

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

The information requiredby this item concerning our directors and executive officers is incorporated byreference from Valentis’ definitive proxy statement to be filed not later than120 days following the close of the fiscal year (the “Definitive ProxyStatement”).

**ITEM 11.**         EXECUTIVECOMPENSATION

The information requiredby this item is hereby incorporated by reference from the Definitive ProxyStatement.

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

The information requiredby this item is hereby incorporated by reference from the Definitive ProxyStatement.

**ITEM 13.**         CERTAINRELATIONSHIPS AND RELATED TRANSACTIONS

The information requiredby this item is hereby incorporated by reference from the Definitive ProxyStatement.

**ITEM 14.**         PRINCIPALACCOUNTANT FEES AND SERVICES

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

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**PART IV**

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

(a)(1)   Index to Financial Statements

TheFinancial Statements and report of independent auditors required by this itemare submitted in a separate section beginning on page 47 of this Report.
|                                                                                                 | **Page No.** |
|-------------------------------------------------------------------------------------------------|-------------------|
| Report of Ernst &  Young LLP, Independent Registered Public Accounting Firm            | 47                |
| Consolidated Balance Sheets                                                                     | 48                |
| Consolidated Statements of  Operations                                                          | 49                |
| Consolidated Statement of  Redeemable Convertible Preferred Stock and Stockholders’ Equity | 50                |
| Consolidated  Statements of Cash Flows                                                          | 51                |
| Notes  to Consolidated Financial Statements                                                     | 52                |

 

(a)(2)   No schedules have been filed, as theywere not required or are inapplicable and therefore 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.                                                             |
| †             |       |       | 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.                                                                                                                      |
|   |   |   | 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.                                                                                                                                                                                                              |
|   |   |   | 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.                                                                                                                                                                                                              |

----

(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 to GeneMedicine’sRegistration Statement on Form S-1 (No. 33-77126) oramendments thereto and incorporated herein by reference.

43

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(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 and Exchange 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 and Exchange 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.

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

†       Confidential treatment has been requestedwith respect to certain portions of this Exhibit. The omitted portions havebeen separately filed with the Securities and Exchange Commission.

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**SIGNATURES**

Pursuantto the requirements of Section 13 or 15(d) of the Securities Act of1934, 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 26, 2005.
|        | 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, 2005 |
| 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, 2005 |
| Joseph A. Markey                        |          | Administration  (Principal Financial and Accounting Officer)    |       |                    |
| /s/  PATRICK G. ENRIGHT                 |          | Director                                                             |       | September 26, 2005 |
| Patrick G.  Enright                     |          |                                                                 |       |                    |
| /s/  REINALDO M. DIAZ                   |          | Director                                                             |       | September 26, 2005 |
| Reinaldo M. Diaz                        |          |                                                                 |       |                    |
| /s/  GEORGE M. LASEZKAY                 |          | Director                                                             |       | September 26, 2005 |
| George M.  Lasezkay                     |          |                                                                 |       |                    |
| /s/  MARK MCDADE                        |          | Director                                                             |       | September 26, 2005 |
| Mark McDade                             |          |                                                                 |       |                    |

45

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| /s/ ALAN C. MENDELSON    |   | Director |   | September 26, 2005 |
|--------------------------|--------|----------|--------|-------------------------|
| Alan C. Mendelson        |   |     |   |                    |
| /s/  DENNIS J. PURCELL   |   | Director |   | September 26, 2005 |
| Dennis J. Purcell        |   |     |   |                    |
| /s/  JOHN S. SCHROEDER   |   | Director |   | September 26, 2005 |
| John S.  Schroeder, M.D. |   |     |   |                    |

 

46

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**REPORT OF INDEPENDENT REGISTEREDPUBLIC ACCOUNTING FIRM**

The Board of Directors and StockholdersValentis, Inc.

We have audited the accompanying consolidated balancesheets of Valentis, Inc. as of June 30, 2005 and 2004, and therelated consolidated statements of operations, redeemable convertible preferredstock and stockholders’ equity and cash flows for each of the three years inthe period ended June 30, 2005. These financial statements are theresponsibility of the Company’s management. Our responsibility is to express anopinion on these financial statements based on 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, 2005 and 2004, and theconsolidated results of its operations and its cash flows for each of the threeyears in the period ended June 30, 2005, in conformity with U.S.generally accepted accounting principles.

Theaccompanying consolidated financial statements have been prepared assuming thatValentis, Inc. will continue as a going concern. As more fully describedin Note 1, the Company has incurred losses since inception, including anet loss of $11.1 million for the year ended June 30, 2005 andits accumulated deficit was $224.6 million at June 30, 2005.Additionally, the Company anticipates requiring additional financial resourcesto fund its operations at least through June 30, 2006. These conditionsraise substantial doubt about the Company’s ability to continue as a goingconcern. 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.
|                           | /s/ ERNST &  YOUNG LLP |   |
|---------------------------|---------------------------------|--------|
| Palo Alto,  California    |                            |
| August 19, 2005 |                            |

 

47

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**VALENTIS, INC.CONSOLIDATED BALANCE SHEETS(in thousands, except share and per share amounts)**
| ** **                                                                                                                                                           | ** ** | **June 30,** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------|------------|
| ** **                                                                                                                                                           | ** ** | **2005**          | ** ** | **2004** | ** ** |
| **ASSETS**                                                                                                                                                           |       |              |       |   |   |
| Current assets:                                                                                                                                                      |       |              |       |   |   |
| Cash and cash equivalents                                                                                                                                            |       | $                 | 8,865      |   | $ | 9,516 |   |
| Short-term investments                                                                                                                                               |       | 3,648             |       | 10,934 |   |
| Interest and other receivables                                                                                                                                       |       | 357               |       | 190 |   |
| Prepaid expenses and other current assets                                                                                                                            |       | 337               |       | 266 |   |
| Total current assets                                                                                                                                                 |       | 13,207            |       | 20,906 |   |
| Property and equipment, net                                                                                                                                          |       | 39                |       | 79 |   |
| Goodwill                                                                                                                                                             |       | 409               |       | 409 |   |
| Other assets                                                                                                                                                         |       | 497               |       | 497 |   |
| Total assets                                                                                                                                                         |       | $                 | 14,152     |   | $ | 21,891 |   |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                                                       |       |              |       |   |   |
| Current liabilities:                                                                                                                                                 |       |              |       |   |   |
| Accounts payable                                                                                                                                                     |       | $                 | 265        |   | $ | 207 |   |
| Accrued compensation                                                                                                                                                 |       | 496               |       | 1,137 |   |
| Accrued clinical trial costs                                                                                                                                         |       | 863               |       | 1,437 |   |
| Other accrued liabilities                                                                                                                                            |       | 959               |       | 1,120 |   |
| Deferred revenue                                                                                                                                                     |       | —            |       | 100 |   |
| Total current liabilities                                                                                                                                            |       | 2,583             |       | 4,001 |   |
| Commitments                                                                                                                                                          |       | —            |       | — |   |
| Stockholders’ equity:                                                                                                                                           |       |              |       |   |   |
| Common stock, $.001 par value, 190,000,000 shares  authorized; 14,833,379 and 12,996,607 shares issued and outstanding at  June 30, 2005 and 2004, respectively |       | 15                |       | 13 |   |
| Additional paid-in capital                                                                                                                                           |       | 236,889           |       | 232,137 |   |
| Accumulated other comprehensive loss                                                                                                                                 |       | (698              | )          | (706 | ) |
| Accumulated deficit                                                                                                                                                  |       | (224,637          | )          | (213,554 | ) |
| Total stockholders’ equity                                                                                                                                      |       | 11,569            |       | 17,890 |   |
| Total liabilities  and stockholders’ equity                                                                                                                     |       | $                 | 14,152     |   | $ | 21,891 |   |

 

See accompanying notes.

