**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

**FORM 1O-Q**

 

**(Mark One)**
| **ý** | **QUARTERLY  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE  ACT OF 1934** |
|------------|---------------------------------------------------------------------------------------------------------|

 

**For the quarterly period ended September 30, 2005**

 

**Or**

 
| **o** | **TRANSITION  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE  ACT OF 1934** |
|-------|----------------------------------------------------------------------------------------------------------|

 

Commission File Number:**0-50523**

 

**PHARMACOPEIADRUG DISCOVERY, INC.**

(Exact name of registrant as specified 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)

 

**Not Applicable**

(Former name, former address and former fiscal year, if changed sincelast report)

 

Indicateby check mark whether the registrant (1) has filed all reports required tobe filed by Section 13 or 15(d) of the Securities Exchange Act of1934 during the preceding 12 months (or such shorter period that the registrantwas required to file such reports) and (2) has been subject to such filingrequirements for the past 90 days.    Yes ý     Noo

 

Indicateby check mark whether the registrant is an accelerated filer (as defined inRule 12b-2 of the Exchange Act).

Yeso    No ý

Indicateby check mark whether the registrant is a shell company (as defined in Rule12b-2 of the Exchange Act).

Yeso    No ý

 

Indicatethe number of shares outstanding of each of the issuer’s classes of commonstock, as of the latest practicable date:

 
| **Class**                     | ** ** | **Outstanding at November 1, 2005** |
|-------------------------------|------------|-------------------------------------|
| Common Stock, $0.01 par value |       | 14,970,996                          |

 

 

----

 

**PHARMACOPEIA DRUG DISCOVERY, INC.**

 

**Form 10-Q**

 

**Table of Contents**

 
| **Item**          | ** **                                                                                     | ** ** | ** ** |
|-------------------|------------------------------------------------------------------------------------------------|------------|------------|
|              |                                                                                           |       |       |
| PART I.      | FINANCIAL INFORMATION                                                                          | 3          |       |
|              |                                                                                           |       |       |
| Item 1.           | Financial Statements (Unaudited):                                                              | 3          |       |
|              |                                                                                           |       |       |
|              | Balance Sheets as of September 30,  2005 and December 31, 2004                       | 3          |       |
|              |                                                                                           |       |       |
|              | Statements of Operations for the Three and  Nine Months Ended September 30, 2005 and 2004 | 4          |       |
|              |                                                                                           |       |       |
|              | Statements of Cash Flows for the Nine  Months Ended September 30, 2005 and 2004           | 5          |       |
|              |                                                                                           |       |       |
|              | Notes to Unaudited Financial Statements                                                        | 6          |       |
|              |                                                                                           |       |       |
| Item 2.           | Management’s Discussion and Analysis of  Financial Condition and Results of Operations    | 10         |       |
|              |                                                                                           |       |       |
|              | Certain Risks Related to Our Business                                                          | 19         |       |
|              |                                                                                           |       |       |
| Item 3.           | Quantitative and Qualitative Disclosures  about Market Risk                                    | 30         |       |
|              |                                                                                           |       |       |
| Item 4.           | Controls and Procedures                                                                        | 31         |       |
|              |                                                                                           |       |       |
| PART II.     | OTHER INFORMATION                                                                              | 31         |       |
|              |                                                                                           |       |       |
| Item 1.           | Legal Proceedings                                                                              | 31         |       |
|              |                                                                                           |       |       |
| Item 2.           | Unregistered Sales of Equity Securities and  Use of Proceeds                                   | 31         |       |
|              |                                                                                           |       |       |
| Item 3.           | Defaults upon Senior Securities                                                                | 31         |       |
|              |                                                                                           |       |       |
| Item 4.           | Submission of Matters to a Vote of Security  Holders                                           | 31         |       |
|              |                                                                                           |       |       |
| Item 5.           | Other Information                                                                              | 32         |       |
|              |                                                                                           |       |       |
| Item 6.           | Exhibits                                                                                       | 33         |       |
|              |                                                                                           |       |       |
| Signatures        |                                                                                           | 34         |       |
|              |                                                                                           |       |       |
| Index of Exhibits | 35                                                                                             |       |

 

2

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**PART I- FINANCIAL INFORMATION**

 

**Item1.  Unaudited FinancialStatements**

 

**PharmacopeiaDrug Discovery, Inc.**

**Balance Sheets**

**(Amounts inthousands, except share and per share data)**

 
| ** **                                                                                                                          | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------|------------|------------------|------------|
| ** **                                                                                                                          | ** ** | **2005**          | ** ** | **2004**         | ** ** |
| ** **                                                                                                                          | ** ** | **(unaudited)**   | ** ** | ** **       | ** ** |
| **ASSETS**                                                                                                                          | ** ** | ** **        | ** ** | ** **       | ** ** |
| Current  assets:                                                                                                                    | ** ** | ** **        | ** ** | ** **       | ** ** |
| Cash and cash equivalents                                                                                                           |       | $                 | 14,334     |             | $          | 20,173 |   |
| Marketable securities                                                                                                               |       | 20,677            |       | 20,712           |       |
| Accounts receivable                                                                                                                 |       | 740               |       | 1,062            |       |
| Prepaid expenses and other current assets                                                                                           |       | 749               |       | 1,062            |       |
| Total current assets                                                                                                                |       | 36,500            |       | 43,009           |       |
|                                                                                                                                |       |              |       |             |       |
| Property and  equipment, net                                                                                                        |       | 10,941            |       | 11,725           |       |
| Deferred  compensation assets due from Accelrys, Inc.                                                                               |       | —            |       | 2,140            |       |
| Deferred  compensation plan                                                                                                         |       | 2,163             |       | —           |       |
| Other assets                                                                                                                        |       | 173               |       | 131              |       |
| Total assets                                                                                                                        |       | $                 | 49,777     |             | $          | 57,005 |   |
|                                                                                                                                |       |              |       |             |       |
| **LIABILITIES  AND STOCKHOLDERS' EQUITY**                                                                                           |       |              |       |             |       |
| Current  liabilities:                                                                                                               |       |              |       |             |       |
| Accounts payable                                                                                                                    |       | $                 | 1,641      |             | $          | 1,414 |   |
| Accrued liabilities                                                                                                                 |       | 2,824             |       | 2,874            |       |
| Restructuring reserve, current portion                                                                                              |       | 1,506             |       | 2,462            |       |
| Deferred revenue, current portion                                                                                                   |       | 3,537             |       | 3,501            |       |
| Total current liabilities                                                                                                           |       | 9,508             |       | 10,251           |       |
|                                                                                                                                |       |              |       |             |       |
| Deferred  compensation plan                                                                                                         |       | 2,163             |       | 2,140            |       |
| Restructuring  reserve, long-term                                                                                                   |       | —            |       | 906              |       |
|                                                                                                                                |       |              |       |             |       |
| Commitments  and contingencies                                                                                                      |       | —            |       | —           |       |
|                                                                                                                                |       |              |       |             |       |
| Stockholders'  equity:                                                                                                              |       |              |       |             |       |
| Preferred stock, $.01 par value, 2,500,000  shares authorized, none issued and outstanding                                          |       | —            |       | —           |       |
| Common stock, $.01 par value, 50,000,000  shares authorized, 14,962,668 and 12,354,695 shares issued and outstanding,  respectively |       | 150               |       | 123              |       |
| Additional paid-in capital                                                                                                          |       | 58,634            |       | 50,263           |       |
| Accumulated deficit                                                                                                                 |       | (20,322           | )          | (6,235           | )          |
| Accumulated other comprehensive loss                                                                                                |       | (189              | )          | (175             | )          |
| Deferred compensation                                                                                                               |       | (167              | )          | (268             | )          |
| Total stockholders' equity                                                                                                          |       | 38,106            |       | 43,708           |       |
| Total liabilities and stockholders' equity                                                                                          |       | $                 | 49,777     |             | $          | 57,005 |   |

 

Seeaccompanying notes to these unaudited financial statements.

 

3

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**PharmacopeiaDrug Discovery, Inc.**

**Statements of Operations**

**(Amounts inthousands, except share and per share data)**

 
| ** **                                            | ** ** | **For the Three Months** | ** ** | **For the Nine Months** | ** ** |
|-------------------------------------------------------|------------|--------------------------|------------|-------------------------|------------|
| ** **                                            | ** ** | **Ended September 30,**  | ** ** | **Ended September 30,** | ** ** |
| ** **                                            | ** ** | **2005**                 | ** ** | **2004**                | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                            | ** ** | **(unaudited)**          | ** ** | **(unaudited)**         | ** ** |
| Net revenue                                           |       | $                        | 3,908      |                    | $          | 6,376 |   | $ | 14,830 |   | $ | 16,852 |   |
|                                                  |       |                     |       |                    |       |   |   |   |   |
| Collaborative research and development  expense       |       | 4,145                    |       | 5,244                   |       | 14,387 |   | 15,779 |   |
| Proprietary research and development  expense         |       | 2,730                    |       | 1,551                   |       | 7,426 |   | 4,325 |   |
| Sales, general and administrative expense             |       | 2,038                    |       | 2,618                   |       | 7,864 |   | 7,281 |   |
| Restructuring and other charges                       |       | —                   |       | —                  |       | — |   | 5,947 |   |
| Interest and other income, net                        |       | (275                     | )          | (166                    | )          | (781 | ) | (225 | ) |
|                                                  |       | 8,638                    |       | 9,247                   |       | 28,896 |   | 33,107 |   |
| Loss before  income taxes                             |       | (4,730                   | )          | (2,871                  | )          | (14,066 | ) | (16,255 | ) |
| Provision for income taxes                            |       | 7                        |       | 25                      |       | 21 |   | 38 |   |
| Net loss                                              |       | $                        | (4,737     | )                       | $          | (2,896 | ) | $ | (14,087 | ) | $ | (16,293 | ) |
|                                                  |       |                     |       |                    |       |   |   |   |   |
| Net loss per  share:                                  |       |                     |       |                    |       |   |   |   |   |
| - Basic and diluted                                   |       | $                        | (0.33      | )                       | $          | (0.24 | ) | $ | (1.08 | ) | $ | (1.34 | ) |
|                                                  |       |                     |       |                    |       |   |   |   |   |
| Weighted  average number of common stock outstanding: |       |                     |       |                    |       |   |   |   |   |
| - Basic and diluted                                   |       | 14,264,615               |       | 12,220,495              |       | 13,023,929 |   | 12,185,379 |   |

 

Seeaccompanying notes to these unaudited financial statements.

