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U.S. SECURITIES AND EXCHANGE COMMISSION  FORM 10-Q (Mark One) x
    
    QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 OF THE SECURITIES EXCHANGE
ACT OF 1934
 For the quarterly period ended September 30, 2004. o
    
    TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 OF THE SECURITIES EXCHANGE
ACT OF 1934 FOR THE TRANSITION PERIOD FROM  TO .
 Commission file number 0-22170 Epoch Biosciences, Inc. (Exact name of Registrant as specified in its charter)
 Delaware(State or other jurisdiction of incorporation or organization)
    
    91-1311592(I.R.S. Employer Identification No.)
 21720 23rd Drive SE, #150, Bothell, WA 98021(Address of principal executive office, including zip code) (425) 482-5555(Issuers telephone number, including area code) Not Applicable (Former name, former address and former fiscal year, if changed since last report) Check whether the issuer (1) filed all reports to be filed by Section 13 or
15(d) of the Exchange Act during the past 12 months (or for such shorter period
that the registrant was required to file such reports), and (2) has been
subject to such filing requirements for the past 90 days. YES x  NO o Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act). YES o  NO x 28,730,030 shares of Common Stock were outstanding at November 5, 2004.




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Epoch Biosciences, Inc. Index To Form 10-Q
 Page NumberPart I. Financial InformationItem 1. Financial Statements
    
    
    3Item 2. Managements Discussion and Analysis of Financial
Condition and Results of Operations
    
    
    10Item 3. Quantitative and Qualitative Disclosures About Market Risk
    
    
    24Item 4. Controls and Procedures
    
    
    25Part II. Other InformationItem 6. Exhibits
    
    
    26Note: Items 1, 2, 3, 4, and 5 are omitted, as they are not applicable.Signature
    
    
    27EXHIBIT 10.24.2EXHIBIT 10.27.2EXHIBIT 10.28.2EXHIBIT 10.29.1EXHIBIT 31.1EXHIBIT 31.2EXHIBIT 32.1EXHIBIT 32.2
 2




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Part I. Financial Information 
 Item 1. Financial Statements Epoch Biosciences, Inc.
Balance Sheets
(unaudited) December 31,
    
    September 30,2003
    
    2004AssetsCurrent assets:Cash and cash equivalents
    
    $
    4,415,298
    
    
    $
    8,534,534Restricted cash
    
    
    
    
    
    
    102,321Accounts receivable, net of allowance of $63,311 and $70,968
    
    
    1,342,377
    
    
    
    1,730,473Inventory
    
    
    97,540
    
    
    
    92,203Prepaid expenses and other assets
    
    
    216,547
    
    
    
    225,703Total current assets
    
    
    6,071,762
    
    
    
    10,685,234Property and equipment, net
    
    
    2,569,552
    
    
    
    2,411,052Identifiable intangible assets, net
    
    
    867,647
    
    
    
    Restricted cash
    
    
    653,723
    
    
    
    580,666Other assets
    
    
    10,000
    
    
    
    2,296Total assets
    
    $
    10,172,684
    
    
    $
    13,679,248Liabilities and Stockholders EquityCurrent liabilities:Current portion of long-term obligations
    
    $
    524,562
    
    
    $
    426,651Accounts payable and accrued liabilities
    
    
    1,452,733
    
    
    
    1,849,261Deferred revenue  current portion
    
    
    451,338
    
    
    
    401,113Common stock warrants
    
    
    
    
    
    
    879,314Total current liabilities
    
    
    2,428,633
    
    
    
    3,556,339Long-term obligations, less current portion
    
    
    358,764
    
    
    
    290,418Deferred revenue, less current portion
    
    
    2,510,548
    
    
    
    2,561,051Deferred rent
    
    
    332,984
    
    
    
    386,258Stockholders equity:Preferred stock, par value $.01; 10,000,000 shares
authorized; no shares issued and outstanding
    
    
    
    
    
    
    Common stock, par value $.01; 50,000,000 shares
authorized; shares issued and outstanding: 26,155,484 at December 31, 2003 and
28,686,337 at September 30, 2004
    
    
    261,555
    
    
    
    286,863Additional paid-in capital
    
    
    83,191,731
    
    
    
    87,120,182Accumulated deficit
    
    
    (78,911,531
    )
    
    
    (80,521,863
    )Total stockholders equity
    
    
    4,541,755
    
    
    
    6,885,182Total liabilities and stockholders equity
    
    $
    10,172,684
    
    
    $
    13,679,248
 See accompanying notes to financial statements. 3




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Epoch Biosciences, Inc.
Statements of Operations
(unaudited) Three Months Ended
    
    Nine Months EndedSeptember 30,
    
    September 30,2003
    
    2004
    
    2003
    
    2004Revenue:Product sales
    
    $
    690,126
    
    
    $
    779,331
    
    
    $
    2,127,171
    
    
    $
    1,834,778License fees and royalty income
    
    
    1,218,720
    
    
    
    1,525,782
    
    
    
    3,908,474
    
    
    
    4,340,290Contract research revenue
    
    
    101,064
    
    
    
    100,134
    
    
    
    842,064
    
    
    
    100,134Total revenue
    
    
    2,009,910
    
    
    
    2,405,247
    
    
    
    6,877,709
    
    
    
    6,275,202Operating expenses:Cost of product sales
    
    
    462,711
    
    
    
    419,753
    
    
    
    1,845,268
    
    
    
    1,158,728Research and development
    
    
    951,924
    
    
    
    917,681
    
    
    
    3,295,408
    
    
    
    2,827,767Selling, general and administrative
    
    
    932,354
    
    
    
    1,514,487
    
    
    
    3,214,457
    
    
    
    4,104,896Loss on sale of San Diego operations
    
    
    
    
    
    
    
    
    
    
    2,804,862
    
    
    
    Termination of license rights
    
    
    
    
    
    
    823,529
    
    
    
    
    
    
    
    823,529Total operating expenses
    
    
    2,346,989
    
    
    
    3,675,450
    
    
    
    11,159,995
    
    
    
    8,914,920Operating loss
    
    
    (337,079
    )
    
    
    (1,270,203
    )
    
    
    (4,282,286
    )
    
    
    (2,639,718
    )Interest income, net
    
    
    5,488
    
    
    
    21,092
    
    
    
    16,531
    
    
    
    54,631Warrant valuation adjustment
    
    
    
    
    
    
    34,263
    
    
    
    
    
    
    
    974,755Net loss
    
    $
    (331,591
    )
    
    $
    (1,214,848
    )
    
    $
    (4,265,755
    )
    
    $
    (1,610,332
    )Net loss per share - basic and diluted
    
    $
    (0.01
    )
    
    $
    (0.04
    )
    
    $
    (0.16
    )
    
    $
    (0.06
    )Weighted average number of common shares
outstanding  basic and diluted
    
    
    26,088,593
    
    
    
    28,639,526
    
    
    
    25,923,936
    
    
    
    28,140,604
 See accompanying notes to financial statements. 4




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Epoch Biosciences, Inc.
Statements of Cash Flows
(unaudited) Nine Months EndedSeptember 30,2003
    
    2004Cash flows from operating activities:Net loss
    
    $
    (4,265,755
    )
    
    $
    (1,610,332
    )Adjustments to reconcile net loss to net
cash used in operating activities:Depreciation and amortization:Property and equipment
    
    
    625,976
    
    
    
    484,002Intangible assets
    
    
    154,958
    
    
    
    44,118Issuance of common stock warrants for services
    
    
    2,252
    
    
    
    1,164Warrant valuation adjustment
    
    
    
    
    
    
    (974,755
    )Loss on sale of San Diego operations
    
    
    2,804,862
    
    
    
    Termination of license rights
    
    
    
    
    
    
    823,529Interest accrued on restricted cash
    
    
    (29,158
    )
    
    
    (29,264
    )Deferred revenue
    
    
    (141,204
    )
    
    
    278Deferred rent
    
    
    67,666
    
    
    
    53,274Changes in operating assets and liabilities:Accounts receivable
    
    
    685,152
    
    
    
    (388,096
    )Inventory
    
    
    269,110
    
    
    
    5,337Prepaid expenses and other assets
    
    
    3,436
    
    
    
    (1,452
    )Accounts payable and accrued liabilities
    
    
    (418,266
    )
    
    
    396,528Net cash used in operating activities
    
    
    (240,971
    )
    
    
    (1,195,669
    )Cash flows from investing activities:Acquisition of property and equipment
    
    
    (398,125
    )
    
    
    (325,502
    )Proceeds from sale of assets, net
    
    
    1,081,561
    
    
    
    Net cash provided by (used in) investing activities
    
    
    683,436
    
    
    
    (325,502
    )Cash flows from financing activities:Proceeds from bank loan
    
    
    598,043
    
    
    
    271,324Repayment of long-term obligations
    
    
    (411,872
    )
    
    
    (437,581
    )Proceeds from exercise of warrants
    
    
    212,500
    
    
    