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**VALENTIS, INC.CONSOLIDATED STATEMENTSOF OPERATIONS(in thousands, except per share amounts)**
| ** **                                                                                           | ** ** | **Year ended June 30,** | ** ** |
|------------------------------------------------------------------------------------------------------|------------|----------------------------------------|------------|
| ** **                                                                                           | ** ** | **2005**                               | ** ** | **2004** | ** ** | **2003** | ** ** |
| License and  milestone revenue                                                                       |       | $                                      | 1,640      |   | $ | 7,284 |   | $ | 3,958 |   |
| Contract research  revenue                                                                           |       | 476                                    |       | — |   | — |   |
| Other revenue                                                                                        |       | 61                                     |       | 194 |   | — |   |
| Total revenue                                                                                        |       | 2,177                                  |       | 7,478 |   | 3,958 |   |
| Costs and operating  expenses:                                                                       |       |                                   |       |   |   |   |   |
| Cost of contract research revenue                                                                    |       | 521                                    |       | — |   | — |   |
| Research and development                                                                             |       | 9,169                                  |       | 10,054 |   | 9,965 |   |
| General and administrative                                                                           |       | 3,763                                  |       | 3,912 |   | 8,859 |   |
| Restructuring charges                                                                                |       | —                                 |       | — |   | 832 |   |
| Total operating expenses                                                                             |       | 13,453                                 |       | 13,966 |   | 19,656 |   |
| Loss from  operations                                                                                |       | (11,276                                | )          | (6,488 | ) | (15,698 | ) |
| Interest income                                                                                      |       | 285                                    |       | 90 |   | 111 |   |
| Other income and  expense, net                                                                       |       | (92                                    | )          | (86 | ) | 727 |   |
| Net loss                                                                                             |       | (11,083                                | )          | (6,484 | ) | (14,860 | ) |
| Deemed dividend                                                                                      |       | —                                 |       | — |   | (4,972 | ) |
| Adjustment  resulting from the reduction in the Series A preferred stock  conversion price |       | —                                 |       | — |   | (22,293 | ) |
| Dividends on  convertible preferred stock                                                            |       | —                                 |       | — |   | (882 | ) |
| Net loss  applicable to common stockholders                                                          |       | $                                      | (11,083    | ) | $ | (6,484 | ) | $ | (43,007 | ) |
| Basic and diluted net loss per share applicable to  common stockholders                              |       | $                                      | (0.85      | ) | $ | (0.81 | ) | $ | (13.86 | ) |
| Shares used in  computing basic and diluted net loss per common share                                |       | 13,028                                 |       | 8,024 |   | 3,103 |   |

 

See accompanying notes.

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**VALENTIS, INC.**

**CONSOLIDATED STATEMENT OF REDEEMABLE CONVERTIBLEPREFERRED STOCK AND STOCKHOLDERS’ EQUITY**

**(in thousands, except share amounts)**
| ** **                                                                                    | ** ** | **Redeemable  Convertible  Preferred Stock** | ** ** | **Common Stock** | ** ** | **Additional  Paid-In** | ** ** | **Accumulated  Other  Comprehensive** | ** ** | **Accumulated** | ** ** | **Total  Stockholders’  Equity  (net capital** | ** ** |
|-----------------------------------------------------------------------------------------------|------------|---------------------------------------------------|------------|-----------------------|------------|-------------------------|------------|---------------------------------------|------------|-----------------|------------|----------------------------------------------------------|------------|
| ** **                                                                                    | ** ** | **Shares**                                        | ** ** | **Amount**            | ** ** | **Shares**              | ** ** | **Amount**                            | ** ** | **Capital**     | ** ** | **Income (Loss)**                                   | ** ** | **Deficit** | ** ** | **deficiency)** | ** ** |
| Balance at  June 30, 2002                                                                |       | 30,800                                            |       | $                     | 25,828     |                    | 1,227,023  |                                  |       | $               | 1          |                                                     |       |   | $ | 184,631 |   |   |   | $ | (123 | ) |   |   | $ | (192,210 | ) |   |   | $ | (7,701 | ) |   |
| Issuance of common  stock pursuant to Employee Stock Purchase Plan                            |       | —                                            |       | —                |       | 178                     |       |                                  | —     |            |       |                                                     | 4          |   |   |   | — |   |   |   | — |   |   |   | 4 |   |   |
| Issuance of common  stock pursuant to a license agreement                                     |       | —                                            |       | —                |       | 2,106                   |       |                                  | —     |            |       |                                                     | 250        |   |   |   | — |   |   |   | — |   |   |   | 250 |   |   |
| Accretion of  redeemable convertible preferred stock warrants                                 |       | —                                            |       | 3,332                 |       | —                  |       |                                  | —     |            |       |                                                     | (3,332     | ) |   |   | — |   |   |   | — |   |   |   | (3,332 | ) |   |
| Accretion of  redeemable convertible preferred stock beneficial conversion feature            |       | —                                            |       | 593                   |       | —                  |       |                                  | —     |            |       |                                                     | (593       | ) |   |   | — |   |   |   | — |   |   |   | (593 | ) |   |
| Accretion of  redeemable convertible preferred stock issuance costs                           |       | —                                            |       | 1,047                 |       | —                  |       |                                  | —     |            |       |                                                     | (1,047     | ) |   |   | — |   |   |   | — |   |   |   | (1,047 | ) |   |
| Redeemable  convertible preferred stock dividends                                             |       | —                                            |       | —                |       | —                  |       |                                  | —     |            |       |                                                     | (882       | ) |   |   | — |   |   |   | — |   |   |   | (882 | ) |   |
| Redeemable  convertible preferred stock dividends paid in common stock                        |       | —                                            |       | —                |       | 84,336                  |       |                                  | —     |            |       |                                                     | 573        |   |   |   | — |   |   |   | — |   |   |   | 573 |   |   |
| Conversion of  redeemable convertible preferred stock into common stock                       |       | (30,800                                           | )          | (30,800               | )          | 4,242,065               |       |                                  | 5          |            |       |                                                     | 30,795     |   |   |   | — |   |   |   | — |   |   |   | 30,800 |   |   |
| Net loss                                                                                      |       | —                                            |       | —                |       | —                  |       |                                  | —     |            |       |                                                     | —     |   |   |   | — |   |   |   | (14,860 | ) |   |   | (14,860 | ) |   |
| Foreign currency  translation adjustment                                                      |       | —                                            |       | —                |       | —                  |       |                                  | —     |            |       |                                                     | —     |   |   |   | (623 | ) |   |   | — |   |   |   | (623 | ) |   |
| Total  comprehensive loss                                                                     |       |                                              |       |                  |       |                    |       |                                  |       |            |       |                                                     |       |   |   |   |   |   |   |   |   |   |   |   | (15,483 | ) |   |
| 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, 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, 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 |   |   |

 

See accompanying notes.

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**VALENTIS, INC.CONSOLIDATED STATEMENTS OF CASH FLOWS(in thousands)**
| ** **                                                                                                       | ** ** | **Year ended June 30,** | ** ** |
|------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------|------------|
| ** **                                                                                                       | ** ** | **2005**                               | ** ** | **2004** | ** ** | **2003** | ** ** |
| Cash flows from operating activities                                                                             |       |                                   |       |   |   |   |   |
| Net loss                                                                                                         |       | $                                      | (11,083    | ) | $ | (6,484 | ) | $ | (14,860 | ) |
| Adjustments to reconcile  net loss to net cash used in operations:                                               |       |                                   |       |   |   |   |   |
| Depreciation                                                                                                     |       | 48                                     |       | 1,439 |   | 1,842 |   |
| Loss (gain) on  disposal of assets                                                                               |       | —                                 |       | (8 | ) | (121 | ) |
| Stock options,  warrants and stock granted to non-employees for services rendered                                |       | 529                                    |       | 80 |   | — |   |
| 401(k) stock  contribution matching expense                                                                 |       | 55                                     |       | 55 |   | 113 |   |
| Changes in operating  assets and liabilities:                                                                    |       |                                   |       |   |   |   |   |
| Interest and other  receivables                                                                                  |       | (167                                   | )          | (3 | ) | 284 |   |
| Prepaid expenses  and other assets                                                                               |       | (32                                    | )          | (82 | ) | 103 |   |
| Deferred revenue                                                                                                 |       | (100                                   | )          | (75 | ) | 175 |   |
| Accounts payable                                                                                                 |       | 58                                     |       | 41 |   | 98 |   |
| Accrued  liabilities                                                                                             |       | (1,376                                 | )          | 1,101 |   | (2,621 | ) |
| Foreign currency  translation adjustment                                                                         |       | —                                 |       | 53 |   | (623 | ) |
| Net cash used in  operating activities                                                                           |       | (12,068                                | )          | (3,883 | ) | (15,610 | ) |
| Cash flows from investing activities                                                                             |       |                                   |       |   |   |   |   |
| Purchase of  property and equipment                                                                              |       | (8                                     | )          | (7 | ) | (31 | ) |
| Proceeds from sale  of property and equipment                                                                    |       | —                                 |       | 8 |   | 325 |   |
| Purchases of  available-for-sale investments                                                                     |       | (10,474                                | )          | (12,234 | ) | — |   |
| Maturities of  available-for-sale investments                                                                    |       | 17,768                                 |       | 1,287 |   | 7,892 |   |
| Net cash provided  by (used in) investing activities                                                             |       | 7,286                                  |       | (10,946 | ) | 8,186 |   |
| Cash flows from financing activities                                                                             |       |                                   |       |   |   |   |   |
| Payments on long-term  debt                                                                                      |       | —                                 |       | (9 | ) | (129 | ) |
| Preferred stock  dividends paid in cash                                                                          |       | —                                 |       | — |   | (373 | ) |
| Proceeds from  issuance of common stock, net of repurchases                                                      |       | 4,131                                  |       | 21,064 |   | 4 |   |
| Net cash provided  by (used in) financing activities                                                             |       | 4,131                                  |       | 21,055 |   | (498 | ) |
| Net increase  (decrease) in cash and cash equivalents                                                            |       | (651                                   | )          | 6,226 |   | (7,922 | ) |
| Cash and cash  equivalents, beginning of year                                                                    |       | 9,516                                  |       | 3,290 |   | 11,212 |   |
| Cash and cash  equivalents, end of year                                                                          |       | $                                      | 8,865      |   | $ | 9,516 |   | $ | 3,290 |   |
| *Supplemental disclosure of cash flow information:*                                                              |       |                                   |       |   |   |   |   |
| Interest paid                                                                                                    |       | $                                      | —     |   | $ | — |   | $ | 9 |   |
| *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 |   | $ | — |   |
| Accretion of  redeemable convertible preferred stock warrants, beneficial conversion  feature and issuance costs |       | $                                      | —     |   | $ | — |   | $ | 4,972 |   |
| Conversion of  redeemable convertible preferred stock into common stock                                          |       | $                                      | —     |   | $ | — |   | $ | 30,800 |   |
| Preferred stock  dividends declared                                                                              |       | $                                      | —     |   | $ | — |   | $ | 882 |   |
| Preferred stock  dividends paid in common stock                                                                  |       | $                                      | —     |   | $ | — |   | $ | 573 |   |
| Stock issued in  partial consideration for a license agreement                                                   |       | $                                      | —     |   | $ | — |   | $ | 250 |   |