 

4

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**PharmacopeiaDrug Discovery, Inc.**

**Statementsof Cash Flows**

**(Amounts inthousands)**

 
| ** **                                                                  | ** ** | **For the Nine Months** | ** ** |
|-----------------------------------------------------------------------------|------------|-------------------------|------------|
| ** **                                                                  | ** ** | **Ended September 30,** | ** ** |
| ** **                                                                  | ** ** | **2005**                | ** ** | **2004** | ** ** |
| ** **                                                                  | ** ** | **(unaudited)**         | ** ** |
| CASH FLOWS  FROM OPERATING ACTIVITIES:                                      | ** ** | ** **              | ** ** | ** ** | ** ** |
| ** **                                                                  | ** ** | ** **              | ** ** | ** ** | ** ** |
| Net loss                                                                    |       | $                       | (14,087    | ) | $ | (16,293 | ) |
| Adjustments to reconcile net loss to net  cash used in operating activities |       |                    |       |   |   |
| Depreciation and amortization                                               |       | 1,712                   |       | 1,312 |   |
| Contribution of stock to 401(k) Plan                                        |       | 299                     |       | 148 |   |
| Amortization of deferred compensation                                       |       | 90                      |       | 60 |   |
| Accelerated vesting of options                                              |       | 191                     |       | — |   |
| Changes in assets and liabilities:                                          |       |                    |       |   |   |
| Accounts receivable                                                         |       | 322                     |       | 482 |   |
| Prepaid expenses and other current assets                                   |       | 313                     |       | 272 |   |
| Other assets                                                                |       | (42                     | )          | 9 |   |
| Accounts payable                                                            |       | 227                     |       | (1,567 | ) |
| Accrued liabilities                                                         |       | (50                     | )          | 1,552 |   |
| Restructuring reserve                                                       |       | (1,862                  | )          | 4,400 |   |
| Deferred revenue                                                            |       | 36                      |       | (234 | ) |
| Net cash used in operating activities                                       |       | (12,851                 | )          | (9,859 | ) |
| CASH FLOWS  FROM INVESTING ACTIVITIES:                                      |       |                    |       |   |   |
| Capital expenditures, net                                                   |       | (928                    | )          | (6,041 | ) |
| Purchases of marketable securities                                          |       | (10,536                 | )          | (16,132 | ) |
| Proceeds from sales/maturities of  marketable securities                    |       | 10,557                  |       | 30,859 |   |
| Net cash (used in) provided by investing  activities                        |       | (907                    | )          | 8,686 |   |
| CASH FLOWS  FROM FINANCING ACTIVITIES:                                      |       |                    |       |   |   |
| Proceeds from issuance of common stock                                      |       | 7,872                   |       | 286 |   |
| Investment by Accelrys, Inc.                                                |       | 47                      |       | 13,984 |   |
| Net cash provided by financing activities                                   |       | 7,919                   |       | 14,270 |   |
| Net  (decrease) increase in cash and equivalents                            |       | (5,839                  | )          | 13,097 |   |
| Cash and  equivalents, beginning of period                                  |       | 20,173                  |       | 524 |   |
| Cash and  equivalents, end of period                                        |       | $                       | 14,334     |   | $ | 13,621 |   |

 

Included in the capital contribution byAccelrys upon distribution on April 30, 2004 was $41,652 of marketablesecurities.

 

Seeaccompanying notes to these unaudited financial statements.

 

5

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**PharmacopeiaDrug Discovery, Inc.**

**Notes to UnauditedFinancial Statements**

 

**1.  Background and Basis of Presentation**

 

Pharmacopeia DrugDiscovery, Inc. (“Pharmacopeia” or the “Company”) was incorporated onMay 31, 2002 as a wholly owned subsidiary of Accelrys, Inc. (“Accelrys”),formerly Pharmacopeia, Inc.  OnApril 30, 2004 (“the distribution date”), Accelrys spun-off 100 percent ofthe shares of Pharmacopeia in a pro rata tax-free distribution and distributedto its stockholders of record one share of Pharmacopeia common stock for everytwo shares of Accelrys common stock held. A total of 12,181,471 shares were distributed.

 

Accelrys contributed cash, cash equivalentsand marketable securities to Pharmacopeiasuch that upon consummation of the distribution on April 30, 2004,Pharmacopeia had a cash, cash equivalents and marketable securities balanceaggregating $46.5 million and all inter-company balances due to Accelrys wereforgiven in their entirety by Accelrys and treated as a capital contribution;accordingly, such balances were reflected as investment by Accelrys for periodsprior to April 30, 2004, at which time the amount was reclassified toadditional paid-in capital.  Earnings andlosses accumulate in retained earnings (deficit) starting May 1, 2004.

 

Pharmacopeia creates and deliverstherapeutics to address significant medical needs.  Using proprietary technologies and processes,Pharmacopeia identifies, optimizes, and develops novel drug candidates throughits own internally funded drug discovery programs and in collaboration withmajor pharmaceutical and biotechnology companies.  Pharmacopeia’s collaborative research effortshave resulted in a portfolio of four partnered programs that have been advancedinto human clinical trials, with additional programs in late-stage pre-clinicaldevelopment.  Pharmacopeia currently hasfour internal programs in advanced discovery in addition to multiple partneredprograms in discovery.

 

For periods prior to thedistribution date, Pharmacopeia’s financial statements were derived from thefinancial statements and accounting records of Accelrys using the historicalresults of operations and historical basis of the assets and liabilities of theCompany’s business.  For periods prior tothe distribution date, such financial statements included allocations ofcertain Accelrys corporate headquarter assets, liabilities and expensesrelating to the Company’s business that have been transferred to the Companyfrom Accelrys.  General corporateoverhead was allocated based on the Company’s revenue as a percentage ofAccelrys total revenue.  Generalcorporate overhead primarily includes salaries and expenses for executivemanagement, finance, legal, human resources, information services and investorrelations, and was $668 thousand for the nine months ended September 30,2004.  These costs are included in sales,general and administrative expenses in the accompanying statements ofoperations.  Management believes theassumptions underlying such financial statements are reasonable.  The financial statements included herein thatinclude periods prior to the distribution date may not necessarily reflect theCompany’s results of operations, financial position and cash flows in thefuture or what its results of operations, financial position and cash flowswould have been had the Company been a stand-alone company during the periodspresented.

 

The accompanying unauditedfinancial statements have been prepared in accordance with U. S. generallyaccepted accounting principles for interim financial information and withinstructions to Form 10-Q and Article 10 of Regulation S-X.  Accordingly, these unaudited financialstatements do not include all of the information and disclosures required by U.S. generally accepted accounting principles for complete financialstatements.  In the opinion ofmanagement, all adjustments (consisting of normal recurring accruals)considered necessary for a fair presentation of the financial statements havebeen included.  Interim results are notnecessarily indicative of the results that may be expected for the year.  The unaudited interim financial statementsshould be read in conjunction with the financial statements and notes theretoincluded in the Company’s Annual Report on Form 10-K for the year endedDecember 31, 2004.

 

6

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**2.Significant Collaborations**

 

For the quarters endedSeptember 30, 2005 and 2004, the Company’s research collaborations withSchering-Plough accounted for 51% and 61%, respectively, of revenue.  For the nine months ended September 30,2005 and 2004, the Company’s research collaborations with Schering-Ploughaccounted for 55% and 62%, respectively, of revenue.  In the third quarter of 2003, the Companyentered into new drug discovery collaborations with Schering-Plough, whichcontinued certain existing programs and implemented a number of newactivities.  The 2003 agreements continuethe Company’s collaboration with Schering-Plough through August 2006.  Under the 2003 agreements the Company receives researchfunding which is recognized as revenue as services are performed.  Schering-Ploughwas obligated to fund a specified number of full-time employees (“FTEs”) in thefirst year of the agreement. Subsequently, Schering-Plough decided to focus on optimization programsand terminated the Company’s screening activities on Schering-Plough’sbehalf.  This decision resulted in anapproximately 11% reduction of the number of the FTEs that Schering-Plough wasobligated to fund.  Schering-Ploughreduced its FTE funding by an additional 41% (or approximately $1.1 million percalendar quarter) effective August 2005. The Company may receive milestone payments upon thesuccessful achievement of preclinical and clinical milestones.  Milestone payments will be recognized asrevenue to the extent that milestones are achieved. In the event of successfulcommercialization, if any, of most products resulting from this relationship,the Company will be entitled to receive royalties on sales of thoseproducts.  Discussions have been initiated regarding the possible modification orreplacement of the 2003 agreements to continue the future funding of a numberof our FTEs beyond August 2006.  Therecan be no assurance that the 2003 agreements will be modified or replaced orthat FTE funding will be maintained at reduced August 2005 levels beyondAugust 2006.