    Proceeds from exercise of stock options
    
    
    237,267
    
    
    
    58,567Proceeds from the issuance of common stock and warrants
    
    
    
    
    
    
    5,748,097Net cash provided by financing activities
    
    
    635,938
    
    
    
    5,640,407Net increase in cash and cash equivalents
    
    
    1,078,403
    
    
    
    4,119,236Cash and cash equivalents at beginning of period
    
    
    3,507,645
    
    
    
    4,415,298Cash and cash equivalents at end of period
    
    $
    4,586,048
    
    
    $
    8,534,534Supplemental disclosure of cash flow information Interest payments
    
    $
    28,368
    
    
    $
    25,865Non-cash financing activities -Fair value of common stock warrants originally classified as liability
    
    $
    
    
    
    $
    1,854,069
 See accompanying notes to financial statements. 5




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Epoch Biosciences, Inc.
Notes to Financial Statements
September 30, 2004
(unaudited) 1. Summary of Significant Accounting Policies (a) Nature of Business Epoch Biosciences, Inc. is a biotechnology company developing technologies
and products to help scientists, clinicians, and physicians around the world
perform genetic research to improve our lives and our environment. Genetic
analysis has become a pervasive activity in academic, biopharmaceutical,
clinical, agricultural, veterinary and forensic laboratories. Our technologies
facilitate rapid, accurate and cost-effective genetic analysis at the scale
necessary to generate the massive amounts of genetic information being studied
today. As the human genome and other animal and plant genomes are sequenced, the
task of understanding the structure and function of genes lies before us.
Researchers want to know when and why a gene switches on and begins producing
its protein (gene expression) and what the genes protein does in the body
(proteomics); they also want to know what the genetic differences among
individuals mean for their health and susceptibility to disease. For example,
single nucleotide polymorphisms, or SNPs, are tiny differences in our DNA that
make humans different from one another. SNPs have been linked to
susceptibility to diseases, and to peoples response to medications. Our technologies are useful in genetic research, drug development,
prenatal testing, molecular diagnostics, including infectious disease,
oncology, genetic disease and population screening to assess our risk of
disease or to predict our response to drugs. Our products also have
application in forensics, food testing, and environmental testing, including
bio-warfare and bioterrorism. We market our products directly to end-users and through distributors that
provide worldwide reach, and license our technologies to other companies for
incorporation into their products. In September 2004, we announced a definitive agreement to merge with a
wholly-owned subsidiary of Nanogen, Inc. (Nanogen), pursuant to which each
share of Epoch common stock outstanding at the effective time of the merger
will be converted into the right to receive a fraction of a share of Nanogen
common stock and Epoch will become a wholly-owned subsidiary of Nanogen. See
Merger Agreement with Nanogen in Managements Discussion and Analysis of
Financial Condition and Results of Operations. (b) Basis of Presentation The unaudited financial statements have been prepared in accordance with
accounting principles generally accepted in the United States for interim
financial information and with the instructions to Form 10-Q. Accordingly,
they do not include all of the information and footnotes required to be
presented for complete financial statements. The accompanying financial
statements include all adjustments (consisting only of normal recurring
accruals), which are, in the opinion of management, necessary for a fair
presentation of the results for the interim periods presented. The financial statements and related disclosures have been prepared with
the presumption that users of the interim financial information have read or
have access to the audited financial statements for the preceding fiscal year.
Accordingly, these financial statements should be read in conjunction with the 6




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audited financial statements and the related notes included in our 2003
Annual Report on Form 10-K as filed with the Securities and Exchange
Commission. (c) Stock-Based Compensation We apply APB Opinion No. 25, Accounting for Stock Issued to Employees
and related interpretations in measuring compensation costs for our employee
stock option plans. We disclose proforma net loss and net loss per share as if
compensation cost had been determined consistent with Statement of Financial
Accounting Standard (SFAS) No. 123, Accounting for Stock-Based Compensation.
Stock options and warrants issued to non-employees are accounted for using the
fair value method prescribed by SFAS 123 and Emerging Issues Task Force 96-18. Had we determined compensation cost based on the fair value of our stock
options on the grant date under SFAS 123, our net loss and net loss per share
would have been the pro forma amounts indicated below: Three months ended
    
    Nine months endedSeptember 30,
    
    September 30,2003
    
    2004
    
    2003
    
    2004Net loss:As reported
    
    $
    (331,591
    )
    
    $
    (1,214,848
    )
    
    $
    (4,265,755
    )
    
    $
    (1,610,332
    )Add: Stock-based employee
compensation expense included in
reported net loss
    
    
    -0-
    
    
    
    -0-
    
    
    
    -0-
    
    
    
    -0-Deduct: Stock-based employee
compensation determined under
fair value based method for all
awards
    
    
    (267,098
    )
    
    
    (227,297
    )
    
    
    (765,368
    )
    
    
    (714,484
    )Pro forma
    
    $
    (598,689
    )
    
    $
    (1,442,145
    )
    
    $
    (5,031,123
    )
    
    $
    (2,324,816
    )Net loss per share  basic and diluted:As reported
    
    $
    (0.01
    )
    
    $
    (0.04
    )
    
    $
    (0.16
    )
    
    $
    (0.06
    )Pro forma
    
    $
    (0.02
    )
    
    $
    (0.05
    )
    
    $
    (0.19
    )
    
    $
    (0.08
    )
 Three months ended
    
    Nine months endedSeptember 30,
    
    September 30,2003
    
    2004
    
    2003
    
    2004Weighted average fair value of option
granted using the Black-Scholes option
pricing model
    
    $
    2.29
    
    
    $
    1.30
    
    
    $
    1.76
    
    
    $
    1.87Options granted during the period
    
    
    30,000
    
    
    
    60,000
    
    
    
    202,500
    
    
    
    662,420Expected dividend yield
    
    
    0.00
    %
    
    
    0.00
    %
    
    
    0.00
    %
    
    
    0.00
    %Risk-free interest rate
    
    
    3.15
    %
    
    
    3.41
    %
    
    
    2.88
    %
    
    
    3.33
    %Expected volatility
    
    
    126
    %
    
    
    90
    %
    
    
    126
    %
    
    
    96
    %Expected life in years
    
    
    5
    
    
    
    5
    
    
    
    5
    
    
    
    5
 In March 2004, the Financial Accounting Standards Board issued an Exposure
Draft of a proposed Statement of Financial Accounting Standards entitled
Share-Based Payment. This proposed Statement addresses accounting for
stock-based compensation and would result in stock-based compensation costs,
including employee options, being recognized as an expense in the financial
statements. The proposed Statement would eliminate the ability to account for
stock-based compensation 7




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transactions using the intrinsic value method under APB Opinion No. 25, and
generally would require that such transactions be accounted for using a
fair-value based method. If approved, the proposed statement would be applied
to public entities, prospectively, for periods beginning after June 15, 2005. (d) Net Loss Per Share Basic loss per share is computed based on weighted average shares
outstanding during the reporting period and excludes any potential dilution.
Diluted per share amounts reflect potential dilution from the exercise or
conversion of securities into common stock or from other contracts to issue
common stock. Our capital structure includes common stock options and common
stock warrants, of which the following have been excluded from the net loss per
share calculation as they are antidilutive. September 30,2003
    
    2004Outstanding options excluded from net loss per share
    
    
    2,352,542
    
    
    
    2,651,535Outstanding warrants excluded from net loss per
share
    
    
    90,000
    
    
    
    906,000
 (e) Concentration of Credit Risk Credit is extended based on an evaluation of a customers financial
condition and collateral is generally not required. The majority of revenues
are derived from private and public companies and public enterprises in the
research market in the United States. The table below summarizes the revenue and approximate accounts receivable
of our customers where our risk is significantly concentrated. Percent of Revenues
    
    Accounts ReceivableThree months
    
    Nine monthsended Sept 30,
    
    ended Sept 30,
    
    Dec 31, 2003
    
    Sept 30, 20042003
    
    2004
    
    2003
    
    2004Customer:Applied Biosystems,
Inc.
    
