Table of Contents

 

 

 

**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

 

**FORM 10-Q**

 

**(Mark One)**

 
| **x**                                                       | ** ** | **QUARTERLY REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES  EXCHANGE ACT OF 1934**  |
|-------------------------------------------------------------|------------|----------------------------------------------------------------------------------------------------------|
|                                                        |       |                                                                                                     |
| **For the quarterly period ended  September 30, 2008** |
| ** **                                                  | ** ** | ** **                                                                                               |
| **Or**                                                      |
|                                                        |       |                                                                                                     |
| **o**                                                       | ** ** | **TRANSITION REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES  EXCHANGE ACT OF 1934** |

 

**CommissionFile Number: 0-50523**

 

**PHARMACOPEIA, INC.**

(Exact name of registrant asspecified in its charter)

 

| **Delaware**                                  | ** ** | **51-0418085**                       |
|-----------------------------------------------|------------|--------------------------------------|
| (State or other jurisdiction of               |       | (I.R.S. Employer Identification No.) |
| incorporation or organization)                |       |                                 |
|                                          |       |                                 |
| **P.O. Box 5350, Princeton, New Jersey** | ** ** | **08543-5350**                       |
| (Address of principal executive offices)      |       | (Zip Code)                           |

 

**(609)452-3600**

(Registrant’s telephone number,including area code)

 

 

(Former name, former addressand former fiscal year, if changed since last report)

 

Indicate by check mark whether the registrant (1) has filed allreports required to be filed by Section 13 or 15(d) of the SecuritiesExchange Act of 1934 during the preceding 12 months (or such shorter periodthat the registrant was required to file such reports) and (2) has beensubject to such filing requirements for the past 90 days.    Yes x     No o

 

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

 

Large acceleratedfiler   o   Acceleratedfiler   x   Non-acceleratedfiler  o   Smaller reporting company  o

 

Indicate by check mark whether the registrant is a shell company (asdefined in Rule 12b-2 of the ExchangeAct).    Yes o    No x

 

Indicate the number of shares outstanding of each of the issuer’sclasses of common stock, as of the latest practicable date:

 

| **Class**                     | ** ** | **Outstanding at November 3, 2008** |
|-------------------------------|------------|---------------------------------------------------------|
| Common Stock, $0.01 par value | ** ** | **29,861,817**                                          |

 

 

 

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**PHARMACOPEIA,INC.**

 

**Form 10-Q**

 

**Tableof Contents**

 
| **Item**          | ** ** | ** **                                                                                                  | ** ** | ** ** |
|-------------------|------------|-------------------------------------------------------------------------------------------------------------|------------|------------|
| ** **        | ** ** | ** **                                                                                                  | ** ** | ** ** |
| PART I.      |       | FINANCIAL INFORMATION                                                                                       |       | 2          |
|              |       |                                                                                                        |       |       |
| Item 1.           |       | Consolidated Financial Statements (Unaudited):                                                              |       | 2          |
|              |       |                                                                                                        |       |       |
|              |       | Consolidated Balance Sheets as of September 30, 2008 and  December 31, 2007                       |       | 2          |
|              |       |                                                                                                        |       |       |
|              |       | Consolidated Statements of Operations for the three and nine months  ended September 30, 2008 and 2007 |       | 3          |
|              |       |                                                                                                        |       |       |
|              |       | Consolidated Statements of Cash Flows for the nine months ended  September 30, 2008 and 2007           |       | 4          |
|              |       |                                                                                                        |       |       |
|              |       | Notes to Unaudited Consolidated Financial  Statements                                                       |       | 5          |
|              |       |                                                                                                        |       |       |
| Item 2.           |       | Management’s Discussion and Analysis of  Financial Condition and Results of Operations                 |       | 20         |
|              |       |                                                                                                        |       |       |
| Item 3.           |       | Quantitative and Qualitative Disclosures  about Market Risk                                                 |       | 34         |
|              |       |                                                                                                        |       |       |
| Item 4.           |       | Controls and Procedures                                                                                     |       | 34         |
|              |       |                                                                                                        |       |       |
| PART II.     |       | OTHER INFORMATION                                                                                           |       | 35         |
|              |       |                                                                                                        |       |       |
| Item 1.           |       | Legal Proceedings                                                                                           |       | 35         |
|              |       |                                                                                                        |       |       |
| Item 1A.          |       | Risk Factors                                                                                                |       | 35         |
|              |       |                                                                                                        |       |       |
| Item 2.           |       | Unregistered Sales of Equity Securities and  Use of Proceeds                                                |       | 41         |
|              |       |                                                                                                        |       |       |
| Item 3.           |       | Defaults upon Senior Securities                                                                             |       | 41         |
|              |       |                                                                                                        |       |       |
| Item 4.           |       | Submission of Matters to a Vote of Security  Holders                                                        |       | 41         |
|              |       |                                                                                                        |       |       |
| Item 5.           |       | Other Information                                                                                           |       | 42         |
|              |       |                                                                                                        |       |       |
| Item 6.           |       | Exhibits                                                                                                    |       | 43         |
|              |       |                                                                                                        |       |       |
| Signatures        |       | 44                                                                                                          |
|              |       |                                                                                                        |
| Index to Exhibits |       | 45                                                                                                          |

 

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**PART I - FINANCIALINFORMATION**

 

**Item 1. Consolidated Financial Statements(Unaudited)**

 

**Pharmacopeia, Inc.**

**Consolidated Balance Sheets**

**(Amounts in thousands, exceptshare and per share data)**

 
| ** **                                                                                                                           | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                                                                                                           | ** ** | **2008**               | ** ** | **2007**              | ** ** |
| **ASSETS**                                                                                                                           | ** ** | ** **             | ** ** | ** **            | ** ** |
| Current assets:                                                                                                                      | ** ** | ** **             | ** ** | ** **            | ** ** |
| Cash and cash equivalents                                                                                                            |       | $                      | 33,436     |                  | $          | 30,186 |   |
| Marketable securities                                                                                                                |       | —                 |       | 41,129                |       |
| Prepaid expenses and other current assets                                                                                            |       | 822                    |       | 2,026                 |       |
| Total current assets                                                                                                                 |       | 34,258                 |       | 73,341                |       |
|                                                                                                                                 |       |                   |       |                  |       |
| Property and equipment, net                                                                                                          |       | 14,053                 |       | 14,840                |       |
| Deferred compensation plan assets                                                                                                    |       | 1,571                  |       | 2,073                 |       |
| Other assets                                                                                                                         |       | 144                    |       | 144                   |       |
| Total assets                                                                                                                         |       | $                      | 50,026     |                  | $          | 90,398 |   |
|                                                                                                                                 |       |                   |       |                  |       |
| **LIABILITIES AND STOCKHOLDERS’ (DEFICIT)  EQUITY**                                                                             |       |                   |       |                  |       |
| Current liabilities:                                                                                                                 |       |                   |       |                  |       |
| Accounts payable                                                                                                                     |       | $                      | 2,294      |                  | $          | 2,871 |   |
| Accrued and other liabilities                                                                                                        |       | 9,838                  |       | 6,928                 |       |
| Accrued restructuring, current portion                                                                                               |       | 1,773                  |       | —                |       |
| Deferred revenue, current portion                                                                                                    |       | 23,001                 |       | 22,398                |       |
| Notes payable, current portion                                                                                                       |       | 1,260                  |       | 1,069                 |       |
| Warrant liability                                                                                                                    |       | 472                    |       | 4,205                 |       |
| Total current liabilities                                                                                                            |       | 38,638                 |       | 37,471                |       |
|                                                                                                                                 |       |                   |       |                  |       |
| Deferred revenue, long-term                                                                                                          |       | 19,702                 |       | 24,769                |       |
| Deferred compensation plan liabilities                                                                                               |       | 1,571                  |       | 2,073                 |       |
| Notes payable, long-term                                                                                                             |       | 2,422                  |       | 3,001                 |       |
| Accrued restructuring, long-term                                                                                                     |       | 311                    |       | —                |       |
|                                                                                                                                 |       |                   |       |                  |       |
| Commitments and contingencies                                                                                                        |       |                   |       |                  |       |
|                                                                                                                                 |       |                   |       |                  |       |
| Stockholders’ (deficit) equity:                                                                                                 |       |                   |       |                  |       |
| Preferred stock, $.01 par value, 2,500,000  shares authorized, none issued and outstanding                                           |       | —                 |       | —                |       |
| Common stock, $.01 par value, 100,000,000  shares authorized, 29,834,494 and 29,630,931 shares issued and outstanding,  respectively |       | 298                    |       | 296                   |       |
| Additional paid-in capital                                                                                                           |       | 124,215                |       | 121,785               |       |
| Accumulated deficit                                                                                                                  |       | (137,131               | )          | (98,997               | )          |
| Total stockholders’ (deficit) equity                                                                                            |       | (12,618                | )          | 23,084                |       |
| Total liabilities and stockholders’ (deficit)  equity                                                                           |       | $                      | 50,026     |                  | $          | 90,398 |   |

 

See accompanying notes to theseunaudited consolidated financial statements

 

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**Pharmacopeia, Inc.**

**ConsolidatedStatements of Operations**

**(Amountsin thousands, except share and per share data)**

 
| ** **                                                   | ** ** | **For the Three Months** | ** ** | **For the Nine Months** | ** ** |
|--------------------------------------------------------------|------------|-----------------------------------------|------------|----------------------------------------|------------|
| ** **                                                   | ** ** | **Ended September 30,**       | ** ** | **Ended September 30,**      | ** ** |
| ** **                                                   | ** ** | **2008**                                | ** ** | **2007**                               | ** ** | **2008** | ** ** | **2007** | ** ** |
| ** **                                                   | ** ** | ** **                              | ** ** | ** **                             | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Revenue**                                                  | ** ** | ** **                              | ** ** | ** **                             | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net revenue                                                  |       | $                                       | 5,922      |                                   | $          | 5,089 |   | $ | 18,008 |   | $ | 16,395 |   |
|                                                         |       |                                    |       |                                   |       |   |   |   |   |
| **Operating Expenses**                                       |       |                                    |       |                                   |       |   |   |   |   |
| Collaborative research and development  expense              |       | 5,331                                   |       | 5,775                                  |       | 20,466 |   | 16,697 |   |
| Proprietary research and development  expense                |       | 6,825                                   |       | 9,514                                  |       | 24,777 |   | 21,965 |   |
| General and administrative expense                           |       | 3,745                                   |       | 2,566                                  |       | 11,209 |   | 8,025 |   |
| Restructuring expense                                        |       | 3,173                                   |       | —                                 |       | 4,868 |   | — |   |
| Total operating expenses                                     |       | 19,074                                  |       | 17,855                                 |       | 61,320 |   | 46,687 |   |
| Operating loss                                               |       | (13,152                                 | )          | (12,766                                | )          | (43,312 | ) | (30,292 | ) |
| Other income                                                 |       | —                                  |       | —                                 |       | 700 |   | 94 |   |
| Interest income                                              |       | 166                                     |       | 1,142                                  |       | 1,053 |   | 2,686 |   |
| Interest and other expense, net                              |       | (103                                    | )          | (15                                    | )          | (306 | ) | (20 | ) |
| Decrease (increase) in warrant liability                     |       | 2,272                                   |       | (57                                    | )          | 3,733 |   | (1,125 | ) |
| Loss before income taxes                                     |       | (10,817                                 | )          | (11,696                                | )          | (38,132 | ) | (28,657 | ) |
| Provision for (benefit from) income taxes                    |       | —                                  |       | —                                 |       | 2 |   | (52 | ) |
| Net loss                                                     |       | $                                       | (10,817    | )                                      | $          | (11,696 | ) | $ | (38,134 | ) | $ | (28,605 | ) |
|                                                         |       |                                    |       |                                   |       |   |   |   |   |
| Net loss per share:                                          |       |                                    |       |                                   |       |   |   |   |   |
| - Basic and diluted                                          |       | $                                       | (0.36      | )                                      | $          | (0.40 | ) | $ | (1.28 | ) | $ | (1.07 | ) |
|                                                         |       |                                    |       |                                   |       |   |   |   |   |
| Weighted average number of common stock  shares outstanding: |       |                                    |       |                                   |       |   |   |   |   |
| - Basic and diluted                                          |       | 29,756,487                              |       | 29,566,714                             |       | 29,730,928 |   | 26,737,034 |   |

 

See accompanying notes to theseunaudited consolidated financial statements

 

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**Pharmacopeia, Inc.**

**ConsolidatedStatements of Cash Flows**

**(Amounts in thousands)**

 
| ** **                                                                   | ** ** | **For the Nine Months** | ** ** |
|------------------------------------------------------------------------------|------------|----------------------------------------|------------|
| ** **                                                                   | ** ** | **Ended September 30,**      | ** ** |
| ** **                                                                   | ** ** | **2008**                               | ** ** | **2007** | ** ** |
| ** **                                                                   | ** ** | ** **                             | ** ** | ** ** | ** ** |
| CASH FLOWS FROM OPERATING ACTIVITIES:                                        | ** ** | ** **                             | ** ** | ** ** | ** ** |
| Net loss                                                                     |       | $                                      | (38,134    | ) | $ | (28,605 | ) |
| Adjustments to reconcile net loss to net  cash used in operating activities: |       |                                   |       |   |   |
| Depreciation and amortization                                                |       | 2,188                                  |       | 1,690 |   |
| Change in warrant liability                                                  |       | (3,733                                 | )          | 1,125 |   |
| Contribution of stock to 401(k) Plan                                    |       | 405                                    |       | 342 |   |
| Share-based compensation                                                     |       | 2,018                                  |       | 1,604 |   |
| Fixed asset write-offs                                                       |       | 256                                    |       | — |   |
| Changes in assets and liabilities:                                           |       |                                   |       |   |   |
| Accounts receivable                                                          |       | —                                 |       | 3,993 |   |
| Prepaid expenses and other current assets                                    |       | 1,584                                  |       | (139 | ) |
| Other assets                                                                 |       | —                                 |       | 30 |   |
| Accounts payable                                                             |       | (577                                   | )          | 242 |   |
| Accrued and other liabilities                                                |       | 2,910                                  |       | 2,043 |   |
| Accrued restructuring                                                        |       | 2,084                                  |       | — |   |
| Deferred revenue                                                             |       | (4,464                                 | )          | 16,205 |   |
| Net cash used in operating activities                                        |       | (35,463                                | )          | (1,470 | ) |
| CASH FLOWS FROM INVESTING ACTIVITIES:                                        |       |                                   |       |   |   |
| Capital expenditures                                                         |       | (1,657                                 | )          | (3,349 | ) |
| Purchases of marketable securities                                           |       | —                                 |       | (20,000 | ) |
| Proceeds from sale and maturities of  marketable securities                  |       | 40,750                                 |       | 2,980 |   |
| Net cash provided by (used in) investing  activities                         |       | 39,093                                 |       | (20,369 | ) |
| CASH FLOWS FROM FINANCING ACTIVITIES:                                        |       |                                   |       |   |   |
| Proceeds from registered equity offering,  net                               |       | —                                 |       | 37,070 |   |
| Proceeds from issuance of common stock  related to compensation plans        |       | 8                                      |       | 760 |   |
| Proceeds from borrowings of notes payable                                    |       | 416                                    |       | 2,290 |   |
| Repayments of notes payable                                                  |       | (804                                   | )          | (93 | ) |
| Net cash (used in) provided by financing  activities                         |       | (380                                   | )          | 40,027 |   |
| Net increase in cash and cash equivalents                                    |       | 3,250                                  |       | 18,188 |   |
| Cash and cash equivalents, beginning of  period                              |       | 30,186                                 |       | 43,099 |   |
| Cash and cash equivalents, end of period                                     |       | $                                      | 33,436     |   | $ | 61,287 |   |

 

See accompanying notes to these unauditedconsolidated financial statements

 

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**Pharmacopeia, Inc.**

 

**Notes to Unaudited Consolidated FinancialStatements**

 

**1. Background and Basis of Presentation**

 

Pharmacopeia, Inc. (Pharmacopeia or theCompany) was incorporated in 2002 as Pharmacopeia Drug Discovery, Inc., awholly owned subsidiary of Accelrys, Inc. (Accelrys). On April 30,2004 (the distribution date), Accelrys spun-off 100 percent of the sharesof Pharmacopeia Drug Discovery, Inc. in a pro rata tax-free distributionand distributed to its stockholders of record one share of Pharmacopeia DrugDiscovery, Inc. common stock for every two shares of Accelrys common stockheld. Effective May 3, 2007, Pharmacopeia Drug Discovery, Inc.changed its name to Pharmacopeia, Inc.

 

Pharmacopeia is a clinical development stagebiopharmaceutical company dedicated to discovering and developing novel smallmolecule therapeutics to address significant medical needs. The Company’sstrategy is to retain the rights to product candidates at least to clinicalvalidation, and to continue development on its own to New Drug Application(NDA) filing and commercialization for selected indications. The Company has abroad portfolio of clinical and preclinical candidates under developmentinternally or by partners.

 

OnSeptember 24, 2008, Pharmacopeia entered into an Agreement and Plan ofMerger with Ligand Pharmaceuticals Incorporated (Ligand), Marguax AcquisitionCorp., a wholly-owned subsidiary of Ligand, and Latour Acquisition, LLC, awholly-owned subsidiary of Ligand.  The Company currently expects themerger transaction to close by January 2009, subject to approval by theCompany’s stockholders, certain regulatory clearances and other closingconditions.  See Note 3 to the UnauditedConsolidated Financial Statements for further disclosure of the MergerAgreement.

 

The consolidated financial statements includethe accounts of the Company and its wholly-owned subsidiary Pharmacopeia UKHoldings Limited (Pharmacopeia UK), which was formed in March 2007. Allintercompany accounts and transactions have been eliminated in consolidation.

 

The accompanying unaudited consolidated financial statements have beenprepared in accordance with U. S. generally accepted accounting principles forinterim financial information and with instructions to Form 10-Q and Article 10of Regulation S-X. Accordingly, these unaudited consolidated financialstatements do not include all of the information and disclosures required by U.S. generally accepted accounting principles for complete consolidated financialstatements. In the opinion of management, all adjustments (of a normalrecurring nature) considered necessary for a fair presentation of theconsolidated financial statements have been included. Interim results are notnecessarily indicative of the results that may be expected for the year. Theunaudited interim consolidated financial statements should be read inconjunction with the financial statements and notes thereto included in theCompany’s Annual Report on Form 10-K for the year ended December 31,2007.

 

**2. Significant Accounting Policies**

 

**Use of Estimates**

 

The preparation of financial statements inconformity with U.S generally accepted accounting principles requiresmanagement to make estimates and assumptions that affect the reported amountsof assets, liabilities, revenues and expenses, and the disclosure of contingentassets and liabilities. Actual future results could differ from thoseestimates.

 

**Revenue Recognition**

 

Contract revenue is generally recognizedeither (i) on a proportional performance basis for contracts specifyingpayment for services over a given period, or (ii) as services areperformed under the agreement for contracts specifying payment on a full-timeemployee basis.

 

Revenue earned related to up-front productand technology license fees is recognized in accordance with Staff AccountingBulletin (SAB) 104 issued by the Securities and Exchange Commission (SEC) andEmerging Issue Task Force (EITF) No. 00-21, “Revenue Arrangements withMultiple Deliverables” (EITF 00-21) issued by the Financial AccountingStandards Board (FASB). Accordingly, amounts received under multiple-elementarrangements requiring ongoing services or performance by the Company arerecognized over the period of such services or performance.

 

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Revenue from milestones is recognized whenearned, as evidenced by written acknowledgement from the collaborator, providedthat (i) the milestone event is substantive, its achievability was notreasonably assured at the inception of the agreement, and the Company has nofurther performance obligations relating to that event, and (ii) collectibilityis reasonably assured. If these criteria are not met, the milestone payment isrecognized over the remaining period of the Company’s performance obligationsunder the arrangement. Royalties are recognized as earned in accordance withthe terms of various research and collaboration agreements.

 

**Share-based Compensation**

 

The Company’s share-based compensation isaccounted for in accordance with the fair value recognition provisions ofSFAS No. 123 (revised 2004) “Share-Based Payments” (SFAS 123R).

 

Under SFAS 123R, the Company uses theBlack-Scholes option-pricing model to estimate the fair value of theshare-based awards as of the grant date. The Black-Scholes model, by itsdesign, is highly complex and dependent upon key data inputs estimated bymanagement. The primary data inputs with the greatest degree of judgment arethe estimated lives of the share-based awards and the estimated volatility ofthe Company’s stock price. The Black-Scholes model is sensitive to changes inthese two data inputs. Beginning in fiscal year 2006, the Company calculatedthe estimated life of stock options granted using a “simplified” method, whichis based on the average of the vesting term and the actual term of the option,as a result of guidance from the SEC contained in SAB 107 permitting theinitial use of this method through 2007. In December 2007, the SEC issuedSAB 110, which became effective January 1, 2008, expressing theexpectation that companies should be employing information from internal orexternal sources about employee stock option exercise behavior when developingestimates of expected term as they relate to stock option valuations.SAB 110 states that the SEC will continue to accept the use of the “simplified”method beyond December 31, 2007 under certain circumstances. The Companyevaluated the exercise behavior of its employees for stock options grantedsince its spin-off from Accelrys in April 2004 and determined that theexercise history was an inadequate measure of the expected term of its stockoptions.  Therefore, the Company hascontinued its use of the simplified method as prescribed in SAB 107. Expectedstock price volatility is typically based on the daily historical trading datafrom an appropriate point in time through the last day of the applicableperiod. Because the Company’s historical trading data only dates back to May 3,2004, the first trading date after its spin-off from Accelrys, the Company hasestimated expected volatility using an analysis of the stock price volatilityof comparable companies in its industry.