 

For the quarters endedSeptember 30, 2005 and 2004, the Company’s research collaborations withN.V. Organon (“Organon”) accounted for 24% and 14%, respectively, ofrevenue.  For the nine months endedSeptember 30, 2005 and 2004, the Company’s research collaborations withN.V. Organon (“Organon”) accounted for 24% and 16%, respectively, ofrevenue.  The principal agreement withOrganon, entered into in February 2002, has a stated term of five years;however, Organon had the right to terminate the agreement in December 2005if Pharmacopeia failed to (i) deliver to Organon a cumulative total ofthree lead compound series and (ii) show demonstrated progress towards oneadditional lead compound series.  Becausethe Company has delivered to Organon three such lead compound series and showedsuch demonstrated progress, Organon no longer has such right to terminate the agreement.  Under this agreement, Pharmacopeia receivesresearch funding to conduct its drug discovery activities to identify andoptimize new drug candidates for multiple therapeutic targets provided byOrganon.  This revenue is recognized on astraight-line basis over the term of the collaboration.  The Company may receive milestone paymentsupon the successful achievement of preclinical and clinical milestones.  These milestone payments will be recognizedas revenue to the extent that milestones are achieved.  Upon successful commercialization of anyproduct resulting from this relationship, Pharmacopeia will be entitled toreceive royalties on sales of that product.

 

**3.  Net Loss Per Share**

 

The Company computes net income(loss) per share in accordance with Statement of Financial Accounting StandardNo. 128, “Earnings Per Share” (“SFAS 128”).  Under the provisions of SFAS 128, basic netincome (loss) per share is computed by dividing the net income (loss) for theperiod by the weighted-average number of common shares outstanding during theperiod.  Diluted net income per share iscomputed by dividing the net income for the period by the weighted-averagenumber of common and dilutive common equivalent shares outstanding during theperiod.  Diluted earnings per shareinclude the potentially dilutive effect of outstanding stock options, or otherdilutive securities.  Shares outstandingfor the Company for the period prior to the distribution are calculated basedon the 12,181,471 shares distributed in the spin-off, adjusted for unvestedrestricted shares (see note 1). Potentially dilutive common stock equivalents totaled approximately3,219,240 and 3,101,421 shares for the nine months ended September 2005 and2004.  The Company has a net loss for theperiods presented; accordingly, the inclusion of common stock equivalents foroutstanding stock options would be anti-dilutive and, therefore, theweighted-average shares used to calculate both basic and diluted loss per shareare the same.

 

**4.  Segment Information**

 

The Company classifies its businessoperations in one operating segment.  Allof the Company’s revenues are generated from this segment.  In the quarters ended September 30, 2005and 2004, approximately 45% and 48%, respectively, of the Company’s revenuefrom customers was derived from within the United States, 54% and 51%,respectively, was derived from Europe, and 1% and 1%, respectively, was derivedfrom Asia.  In the nine months endedSeptember 30, 2005 and 2004, approximately 43% and 44%, respectively, ofthe Company’s revenue from customers was derived from within the United States,56% and 52%, respectively, was derived from Europe, and 1% and 4%,respectively, was derived from Asia.

 

7

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**5.  Stock-Based Compensation**

 

Generally, at the distributiondate, any outstanding options to purchase Accelrys common stock held byemployees, directors and consultants of Pharmacopeia under Accelrys incentivecompensation plans were adjusted or converted to options to purchasePharmacopeia common stock to maintain the intrinsic value existing at the timeof the distribution and maintain the ratio existing at the time of thedistribution of the exercise price per share to the market value per share.

 

Statement of Financial AccountingStandards No. 123, “Accounting for Stock-Based Compensation” (“SFAS 123”)encourages, but does not require, companies to record compensation cost forstock-based compensation plans at fair value. As permitted by SFAS 123, the Company has elected to continue followingAccounting Principles Board Opinion No. 25 “Accounting for Stock Issued toEmployees” (“APB 25”) and related interpretations, to account for stock-basedcompensation.  Under APB 25, nocompensation expense is recognized at the time of option grant because theexercise price of the Company’s employee stock options equals the fair marketvalue of the underlying common stock on the date of grant.

 

In December 2004, the FASB issued Statement of FinancialAccounting Standards (SFAS) No 123 (revised 2004), “Share-Based Payment” (SFASNo. 123R), which replaces SFAS No. 123 and supersedes APB 25.  SFAS No. 123R requires all share-basedpayments to employees, including grants of employee stock options, to berecognized in the financial statements based on their fair values.  The pro forma disclosures previouslypermitted under SFAS No. 123 no longer will be an alternative to financialstatement recognition.  Under SFASNo. 123R, the Company must determine the appropriate fair value model tobe used for valuing share-based payments, the amortization method forcompensation cost, and the transition method to be used at date ofadoption.  The permitted transitionmethods include either retrospective or prospective adoption. Under theretrospective option, prior periods may be restated either as of the beginningof the year of adoption or for all periods presented.  The prospective method requires thatcompensation expense be recorded for all unvested stock options at thebeginning of the first quarter of adoption of SFAS No. 123R, while theretrospective methods would record compensation expense for all unvested stockoptions beginning with the first period presented.  The Company is currently evaluating therequirements of SFAS No. 123R and expects that adoption of SFASNo. 123R will have a material impact on the Company’s results ofoperations.  The Company has not yetdetermined the method of adoption or the effect of adopting SFAS No. 123Rand it has not determined whether the adoption will result in amounts that aresimilar to the current pro forma disclosures under SFAS No. 123.

 

On April 14, 2005, the Securities and Exchange Commissionannounced the adoption of a new rule that amends the compliance dates forSFAS No. 123R.  The newrule allows companies to implement SFAS No. 123R at the beginning oftheir next fiscal period; therefore, the Company will need to be in compliancewith SFAS No. 123R commencing with its fiscal year beginningJanuary 1, 2006.  The Commission’snew rule does not change the accounting required by SFAS No. 123R; itchanges only the dates for compliance with the standard.

 

Had the Company followed the fairvalue measurement provisions of SFAS 123, the following table summarizes thepro forma net loss and pro forma net loss per share that would have been recorded(in thousands, except per share data):

 

 
| ** **                                                                                                                                    | ** ** | **Three Months Ended September 30,** | ** ** | **Nine Months Ended September 30,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------|------------|-------------------------------------|------------|
| ** **                                                                                                                                    | ** ** | **2005**                             | ** ** | **2004**                            | ** ** | **2005** | ** ** | **2004** | ** ** |
| Net loss:                                                                                                                                     |       |                                 |       |                                |       |   |   |   |   |
| As reported                                                                                                                                   |       | $                                    | (4,737     | )                                   | $          | (2,896 | ) | $ | (14,087 | ) | $ | (16,293 | ) |
|                                                                                                                                          |       |                                 |       |                                |       |   |   |   |   |
| Add: Stock-based employee compensation  expense included in reported net loss                                                                 |       | 25                                   |       | 26                                  |       | 281 |   | 60 |   |
| Deduct: Total stock-based employee  compensation expense determined under fair value based method for all awards,  net of related tax effects |       | (413                                 | )          | (595                                | )          | (1,512 | ) | (1,646 | ) |
| Pro forma                                                                                                                                     |       | $                                    | (5,125     | )                                   | $          | (3,465 | ) | $ | (15,318 | ) | $ | (17,879 | ) |
| Basic and  diluted net loss per common share:                                                                                                 |       |                                 |       |                                |       |   |   |   |   |
| As reported                                                                                                                                   |       | $                                    | (0.33      | )                                   | $          | (0.24 | ) | $ | (1.08 | ) | $ | (1.34 | ) |
| Pro forma                                                                                                                                     |       | $                                    | (0.36      | )                                   | $          | (0.28 | ) | $ | (1.18 | ) | $ | (1.47 | ) |

 

8

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The fair value of each optiongranted is estimated using the Black-Scholes option-pricing model with thefollowing assumptions:

 
| ** **               | ** ** | **Three and Nine Months Ended September 30,** | ** ** |
|--------------------------|------------|-----------------------------------------------|------------|
| ** **               | ** ** | **2005**                                      | ** ** | **2004** | ** ** |
| Dividend  yield          |       | 0.00                                          | %          | 0.00 | % |
| Expected  volatility     |       | 75.00                                         | %          | 85.24 | % |
| Risk-free  interest rate |       | 4.08                                          | %          | 4.35 | % |
| Expected  life (years)   |       | 5.0                                           |       | 5.8 |   |

 

**6.  Restructuring**

 

During the quarter endedMarch 31, 2004, the Company executed a restructuring plan for the purposeof consolidating its research and development facilities.  Also a reduction in force of sixadministrative Pharmacopeia employees occurred during that quarter, of whom allwere terminated as of June 30, 2004. As a result, restructuring related charges of approximately $5.9 millionwere accrued and recognized as operating expense during the quarter endedMarch 31, 2004.

 

The following table summarizes theactivity of the accrued restructuring reserve for the nine months endedSeptember 30, 2005 (dollars in thousands):

 

| ** **                     | ** ** | **Costs to Exit Leased  Facility** | ** ** |
|--------------------------------|------------|------------------------------------|------------|
| Balance at  December 31, 2004  |       | $                                  | 3,368      |   |
| Lease  payments                |       | (1,862                             | )          |
| Balance at  September 30, 2005 |       | $                                  | 1,506      |   |

** **

**7**.  Commitments and Contingencies

** **

In accordance with FASB Statement No. 5, “Accountingfor Contingencies” and FASB Interpretation No. 14, “Reasonable Estimationof the Amount of a Loss”, the Company accrued and recognized as operatingexpense a charge of $0.5 million for the nine months ended September 30, 2004for the probable outcome of the resolution (which estimate changed to $1.0million for the fiscal year ended December 31, 2004) of a dispute between theCompany, on the one hand, and the Trustees of Columbia University in the Cityof New York (“Columbia”) and Cold Spring Harbor Laboratory (“Cold Spring”), onthe other hand, in connection with the License Agreement (the “OriginalAgreement”) dated July 16, 1993 and as amended October 6, 1995 among them.