    
    69
    %
    
    
    60
    %
    
    
    54
    %
    
    
    66
    %
    
    $
    1,134,000
    
    
    $
    1,324,999Amersham Biosciences
    
    
    1
    %
    
    
    0
    %
    
    
    16
    %
    
    
    0
    %
    
    $
    18,000
    
    
    $
    
 The amounts due from Applied Biosystems in the above chart primarily
represent quarterly royalties and have historically been paid in accordance
with the terms of the underlying agreement. (f) Private Equity Financing On February 23, 2004, we consummated the issuance of 2,470,000
newly-issued shares of our common stock, and warrants to purchase 741,000
newly-issued shares of our common stock, to a small number of institutional
investors, resulting in our receipt of $6,175,000 in gross proceeds, prior to
placement agent fees and other offering costs totaling $427,000 and the
exercise of the warrants. Investors received a warrant to purchase 0.3 shares
of common stock for each share of common stock purchased. The effective price
in the private placement was $2.50 for each unit, consisting of one share of
common stock and a warrant to purchase 0.3 shares of common stock. The
warrants have an exercise period of five years and an exercise price of $3.89
per share. Our placement agent with respect to the transaction received a cash
fee equal to 5.5% of the gross proceeds, and its affiliates received warrants
to purchase an aggregate of 75,000 shares of our common stock, carrying the
same terms as the warrants received by the investors. The registration
statement covering the resale by the investors of these shares and the shares
of common stock issuable upon exercise of the warrants was declared effective
by the 8




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SEC on April 30, 2004. Accordingly, these shares and the shares issuable upon
exercise of the warrants may be offered or re-sold in the United States,
pursuant to the effective registration statement or an applicable exemption
from the registration requirements of the Securities Act. The warrants issued in the private equity placement provide for cash
redemption by the warrant holders upon the occurrence of a change in control
that may be outside of the control of our Board of Directors, subject to
certain exceptions. As a result, and in accordance with EITF 00-19,
Accounting for Derivative Financial Instruments Indexed To, and Potentially
Settled In a Companys Own Stock, the fair value of the warrants, measured
using the Black-Scholes valuation method, is recorded as a current liability on
our balance sheet. The decrease in the market price of our common stock and
other changes in the valuation assumptions from the closing of the equity
placement on February 23, 2004 to June 30, 2004 resulted in a decrease in the
value of the warrants between these dates of $941,000 and further changes in
the valuation assumptions between July 1, 2004 and September 30, 2004 resulted
in a decrease in the value of the warrants between these dates of $34,000.
Therefore, we reported $34,000 and $975,000 as a warrant valuation adjustment
in our statements of operations for the three and nine month periods,
respectively, ending September 30, 2004. The assumptions used in the Black-Scholes pricing model were: February 23,
    
    March 31,
    
    June 30,
    
    September 30,2004
    
    2004
    
    2004
    
    2004Expected dividend yield
    
    
    0.0
    %
    
    
    0.0
    %
    
    
    0.0
    %
    
    
    0.0
    %Risk-free interest rate
    
    
    3.03
    %
    
    
    2.81
    %
    
    
    3.81
    %
    
    
    3.41
    %Expected volatility
    
    
    104
    %
    
    
    99
    %
    
    
    90
    %
    
    
    90
    %Remaining contractual life in years
    
    
    5.0
    
    
    
    4.9
    
    
    
    4.7
    
    
    
    4.4
 Until the warrants are exercised or expire, the valuation of the warrants
and the corresponding liability will be re-measured quarterly and the financial
statements will reflect a non-cash valuation adjustment based on the change in
the fair value of the warrants at the end of each reporting period. (g) Bank Financing Our term loan facility expired on June 30, 2004 and our working capital
line of credit expired August 2004. We have had discussions with the
commercial lender about the renewal of the term loan facility. There can be no
assurance that such discussions will lead to a renewal of that facility on
acceptable terms, or at all. (h) Amendment to Stock Option Plans In accordance with the terms of our stock option plans (the Plans), our
Compensation Committee, as the administrator of the Plans, has resolved to
extend the option exercise period for optionees whose services are terminated
under certain circumstances following the closing of the proposed merger with
Nanogen. Each of the outstanding options held by our officers has been amended in
connection with the proposed merger with Nanogen so that in the event such
individuals employment is terminated without cause, or he resigns for good
reason, within 12 months following the closing of the merger, such options
shall remain exercisable for the vested shares subject to that option,
including the shares which vest upon an accelerated basis at the time of such
cessation of service, until the earliest to occur of (i) the end of the
twelve-month period following such cessation of service, (ii) the expiration of
the option term or (iii) a merger or acquisition of Nanogen in which that
option is not assumed or otherwise continued. 9




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Each of the outstanding stock options held by the non-employee members of
the Epoch Board and non-officer employees has been amended in connection with
the proposed merger with Nanogen so that in the event such individuals service
or employment, respectively, is terminated without cause, or he resigns for
good reason, within six months following closing of the merger, such options
shall remain exercisable for the vested shares subject to that option,
including the shares which vest upon an accelerated basis at the time of the
merger, until the earliest to occur of (i) the end of the 12-month period
following such cessation of board service, (ii) the expiration of the option
term or (iii) a merger or acquisition of Nanogen in which that option is not
assumed or otherwise continued. The foregoing amendment shall only be effective if the proposed merger
with Nanogen is consummated, and, with respect to options that have been
designated as incentive stock options, if the optionee consents in writing,
agreeing to the amendment of the option and its impact on the incentive stock
option status of the option. All other terms and conditions of the Plans, and the Stock Option
Agreements thereunder, shall remain in full force and affect. (i) Termination of License Rights In the third quarter of 2004, we terminated a license agreement we had
entered into in October 2001 with Incyte Corporation (Incyte) which provided
us with access to the gene sequence content from Incytes LifeSeq Gold® and
ZooSeq® databases for use in the design, manufacture, and sale of MGB Eclipse
probe products. As a result of the termination, we recognized an $824,000
non-cash charge in the third quarter, representing the remaining book value of
the consideration originally paid for the license. In our determination, the
value of the databases content no longer justified the minimum cash royalty
payments under the original license agreement and termination of this agreement
eliminates the future payment of royalties that were required by this license. 
 Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations This Quarterly Report on Form 10-Q includes forward-looking statements
within the meaning of the Private Securities Litigation Reform Act of 1995.
That Act provides a safe harbor for forward-looking statements to encourage
companies to provide prospective information about themselves so long as they
identify these statements as forward-looking and provide meaningful, cautionary
statements identifying important factors that could cause actual results to
differ from the projected results. Other than statements of historical fact, all statements in this Quarterly
Report on Form 10-Q and, in particular, any projections of or statements as to
our expectations or beliefs concerning our future financial performance or
financial position or as to future trends in our business or in our markets,
are forward-looking statements. Forward-looking statements reflect our current
expectations and are inherently uncertain and our actual results in future
periods may differ materially from our expectations concerning our projections
of those results or of future business trends described in this Quarterly
Report on Form 10-Q. The sections below entitled Certain Factors that May
Affect Our Business and Future Results and Managements Discussion and
Analysis of Financial Condition and Results of Operations, describe some, but
not all, of the factors, risks and uncertainties that could cause these
differences, including but not limited to the fact that we have realized
operating profitability in only one quarter and anticipate future losses, and
that we may require additional capital; the fact that we will be dependent upon
our agreement with Applied Biosystems for a significant portion of our revenues
for 2004 and future periods; the possibility that potential products utilizing
the Companys technology may be ineffective or, although effective, may be
uneconomical to market; that third parties may hold 10




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proprietary rights that preclude Epoch or its licensees from marketing its
products; or that third parties may market superior products. Readers of this
Quarterly Report on Form 10-Q are urged to read those sections in their
entirety. In light of the significant uncertainties inherent in the
forward-looking information included in this document, the inclusion of
information should not be regarded as a representation by us or any other
person that our objectives or plans will be achieved. The forward-looking
statements contained in this Quarterly Report on Form 10-Q are made only as of
the date of this Quarterly Report on Form 10-Q and Epoch undertakes no
obligation to update or revise the forward-looking statements, whether as a
result of new information, future events or otherwise. The following discussion of Epochs financial condition and results of
operations should be read in conjunction with the financial statements and the
related notes thereto included elsewhere in this Quarterly Report on Form 10-Q
and other documents Epoch files from time to time with the Securities and
Exchange Commission, including subsequent Current Reports on Form 8-K,
Quarterly Reports on Form 10-Q and Annual Reports on Form 10-K. Merger Agreement with Nanogen In September 2004 we announced the signing of a definitive agreement to
merge Epoch with a wholly-owned subsidiary of Nanogen, a developer of advanced
in vitrodiagnostic products, in an all-stock transaction. Under the terms of the merger, Epoch shareholders will receive a number of
Nanogen shares based on an exchange ratio determined by dividing the offer
price of $2.00 per share by Nanogens issue price as calculated at closing.
Nanogens issue price will be calculated based on the average closing price of
Nanogens shares for the 20 trading days ending on and including the third
trading day prior to the closing. The companies have agreed that the exchange
ratio will not be less than 0.4673 nor exceed 0.6329 of one Nanogen share. The
transaction is subject to approval by Nanogen and Epoch stockholders and other
customary closing conditions. The merger is expected to close on December 9,
2004. In July 2004, we executed a term sheet with Nanogen for a collaborative
research project regarding utilization of our proprietary chemistries on
Nanogens Molecular Biology Workstation. Under the term sheet, we are
providing contract research over an eight month period and supplying small
amounts of test material for Nanogens use. During the three months ended
September 30, 2004, we completed three months of the research activities and
recognized $100,000 in contract research revenue and recognized product sales
of $86,000 for shipments of test material pursuant to the term sheet. Results of Operations Overview Epoch develops technology and products that enable and accelerate genomic
analysis. The foundation of our business strategy is the continued funding of
innovative research and development and commercialization of the resultant
products through a number of channels. We earn revenues through a variety of sources. Historically, the majority
of our revenues have been generated in the research field, however we announced
the commercial availability of our analyte specific reagents to sophisticated
clinical testing laboratories for diagnostic testing in July 2004. We license
our technology and sell chemical intermediates to companies, thereby allowing
them to incorporate our technology into their products and we generate product
revenue and earn license fees and royalties from those companies. We also sell
our products to end-users through our direct sales force and 11