 

See accompanying notes.

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**NOTESTO CONSOLIDATED FINANCIAL STATEMENTSJune 30, 2005**

**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 clinical-stage biotechnology companyengaged in the development of innovative products for peripheral arterialdisease (PAD), a large and unsatisfied market. PAD is due to chronicinflammation of the blood vessels of the legs leading to the formation ofplaque which obstructs blood flow. VLTS 934, the company’s lead product,is an anti-inflammatory drug in Phase IIb testing. The company’s secondproduct for the treatment of PAD is the DEL-1 angiogenic protein, a productwhich causes the formation of new blood vessels.

Valentis has a series of technologies includingcardiovascular therapies, gene delivery and expression technologies, andproprietary formulation and manufacturing technologies that allow us togenerate novel therapeutics to treat a wide range of diseases. While Valentisis focusing its efforts on the development of novel cardiovasculartherapeutics, its technologies are being applied by its collaborators for thedevelopment of therapeutics to treat a variety of indications includinginfectious diseases and cancer.

The Company’s commercial strategy is to enter intocorporate collaborations for late stage clinical trials, sales, marketing andlarge-scale clinical and commercial manufacturing.

The consolidated financial statements include theaccounts of Valentis and its wholly owned subsidiary, PolyMASC. The Companytranslates the assets and liabilities of its foreign subsidiary stated in localfunctional currency to U.S. dollars at the rates of exchange in effect at theend of the period. Revenues and expenses are translated using rates of exchangein effect during the period. Gains and losses from currency translation areincluded in other comprehensive income (loss).

We are currently supporting the ongoing VLTS 934Phase IIb clinical trial. The results of this trial are expected inmid-calendar 2006. A positive outcome for the clinical trial demonstrating astatistically significant drug effect and safety for use in the targetedpopulation is critical to the continued development of VLTS 934. Anegative trial outcome could have a material and adverse effect on the furtherdevelopment of VLTS 934, negatively affect Valentis’ ability to raiseadditional financing on acceptable terms, if at all, and negatively impact ourbusiness and prospects. If results of the Phase IIb clinical trial justifyproceeding to a Phase III clinical trial of VLTS 934, because of thesize of the potential market for the product and the number of possible usesfor the product, we expect to license VLTS 934 to a pharmaceutical companythat will assume responsibility for late-stage development andcommercialization.

Except for the quarter ended September 30, 2003,in which we reported net income of approximately $3.4 million resultingprincipally from the $6.5 million non-recurring license revenue recognizedunder the license and settlement agreement with ALZA Corporation (seeNote 14), we have experienced net losses since our inception through June 30, 2005,and reported a net loss of $11.1 million for the fiscal year ended June 30, 2005.Our accumulated deficit was $224.6 million at June 30, 2005. Weexpect such losses to continue into the foreseeable future as we proceed withthe research, development and commercialization of our technologies. Dependingon the outcome of the VLTS 934 Phase IIb clinical trial and if the Companyis successful in securing additional new funding and strategic partnerships tosupport increased 

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expenses, spending levelsfor research and development and general and administrative expenses mayincrease above current levels, to reflect increases in clinical trial effortsto advance the VLTS 934 PAD product to Phase III testing. At June 30, 2005,we had $12.5 million in cash, cash equivalents and investments, and weanticipate that we will require additional financial resources to advance theVLTS 934 product and continue our planned operations at least through June 30, 2006.

Should the outcome of the VLTS 934 PADPhase IIb clinical trial demonstrate a statistically significant drugeffect and is safe for the targeted population, we may seek additional financingand pursue corporate partners, to advance VLTS 934 PAD to Phase IIIclinical testing. We may not be able to obtain additional financing and pursuecorporate partners on acceptable terms, or at all. Any failure to obtain anadequate and timely amount of additional capital on commercially reasonableterms will have a material adverse effect on our business, financial conditionand results of operations, including our viability as an enterprise. As aresult of these concerns, management may pursue strategic alternatives, whichmay include the sale of securities, the sale or merger of the business, thesale of certain assets or other actions.

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.

***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 theCompany’s core technology, are deferred and recognized on a straight-line basisover the relevant period specified in the agreement, generally the researchterm.

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 to substantive,at-risk incentive milestones, if any, are recognized as revenue uponachievement of the incentive milestone event because the Company has no futureperformance obligations related to the payment. Incentive milestone paymentsare triggered either by results of the Company’s research efforts or by eventsexternal 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 

53

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optionsare deferred and recognized at the time the option is exercised or expiresunexercised. Additionally, certain of these license agreements involvetechnology that the Company has licensed or otherwise acquired througharrangements with third parties pursuant to which the Company is required topay a royalty equal to a fixed percentage of amounts received by the Company asa result of licensing this technology to others. Such royalty obligations arerecorded as a reduction of the related revenue. Furthermore, the Companyreceives royalty and profit sharing payments under a licensing agreement with acontract manufacturing company. Royalty and profit sharing payments arerecognized as revenue when received. The Company also provides contractresearch services for research and development manufacturing of biologicalmaterials for other companies. Under these contracts, the Company generallyreceives payments based on a contractual cost per full-time equivalent employeeworking on the project. Revenue is recognized for actual research work performedduring 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 theappropriate trial expenses in its consolidated financial statements by matchingperiod expenses with period services and efforts expended. In the event ofearly termination of a clinical trial, the Company accrues expenses associatedwith an estimate of the remaining, non-cancelable obligations associated withthe winding down of the trial.

***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 

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andgovernment agency securities. Therefore, the Company believes that its exposuredue to concentration of credit risk is minimal and has not experienced creditlosses on investments in these instruments 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 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 has not recorded anygoodwill impairment charges through June 30, 2005.

***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.

***Stock-Based Compensation***

Valentis has elected to follow Accounting PrinciplesBoard Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”)and related interpretations in accounting for its employee stock optionsbecause, as discussed below, the alternative fair value accounting provided forunder SFAS 123, “Accounting for Stock-Based Compensation”, requiresuse of valuation models that were not developed for use in valuing employeestock options. Under APB 25, if the exercise price of Valentis’ employeestock options equals or exceeds the market price of the underlying stock on thedate of grant, no compensation expense is recognized.

Pro forma net loss and net loss per share informationis required by SFAS 148, “Accounting for Stock-BasedCompensation—Transition and Disclosure an amendment of FASB Statement No. 123”which also requires that the information be determined as if Valentis hasaccounted for its employee stock options under the fair value method ofSFAS 123. The fair value for these options was estimated at the date ofgrant using a Black-Scholes option-pricing model.