 

On May 24, 2005, the parties to the OriginalAgreement entered into a license agreement (the “Agreement”) that amended andrestated the Original Agreement.  TheAgreement provides that in connection with the resolution of the dispute theCompany will pay Columbia and Cold Spring an aggregate of $1.0 million dollarsin two installments of $500 thousand. The first installment was paid in June 2005. As ofSeptember 30, 2005, the remaining $500 thousand obligation to be paid toColumbia and Cold Spring, in connection with the Agreement, is included inaccrued liabilities on the Company’s balance sheet.

 

Under the Agreement, the Company has an exclusivelicense for technology used in its proprietary combinatorial chemistry encodingtechnology, Encoded Combinatorial Libraries on Polymeric Support, orECLiPS®.  The Agreement obligates the Company to pay a minimum annuallicense fee of $100 thousand to Columbia and Cold Spring.  The term of theAgreement is the later of (i) 20 years from July 16, 1993 or(ii) the expiration of the last patent relating to the technology, atwhich time the Company will have a fully paid license to the technology. The license granted to the Company under the Agreement can be terminated byColumbia and Cold Spring (i) upon 30 days written notice to the Company ifthe Company materially breaches the Agreement and the Company fails to curesuch material breach in accordance with the Agreement or (ii) if theCompany commits any act of bankruptcy, becomes insolvent, files a petitionunder any bankruptcy or insolvency act or has any such petition filed againstit that is not dismissed within 60 days.  The Company is obligated to payroyalties to Columbia and Cold Spring based upon net sales of pharmaceuticalproducts the Company develops as well as a percentage of all other payments(such as milestones and royalties) the Company receives from customers in casesin which the Company has utilized the technology licensed from Columbia andCold Spring.

 

9

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**8.  Equity Financing**

 

On July 28, 2005, the Company entered into purchase agreements to sell an aggregate 2,470,000 shares of newly issued common stock (the “Shares”) to institutional investors (collectively, the “Purchasers”) at a price of $3.43 per share (the “Private Placement”).  On August 1, 2005, the Company sold the Shares and realized gross proceeds of approximately $8.5 million from the Private Placement.  The Company realized net proceeds of approximately $7.7 million from the Private Placement after deducting fees payable to the placement agent and other transaction expenses.

 

Pursuant to the purchase agreements executed in connection with the Private Placement, the Company filed a registration statement on Form S-3 with the Securities and Exchange Commission (the “Commission”) to register the resale of the Shares.  The registration statement on Form S-3 was declared effective on August 26, 2005.  In addition, the Company agreed to use its best efforts, subject to receipt of necessary information from the Purchasers, to keep the registration statement effective until the earliest of (i) 2 years after the effective date of the registration statement or (ii) the date on which the Shares become eligible for resale pursuant to Rule 144(k) under the Securities Act of 1933, as amended (the “Securities Act”) (the “Effectiveness Period”).

 

If (i) the registration statement ceases to be effective as to all the Shares to which it is required to relate at any time prior to the expiration of the Effectiveness Period without being succeeded within 10 trading days by an amendment to such registration statement or by a subsequent registration statement filed with and declared effective by the Commission, or (ii) the Company’s common stock is not listed or quoted, or is suspended from trading on, the Nasdaq National Market or the facilities of any national securities exchange on which the common stock is then traded for a period of 3 trading days (any such failure or breach being referred to as an “Event,” and the date on which such Event occurs being referred to as “Event Date”), then: (x) on each such Event Date the Company shall pay to each Purchaser an amount in cash, as partial liquidated damages and not as a penalty, equal to 1.0% of the aggregate purchase price paid by such Purchaser pursuant to the purchase agreements; and (y) on each monthly anniversary of each such Event Date thereof (if the applicable Event shall not have been cured by such date) until the applicable Event is cured, the Company shall pay to each Purchaser an amount in cash, as partial liquidated damages and not as a penalty, equal to 1.0% of the aggregate purchase price paid by such Purchaser pursuant to the purchase agreements.  The purchase agreements provide that such payments shall not constitute the Purchasers’ exclusive remedy for such events.  If the Company fails to pay any such liquidated damages in full within 7 days after the date payable, the Company will pay interest thereon at a rate of 10.0% per annum (or such lesser maximum amount that is permitted to be paid by applicable law) to the Purchasers, accruing daily from the date such liquidated damages are due until such amounts, plus all such interest thereon, are paid in full.

 

**Item2. Management’s Discussion and Analysis ofFinancial Condition and Results Of Operations.**

** **

Forward-Looking Statements

 

This Quarterly Report onForm 10-Q contains forward-looking statements regarding us and ourbusiness, financial condition, results of operations and prospects within themeaning of the Private Securities Litigation Reform Act of 1995.  Such forward-looking statements include thosethat express plans, 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.  Theseforward-looking statements include statements about the following:

 

•                  ourintentions regarding the establishment and continuation of drug discovery anddevelopment collaborations with leading pharmaceutical and biotechnologyorganizations, in particular, the continuation and funding level of ourexisting collaborations with Schering-Plough and N.V. Organon;

 

•                  ourability to build our pipeline of novel drug candidates, through our owninternally-funded drug discovery programs, our collaborations and in-licensing;

 

•                  ourability to raise additional capital;

 

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

 

•                  ourexpectations concerning the development priorities of our collaborativepartners, and their ability to successfully develop compounds;

 

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

 

•                  ourbeliefs as to the trends and opportunities impacting us and our industry;

 

•                  ourestimates of the market opportunity for our product candidates;

 

•                  ourability to acquire or invest in complementary businesses or technologies.

 

In some cases, you can identifyforward-looking statements by terminology, such as “expects,” “anticipates,” “intends,”“plans,” “believes,” “seeks,” “estimates,” or the negative of such terms orother similar expressions.  Factors thatcould cause or contribute to differences in results and outcomes include,without limitation, those discussed elsewhere in this Report in Item 2.  “Management’s Discussion and Analysis ofFinancial Condition and Results of Operations” (including asubsection thereof entitled “Certain Risks Related to Our Business”) anddiscussed in our other Securities and Exchange Commission (“SEC”) filings.

 

We urge you to carefully readand consider the disclosures found in these filings, all of which are availablein the SEC EDGAR database at www.sec.gov. You are urged not to place undue reliance on any such forward-lookingstatements, any of which may turn out to be wrong due to inaccurateassumptions, unknown risks, uncertainties or other factors.  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.

 

**The Company**

** **

**Overview**

** **

We create and delivertherapeutics to address significant medical needs.  Using proprietary technologies and processes,we identify, optimize and develop novel drug candidates through our owninternally-funded drug discovery programs and in collaboration with majorpharmaceutical and biotechnology companies. Our collaborative research efforts have resulted in a portfolio of fourpartnered programs that have been advanced into human clinical trials, withadditional programs in late-stage pre-clinical development.  We have four internal programs in advanceddiscovery in addition to multiple partnered programs in discovery.

 

Our internal proprietaryresearch programs are primarily focused on immunobiology and immunologicaldiseases.  We fully fund these programsand retain intellectual property and ownership rights to any compoundsdiscovered.  At an appropriate point, wemay license one or more of these compounds or programs to a third party(probably a larger pharmaceutical or biotechnology organization).  Out-licensing at an appropriate point in thecompound’s development would enable us to take advantage of the additionalresources, expertise, technologies and commercial organization of the licenseecompany in order to further the development and commercialization of thecompound and would provide us with fees and milestone payments, as well asrecurring royalty payments if these compounds are developed into and marketedas new commercial drugs.  Typically,these royalty payments would be due to us for the length of the relevant patentlife on a marketed drug.  We expectout-licensing could convert our proprietary programs into collaborativepartnerships on terms we anticipate would be more favorable to us than ourexisting collaborations due to the reduction in the risk for the partner andthe investment that we have made advancing the program to the stage at which itis licensed.

 

We focus the majority of ourinternally-funded drug discovery programs on immunobiology and immunologicaldiseases such as rheumatoid arthritis, psoriasis and other inflammatorydiseases for several reasons:

 

•                  We believe many existing therapies for thesediseases are lacking in one or more respects. For example, methotrexate, the standard of care for rheumatoid arthritishas serious side effects while newer biologicals are costly and may have safetyand immunogenic concerns.

 

•                  There are increasing commercial opportunitiesprovided by a large, growing population of patients with immunobiologicaldiseases including chronic and acute inflammation, autoimmune diseases, asthmaand transplantation.

 

 

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•                  The global market for immunosuppressanttherapy for transplant patients alone is in excess of $4 billion per year, andwe believe a drug developed to meet the needs of such patients is likely toalso offer medical benefit and commercial opportunity in other chronic diseaseswith similar underlying etiologies.

 

•                  The last decade has seen significant progressin the understanding of the biology underlying the immune system and immunediseases and its involvement in other therapeutic segments like Alzheimer’sdisease, atherosclerosis and cancer.

 

•                  We believe a treatment developed for oneimmunobiological disease may be further developed for another and,consequently, an investment in one treatment may potentially yield results formultiple treatments.

 

•                  We have significant internal expertise withrespect to discovering drug candidates for these diseases as evidenced by ourproven record of delivering candidates in these therapeutic segments to ourcollaborators.