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through distributors that provide worldwide reach. We also earn revenues
through contract research activities, whereby third parties pay for specific
research and development activities carried out by our scientists, and through
research grants. We expect to incur operating losses for at least the current fiscal year
as we continue funding research and development to apply our technology to
genomic analysis for the research markets and other fields, and as we incur
costs to commercialize the resultant products through various channels. Critical Accounting Policies Our accounting policies are more fully described in Note 1 to our
financial statements included with Form 10-K. However, certain of our
accounting policies are particularly important to the portrayal of our
financial position and results of operations and require the application of
significant judgment by our management. As a result they are subject to an
inherent degree of uncertainty. In applying those policies, our management
uses its judgment to determine the appropriate assumptions to be used in the
determination of certain estimates. Those estimates are based on our
historical experience, terms of existing contracts, our observance of trends in
the industry, information provided by our customers and information available
from other outside sources, as appropriate. Our critical accounting policy is
revenue recognition. Revenue recognition. We earn revenues from sales of chemical
intermediates and reagents to manufacturers for incorporation into their
products, from the sale of specialty oligonucleotides and value added reagents
to end users and distributors in the fields of genomics and molecular
diagnostics, from license fees for the use of our proprietary technology and
know-how, and by providing services to third parties for performing research
and development on their behalf. We also have license agreements that result
in royalties to us upon ultimate sales of products by our partners. Many of
our arrangements contain multiple deliverables which require us to determine
the fair value of the various deliverables. To the extent we are unable to
determine the fair value of undelivered elements, we are required to defer all
revenue and recognize it over the appropriate period or until such time that
the fair value of remaining undelivered elements can be determined.  
    
    Revenues from product sales that require no ongoing
obligations are recognized when shipped to the customer and title
has passed. To the extent that sales are made to distributors and
not sold through to end users our future sales could decline
although distributors generally have no right of return.  
    
    License fees are recognized over the term of the agreement to
which the license fees correspond, which may extend to the
expiration of the underlying patents, and based on the terms and
future performance obligations in the underlying agreements. These
upfront fees are generally nonrefundable regardless of future
performance. Deferred revenue principally represents these license
fees received in advance and prepayments for product purchases.  
    
    Contract research revenues are recognized as the applicable
research and development activities are performed under the terms of
commercial collaboration and supply agreements and government
grants. Direct costs related to these contracts and grants are
reported as research and development expenses.  
    
    Royalty revenues are recognized when earned under the terms
of the related agreements, which is generally upon sale of products
by our partner containing our component products. To the extent our
partners no longer use our component products or sales of their
products are less than expected, our royalty revenues could decrease
in the future. 12




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Revenues Revenues for the three month period ended September 30, 2004 increased 20%
over the similar period of 2003 as a result of increased sales of MGB Eclipse
products and increased royalties. Revenue for the nine month period ended
September 30, 2004 decreased 9% over the similar period of 2003, primarily due
to the reduction in product sales caused by the sale of the assets and customer
base of our non-proprietary oligonucleotide business located in San Diego (San
Diego Operations) in May 2003, and a reduction in contract research revenues,
partially offset by increased sales of our MGB Eclipse products. Product Sales. Product sales include sales of specialty oligonucleotides
to end users and to our distribution partners in the research and molecular
diagnostic markets and sales of chemical intermediates and our dyes, quencher,
and modified bases to collaborative partners and distributors. Product sales
increased 13% in the third quarter of 2004 to $779,000 from $690,000 in the
comparable quarter of 2003. The increase in product sales in the quarter was
primarily the result of increased sales of our MGB Eclipse products in the
research market, offset by reduced sales of our chemical intermediates.
Product sales decreased 14% in the nine month period ended September 30, 2004
to $1,835,000 from $2,127,000 in the comparable period of 2003. The decrease
in product sales in the nine month period was primarily due to the absence of
sales from our San Diego Operations that were sold in May 2003 and a reduction
in sales of chemical intermediates to Applied Biosystems. During the nine
month period ended September 30, 2003, we recognized $451,000 in product sales
from our San Diego Operations. Product sales other than from our San Diego
Operations increased 9% for the nine month period ending September 30, 2004. In both periods, we realized increased sales of our MGB Eclipse Probe
System products into the research field. These products are sold directly to
end users, and also through QIAGEN, our worldwide distributor. Revenues from
the sale of these products in the third quarter of 2004 were 39% higher than in
the comparable quarter of 2003, and 41% higher for the nine month period ended
September 30, 2004 compared to the comparable period of 2003, due to increased
levels of direct selling activities by Epoch personnel and the introduction in
late 2003 of MGB Eclipse By Designassays that we design, manufacture, and
functionally validate. Further, initial shipments of MGB Eclipse Detection
Reagents into the molecular diagnostic field occurred in the third quarter. We
expect continued growth in our MGB Eclipse Probe System sales in the research
and molecular diagnostic markets. Chemical intermediate revenues represent component chemistries that we
generally supply on cost-plus terms for incorporation in our partners
products, and sales of dyes, quencher, and modified bases through distributors.
These revenues decreased 35% in the quarter ended September 30, 2004 and also
decreased 40% in the nine month period ended September 30, 2004 from the
comparable periods of 2003 primarily as a result of a continued decrease in
shipments to Applied Biosystems. In 2002 Applied Biosystems actively built an
initial inventory of finished goods as well as component materials in support
of their Assays-on-Demand and Assays-by-Design product launches. In 2002,
the initial inventory levels were established and the products launched, and in
2003 operating inventory levels were achieved. As a result, shipments to
Applied Biosystems continued to decline in the first nine months of 2004
compared to 2003, and are expected to be lower throughout 2004 compared to
2003. License Fees and Royalty Income. License fees reflect the amortization of
initial payments for technology and know-how. These amounts are amortized over
the life of the contract. Royalty income represents amounts due under license
agreements with other companies for their sales of products that include our
technologies and/or for contractual minimum amounts. License fees and royalty
income increased to $1,526,000 in the quarter ended September 30, 2004 from
$1,219,000 in the comparable 13




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period of 2003 and also increased to $4,340,000 in the nine month period ended
September 30, 2004 from $3,908,000 in the comparable period of 2003. These
increases are the result of higher contractual minimums from Applied Biosystems
and higher sales of products that incorporate our technologies by our partners,
partially offset by a reduction in technology access fees from our
collaboration with Amersham Biosciences. Amersham Biosciences paid us
technology access fees for a specified period that expired in June 2003. In
October 2003 we terminated our distribution agreement with Amersham that gave
rise to such technology access fees. Contract Research Revenue. Contract research revenue reflects payments
for contract research and development performed for our corporate partners and
research grants from the National Institute of Health. We currently have a
research collaboration agreement with Nanogen regarding utilization of our
proprietary chemistries on Nanogens Molecular Biology Workstation which
generated $100,000 in revenue in the quarter. See Merger Agreement with
Nanogen for additional information on our relationship with Nanogen. We do
not have any other contract research agreements at this time as a result of
completion of work under grants from the National Institute of Health and the
termination of contract programs with Amersham Biosciences. In 2003, Amersham
Biosciences paid us for specified research activities related to application of
our MGB Eclipse Probe Systems. Those programs terminated in June 2003, and in
October 2003 we terminated our distribution agreement with Amersham that gave
rise to such programs. Cost of Product Sales. The cost of product sales represents the cost of
manufacturing products that we sell, including costs of material, labor and
overhead allocations. The cost of product sales decreased to $420,000 in the
third quarter of 2004 compared to $463,000 in the comparable quarter of the
prior year and decreased to $1,159,000 for the nine month period ended
September 30, 2004 compared to $1,845,000 in the comparable nine month period
of 2003. Costs of product sales as a percentage of product sales decreased
from 67% in the third quarter of 2003 to 54% in the third quarter of 2004, and
decreased from 87% in the nine month period ended September 30, 2003 to 63% in
the comparable nine month period of 2004. Generally, changes in costs of product sales are tied to changes in
revenues, while the changes in costs as a percentage of product sales are
impacted by the product mix and economies of scale resulting from changes in
volume. Shipments of the majority of our chemical intermediates and certain
other products, for example, are to larger volume customers and selling prices
are determined by contract and tied to fully burdened manufacturing costs,
which usually results in lower gross margins. Further, we manufacture MGB
Eclipse Probe System products to various customer specifications - including
custom orders, catalog orders, and functionally validated assays. The gross
margin on these different products can vary significantly. The reductions in the dollar cost of product sales and such cost as a
percentage of product sales in the third quarter of 2004 compared to the
similar period of 2003 is primarily the result of increased sales of higher
margin MGB Eclipse Probe Systems offset by lower sales of, and a change in mix
within, our chemical intermediate products. The reduction in the dollar cost of product sales and in the percentage
cost of product sales in the nine month period ended September 30, 2004
compared to the similar period of 2003 was impacted by the change in product
mix which impacted the quarter and the result of the sale of our San Diego
Operations on May 30, 2003. Many costs of our non-proprietary oligonucleotide
manufacturing operations in San Diego were fixed within a wide range of
capacity output. As a result, the low level of sales volume we experienced in
our San Diego Operations in 2003 did not result in proportionally lower costs
and we experienced very poor gross margins on those sales until we sold the
assets and customer base in May 2003. 14