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Forpurposes of pro forma disclosures, the estimated fair value of the options isamortized to expense over the options’ vesting periods using the graded vestingmethod. Valentis’ pro forma information follows (in thousands except for netloss per share information):
| ** **                                                                              | ** ** | **Year ended June 30,** | ** ** |
|-----------------------------------------------------------------------------------------|------------|----------------------------------------|------------|
| ** **                                                                              | ** ** | **2005**                               | ** ** | **2004** | ** ** | **2003** | ** ** |
| Net loss  applicable to common stockholders—as reported                            |       | $                                      | (11,083    | ) | $ | (6,484 | ) | $ | (43,007 | ) |
| Deduct: Stock-based  employee stock compensation expense determined under SFAS 123 |       | (3,195                                 | )          | (1,880 | ) | (545 | ) |
| Net loss  applicable to common stockholders—pro forma                              |       | $                                      | (14,278    | ) | $ | (8,364 | ) | $ | (43,552 | ) |
| Net loss  applicable to common stockholders per share—as reported                  |       | $                                      | (0.85      | ) | $ | (0.81 | ) | $ | (13.86 | ) |
| Net loss applicable to  common stockholders per share—pro forma               |       | $                                      | (1.10      | ) | $ | (1.04 | ) | $ | (14.04 | ) |

 

All stock-basedawards to non-employees are accounted for at fair value, as calculated usingthe Black-Scholes option-pricing model, in accordance withSFAS 123 and Emerging Issues Task Force (“EITF”) Issue No. 96-18, “Accountingfor Equity Instruments That Are Issued to Other Than Employees for Acquiring,or in Conjunction with Selling, Goods or Services” (“EITF 96-18”). Stock-basedawards to non-employees not immediately vested are subject to periodicrevaluation over their vesting terms.

***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,** | ** ** |
|------------------------------------------------------------------------------------|------------|----------------------------------------|------------|
| ** **                                                                         | ** ** | **2005**                               | ** ** | **2004** | ** ** | **2003** | ** ** |
| Net loss  applicable to common stockholders                                        |       | $                                      | (11,083    | ) | $ | (6,484 | ) | $ | (43,007 | ) |
| Basic and Diluted:                                                                 |       |                                   |       |   |   |   |   |
| Weighted average shares of common stock outstanding                                |       | 13,123                                 |       | 8,211 |   | 3,105 |   |
| Less: Shares in escrow, subject to return                                          |       | (2                                     | )          | (2 | ) | (2 | ) |
| Less: Shares subject to repurchase                                                 |       | (93                                    | )          | (185 | ) | — |   |
| Weighted-average  shares of common stock used in computing net loss per share |       | 13,028                                 |       | 8,024 |   | 3,103 |   |
| Basic and diluted net  loss per share applicable to common stockholders            |       | $                                      | (0.85      | ) | $ | (0.81 | ) | $ | (13.86 | ) |

 

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:

·       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.

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·       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.

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 2,319,674 shares of common stock at a weighted average price of$8.45 per share, options to purchase 1,744,280 shares of common stock at aweighted average price of $11.24 per share and options to purchase1,002,327 shares of common stock at a weighted average price of $22.04 pershare at June 30, 2005, 2004 and 2003, respectively.

·       Warrantsto purchase 3,666,575 shares of common stock at a weighted average price of$4.09 per share, warrants to purchase 2,821,625 shares of common stock at aweighted average price of $8.69 per share and warrants to purchase 42,226shares of common stock at a price of $307.5 per share at June 30, 2005,2004 and 2003, respectively.

The options, common stockpurchase warrants, shares of common stock held in escrow and shares ofoutstanding common stock subject to our right of repurchase will be included inthe calculation of income (loss) per share at such time as the effect is nolonger antidilutive, as calculated using the treasury stock method for optionsand warrants.

***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 20% of their annual salary, not to exceed the annual dollar limit set bylaw, deferred and contributed to the 401(k) Plan. In December 2002,the Board of Directors approved the restatement of the 401(k) Plan.Pursuant to the restated 401(k) Plan, all employees are eligible toparticipate in the 401(k) Plan, and may elect to have up to 75% of theirannual salary, not to exceed the annual dollar limit set by law, deferred andcontributed to the 401(k) Plan. Valentis has the discretion to make amatching contribution in common stock each year for every dollar contributed tothe 401(k) Plan. The stock match vests according to the employee’s yearsof employment with the Company (see Note 10).

***Current Vulnerability to Certain Concentrations***

Valentis has contractedwith third-party manufacturers to produce GMP (Good ManufacturingPractices) biopharmaceuticals. The Company has also contracted for drugformulation filling and finishing. Should the Company not be able to obtainsufficient quantities of GMP biopharmaceuticals, or sufficient drug formulationand finishing capacity from its third-party suppliers, or additionalthird-party GMP contract manufacturing organizations or drug formulationfilling and finishing suppliers, certain development and clinical activitiesmay be delayed.

***Recent Accounting Pronouncements***

In December 2004, theFASB issued Statement No. 123 (revised 2004, or Statement 123R), “Share-BasedPayment”. FAS 123R supersedes APB Opinion No. 25, “Accounting forStock Issued to Employees,” and will require companies to recognizecompensation expense, using a fair-value based method, for costs related toshare-based payments including stock options and employee stock purchase plans.We adopted FAS 123R on July 1, 2005. Statement 123R permitspublic companies to adopt its requirements using either the modifiedprospective or modified retrospective transition method. We have decided to usethe modified prospective transition method, which requires that compensationcost is recognized for all awards granted, modified or settled after theeffective date as well as for all awards 

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grantedto employees prior to the effective date that remain unvested as of theeffective date. We expect that our adoption of FAS 123R will have amaterial adverse impact on our consolidated financial statements. However,uncertainties such as stock price volatility, estimated forfeitures andemployee stock option exercise behavior, make it difficult to determine whetherfuture stock-based compensation expenses will be similar to the pro formaexpenses disclosed above.

***Business Segments***

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

***Reclassifications***

Certain prior year amountshave been reclassified in the Consolidated Balance Sheets and ConsolidatedStatement of Cashflows to conform to current year presentation, including thepresentation of current assets, other assets and supplemental disclosure ofcash flow information.

**2.**   FINANCIALINSTRUMENTS

At June 30, 2005and 2004, financial instruments held by the Company consist of the following(in thousands):
| ** **                                   | ** ** | **Amortized  Cost** | ** ** | **Unrealized  Gain/(Loss)** | ** ** | **Estimated  Fair Value** | ** ** |
|----------------------------------------------|------------|---------------------|------------|-----------------------------|------------|--------------------------------|------------|
| **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 |   |   |
| **June 30,  2004**                      |       |                |       |                        |       |                           |       |   |   |   |   |   |   |
| Money market  mutual funds                   |       |                | $          | 4,801                       |       |                           |       | $ | — |   |   |   | $ | 4,801 |   |   |
| Commercial paper                             |       |                | $          | 3,997                       |       |                           |       | — |   |   |   | $ | 3,997 |   |   |
| Corporate debt  securities                   |       |                | 10,947     |                        |       |                           | (13        | ) |   |   | 10,934 |   |   |
|                                         |       |                | 19,745     |                        |       |                           | (13        | ) |   |   | 19,732 |   |   |
| Less amounts  classified as cash equivalents |       |                | (8,798     | )                           |       |                           | —     |   |   |   | (8,798 | ) |   |
| Total short-term  investments                |       |                | $          | 10,947                      |       |                           |       | $ | (13 | ) |   |   | $ | 10,934 |   |   |

 

Unrealized gains or losses have not been material andhave been presented net. There were no realized gains or losses in any periodpresented. The Company’s cash and cash equivalents, interest and otherreceivables, and accounts payable are carried at historical cost, whichapproximates fair value because of the short-term nature of these accounts.