 

**Warrant Liability**

 

The Company, in accounting for its warrants,follows EITF No. 00-19, “Accounting for Derivative Financial InstrumentsIndexed to, and Potentially Settled in, a Company’s Own Stock” (EITF 00-19),which provides guidance for distinguishing between permanent equity, temporaryequity and assets and liabilities. Under EITF 00-19, to qualify aspermanent equity, an equity derivative, including warrants, must permit theCompany to settle in unregistered shares. Under securities law, if the warrantswere issued in connection with a public offering and have a cash settlementfeature at the holder’s option, the Company does not have the ability to settlein unregistered shares. Therefore, the warrants cannot be classified aspermanent equity and are instead classified as a liability. The approximately1,450,000 warrants that the Company issued as part of its equity financing in October 2006meet this criteria, and their fair value has been recorded as a liability inthe accompanying balance sheets. Other warrants the Company had previouslyissued qualify as permanent equity and do not require remeasurement.

 

The Company records its warrant liabilitiesat fair value using a Black-Scholes option-pricing model and remeasures at eachreporting date until the warrants are exercised or have expired. Changes in thefair value of the warrants are reported in the statements of operations asincome or expense. The fair value of the warrants is subject to significantfluctuation based on changes in the Company’s stock price, expected volatility,expected life, the risk-free interest rate and dividend yield. The market pricefor the Company’s common stock has been and may continue to be volatile.Consequently, future fluctuations in the price of the Company’s common stockmay cause significant increases or decreases in the fair value of the warrantsissued in October 2006.

 

**Research and Development Expense**

 

Collaborative research and developmentexpense consists of the labor, material, equipment and allocated facilitiescost of the Company’s scientific staff who are working pursuant to the Company’scollaborative agreements. From time to time, collaborative research anddevelopment expense includes costs related to research efforts in excess ofthose required under certain collaborative agreements. Management has thediscretion to set the scope of such excess efforts and may increase or decreasethe level of such efforts depending on the Company’s strategic priorities.

 

Proprietary research and development expense consistsof intellectual property in-licensing costs, labor, materials, contractedservices, and allocated facility costs that are incurred in connection withinternally funded drug discovery and development programs.

 

All research and development costs are charged tooperations as incurred.

 

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**Preclinical Study and ClinicalTrial Accruals**

 

Substantialportions of the Company’s preclinical studies and all of the Company’s clinicaltrials have been performed by third-party laboratories, contract researchorganizations, or other vendors (collectively CROs).  Some CROs bill monthlyfor services performed, while others bill based upon milestoneachievement.  The Company accrues for each of the significant agreementsit has with CROs on a monthly basis.  Forpreclinical studies, accruals are estimated based upon the percentage of workcompleted and the contract milestones achieved.  For clinical studies,accruals are estimated based upon a percentage of work completed, the number ofpatients enrolled and the duration of the study.  The Company monitorspatient enrollment, the progress of clinical studies and related activities tothe extent possible through internal reviews of data reported to it by theCROs, correspondence with the CROs and clinical site visits.  The Company’sestimates are dependent upon the timelines and accuracy of the data provided byits CROs regarding the status of each program and total program spending. TheCompany periodically evaluates its estimates to determine if adjustments arenecessary or appropriate based on information it receives concerning changingcircumstances, and conditions or events that may affect such estimates. No material adjustments to preclinical study and clinical trial accruedexpenses have been recognized to date.

 

**Accounting for Uncertain Tax Positions**

 

The Company adopted the provisions of FASBInterpretation No. 48, “Accounting for Uncertainty in Income Taxes—aninterpretation of FAS Statement No. 109” (FIN 48). FIN 48applies to all uncertain tax positions accounted for in accordance with SFAS No. 109,“Accounting for Income Taxes”, and is intended to result in increased relevanceand comparability in financial reporting of income taxes and to provide moreinformation about the uncertainty in income tax assets and liabilities. TheCompany will recognize potential interest and penalties related to income taxpositions as a component of the benefit or provision for income taxes on theconsolidated statements of operations in any future periods in which theCompany must record a liability. Because the Company has not recorded such a liabilityat September 30, 2008, there is no impact to the Company’s effective taxrate. The Company does not anticipate that total unrecognized tax benefits willsignificantly change during the next twelve months.

 

**Concentrations of Risk**

 

See Note 5 and Note 6 to the UnauditedConsolidated Financial Statements regarding Concentrations of Risk as theyrelate to the Company’s revenue concentrations.

 

**Net Loss Per Share**

 

The Company computes net loss per share inaccordance with SFAS No. 128, “Earnings Per Share” (SFAS 128). Underthe provisions of SFAS 128, basic net loss per share is computed bydividing the net loss for the period by the weighted-average number of commonshares outstanding during the period. Diluted net loss per share is computed bydividing the net loss for the period by the weighted-average number of commonand dilutive common equivalent shares outstanding during the period. TheCompany had a net loss for the periods presented; accordingly, the inclusion ofcommon stock equivalents for outstanding stock options would be anti-dilutiveand, therefore, the weighted average shares used to calculate both basic anddiluted earnings per share are the same.

 

**Recent Accounting Pronouncements**

 

*Fair Value Measurements*

 

In September 2006, the FASB issued SFAS No. 157, “Fair ValueMeasurements” (SFAS 157). SFAS 157 establishes a framework formeasuring fair value in accordance with generally accepted accountingprinciples and expands disclosures about fair value measurements. Thestatement defines fair value as the exit price that would be received to sellan asset or paid to transfer a liability.  Fair value is a market-based measurement that should be determined usingassumptions that market participants would use in pricing an asset orliability.  The statement establishes athree-level hierarchy to prioritize the inputs used in measuring fairvalue.  The levels are described in thetable below with Level 1 having the highest priority and Level 3 having thelowest.

 

In February 2008, the FASB issued FASBStaff Position (FSP) 157-b which delayed the effective date of SFAS 157for one year for all nonfinancial assets and nonfinancial liabilities, exceptthose that are recognized or disclosed at fair value in the financialstatements on a recurring basis (at least annually). SFAS 157 and FSP157-b are effective for financial statements issued for fiscal years beginningafter November 15, 2007. The Company has elected a partial deferral ofStatement 157 under the provisions of FSP 157-b and, effective January 1,2008, the Company adopted SFAS 157 for those assets and liabilities thatare remeasured at fair value on a recurring basis. This partial adoption ofSFAS 157 did not have a material effect on the Company’s consolidated financialstatements as of and for the three and nine months ended September 30,2008.

 

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Thefollowing table provides a summary of the assets and liabilities that aremeasured at fair value on a recurring basis as of September 30, 2008:

 
| ** **                               | ** ** | ** **                         | ** ** | **Basis of Fair Value Measurements**                        | ** ** |
|------------------------------------------|------------|------------------------------------|------------|---------------------------------------------------------------------------------|------------|
| ** **                               | ** ** | **As of  September 30,** | ** ** | **Quoted prices  in active  markets for  identical assets** | ** ** | **Significant  other  observable  inputs** | ** ** | **Significant  unobservable  inputs** | ** ** |
| ** **                               | ** ** | **2008**                           | ** ** | **Level 1**                                                                | ** ** | **Level 2** | ** ** | **Level 3** | ** ** |
| **Assets**                               |       |                               |       |                                                                            |       |   |   |   |   |
| Cash and cash equivalents                |       | $                                  | 33,436     |                                                                            | $          | 33,436 |   | $ | — |   | $ | — |   |
| Deferred compensation plan assets        |       | 1,571                              |       | 1,571                                                                           |       | — |   | — |   |
|                                     |       |                               |       |                                                                            |       |   |   |   |   |
| Total assets measured at fair value      |       | $                                  | 35,007     |                                                                            | $          | 35,007 |   | $ | — |   | $ | — |   |
|                                     |       |                               |       |                                                                            |       |   |   |   |   |
| Percentage of total assets               |       | 70                                 | %          | 70                                                                              | %          | — |   | — |   |
|                                     |       |                               |       |                                                                            |       |   |   |   |   |
| **Liabilities**                          |       |                               |       |                                                                            |       |   |   |   |   |
| Warrant liability                        |       | $                                  | 472        |                                                                            | $          | — |   | $ | 472 |   | $ | — |   |
| Deferred compensation plan liabilities   |       | 1,571                              |       | —                                                                          |       | 1,571 |   | — |   |
|                                     |       |                               |       |                                                                            |       |   |   |   |   |
| Total liabilities measured at fair value |       | $                                  | 2,043      |                                                                            | $          | — |   | $ | 2,043 |   | $ | — |   |
|                                     |       |                               |       |                                                                            |       |   |   |   |   |
| Percentage of total liabilities          |       | 3                                  | %          | —                                                                          |       | 3 | % | — |   |

 

As noted above, the fair value of the Company’scash and cash equivalents and deferred compensation plan assets are determinedusing quoted market prices in active markets. The fair value of the deferredcompensation plan liabilities is based upon significant observable inputs suchas the fair value of the underlying securities of the deferred compensation planand the Company’s credit risk. The fair value of the warrant liability isdetermined using the Black-Scholes option-pricing model, which uses certainsignificant observable inputs, including stock price (quoted market prices inactive market), warrant exercise price (defined in warrant agreement), expectedlife of warrant (defined in warrant agreement), dividend yields (determined bythe Company), and risk-free interest rate (quoted market prices based onexpected life assumption). The only input in the Black-Scholes option-pricingmodel that is not readily observable is the expected stock price volatility.Because the Company’s historical trading data only dates back to May 3,2004, the first trading date after its spin-off from Accelrys, the Companyestimates its expected volatility using an analysis of the stock pricevolatility of comparable companies in its industry. The fair value of thewarrant liability is subject to significant fluctuations and has ranged fromapproximately $0.5 million as of September 30, 2008 to approximately $5.5million as of September 30, 2007. These fluctuations have primarilyresulted from fluctuations in the market price of the Company’s common stock,which ranged from $1.49 per share to $5.72 per share at the Company’s quarterlyremeasurement dates since September 30, 2007. Changes in the warrantliability are recorded in the statement of operations as income (decreases) orexpense (increases).

 

*Fair Value Option for Financial Assets and Liabilities*

 

In February 2007, the FASB issued SFAS No. 159,“The Fair Value Option for Financial Assets and Liabilities Including anAmendment of FASB Statement No. 115” (SFAS 159). SFAS 159permits reporting entities to choose to measure eligible financial assets orliabilities, which include marketable securities available-for-sale and equitymethod investments, at fair value at specified election dates, or according toa pre-existing policy for specific types of eligible items. Unrealized gainsand losses for which the fair value option has been elected are reported inearnings. SFAS 159 is effective for fiscal years beginning after November 15,2007. The Company’s adoption of SFAS 159, which was effective January 1,2008, did not have any impact on its consolidated financial statements as ofand for the three and nine month periods ended September 30, 2008.

 

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*Non-Refundable Advance Payments for Goods orServices to Be Used in Future Research and Development Activities*

 

In June 2007, the EITF of the FASBreached a consensus on Issue No. 07-3, “Accounting for NonrefundableAdvance Payments for Goods or Services Received for Use in Future Research andDevelopment Activities” (EITF 07-3). EITF 07-3 requires thatnon-refundable advance payments for goods or services that will be used orrendered for future research and development activities be deferred andcapitalized. As the related goods are delivered or the services are performed,or when the goods or services are no longer expected to be provided, thedeferred amounts would be recognized as an expense. EITF 07-3 is effectivefor financial statements issued for fiscal years beginning after December 15,2007. The Company’s adoption of EITF 07-3, which was effective January 1,2008, did not have a material effect on its consolidated financial statementsas of and for the three and nine month periods ended September 30, 2008.

 

*Business Combinations*

 

InDecember 2007, the FASB issued SFAS No. 141R (SFAS 141R), “Business Combinations, a revision to SFAS No. 141,Business Combinations”*.*  SFAS141R provides revised guidance for recognition and measurement of identifiableassets and goodwill acquired, liabilities assumed, and any noncontrollinginterest in the acquiree at fair value.  The Statement alsoestablishes disclosure requirements to enable the evaluation of the nature andfinancial effects of a business combination.  SFAS 141R is requiredto be applied prospectively to business combinations for which the acquisitiondate is on or after the beginning of the first annual reporting periodbeginning on or after December 15, 2008 (January 1, 2009 for theCompany).  The Company is currently evaluating the potential impact,if any, of the adoption of SFAS 141R on its consolidated financial statements.

 

**3. Agreement and Plan of Merger with LigandPharmaceuticals Incorporated**

 

OnSeptember 24, 2008, Pharmacopeia entered into an Agreement and Plan ofMerger with Ligand, Marguax Acquisition Corp., a wholly-owned subsidiary ofLigand (Merger Sub 1), and Latour Acquisition, LLC, a wholly-owned subsidiaryof Ligand (Merger Sub 2) (the Merger Agreement).  The Merger Agreementprovides that, upon the terms and subject to the conditions set forth in theMerger Agreement, the Company will merge with and into Merger Sub 1, with theCompany continuing as the surviving entity (the Intermediate SurvivingCorporation), and immediately thereafter the Intermediate Surviving Corporationwill merge with and into Merger Sub 2, with Merger Sub 2 continuing as thesurviving entity (collectively, the Merger).  The Company’s and Ligand’sBoards of Directors have each approved the Merger and the MergerAgreement.  The Company currently expectsthe Merger to close by January 2009 subject to approval by the Company’sstockholders, certain regulatory clearances and other closing conditions.

 

Ifthe Merger Agreement is adopted by Pharmacopeia’s stockholders and the otherconditions to the mergers are satisfied or waived, upon completion of theMerger, Ligand would issue approximately 0.58 of a share for each share ofPharmacopeia common stock outstanding immediately prior to the effective timeof the Merger, subject to certain adjustments for cancelled stock options.However, this exchange ratio is fixed only if the value of a share of Ligandcommon stock (the Ligand Common Stock Value) falls within the range between$3.00 and $3.75. Otherwise, the following will apply:

 

· if theLigand Common Stock Value is greater than $3.75 but not greater than $4.50, theoverall transaction value will be fixed at $66.0 million, and the exchangeratio will decrease as prices increase within the range;

 

· if theLigand Common Stock Value is greater than $4.50, then the exchange ratio willbe approximately 0.49;

 

· if theLigand Common Stock Value is equal to or greater than $2.38 but less than$3.00, then the exchange ratio will increase as prices decrease within therange (provided that if the Ligand Common Stock Value is less than $2.93, theexchange ratio will not exceed approximately 0.60), subject to specifiedlimitations in the Merger Agreement. Under this scenario, in addition toreceiving shares of Ligand common stock, Pharmacopeia stockholders will beentitled to receive cash consideration for an overall transaction value fixedat $52.8 million; or

 

· if theLigand Common Stock Value is less than $2.38, then the exchange ratio will beapproximately 0.60. Under this scenario, in addition to receiving shares ofLigand common stock, Pharmacopeia stockholders will be entitled to receive aproportionate share of $10.0 million in cash.

 

Atthe closing of the Merger, the Company, Ligand and a rights agent will enterinto a Contingent Value Rights Agreement (the CVR Agreement). The CVR Agreementsets forth the rights that former Company stockholders will have with respectto each Contingent Value Right (CVR) to be held by them after the closing ofthe Merger. The CVR Agreement provides for the payment of an aggregate of $15.0million in cash payable to the holders of the CVRs if, on or prior to December 31,2011, Ligand enters into a license or sale agreement related to Pharmacopeia’sPS433540 program or any other agreement for the development, marketing or saleof the PS433540 program, or any option to enter into such agreement, with anyparty other than Bristol-Myers Squibb Company (BMS) or any of its affiliates.The potential values of consideration to be received by Pharmacopeiastockholders in the Merger discussed above exclude any potential CVR payments.

 

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Ligandwill issue between approximately 14,000,000 and 18,976,461 shares of commonstock to Pharmacopeia stockholders in the Merger, depending on the market priceof Ligand’s common stock during the twenty consecutive trading days ending atthe close of trading on the fifth trading day prior to the date of the specialmeeting of Pharmacopeia stockholders. Each share of Ligand common stock that isissued in connection with the Merger will be accompanied by a right underLigand’s rights agreement.

 

TheCompany has made customary representations, warranties and covenants in theMerger Agreement. Consummation of the Merger is subject to customaryconditions, including (i) approval of the Merger Agreement and Merger bythe stockholders of the Company, (ii) absence of any law or orderprohibiting the consummation of the Merger, (iii) expiration ortermination of the applicable Hart-Scott-Rodino waiting period, (iv) subjectto certain exceptions, the accuracy of the representations and warranties and (v) theabsence of any material adverse effect on the Company.

 

TheMerger Agreement contains certain termination rights for both the Company andLigand, and further provides that, upon termination of the Merger Agreementunder specified circumstances, the Company may be required to pay Ligand atermination fee of approximately $3.4 million or to reimburse Ligand forcertain of its actual documented reasonable expenses, subject to a cap of $1.4million.

 

OnOctober 20, 2008, Ligand filed with the SEC a Registration Statement on Form S-4,which included a proxy statement of the Company and other relevant materials inconnection with the proposed transaction. The proxy statement, once finalized,will be mailed to the Company’s stockholders.

 

**4.****Notice of Delisting orFailure to Satisfy a Continued Listing Rule or Standard; Transfer ofListing**

 

OnSeptember 30, 2008, the Company received a notice from the Staff of TheNASDAQ Stock Market (the Staff) indicating that the Company is not incompliance with the continued listing requirements of The NASDAQ Global Marketunder NASDAQ Marketplace Rule 4450(b)(1)(A) (the Rule).  TheCompany received this notice because the market value of its listed securitieswas below $50.0 million for 10 consecutive trading days.  The noticefurther states that the Company is not in compliance with the alternative testunder NASDAQ Marketplace Rule 4450(b)(1)(B), which requires total assetsand total revenue of $50.0 million each for the most recently completed fiscalyear or two of the last three most recently completed fiscal years.  In accordance with NASDAQ Marketplace Rule 4450(e)(4), the Company was provided30 calendar days, or until October 30, 2008, to regain compliance with theRule.

 

TheCompany did not regain compliance and accordingly, on November 4, 2008,received a further notice from the Staff indicating that the Company’ssecurities were subject to delisting unless the Company timely requested ahearing before a NASDAQ Listing Qualifications Panel (the Panel).  TheCompany intends to request a hearing, which will automatically stay thedelisting of the Company’s common stock pending the issuance of the Panel’sdecision after the hearing.  The Company plans to exercise diligent effortsto maintain the listing of its common stock on NASDAQ, but there is noassurance that it will be successful in doing so.

 

**5. License Agreements with Bristol-MyersSquibb (DARA program and SARM program)**

 

**DARA License Agreement**

 

In March 2006, the Company and BMSentered into an exclusive licensing agreement (the DARA License Agreement)providing the Company an exclusive license under certain BMS patents withrespect to worldwide development and commercialization of certain compoundsdiscovered by BMS that possess dual angiotensin and endothelin receptorantagonist (DARA) activity, including the Company’s lead product candidatePS433540 and backup development candidates.

 

Under the terms of the DARA LicenseAgreement, in lieu of an up-front cash payment, the Company is providing BMS aset of compound libraries, over a period of approximately three years followingthe execution of the DARA License Agreement. In the event the Company fails todeliver such compound libraries to BMS, the Company would be required to makecash payments to BMS on a pro rata basis of up to $0.8 million as of September 30,2008; however, the Company expects to complete its delivery of these compoundlibraries by the end of the first quarter of 2009.

 

In March 2006, the Company estimatedthat the fair value of the compound library services to be provided to BMS wasapproximately $2.0 million. In accordance with SFAS 2 “Accounting forResearch and Development Costs,” the Company recorded a non-cash charge of$2.0 million to proprietary research and development expense related tothe acquisition of the license to the DARA program during the year ended December 31,2006. The Company also recorded deferred revenue of approximately $2.0 millionduring the year ended December 31, 2006, which represented the estimatedfair value of the compound library services it is to provide to BMS under theDARA License Agreement.  In June 2008,the Company increased its estimate of the fair value of the compound libraryservices it is providing to BMS to approximately $2.2 million.  The increase related to an increase in costs 

 

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associated with providing such services.  Included in deferred revenue as of September 30,2008 was approximately $1.0 million, all of which was classified asdeferred revenue, current portion. During the three months ended September 30, 2008 and 2007, theCompany did not recognize any revenue in connection with these compound libraryservices. During the nine months ended September 30, 2008, the Companyrecognized approximately $429 thousand of revenue in connection with thesecompound library services.  During thenine months ended September 30, 2007, the Company did not recognize anyrevenue in connection with these compound library services.

 

The Company incurred expense of $2.0 millionand $3.0 million during the three and nine month periods ended September 2007,respectively, related to milestone payments it paid to BMS for the achievementof certain clinical and regulatory events. These expenses were recorded as proprietary research and developmentexpense in the respective periods. The Company is obligated to pay BMSadditional milestone payments upon the achievement, if any, of furthersuccessive clinical and regulatory events in the United States and certainother jurisdictions, and royalties on sales of products, if any, resulting fromthe DARA program. BMS has a limited right of first negotiation in the eventthat the Company desires to license compounds that are the subject of the DARALicense Agreement to a third party other than BMS.