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Research and Development. Research and development costs of $918,000 in
the third quarter of 2004 decreased 4% compared to the comparable period of
2003. Research and development costs of $2,828,000 in the nine month period
ended September 30, 2004 similarly decreased 14% compared to the comparable
period of 2003. Research and development costs are impacted by our use of
research and development personnel in our manufacturing operations to meet
variations in customer demand. As such, the use of research and development
personnel in manufacturing has, and will continue to fluctuate depending on
volumes and mix of product sales and the availability of research and
development personnel to conduct such activities. Significant changes in
research and development costs were due to:  
    
    Transfer of personnel from research and development to
manufacturing reduced research and development expenses by $66,000
in the third quarter of 2004, and by $383,000 in the nine month
period ended September 30, 2004, compared to the similar periods of
2003.  
    
    Costs of chemicals and supplies used in research activities
in the first nine months of 2004 were $72,000 lower than in the
comparable period of 2003.  
    
    Decreased consulting costs from those incurred in 2003,
primarily related to our efforts to obtain a Department of Defense
contract, which resulted in lower costs of $98,000 in nine month
period ended September 30, 2004, compared to the similar period of
2003.  
    
    Increased patent expenses of $59,000 in the three month
period ended and $115,000 in the nine month period ended September
30, 2004 compared to the similar periods of 2003. Selling, General and Administrative. Selling, general and administrative
expenses of $1,514,000 in the third quarter of 2004 increased $582,000, or 62%,
compared to the comparable period of 2003 and similarly increased $890,000, or
28%, to $4,105,000 in the nine month period ended September 30, 2004 compared
to the comparable period of 2003. Selling, general and administrative expenses
are expected to continue above 2003 levels due to significantly expanded direct
sales and marketing activities and professional fees related to the proposed
merger with Nanogen (see Merger Agreement with Nanogen). Significant changes
in the 2004 periods compared to the 2003 periods were primarily the result of:  
    
    Increased selling and marketing expenses of $251,000 and
$597,000 for the three and nine month periods ending September 30,
2004, respectively, as compared to the similar periods of 2003, due
to overall increased sales and marketing efforts in the research
market and in support of our launch of molecular diagnostic products
in July 2004.  
    
    The sale of our San Diego Operations in May 2003 resulted in
the elimination of our administrative functions which supported
those operations and reduced administrative expenses and associated
goodwill amortization by a total of $424,000 in the nine month
period ended September 30, 2004, compared to the similar period of
2003.  
    
    Increased personnel and other expenses of $119,000 in the
nine month period ended September 30, 2004, resulting from our
implementation of the FDAs quality systems regulation which began
in June 2003.  
    
    Increased professional fees associated with business
development efforts of $39,000 and $243,000 in the three and nine
month periods ended September 30, 2004, respectively, compared to
the similar periods of 2003.  
    
    Increased professional fees associated with our proposed
merger with Nanogen, of $237,000 in both the three and nine month
periods ended September 30, 2004. See Merger Agreement with
Nanogen. 15




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Liquidity and Capital Resources Cash and cash equivalents amounted to $8,535,000 at September 30, 2004, a
$4,119,000 increase from December 31, 2003 balances, primarily as a result of
the private equity financing we completed in February 2004. Also impacting
cash flow were our net losses in 2004, changes in working capital accounts, the
purchase and financing of equipment, and the repayment of bank debt. Cash used in operations during the nine months ended September 30, 2004
amounted to $1,196,000 primarily as a result of our net loss of $1,610,000
adjusted by the non-cash change in fair value of common stock warrants of
$975,000, the non-cash termination of license rights of $824,000, and for
certain non-cash reconciling items and fluctuations in working capital
accounts. The other significant reconciling items were depreciation and
amortization of $528,000 and changes in working capital accounts that impacted
cash used in operations, including increases in accounts receivable of $388,000
and in accounts payable and accrued liabilities of $397,000, all the result of
normal business fluctuations. Cash used in investing activities represents the purchase of $326,000 of
manufacturing and other equipment. Future capital expenditures may include
increased manufacturing capacity for our Bothell facility and other investments
to support our operational growth. We may also require a larger inventory of
raw materials and products to provide better service to our customers or to
meet our customers demands, particularly in light of our launch of molecular
diagnostic products in July 2004. We may finance these purchases from our cash
and cash equivalents on hand, cash generated from our operations, borrowings,
equity offerings, or a combination thereof. Cash provided by financing activities in the nine months ended September
30, 2004 of $5,640,000 was the result of $5,748,000 received in a private
equity transaction in February 2004, $271,000 in proceeds from bank loans, and
$59,000 received from the exercise of stock options, offset by repayments on
term loans of $438,000. Private Equity Financing. On February 23, 2004, we consummated the
issuance of 2,470,000 newly-issued shares of our common stock, and warrants to
purchase 741,000 newly-issued shares of our common stock, to a small number of
institutional investors, resulting in our receipt of $6,175,000 in gross
proceeds, prior to placement agent fees and other offering costs totaling
$427,000 and the exercise of the warrants. Investors received a warrant to
purchase 0.3 shares of common stock for each share of common stock purchased.
The effective price in the private placement was $2.50 for each unit,
consisting of one share of common stock and a warrant to purchase 0.3 shares of
common stock. The warrants have an exercise period of five years and an
exercise price of $3.89 per share. Our placement agent with respect to the
transaction received a cash fee equal to 5.5% of the gross proceeds, and its
affiliates received warrants to purchase an aggregate of 75,000 shares of our
common stock, carrying the same terms as the warrants received by the
investors. The warrants issued in the private equity placement provide for cash
redemption by the warrant holders upon the occurrence of a change in control
that may be outside of the control of our Board of Directors, subject to
certain exceptions. As a result, and in accordance with EITF 00-19,
Accounting for Derivative Financial Instruments Indexed To, and Potentially
Settled In a Companys Own Stock, the fair value of the warrants, measured
using the Black-Scholes valuation method, is recorded as a current liability on
our balance sheet. The decrease in the market price of our common stock and
other changes in the valuation assumptions from the closing of the equity
placement on February 23, 2004 to September 30, 2004 resulted in a decrease in
the value of the warrants between these dates and the $975,000 warrant
valuation adjustment reported in our statements of operations for the period
ending September 30, 2004. 16




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Until the warrants are exercised or expire, the valuation of the warrants
and the corresponding liability will be re-measured quarterly and the financial
statements will reflect a non-cash valuation adjustment based on the change in
the fair value of the warrants at the end of each reporting period. Bank Financing. Our term loan facility expired on June 30, 2004 and our
working capital line of credit expired August 2004. Advances under the term
loan are secured by a first position security interest in our assets excluding
intellectual property, and are repayable in 36 monthly payments of principal
and interest at the banks prime rate plus 0.5%. We did not take any advances
against the working capital line of credit. We have had discussions with the
commercial lender about the renewal of the term loan facility. There can be no
assurance that such discussions will lead to a renewal of that facility on
acceptable terms, or at all. Summary. Based on cash and cash equivalents on hand at September 30,
2004, as well as on results of operations and cash flows for the quarter ended
September 30, 2004, we currently anticipate that existing cash balances,
projected cash from operations and unused borrowing capacity under existing
bank loans will be sufficient to meet our anticipated working capital and
capital expenditures needs through the completion of the merger, or if the
merger is not completed, then through at least 2005. However, our future
capital requirements depend on numerous factors, including but not limited to:  
    
    the magnitude of our future losses;  
    
    the timing and terms of new technology licensing agreements
or other strategic relationships that may provide up front license
fees or other payments;  
    
    resources that we devote to research and development and
sales and marketing in support of our business strategy;  
    
    technology licenses necessary to support our molecular
diagnostic products that may require upfront license fees or other
payments; and  
    
    capital expenditures necessary to expand manufacturing
capacity. It is possible that we may need to raise additional capital to fund our
activities and/or to consummate acquisitions of other businesses, products or
technologies. We may be able to raise such funds by selling more stock to the
public or to selected investors, or by borrowing money. In addition, even
though we may not need additional funds, we may still elect to sell additional
equity securities or obtain credit facilities for other reasons. We may not be
able to obtain additional funds on terms that would be favorable to our
shareholders and us, or at all. If we raise additional funds by issuing
additional equity or convertible debt securities, the ownership percentages of
existing shareholders would be reduced. In addition, the equity or debt
securities that we issue may have rights, preferences or privileges senior to
those of the holders of our common stock. Certain Factors That May Affect Our Business And Future Results Forward Looking Statements Some of the information included herein contains forward-looking
statements. These statements can be identified by the use of forward-looking
terms such as may, will, expect, anticipates, estimate, continue,
or other similar words. These statements discuss future expectations,
projections or results of operations or of financial condition or state other
forward-looking information. When considering these forward-looking
statements, you should keep in mind the risk factors and other cautionary
statements we make. These risk factors could cause our actual results to
differ materially from those contained in any forward-looking statement. If
any of the following risks actually occur, our business could be harmed and the
trading price of our common stock could decline. 17