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**3.   ACCUMULATEDOTHER COMPREHENSIVE 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, 2005** | ** ** | **June 30, 2004** | ** ** |
|---------------------------------------------------|------------|-----------------------------|------------|-----------------------------|------------|
| Unrealized loss  on available-for-sale securities |       |                        | $          | (5                          | )          |   |   | $ | (13 | ) |   |
| Foreign currency  translation adjustments         |       |                        | (693       | )                           |       |   | (693 | ) |   |
| Accumulated other comprehensive  loss             |       |                        | $          | (698                        | )          |   |   | $ | (706 | ) |   |

 

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

Revenuerecognized in the fiscal years ended June 30, 2005, 2004 and 2003 isas follows (in thousands):

| ** **                                                   | ** ** | **Year ended June 30,** | ** ** |
|--------------------------------------------------------------|------------|----------------------------------------|------------|
| ** **                                                   | ** ** | **2005**                               | ** ** | **2004** | ** ** | **2003** | ** ** |
| License and  milestone revenue:                              |       |                                   |       |   |   |   |   |
| GeneSwitch® licenses                                    |       | $                                      | 1,021      |   | $ | 284 |   | $ | 1,888 |   |
| DNAVaxTM gene delivery technology license and  milestone |       | —                                 |       | 500 |   | — |   |
| PINCTM gene delivery technology licenses                 |       | 619                                    |       | — |   | 570 |   |
| Manufacturing technology milestone                           |       | —                                 |       | — |   | 1,500 |   |
| PEGylation technology licenses                               |       | —                                 |       | 6,500 |   | — |   |
|                                                         |       | 1,640                                  |       | 7,284 |   | 3,958 |   |
| Contract research revenue                                    |       | 476                                    |       | — |   | — |   |
| Other revenue                                                |       | 61                                     |       | 194 |   | — |   |
| Total Revenue                                                |       | $                                      | 2,177      |   | $ | 7,478 |   | $ | 3,958 |   |

 

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.

***DSM Biologics (“DSM”)***

In June 2003, Valentis announced that itcompleted an agreement with DSM Biologics under which the license granted byValentis to DSM Biologics for Valentis’ plasmid DNA manufacturing technologywas affirmed on revised financial terms. The agreement further resolvedoutstanding disputes between Valentis and DSM Biologics regarding prior plasmidDNA manufacturing services performed by DSM Biologics for Valentis.

Under this agreement, thepAllianceTM plasmid DNA contract manufacturing alliance that had includedValentis, DSM Biologics and Qiagen GmbH was dissolved. The new agreementreinstated the license to DSM Biologics under the terms of the originalagreement between Valentis and DSM Biologics, modified to add a royalty toValentis (in addition to the previously-agreed profit-sharingarrangement). In consideration for the license reinstatement, DSM Biologicspaid a $1.3 million milestone payment. The milestone payment, net ofapproximately $0.6 million of outstanding debt owed to DSM Biologics byValentis, which had been accrued by Valentis as of June 30, 2002, wasreceived in cash during fiscal 2003. 

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Werecorded an expense reversal of approximately $0.5 million duringfiscal 2003 for the remaining amount, which we were no longer obligated topay to DSM Biologics as a result of the new agreement.

***Other license-out agreements***

Valentis has licensed-out its proprietary GeneSwitch®gene regulation technology on a non-exclusive basis to Wyeth-AyerstLaboratories, GlaxoSmithKline, Lexicon Genetics, Pfizer Inc., LARNAX GmbH,Schering AG and Organon Laboratories, LTD for research purposes. In addition,the Company has licensed its gene delivery technology on a non-exclusivebasis to IDM Pharma, Inc. Further, the Company has licensed to Schering AGthe exclusive, worldwide rights to its GeneSwitch® gene regulation and genedelivery technologies to develop and commercialize two gene-based therapeuticproducts. These agreements generally include (i) up front payments andannual maintenance fees, which are non-cancelable and recognized at the time ofcontract signing; and, (ii) milestone and royalty payments. Revenues, inaggregate, recognized from these agreements were approximately$1.6 million, $784,000 and $2.5 million for the fiscal year ended June 30, 2005,2004 and 2003, respectively. The Company has also granted a license to ALZACorporation under a license and settlement agreement related to its PEGylationtechnology. Valentis recognized $6.5 million of license revenue infiscal 2004 under this agreement. (See Note 14)

Valentis has established anon-exclusive cross license with Genzyme Corporation in which Genzyme receivesrights to GeneSwitch® gene regulation technology for research use and Valentisreceives certain rights to Genzyme’s plasmid DNA manufacturing technology.

***Contract research agreement***

Valentis has entered intocontract research agreements with other companies. Under the agreement, we arerequired to conduct research on the manufacturing of certain biologicalmaterials for other companies. For the year ended June 30, 2005, werecognized approximately $476,000 of contract research revenue, based onresearch performed during the year and recorded approximately $521,000 of costsof contract research, which included direct and related overhead expensesincurred and costs 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 $74,000,$55,000 and $208,000 for the fiscal years ended June 30, 2005, 2004and 2003, respectively.

**5.   OTHERACQUIRED TECHNOLOGY**

In April 1999, Valentis acquired rights tointellectual property related to the DEL-1 gene and protein. DEL-1 is a novelextracellular matrix protein involved in early growth and development of bloodvessels and bone that has been demonstrated to have potential application inthe treatment of certain vascular diseases by stimulating angiogenesis.Valentis is obligated to make payments to Vanderbilt University upon theachievement of certain milestones, to share revenue received from sublicensingat a specified rate, and to make royalty payments on sales of products, if any.As of June 30, 2005, no revenues have been derived from the licenseof this technology.

In June 2005,Valentis gained rights to the DEL-1 antibody and associated intellectualproperty from Cambridge Antibody Technology. No payment was required by theCompany for the acquisition of these rights.

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**6.   PROPERTYAND EQUIPMENT**

Propertyand equipment consist of the following (in thousands):

| ** **                                      | ** ** | **June 30,** | ** ** |
|-------------------------------------------------|------------|-------------------|------------|
| ** **                                      | ** ** | **2005**          | ** ** | **2004** | ** ** |
| Machinery and  equipment                        |       | $                 | 6,287      |   | $ | 6,279 |   |
| Furniture and  fixtures                         |       | 1,251             |       | 1,251 |   |
| Leasehold  improvements                         |       | 9,868             |       | 9,868 |   |
|                                            |       | 17,406            |       | 17,398 |   |
| Less accumulated  depreciation and amortization |       | (17,367           | )          | (17,319 | ) |
| Property and equipment,  net                    |       | $                 | 39         |   | $ | 79 |   |

 

**7.   GOODWILL**

At June 30, 2005and 2004, goodwill is associated with the acquisitions of PolyMASCPharmaceuticals, plc. in fiscal 2000. The Company performed impairmentanalyses in accordance with SFAS 142 as of each date, and determined thatin each case goodwill was not impaired.

**8.   OTHERACCRUED LIABILITIES**

Otheraccrued liabilities consist of the following (in thousands):

| ** **                                 | ** ** | **June 30,** | ** ** |
|--------------------------------------------|------------|-------------------|------------|
| ** **                                 | ** ** | **2005**          | ** ** | **2004** | ** ** |
| Accrued research  and development expenses |       | $                 | 208        |   | $ | 125 |   |
| Accrued rent                               |       | 80                |       | 95 |   |
| Accrued property  and use taxes            |       | 378               |       | 441 |   |
| Accrued legal  expenses                    |       | 121               |       | 179 |   |
| Other                                      |       | 172               |       | 280 |   |
| Total                                      |       | $                 | 959        |   | $ | 1,120 |   |

 

**9.   COMMITMENTS**

***Operating Lease***

We lease our facilities under operating leases. Theseleases expire between November 2006 and October 2007 with renewaloptions at the end of the initial terms to extend the leases for an additionalsix and five years, respectively.

Minimalannual rental commitments under the operating leases at June 30, 2005 areas follows (in thousands):

| **Year ended June 30,** | ** ** | ** ** | ** ** | ** ** | ** ** |
|----------------------------------------|------------|------------|------------|------------|------------|
| 2006                                   |       | $          | 1,177      |       |
| 2007                                   |       | 650        |       |
| 2008                                   |       | 65         |       |
|                                   |       | $          | 1,892      |       |

 

The Company leased an approximately 38,000 square-footbuilding in The Woodlands, Texas. The term of The Woodlands facility lease,which began in January 1995, was 10 years. However, during the fourthquarter of fiscal 2003, the Company ceased using the facility and in September 2003,the Company entered into a lease termination agreement with the landlord of thefacility. Pursuant to the lease termination agreement, The Woodlands facilitylease was terminated on September 4, 2003, and on the 

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same date, the Companypaid to the landlord a termination fee consisting of (i) $232,000 in cash,and (ii) 185,000 shares of the Company’s common stock, together withcertain registration rights for, and the Company’s option to repurchase, thoseshares. The Company recorded the termination fee in the year ended June 30, 2003,as lease exit cost of $232,000 for the cash payment and approximately $433,000for the issuance of 185,000 shares of its common stock, as it ceased using thefacility during the fourth quarter of fiscal 2003. This lease exit cost isincluded in general and administrative expenses for fiscal 2003.