 

We are building expertiseand extending our platform into preclinical and clinical development so that wecan advance both internal and partnered programs into preclinical and clinicaldevelopment.  In addition to ourproprietary research, we have drug discovery collaborations with leadingpharmaceutical companies and biotechnology companies.  In contrast to many of our partneringefforts in the past (with the key exceptions of our relationships withSchering-Plough and Organon), we now seek to establish broad, multi-yearalliances with the potential to result in drug candidates in which we retain alarge share of ownership. We intend to participate in the clinical developmentof some of the compounds that may result from these collaborations.  As a consequence, our goal is to enter intoagreements in which we receive improved fees, milestone payments and royaltieson net sales compared to our existing collaborations.

 

Wecurrently contribute the following to collaborative drug discovery programs:

 

•                  high and ultra high throughput screeningcapabilities that enable us to test hundreds of thousands to millions of  compounds per week against disease-relatedtargets to identify active compounds that are further studied to determine ifthey meet the criteria of an early lead compound;

 

•                  pharmacological results *in vitro*and*in vivo*;

 

•                  optimized lead compounds resulting from theiterative modification of the molecular structure of early lead compounds toincrease structural novelty, potency, selectivity and pharmacokineticproperties and reduce toxicity; and

 

•                  potential drug candidates resulting from leadoptimization studies that meet specific potency, selectivity and safetycriteria and possessing the appropriate pharmacokinetic properties consistentwith advancement to further stages of drug discovery and development.

 

Todate, our collaborative drug discovery efforts have resulted in theidentification of four clinical compounds, which are under development by ourcollaborators.  We initially identifiedp38 kinase inhibitor lead compounds in 1997 and entered into a collaborativepartnering agreement with Bristol-Myers Squibb in 1999.

 

Thiscollaboration resulted in a compound that entered clinical trials inAugust 2003.  A second compounddiscovered in our laboratories, aimed at an allergic asthma indication, was thebasis of a collaboration with Daiichi Pharmaceutical Co. and resulted in a drugcandidate that entered clinical trials in November 2003.  A third clinical compound, which also targetsa respiratory indication, was developed in collaboration with Schering-Ploughand commenced clinical trials in December 2003.  The Schering-Plough relationship also produceda second compound, our fourth clinical candidate, which entered clinical trialsin March 2004 for an inflammation indication.  Associated with these development programs,we have received milestone payments from each of Bristol-Myers Squibb, Daiichiand Schering-Plough and, to the extent the compounds successfully progressthrough clinical development, we will be entitled to receive additionalmilestone payments.  We are also entitled under the agreements with eachof these partners to receive royalties on the commercial sale, if any, of mostnew drugs resulting from these collaborations. However, numerous additional studies are required to fully assess thepotential of these clinical candidates before they reach the marketplace, andthe results from preclinical studies and clinical studies conducted to datewith these compounds are not necessarily indicative of the results that may beobtained in future clinical studies.

 

12

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Inaddition to the compounds in the clinic, six more programs are at variousstages of preclinical development, the point at which compounds are tested forsafety in animals prior to filing an Investigational New Drug application andtheir introduction into humans during Phase I of clinical development.

 

Preclinicaland clinical development of drug candidates is a long, expensive and uncertainprocess.  The drug candidates described above are at an early stage, andnone has received regulatory approval for commercial sale.  Both our partneredclinical candidates and our internally-derived compounds face the substantialrisk of failure inherent in drug discovery and development.  At any stageof the clinical development process, our collaborators, or we, may decide todiscontinue development of our product candidates.  We do not expect thatour product candidates will be commercially available for many years, ifever.  Therefore, we continue to pursue the discovery and development ofproduct candidates using our integrated technology platform in both ourinternal and collaborative programs.  To date, none of the compounds towhich we hold complete or partial rights has reached the stage of a commercialproduct and, although we have received license and milestone fees, we may neverreceive any royalty payments, or any additional license and milestone fees,under our current or any future collaborations.

 

Fromtime to time we have considered, and we will continue to consider strategicinitiatives intended to further the development of our business.  In addition, we consider opportunities toexpand our product pipeline through the acquisition or in-licensing of, orinvestment in, product development candidates, and we intend to continue toexplore and evaluate those opportunities.

 

**Liquidity and Capital Resources**

** **

Prior to our spin-off from Accelrys, we hadfunded our activities primarily through Accelrys’ consolidated operations,including revenue derived from collaborative partnerships and milestonepayments.  Accelrys contributed cash,cash equivalents and marketable securities such that upon consummation of thedistribution on April 30, 2004, we had a cash, cash equivalents andmarketable securities balance aggregating $46.5 million.

 

As of September 30,2005, we had cash, cash equivalents and marketable securities of $35.0 millioncompared to $40.9 million at December 31, 2004, representing 70% and 72%of our total assets, respectively.  Weinvest excess cash in highly liquid investment-grade marketable securities,including corporate bonds and United States government and agency securities.

 

13

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The following is a summary ofselected cash flow information for the nine months ended September 30,2005 and 2004:

 

| ** **                                           | ** ** | **Nine months ended**   | ** ** |
|------------------------------------------------------|------------|-------------------------|------------|
| ** **                                           | ** ** | **September 30,**       | ** ** |
| ** **                                           | ** ** | **2005**                | ** ** | **2004** | ** ** |
| ** **                                           | ** ** | **(in thousands of $)** | ** ** |
| Net loss                                             |       | $                       | (14,087    | ) | $ | (16,293 | ) |
| Adjustments  for noncash operating items             |       | 2,292                   |       | 1,520 |   |
|                                                 |       |                    |       |   |   |
| Net cash  operating loss                             |       | (11,795                 | )          | (14,773 | ) |
| Net change  in assets and liabilities                |       | (1,056                  | )          | 4,914 |   |
|                                                 |       |                    |       |   |   |
| Net cash  used in operating activities               |       | $                       | (12,851    | ) | $ | (9,859 | ) |
|                                                 |       |                    |       |   |   |
| Net cash  (used in) provided by investing activities |       | $                       | (907       | ) | $ | 8,686 |   |
|                                                 |       |                    |       |   |   |
| Net cash  provided by financing activities           |       | $                       | 7,919      |   | $ | 14,270 |   |

 

**Netcash used in operating activities**

 

Net cash operatingoutflows for the nine months ended September 30, 2005 have resultedprimarily from our operating loss due to our funding of our proprietaryinternal drug discovery efforts, the payment of restructuring expenses relatedto the 2004 consolidation of our facilities and the payment to Columbia andCold Spring of $500 thousand in connection with the settlement of our disputewith them.

 

14

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** **

**Net cash (used in) provided by investing activities**

** **

Net cash used ininvesting activities for the nine months ended September 30, 2005 relatesprimarily to capital expenditures.  Netcash provided by investing activities for the nine months ended September 30,2004 relates primarily to the sales and maturities of marketable securities,partially offset by expenditures for leasehold improvements undertaken inconnection with the consolidation of our facilities to one location.

 

**Net cash provided by financing activities**

 

On July 28, 2005, we entered into purchase agreements to sell an aggregate of 2,470,000 shares of newly issued common stock (the “Shares”) to institutional investors (collectively, the “Purchasers”) at a price of $3.43 per share (the “Private Placement”).  On August 1, 2005, we sold the Shares and realized gross proceeds of approximately $8.5million from the Private Placement.  We realized net proceeds of approximately $7.7 million from the Private Placement after deducting fees payable to the placement agent and other transaction expenses.

** **

Net cash providedby financing activities for the nine months ended September 30, 2005 also consistsof a capital contribution made to us by Accelrys and proceeds from the issuanceof common stock in connection with our employee stock option and stock purchaseplans.

 

**Liquidity and Capital Resources Outlook**

 

We expect to continue to use ourcapital to fund operating losses.  Weexpect that our research and development expenditures will increase in thefuture as we increase our internal drug discovery efforts.  Conducting our own drug discovery research isa key component of our business model.

 

In addition, ourcapital requirements may increase in future periods as we seek to expand ourtechnology platform through investments, licensing arrangements, technologyalliances, or acquisitions.

 

Pursuant to the purchase agreements executed in connection with the Private Placement we agreed to file a registration statement on Form S-3 with the Securities and Exchange Commission (the “Commission”) to register the resale of the Shares.  The registration statement on Form S-3 was declared effective on August 26, 2005.  In addition, we agreed to use our best efforts, subject to receipt of necessary information from the Purchasers, to keep the registration statement effective until the earlier of (i) 2 years after the effective date of the registration statement or (ii) the date on which the Shares become eligible for resale pursuant to Rule 144(k) under the Securities Act of 1933, as amended (the “Securities Act”) (the “Effectiveness Period”).

 

If (i) the registration statement ceases to be effective as to all the Shares to which it is required to relate at any time prior to the expiration of the Effectiveness Period without being succeeded within 10 trading days by an amendment to such registration statement or by a subsequent registration statement filed with and declared effective by the Commission, or (ii) our common stock is not listed or quoted, or is suspended from trading on, the Nasdaq National Market or the facilities of any national securities exchange on which the common stock is then traded for a period of 3 trading days (any such failure or breach being referred to as an “Event,” and the date on which such Event occurs being referred to as “Event Date”), then: (x) on each such Event Date we shall pay to each Purchaser an amount in cash, as partial liquidated damages and not as a penalty, equal to 1.0% of the aggregate purchase price paid by such Purchaser pursuant to the purchase agreements; and (y) on each monthly anniversary of each such Event Date until the applicable Event is cured, we shall pay to each Purchaser an amount in cash, as partial liquidated damages and not as a penalty, equal to 1.0% of the aggregate purchase price paid by such Purchaser pursuant to the purchase agreements.  The purchase agreements provide that such payments shall not constitute the Purchasers’ exclusive remedy for such events.  If we fail to pay any such liquidated damages in full within 7 days after the date payable, the Company will pay interest thereon at a rate of 10.0% per annum (or such lesser maximum amount that is permitted to be paid by applicable law) to the Purchasers, accruing daily from the date such liquidated damages are due until such amounts, plus all such interest thereon, are paid in full.