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Risks Relating to Our Proposed Merger With Nanogen Failure to consummate the merger with Nanogen could have an adverse impact on
us and our stock price could decline Since entering into the merger agreement in September 2004 we have made
certain planning and operating decisions on the basis that the merger will be
consummated. These planning and operating decisions may have been different
had we not entered into the merger agreement. For example, we will have
incurred a significant amount of legal and other expenses associated with the
merger that we otherwise would not have incurred. In addition to the legal and
other expenses that have been or will be incurred, we may be required to pay
Nanogen a termination fee in the amount of $1.75 million if the merger is not
consummated. Consequently, if the merger is not consummated, our financial
condition likely will be worse than it would have been had we never entered
into the merger agreement. Additionally, if the merger is not completed, out
stock would no longer be influenced by the exchange ratio established by the
merger agreement, which could negatively impact out current market valuation
and stock price. Satisfying closing conditions may delay completion of the merger There are many conditions to Nanogens and Epochs obligations to complete
the merger, many of which are beyond Nanogens or our control. These
conditions include obtaining requisite approvals from both our stockholders and
Nanogens stockholders, and either of us may be unable to obtain these
approvals on a timely basis, if at all. In response to the announcement of the merger, our customers or suppliers
may delay or defer product purchase or other decisions. Any delay or deferral
in product purchase or other decisions by customers or suppliers could
adversely affect the business of the combined company, regardless of whether
the merger is ultimately completed. Similarly, current and prospective
employees may experience uncertainty about their future roles with Nanogen or
Epoch until the merger is completed and until Nanogens strategies with regard
to the integration of our operations are announced or executed. This may
adversely affect our ability to attract and retain key management, sales and
technical personnel. The number of shares and value of the Nanogen common stock that our
stockholders will receive in the merger will fluctuate The number of shares and precise value of the merger consideration to be
received by our stockholders at the effective time of the merger cannot
presently be determined. The exchange ratio, which determines the number of
shares of Nanogen common stock that our stockholders will receive in the
merger, will not be determined until the closing of the merger. Upon
completion of the merger, each share of our common stock will be converted into
the right to receive a fraction of a share of Nanogen common stock equal to the
exchange ratio. Under the terms of the merger agreement, the exchange ratio is
subject to a collar and will range from 0.4673 and 0.6329 of one share of
Nanogen common stock. The exact exchange ratio will depend on the average
closing price of Nanogen common stock for the 20 trading days ending on and
including the third trading day prior to the closing of the merger.
Accordingly, at the time of the special meeting, stockholders will not know the
exact value of the consideration to be received under the merger agreement. The prices of our common stock and Nanogen common stock at the closing of
the merger may vary from their respective prices on the date the merger
agreement was executed, on the date of the joint proxy statement/prospectus and
on the dates of the special meetings. Stock price changes may result 18




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from a variety of factors beyond our control or the control of Nanogen,
including general market and economic conditions. In addition, there will be a
time between the completion of the merger and the time at which our former
stockholders actually receive stock certificates evidencing the Nanogen common
stock. Until stock certificates are received, our former stockholders may not
be able to sell their Nanogen shares in the open market, and, therefore, would
not be able to avoid losses resulting from any decrease in the trading price of
Nanogen common stock during this period. Risks Relating to Epochs Business We have realized operating profits in only one quarter and anticipate future
losses, and we may require additional capital Since our formation in 1985, we have generated limited revenues and
realized operating profit in only one quarter, which was the quarter ended
December 31, 2002. As of September 30, 2004, we had an accumulated deficit of
approximately $81 million. Prior to adequate revenues being generated from the
commercialization of our products and technologies, we expect to incur
additional operating losses as we expand our manufacturing capacity, continue
our research and development activities and fund our product commercialization
efforts. There is no assurance that we will ever become profitable from
operations or that we will sustain operational profitability if we do become
profitable. Should we experience continued or unforeseen operating losses, our
capital requirements would increase and our stock price would likely decline. Additionally, as of September 30, 2004 we had approximately $8.5 million
in cash and cash equivalents. We currently anticipate that our current cash
balances and cash from operations will be sufficient to meet our cash needs
through the completion of the merger, or if the merger is not completed, then
at least through 2005. However, we may need to seek additional equity and/or
debt capital, and there can be no assurance that such capital will be available
to us on favorable terms, or at all. If additional funds are not available, we
would be required to delay, reduce, or eliminate expenditures for some or all
of our programs or products. We will be dependent upon our agreement with Applied Biosystems for a
significant portion of our revenues for 2004 and future periods, and a
reduction of sales under or early termination of this agreement would seriously
harm our revenues and operating results and would likely cause our stock price
to decline In January 1999, Epoch and Applied Biosystems entered into a License and
Supply Agreement pursuant to which we licensed some of our technology to
Applied Biosystems for use in its TaqMan® 5-nuclease real-time PCR assays,
(TaqMan® is a registered trademark of Roche Molecular Systems, Inc.). In July
1999, we licensed our proprietary software, which speeds the design of
oligonucleotide probes used in the study of genes, to Applied Biosystems. In
August 2000, the agreement was amended to, among other things, provide for
Epoch manufacturing product for Applied Biosystems. In July 2002 this
agreement was further amended to remove the manufacturing rights from the
contract effective October 2002, redefine product categories, increase the
minimum royalties and royalty rates, and establish that minimum royalties are
measured and paid quarterly. We will depend upon product sales and royalties
from Applied Biosystems sales of its TaqMan® assays under this agreement for a
significant portion of our revenues in 2004 and future periods. The technology licenses and Applied Biosystems obligation to pay us
royalties on their sale of products that incorporate our technologies continue
until the expiration of the underlying patents. Since the July 2002 amendment
that increased the minimum royalty levels, quarterly royalties earned based on
actual sales by Applied Biosystems have been less than the contractual minimum
royalty levels. As a 19




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result, we have received the specified quarterly minimum amounts. The current
agreement calls for quarterly royalty minimums through September 2005.
Thereafter, we will receive royalty payments based on actual sales. Based on
experience to date, those payments may be significantly less than the minimum
payments currently being made. Either party may terminate the agreement upon 180 days written notice. In
the event that this agreement is terminated, our revenues, financial condition
and operating results would be adversely affected and our stock price would
likely decline. There is a risk that our technology may not be as effective as alternatives The science and technology of synthetic DNA-based products is rapidly
evolving. While we believe that our technology is cost-effective and produces
results equal or superior to other competing technologies, we face the risk
that any or all of our products and proposed products could prove to be less
effective or more costly than products currently marketed, or under
development, by others. If we do not have commercially viable products, we
will not be able to sell our products, we will not be able to attract partners,
and we will not be able to generate funds internally to support operations. Our inability to implement effective marketing programs and build a successful
direct sales force and other distribution channels would limit our revenue
growth We have limited direct sales and marketing experience in general, little
infrastructure, and no recent experience selling to the molecular diagnostics
market. We believe that to market our products effectively, in particular our
new analyte specific reagents, we must continue to expand our direct sales
operations. This expansion will require significant management attention and
financial resources to successfully develop direct and indirect U.S. and
international sales and support channels, and theres no assurance that we will
be successful or that our expenditures in this effort will not exceed the
amount of any resulting revenues. Competition for qualified sales personnel is
intense and we may not be able to hire and train as many qualified individuals
as we may require in the future. We will continue to incur the expenses for a
sales and marketing infrastructure before we recognize significant revenue from
sales of the products. If we are not able to successfully build a sales and
marketing infrastructure or if our direct sales force is not successful we may
not meet our revenue goals and our stock price would likely decline. We introduced our initial menu of molecular diagnostic products in July 2004.
There is a risk that these products may not be commercially viable or
successful, which would limit our revenue growth We are currently developing and commercializing only a limited number of
molecular diagnostic products based on our technologies. We plan to develop
additional molecular diagnostic products. We cannot assure you that we will be
able to complete development of our products that are currently under
development or that we will be able to develop additional new products. In
addition, some of the products we develop may not be useful or cost effective
in molecular diagnostic applications. If our molecular diagnostic products are
not commercially successful, we may not meet our revenue goals and our stock
price would likely decline. 20