 

**SARM License Agreement**

 

In October 2007, the Company enteredinto an agreement to acquire the development and commercialization rights toits SARM program from BMS (the SARM License Agreement), including PS178990, aproduct candidate in Phase 1 clinical development. In consideration forthe licenses to the SARM program, the Company entered into a discoverycollaboration agreement with BMS (the Discovery Collaboration Agreement) toprovide a portion of the Company’s medicinal chemistry resources to a BMSdiscovery program unrelated to the SARM program for a period up to threeyears.  The Discovery CollaborationAgreement provides that each such year, the Company will provide a fixed numberof full time workers for the BMS discovery program, divided between employeeslocated at the Company’s corporate headquarters in Cranbury, New Jersey andcontracted headcount located outside the United States.  Following the reduction in workforce theCompany implemented in August 2008, the Company has provided feweremployees located at the Company’s corporate headquarters in Cranbury, NewJersey than contemplated under the Discovery Collaboration Agreement. However,as stated above, the Company’s worker commitment is an annual requirement andcompliance with such requirement will be evaluated under the DiscoveryCollaboration Agreement on that basis.

 

The Company estimated that the fair value ofthe medicinal chemistry resources to be provided to BMS under the DiscoveryCollaboration Agreement is approximately $9.2 million. In accordance withSFAS 2, the Company recorded a non-cash charge of $9.2 million toproprietary research and development expense related to the acquisition of thelicense to the SARM program during the year ended December 31, 2007. TheCompany also recorded deferred revenue of approximately $9.2 million during theyear ended December 31, 2007, which represented the estimated fair valueof the medicinal chemistry resources the Company is to provide to BMS under theDiscovery Collaboration Agreement.  As ofSeptember 30, 2008, included in deferred revenue was approximately $7.2million, of which $5.3 million was classified as long-term. For the three andnine month periods months ended September 30, 2008, the Company recognizedrevenue of approximately $0.5 million, or 9% of net revenue, and approximately$2.1 million, or 11% of net revenue, respectively, in connection with themedicinal chemistry resources it provided to BMS.

 

In addition, the Company will pay BMSmilestone payments associated with submission and approval of a therapeuticproduct for marketing and a stepped royalty on net sales of therapeuticproducts, if any, resulting from the SARM program. BMS has a limited right offirst negotiation in the event that the Company desires to license compoundsthat are the subject of the SARM License Agreement to a third party other thanBMS.

 

**6. Significant Collaborations**

 

**ProductDevelopment and Commercialization Agreement with GSK**

 

In March 2006, the Company andSmithKline Beecham Corporation and Glaxo Group Limited (together GSK) enteredinto a product development and commercialization agreement (the GSK Agreement).The Company’s role in the alliance with GSK is to (i) identify and (ii) advancemolecules in chosen therapeutic programs to development stage and (iii) subjectto certain provisions in the GSK Agreement, further develop the candidates toclinical demonstration of efficacy in humans. The Company has agreed that itwill not screen its compound library for other collaborators, or for its ownaccount, against any target it screens under the GSK Agreement for a specifiedperiod.

 

The GSK Agreement provides GSK an exclusiveoption, exercisable at defined points during the development process for eachprogram (up to the point of clinical demonstration of efficacy in humans), tolicense that program. Upon licensing a program, GSK is obligated to conductpreclinical development and/or clinical trials and commercialize pharmaceuticalproducts, if any,  resulting from suchlicensed programs on a worldwide basis. In addition to the cash payments above,the Company is entitled to 

 

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receive success-based milestone payments, starting in preclinicalresearch, from GSK for each drug development program under the alliance and thepotential for double-digit royalties upon the successful commercialization byGSK of any product resulting therefrom.

 

In the event that GSK does not exercise itsoption to license a program, the Company will retain all rights to that programand may continue to develop the program and commercialize any productsresulting from the program, or it may elect to cease progressing the programand/or seek other partners for further development and commercialization.Should the Company develop or partner such a program and commercialize anyproducts resulting from that program, the Company will be obligated to pay GSKsuccess-based milestone payments and royalties upon successfulcommercialization, if any.

 

Since the inception of the GSK Agreement, theCompany has received $15.0 million in connection with initial discoveryactivities the Company is obligated to perform under the GSK Agreement. TheCompany recorded deferred revenue of approximately $14.5 million associatedwith these payments, net of the fair value of the warrants described below. TheCompany has also earned non-refundable milestone payments totaling$3.0 million from GSK related to the identification of six lead compounds.These milestone payments were also recorded as deferred revenue due to theCompany’s continuing performance obligations under the GSK Agreement. Includedin deferred revenue as of September 30, 2008 was approximately$12.0 million, of which approximately $6.9 million was classified aslong-term. The Company recognizes revenue on a proportional performance basisas it performs the required discovery activities in an amount from time to timeless than or equal to the non-refundable portion of payments received inconnection with the GSK Agreement. The Company’s revenue under the GSKAgreement accounted for approximately $1.3 million, or 22% of net revenue,and approximately $0.5 million, or 9% of net revenue, for the three monthsended September 30, 2008 and 2007, respectively.  The Company’s revenue under the GSK Agreementaccounted for approximately $3.5 million, or 20% of net revenue, andapproximately $1.2 million, or 7% of net revenue, for the nine monthsended September 30, 2008 and 2007, respectively.  The initial research term of the GSKAgreement expires in March 2011.

 

In connection with the GSK Agreement, theCompany issued two warrants to GSK for the purchase of up to an aggregate of176,367 shares of its common stock at an exercise price of $5.67 per share,which was a 25% premium over the trailing 30-day closing price averagepreceding March 24, 2006. The warrants are exercisable at any time beforethe earlier to occur of (i) March 24, 2011 and (ii) theeffective date of certain types of termination of the GSK Agreement. These warrantswere issued in a transaction not involving a public offering under Section 4(2) ofthe Securities Act of 1933, as amended. The fair value of the warrants at thetime of the execution of the GSK Agreement was determined to be$505 thousand. This amount was calculated using the Black-Scholesoption-pricing model with the following assumptions: 80% volatility; expectedterm of 5 years; 4.66% risk-free rate; and 0% dividend.

 

The Company and GSK each have the right toterminate the GSK Agreement in its sole discretion under certain specifiedcircumstances at any time during the term of the GSK Agreement. In addition,the Company and GSK each have the right to terminate the GSK Agreement underother circumstances that are customary in these types of agreements. If theCompany exercises its discretionary termination right at any time during thefirst five years of the term, under certain circumstances, it could be requiredto refund to GSK a portion of the $15.0 million it has received related toinitial discovery activities to be conducted by the Company referred to above.The amount of any such refund will be calculated based upon when during theterm of the GSK Agreement that termination occurs and the amount of researchfunding the Company had received prior to such termination. However, there areno instances where the deferred revenue would be amortized below the amountthat could be potentially refundable pursuant to the terms of the GSKAgreement. Further, should GSK exercise its discretionary termination rights,there are no provisions in the GSK Agreement that would require the Company torefund payments received relating to its performance of initial discoveryactivities or milestone payments received under the GSK Agreement.

 

**Researchand License Agreement with Wyeth**

 

In December 2006, the Company enteredinto a research and license agreement (the Wyeth Agreement) with Wyeth, actingthrough its Wyeth Pharmaceuticals Division, providing for the formation of anew alliance based on the Company’s Janus Kinase-3 (JAK3) inhibitor program.The alliance’s goal is to identify, develop and commercialize therapeuticproducts for the treatment of certain immunological conditions in humans.

 

The companies each have certain exclusiverights to develop and commercialize products resulting from the JAK3 programand the alliance. The Company retains the right to develop and commercializetherapeutic products for the treatment of dermatological and ocular diseasesemploying topical administration, and Wyeth has the right to develop humantherapeutic products for all other indications and routes of delivery. Underthe terms of the Wyeth Agreement, the Company has received an up-frontnon-refundable $5.0 million cash payment, approximately $6.1 millionin quarterly research funding, and a non-refundable milestone payment $500thousand. The Company may also receive an additional $3.1 million over theremaining portion of the initial three-year research term, which expires in December 2009.In addition, the Company may receive up to $175.0 million if Wyethachieves preclinical and clinical development and regulatory andcommercialization milestones, as well as double-digit royalties on the netsales of any 

 

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products commercialized by Wyeth under the alliance. Each company isresponsible for all development, regulatory, manufacturing andcommercialization activities for any products it develops and commercializes inits field.

 

The revenue for this research is recognizedon a proportional performance basis, which is expected to approximatestraight-line recognition of revenue over the initial three year term of thealliance. For the three months ended September 30, 2008 and 2007, theCompany recognized revenue of approximately $1.3 million, or 22% of netrevenue, and approximately $1.2 million, or 23% of net revenue, respectively,under the Wyeth Agreement. For the nine months ended September 30, 2008and 2007, the Company recognized approximately $3.7 million, or 20% of netrevenue, and approximately $3.5 million, or 21% of net revenue, respectively,under the Wyeth Agreement.  As of September 30,2008, approximately $3.3 million was recorded in deferred revenue, ofwhich approximately $0.5 million was classified as long-term.

 

Pharmacopeia and Wyeth each have the right toterminate the Wyeth Agreement under certain specified circumstances at any timeduring the term of the Wyeth Agreement. In addition, Wyeth has the right, uponsix months’ prior written notice provided to the Company, to terminate theresearch collaboration and/or the Wyeth Agreement in its entirety or in part.Such right to termination would not apply to Wyeth’s obligations with respectto any program developed by the collaboration and licensed by Wyeth. Notermination will require the Company to refund to Wyeth any or all of the cashpayments described above.

 

**Collaborationand License Agreement with Cephalon**

 

In May 2006, the Company entered into aCollaboration and License Agreement (the Cephalon Agreement) with Cephalon, Inc.(Cephalon) providing for the formation of a new drug discovery, development andcommercialization alliance. Under the Cephalon Agreement, the Company receivedan up-front, non-refundable payment of $15.0 million in June 2006 tosupport the Company’s research efforts.

 

Cephalon is responsible for identifying hitand lead compounds, and the Company and Cephalon will then work collaborativelyto advance the lead compounds to clinical candidates. The Company isprincipally responsible for medicinal chemistry research and Cephalon providesbiology support, including preclinical disease models, as required by theCephalon Agreement. The Company has agreed that, for a specified period, itwill not screen its compound library for other collaborators, or for its ownaccount, against any target it works on under the Cephalon Agreement.

 

Upon the nomination of any clinicalcandidates by the alliance, Cephalon will be primarily responsible for theirdevelopment and commercialization. The Company will retain an option to developcertain candidates from the alliance, subject to Cephalon’s agreeing to suchdevelopment. For any preclinical development candidate advanced under thealliance, the developing company will make clinical, regulatory and salesmilestone payments to the non-developing company. In addition, the companycommercializing any resulting product will pay the non-commercializing companyup to double-digit royalties based on the sales level achieved.

 

As stated above, under the CephalonAgreement, the Company received a non-refundable payment of $15.0 millionand is principally responsible for performing medicinal chemistry research. Therevenue for this research is recognized on a proportional performancebasis.  Included in deferred revenue at September 30,2008 was approximately $3.8 million related to the Cephalon Agreement, allof which was classified as deferred revenue, current portion. The Companyrecognized revenue of approximately $0.8 million, or 14% of net revenue,and $1.3 million, or 25% of net revenue, for the three month period ended September 30,2008, and 2007, respectively, under the Cephalon Agreement. For the nine monthsended September 30, 2008 and 2007, the Company recognized approximately$3.3 million, or 19% of net revenue, and approximately $3.8 million, or23% of net revenue, respectively, under the Cephalon Agreement.  The initial research term of the Cephalon Agreementexpires in May 2009.

 

The Company and Cephalon each have the rightto terminate the Cephalon Agreement under certain specified circumstances atany time during the term of the Cephalon Agreement. In addition, Cephalon hasthe right to terminate the Cephalon Agreement in its sole discretion, uponninety days written notice to the Company, during the initial three-year phaseof the alliance, which phase may be extended by agreement of the parties. Nosuch termination shall require the Company to refund to Cephalon any or all ofthe above research and development funding.

 

Following the reduction in workforce theCompany implemented in August 2008, the Company has provided feweremployees to work on the Cephalon collaboration than contemplated under theCephalon Agreement. The Company and Cephalon are currently negotiating withrespect to an early wind-down of the Company’s remaining obligations under theCephalon Agreement.

 

One of the Company’s directors currentlyserves as the Chairman and Chief Executive Officer of Cephalon.

 

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**Collaborationand License Agreement with Schering-Plough**

 

In February 2007, the Company enteredinto an amended and restated collaboration and license agreement with N.V.Organon (Organon), providing for the formation of a new alliance to discover,develop and commercialize therapeutic products across a broad range of therapeuticindications. The new alliance followed the companies’ past collaborations,including the February 2002 agreement between the Company and Organon (the2002 Collaboration). In November 2007, Organon was acquired by, and is nowa part of, Schering-Plough. The Company refers to the February 2007agreement with Organon as the 2007 Schering-Plough Agreement.

 

Since inception of the 2007 Schering-PloughAgreement, the Company has received an up-front payment of $15.0 million,$1.0 million for the transfer of rights to certain programs from the 2002Collaboration, and $7.0 million in quarterly research funding. The 2007Schering-Plough Agreement provides that the Company may also receive up to anadditional $4.0 million per year in quarterly research funding over the remainingportion of the five-year research term of the alliance, which began in February 2007.The 2007 Schering-Plough Agreement also provides that the Company waives itsrights to receive further compensation (e.g., future milestone and royaltypayments) with respect to programs resulting from lead series identified by theCompany and delivered to Organon under the 2002 Collaboration and certain otherprograms from earlier agreements.

 

The 2007 Schering-Plough Agreement providesthe Company the option to purchase the right to co-develop and co-commercializecertain therapeutic candidates discovered through the alliance. For therapeuticcandidates the Company does not elect to co-develop and co-commercialize,Schering-Plough will retain exclusive development and commercialization rights,and the Company will receive milestone payments as a result of Schering-Plough’ssuccessful advancement, if any, of each candidate through clinical development,and up to double-digit royalties based on commercialization of any resultingpharmaceutical products.

 

The revenue associated with the research theCompany performs under the 2007 Schering-Plough Agreement is recognized on aproportional performance basis. The Company has received $23.0 million inconnection with the 2007 Schering-Plough Agreement which the Company recordedas deferred revenue. Included in deferred revenue as of September 30, 2008was approximately $15.4 million related to the 2007 Schering-PloughAgreement, of which approximately $6.9 million was classified as deferredrevenue, long-term. For the three months ended September 30, 2008 and2007, the Company recognized revenue of approximately $1.9 million, or 32%of net revenue, and approximately $1.0 million, or 20% of net revenue,respectively, in connection with the 2007 Schering-Plough Agreement.  For the nine months ended September 30,2008, the Company recognized revenue of approximately $4.7 million, or 26%of net revenue, in connection with the 2007 Schering-Plough Agreement. For thenine months ended September 30, 2007, the Company recognized approximately$2.4 million, or 15% of net revenue, under the 2007 Schering-Plough Agreementand the 2002 Collaboration, the research term of which ended February 2007.

 

Both Pharmacopeia and Schering-Plough havethe right to terminate the 2007 Schering-Plough Agreement under certainspecified circumstances at any time during the term of the 2007 Schering-PloughAgreement. In addition, the Company and Schering-Plough each have the right toterminate the 2007 Schering-Plough Agreement under other circumstances that arecustomary in these types of agreements. Further, each party has the right,upon  prior written notice provided tothe other party at any time beginning two and one-half years after February 8,2007, to terminate the research portion of the alliance and/or the 2007Schering-Plough Agreement. Such a termination of the research portion of thealliance by Schering-Plough would not apply to Schering-Plough’s obligationswith respect to any program developed by the alliance that Schering-Plough isadvancing or to therapeutic candidates with respect to which the Company haspreviously exercised its option to purchase the right to co-develop andco-commercialize. Should Schering-Plough exercise its discretionary terminationright, there are no provisions in the 2007 Schering-Plough Agreement that wouldrequire the Company to refund payments received under the 2007 Schering-PloughAgreement. If the Company exercises its discretionary termination right, under certaincircumstances, it could be subject to a termination fee of $5.0 million.Whether or not the Company is subject to the termination fee is based upon whenduring the term of the 2007 Schering-Plough Agreement the Company’sdiscretionary termination right is exercised. However, until such time as theCompany is no longer subject to the termination fee, there will be no instanceswhere the deferred revenue associated with the 2007 Schering-Plough Agreementwould be amortized below $5.0 million.

 

**AdditionalCollaboration and License Agreements with Schering-Plough**

 

Separate from the 2007 Schering-PloughAgreement, in April 2007 the Company completed its research activitiesunder its other agreements with Schering-Plough. Under the terms of the Company’sagreements with Schering-Plough in which the Company’s research activities haveceased, the cessation of those research activities did not affect other areasof those collaborations, including the ongoing Phase 2 and Phase 1clinical trials and preclinical programs that Schering-Plough is conducting.The Company continues to be entitled to payments resulting from the successfulachievement by Schering-Plough, if any, of clinical milestones, as well asroyalty payments from sales, if any, of products resulting from compoundsalready delivered by the Company and accepted by Schering-Plough under thosecollaborations.

 

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For the three and nine months ended September 30,2008, the Company did not recognize any revenue under its collaborations withSchering-Plough in which its research activities ceased in April 2007.  For the three and nine months ended September 30,2007, the Company recognized revenue of approximately $1.0 million relatedto milestone achievements, or 20% of net revenue, and approximately $3.8million, or 23% of net revenue, including $3.0 million in milestonerevenue, related to those collaborations, respectively.

 

**OtherItems**

 

In the three and nine months ended September 30,2008, the Company recognized approximately $0.5 million, or 9%, and  approximately $2.5 million, or 14%, of netrevenue, in connection with its Discovery Collaboration Agreement and DARALicense Agreement with BMS. There was no revenue recognized in the three andnine months ended September 30, 2007 in connection with its DiscoveryCollaboration Agreement or its DARA License Agreement with BMS.  See Note 5 above for further discussion ofthe Company’s Discovery Collaboration Agreement and DARA License Agreement withBMS.

 

Except as disclosed above, no othercollaborator accounted for more than 10% of the Company’s total revenue in thethree and nine month periods ended September 30, 2008.

 

**7. Business Segment and GeographicalInformation**

 

The Company classifies its businessoperations in one operating segment. All of the Company’s revenues aregenerated from this segment. Revenue was derived from collaborators located inthe following geographic regions:

 
| ** **            | ** ** | **Three months ended September 30,** | ** ** | **Nine months ended September 30,** | ** ** |
|-----------------------|------------|----------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **            | ** ** | **2008**                                                 | ** ** | **2007**                                                | ** ** | **2008** | ** ** | **2007** | ** ** |
| Customers located in: |       |                                                     |       |                                                    |       |   |   |   |   |
| United States         |       | 68                                                       | %          | 70                                                      | %          | 74 | % | 67 | % |
| Europe                |       | 32                                                       | %          | 30                                                      | %          | 26 | % | 33 | % |

 

**8. Share-based Compensation**

 

The fair value of the Company’s equity awardswere estimated at the date of grant using the Black-Scholes option-pricingmodel with the following ranges of assumptions:

 

**Black-Scholes Assumptions**

 
| ** **              | ** ** | **2008**  | ** ** | **2007**  | ** ** |
|-------------------------|------------|-----------|------------|-----------|------------|
| Dividend yield          |       | 0         | %          | 0         | %          |
| Expected volatility     |       | 70-75     | %          | 80-90     | %          |
| Risk-free interest rate |       | 3.04-3.45 | %          | 4.39-4.60 | %          |
| Expected life (years)   |       | 6.25      |       | 6.25      |       |

 

For the three months ended September 30,2008 and 2007, total share-based compensation costs related to stock optionswere approximately $263 thousand, and $556 thousand, respectively.  For the three months ended September 30,2008, the Company also incurred share based compensation costs related torestricted stock unit awards (RSUs) of approximately $227 thousand, whichincluded approximately $42 thousand relating to the accelerated vesting of RSUsof a former executive of the Company in September 2008. There was noexpense related to RSUs during the three months ended September 30, 2007.

 

For the nine months ended September 30,2008 and 2007, total share-based compensation costs related to stock optionswere approximately $1.5 million and $1.6 million, respectively.  For the nine months ended September 30,2008 and 2007, the Company also incurred share based compensation costs relatedto restricted stock unit awards of approximately $490 thousand, which includedapproximately $177 thousand relating to the accelerated vesting of RSUs ofcertain former executives of the Company, and $13 thousand, respectively.

 

As of September 30, 2008, there wasapproximately $4.0 million of unrecognized compensation costs, net ofestimated forfeitures, related to stock option grants which are expected to berecognized over a weighted average period of 2.3 years. In addition, as ofSeptember 30, 2008, there was approximately $0.3 million of unrecognizedcompensation costs, net of estimated forfeitures, related to RSU grants whichare expected to be recognized over a weighted average period of 1.1 years.There were no cash proceeds from options exercised during the three months endedSeptember 30, 2008. Cash proceeds from options exercised during the threemonths ended September 30, 2007 were approximately $130 thousand. Cashproceeds from options exercised during the nine months ended September 30,2008 and 2007 were approximately $8 thousand and $760 thousand, respectively.