 

We are obligated to pay approximately $1.5 million in costs inconnection with a leased facility we vacated in the first quarter of 2004.  The lease on this facility expires inApril 2006.  We are also obligatedto pay approximately $500 thousand in June 2006 in connection with thesettlement of our dispute with Columbia and Cold Spring.

 

We anticipate that our capital resources will beadequate to fund our operations at their current levels at least through 2006. However, there can be no assurance that changeswill not occur that would consume available capital resources before then.

 

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Our capital requirements dependon numerous factors, including our ability to continue and extend existingcollaborative agreements and to enter into additional arrangements.  Approximately 75% and 75% of our revenue forboth three months periods ended September 30, 2005 and 2004, was generatedfrom our collaborations with Schering Plough and N.V. Organon.  Approximately 79% and 78% of our revenue forthe nine months ended September 30, 2005 and 2004, respectively, wasgenerated from our collaborations with Schering Plough and N.V. Organon.

 

The collaborations with ScheringPlough are scheduled to expire in August 2006, and Schering-Plough reducedby 41% (or approximately $1.1 million per calendar quarter) its FTE fundingunder the 2003 agreements effective August 2005. Discussions have beeninitiated regarding the possible modification or replacement of the 2003agreements to continue the future funding of a number of our FTEs beyond August2006.  There can be no assurance that the2003 agreements will be modified or replaced or that FTE funding will bemaintained at reduced August 2005 levels beyond August 2006.  In light of the financial significance to usof the Schering-Plough relationship, the expiration or termination of or ourfailure to modify or replace the 2003 agreements would have a material adverseeffect on our financial condition and our results of operations because of theresulting decrease in our revenue.  Ifadequate funds from sources other than Schering-Plough do not become available,we may be required to curtail operations significantly or obtain funds byentering into arrangements with collaborative partners or others that mayrequire us to relinquish rights to certain of our technologies, programs orpotential markets.

 

Theprincipal agreement with Organon, entered into in February 2002, has astated term of five years; however, Organon had the right to terminate theagreement in December 2005 if we failed to (i) deliver to Organon acumulative total of three lead compound series and (ii) show demonstratedprogress towards one additional lead compound series.  Because we have delivered to Organon threesuch lead compound series and showed such demonstrated progress, Organon nolonger has such right to terminate the agreement.

 

In addition, our capitalrequirements depend on competing technological and market developments, changesin our existing collaborative relationships, the cost of filing, prosecuting,defending, and enforcing patent claims and other intellectual property rightsand the outcome of related litigation, the purchase of additional capitalequipment, acquisitions of other businesses or technologies, and the progressof our collaborators’ milestone and royalty producing activities.  Prior to exhausting our current capitalresources, we will need to raise additional funds to finance our operatingactivities or enter into strategic initiatives intended to further thedevelopment of our business.  There canbe no assurance that additional funding, if necessary, will be available onfavorable terms, if at all.  Ourforecasts of the period of time through which our financial resources will beadequate to support our operations are forward-looking information, and actualresults could vary.  The factorsdescribed earlier in this section will impact our future capital requirementsand the adequacy of our available funds.

 

**Results of Operations**

 

This section should be read in conjunction with the discussion under “Liquidityand Capital Resources”.

 

**Three months ended**September 30, 2005 and 2004

** **

Our net revenue decreased 39% to $3.9 millionin the quarter ended September 30, 2005 compared to $6.4 million in thequarter ended September 30, 2004.  Netrevenue consists of the funding of our collaborative research activities, aswell as our receipt of milestones, success fees and license revenue if and asour discoveries progress through our collaborators’ development processes.  Net revenue for the three months endedSeptember 30, 2005 and 2004 is summarized as follows:

 

| ** **                      | ** ** | **For the Three Months Ended  September 30,** | ** ** |
|---------------------------------|------------|-----------------------------------------------|------------|
| ** **                      | ** ** | **2005**                                      | ** ** | **2004** | ** ** |
| ** **                      | ** ** | **(in thousands of $)**                       | ** ** |
|                            |       |                                          |       |   |   |
| Collaborative  research funding |       | $                                             | 3,758      |   | $ | 4,801 |   |
| Milestones  and success fees    |       | —                                        |       | 1,450 |   |
| License  revenue                |       | 150                                           |       | 125 |   |
|                            |       | $                                             | 3,908      |   | $ | 6,376 |   |

 

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Schering-Plough accounted for 51% and 61% ofour net revenue in the three months ended September 30, 2005 and 2004, respectively.  N.V. Organon accounted for 24% and 14% of ournet revenue in the three months ended September 30, 2005 and 2004, respectively.  The decrease in collaborative researchfunding was largely due to reduced funding from our collaborations withSchering Plough.  Our milestone andsuccess fee revenue for the three months ended September 30, 2004 was from ourcollaborations with Schering-Plough and Neurocrine.

 

Collaborativeresearch and development expense includes the labor, material, equipment andallocated facilities cost of our scientific staff that is working oncollaborative partnerships. Collaborative research and development expenses decreased 21% to $4.1million for the three months ended September 30, 2005, compared to $5.2 million forthe three months ended September 30, 2004.  This decrease was due to decreased resourcesallocated to our collaborative partnerships.

 

Proprietaryresearch and development expense includes labor, material, equipment and allocatedfacilities cost of scientific staff working on self-funded internal drugdiscovery programs.  Our internal drugdiscovery projects are focused on the creation of new small moleculetherapeutics using proprietary technologies and our proprietary collection ofcompounds to identify and optimize novel drug candidates.  Because of the speculative nature of theseinternal drug discovery projects, it is not possible to estimate completiondates, or estimated costs of completion. Additionally, from time to time, depending on certain staff and otherresearch and development resources may be temporarily redirected from oneproject to another, which redirection may also delay or impact the cost ofinternal drug discovery projects. Consistent with our strategy to increase our investment in internal drugdiscovery programs, proprietary research and development expenses increased 76%to $2.7 million for the three months ended September 30, 2005 compared to $1.6 million forthe three months ended September 30, 2004.

 

Sales,general and administrative expense decreased by 22% to $2.0 million for thethree months ended September 30, 2005 compared to $2.6 million forthe three months ended September 30, 2004.  Sales, general and administrative expense forthe three months ended September 30, 2004 included a charge of $500 thousand inconnection with our dispute with Columbia and Cold Spring.

 

Interestand other income, net increased to $275 thousand for the three months ended September 30, 2005 compared to $166 thousand forthe three months ended September 30, 2004.  This increase is due tohigher yields.

 

Werecorded an income tax provision of $7 thousand and $25 thousand for the threemonths ended September 30,2005 and 2004, respectively, related to minimum state income taxes.

 

Asa result of the net revenues and expenses described above, we generated a netloss of $4.7 million ($0.33 per basic and diluted share) for the three monthsended September 30,2005, compared to a net loss of $2.9 million ($0.24 per basic and dilutedshare) for the three months ended September 30, 2004.

 

**Nine months ended**September 30, 2005 and 2004

** **

Our net revenue decreased 12% to $14.8million in the nine months ended September 30, 2005 compared to $16.9 million in thenine months ended September 30,2004.  Net revenue consists of thefunding of our collaborative research activities, as well as our receipt ofmilestones, success fees and license revenue if and as our discoveries progressthrough our collaborators’ development processes.  Net revenue for the nine months ended September 30, 2005 and 2004 is summarized as follows:

 

| ** **                      | ** ** | **For the Nine Months Ended  September 30,** | ** ** |
|---------------------------------|------------|----------------------------------------------|------------|
| ** **                      | ** ** | **2005**                                     | ** ** | **2004** | ** ** |
| ** **                      | ** ** | **(in thousands of $)**                      | ** ** |
|                            |       |                                         |       |   |   |
| Collaborative  research funding |       | $                                            | 12,814     |   | $ | 14,140 |   |
| Milestones  and success fees    |       | 1,500                                        |       | 2,450 |   |
| License  revenue                |       | 516                                          |       | 262 |   |
|                            |       | $                                            | 14,830     |   | $ | 16,852 |   |

 

Schering-Plough accounted for 55% and 62% ofour net revenue in the nine months ended September 30, 2005 and 2004, respectively.

 

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N.V. Organon accounted for 24% and 16% of ournet revenue in the nine months ended September 30, 2005 and 2004, respectively.  Schering-Plough and N.V.  Organon accounted for 100% of the milestonepayments and success fees that we received for the nine months ended September 30, 2005 and 2004.  The decrease in collaborative researchfunding was largely due to reduced funding from our collaboration withSchering-Plough.

 

Collaborativeresearch and development expense includes the labor, material, equipment andallocated facilities cost of our scientific staff that is working oncollaborative partnerships. Collaborative research and development expenses decreased 9% to $14.4million in the nine months ended September 30, 2005 compared to $15.8 million inthe nine months ended September 30,2004.  This decrease was due to decreasedresources allocated to our collaborative partnerships.

 

Proprietaryresearch and development expense includes labor, material, equipment andallocated facilities cost of scientific staff working on self-funded internaldrug discovery programs.  Our internaldrug discovery projects are focused on the creation of new small moleculetherapeutics using proprietary technologies and our proprietary collection ofcompounds to identify and optimize novel drug candidates.  Because of the speculative nature of theseinternal drug discovery projects, it is not possible to estimate completiondates, or estimated costs of completion. Additionally, from time to time, depending on certain staff and otherresearch and development resources may be temporarily redirected from oneproject to another which redirection may also delay or impact the cost ofinternal drug discovery projects. Consistent with our strategy to increase our investment in internal drugdiscovery programs, proprietary research and development expenses increased 72%to $7.4 million in the nine months ended September 30, 2005 compared to $4.3 million inthe nine months ended September 30,2004.