In addition, the Company exited 7,500 square feet ofits leased Burlingame, CA facility in October 2003. In July 2003, theCompany entered into a lease termination agreement with the landlord of theBurlingame facility. Pursuant to the lease termination agreement, theBurlingame facility lease terminated on October 6, 2003. Inconsideration for the lease termination, the Company paid to the landlord acash termination fee of $115,000, which was recorded as a lease exit cost andincluded in general and administrative expenses for fiscal 2004.

Aggregate future minimumsublease income to be received under the Company’s facility subleases as of June 30, 2005totals approximately $260,000, which will offset rent expense in the fiscalyear ended June 30, 2006. Gross rent expense for the fiscal years ended June 30, 2005,2004 and 2003 was approximately $1.2 million, $677,000 and$1.8 million, respectively. Gross sublease income for the fiscal yearsended June 30, 2005, 2004 and 2003 was approximately $517,000,$502,000 and $549,000, respectively.

***Long- term follow up program for the DeltavascTMPhase IIa clinical trial***

The safety and long-termeffects of gene-based therapy has been evaluated and debated extensively inrecent years. In 2000, the Food and Drug Administration issued a guidancedocument that mandated long-term follow up of patients treated in genetherapy clinical trials. Currently all gene therapy clinical trials arerequired to include a long-term follow-up program to collect patient safetydata for selected morbidities in patients over the course of 15 years. Valentisinitiated the long-term follow-up program for the DeltavascTM Phase IIaclinical trial in January 2005. The Company estimated the total expensesfor this program to be approximately $700,000 over the period of fifteen yearsand the expenses for the first year of the program to be approximately$140,000, of which approximately $70,000 of expenses have been incurred andrecorded in the year ended June 30, 2005. It is anticipated thatannual expenses for this program will decline substantially over the 15-yearperiod due to the length of follow up and the age of the patients. In September 2005,the FDA stated that it generally will not require long-term follow-upobservations of participants in clinical trials of gene transfer technologywhen the risk of delayed adverse events is low, according to draft guidance.Valentis intends to work with the FDA to determine its long-term follow-uprequirements.

***Restricted Cash***

At June 30, 2005,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, 2005and 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 indemnities todirectors and officers of the Company to the maximum extent permitted under thelaws of 

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theState of Delaware. The duration of these indemnities, commitments andguarantees varies, and in certain cases, is indefinite. The majority of theseindemnities, commitments and guarantees do not provide for any limitation ofthe maximum potential future payments the Company could be obligated to make.The Company has not recorded any liability for these indemnities, commitmentsand guarantees in the accompanying consolidated balance sheets. However, theCompany accrues for losses for any known contingent liability, including thosethat may arise from indemnification provisions, when future payment is probableand in accordance with SFAS No. 5, Accounting for Contingencies. Nosuch losses have been recorded to date.

***Liquidated Damages Contingencies***

In January and June 2004 and June 2005,the Company completed three separate private placements of common stock (see Note 10)for gross proceeds of approximately $10.0 million, $12.0 million and$4.2 million, respectively.

The Company entered into registration rightsagreements with the purchasers in these three 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 privateplacement completed in June 2005, while there is an effective registrationstatement and if the Company fails to deliver a stock certificate that is free ofrestrictive legends within three trading days upon delivery of such a requestby a purchaser, the Company is required to pay to the purchaser, for each$1,000 of shares of stock or shares issuable upon exercise of warrantsrequested, $10 per trading day for each trading day beginning five trading daysafter the delivery of the request, increasing to $20 per trading day after thefirst five trading days for which such damages have begun to accrue, until suchcertificate is delivered without restrictive legends.

**10.   REDEEMABLECONVERTIBLE PREFERRED STOCK AND STOCKHOLDERS’ EQUITY**

***Redeemable Convertible Preferred Stock and CommonStock Warrants***

On December 5, 2000, Valentis completed theprivate placement of 31,500 shares of Series A redeemable convertiblepreferred stock and common stock purchase warrants. On January 24, 2003,all outstanding shares of Series A preferred stock were converted intoshares of common stock.

Prior to the conversion of the Series A preferredstock to Common Stock on January 24, 2003, the Series Apreferred stockholders were entitled to cumulative dividends, which accrued atan annual rate of 5%, payable quarterly, in cash or, at the Company’s election,in shares of common stock. If the Company elected to pay dividends in shares ofits common stock, those shares were valued at the average closing bid price forValentis common stock during the twenty consecutive trading days ending on andincluding the trading day immediately prior to the dividend payment date.During the fiscal year ended June 30, 2003, the Company issued 84,338shares of common stock for dividends amounting to $882,000.

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***Summary of Certain Preferred Stock and WarrantAccounting***

The total cash proceeds from the sale of Series Apreferred stock and common stock purchase warrants of $31.5 million werediscounted by approximately $6.0 million, representing the value assignedto the Class A and B warrants exercisable for an aggregate of 42,226shares of common stock issued in the private placement. The $6.0 millionvalue of the warrants was subject to accretion over the 3.5-year redemptionperiod. After reducing the proceeds by the value of the warrants, the remainingproceeds were used to compute a discounted conversion price in accordance withEITF 00-27, “Application of EITF Issue No. 98-5, Accounting forConvertible Securities with Beneficial Conversion Features or ContingentlyAdjustable Conversion Ratios to Certain Convertible Instruments.” Thediscounted conversion price was compared to the fair market value of theValentis common stock on December 5, 2000 (the date of issuance ofthe Series A preferred stock) resulting in a beneficial conversion featureof approximately $1.1 million which represents the difference between thefair market value of Valentis’ common stock and the discounted conversionprice, and was subject to accretion over the 3.5-year redemption period.

Upon conversion of the Series A preferred stockto common stock in January 2003, the remaining $3.5 million ofunaccreted deemed dividend representing the balance of amounts attributed tocommon stock purchase warrants, beneficial conversion feature and issuancecosts related to the Series A preferred stock was fully accreted andrecorded as a deemed dividend.

Additionally, as a resultof the simultaneous conversion of the Series A preferred stock to commonstock and the reduction in the Series A preferred stock conversion price(see below), the excess of the fair value of the common stock issued to the Series Apreferred stockholders over the fair value of the common stock issuablepursuant to the original conversion terms was approximately $22.3 million.

***Common Stock***

In January 2003, the Company received stockholderapproval for, and completed, its proposed capital restructuring. Specifically,the Company effected the conversion of all outstanding shares of its Series Apreferred stock into common stock and, immediately thereafter, effected areverse stock split of its common stock at a ratio of one-for-thirty. All shareand per share amounts have been restated to reflect this reverse stock split.

The conversion and reverse stock split were approvedby the holders of the Company’s common stock on January 23, 2003. Thestockholders approved the Company’s Amended and Restated Certificate ofIncorporation (the “Restated Certificate”), which provided for the following: (i) anincrease in the authorized shares of Common Stock from 65 million to190 million; (ii) the elimination of all redemption rights of the Series Apreferred stock; (iii) an adjustment of the conversion price of the Series Apreferred stock from $270.00 to $7.26 (these conversion prices reflect the impactof the reverse stock split); (iv) the automatic conversion into commonstock of all outstanding shares of Series A preferred stock (plus accruedand unpaid dividends and arrearage interest on unpaid dividends) on the filingdate of the Restated Certificate; and (v) a reverse stock split of theCompany’s outstanding Common Stock on the filing date of the RestatedCertificate, in the range of 1:5 to 1:40, as determined at the discretion ofthe Board of Directors of the Company.

The Board of Directors authorized a one-for-thirtyreverse stock split whereby each outstanding share of common stockautomatically converted into one-thirtieth of a share of common stock. As aresult of the conversion of the Series A preferred stock (and the paymentof accrued and unpaid dividends and arrearage interest on unpaid dividends),the Company issued approximately 4.3 million shares after giving effect tothe reverse stock split. In lieu of fractional shares of common stock,stockholders received a cash payment based on the closing price of the commonstock on January 23, 2003. The par value of the common stock remains$0.001.

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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 purchase 223,478 sharesof common stock at $5.4075 per share, exercisable for a five-year period.

In June 2005, theCompany completed an additional private placement, in which the Company issuedand sold 1,680,840 shares of the Company’s common stock and warrants,exercisable for a five-year period, to purchase up to 840,420 additional sharesof the Company’s common stock at $2.50 per unit, for net proceeds ofapproximately $3.9 million. The warrants are exercisable at $3.51 pershare. In addition, the Company issued to the designees of Reedland CapitalPartners, the placement agent of the private placement, warrants to purchase63,000 shares of common stock at $3.29 per share, exercisable for a five-yearperiod.