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We have limited manufacturing experience While we have experience in researching and developing unique, proprietary
technologies to enhance the study of genes, and in manufacturing
oligonucleotides and other chemical intermediates at relatively small scales,
our experience in manufacturing at larger scales is relatively limited. We
currently have sufficient manufacturing capacity to meet current customer
needs. Anticipated increases in customer demand over the next year may require
us to expand our manufacturing capacity in Bothell, acquire additional
manufacturing capacity, or utilize costly third-party manufacturing vendors, as
necessary. Any delay or inability to expand our manufacturing capacity could
materially and adversely affect our manufacturing ability. There is a risk that we do not own exclusive rights to our technology, or that
our competition may have access to our technology which may prevent us from
selling our products We attempt to protect our proprietary technology by relying on several
methods, including United States patents. We also have international patent
applications that correspond to many of the U.S. patents and patent
applications. The issued patents and pending patent applications cover
inventions relating to the components of our core technologies. The expiration
dates of these patents range from January 2012 to July 2020. Additionally, as
sales of our MGB Eclipse products to parties other than Applied Biosystems have
become a larger proportion of our revenues, we have become increasingly
dependent upon certain patent rights that we licensed from Applied Biosystems
covering certain technology necessary for the manufacture and use of our MGB
Eclipse products. We make no guarantee that any licensed patents or our issued
patents will provide us with significant proprietary protection, that pending
patents will be issued, or that products incorporating the technology covered
by licensed patents, our issued patents or pending applications will be free
from challenges by competitors. Further, third parties may hold proprietary
rights which precede our claims or claims made under licensed patents and could
therefore prohibit us from marketing our current or proposed products. Some of our technology might infringe on the rights of others, which may
prevent us from selling our products There is a great deal of litigation regarding patents and other
intellectual property rights in the biomedical industry. We were defendants in
one intellectual property litigation case, which we settled prior to 1997.
Although patent and intellectual property disputes in the biomedical area are
sometimes settled through licensing or similar arrangements, this kind of
solution can be expensive, if a license can be obtained at all. An adverse
determination in a judicial or administrative proceeding or our failure to
obtain necessary licenses could prevent us from manufacturing and selling our
products. This would substantially hurt our business. We face numerous competitors and changing technologies which could make our
products obsolete Many companies do research and development and market products designed to
analyze genes and diagnose conditions based on a number of technologies and are
developing additional products. In the molecular diagnostics market, we also
potentially compete with several companies offering alternative technologies to
our MGB Eclipse Detection Reagents. Many of these companies have substantially
greater capital resources, larger research and development and marketing staffs
and facilities and greater experience in developing and commercializing
products than we have. Furthermore, the fields in which we operate are subject
to significant and rapid technological change. Even if we successfully
introduce our products or proposed products, our technologies could be replaced
by new technologies or our products or proposed products might be obsolete or
non-competitive. 21




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We will be dependent on our agreement with QIAGEN N.V. for the distribution of
our MGB Eclipse products and the resultant revenues. Lower than expected
sales, or early termination of this agreement would seriously harm our
projected revenues and operating results and would likely cause our stock price
to decline In October 2002, Epoch and QIAGEN entered into a license and supply
agreement under which QIAGEN became the co-exclusive worldwide sales, marketing
and distribution partner to the research field of our MGB Eclipse Probe Systems
for gene expression. We will depend upon product sales to QIAGEN under this agreement for a
significant portion of our revenues in future periods. In the event that this
agreement is terminated, or if QIAGEN is unsuccessful at commercializing our
technologies, our revenues, financial condition and operating results would be
adversely affected and our stock price would likely decline. Some of our customers may experience financial difficulties, which could
adversely impact our collection of accounts receivable Although historically we have experienced limited credit losses from our
trade receivables, our experience is limited. At September 30, 2004, our
allowance for doubtful accounts was $71,000. We regularly review the
collectibility and credit worthiness of our customers and the receivables to
determine an appropriate allowance for doubtful accounts, however future
uncollectible accounts could exceed our current or future allowances. The loss of key personnel could adversely affect operations by impairing our
research and our efforts to commercialize and license our products Our performance is greatly dependent upon our key management, including
our Chief Executive Officer, Dr. William Gerber, and technical personnel and
consultants. Our future success will depend in part upon our ability to retain
these people and to recruit additional qualified personnel. We must compete
with other companies, universities, research entities and other organizations
in order to attract and retain highly qualified personnel. The proposed merger
with Nanogen may also have a negative impact on our ability to attract and
retain employees. See - Satisfying closing conditions may delay completion of
the merger. Although we have entered into agreements with our key executive
officers, we make no guarantee that we will retain these highly qualified
personnel or hire additional qualified personnel. We currently maintain no key
man life insurance on any of our management or technical personnel. The value of our common stock could change significantly in a very short time The market price of our common stock may fluctuate significantly. For
example, in the 52 weeks ended November 5, 2004 our stock traded as high as
$3.45, and as low as $1.11. The rapid price changes that our stock has
experienced recently, and throughout our history, place your investment in our
common stock at risk of total loss over a short period of time. We are in the
biotechnology industry and the market price of securities of biotechnology
companies have fluctuated significantly and these fluctuations have often been
unrelated to the companies operating performance. Announcements by us or our
competitors concerning technological innovations, new products, proposed
governmental regulations or actions, developments or disputes relating to
patents or proprietary rights, and other factors that affect the market
generally could significantly impact our business and the market price of our
securities. 22




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Public opinion regarding ethical issues surrounding the use of genetic
information may adversely affect demand for our products Public opinion regarding ethical issues related to the confidentiality and
appropriate use of genetic testing results may influence governmental
authorities to call for limits on, or regulation of the use of, genetic
testing. In addition, these authorities could prohibit testing for genetic
predisposition to certain conditions, particularly for those that have no known
cure. Furthermore, adverse publicity of public opinion relating to genetic
research and testing, even in the absence of any governmental regulation, could
harm our business. Any of these scenarios could reduce the potential markets
for our products and technologies, which could materially and adversely affect
our revenues. Government regulation of genetic research or testing may adversely affect the
demand for our products and impair our business and operations Federal, state and local governments may adopt regulations relating to the
conduct of genetic research and genetic testing. These regulations could limit
or restrict genetic research activities as well as genetic testing for research
or clinical purposes. In addition, if state and local regulations are adopted,
these regulations may be inconsistent with, or in conflict with, regulations
adopted by other state or local governments. Regulations relating to genetic
research activities could adversely affect our ability to conduct our research
and development activities. Regulations restricting genetic testing could
adversely affect our ability to market and sell our products and our
technologies. Accordingly, any regulations of this nature could harm our
business. Health care cost containment initiatives could limit the adoption of genetic
testing as a clinical tool, which would harm our revenues and prospects In recent years, health care payers as well as federal and state
governments have focused on containing or reducing health care costs. We
cannot predict the effect that any of these initiatives may have on our
business, and it is possible that they will adversely affect it. Health care
cost containment initiatives focused on genetic testing could cause the growth
in the clinical market for genetic testing to be curtailed or slowed. In
addition, health care cost containment initiatives could also cause
pharmaceutical companies to reduce research and development spending. In
either case, our business and our operating results could be harmed. We introduced products for the molecular diagnostics market in July 2004, and
need to comply with FDA quality system regulations and other regulations
relating to the manufacturing, marketing and sale of such products The manufacturing, labeling, distribution and marketing of our analyte
specific reagents are subject to regulation in the United States and in certain
other countries. In the United States, the Food and Drug Administration, or the FDA,
regulates, as medical devices, most diagnostic tests and in vitroreagents that
are marketed as finished test kits. Some clinical laboratories, however,
purchase molecular diagnostic products which are marketed under FDA regulations
as analyte specific reagents, or ASRs, and develop and prepare their own
diagnostic tests generically referred to as home brews. The FDA regulates
ASRs as medical devices that are exempt from premarket approval requirements. Unless otherwise exempt, medical devices require FDA approval or clearance
prior to marketing in the United States. We believe our currently marketed
products, as well as those ASRs we intend to market in the future, are exempt
from 510(k) premarket notification and premarket approval 23