 

Sales,general and administrative expense increased by 8% to $7.9 million in the ninemonths ended September 30,2005 compared to $7.3 million in the nine months ended September 30, 2004.  The increase in sales,general and administrative expense is primarily attributable to the severancepayable to our former Chief Operating Officer and Executive Vice President,Human Resources.  In connection with ourseverance cash payment obligations we recorded a charge of approximately $838thousand in the nine months ended September 30, 2005.  In addition, we recorded a non-cash charge ofapproximately $191 thousand related to the accelerated vesting of stockoptions.  Also contributing to theincrease were additional costsassociated with our being an independent company, including salary and expensesfor executive management, finance, legal, human resources, informationservices, investor relations, and corporate governance.  Prior to the distribution, general corporateoverhead had been allocated based on our revenue as a percentage of Accelrys’total revenue.  This increase was offsetby the moving costs incurred in the nine months ended September 30, 2004 inconnection with the consolidation of our facilities and a charge of $500thousand in connection with our dispute with Columbia and Cold Spring alsorecorded in the nine months ended September 30, 2004.

 

During the nine months ended September 30, 2004, we executed arestructuring plan for the purpose of consolidating our research anddevelopment facilities.  As a result,restructuring related charges of $5.9 million were accrued and recognizedas operating expense during the nine months ended September 30, 2004.

 

Interestand other income, net increased to $781 thousand in the nine months ended September 30, 2005 compared to $225 thousand inthe nine months ended September 30,2004.  This increase is due to higher cash balances and yields.

 

Werecorded an income tax provision of $21 thousand and $38 thousand in the ninemonths ended September 30,2005 and 2004, respectively, related to minimum state income taxes.

 

Asa result of the net revenues and expenses described above, we generated a netloss of $14.1 million ($1.08 per basic and diluted share) in the nine monthsended September 30,2005, compared to a net loss of $16.3 million ($1.34 per basic and dilutedshare) in the nine months ended September 30, 2004.

 

**Contractual Obligations**

 

For a discussion of our contractual obligations, see “Item 7.Management’s Discussion and Analysis of Financial Condition and Results ofOperations” in our report on Form 10-K for the year endedDecember 31, 2004.  No materialchanges have occurred to contractual obligations subsequent toDecember 31, 2004.

 

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**Net Loss Outlook**

 

We have had net losses in recent years and weexpect to incur losses in future periods. Our net loss is highly dependent on the continued funding and success ofour research and development programs with our existing collaborators.  One such collaborator, Schering-Plough, hasexercised its right to reduce by 41% (or approximately $1.1 million percalendar quarter) its funding of our FTEs effective August 2005.  The principal agreement withOrganon, entered into in February 2002, has a stated term of five years.  On aquarterly basis, our future operating results are likely to be highly volatilebecause they depend upon our receipt of milestone payments from ourcollaborators. We may not receive milestone payments on a regular basis or atall.  In addition, our ability to achieveprofitability will be significantly impacted by the increased level ofinvestment we have determined to make in our internal proprietary programs inthe future as well as the results of those programs.  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**

 

The preparation of our financial statements and disclosures involve theuse of judgments and estimates.  Webelieve the following critical accounting policies involve significantjudgments and estimates used.

 

*Revenue Recognition*-Contractrevenue is recognized either (i) on a percentage of completion basis, forcontracts specifying payment for services over a given period, or (ii) as servicesare performed under the agreement for contracts specifying payment on afull-time employee basis.

 

Revenue earned related to up-front product and technology license feesis recognized in accordance with Staff Accounting Bulletin 104 issued by the SEC.  Accordingly, amounts received undermultiple-element arrangements requiring ongoing services or performance by usare recognized over the period of such services or performance.

 

Revenue from milestones are recognized when earned, as evidenced by writtenacknowledgement from the collaborator, provided that (i) the milestoneevent is substantive and its achievability was not reasonably assured at theinception of the agreement, and (ii) our performance obligation after themilestone achievement will continue to be funded by the collaborator at acomparable level to before the milestone achievement.  If both of these criteria are not met, themilestone payment is recognized over the remaining minimum period of our performanceobligations under the arrangement. Royalties are recognized as earned in accordance with the terms ofvarious research and collaboration agreements.

 

*Long-Lived Assets-*Wereview long-lived assets, including leasehold improvements, property andequipment, and acquired technology rights, for impairment whenever events orchanges in business circumstances indicate that the carrying amount of theassets may not be fully recoverable. This requires us to estimate future cash flows related to these assets.  Actual results could differ from theseestimates, which may affect the carrying amount of assets and the actualamortization expense.  As of September 30,2005, we had long-lived assets with a net book value of $10.9 million.

 

**Certain Risks Related to Our Business**

** **

Asfurther described herein, our performance and financial results are subject torisks and uncertainties including, but not limited to, the following specificrisks:

 

**RISKS RELATED TO OUR BUSINESS AND INDUSTRY**

 

***Our revenue is highly concentratedin our largest collaborators and the termination of our collaboration with anyof these collaborators would have a material adverse effect on our business asit is currently conducted, financial condition and results of operations.***

 

Duringthe nine months ended September 30, 2005, we earned approximately $11.8million, or approximately 79% of our revenue, under our research collaborationagreements with two collaborators, Schering-Plough and N.V. Organon.  During the nine months ended September 30, 2005, we earned approximately $8.2million, or 55% of our revenue, of which $7.2 million was full-time employee(FTE) funding and $1.0 million was milestone payments, under our researchcollaboration agreements with Schering-Plough, one of our longest-standingcollaborative partners.  In the thirdquarter of 2003, we entered into new drug discovery collaborations withSchering-Plough, which continued certain existing programs and implemented anumber of new activities.

 

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The2003 agreements continue our collaboration with Schering-Plough throughAugust 2006.  Under the 2003agreements, we receive research funding which is recognized as revenue asservices are performed.  Schering-Ploughwas obligated to fund a specified number of our FTEs in the first year of theagreements.  Subsequently, Schering-Plough decided to focus onoptimization programs and terminated our screening activities onSchering-Plough’s behalf.  This decisionresulted in an approximately 11% reduction of the number of the FTEs thatSchering-Plough was obligated to fund. Schering-Plough has reduced its FTE funding by an additional 41% (orapproximately $1.1 million per calendar quarter) effective August 2005.  We may receive milestone paymentsupon the successful achievement of preclinical and clinical milestones.  Milestone payments will be recognized asrevenue to the extent that milestones are achieved.  In the event of successful commercialization,if any, of most products resulting from this relationship, we will be entitledto receive royalties on sales of those products.  Discussions have been initiatedregarding the possible modification or replacement of the 2003 agreements tocontinue the future funding of a number of our FTEs beyond August 2006.  There can be no assurance that the 2003agreements will be modified or replaced or that FTE funding will be maintainedat reduced August 2005 levels beyond August 2006.  In light of the financial significance to usof the Schering-Plough relationship, the expiration or termination of or ourfailure to modify or replace the 2003 agreements would have a material adverseeffect on our financial condition and our results of operations because of theresulting decrease in our revenue.

 

Duringthe nine months ended September 30, 2005, we earned approximately $3.6million, or 24% of our revenue, of which $3.1 million was FTE funding and $0.5million was milestones and success fees, under our research collaborationagreements with N.V. Organon, our second largest collaborator.  The principal agreement with Organon, enteredinto in February 2002, has a stated term of five years.  The expiration of this agreement would have amaterial adverse effect on our business as it is currently conducted, ourfinancial condition and our results of operations because of the resultingdecrease in our revenue.

 

***The development of our products isat an early stage and is uncertain.***

 

Drugdevelopment is a highly uncertain process. Our approach and technology may never result in a commercial drug.  None of our programs has resulted in productsthat have received regulatory approval for commercial sale.  Currently we have four compounds that ourcollaborators have advanced into clinical trials (i.e., human testing).  All of our therapeutic candidates, includingthese clinical candidates, face the substantial risks of failure inherent inthe drug development process.  Anypotential pharmaceutical product emanating from one of our internal orcollaborative programs must satisfy rigorous standards of safety and efficacybefore the United States Food and Drug Administration (FDA) and foreignregulatory authorities will approve them for commercial use.  To satisfy these standards, significantadditional research, preclinical studies (i.e., animal testing) and clinicaltrials will be required.

 

Thesedevelopment programs are in early stages relative to generating a commercialproduct.  Therefore, there remainsignificant, time-consuming and costly research and development effortsfollowed by the requirements of regulatory approvals.  Consequently, we do not expect compounds fromthese development activities to result in commercially available products formany years, if at all.

 

***If we consume cash more quickly thanexpected, we may be unable to raise additional capital and we may be forced tocurtail operations.***

 

Weanticipate that our capital resources, including our existing cash, cashequivalents and marketable securities as of September 30, 2005 of approximately $35.0million, will be adequate to fund our operations at their current levels atleast through 2006.  However, changes mayoccur that would cause us to consume available capital resources before thattime.  On July 28, 2005, we enteredinto purchase agreements to sell an aggregate 2,470,000 shares of newly issuedcommon stock (the “Shares”) to institutional investors at a price of $3.43 pershare (the “Private Placement”).  OnAugust 1, 2005, we sold the Shares and realized gross proceeds ofapproximately $8.5 million from the Private Placement.  We received net proceeds of approximately$7.7 million from the Private Placement after deducting fees payable to theplacement agent and other transaction expenses. While we are unaware of aspecific reason that any factor will have a material impact on our capital requirements,examples of relevant factors include:

 

•                  changes in our existing collaborativerelationships, particularly those with Schering-Plough and Organon, includingthe revenues we receive in connection with those relationships;

 

•                  the costs associated with our drug discoveryand development activities;

 

•                  acquisitions of other businesses ortechnologies;

 

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•                  penalties we may be required to pay thepurchasers in the Private Placement if we fail to comply with certain covenantsand obligations related to that transaction;

 

•                  competing technological and marketdevelopments;

 

•                  the cost of filing, prosecuting, defendingand enforcing patent claims and other intellectual property rights, and theoutcome of related litigation;

 

•                  the purchase of additional capital equipment;and

 

•                  the progress of our milestone and royaltyproducing activities.