 

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**9. Line of Credit / Notes Payable**

 

In December 2006, the Company enteredinto a loan and security agreement (the Line of Credit) with a lendinginstitution. The Line of Credit is intended to provide the Company withfunding, in exchange for a security interest in certain of the Company’sequipment. The Line of Credit provides up to a total of $5.0 million infunding in the form of term loans, from time to time through December 2008.Term loans secured by laboratory equipment have a fixed term of 48 months.Term loans secured by all other collateral categories have a fixed term of36 months.

 

As of September 30, 2008, the aggregatebalance of term loans originated under the Line of Credit was approximately$3.7 million, of which approximately $2.4 million was classified asnotes payable, long-term. Interest rates on these term loans range from 10.08%to 10.28%. Additionally, the Company had approximately $0.3 millionavailable for borrowings under the Line of Credit as of September 30,2008.

 

**10. Warrant Liability**

 

Inconnection with its October 2006 financing, the Company issuedapproximately 1,450,000 warrants to purchase its common stock. UnderEITF 00-19, to qualify as permanent equity, an equity derivative mustpermit the issuer to settle in unregistered shares. Under securities law, ifthe warrants were issued in connection with a public offering and have a cashsettlement feature at the holder’s option, a company does not have the abilityto settle in unregistered shares. Therefore, the warrants cannot be classifiedas permanent equity and are instead classified as a liability. The warrantsthat the Company issued as part of its equity financing in October 2006meet this criteria, and have been recorded as a liability in the accompanyingbalance sheet. The fair value of the warrants was determined as of October 18,2006, and the Company recorded a liability relating to the issuance of thewarrants of approximately $4.5 million. Equity derivatives not qualifyingfor permanent equity accounting are recorded at fair value on the measurementdate, and are remeasured at each reporting date until the warrants areexercised or have expired. Changes in the fair value of the warrants arereported in the statement of operations as income (decreases) or expense(increases).

 

At September 30, 2008, the fair value of the warrants decreased toapproximately $0.5 million from approximately $2.7 million at June 30,2008. As a result of this decrease, the Company recorded approximately $2.3million in income in the statement of operations for the three months ended September 30,2008. At September 30, 2007, the fair value of the warrants had increasedto approximately $5.5 million from approximately $5.4 million at June 30,2007. As a result of this increase, the Company recorded approximately $0.1million expense in the statement of operations for the three months ended September 30,2007.

 

As of September 30, 2008, the fair value of the warrants decreasedto approximately $0.5 million from approximately $4.2 million as of December 31,2007. As a result of this decrease, the Company recorded approximately$3.7 million in income in the statement of operations for the nine monthsended September 30, 2008. At September 30, 2007, the fair value ofthe warrants had increased to approximately $5.5 million fromapproximately $4.4 million as of December 31, 2006. As a result of thisincrease, the Company recorded approximately $1.1 million in expense inthe statement of operations for the nine months ended September 30, 2007.

 

The fair value of the warrants was calculatedusing the Black-Scholes option-pricing model with the following assumptions atthe respective measurement dates:

 
| ** **              | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|-------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **              | ** ** | **2008**               | ** ** | **2007**              | ** ** |
| Dividend yield          |       | 0                      | %          | 0                     | %          |
| Expected volatility     |       | 70.00                  | %          | 80.00                 | %          |
| Risk-free interest rate |       | 2.63                   | %          | 3.45                  | %          |
| Expected life (years)   |       | 3.55                   |       | 4.30                  |       |
| Stock Price             |       | $                      | 1.49       |                  | $          | 4.77 |   |
| Exercise Price          |       | $                      | 5.14       |                  | $          | 5.14 |   |

 

**11. Commitments and Contingencies**

 

**DARALicense Agreement with BMS**

 

Under the terms of the DARA LicenseAgreement, in lieu of an up-front cash payment, the Company is providing BMS aset of compound libraries, over a period of approximately three years followingthe execution of the agreement. As of September 30, 

 

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2008, the Company had approximately $1.0 million of deferredrevenue related to compound libraries that the Company will provide after September 30,2008. In the event the Company fails to deliver the aforementioned compoundlibraries to BMS, the Company would be required to make cash payments on a prorata basis of up to approximately $0.8 million; however, the Companyexpects to complete its delivery of these compound libraries by the end of thefirst quarter of 2009.

 

In addition, the Company will pay BMSmilestone payments upon the achievement of successive clinical and regulatoryevents in the United States and certain other jurisdictions, and royalties onsales of products, if any, resulting from the DARA program.

 

**SARMLicense Agreement with BMS**

 

In consideration for the licenses to the SARMprogram, in October 2007, the Company entered into the DiscoveryCollaboration Agreement with BMS. The Discovery Collaboration Agreementprovides that the Company will apply a portion of its medicinal chemistryresources to a BMS discovery program that is unrelated to the SARM program forup to three years. The Discovery Collaboration Agreement also provides thateach such year, the Company will provide a fixed number of full time workersfor the BMS discovery program, divided between employees located at the Company’scorporate headquarters in Cranbury, New Jersey and contracted headcount locatedoutside the United States.  Following thereduction in workforce the Company implemented in August 2008, the Companyhas been providing fewer employees located at the Company’s corporateheadquarters in Cranbury, New Jersey than contemplated under the DiscoveryCollaboration Agreement. However, as stated above, the Company’s worker commitmentis an annual requirement and compliance with such requirement will be evaluatedunder the Discovery Collaboration Agreement on that basis.

 

The Company recorded deferred revenue of$9.2 million, which approximates the fair value of the chemistry resourcesthat the Company is to provide to BMS. As of September 30, 2008, the Company had approximately$7.2 million of deferred revenue related to services that it is to provideunder the Discovery Collaboration Agreement after September 30, 2008.

 

In addition, the Company will pay BMSmilestone payments associated with submission and approval of a therapeuticproduct for marketing and a stepped royalty on net sales of therapeuticproducts, if any, resulting from the SARM program.

 

**ProductDevelopment and Commercialization Agreement with GSK**

 

Under the GSK Agreement, the Company and GSKeach have the right to terminate the GSK Agreement in its sole discretion undercertain specified circumstances at any time during the term of the GSKAgreement. In addition, the Company and GSK each have the right to terminatethe GSK Agreement under circumstances that are customary in these types ofagreements. If the Company exercises its discretionary termination right at anytime during the first five years of the term, under certain circumstances, itcould be required to refund to GSK a portion of the $15.0 million it hasreceived related to initial discovery activities to be conducted by theCompany. The amount of any such refund will be calculated based upon when duringthe term of the GSK Agreement that termination occurs. However, there are noinstances where the deferred revenue would be amortized below the amount thatcould be potentially refundable pursuant to the terms of the GSK Agreement.Further, should GSK exercise its discretionary termination rights, there are noprovisions in the GSK Agreement that would require the Company to refundpayments received relating to its performance of initial discovery activitiesunder the GSK Agreement.

 

The Company’s role in the alliance is to (i) identifyand (ii) advance molecules in chosen therapeutic programs to developmentstage and (iii) subject to certain provisions in the GSK Agreement,further develop the candidates to clinical demonstration of efficacy in humans.As of September 30, 2008, the Company had approximately $12.0 millionof deferred revenue related to services that are to be provided under the GSKAgreement by the Company after September 30, 2008.

 

**Researchand License Agreement with Wyeth**

 

Under the Wyeth Agreement, the Company hasreceived non-refundable payments of $11.6 million to support the Company’sresearch efforts. As of September 30, 2008, the Company had approximately$3.3 million of deferred revenue related to services that the Company isto provide under the Wyeth Agreement.

 

**Collaborationand License Agreement with Cephalon**

 

Under the Cephalon Agreement, the Companyreceived an up-front, non-refundable payment of $15.0 million in June 2006to support the Company’s research efforts. The Company is principallyresponsible for performing medicinal chemistry research over the alliance term.As of September 30, 2008, the Company had approximately $3.8 millionof deferred revenue related to services that are to be provided under theCephalon Agreement by the Company after September 30, 2008.

 

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Following the reduction in workforce theCompany implemented in August 2008, the Company has provided feweremployees to work on the Cephalon collaboration than contemplated under theCephalon Agreement. The Company and Cephalon are currently negotiating withrespect to an early wind-down of the Company’s remaining obligations under theCephalon Agreement.

 

**Collaborationand License Agreement with Schering-Plough**

 

Under the 2007 Schering-Plough Agreement, theCompany has received $23.0 million (the $15.0 million up-frontpayment, $1.0 million for the transfer of rights to certain programs fromthe 2002 Collaboration, and $7.0 million in quarterly research funding) since February 2007to support its research efforts. As of September 30, 2008, the Company hadapproximately $15.4 million of deferred revenue related to services it isto provide under the 2007 Schering-Plough Agreement after September 30,2008.

 

In addition, if the Company exercises itsdiscretionary termination right, under certain circumstances, the Company couldbe subject to a termination fee of $5.0 million. Whether or not theCompany is subject to the termination fee is based upon when during the term ofthe 2007 Schering-Plough Agreement the Company exercise its discretionarytermination right. However, until such time as the Company is no longer subjectto the termination fee, there will be no instances where the deferred revenueassociated with the 2007 Schering-Plough Agreement would be amortized below$5.0 million.

 

**MergerAgreement**

 

TheMerger Agreement contains certain termination rights for both the Company andLigand, and further provides that, upon termination of the Merger Agreementunder specified circumstances, the Company may be required to pay Ligand atermination fee of approximately $3.4 million or to reimburse Ligand forcertain of its actual documented reasonable expenses, subject to a cap of $1.4million.

 

**ProductManufacturing Contracts**

 

The Company has entered into contracts withthird parties related to the manufacturing of materials that are to be used inconnection with the Company’s clinical trials for PS433540. The terminationprovisions for these contracts are such that, as of September 30, 2008,the Company had aggregate commitments thereunder totaling approximately$2.3 million, which are expected to be fulfilled in the fourth quarter of2008.

 

**Milestoneand Royalty Commitments**

 

Under the terms of certain agreements towhich the Company is a party, it is possible that the Company may becomeobligated to pay aggregate milestone payments totaling up to $247 millionupon the achievement of successive clinical and regulatory events and royaltieson sales of products, if any, resulting from programs for which the Company hasdevelopment responsibility under such agreements. The Company will not beresponsible for the payment of future milestone and/or royalty payments in theevent that development of such a program is discontinued. Preclinical andclinical development of drug candidates is a long, expensive and uncertainprocess. At any stage of the preclinical or clinical development process, theCompany may decide to discontinue the development of its product candidates. Todate, none of the compounds to which the Company holds complete or partialrights has reached the stage of commercial product. The Company expects thatits product candidates will not be commercially available for many years, ifever.

 

**12. Restructuring Costs**

 

In May 2008, the Company announced areduction in its workforce of twenty-three positions, twenty of which wereeliminated effective May 30, 2008 and the remaining three of which wereeliminated by July 31, 2008 (the May 2008 Restructuring).  In addition, the Company streamlined itsfacilities.  As a result of the May 2008Restructuring,  the Company recorded arestructuring charge of approximately $1.7 million during the three monthsended June 30, 2008.

 

In August 2008, the Company announced afurther reduction of its workforce by an additional sixty-four positions, oneof which was eliminated effective September 5, 2008, fifty-nine of whichwere eliminated effective October 3, 2008, and the remaining four of whichwill be eliminated as of December 5, 2008 (the August 2008Restructuring).  In addition, the Companyrecorded an impairment charge related to a leasehold improvement project thatwill not be completed. As a result of August 2008 Restructuring, theCompany recorded a restructuring charge of approximately $3.2 million duringthe three months ended September 30, 2008.

 

The following table summarizes the activityand balance of the restructuring reserve as of September 30, 2008 (inthousands):

 

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| ** **                         | ** ** | **Severance Cost for  Involuntary Employee  Terminations** | ** ** | **Costs to Exit Leased  Facility** | ** ** | **Asset Impairment  Related to  Restructuring** | ** ** | **Total** | ** ** |
|------------------------------------|------------|---------------------------------------------------------------------------|------------|---------------------------------------------------|------------|-----------------------------------------------------------|------------|-----------|------------|
| Restructuring expense              |       | $                                                                         | 4,229      |                                              | $          | 493                                                       |       | $         | 146        |   | $ | 4,868 |   |
| Utilization of Reserves:           |       |                                                                      |       |                                              |       |                                                      |       |      |       |
| Cash payments                      |       | (2,423                                                                    | )          | (46                                               | )          | (146                                                      | )          | (2,615    | )          |
| Equity compensation                |       | (177                                                                      | )          | —                                            |       | —                                                    |       | (177      | )          |
| Accretion                          |       | —                                                                    |       | 8                                                 |       | —                                                    |       | 8         |       |
| Balance at September 30, 2008 |       | $                                                                         | 1,629      |                                              | $          | 455                                                       |       | $         | —     |   | $ | 2,084 |   |

 

Restructuring costs related to the Company’s facilities are comprisedof the difference between the remaining lease obligations of the abandonedoperating leases, which run through the year 2016, and the Company’s estimateof potential future sublease income, discounted to present value.

 

Included in Accrued restructuring, current portion as of September 30,2008 was approximately $1.8 million relating to the current portion of therestructuring reserve. Included in Accrued restructuring, long-term wasapproximately $311 thousand relating to the long-term portion of therestructuring reserve.

 

**13. Severance Costs**

 

In April 2008, the Company recorded a charge of approximately $0.9million in connection with a separation agreement between the Company and itsformer President and Chief Executive Officer. This severance cost was unrelatedto the May 2008 Restructuring and the August 2008 Restructuring andwas recorded as general and administrative expense in the Company’s statementsof operations during the nine months ended September 30, 2008.

 

**14. Related Party Transactions**

 

A member of Pharmacopeia’s board of directorscurrently serves as the Chairman and Chief Executive Officer of Cephalon. In June 2006,the Company received an up-front non-refundable $15.0 million payment tosupport the Company’s research efforts under the Cephalon Agreement.  For the three and nine month periods ended September 30,2008, the Company recognized revenue under the Cephalon Agreement ofapproximately $0.8 million or, 14% of net revenue, and $3.3 million, or19% of net revenue, respectively. For the three and nine month periods ended September 30,2007, the Company recognized revenue of approximately $1.3 million, or 25% ofnet revenue, and $3.8 million, or 23% of net revenue, respectively. Followingthe August 2008 Restructuring, the Company has provided fewer employees towork on the Cephalon collaboration than contemplated under the Cephalon Agreement.The Company and Cephalon are currently negotiating with respect to an earlywind-down of the Company’s remaining obligations under the Cephalon Agreement.

 

A former member of Pharmacopeia’s clinicaladvisory board is affiliated with a contract research organization (CRO) thatthe Company contracted with to conduct one of its clinical trials. For thethree months ended September 30, 2008 and 2007, the Company incurredexpense of approximately $20 thousand and $406 thousand, respectively, relatedto the clinical trial this CRO conducted. In addition, the Company incurredexpense of approximately $1.1 million and $440 thousand, respectively, relatedto this same clinical trial during the nine months ended September 30,2008 and 2007, respectively.

 

**15. Subsequent Event**

 

**Notice of Putative Class Action Complaint**

 

OnOctober 10, 2008, the Company received notice that a putative class actioncomplaint was filed by Allen Heilman, one of its stockholders, against it andthe members of the Company’s Board of Directors in the Superior Court of NewJersey, Mercer County (Equity Division).  The complaint generally allegesthat the Board’s decision to enter into the Merger with Ligand, on the termscontained in the Merger Agreement constitutes a breach of fiduciary duty andgives rise to other unspecified state law claims.  The complaint allegesthat the named plaintiff will seek “equitable relief,” including among otherthings, an order preliminarily and permanently enjoining the Merger.  Thecomplaint also names Ligand and two of its wholly-owned subsidiaries asdefendants.  The Company believes that the allegations inthe complaint are without merit and intends to vigorously defend against thisaction.

 

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**Item 2. Management’sDiscussion and Analysis of Financial Condition and Results of Operations**

 

**FORWARD-LOOKING STATEMENTS**

 

This Report on Form 10-Qcontains forward-looking statements regarding us and our business, financialcondition, results of operations and prospects within the meaning of thePrivate Securities Litigation Reform Act of 1995.  Such forward-looking statements include thosethat express plan, anticipation, intent, contingency, goals, targets or futuredevelopment and/or otherwise are not statements of historical fact.  These forward-looking statements are based onour current expectations and projections about future events and they aresubject to risks and uncertainties known and unknown that could cause actualresults and developments to differ materially from those expressed or impliedin such statements. These forward-looking statements include statements aboutthe following:

 

·                  ourplans to merge our operations with those of Ligand, the timing of the Mergerand consequences that could arise if the Merger is not consummated;

 

·                  ourneed and our ability to raise additional funds if  the Merger is not consummated;

 

·                  ourplans to develop PS433540, a Phase 2 product candidate from our DARAprogram and our need and our ability to raise additional funds to attempt tofurther progress the DARA program; the medical indications for which we intendto pursue development of PS433540; and our existing and proposed Phase 2and Phase 1 clinical studies with respect to PS433540;

 

·                  ourability to successfully perform under our agreements with BMS, GSK, Wyeth,Cephalon and Schering-Plough;

 

·                  our ability to further reduce our operatingexpenses;

 

·                  ouranticipated operating results, financial condition, liquidity and capitalresources;

 

·                  ourestimates of the market opportunity for our product candidates;

 

·                  theexpiration of the initial research terms of our alliances with Cephalon andWyeth;

 

·                  ourplans to develop PS178990, a Phase 1 product candidate from our SARMprogram, and PS031291, a preclinical development product candidate from ourchemokine receptor CCR1 program;

 

·                  ourability to build our pipeline of novel drug candidates through our owninternally-funded drug discovery and development programs and third partycollaborations;

 

·                  ourexpectations concerning the development priorities of our collaborators, theirrespective abilities to successfully develop compounds and our receipt ofmilestones and royalties;

 

·                  ourexpectations concerning the legal protections afforded by U.S. andinternational patent laws;

 

·                  ourability to pursue the development of new compounds and other business matterswithout infringing the patent rights of others;

 

·                  additionalcompetition and changes in economic conditions.

 

In some cases, you can identify forward-looking statements byterminology, such as “goals,” or “expects,” “anticipates,” “intends,” “plans,” “believes,”“seeks,” “estimates,” or the negative of such terms or other similarexpressions. You are urged not to place undue reliance on any suchforward-looking statements, any of which may turn out to be wrong due toinaccurate assumptions, unknown risks, uncertainties or other factors.  Factors that could cause or contribute todifferences in results and outcomes from those in our forward-lookingstatements include, without limitation, those discussed elsewhere in thisReport in Part II, Item 1A “Risk Factors” and in this Part I, Item 2,as well as those discussed in our other Securities and Exchange Commission(SEC) filings.

 

We urge you to carefully read and consider the disclosures found in ourSEC filings, all of which are available in the SEC EDGAR database at *www.sec.gov*.  We undertake no obligation to (and expresslydisclaim any such obligation to) revise or update the statements made herein orthe risk factors that may relate thereto whether as a result of newinformation, future events or otherwise.

 

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The followingdiscussions should be read in conjunction with the section of this Reportentitled “Risk Factors”.

 

**The Company**

 

**Overview**

 

We are a clinical development stage biopharmaceutical company dedicatedto discovering and developing novel small molecule therapeutics to addresssignificant medical needs. Our strategy is to retain the rights to productcandidates at least to clinical validation, and to continue development on ourown to New Drug Application (NDA) filing and commercialization for selectedindications. We have a broad portfolio of clinical and preclinical candidatesunder development internally or by partners.

 

**Our Merger with Ligand**

 

OnSeptember 24, 2008, we entered into the Merger Agreement with Ligand,Merger Sub 1 and Merger Sub 2.  The Merger Agreement provides that, uponthe terms and subject to the conditions set forth in the Merger Agreement, wewill merge with and into Merger Sub 1, with us continuing as the IntermediateSurviving Corporation and immediately thereafter the Intermediate SurvivingCorporation will merge with and into Merger Sub 2, with Merger Sub 2 continuingas the surviving entity.  Our and Ligand’s Boards of Directors have eachapproved the Merger and the Merger Agreement. We currently expect the Merger toclose by January 2009 subject to approval by our stockholders, certainregulatory clearances and other closing conditions.

 

Ifthe Merger Agreement is adopted by our stockholders and the other conditions tothe mergers are satisfied or waived, upon completion of the Merger, Ligandwould issue approximately 0.58 of a share for each share of our common stockoutstanding immediately prior to the effective time of the Merger, subject tocertain adjustments for cancelled stock options. However, this exchange ratiois fixed only if the Ligand Common Stock Value falls within the range between$3.00 and $3.75. Otherwise, the following will apply:

 

· if theLigand Common Stock Value is greater than $3.75 but not greater than $4.50, theoverall transaction value will be fixed at $66.0 million, and the exchangeratio will decrease as prices increase within the range;

 

· if theLigand Common Stock Value is greater than $4.50, then the exchange ratio willbe approximately 0.49;

 

· if theLigand Common Stock Value is equal to or greater than $2.38 but less than$3.00, then the exchange ratio will increase as prices decrease within therange (provided that if the Ligand Common Stock Value is less than $2.93, theexchange ratio will not exceed approximately 0.60), subject to specifiedlimitations in the Merger Agreement. Under this scenario, in addition toreceiving shares of Ligand common stock, our stockholders will be entitled toreceive cash consideration for an overall transaction value fixed at$52.8 million; or

 

· if theLigand Common Stock Value is less than $2.38, then the exchange ratio will beapproximately 0.60. Under this scenario, in addition to receiving shares ofLigand common stock, our stockholders will be entitled to receive aproportionate share of $10.0 million in cash.