***Equity Incentive Plan***

The 1997 Equity Incentive Plan (the “Incentive Plan”),as amended and restated in December 2004, provides for grants of optionsto employees, directors and consultants of Valentis. The exercise price ofoptions granted under the Incentive 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 Incentive Plan generally vest25% 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. Options granted under the plan cannot berepriced without the prior approval of Valentis’ stockholders. As of June 30, 2005,an aggregate of 3.7 million shares have been authorized for issuance andoptions to purchase approximately 1.7 million shares of common stock hadbeen granted under this plan.

Pursuant to the terms of the 1998 Non-EmployeeDirectors’ Plan (the “Directors’ Plan”), as amended and restated in December 2004,each non-employee director, other than a non-employee director who currentlyserves on the Board, automatically shall be granted, upon his or her initialelection or appointment as a non-employee director, an option to purchase26,000 shares of common stock, and commencing with the annual meeting ofstockholders for the fiscal year 2003, each person who is serving as anon-employee director on the day following each Annual Meeting of Stockholdersautomatically shall be granted an option to purchase 10,000 shares of commonstock. As of June 30, 2005, an aggregate of 575,000 shares have beenauthorized for issuance under this plan, and options to purchase 258,662 sharesof common stock had been granted to non-employee directors under this plan.

The merger with GeneMedicine in 1999 included theconversion of outstanding GeneMedicine stock options into options to purchase50,000 shares of Valentis common stock. These options relate to Valentis’assumption of GeneMedicine’s 1993 Stock Option Plan referred to as the “GeneMedicinePlan.” Under the terms of the GeneMedicine Plan, eligible key employees,directors and consultants received options to purchase shares of GeneMedicine’spreviously outstanding common stock at prices not less than 100% and 85% forincentive stock and nonqualified options, respectively, of the fair value onthe date of grant as determined by GeneMedicine’s Board of Directors. Optionsunder the GeneMedicine Plan typically vest over a four-year period and expireten years after the date of grant or 90 days after termination ofemployment. The GeneMedicine Plan expired in March 2004.

In May 2001, the Board of Directors adopted the2001 Nonstatutory Incentive Plan (the “NQ Plan”) covering 100,000 shares ofcommon stock of Valentis. An additional 590,000 shares were added to the plan 

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as approved by the Boardof Directors in May 2003, when the plan was amended and restated. The NQPlan provides for grants of nonstatutory stock options to employees, directorsand consultants of Valentis. The exercise price of options granted under the NQPlan is determined by the Board of Directors but cannot be less than 100% ofthe fair market value of the common stock on the date of the grant. Optionsunder the NQ Plan generally vest 25% one year after the date of grant and on apro rata basis over the following 36 months and expire ten years after thedate of grant or 90 days after termination of employment. Options grantedunder the plan cannot be repriced without the prior approval of Valentis’stockholders. As of June 30, 2005, options for 443,741 shares hadbeen granted under this plan.

Activityunder all option plans was as follows:
| ** **                     | ** ** | ** **                            | ** ** | **Outstanding Stock Options** | ** ** |
|--------------------------------|------------|---------------------------------------|------------|-----------------------------------------|------------|
| ** **                     | ** ** | **Shares  Available  for Grant** | ** ** | **Number  of  Shares**                  | ** ** | **Exercise Price  Per Share** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
| Balance at  June 30, 2002 |       | 140,384                               |       | 137,225                                 |       | $ |   9.00 –  $485.99 |   | $ | 178.80 |   |
| Additional  authorization      |       | 1,381,666                             |       |                                    |       |   |   |   |   |
| Options granted                |       | (925,388                              | )          | 925,388                                 |       | $ |   3.19 –  $  44.40 |   | $ | 4.25 |   |
| Options exercised              |       | —                                |       | —                                  |       |   |   |   |   |
| Options forfeited              |       | 60,286                                |       | (60,286                                 | )          | $ | 31.20 – $466.88 |   | $ | 102.24 |   |
| Balance at  June 30, 2003 |       | 656,948                               |       | 1,002,327                               |       | $ |   3.19 – $485.99 |   | $ | 22.04 |   |
| Additional  authorization      |       | 1,100,000                             |       |                                    |       |   |   |   |   |
| Options granted                |       | (779,450                              | )          | 779,450                                 |       | $ |   3.20 –  $    5.35 |   | $ | 4.46 |   |
| Options exercised              |       | —                                |       | —                                  |       |   |   |   |   |
| Options forfeited              |       | 37,497                                |       | (37,497                                 | )          | $ |   3.39 – $485.99 |   | $ | 165.86 |   |
| Plan shares  expired           |       | (30,012                               | )          | —                                  |       |   |   |   |   |
| Balance at  June 30, 2004 |       | 984,983                               |       | 1,744,280                               |       | $ |   3.19 – $465.00 |   | $ | 11.24 |   |
| Additional  authorization      |       | 2,200,000                             |       |                                    |       |   |   |   |   |
| Options granted                |       | (692,354                              | )          | 692,354                                 |       | $ |   1.97 –  $    9.97 |   | $ | 6.09 |   |
| Options exercised              |       | —                                |       | —                                  |       |   |   |   |   |
| Options forfeited              |       | 116,960                               |       | (116,960                                | )          | $ |   3.39 – $446.59 |   | $ | 36.20 |   |
| Plan shares  expired           |       | (3,754                                | )          | —                                  |       |   |   |   |   |
| Balance at June 30,  2005 |       | 2,605,835                             |       | 2,319,674                               |       | $ |   1.97 – $465.00 |   | $ | 8.45 |   |

 

Theoptions outstanding at June 30, 2005 have been segregated into ranges foradditional disclosure as follows:
| **Exercise  Price  Per Share**         | ** ** | **Options  Outstanding** | ** ** | **Weighted Average  Remaining  Contractual Life  (in years)** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Options Vested  and  Exercisable** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
|---------------------------------------------|------------|--------------------------|------------|------------------------------------------------------------------------------|------------|----------------------------------------|------------|-------------------------------------------|------------|----------------------------------------|------------|
| $1.97 –  $    3.19 |       |                     | 296,000    |                                                                         |       |                                   | 8.69       |                                      |       | $                                      | 2.80       |   |   | 94,371 |   |   | $ | 3.06 |   |
| $3.20 –  $    3.39 |       |                     | 430,066    |                                                                         |       |                                   | 8.01       |                                      |       | $                                      | 3.31       |   |   | 204,542 |   |   | $ | 3.33 |   |
| $3.52 –  $    3.52 |       |                     | 451,000    |                                                                         |       |                                   | 7.93       |                                      |       | $                                      | 3.52       |   |   | 225,500 |   |   | $ | 3.52 |   |
| $4.70 –  $    4.80 |       |                     | 69,000     |                                                                         |       |                                   | 8.90       |                                      |       | $                                      | 4.76       |   |   | 44,666 |   |   | $ | 4.78 |   |
| $5.35 –  $    5.35 |       |                     | 521,366    |                                                                         |       |                                   | 8.75       |                                      |       | $                                      | 5.35       |   |   | 458,367 |   |   | $ | 5.35 |   |
| $6.50 –  $    6.94 |       |                     | 124,890    |                                                                         |       |                                   | 9.01       |                                      |       | $                                      | 6.93       |   |   | — |   |   | — |   |
| $7.02 –  $    7.02 |       |                     | 361,000    |                                                                         |       |                                   | 9.11       |                                      |       | $                                      | 7.02       |   |   | — |   |   | — |   |
| $9.00 –  $465.00                       |       |                     | 66,352     |                                                                         |       |                                   | 5.89       |                                      |       | $                                      | 139.20     |   |   | 52,826 |   |   | $ | 169.77 |   |
|                                        |       |                     | 2,319,674  |                                                                         |       |                                   | 8.45       |                                      |       | $                                      | 8.45       |   |   | 1,080,272 |   |   | $ | 12.40 |   |

 

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The weighted average fairvalue of options granted in fiscal 2005, 2004 and 2003 was $4.76, $2.98and $3.55, respectively.

***Stock Purchase Plan***

In May 2003, theBoard of Directors adopted the 2003 Employee Stock Purchase Plan (the “PurchasePlan”) covering an aggregate of 600,000 shares of common stock. The PurchasePlan was approved by stockholders in May 2003 and is qualified under Section 423of the Internal 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. 554,113 shares reserved under the plan remain available forissuance as of June 30, 2005.