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requirements. To date, we have not applied for FDA or any other regulatory
approvals or clearances with respect to any of our molecular diagnostic
products. However, products that we may seek to introduce in the future may
require FDA approvals or clearances prior to commercial sale in the United
States and that process can be time-consuming, expensive, and uncertain. We
may experience difficulties that could delay or prevent the successful
development, introduction and marketing of new clinical products. There can be
no assurance that the FDA will not require us to conduct clinical studies as a
condition of approval or clearance. In addition, we cannot assure you that
regulatory approval or clearance of any molecular diagnostic products for which
we seek such approvals will be granted by the FDA or foreign regulatory
authorities on a timely basis, if at all. If approval or clearance is obtained
we will be subject to continuing FDA obligations. When manufacturing medical devices, including ASRs, we are required to
adhere to Quality System Regulations, which require us to manufacture our
products and maintain records in a prescribed manner. Our manufacturing
facility for ASRs is subject to periodic and unannounced inspections by the FDA
and state agencies for compliance with quality system regulations. We have
never undergone an FDA Quality System inspection, and we cannot assure you that
we can pass an FDA audit or maintain compliance in the future. Further, the
FDA may place substantial restrictions on the indications for which our
products may be marketed or to whom they may be marketed. Failure to comply
with applicable FDA requirements can result in, among other things:  
    
    administrative or judicially imposed sanctions;  
    
    injunctions, civil penalties, recall or seizure of our products;  
    
    total or partial suspension of production;  
    
    failure of the government to grant premarket clearance or
premarket approval for our products;  
    
    withdrawal of marketing clearance or approvals; and  
    
    criminal prosecution. Customers purchasing our products for molecular diagnostics use in the
United States may be regulated under the Clinical Laboratory Improvement
Amendments of 1998, known as CLIA. CLIA is intended to ensure the quality and
reliability of clinical laboratories in the United States by mandating specific
standards in the areas of personnel qualification, administration,
participation in proficiency testing, patient test management, quality control,
quality assurance and inspections. The regulations promulgated under CLIA
establish three levels of clinical tests and the standards applicable to a
clinical laboratory depend on the level of the tests it performs. CLIA
requirements may prevent some clinical laboratories from using our products.
The FDA restricts the sale of our current ASR products to clinical laboratories
certified under CLIA to perform high complexity testing. CLIA regulations and
future administrative interpretations of CLIA could harm our business by
limiting the potential market for our current and future products. 
 Item 3. Quantitative and Qualitative Disclosures About Market Risk Our financial instruments include cash and short-term investment grade
debt securities. We also have term loans on capital equipment through a
commercial bank. At December 31, 2003 and September 30, 2004 the carrying
values of our financial instruments approximated their fair values based on
current market prices and rates. We do not believe that fluctuations in
interest rates would have a material impact on us. It is our policy not to
enter into derivative financial instruments. We do not currently have material
foreign currency exposure as our international transactions are minimal and the
majority of our international transactions are denominated in U.S. currency.
Accordingly, we do not have significant exposure to foreign currency exchange
rate risk at September 30, 2004. In the future, under the terms of the QIAGEN
agreement, we anticipate conducting increasing volumes of business in Euros for
QIAGEN 24




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sales in Europe and in Yen for QIAGEN sales in Japan. We do not anticipate
that these transactions will create significant exposure to foreign currency
exchange rate risk. 
 Item 4. Controls and Procedures We carried out an evaluation, under the supervision and with the
participation of our management, including our Chief Executive Officer and
Chief Financial Officer, of the effectiveness of our disclosure controls and
procedures as of the end of the period covered by this report, pursuant to
Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as
amended. Based on that evaluation, our Chief Executive Officer and Chief
Financial Officer have concluded that our disclosure controls and procedures,
as of the end of the period covered by this report, were effective in timely
alerting them to material information relating to us required to be included in
our periodic SEC filings. There has been no change in our internal control over financial reporting
during the period covered by this report that has materially affected, or is
reasonably likely to materially affect, our internal control over financial
reporting. 25




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Part II. Other Information 
 Item 6. Exhibits ExhibitNumber
    
    Description2.1*
    
    Agreement and Plan of Merger and Reorganization,
dated as of September 7, 2004, by and among
Nanogen, Inc., Epoch Biosciences, Inc. and Empire
Acquisition Corp., including the form of Company
Voting Agreement and Parent Voting Agreement
attached as Annex A and Annex B thereto
(incorporated by reference to Exhibit 2.1 of Epoch
Biosciences, Inc.s current report on Form 8-K
filed with the SEC on September 8, 2004).10.24.2
    
    Third Amendment to Second Amended and Restated
Employment Agreement dated August 19, 2004, by and
between Epoch and William G. Gerber, M.D.10.27.2
    
    Second Amendment to Employment Agreement dated
August 19, 2004, by and between Epoch and Merl F.
Hoekstra.10.28.2
    
    Second Amendment to Employment Agreement dated
August 19, 2004, by and between Epoch and Bert W. Hogue.10.29.1
    
    First Amendment to Employment Agreement dated
August 19, 2004, by and between Epoch and Walter Mahoney.10.42
    
    Form of Letter Amendment to Epoch Biosciences,
Inc.s Stock Option Agreements for options held by
Director and non-executive employees (incorporated
by reference to Exhibit 10.1 of Epoch Biosciences,
Inc.s current report on Form 8-K filed with the
SEC on September 8, 2004).10.43
    
    Form of Letter Amendment to Epoch Biosciences,
Inc.s Stock Option Agreements for options
held by Executive Officers (incorporated by
reference to Exhibit 10.2 of Epoch Biosciences,
Inc.s current report on Form 8-K filed with the
SEC on September 8, 2004).31.1
    
    Certification of Chief Executive Officer Pursuant
to Rule 13a-14(a)/15d-14(a), As Adopted Pursuant to
Section 302 of the Sarbanes-Oxley Act of 2002.31.2
    
    Certification of Chief Financial Officer Pursuant
to Rule 13a-14(a)/15d-14(a), As Adopted Pursuant to
Section 302 of the Sarbanes-Oxley Act of 2002.32.1
    
    Certification of Chief Executive Officer Pursuant
to 18 U.S.C. Section 1350, As Adopted Pursuant to
Section 906 of the Sarbanes-Oxley Act of 2002.32.2
    
    Certification of Chief Financial Officer Pursuant
to 18 U.S.C. Section 1350, As Adopted Pursuant to
Section 906 of the Sarbanes-Oxley Act of 2002.
 *Schedules and similar attachments to the Agreement and Plan of
Merger and Reorganization have been omitted pursuant to Item
601(b)(2) of Regulation S-K. Registrant will furnish supplementally
a copy of any omitted schedule or similar attachment to the
Securities and Exchange Commission upon request. 26




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Signatures In accordance with the requirements of the Exchange Act, the registrant
caused this report to be signed on its behalf by the undersigned, thereunto
duly authorized. Epoch Biosciences, Inc.Date: November 10, 2004
    By:
    /s/ Bert W. HogueBert W. HogueVice President and Chief Financial Officer 27




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EXHIBIT INDEX ExhibitNumber
    
    Description2.1*
    
    Agreement and Plan of Merger and Reorganization, dated as
of September 7, 2004, by and among Nanogen, Inc., Epoch
Biosciences, Inc. and Empire Acquisition Corp., including
the form of Company Voting Agreement and Parent Voting
Agreement attached as Annex A and Annex B thereto
(incorporated by reference to Exhibit 2.1 of Epoch
Biosciences, Inc.s current report on Form 8-K filed with
the SEC on September 8, 2004).10.24.2
    
    Third Amendment to Second Amended and Restated Employment
Agreement dated August 19, 2004, by and between Epoch and
William G. Gerber, M.D.10.27.2
    
    Second Amendment to Employment Agreement dated August 19,
2004, by and between Epoch and Merl F. Hoekstra.10.28.2
    
    Second Amendment to Employment Agreement dated August 19,
2004, by and between Epoch and Bert W. Hogue.10.29.1
    
    First Amendment to Employment Agreement dated August 19,
2004, by and between Epoch and Walter Mahoney.10.42
    
    Form of Letter Amendment to Epoch Biosciences, Inc.s Stock
Option Agreements for options held by Director and
non-executive employees (incorporated by reference to
Exhibit 10.1 of Epoch Biosciences, Inc.s current report on
Form 8-K filed with the SEC on September 8, 2004).10.43
    
    Form of Letter Amendment to Epoch Biosciences, Inc.s Stock
Option Agreements for options held by Executive
Officers (incorporated by reference to Exhibit 10.2 of
Epoch Biosciences, Inc.s current report on Form 8-K filed
with the SEC on September 8, 2004).31.1
    
    Certification of Chief Executive Officer Pursuant to Rule
13a-14(a)/15d-14(a), As Adopted Pursuant to Section 302 of
the Sarbanes-Oxley Act of 2002.31.2
    
    Certification of Chief Financial Officer Pursuant to Rule
13a-14(a)/15d-14(a), As Adopted Pursuant to Section 302 of
the Sarbanes-Oxley Act of 2002.32.1
    
    Certification of Chief Executive Officer Pursuant to 18
U.S.C. Section 1350, As Adopted Pursuant to Section 906 of
the Sarbanes-Oxley Act of 2002.32.2
    
    Certification of Chief Financial Officer Pursuant to 18
U.S.C. Section 1350, As Adopted Pursuant to Section 906 of
the Sarbanes-Oxley Act of 2002.
 *Schedules and similar attachments to the Agreement and Plan of Merger and
Reorganization have been omitted pursuant to Item 601(b)(2) of Regulation S-K.
Registrant will furnish supplementally a copy of any omitted schedule or
similar attachment to the Securities and Exchange Commission upon request. 28