 

Atthe closing of the Merger, we, Ligand and a rights agent will enter into theCVR Agreement. The CVR Agreement sets forth the rights that our formerstockholders will have with respect to each CVR to be held by them after theclosing of the Merger. The CVR Agreement provides for the payment of anaggregate of $15.0 million in cash payable to the holders of the CVRs if, on orprior to December 31, 2011, Ligand enters into a license or sale agreementrelated to our PS433540 program or any other agreement for the development,marketing or sale of the PS433540 program, or any option to enter into suchagreement, with any party other than BMS or any of its affiliates. Thepotential values of consideration to be received by our stockholders in theMerger discussed above exclude any potential CVR payments.

 

Ligandwill issue between approximately 14,000,000 and 18,976,461 shares of commonstock to our stockholders in the Merger, depending on the market price ofLigand’s common stock during the twenty consecutive trading days ending at theclose of trading on the fifth trading day prior to the date of the specialmeeting of our stockholders. Each share of Ligand common stock that is issuedin connection with the Merger will be accompanied by a right under Ligand’srights agreement.

 

Wehave made customary representations, warranties and covenants in the MergerAgreement. Consummation of the Merger is subject to customary conditions,including (i) approval of the Merger Agreement and Merger by the ourstockholders, (ii) absence of any law or order prohibiting theconsummation of the Merger, (iii) expiration or termination of theapplicable Hart-Scott-Rodino 

 

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waitingperiod, (iv) subject to certain exceptions, the accuracy of therepresentations and warranties and (v) the absence of any material adverseeffect on us.

 

TheMerger Agreement contains certain termination rights for both us and Ligand,and further provides that, upon termination of the Merger Agreement underspecified circumstances, we may be required to pay Ligand a termination fee ofapproximately $3.4 million or to reimburse Ligand for certain of its actualdocumented reasonable expenses, subject to a cap of $1.4 million.

 

OnOctober 20, 2008, Ligand filed with the SEC a Registration Statement on Form S-4,which included our proxy statement and other relevant materials in connectionwith the proposed transaction. The proxy statement, once finalized, will bemailed to our stockholders.

 

**Our Future as a Stand-Alone Company**

 

As of September 30, 2008, we had cash,cash equivalents and marketable securities of approximately$33.4 million.  In addition, as of September 30,2008, we had deferred revenue of approximately $42.7 million representingcash payments and licenses to certain product candidates we have received underour alliance and license agreements in exchange for research and developmentactivities that are to be performed by us subsequent to September 30,2008.  Our obligations to perform theseresearch and development activities extend over multiple years and we expectthat we will incur significant costs in fulfilling these obligations. If we donot consummate the Merger with Ligand and we remain an independent company, inorder to progress our internal development programs and to satisfy ourcommitments to our corporate partners and our other contractual obligations, wewill need to raise additional funds from one or a combination ofapproaches.  We may obtain funds byentering into arrangements with partners or others that may require us torelinquish rights to certain of our technologies, products or potential marketsthat we would not otherwise relinquish. Additional capital may not be available on favorable terms, or atall.  Despite active efforts, we were notable to secure appropriate financing to further the development of our businessduring the period from November 2007 through August 2008.  We have curtailed our operationssignificantly since the beginning of 2008, and we may further curtail ourcurrent operations, perhaps significantly.

 

**Our Internal Clinical Programs**

 

PS433540, our leadproduct candidate we are developing internally, is in Phase 2 clinicaldevelopment. PS433540 is a Dual-Acting angiotensin and endothelin ReceptorAntagonist (DARA) that we in-licensed from BMS. Our license agreement with BMS provides us with an exclusive licenseunder certain BMS patents with respect to worldwide development andcommercialization of PS433540, as well as certain other compounds discovered byBMS that possess DARA activity.

 

In the event we were toremain an independent company and assuming we are able to raise sufficientfunds to support the further development of the DARA program, the focus of ourfuture development of PS433540 would be on the indication of diabeticnephropathy, which we believe would represent the best opportunity for us topursue with our available financial resources.

 

In May 2008, weannounced that Study 008, a Phase 2a clinical trial of PS433540 in subjectswith Stage I and Stage II hypertension, showed statistically significant bloodpressure reductions.  Study 008 met itsprimary endpoint by showing a statistically significant reduction in mean24-hour systolic ambulatory blood pressure over placebo.  Study 008 also showed statisticallysignificant improvements over placebo in mean 24-hour diastolic ambulatoryblood pressure as well as seated blood pressure.  There were no serious adverse events insubjects treated with PS433540. Three subjects discontinued therapy for adverseevents, all of whom were in the placebo group.

 

In July 2008, weannounced a reduction from 375 to approximately 250 subjects expected to bestudied in Study 006, a Phase 2b clinical trial of PS433540 which isdesigned to further evaluate safety and efficacy of PS433540 in subjects withStage I and Stage II hypertension. Our decision to reduce the number of subjects in Study 006 was madeafter fully evaluating the efficacy and safety data reported from Study008.  Study 006 will study 200 mg and 400mg doses of PS433540 versus placebo and will also compare efficacy and safetydata of PS433540 with that of irbesartan. To date, there have been no serious adverse events that were attributedto study therapy in Study 006. We expect Study 006 to be completed in thefourth quarter of 2008.

 

In October 2007, we entered into an additional license agreementwith BMS providing us exclusive worldwide development and commercializationrights to a selective androgen receptor modulator (SARM) program (the SARMprogram).  PS178990 is a non-steroidalSARM that was designed to provide the benefits of testosterone to patientswithout unwanted side effects on the prostate. BMS completed a Phase 1single ascending dose study with PS178990.

 

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In February 2008, we announced the nomination of PS031291 as apreclinical development compound from our internal chemokine receptor CCR1program. PS031291 is a potent and highly selective antagonist at the chemokinereceptor CCR1, which has been implicated in playing a significant role inmultiple inflammatory and autoimmune disease processes. We believe PS031291 maypossess significant potential in the treatment of various inflammatory diseasesincluding rheumatoid arthritis. We initiated good laboratory practice (oftenreferred to as GLP) toxicology studies on PS031291 in the second quarter of2008, and those studies are ongoing.

 

Upon consummation of theMerger, Ligand will determine the course of future development of PS433540,PS178990, and PS031291.

 

We also have certain other agreements with leading pharmaceutical andbiotechnology companies, including Schering-Plough, BMS and Celgene Corporation(Celgene), where we have completed our research activities and our partner isnow responsible for the development of potential therapeutic products. Ourcollaborative research efforts with Schering Plough, BMS and Celgene haveresulted in a portfolio that includes two partnered programs currently inPhase 2 clinical trials targeting chronic obstructive pulmonary disease(COPD), psoriasis and asthma in the first instance and psoriasis, rheumatoidarthritis and atherosclerosis in the second instance, as well as five partneredprograms in active Phase 1 clinical trials targeting oncology,inflammatory, metabolic and respiratory diseases. Associated with theseclinical development programs, we have received milestone payments fromSchering-Plough, BMS and Celgene and, to the extent the compounds successfullyprogress through clinical development and registration, we will be entitled to receiveadditional milestone payments. We are also entitled to receive royalties on thecommercial sale, if any, of drugs resulting from these collaborations. However,numerous additional studies are required to fully assess the potential of theseclinical candidates before they reach the marketplace, and the results frompreclinical and clinical studies conducted to date with these compounds are notnecessarily indicative of the results that may be obtained in future clinicalstudies.

 

In addition to the compounds in clinical development, another of ourpartnered programs is in preclinical development, the point at which compoundsare tested for safety in animals and are subjected to other studies requiredprior to testing compounds in humans.

 

In addition to our proprietary research and development, we currentlyhave collaborations under which we are actively performing research anddevelopment activities with leading pharmaceutical and biotechnology companies,including GSK, Wyeth,****Cephalon andSchering-Plough. While the nature of our collaborative relationships vary witheach of these companies, we retain certain development and/or commercializationrights under the terms of each agreement.

 

Clinical and preclinical development of product drug candidates is along, expensive and uncertain process that requires us to raise funds from timeto time to support our internal development programs.  In the event the Merger is not consummatedand we remain an independent company, we will need to raise funds from one or acombination of approaches, which could include public and/or private financing,sale and/or partnering of one or more of our internal programs, and partneringof our internal drug discovery capabilities or other strategic initiatives. Wecontinue to pursue the discovery and development of product candidates in bothour internal and collaborative programs. Our financial commitment with respectto our internal programs will be consistent with our available capitalresources. The product candidates described above are at early stages and nonehave received regulatory approval for commercial sale. All of the compoundsface the substantial risk of failure inherent in drug discovery anddevelopment. At any stage of the clinical development process, we or our collaboratorsmay decide to discontinue development of our product candidates. To date, noneof the compounds in which we hold complete or partial rights has reached thestage of a commercial product and, although we have received license andmilestone fees, we may never receive any sales revenues, royalty payments orany additional license and milestone fees, under our current or any futurecollaborations. We do not expect that our product candidates will becommercially available for many years, if ever.

 

**Liquidity and Capital Resources**

 

As of September 30, 2008, we had cash,cash equivalents and marketable securities of $33.4 million compared to$71.3 million at December 31, 2007, representing 67% and 79% of ourtotal assets, respectively. We make investments in highly liquidinvestment-grade marketable securities, primarily consisting of securities andmoney market funds backed by the United States Treasury. As of September 30,2008, our investment portfolio did not include any auction rate securities and hasnot been materially affected by the recent turmoil in the investment and creditmarkets.   In addition, as of September 30,2008, we had deferred revenue of $42.7 million related to cash paymentsand licenses to certain product candidates that we have received under ouralliances and license agreements in exchange for research and developmentactivities that are to be performed by us subsequent to September 30,2008.

 

The following is a summary of selected cashflow information for the nine months ended September 30, 2008 and 2007:

 

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| ** **                                           | ** ** | **Nine months ended September 30,** | ** ** |
|------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                           | ** ** | **2008**                                                | ** ** | **2007** | ** ** |
| Net loss                                             |       | $                                                       | (38,134    | ) | $ | (28,605 | ) |
| Adjustments for noncash operating items              |       | 1,134                                                   |       | 4,761 |   |
|                                                 |       |                                                    |       |   |   |
| Net cash operating loss                              |       | (37,000                                                 | )          | (23,844 | ) |
| Net change in assets and liabilities                 |       | 1,537                                                   |       | 22,374 |   |
|                                                 |       |                                                    |       |   |   |
| Net cash used in operating activities                |       | $                                                       | (35,463    | ) | $ | (1,470 | ) |
|                                                 |       |                                                    |       |   |   |
| Net cash provided by (used in) investing  activities |       | $                                                       | 39,093     |   | $ | (20,369 | ) |
|                                                 |       |                                                    |       |   |   |
| Net cash (used in) provided by financing  activities |       | $                                                       | (380       | ) | $ | 40,027 |   |

 

**Net cash used in operating activities**

 

Net cash used in operating activities for thenine months ended September 30, 2008 was primarily due to cash used tofund both our proprietary internal drug research and development efforts,including our Phase 2 clinical trials for PS433540, and the fulfillment ofour research and development performance obligations under our collaborations.We also paid approximately $3.5 million in severance payments related to theimplementation of our May 2008 and August 2008 restructuring plansand the separation of our former President and Chief Executive Officer. The netcash used in operating activities was partially offset by the receipt of a$5.0 million payment received in March 2008 relating to additionalresearch funding under the GSK Agreement. Absent the receipt of the $5.0 million from GSK, our net cash usedin operating activities would have been approximately $40.5  millionduring the nine months ended September 30, 2008.

 

**Net cash provided by investing activities**

 

Net cash provided by investing activities forthe nine months ended September 30, 2008 related primarily to the maturityof marketable securities offset by capital expenditures related to ourfacilities and capital expenditures for research and development andinformation technology equipment and software.

 

**Net cash used in financing activities**

 

Net cash used infinancing activities for the nine months ended September 30, 2008consisted primarily of repayments of the loans originated under our Line ofCredit, net of borrowings during the period.

 

**Liquidity and Capital Resources Outlook**

 

As of September 30, 2008, we had cash,cash equivalents and marketable securities of approximately $33.4 million.In addition, as of September 30, 2008, we had deferred revenue ofapproximately $42.7 million related to cash payments and licenses tocertain product candidates that we have received under our alliances andlicense agreements in exchange for research and development activities that areto be performed by us subsequent to September 30, 2008.  Our cash used in operating activities for thenine months ended September 30, 2008 was approximately $35.5 million,which included $5.0 million in research funding from GSK. Excluding thisreceipt, our cash used in operating activities would have been approximately$40.5 million for the nine months ended September 30, 2008.

 

In September 2008, we entered into theMerger Agreement with Ligand, Merger Sub 1 and Merger Sub 2.  We currently expect the Merger to close by January 2009,subject to stockholder approval, certain regulatory clearances and otherclosing conditions.  If the Mergeris not consummated and we remain as an independent company, to progress ourinternal programs and to satisfy our commitments to our corporate partners andour other contractual obligations, we will need to raise funds from one or acombination of approaches. Those approaches could include public and/or privatefinancing, sale and/or partnering of one or more of our internal programs,partnering of our internal drug discovery capabilities or other strategicinitiatives.  However, additional capitalmay not be available on favorable terms, or at all.  Despite active efforts, we were not able tosecure appropriate financing to further the development of our business duringthe period November 2007 through August 2008. We intend to manage allof our expenditures, including our research and development expenditures, in amanner consistent with our available capital resources.

 

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Clinical and preclinical development of drugcandidates is a long, expensive and uncertain process that requires us to raisefunds from time to time to support our internal development programs.  Conducting our own drug research and developmentis a key component of our business model. We are currently conductingPhase 2 and Phase 1 clinical trials for PS433540, our lead productcandidate from our DARA program that we are developing internally. In May 2008,we announced positive results from Study 008, a Phase 2a clinical trial ofPS433540 in subjects with Stage I and Stage II hypertension. Afterfully evaluating the efficacy and safety data reported in Study 008, we reducedthe number of subjects in Study 006, a Phase 2b clinical trial we areconducting to further evaluate safety and efficacy of PS433540 in subjects withStage I and Stage II hypertension. This reduction will allow us theopportunity to begin a Phase 2 clinical trial focusing on the indication ofdiabetic nephropathy sooner than otherwise would have been possible.  However, the timing of such a clinical trialwill be based on our available capital resources.  We are also considering opportunities topartner the development of PS433540 for various indications, including diabeticnephropathy and various forms of cardiovascular disease.

 

As part of our alliances with GSK, Wyeth,Cephalon and Schering-Plough and our Discovery Collaboration Agreement withBMS, we have received up-front cash payments and licenses to certain productcandidates. In connection with these agreements, we are obligated to performsignificant research and development activities over multiple years and assuch, expect to incur significant costs performing such activities. Thefollowing table provides the period over which these research and developmentactivities are to be provided, as well as the deferred revenue currentlyrecorded for each agreement as of September 30, 2008:

 
| **Collaborative Agreement**      | ** ** | **Expiration of  Initial Research Term** | ** ** | **Deferred Revenue  as of  September 30, 2008** | ** ** |
|---------------------------------------|------------|---------------------------------------------------------|------------|---------------------------------------------------------------------|------------|
|                                  |       |                                                    |       |                                                                |       |
| 2007 Schering-Plough Agreement        |       | February 2012                                      |       | $                                                                   | 15,355     |   |
| GSK Agreement                         |       | March 2011                                         |       | 12,024                                                              |       |
| BMS Discovery Collaboration Agreement |       | December 2010                                      |       | 7,171                                                               |       |
| Cephalon Agreement                    |       | May 2009(1)                                        |       | 3,750                                                               |       |
| Wyeth Agreement                       |       | December 2009                                      |       | 3,281                                                               |       |
| Other                                 |       | June 2009(2)                                       |       | 1,122                                                               |       |
|                                  |       |                                                    |       | $                                                                   | 42,703     |   |

 

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(1) We are currently in negotiationswith Cephalon with respect to an early wind-down of the Company’s remainingobligations under the Cephalon Agreement.

 

(2) June 2009 represents the latestexpiration of agreements in this category.

 

Since February 2007, under the 2007Schering-Plough Agreement, we have received $23.0 million (a$15.0 million up-front payment, $1.0 million for the transfer ofrights to certain programs from the 2002 Collaboration, and $7.0 million inquarterly research funding). We may receive up to an additional$13.0 million of research and development funding over the remainingportion of the five-year research term, which began in February 2007.

 

Since January 2007, we have receivedapproximately $11.6 million in connection with our research and licenseagreement with Wyeth. We may receive an additional $3.1 million ofresearch and development funding over the remaining portion of the initialthree-year research term, which expires in December 2009.

 

As of September 30, 2008, we hadborrowings associated with our Line of Credit of approximately$3.7 million, which have repayment terms ranging from 36 to48 months, including approximately $1.3 million that is classified ascurrent. In addition, we had approximately $0.3 million available forborrowings under our Line of Credit as of September 30, 2008.

 

In August 2008, we announced a further reduction in our workforce by an additional 64 positions.  We paid a portion of the severance associated with this reduction in the three months ending September 30, 2008.  We expect to pay approximately $2.2 million related to the remaining severance and accrued vacation payable in the fourth quarter of 2008. This reduction in force is in addition to the restructuring plan we committed to in May 2008. While this reduction in force will increase our cash outlay during the fourth quarter of 2008, the reduction will reduce our operating expenditures in the future.

 

Wehave incurred and expect to further incur significant costs related to theMerger, including investment banking fees, legal fees, and other costsnecessary to complete the Merger. Many of these costs have been or will beincurred irrespective of whether or not the Merger is consummated. In addition,the Merger Agreement contains certain termination rights for both us andLigand, and 

 

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furtherprovides that, upon termination of the Merger Agreement under specifiedcircumstances, we may be required to pay Ligand a termination fee ofapproximately $3.4 million or reimburse Ligand for certain of its actualdocumented reasonable expenses, subject to a cap of $1.4 million.

 

We anticipate that our capital resources willbe adequate to fund our operations at their current levels at least through June 30,2009.  We intend to manage ourexpenditures in a manner consistent with our available capital resources.However, there can be no assurance that changes will not occur that wouldconsume available capital resources before then.

 

Our capital requirements will depend on theoutcome of our proposed Merger, competing technological and market developments,changes in our existing collaborative relationships, progress of PS433540 inclinical trials, our development plans for PS433540, PS178990 and PS03129, thecost of filing, prosecuting, defending, and enforcing patent claims and otherintellectual property rights and the outcome of related litigation, thepurchase of additional capital equipment, acquisitions of other businesses ortechnologies, and the progress of our collaborators’ milestone and royaltyproducing activities. Prior to exhausting our current capital resources, wewill need to raise additional funds or enter into strategic initiativesintended to further the development of our business in order to finance ouroperating activities and to satisfy our commitments to our corporate partnersand our other contractual obligations. There can be no assurance thatadditional funding, if necessary, will be available to us on favorable terms,if at all. Failure to raise adequate funds would likely lead us to curtail ouroperations further.  Our forecasts of theperiod of time through which our financial resources will be adequate tosupport our operations are forward-looking information and actual results couldvary. The factors described earlier in this section will impact our futurecapital requirements and the adequacy of our available funds.

 

**Results of Operations**

 

This section should be read in conjunctionwith the discussion above under “Liquidity and Capital Resources.”