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

Pursuant to the Valentis, Inc.401(k) Plan (the “4011(k) Plan”), the Company made matchingcontributions to all eligible participants who had elective deferrals duringcalendar year 2004, 2003 and 2002, 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 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 and36,502 shares of its common stock to the 401(k) Plan as the Company’sfiscal 2004 and 2003 matching contributions. Compensation expense relatedto this match was approximately $55,000, $55,000 and $113,000 infiscal 2005, 2004 and 2003, respectively.

***Stock-Based Compensation Pro Forma Information***

Proforma net loss and net loss per share information is required by SFAS 123,which also requires that the information be determined as if Valentis hasaccounted for employee stock options and the Purchase Plan under the fairmarket value method of that statement (see Note 1 for such pro formainformation). The fair value for these options was estimated at the date ofgrant using a Black-Scholes option-pricing model with the followingweighted-average assumptions:
| ** **                              | ** ** | **Employee Stock  Options** | ** ** | **Purchase Plan  Shares** | ** ** |
|-----------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| **Years ended June 30,** | ** ** | ** **                       | ** ** | **2005**                       | ** ** | **2004** | ** ** | **2003** | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
| Expected life (in  years)               |       | 4.17                             |       | 2.5                            |       | 4.6 |   | 0.5 |   | 0.5 |   | 0.5 |   |
| Risk-free  interest rate                |       | 4.22                             | %          | 4.19                           | %          | 4.47 | % | 3.53 | % | 1.61 | % | 1.04 | % |
| Volatility                              |       | 1.20                             |       | 0.98                           |       | 1.20 |   | 0.67 |   | 0.87 |   | 1.63 |   |
| Dividend yield                          |       | —                           |       | —                         |       | — |   | — |   | — |   | — |   |
|                                         |            |                                  |            |                                |            |  |  |  |  |  |  |  |  |  |  |

 

The Black-Scholes option valuation model wasdeveloped for use in estimating the fair value of traded options that have no vestingrestrictions and are fully transferable. In addition, option valuation modelsrequire the input of highly subjective assumptions including the expected stockprice volatility. Because Valentis’ employee stock options and employee stockpurchase plans have characteristics significantly different from those oftraded options, and because changes in the subjective input assumptions canmaterially affect the fair market value estimate, in management’s opinion, theexisting models do not necessarily provide a reliable single measure of thefair value of its employee stock options and shares issued pursuant to theemployee stock purchase plan, nor do they necessarily represent the effects ofemployee stock options and employee stock purchase plans on reported net incomefor future years.

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***Stock-Based Awards to Non-Employees***

In fiscal year 2004, Valentis granted options toconsultants to purchase 152,000 shares of common stock. Options granted toconsultants are periodically revalued as they vest in accordance withSFAS 123 and EITF 96-18 using the Black-Scholes option-pricingmodel. Assumptions used for valuing the options for fiscal 2005 were anestimated volatility of 1.15, risk free interest rate of 4.26%, no dividendyield and an expected life of each option of 8.74 years. Assumptions usedfor valuing the options for 2004 were an estimated volatility of 0.90, riskfree interest rate of 4.29%, no dividend yield and an expected life of eachoption of 10 years. Expenses of approximately $63,000 and $80,000 wererecognized in fiscal 2005 and 2004, respectively, related to these grants.The Company did not recognize expense related to stock-based awards tonon-employees in fiscal 2003 because the value of shares vested during theyear was immaterial.

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 0.96, 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, 2005, the company recorded $38,000 of general andadministrative expenses under this agreement.

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

At June 30, 2005,shares of common stock reserved for future issuance are as follows:
| ** **                                             | ** ** | **Number of  shares** | ** ** |
|--------------------------------------------------------|------------|----------------------------|------------|
| Common stock  warrants                                 |       | 3,676,575                  |       |
| 401(k) Plan—employer  matching contributions |       | 183,555                    |       |
| Employee stock  purchase plan                          |       | 554,113                    |       |
| Stock option  plans                                    |       | 4,925,509                  |       |
| Total                                                  |       | 9,339,752                  |       |

 

**11.   INCOME TAXES**

Forfinancial reporting purposes, income (loss) before taxes includes the followingcomponents (in thousands):
| ** **              | ** ** | **Year ended June 30,** | ** ** |
|-------------------------|------------|----------------------------------------|------------|
| ** **              | ** ** | **2005**                               | ** ** | **2004** | ** ** | **2003** | ** ** |
| Pre-tax income  (loss): |       |                                   |       |   |   |   |   |
| United States           |       | $                                      | (11,083    | ) | $ | (14,596 | ) | $ | (14,860 | ) |
| Foreign                 |       | —                                 |       | 8,112 |   | — |   |
| Total pre-tax loss      |       | $                                      | (11,083    | ) | $ | (6,484 | ) | $ | (14,860 | ) |

 

Thereis no provision for income taxes because the Company has incurred operatinglosses. Deferred income taxes reflect the net tax effects of operating loss andtax credit carryovers and temporary 

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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,** | ** ** |
|---------------------------------------|------------|-------------------|------------|
| ** **                            | ** ** | **2005**          | ** ** | **2004** | ** ** |
| Deferred tax assets:                  |       |              |       |   |   |
| Net operating loss                    |       | $                 | 72,900     |   | $ | 69,300 |   |
| Research and development  credits     |       | 3,600             |       | 3,300 |   |
| Capitalized research and  development |       | 22,500            |       | 22,000 |   |
| Other                                 |       | 100               |       | 300 |   |
| Total deferred tax  assets            |       | 99,100            |       | 94,900 |   |
| Valuation allowance                   |       | (99,100           | )          | (94,900 | ) |
| 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$4.2 million and $16.3 million during 2005 and 2004, respectively.

As of June 30, 2005, the Company had netoperating loss carryforwards for federal income tax purposes of approximately$195.5 million, which expire in the years 2006 through 2025, and federalresearch and development tax credits of approximately $2.8 million, whichexpire in the years 2008 through 2025.

As of June 30, 2005, the Company had netoperating loss carryforwards for state income tax purposes of approximately$77.2 million, which expire in the years 2006 through 2015, and stateresearch, and development tax credits of approximately $1.3 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.

**12.   QUARTERLYFINANCIAL INFORMATION (UNAUDITED)**
| ** **                            | ** ** | **Quarter**                                                        | ** ** |
|---------------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                            | ** ** | **First**                                                          | ** ** | **Second** | ** ** | **Third** | ** ** | **Fourth** | ** ** |
| ** **                            | ** ** | **(in thousands, except per share data)** | ** ** |
| **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 | ) |
| **2004**                              |       |                                                               |       |   |   |   |   |   |   |
| Revenue(1)                            |       | $                                                                  | 6,709      |   | $ | 395 |   | $ | 334 |   | $ | 40 |   |
| Operating expenses                    |       | 3,240                                                              |       | 3,302 |   | 3,666 |   | 3,758 |   |
| Net income (loss)                     |       | 3,440                                                              |       | (2,896 | ) | (3,359 | ) | (3,669 | ) |
| Basic net income (loss)  per share    |       | 0.62                                                               |       | (0.52 | ) | (0.34 | ) | (0.33 | ) |
| Diluted net income (loss) per share   |       | 0.61                                                               |       | (0.52 | ) | (0.34 | ) | (0.33 | ) |

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(1)          Revenueof approximately $6.7 million recorded in the first quarter of fiscal 2004includes non-recurring license revenue of $6.5 million recognized under alicense and settlement agreement with ALZA Corporation (see Note 14).

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**13.   CORPORATE RESTRUCTURING**

In October 2002, theCompany announced that it had reduced its staff and planned expenditures toallow it to continue the development of its then lead product, DEL-1 forthe treatment of a variety of cardiovascular diseases including peripheralarterial disease (PAD) and ischemic heart disease (IHD). In addition, theCompany continued to advance its GeneSwitch® gene regulation technology throughthe licensing to other companies. In connection therewith, the Company reducedstaff by 34 individuals in order to reduce the Company’s cash expenditures. Forthe year ended June 30, 2003, we recorded restructuring and relatedcharges of approximately $832,000.

**14.   ALZALICENSE AND SETTLEMENT AGREEMENT**

In July 2003, our wholly owned subsidiary,PolyMASC Pharmaceuticals plc., settled its patent infringement litigationagainst ALZA Corporation, a unit of Johnson & Johnson. Under thelicense and settlement agreement, PolyMASC received $6.5 million, andgranted a worldwide license to ALZA under its PEG-liposome patents. Theagreement resolves pending patent infringement litigation in the United Statesand Germany, as well as Opposition proceedings in Japan and before the EuropeanPatent Office. The $6.5 million payment received under the license andsettlement agreement was recorded as license revenue in the first quarter offiscal 2004.

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