 

**Three Months Ended September 30, 2008and 2007**

 

Our net revenue increased 16% to$5.9 million in the three months ended September 30, 2008 compared to$5.1 million in the three months ended September 30, 2007. Netrevenue consists of revenue recorded in connection with research anddevelopment efforts we perform under our various collaborative agreements, aswell as our earning of milestones, success fees and license revenue if and asthe compounds we and our collaborators have identified progress through ourcollaborators’ development processes. Net revenue for the three months ended September 30,2008 and 2007 is summarized as follows:

 
| ** **                                    | ** ** | **For the three months ended September 30,** | ** ** |
|-----------------------------------------------|------------|----------------------------------------------------------------------------|------------|
| ** **                                    | ** ** | **2008**                                                                   | ** ** | **2007** | ** ** |
|                                          |       |                                                                       |       |   |   |
| Collaborative research revenue                |       | $                                                                          | 5,861      |   | $ | 3,939 |   |
| Milestones, success fees and license  revenue |       | 61                                                                         |       | 1,150 |   |
|                                          |       | $                                                                          | 5,922      |   | $ | 5,089 |   |

 

Revenue recognized from our collaborative relationships for the threemonths ended September 30, 2008 and 2007, respectively, was as follows:

 
| ** **         | ** ** | **For the three months ended September 30,** | ** ** |
|--------------------|------------|----------------------------------------------------------------------------|------------|
| ** **         | ** ** | **2008**                                                                   | ** ** | **% of  Total  Revenue** | ** ** | **2007** | ** ** | **% of  Total  Revenue** | ** ** | **Change** | ** ** |
|               |       |                                                                       |       |   |   |   |   |   |   |   |   |
| Schering-Plough(1) |       | $                                                                          | 1,906      |   | 32 | % | $ | 2,024 |   | 40 | % | $ | (118 | ) |
| Wyeth              |       | 1,281                                                                      |       | 22 | % | 1,167 |   | 23 | % | 114 |   |
| GSK                |       | 1,275                                                                      |       | 22 | % | 475 |   | 9 | % | 800 |   |
| Cephalon           |       | 833                                                                        |       | 14 | % | 1,250 |   | 25 | % | (417 | ) |
| BMS                |       | 517                                                                        |       | 9 | % | — |   | — |   | 517 |   |
| Other              |       | 110                                                                        |       | 1 | % | 173 |   | 3 | % | (63 | ) |
| Total Revenue      |       | $                                                                          | 5,922      |   | 100 | % | $ | 5,089 |   | 100 | % | $ | 833 |   |

 

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(1) Revenue from our collaborations withSchering-Plough includes net revenue of approximately $1.9 million recognizedunder the 2007 Schering-Plough Agreement during the three months ended September 30,2008. During the three months ended September 30, 2007, revenue from ourcollaborations with Schering-Plough consisted of net revenue of approximately$1.0 million recognized under the 2007 Schering-Plough Agreement and $1.0million in milestone revenue recognized under those collaborations withSchering-Plough in which our research activities ceased in April 2007.

 

The increase in collaborative researchrevenue in the three months ended September 30, 2008 was largely due toincreased research revenue from our 2007 Schering-Plough Agreement and ouragreements with GSK and BMS offset by decreased research revenue from ourCephalon agreement and lower milestone revenue from our collaborations withSchering-Plough in which our research activities ceased in April 2007.

 

Collaborative research and developmentexpense includes the labor, material, equipment and allocated facilities costof our scientific staff that is working on collaborative partnerships.Collaborative research and development expense decreased 8% to$5.3 million in the three months ended September 30, 2008 compared to$5.8 million in the three months ended September 30, 2007. Thisdecrease primarily related to a decrease in resources allocated to ouralliances with GSK, Schering-Plough, specifically under our 2007Schering-Plough Agreement, Cephalon and Wyeth offset by resources allocated toour Discovery Collaboration Agreement with BMS for the 2008 period. The overalldecrease in resources related primarily to our workforce reductions in May 2008and August 2008.  Share-basedcompensation costs for the three months ended September 30, 2008 and 2007were approximately $95 thousand and $153 thousand, respectively.

 

Proprietary research and development expenseincludes research and development acquisition costs, clinical trial andpreclinical study costs, and labor, material, equipment and allocatedfacilities cost of scientific staff working on self-funded internal drugdiscovery and development programs. Our most advanced internal program is ourDARA program. The most advanced compound in our DARA program is our leadproduct candidate PS433540, which is in Phase 2 clinical trials.  We licensed our DARA program from BMS in March 2006.In addition, we in-licensed our SARM program from BMS in October 2007. Themost advanced compound in our SARM program is our product candidate PS178990,which is in Phase 1 clinical development. Proprietary research anddevelopment expense decreased 28% to $6.8 million in the three monthsended September 30, 2008 compared to $9.5 million in the three monthsended September 30, 2007. This decrease was primarily attributable todecreased costs relating to clinical trials for PS433540, a $2.0 millionmilestone payment we made to BMS upon initiation of a Phase 2 clinical trial inthe third quarter of 2007, and costs related to our CCR1 program offset byincreased costs relating to toxicology studies for PS178990.  Share-based compensation costs for the threemonths ended September 30, 2008 and 2007 were approximately$105 thousand and $84 thousand, respectively. Because of thespeculative nature of these internal drug discovery and development projects,it is not possible to estimate completion dates or costs of completion.Additionally, from time to time, certain staff and other research anddevelopment resources may be temporarily redirected from one project toanother, which redirection may also delay or impact the cost of internal drugdiscovery and development projects.

 

General and administrative expense increasedby 46% to $3.7 million in the three months ended September 30, 2008compared to $2.6 million in the three months ended September 30,2007. The increase in general and administrative expense was primarilyattributable to consulting and legal costs in connection with the Merger ofapproximately $1.2 million.  Share-basedcompensation costs for the three months ended September 30, 2008 and 2007were approximately $291 thousand and $311 thousand, respectively.

 

Restructuring expense relates to costsassociated with the August 2008 Restructuring.  These costs consisted of approximately $3.0million in severance costs, including approximately $42 thousand in share-basedcompensation costs related to the accelerated vesting of restricted stockunits, and approximately $146 thousand related to asset impairments.  There was no such restructuring expense inthe three months ending September 30, 2007.

 

Interest income decreased to $166thousand in the three months ended September 30, 2008 compared to$1.1 million in the three months ended September 30, 2007. This decreasewas primarily due to our decreased cash, cash equivalents, and marketablesecurities balances during the three months ended September 30, 2008 ascompared to the three months ended September 30, 2007.  In addition, our investment yields decreasedas we shifted our a majority of our investment portfolio investments tosecurities backed by the United States Treasury.

 

Interest and other expense, net increased to$103 thousand in the three months ended September 30, 2008 comparedto $15 thousand in the three months ended September 30, 2007.  This increase related to our increasedborrowing balances under our line of credit during the period.  As of September 30, 2008 and 2007, theaggregate balance of loans originated under the Line of Credit wasapproximately $3.7 million and $2.2 million, respectively.

 

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Non-operating income associated with thechange in warrant liability was $2.3 million for the three months ended September 30,2008. This income represents the decrease in the fair value from June 30,2008 to September 30, 2008 of the warrants we issued in connection withour equity financing in October 2006. For the three months ended September 30, 2007, non-operatingexpense associated with the change in warrant liability totaled approximately$57 thousand.  This expense represents anincrease in the fair value from June 30, 2007 to September 30, 2007of the warrants we issued in connection with our equity financing in October 2006.The fair value of the warrants was determined using the Black-Scholesoption-pricing model and is remeasured at each reporting period.

 

As a result of the net revenues and expensesdescribed above, we generated a net loss of $10.8 million ($0.36 per basicand diluted share) in the three months ended September 30, 2008, comparedto a net loss of $11.7 million ($0.40 per basic and diluted share) in thethree months ended September 30, 2007.

 

**Nine months Ended September 30, 2008 and2007**

 

Our net revenue increased 10% to$18.0 million in the nine months ended September 30, 2008 compared to$16.4 million in the nine months ended September 30, 2007. Netrevenue consists of revenue recorded in connection with research anddevelopment efforts we perform under our various collaborative agreements, aswell as our earning of milestones, success fees and license revenue if and asthe compounds we and our collaborators have identified progress through ourcollaborators’ development processes. Net revenue for the nine months ended September 30,2008 and 2007 is summarized as follows:

 
| ** **                                    | ** ** | **For the nine months ended September 30,** | ** ** |
|-----------------------------------------------|------------|---------------------------------------------------------------------------|------------|
| ** **                                    | ** ** | **2008**                                                                  | ** ** | **2007** | ** ** |
|                                          |       |                                                                      |       |   |   |
| Collaborative research revenue                |       | $                                                                         | 17,797     |   | $ | 11,776 |   |
| Milestones, success fees and license  revenue |       | 211                                                                       |       | 4,619 |   |
|                                          |       | $                                                                         | 18,008     |   | $ | 16,395 |   |

 

Revenue recognized from our collaborative relationships for the ninemonths ended September 30, 2008 and 2007, respectively was as follows:

 
| ** **         | ** ** | **For the nine months ended September 30,** | ** ** |
|--------------------|------------|---------------------------------------------------------------------------|------------|
| ** **         | ** ** | **2008**                                                                  | ** ** | **% of  Total  Revenue** | ** ** | **2007** | ** ** | **% of  Total  Revenue** | ** ** | **Change** | ** ** |
|               |       |                                                                      |       |   |   |   |   |   |   |   |   |
| Schering-Plough(1) |       | $                                                                         | 4,672      |   | 26 | % | $ | 6,222 |   | 38 | % | $ | (1,550 | ) |
| Wyeth              |       | 3,675                                                                     |       | 20 | % | 3,500 |   | 21 | % | 175 |   |
| GSK                |       | 3,543                                                                     |       | 20 | % | 1,182 |   | 7 | % | 2,361 |   |
| Cephalon           |       | 3,333                                                                     |       | 19 | % | 3,750 |   | 23 | % | (417 | ) |
| BMS                |       | 2,483                                                                     |       | 14 | % | — |   | — |   | 2,483 |   |
| Other              |       | 302                                                                       |       | 1 | % | 645 |   | 4 | % | (343 | ) |
| Biovitrum(2)       |       | —                                                                    |       | — |   | 1,096 |   | 7 | % | (1,096 | ) |
| Total Revenue      |       | $                                                                         | 18,008     |   | 100 | % | $ | 16,395 |   | 100 | % | $ | 1,613 |   |

 

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(1) Revenue from our collaborations withSchering-Plough included net revenue of approximately $4.7 million recognizedunder the 2007 Schering-Plough Agreement during the nine months ended September 30,2008. During the nine months ended September 30, 2007, revenue from ourcollaborations with Schering-Plough included net revenue of approximately $1.9million recognized under our 2007 Schering-Plough Agreement, $0.5 million ofnet revenue recognized under our 2002 Collaboration and approximately $3.8million of net revenue, including $3.0 million in milestone revenue, recognizedunder those collaborations with Schering-Plough in which our research activitiesceased in April 2007.

 

(2) Revenue from our Biovitrumcollaborations included $1.0 million in milestone revenue for the ninemonths ended September 30, 2007.

 

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The increase in collaborative researchrevenue in the nine months ended September 30, 2008 was largely due toincreased research revenue from our 2007 Schering-Plough Agreement and ouragreements with GSK and BMS offset by lower milestone revenue from ourcollaborations with Schering-Plough in which our research activities ceased in April 2007and Biovitrum.

 

Collaborative research and developmentexpense includes the labor, material, equipment and allocated facilities costof our scientific staff that is working on collaborative partnerships.Collaborative research and development expenses increased 23% to$20.5 million in the nine months ended September 30, 2008 compared to$16.7 million in the nine months ended September 30, 2007. Thisincrease primarily related to an increase in resources allocated to ouralliances with GSK, and Schering-Plough, specifically under our 2007Schering-Plough Agreement, during the first and second quarters of 2008 and resourcesallocated to our Discovery Collaboration Agreement with BMS. This increase wasoffset by decreased resources allocated to our alliances with Wyeth andCephalon and those collaborations with Schering-Plough in which we completedour research activities in April 2007. Beginning in June 2008, theresources we allocated to our collaborative partnerships decreased as a resultof our May 2008 and August 2008 Restructuring.  Share-based compensation costs for the ninemonths ended September 30, 2008 and 2007 were approximately$491 thousand and $416 thousand, respectively.

 

Proprietary research and development expenseincludes research and development acquisition costs, clinical trial andpreclinical study costs, and labor, material, equipment and allocatedfacilities cost of scientific staff working on self-funded internal drugdiscovery and development programs. Our most advanced internal program is ourDARA program. The most advanced compound in our DARA program is our leadproduct candidate PS433540, which is in Phase 2 clinical trials. Welicensed our DARA program from BMS in March 2006. In addition, wein-licensed our SARM program from BMS in October 2007. The most advancedcompound in our SARM program is our product candidate PS178990, which is inPhase 1 clinical development. Proprietary research and developmentexpenses increased 13% to $24.8 million in the nine months ended September 30,2008 compared to $22.0 million in the nine months ended September 30,2007. This increase was primarily attributable to costs relating to clinicaltrials for PS433540 and toxicology studies for PS178990 offset by decreasedmilestone payments made in connection with PS433540’s clinical achievements anddecreased costs on our CCR1 program. In the three and nine months ended September 30,2007, we paid $2.0 million and $3.0 million, respectively, in milestonepayments related to the initiation of Phase 1 and Phase 2 clinical trials forPS433540.  Share-based compensation costsfor the nine months ended September 30, 2008 and 2007 were approximately$298 thousand and $234 thousand, respectively. Because of thespeculative nature of these internal drug discovery and development projects,it is not possible to estimate completion dates or costs of completion. Additionally,from time to time, certain staff and other research and development resourcesmay be temporarily redirected from one project to another, which redirectionmay also delay or impact the cost of internal drug discovery and developmentprojects.

 

General and administrative expense increasedby 40% to $11.2 million in the nine months ended September 30, 2008compared to $8.0 million in the nine months ended September 30, 2007.The increase in general and administrative expense was primarily attributableto $1.0 million in severance costs in connection with the separations of ourformer President and Chief Executive Officer and our former Senior VicePresident, Business Development and approximately $1.2 million related toconsulting and legal costs in connection with the Merger.  Also contributing to the increase were patentprosecution and other legal costs, and compensation costs during the ninemonths ended September 30, 2008. Share-based compensation costs for thenine months ended September 30, 2008 and 2007 were approximately $1.2million and $0.9 million, respectively.

 

Restructuring expense relates to costsassociated with the implementation of our May 2008 and August 2008Restructurings during the nine months ended September 30, 2008.  These costs consisted of approximately $4.2million in severance costs, including approximately $0.2 million in share-basedcompensation costs related to the accelerated vesting of restricted stockunits, approximately $0.5 million related the abandonment of certain facilityleases and approximately $0.1 million related to certain assetimpairments.  There was no suchrestructuring expense in the nine months ending September 30, 2007.

 

Other income for the nine months ended September 30,2008 consisted of $700 thousand we received in connection with the assignmentof certain intellectual property to a collaborator in which our researchactivities had ceased. Other income for the nine months ended September 30,2007 related to $94 thousand in proceeds from an insurance claim.

 

Interest income decreased to approximately$1.1 million in the nine months ended September 30, 2008 compared toapproximately $2.7 million in the nine months ended September 30, 2007.This decrease was primarily due to significantly lower yields on our cash, cashequivalents, and marketable securities balances during the nine months ended September 30,2008 as compared to the nine months ended September 30, 2007.  The lower yields were primarily related toour shifting of our investment portfolio primarily to United States Treasurysecurities.

 

Interest and other expense, net increased to$306 thousand in the nine months ended September 30, 2008, comparedto $20 thousand in the nine months ended September 30, 2007.  The increase related to our increased borrowingbalance under our line of

 

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credit during the period.  As of September 30,2008 and 2007, the aggregate balance of loans originated under the Line ofCredit was approximately $3.7 million and $2.2 million, respectively.

 

Non-operating income associated with thechange in warrant liability was approximately $3.7 million for the nine monthsended September 30, 2008. This income represents the decrease in the fairvalue from December 31, 2007 to September 30, 2008 of the warrantsthat were issued in connection with our equity financing in October 2006.  For the nine months ended September 30,2007 non-operating expense associated with the change in warrant liabilitytotaled approximately $1.1 million.  Thisexpense represents the increase in the fair value from December 31, 2006to September 30, 2007 of the warrants that were issued in connection withour equity financing in October 2006. The fair value of the warrants was determined using the Black-Scholesoption-pricing model and is remeasured at each reporting period.

 

We recorded an income tax provision of $2thousand for the nine months ended September 30, 2008, which related tominimum state income taxes.   For thenine months ended September 30, 2007, we recorded an income tax benefit ofapproximately $52 thousand which represented an adjustment to our estimated2006 tax provision to reflect actual taxes due.

 

As a result of the net revenues and expensesdescribed above, we generated a net loss of $38.1 million ($1.28 per basicand diluted share) in the nine months ended September 30, 2008, comparedto a net loss of $28.6 million ($1.07 per basic and diluted share) in thenine months ended September 30, 2007.

 

**Net Loss Outlook**

 

We have had net losses in recent years and weexpect to incur losses in future periods. Under our proposed Merger with Ligand, Merger Sub 1 and Merger Sub 2,our results of operations would be consolidated with those of Ligand.  If the Merger is not consummated and weremain as an independent company, our losses are expected to decrease ascompared to prior periods.  This expecteddecrease is a result of our reductions in workforce by approximately 50% in2008. Our efforts to progress our clinical development programs still representsignificant expenditures. However we intend to manage all of our expenditures,including those related to our clinical development programs, in a manner consistentwith our available capital resources.

 

The amount of our net loss is highlydependent on the continued funding and success of our research and developmentprograms with our existing collaborators. The initial research terms of our alliances with Cephalon and Wyeth arescheduled to end in May and December 2009, respectively.  Cephalon and Wyeth represented 19% and 20%,respectively, of our total revenue during the nine months ended September 30,2008.  We are currently in negotiationswith Cephalon with respect to an early wind-down of the Company’s remainingobligations under the Cephalon Agreement and as such, our research activitiescould cease sooner than the end of the initial research term. We expect torecord revenue from our alliance with Wyeth through the end of the initialresearch term, at which time our research activities under these alliancescould cease.  We are uncertain whether wewill extend or replace these alliances. Failure to earn additional research and milestone payments under ourcurrent alliances and alliances we may seek to enter into after the end ofthese initial research terms would have a material adverse effect on ourfinancial condition and our results of operations.  If we fail to earnadequate additional research and milestone payments, we may be required tocurtail operations significantly or to obtain funds by entering intoarrangements with collaborative partners or others that may require us torelinquish rights to certain of our technologies, products or potential marketsthat we would not otherwise relinquish.

 

Our adoption of SFAS 123R, which waseffective January 1, 2006, increased our compensation costs and willcontinue to have a significant impact on our results of operations. Changes inthe fair value of the warrants we issued in October 2006 are reported inour statements of operations as income or expense. As such, changes to themarket price of our common stock or to the assumptions used in calculating thefair value of the warrants may cause significant increases or decreases to ourresults of operations. However, neither the impact of share-based compensationcosts, nor the impact of changes in the fair value of the warrant liabilitywill have an impact on our cash flows.

 

There is no assurance that we will everachieve profitable operations, or that profitable operations, if achieved,could be sustained on a continuing basis.

 

**Critical Accounting Policies and Estimates**

 

The preparation of our financial statementsand disclosures involve the use of judgments and estimates. We believe thefollowing critical accounting policies which we follow involve significantjudgments and use estimates.

 

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*Revenue Recognition*

 

Contract revenue is generally recognizedeither (i) on a proportional performance basis, for contracts specifyingpayment for services over a given period, or (ii) as services areperformed under the agreement for contracts specifying payment on a full-timeemployee basis.

 

Revenue earned related to up-front productand technology license fees is recognized in accordance with SAB 104 issued bythe SEC and EITF 00-21 issued by the FASB. Accordingly, amounts receivedunder multiple-element arrangements requiring ongoing services or performanceby us are recognized over the period of such services or performance.

 

Revenue from milestones is recognized whenearned, as evidenced by written acknowledgement from the collaborator, providedthat (i) the milestone event is substantive, its achievability was notreasonably assured at the inception of the agreement, and we have no furtherperformance obligations relating to that event, and (ii) collectibility isreasonably assured. If these criteria are not met, the milestone payment isrecognized over the remaining minimum period of our performance obligationsunder the arrangement. Royalties are recognized as earned in accordance withthe terms of various research and collaboration agreements.

 

*Share-based Compensation*

 

Our share-based compensation is accounted forin accordance with the fair value recognition provisions of SFAS 123R. UnderSFAS 123R, we use the Black-Scholes option pricing model to estimate thefair value of the share-based awards as of the grant date. The Black-Scholesmodel, by its design, is highly complex and dependent upon key data inputsestimated by management. The primary data inputs with the greatest degree ofjudgment are the estimated lives of the share-based awards and the estimatedvolatility of our stock price. The Black-Scholes model is sensitive to changesin these two data inputs. Beginning in fiscal year 2006, we calculated theestimated life of stock options granted using a “simplified” method, which isbased on the average of the vesting term and the actual term of the option, asa result of guidance from the SEC contained in SAB 107 permitting theinitial use of this method through 2007. In December 2007, the SEC issuedSAB 110, which became effective January 1, 2008, expressing theexpectation that companies should be employing information from internal orexternal sources about employee stock option exercise behavior when developingestimates of expected term as they relate to stock option valuations.SAB 110 states that the SEC will continue to accept the use of the “simplified”method, under certain circumstances, beyond December 31, 2007. Weevaluated the exercise behavior of our employees for stock options grantedsince our spin-off from Accelrys in April 2004 and determined that theexercise history was an inadequate measure of the expected term of our stockoptions. Therefore, we have continued our use of the simplified method asprescribed in SAB 107. Expected stock price volatility is typically based onthe daily historical trading data from an appropriate point in time through thelast day of the applicable period. Because our historical trading data onlydates back to May 3, 2004, the first trading date after our spin-off fromAccelrys, Inc., we estimate expected volatility using an analysis of thestock price volatility of companies comparable to ours in our industry.

 

*Warrant Liability*

 

We follow EITF 00-19 in accounting forour warrants which provides guidance for distinguishing between permanentequity, temporary equity and assets and liabilities. Under EITF 00-19, toqualify as permanent equity, the equity derivative must permit us to settle inunregistered shares. Under securities law, if the warrants were issued inconnection with a public offering and have a cash settlement feature at theholder’s option, we do not have the ability to settle in unregistered shares.Therefore, the warrants cannot be classified as permanent equity and areinstead classified as a liability. The approximately 1,450,000 warrants that weissued as part of our equity financing in October 2006 meet this criteria,and have been recorded as a liability in the accompanying balance sheets. Otherwarrants we had previously issued qualify as permanent equity and do notrequire remeasurement.

 

We record our warrant liabilities at fairvalue using a Black-Scholes option-pricing model and remeasure at eachreporting date until the warrants are exercised or have expired. Changes in thefair value of the warrants are reported in the statements of operations asincome or expense. The fair value of the warrants could be subject tosignificant fluctuation based on changes in our stock price, expectedvolatility, expected life, the risk-free interest rate and dividend yield. Themarket price for our common stock has been and may continue to be volatile.Consequently, future fluctuations in the price of our common stock may causesignificant increases or decreases in the fair value of the warrants issued in October 2006.

 

*Long-Lived Assets*

 

We review long-lived assets, includingleasehold improvements, property and equipment, and acquired technology rights,for impairment whenever events or changes in business circumstances indicatethat the carrying amount of the assets may not be fully recoverable. Thisrequires us to estimate future cash flows related to these assets. Actualresults could differ from these estimates, which may affect the carrying amountof assets and the actual amortization expense. As of September 30, 2008,we had long-lived assets with a net book value of $14.1 million.

 

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*Accounting for Uncertain Tax Positions*

 

We have adopted the provisions FIN 48.FIN 48 applies to all uncertain tax positions accounted for in accordancewith SFAS No. 109, “Accounting for Income Taxes” and is intended to resultin increased relevance and comparability in financial reporting of income taxesand to provide more information about the uncertainty in income tax assets andliabilities. We will recognize potential interest and penalties related toincome tax positions as a component of the benefit or provision for incometaxes on the consolidated statements of operations in any future periods inwhich we must record a liability. Because we have not recorded a liability at September 30,2008, there is no impact to our effective tax rate. We do not anticipate thattotal unrecognized tax benefits will significantly change during the nexttwelve months.

 

**Recent Accounting Pronouncements**

 

*Fair Value Measurements*

 

In September 2006, the FASB issued SFAS No. 157, “Fair ValueMeasurements” (SFAS 157). SFAS 157 establishes a framework formeasuring fair value in accordance with generally accepted accountingprinciples and expands disclosures about fair value measurements. Thestatement defines fair value as the exit price that would be received to sellan asset or paid to transfer a liability.  Fair value is a market-based measurement that should be determined usingassumptions that market participants would use in pricing an asset orliability.  The statement establishes athree-level hierarchy to prioritize the inputs used in measuring fair value.  The levels are described in the table belowwith Level 1 having the highest priority and Level 3 having the lowest.

 

In February 2008, the FASB issued FASBStaff Position (FSP) 157-b which delayed the effective date of SFAS 157for one year for all nonfinancial assets and nonfinancial liabilities, exceptthose that are recognized or disclosed at fair value in the financialstatements on a recurring basis (at least annually). SFAS 157 and FSP157-b are effective for financial statements issued for fiscal years beginningafter November 15, 2007. We have elected a partial deferral of Statement157 under the provisions of FSP 157-b and, effective January 1, 2008, theCompany adopted SFAS 157 for those assets and liabilities that areremeasured at fair value on a recurring basis. Our partial adoption of SFAS 157did not have a material effect on our consolidated financial statements as ofand for the nine months ended September 30, 2008.

 

The following table provides a summary of the assets and liabilitiesthat are measured at fair value on a recurring basis as of September 30,2008.

 

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| ** **                               | ** ** | ** **                         | ** ** | **Basis of Fair Value Measurements**                        | ** ** |
|------------------------------------------|------------|------------------------------------|------------|---------------------------------------------------------------------------------|------------|
| ** **                               | ** ** | **As of  September 30,** | ** ** | **Quoted prices  in active  markets for  identical assets** | ** ** | **Significant  other  observable  inputs** | ** ** | **Significant  unobservable  inputs** | ** ** |
| ** **                               | ** ** | **2008**                           | ** ** | **Level 1**                                                                | ** ** | **Level 2** | ** ** | **Level 3** | ** ** |
| **Assets**                               |       |                               |       |                                                                            |       |   |   |   |   |
| Cash and cash equivalents                |       | $                                  | 33,436     |                                                                            | $          | 33,436 |   | $ | — |   | $ | — |   |
| Deferred compensation plan assets        |       | 1,571                              |       | 1,571                                                                           |       | — |   | — |   |
|                                     |       |                               |       |                                                                            |       |   |   |   |   |
| Total assets measured at fair value      |       | $                                  | 35,007     |                                                                            | $          | 35,007 |   | $ | — |   | $ | — |   |
|                                     |       |                               |       |                                                                            |       |   |   |   |   |
| Percentage of total assets               |       | 70                                 | %          | 70                                                                              | %          | — |   | — |   |
|                                     |       |                               |       |                                                                            |       |   |   |   |   |
| **Liabilities**                          |       |                               |       |                                                                            |       |   |   |   |   |
| Warrant liability                        |       | $                                  | 472        |                                                                            | $          | — |   | $ | 472 |   | $ | — |   |
| Deferred compensation plan liabilities   |       | 1,571                              |       | —                                                                          |       | 1,571 |   | — |   |
|                                     |       |                               |       |                                                                            |       |   |   |   |   |
| Total liabilities measured at fair value |       | $                                  | 2,043      |                                                                            | $          | — |   | $ | 2,043 |   | $ | — |   |
|                                     |       |                               |       |                                                                            |       |   |   |   |   |
| Percentage of total liabilities          |       | 3                                  | %          | —                                                                          |       | 3 | % | — |   |

 

As noted above, the fair value of our cashand cash equivalents  and deferredcompensation plan assets are determined using quoted market prices in activemarkets. The fair value of the deferred compensation plan liabilities is basedupon significant observable inputs such as the fair value of the underlyingsecurities of the deferred compensation plan and our credit risk. The fairvalue of the warrant liability is determined using the Black-Scholesoption-pricing model, which uses certain significant observable inputs,including stock price (quoted market prices in active market), warrant exerciseprice (defined in warrant agreement), expected life of warrant (defined inwarrant agreement), dividend yields (determined by us), and risk-free interestrate (quoted market prices based on expected life assumption). The only inputin the Black-Scholes option-pricing model that is not readily observable is theexpected stock price volatility. Because our historical trading data only datesback to May 3, 2004, the first trading date after our spin-off fromAccelrys, Inc., we estimate our expected volatility using an analysis ofthe stock price volatility of comparable companies in our industry. The fairvalue of the warrant liability is subject to significant fluctuations and hasranged from approximately $0.5 million as of September 30, 2008 toapproximately $5.5 million as of September 30, 2007. These fluctuationshave primarily resulted from fluctuations in the market price of our commonstock, which ranged from $1.49 per share to $5.72 per share at our quarterlyremeasurement dates since September 30, 2007. Changes in the warrantliability are recorded in the statement of operations as income (decreases) orexpense (increases).

 

*Fair Value Option for Financial Assets and Liabilities*

 

In February 2007, the FASB issued SFAS No. 159, “The FairValue Option for Financial Assets and Liabilities Including an Amendment ofFASB Statement No. 115” (SFAS 159). SFAS 159 permits reportingentities to choose to measure eligible financial assets or liabilities, whichinclude marketable securities available-for-sale and equity method investments,at fair value at specified election dates, or according to a pre-existingpolicy for specific types of eligible items. Unrealized gains and losses forwhich the fair value option has been elected are reported in earnings.SFAS 159 is effective for fiscal years beginning after November 15,2007. Our adoption of SFAS 159, which was effective January 1, 2008, didnot have any impact on our consolidated financial statements as of and for thethree and nine month periods ended September 30, 2008.

 

*Non-Refundable Advance Payments for Goods orServices to Be Used in Future Research and Development Activities*

 

In June 2007, the EITF of the FASBreached a consensus on Issue No. 07-3, “Accounting for NonrefundableAdvance Payments for Goods or Services Received for Use in Future Research andDevelopment Activities” (EITF 07-3). EITF 07-3 requires thatnon-refundable advance payments for goods or services that will be used orrendered for future research and development

 

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activities should be deferred and capitalized. As the related goods aredelivered or the services are performed, or when the goods or services are nolonger expected to be provided, the deferred amounts would be recognized as anexpense. EITF 07-3 is effective for financial statements issued for fiscalyears beginning after December 15, 2007. Our adoption of EITF 07-3,which was effective January 1, 2008, did not have a material effect on ourconsolidated financial statements as of and for the three and nine monthperiods ended September 30, 2008.

 

*Business Combinations*

 

InDecember 2007, the FASB issued SFAS No. 141R (SFAS 141R), “Business Combinations, a revision to SFAS No. 141,Business Combinations”.  SFAS 141R provides revised guidancefor recognition and measurement of identifiable assets and goodwill acquired,liabilities assumed, and any noncontrolling interest in the acquiree at fairvalue.  The Statement also establishes disclosure requirements toenable the evaluation of the nature and financial effects of a businesscombination.  SFAS 141R is required to be applied prospectively tobusiness combinations for which the acquisition date is on or after thebeginning of the first annual reporting period beginning on or after December 15,2008 (January 1, 2009 forus).  We are currently evaluating the potential impact, ifany, of the adoption of SFAS 141R on our consolidated financial statements.

 

**Item 3. Quantitative andQualitative Disclosures about Market Risk**

 

Therecent decline in the market value of certain securities backed by residentialmortgage loans has led to a large liquidity crisis effecting the broader U.S.housing market, the financial services industry and global financial markets.Investors in many industry sectors have experienced substantial decreases in assetvaluations and uncertain market liquidity. Furthermore, credit ratingauthorities have, in many cases, been slow to respond to the rapid changes inthe underlying value of certain securities and pervasive market illiquidity ofthese securities.

 

Asa result, this “credit crisis” may have a potential impact on the determinationof the fair value of financial instruments or possibly require impairments inthe future should the value of certain investments suffer a decline in valuewhich is determined to be other than temporary. Our cash, cash equivalents andmarketable securities portfolio currently consists of United States treasurybills and money market funds. As such, we believe the impairment risk to ourportfolio is minimal.

 

Our exposure to market risks associated withchanges in interest rates relates primarily to the increase or decrease in theamount of interest income earned on our investment portfolio since ourborrowings used fixed interest rates. We ensure the safety and preservation ofinvested funds by limiting default risks, market risk and reinvestment risk. Wemitigate default risk by investing in investment grade securities primarilybacked by the United States Treasury.  Ahypothetical 100 basis point adverse move in interest rates along the entireinterest rate yield curve would not have materially affected the fair value ofour interest sensitive financial instruments at September 30, 2008.

 

We do not use derivative financialinstruments for trading or speculative purposes. However, we regularly makeinvestments in overnight repurchase agreements that are subject to changes inshort-term interest rates. We believe that the market risk arising from holdingthese financial instruments is minimal.

 

Our international revenue is generally denominatedin United States Dollars, therefore is not exposed to changes in foreigncurrency exchange rates. Additionally, certain of our preclinical and clinicaldevelopment contracts are denominated in foreign currencies. We believe thatthe foreign currency risk arising from these contracts to be minimal.

 

**Item 4. Controls andProcedures**

 

For the three months ended September 30, 2008, ourmanagement carried out an evaluation, under the supervision and with theparticipation of our Interim President and Chief Executive Officer and ourExecutive Vice President, Chief Financial Officer and Treasurer (our principalfinancial officer and chief accounting officer), of the effectiveness of ourdisclosure controls and procedures pursuant to Rules 13a-15 and 15d-15under the Securities Exchange Act of 1934, or the Exchange Act, as of the endof the period covered by this report. Based upon this evaluation, our InterimPresident and Chief Executive Officer and our Executive Vice President, ChiefFinancial Officer and Treasurer concluded that as of September 30, 2008, our disclosure controls andprocedures were effective to ensure that the information required to bedisclosed by us in reports filed under the Exchange Act was recorded,processed, summarized and reported within the time periods specified in the rules andforms of the SEC. Our management, including our Interim President and ChiefExecutive Officer and our Executive Vice President, Chief Financial Officer andTreasurer, does not expect that our disclosure controls or our internalcontrols will prevent all errors and all fraud. A control system, no matter howwell designed and operated, cannot provide assurance that the objectives of thecontrol system are met, and no evaluation of controls can provide absoluteassurance that all control issues and instances of fraud, if any, within acompany have been detected.

 

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Additionally, our Interim President and ChiefExecutive Officer and our Executive Vice President, Chief Financial Officer andTreasurer determined that there were no changes in our internal control overfinancial reporting during the three month period ended September 30, 2008 that havematerially affected, or are reasonably likely to materially affect, ourinternal control over financial reporting.

 

**PART II. OTHER INFORMATION**

 

**Item 1.****   ****Legal Proceedings**

 

OnOctober 10, 2008, we received notice that a putative class actioncomplaint was filed by Allen Heilman, one of our stockholders, against us andthe members of our Board of Directors in the Superior Court of New Jersey,Mercer County (Equity Division).  The complaint generally alleges that theBoard’s decision to enter into the Merger with Ligand, on the terms containedin the proposed Merger Agreement constitutes a breach of fiduciary duty andgives rise to other unspecified state law claims.  The complaint allegesthat the named plaintiff will seek “equitable relief,” including among otherthings, an order preliminarily and permanently enjoining the Merger.  Thecomplaint also names Ligand and two of its wholly-owned subsidiaries asdefendants.  We believe that the allegations in thecomplaint are without merit and intend to vigorously defend against thisaction.

 

**Item 1A.****            RiskFactors**

 

Our performanceand financial results are subject to risks and uncertainties, including, butnot limited to, the specific risks disclosed in Item 1A Risk Factors in ourAnnual Report on Form 10-K for the year ended December 31, 2007.Except as noted below, there have been no material changes to the risk factorsdisclosed in the Form 10-K.

 

**RISKS RELATED TO OUR BUSINESS AND INDUSTRY**

 

***If we are unable toconsummate the Merger with Ligand, we will be required to raise additionalcapital.  If we cannot raise suchcapital, or if we consume cash more quickly than expected, we will be forced tocurtail operations.***

 

As of September 30, 2008, we had cash,cash equivalents and marketable securities of approximately $33.4 million.In addition, as of September 30, 2008, we had deferred revenue ofapproximately $42.7 million relating to cash payments and licenses to certain product candidates that we havereceived under our alliances and license agreements in exchange for researchand development activities that are to be performed by us subsequent to September 30,2008.  Our obligations to perform theseresearch and development activities extend over multiple years and we expect thatwe will incur significant costs in fulfilling these obligations.  Our cash used in operating activities for thenine months ended September 30, 2008 was approximately $35.5 million,which includes $5.0 million in research funding we received from GSK.  Without this receipt of the $5.0 million fromGSK, our net cash used in operating activities would have been approximately$40.5 million during that period. Clinical and preclinical development of drugcandidates is a long, expensive and uncertain process that requires us to raisefunds from time to time to support our internal development programs.

 

If we do not consummate the Merger withLigand and we remain an independent company, to progress our internal development programs and to satisfy ourcommitments to our corporate partners and our other contractual obligations, wewill need to raise funds from one or a combination of approaches, which couldinclude public and/or private financing, sale and/or partnering of one or moreof our internal programs partnering of our internal drug discovery capabilitiesor other strategic initiatives.  Capitalcould be raised through public or private financings involving debt or commonstock or other classes of our equity. Additional issuances of equity securitieswill further dilute our existing stockholders’ percentage ownership.

 

Additional capital may not be available onfavorable terms, or at all. Despite active efforts, we were not able to secureappropriate financing to further the development of our business during theperiod from November 2007 through August 2008.  We have curtailed our operationssignificantly since the beginning of 2008, and we may further curtail ourcurrent operations, perhaps significantly. If adequate funds are not available, we may obtain funds by enteringinto arrangements with partners or others that may require us to relinquishrights to certain of our technologies, products or potential markets that wewould not otherwise relinquish.

 

We believe that our capital resources will beadequate to fund our operations at their current levels at least through June 30,2009.  We intend to manage ourexpenditures and our staffing in a manner consistent with our available capitalresources.  However, there can be noassurance that changes will not occur that would consume available capitalresources before then.

 

Examples of relevant potential changes thatcould impact our capital resources include:

 

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·                  thecosts associated with our drug research and development activities, includingthe costs associated with clinical development programs for our internalproduct candidates and additional costs we may incur if our developmentprograms are delayed or are more expensive to implement than we currentlyanticipate;

 

·                  changesin existing collaborative relationships, including the funding we receive inconnection with those relationships;

 

·                  theprogress of our milestone and royalty producing activities;

 

·                  acquisitionsof other businesses or technologies;

 

·                  thepurchase of additional capital equipment;

 

·                  cashrefunds we may be required to make to GSK if, prior to March 24, 2011, weexercise our discretionary termination right under the GSK Agreement;

 

·                  cashpayments we may be required to make to Schering-Plough relating to atermination fee if, prior to August 2010, we exercise our discretionarytermination right under the 2007 Schering-Plough Agreement;

 

·                  cashpayments we may be required to make to BMS if we fail to deliver certaincompound libraries under the license agreement for the DARA program;

 

·                  competingtechnological and market developments; and

 

·                  thecost of filing, prosecuting, defending and enforcing patent claims and otherintellectual property rights, and the outcome of related litigation.

 

Failure to earn additional research fundingand milestone payments under our current alliances and alliances we may seek toenter into after the end of the initial research term of our alliance withWyeth in December 2009 would have a material adverse effect on ourbusiness as it is currently conducted, our financial condition and our resultsof operations.  If we fail to earn adequate additional research andmilestone payments, we may be required to curtail operations significantly orto obtain funds by entering into arrangements with collaborative partners orothers that may require us to relinquish rights to certain of our technologies,products or potential markets that we would not otherwise relinquish.

 

As of November 3, 2008, there wereapproximately 4,041,000 stock options and 197,000 restricted stock unitsoutstanding granted under our various equity compensation plans andapproximately 1,626,000 warrants outstanding, which includes approximately 176,000warrants issued in connection with the GSK Agreement and approximately1,450,000 warrants issued in connection with our October 2006 financingtransaction. These equity instruments represent approximately 20% of our sharesoutstanding at November 3, 2008. The significant dilution represented byour outstanding warrants and equity compensation awards may make it moredifficult for us to raise additional capital.

 

***Because our mostadvanced internal clinical development program is only in Phase 2 clinical development,there is a high risk that further development and testing will demonstrate thatour internal clinical development programs are not  suitable for commercialization. In addition,because we exclusively licensed each of PS433540 and PS178990 from BMS, anydispute with BMS may adversely affect our ability to develop and commercializethose product candidates.***

 

We have no products that have received regulatory approval forcommercial sale. Our most advanced internal clinical development program is onlyin Phase 2 clinical development. We face the substantial risks of failureinherent in developing drugs based on new technologies.

 

Both PS433540 and PS178990 must satisfy rigorous standards of safetyand efficacy before the FDA and foreign regulatory authorities will approveeither product candidate for commercial use. In May 2008, we announcedthat Study 008 with PS433540 showed statistically significant blood pressurereductions in subjects with mild to moderate hypertension.  Further Phase 2 clinical trials withPS433540, however, may not demonstrate that it is safe or efficacious withrespect to diabetic nephropathy, the principal clinical indication for which weseek to develop it, or other clinical indications.  In addition, Phase 1 clinical trialswith PS178990 may not demonstrate that the product candidate is sufficientlysafe to warrant its continued development. We will need to conduct significantadditional clinical trials to demonstrate the safety and efficacy of PS433540and PS178990 to the satisfaction of the FDA and foreign regulatory authoritiesto obtain product approval.

 

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Clinical development is a long, expensive and uncertain process. It maytake us many years to complete clinical trials, and failure can occur at anystage of trials. Success in preclinical testing and early clinical trials doesnot ensure that later clinical trials will be successful. We may suffersignificant setbacks in advanced clinical trials, even after promising resultsin earlier trials. We may not be able to enroll a sufficient number of patientsto complete our clinical trials in a timely manner. Based on results at any stageof preclinical testing or clinical trials, we may decide to discontinuedevelopment of PS433540 and PS178990.

 

We do not know whether any future clinical trials of PS433540 orPS178990 will demonstrate sufficient safety and efficacy necessary to obtainthe requisite regulatory approvals or will result in marketable products. Ourfailure to adequately demonstrate the safety and efficacy of PS433540 orPS178990 in their respective development programs will prevent receipt of FDAand foreign regulatory approvals and, ultimately, commercialization.

 

If there is any dispute between us and BMS regarding our rights underthe DARA License Agreement, our ability to develop and commercialize PS433540may be adversely affected. Any loss of our rights from BMS could delay orcompletely terminate our product development efforts for PS433540 and otherDARA compounds licensed from BMS.

 

Similarly, if there is any dispute between us and BMS regarding ourrights under the SARM License Agreement and/or performance under the DiscoveryCollaboration Agreement, our ability to develop and commercialize PS178990 maybe adversely affected. Any loss of our rights from BMS could delay orcompletely terminate our product development efforts for PS178990 and otherSARM compounds licensed from BMS.

 

***Our development ofPS433540 may be adversely impacted if our clinical trials show certain adverseeffects reported by other companies in connection with clinical trials of theirERA and ARB product candidates.***

 

Abnormal liver function test (LFT) results, which are indicative ofpotential liver toxicity, have been reported by other companies ascomplications in their clinical trials of ERA product candidates. Approval ofPS433540 may be delayed or ultimately blocked by such concerns. If the resultsof any of our PS433540 clinical trials indicate abnormal LFTs, we may notreceive regulatory approval to market the product candidate and our productcandidate, if approved for marketing, may not be able to compete with otherproducts. There can be no assurance that the lack of LFT abnormalitiesexperienced with respect to PS433540 to date will be confirmed by subsequentclinical trial results.

 

As developed by other companies, ERAs have been teratogenic in animals.If approved for marketing, we assume that PS433450 will be subject to a blackbox warning regarding teratogenicity and therefore may not be able to competewith other products that do not have a similar warning.

 

Prior clinical trials by other companies have also indicated that theERA therapeutic class may cause peripheral edema (fluid retention) in somepatients. Consequently, we may not receive regulatory approval to marketPS433540, and PS433540, if approved for marketing, may not be able to competewith other products.

 

***Our development ofPS178990 may be adversely impacted if our clinical trials show certain adverseeffects reported in connection with testosterone and other anabolic steroids.***

 

Testosterone and other anabolic steroids may cause serious unwantedside effects, including liver toxicity, stimulation of prostate cancer growthin men and masculinization in women. Approval of PS178990 may be delayed orultimately blocked by such concerns. If the results of any of our PS178990clinical trials indicate such stimulation of prostate cancer growth, we may notreceive regulatory approval to market the product candidate and our productcandidate, if approved for marketing, may not be able to compete with otherproducts.

 

***We had net losses in recent years and ourfuture profitability is uncertain.***

 

During the nine months ended September 30,2008, we had a net loss of approximately $38.1 million. In addition, during theyear ended December 31, 2007, we had a net loss of approximately$47.9 million. The net losses for these periods was primarily due to costsincurred in our internal product development efforts, including the costs ofdeveloping PS433540, which is currently in Phase 2 clinical trials, andthe research and development of our other product candidates. The net loss forthe nine months ended September 30, 2008 included a restructuring chargeof approximately $4.9 million. The net loss for the year ended December 31,2007 included a non-cash charge of $9.2 million to proprietary researchand development expense related to the acquisition of our SARM program.

 

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We expect to incur losses in future periods.However, we intend to manage all of our expenditures in a manner consistentwith our available resources.  Despite activeefforts, we were not able to secure appropriate financing to further thedevelopment of our business during the period from November 2007 through August 2008.

 

Our adoption of SFAS 123R, which waseffective January 1, 2006, increased our compensation costs and willcontinue to have a significant impact on our results of operations. Inaddition, under EITF 00-19, the accounting treatment of the warrants that weissued in our October 2006 equity financing may have a significant impacton our results of operations, depending on the volatility of the market priceof our common stock and the assumptions used in calculating the fair value ofthe warrants.

 

On a quarterly basis, our future operatingresults are likely to be highly volatile depending upon our receipt, if any, ofmilestone payments from our collaborators. We may not receive milestonepayments on a regular basis or at all. Our ability to achieve profitability, ifever, will be significantly impacted by the level of investment we plan to makein our internal proprietary programs in the future, as well as the results ofthose programs.

 

Continuing net losses may limit our abilityto fund our operations and we may not generate income from operations in thefuture.

 

***If third parties donot manufacture PS433540 in sufficient quantities and at an acceptable cost,clinical development of PS433540 would be delayed.***

 

We do not currently own or operatemanufacturing facilities, and we rely, and expect to continue to rely, on thirdparties for the production of clinical quantities of our product candidates.Our current and anticipated future dependence upon others for the manufactureof our product candidates may adversely affect our future profit margins andour ability to develop product candidates and commercialize any productcandidates on a timely and competitive basis.

 

We have relied on third party vendors for themanufacture of clinical quantities of PS433540, and we are currently assessingour manufacturing needs for additional clinical trial supply of PS433540 as wereview our clinical strategy for PS433540. We will evaluate whether to continueto rely on the manufacturing capabilities of our current third party vendors orwhether some or all of the manufacturing process should be transferred to othercontract manufacturers as we plan for our additional clinical trials. If ourcurrent supply of PS433540 becomes unusable, if our PS433540 supply is notsufficient to complete our clinical trials, or if we are unsuccessful inidentifying a contract manufacturer or negotiating a manufacturing agreement ona timely basis and at an acceptable cost for our additional clinical trials, wecould experience a delay in receiving an adequate supply of PS433540.

 

We may not be able to maintain or renew ourexisting or any other third-party manufacturing arrangements on acceptableterms, if at all. Certain of our existing third-party manufacturingarrangements require the third party to grant consent to the transfer of thearrangements to Ligand in connection with the Merger.  If we are unable to continue manufacturingrelationships for PS433540, or to do so at an acceptable cost, or if thirdparties fail to grant such consents, or if these or other suppliers fail tomeet our requirements for PS433540 for any reason, we would be required toobtain alternate suppliers. Any inability to obtain alternate suppliers,including an inability to obtain approval from the FDA of an alternatesupplier, would delay or prevent the clinical development of PS433540.

 

***Failure to attract and retainskilled personnel, including a permanent chief executive officer in the eventthat we do not consummate our merger transaction with Ligand, could materiallyand adversely affect us.***

 

Weare a small company, and our success depends in part on the continued serviceof key management and scientific personnel and our ability to identify, hireand retain additional personnel.  Ourformer president and chief executive officer resigned effective April 9,2008.  Prior to the announcement of theMerger, we had been engaged in a search for his successor.  The Chairman of our Board of Directors iscurrently serving as our Interim President and Chief Executive Officer.  In the event that we do not consummate theMerger, our subsequent failure to identify and hire a permanent successor toour former president and chief executive officer could have a material adverseeffect on our business, financial condition and results of operations.

 

Thereis intense competition for qualified personnel. Immigration laws may further restrict our ability to attract or hirequalified personnel. We may not be able to continue to attract and retain thepersonnel necessary for our growth and development. Further, we are highlydependent on the principal members of our scientific and management staff. Oneor more of these key employees could leave our employ within the foreseeablefuture and the loss of any of these people could have a material adverse effecton our business, financial condition and results of operations. We do not, anddo not intend to, maintain key person life insurance on the life of anyemployee.

 

***The number of shares and the valueof Ligand common stock that our stockholders will receive in connection withthe Merger will fluctuate.***

 

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Thenumber of shares and precise value of the merger consideration to be receivedby our stockholders at the effective time of the Merger cannot be determined atthe present time. The exchange ratio, which determines the number of shares ofLigand common stock that our stockholders will receive in connection with theMerger, will not be determined until shortly before the special meeting of ourstockholders.  Upon the terms of theMerger Agreement, Ligand would issue approximately 0.58 of a share for eachshare of our common stock outstanding immediately prior to the effective timeof the Merger, subject to certain adjustments for cancelled stock options.However, this exchange ratio is fixed only if the Ligand Common Stock Valuefalls within the range between $3.00 and $3.75. Otherwise, the following willapply:

 

· if the LigandCommon Stock Value is greater than $3.75 but not greater than $4.50, theoverall transaction value will be fixed at $66.0 million, and the exchangeratio will decrease as prices increase within the range;

 

· if the LigandCommon Stock Value is greater than $4.50, then the exchange ratio will be approximately0.49;

 

· if the LigandCommon Stock Value is equal to or greater than $2.38 but less than $3.00, thenthe exchange ratio will increase as prices decrease within the range (providedthat if the Ligand Common Stock Value is less than $2.93, the exchange ratiowill be approximately 0.60), subject to specified limitations in the MergerAgreement. Under this scenario, in addition to receiving shares of Ligandcommon stock, our stockholders will be entitled to receive cash considerationfor an overall transaction value fixed at $52.8 million; or

 

· if the LigandCommon Stock Value is less than $2.38, then the exchange ratio will beapproximately 0.60. Under this scenario, in addition to receiving shares ofLigand common stock, our stockholders will be entitled to receive aproportionate share of $10.0 million in cash. The price of Ligand common stockat the closing of the Merger may vary from its price on the date the MergerAgreement was executed and on the date of the special meeting of ourstockholders. Stock price changes may result from a variety of factors beyondLigand’s control, including general economic and market conditions. Inaddition, there will be a period of time between completion of the Merger andthe time at which our former stockholders actually receive stock certificatesevidencing the Ligand common stock. Until stock certificates are received, our formerstockholders may not be able to sell their Ligand shares in the open marketand, therefore, may not be able to avoid losses from any decrease in thetrading price of Ligand common stock during that period.

 

***If a certain trigger event does not occur, no payments will be madeunder the CVRs or, even if this event occurs, Ligand may not be able to makethe cash payments payable pursuant to the CVRs.***

*** ***

Pursuant to the terms of theMerger Agreement, the CVRs provide our former stockholders and certain securityholders with the right to receive an aggregate $15.0 million cash payment ifLigand enters into a license, sale, development, marketing or option agreementwith respect to any product candidate from our DARA program (other than anyagreement with BMS or any of its affiliates) on or prior to December 31,2011.

 

The trigger event for thecontingent payment may not occur due to numerous factors. If this event is notachieved within the required timeframe, the CVRs will expire and no paymentswill be made in connection with the CVRs. Accordingly, the CVRs may ultimatelyhave no value. The CVRs are not transferable other than in certain limitedcircumstances and accordingly you may not sell them prior to their termination.Following the consummation of the Merger, Ligand has informed us that itintends to review the DARA program to determine what financial commitments, ifany, will be made with respect to such program. Ligand has also informed us that it intends to solicit and consider theinterests of potential collaborators and/or partners with respect to anyinvestment by such parties in the DARA program. Ligand has informed us that itdoes not intend to make any investment in the DARA program unless its review ofthe DARA program demonstrates that such investment is likely to increase Ligandstockholder value. Under the terms of the CVR agreement,  Ligand has sole discretion and decisionmaking authority over whether to continue to invest in the DARA program, howmuch to invest in the DARA program and whether and on what terms, if any, toenter into any license, sale, development, marketing or option agreement withrespect to DARA.  Accordingly, Ligand maydecide not to make any investment in the DARA program and may decide not topursue partnering discussions. In addition, the CVRs are unsecured obligationsof Ligand and the necessary funds for the CVR payments have not been placed inan escrow account. Even if the trigger event occurs, at the time the aggregate$15.0 million cash payment is due pursuant to the CVR Agreement, Ligand may nothave available enough cash or cash equivalents to make the aggregate cashpayment due pursuant to the CVRs. Any rights or claims by the CVR holders relatingthereto would be subordinated in the right of payment to the prior payment infull of any senior or secured Ligand obligations.

 

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***Uncertainty regarding the Merger and the effects of the Merger couldcause each company’s licensors, collaborators, suppliers or other strategicpartners to delay or defer decisions, which could increase costs of our and/orLigand’s ongoing business.***

 

Ligand’s and our strategyfor developing and commercializing many of their potential products includesentering into agreements with licensors, collaborators, suppliers and otherstrategic partners. These partners, in response to the announcement of theMerger, may delay or defer decisions regarding their business relationshipswith each company, which could increase costs for the business of the subjectcompany and delay, interrupt or terminate the collaborate research, developmentand commercialization of certain potential products, regardless of whether theMerger is ultimately completed. Under specified circumstances, these partnersmay also terminate their agreements with each company. Any such delay,interruption or termination of the combined company’s relationship with any ofthese partners could materially harm the combined company’s business andfinancial condition, and frustrate any commercialization efforts for itsproduct candidates.

 

***The Merger is subject to closing conditions that could result in thecompletion of the Merger being delayed or not consummated, which couldnegatively impact Ligand’s and/or our stock price and future business andoperations.***

 

Completion of the Merger isconditioned upon Ligand and our satisfying closing conditions, includingadoption of the Merger Agreement by our stockholders, all as set forth in theMerger Agreement.  The requiredconditions to closing may not be satisfied in a timely manner, if at all, or,if permissible, waived, and the Merger may not be consummated. Failure toconsummate the Merger could negatively impact Ligand’s and/or our stock price,future business and operations, and financial condition. Any delay in theconsummation of the Merger or any uncertainty about the consummation of theMerger may adversely affect the future business, growth, revenue and results ofoperations of either or both of the companies.

 

***Failure to complete the Merger could negatively impact the market priceof our common stock and our future business and financial results.***

 

If the Merger is notcompleted for any reason, the our ongoing business and that of Ligand may beadversely affected and will be subject to a number of risks, including:

 

· we may be required, under somecircumstances, to pay Ligand a termination fee of approximately $3.4 million orreimburse Ligand for up to $1.4 million of merger-related expenses;

 

· the diversion of management’s attention, thereduction in capital spending and acquisitions, the suspension of plannedhiring and other affirmative and negative covenants in the Merger Agreementrestricting the companies’ businesses;

 

· failure to pursue other beneficialopportunities as a result of the focus of management of each of the companieson the mergers, without realizing any of the anticipated benefits of theMerger;

 

· the market price our common stock maydecline to the extent that the current market price reflects a marketassumption that the Merger will be completed;

 

· we may experience negative reactions to thetermination of the Merger from licensors, collaborators, suppliers, or otherstrategic partners;

 

· our costs incurred related to the Merger,such as legal and accounting fees, must be paid even if the Merger is notcompleted; and

 

· our common stock may be subject to delistingfrom Nasdaq. 

 

If the Merger Agreement isterminated and Pharmacopeia’s board of directors seeks another merger orbusiness combination, Pharmacopeia stockholders cannot be certain thatPharmacopeia will be able to find a party willing to pay a price equivalent toor more attractive than the price Ligand has agreed to pay in the Merger.Despite active efforts, Pharmacopeia was not able to secure appropriatefinancing to further the development of its business during the period from November 2007through August 2008.

 

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***During the pendency of the Merger, we may not be able to enter intocertain business combinations with other parties because of restrictions in theMerger Agreement.***

*** ***

Covenants in the MergerAgreement impede our ability to make certain acquisitions or complete othertransactions that are not, among other things, in the ordinary course ofbusiness pending completion of the Merger. As a result, if the mergers are notcompleted, we may be at a disadvantage to its competitors.

 

***The Merger Agreement limits our ability to pursue alternatives to theMerger.***

*** ***

The Merger Agreementcontains ‘‘no shop’’ provisions that, subject to limited exceptions, precludeus, whether directly or indirectly through its subsidiaries, officers,directors, agents or other representatives, from soliciting, initiating,knowingly facilitating, encouraging or inducing, any inquiry with respect to,or the making, submission or announcement of, any acquisition proposal,participating in any discussions or negotiations, or furnishing any nonpublicinformation with respect to any acquisition proposal, or taking any otheraction to facilitate any inquiries or proposal that would be reasonablyexpected to result in an acquisition proposal, approving, endorsing orrecommending any acquisition proposal, or entering into any agreementcontemplating or otherwise relating to any acquisition proposal. Under certaincircumstances, the Merger Agreement also provides that we will be required toreimburse Ligand for up to $1.4 million of merger-related expenses or pay atermination fee of approximately $3.4 million to Ligand upon termination of theMerger Agreement. These provisions might discourage a potential competingacquirer that might have an interest in acquiring all or a significant part ofus from considering or proposing an acquisition even if it were prepared to payconsideration with a higher per share market price than that proposed in theMerger, or might result in a potential competing acquirer proposing to pay alower per share price to acquire Pharmacopeia than it might otherwise haveproposed to pay.

 

***The United States federal income tax treatment of the CVRs is unclear.***

 

There is substantialuncertainty as to the tax treatment of the CVRs. The receipt of the CVRs aspart of the Merger consideration may be treated as a ‘‘closed transaction’’ oran ‘‘open transaction’’ for United States federal income tax purposes, whichaffects the amount of gain, if any, that may be recognized at the time ofconsummation of the Merger.

 

***We and Ligand have each been named in a putative class action lawsuitthat could prevent or delay the completion of the Merger.***

 

On October 10, 2008,the Company received notice that a putative class action complaint was filed inthe Superior Court of New Jersey, Mercer County (Equity Division) by Allen Heilman,one of the our stockholders, against us, the members of our board of directors,Ligand, Merger Sub 1 and Merger Sub 2. The complaint generally alleges that theboard of directors’ decision to enter into the proposed transaction with Ligandon the terms contained in the Merger Agreement constitutes a breach offiduciary duty and gives rise to other unspecified state law claims. Thecomplaint also alleges that Ligand, Merger Sub 1 and Merger Sub 2 aided andabetted our board of directors’ breach of fiduciary duty. In addition, thecomplaint alleges that the named plaintiff will seek ‘‘equitable relief,’’including among other things, an order preliminarily and permanently enjoiningthe proposed transaction. Although we will vigorously defend against thelawsuit, neither we nor Ligand  canprovide any assurances as to the outcome of the foregoing legal proceeding andits potential effect on the completion of the Merger.  The defense of this or any future legalproceeding could divert management’s attention and resources from the needs oftheir respective businesses. Either we or Ligand or both of us may be requiredto make substantial payments or incur other adverse effects in the event ofadverse judgments or settlements of any such proceedings.

 

**Item 2.  UnregisteredSales of Equity Securities and Use of Proceeds**

 

**None.**

** **

**Item 3.  ****Defaults upon Senior Securities**

 

None.

 

**Item 4.  Submission ofMatters to a Vote of Security Holders**

 

None.

 

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**Item 5.****  ****Other Information**

 

None.

 

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**Item 6.  Exhibits**

 
| **Exhibits.** | ** ** | ** **                                                                                                                                                                                                                                                                        |
|---------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| ** **    | ** ** | ** **                                                                                                                                                                                                                                                                        |
| 31.1          |       | Certification of the Principal Executive Officer of  Pharmacopeia, Inc. pursuant to Rule 13a-l4(a) of the  Securities Exchange Act of 1934, as amended, as adopted pursuant to  Section 302 of the Sarbanes-Oxley Act of 2002(1)                              |
|          |       |                                                                                                                                                                                                                                                                              |
| 31.2          |       | Certification of the Principal Financial Officer and Chief Accounting  Officer of Pharmacopeia, Inc. pursuant to Rule 13a-14(a) of  the Securities Exchange Act of 1934, as amended, as adopted pursuant to  Section 302 of the Sarbanes-Oxley Act of 2002(1) |
|          |       |                                                                                                                                                                                                                                                                              |
| 32.1          |       | Certification of the Principal Executive Officer of  Pharmacopeia, Inc. pursuant to 18 U.S.C. Section 1350, as adopted  pursuant to Section 906 of the Sarbanes-Oxley Act of 2002(1)                                                                               |
|          |       |                                                                                                                                                                                                                                                                              |
| 32.2          |       | Certification of the Principal Financial Officer and Chief Accounting  Officer of Pharmacopeia, Inc. pursuant to 18 U.S.C. Section 1350,  as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002(1)                                                  |

 

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(1)            Filedherewith.

 

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**SIGNATURES**

 

Pursuantto the requirements of the Securities Exchange Act of 1934, the registrant hasduly caused this report to be signed on its behalf by the undersigned,thereunto duly authorized.

 
|                                         |   | PHARMACOPEIA, INC. |
|-----------------------------------------|--------|--------------------|
|                                    |   |               |
| Date:  November 6,  2008 |   | By:                | /s/ Joseph A. Mollica,  Ph.D. |
|                                    |   |               | Joseph A. Mollica,  Ph.D. |
|                                    |   |               | Chairman of the Board  and Interim President  and Chief Executive Officer |
|                                    |   |               |   |
|                                    |   |               | (Principal Executive  Officer) |
|                                    |   |               |   |
|                                    |   | By:                | /s/ Brian M. Posner |
|                                    |   |               | Brian M. Posner |
|                                    |   |               | Executive Vice  President, |
|                                    |   |               | Chief Financial Officer  and Treasurer |
|                                    |   |               | (Principal Financial  Officer and Chief  Accounting Officer) |

 

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**PHARMACOPEIA,INC.**

 

**INDEX TOEXHIBITS**

 
| **Exhibits.** | ** ** | ** **                                                                                                                                                                                                                                                                        |
|---------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|          |       |                                                                                                                                                                                                                                                                              |
| 31.1          |       | Certification of the Principal Executive Officer of  Pharmacopeia, Inc. pursuant to Rule 13a-l4(a) of the  Securities Exchange Act of 1934, as amended, as adopted pursuant to  Section 302 of the Sarbanes-Oxley Act of 2002(1)                              |
|          |       |                                                                                                                                                                                                                                                                              |
| 31.2          |       | Certification of the Principal Financial Officer and Chief Accounting  Officer of Pharmacopeia, Inc. pursuant to Rule 13a-14(a) of  the Securities Exchange Act of 1934, as amended, as adopted pursuant to  Section 302 of the Sarbanes-Oxley Act of 2002(1) |
|          |       |                                                                                                                                                                                                                                                                              |
| 32.1          |       | Certification of the Principal Executive Officer of  Pharmacopeia, Inc. pursuant to 18 U.S.C. Section 1350, as adopted  pursuant to Section 906 of the Sarbanes-Oxley Act of 2002(1)                                                                               |
|          |       |                                                                                                                                                                                                                                                                              |
| 32.2          |       | Certification of the Principal Financial Officer and Chief Accounting  Officer of Pharmacopeia, Inc. pursuant to 18 U.S.C. Section 1350,  as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002(1)                                                  |

 

----

(1)            Filed herewith.

 

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