 

Weintend to raise additional capital.  Thecapital could be raised through public or private financings involving debt orcommon or other classes of our equity. Any issuance of equity securities would dilute our current stockholders’percentage ownership of us.  As ofSeptember 30, 2005, there were 4,294,398 shares outstanding underlying optionsand restricted stock grants made under our various equity compensation plans,representing approximately 29% of our shares outstanding.  The significant dilution represented by ouroutstanding equity compensation awards may make it more difficult for us toraise additional capital.  Additionalcapital may not be available on favorable terms, or at all.  If adequate funds are not available, we maybe required to curtail operations significantly or to obtain funds by enteringinto arrangements with collaborative partners or others that may require us torelinquish rights to certain of our technologies, products or potentialmarkets.

 

***Our business is highly dependentupon the extent to which the pharmaceutical and biotechnology industriescollaborate with drug discovery and development companies for one or moreaspects of their drug discovery and development process.***

 

Ourrevenue depends to a large extent on research and development expenditures bythe pharmaceutical and biotechnology industries.  Our capabilities include aspects of the drugdiscovery and development process that pharmaceutical companies havetraditionally performed internally. Although there is a history among pharmaceutical and biotechnologycompanies of outsourcing drug research and development functions, this practicemay not continue.

 

Thewillingness of these companies to expand or continue collaborations to enhancetheir research and development activities is based on certain factors that arebeyond our control.  While we are unawareof a specific reason that any of the following factors will have a materialimpact on the willingness of current or potential collaborators to expand orcontinue collaborations, examples of relevant factors include collaborators’changing spending priorities among various types of research activities, theirability to hire and retain qualified scientists, their approach regardingexpenditures during recessionary periods and their policies regarding thebalance of research expenditures versus cost containment.  Also, general economic downturns in ourcollaborators’ industries, or adverse changes in the regulatory environment orthe adverse impact of product litigation on our collaborators’ businesses orany decrease in our research and development expenditures could harm ouroperations, as could increased popularity of management theories, which counselagainst outsourcing of critical business functions.  Continued consolidation in the pharmaceuticaland biotechnology industries may further decrease the number of potentialcollaborators for us.  In addition, thepopularity of scientific thinking that disfavors elements of our technologyplatform, such as large diverse libraries, could negatively impact ourbusiness.  Any decrease in drug discoveryspending by pharmaceutical and biotechnology companies could cause our revenueto decline.

 

Ourability to collaborate with large pharmaceutical and biotechnology companieswill depend on many factors, including our ability to:

 

•                  discover and develop high-quality drugcandidates;

 

•                  identify and utilize scientists andtechnologies that are of the highest caliber; and

 

•                  achieve results in a timely fashion, withacceptable quality and at an acceptable cost.

 

Theimportance of these factors varies from collaborator to collaborator, and wemay be unable to meet any or all of them for some or all of our collaboratorsin the future.

 

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***If our collaborators are not able tosuccessfully develop our existing clinical candidates, our business will be harmed.***

 

Ourcollaborators, Bristol-Myers Squibb Company, Daiichi Pharmaceutical Co. andSchering-Plough Corporation, currently are performing clinical trials ofprospective pharmaceutical products containing our proprietary compounds.

 

Ineach case, the collaborator is responsible for the development of thesepotential products, the level of resources devoted to such development and thedecision as to when, or whether, such development should cease.  Numerous additional studies are necessary tosupport the further development of these product candidates.  Results from preclinical studies conducted todate on these product candidates are not necessarily indicative of the resultsthat may be obtained in clinical studies. Results from additional studies could cause our collaborators todiscontinue or limit development of these product candidates.  There can be no assurance that Bristol-MyersSquibb, Daiichi or Schering-Plough will continue to develop these programs.  In addition, our collaborators may pursuealternative technologies or drug candidates, either on their own or incollaboration with others, that compete with our clinical candidates.  If our collaborators do not continue theirdevelopment efforts or if such efforts do not result in positive clinical results,we will not receive additional milestone and royalty payments from thoseefforts, and our business will be harmed.

 

***Our stock price may be volatile, andyour investment in our stock could decline in value.***

 

Themarket price for our common stock has been highly volatile and may continue tobe highly volatile in the future.  During the quarter ended September 30, 2005 the closing price was $3.49per share at its low point in September 2005 and $4.15 per share at its highpoint in July 2005.  Our quarterly operating results, changes ingeneral conditions in the economy or the financial markets, and otherdevelopments affecting our competitors or us could cause the market price ofour common stock to fluctuate substantially.  In recent years, the stock markethas experienced significant price and volume fluctuations.

 

Whilewe are unaware of a specific reason that any of the following factors will havea material impact on our stock price, the following factors, in addition to thefactors described in the other risk factors contained in this report, may havea significant impact on the market price of our common stock:

 

•                  publicity concerning the status of potentialdrug products under development by us or our collaborators or our competitorsand their partners;

 

•                  reduction, termination or expiration of ourcollaborations;

 

•                  announcements by us or our competitors ofsignificant acquisitions, strategic partnerships or joint ventures;

 

•                  announcements of technological innovations ornew commercial products by our competitors or us;

 

•                  developments concerning proprietary rights,including patents;

 

•                  litigation;

 

•                  economic and other external factors or otherdisasters or crises;

 

•                  actual or anticipated period-to-periodfluctuations in our financial results;

 

•               changes in financial estimates prepared bysecurities analysts;

 

•              differences in the valuations assigned by theequity markets and, in particular, the biopharmaceutical sector of the equitymarkets, to biopharmaceutical companies such as us that have more drugdiscovery than drug development capabilities; and

 

•                  the general performance of the equity marketsand, in particular, the biopharmaceutical sector of the equity markets.

 

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***We had net losses in recent years,and our future profitability is uncertain.***

 

Duringthe nine month period ended September 30, 2005, we had a net loss ofapproximately $14.1 million.  For thefiscal years ended December 31, 2004, 2003 and 2002, we had net losses ofapproximately $17.4 million, $2.8 million and $2.1 million, respectively.

 

Thenet loss for the fiscal year ended December 31, 2004 includedrestructuring and other charges of $5.9 million.  The net loss for thenine months ended September 30, 2005 was due to increased corporateoverhead costs, severance and our increased focus on internal research anddevelopment.  Continuing net losses maylimit our ability to fund our operations, and we may not generate income fromoperations in the future.

 

Ona quarterly basis, our future operating results are likely to be highlyvolatile depending upon our receipt of milestone payments from ourcollaborators.  We may not receivemilestone payments on a regular basis or at all.  Our ability to achieve profitability, ifever, will be significantly impacted by the level of investment we determine tomake in our internal proprietary programs in the future as well as the resultsof those programs.

 

***Disputes mayarise between our partners and us as to royalties and milestones to which webelieve we are entitled.***

 

Thecompound basis for drugs developed by a partner may be a derivative oroptimized version of the compound screened or optimized by us.

 

Whileour existing collaborative agreements provide that we will receive milestonepayments and royalties with respect to certain products developed from certainderivative compounds, there can be no assurance that disputes will not ariseover the application of payment provisions to such products.

 

Therecan be no assurance that current or future partners will not pursue alternativetechnologies, or develop alternative products either on their own or incollaboration with others, including our competitors, as a means for developingtreatments based on the targets which are the subject of the collaborativearrangements with us.

 

Inaddition, many of our agreements that provide for potential royalty payments tous also contain provisions that reduce our expected royalty if a partner isalso required to pay a royalty on a product to a third party.

 

***We may not successfully enter intoadditional collaborations that allow us to participate in the future success ofour product candidates through milestone, royalty and/or license payments, andwe may never receive any milestone, royalty and/or license payments under ourcurrent or any future collaborations.***

 

Oneof our business strategies is to expand our proprietary pipeline of drugcandidates and to then enter into collaborations for the development of thesedrug candidates that will allow us to earn milestone, royalty and/or licensepayments.  Our proprietary drug discoveryprogram is in its early stage of development and is unproven.

 

Althoughwe have expended, and continue to expend, time and money on internal researchand development programs, we may be unsuccessful in creating valuableproprietary drug candidates that would enable us to form additionalcollaborations and receive milestone, royalty and/or license payments.

 

Ourcollaborations and internal programs may not result in the discovery of potentialdrug candidates that will be safe or effective. Although we have received license and milestone fees to date, we maynever receive any royalty payments, or any additional license and milestonefees, under our current or any future collaborations.  Our receipt of any future milestone, royaltyor license payments depends on many factors, including whether ourcollaborators desire to or are able to continue to pursue a potential drugcandidate and the ultimate commercial success of the drug. Development andcommercialization of potential drug candidates depend not only on theachievement of research objectives by our collaborators and us, but also oneach collaborator’s financial, competitive, marketing and strategicconsiderations and regulation in the United States and other countries.  If unforeseen complications arise in thedevelopment or commercialization of the potential drug candidates by ourcollaborators, we may not realize milestone, royalty or license payments.

 

***The drug research and developmentindustry is highly competitive and subject to technological change, and we maynot have the resources necessary to compete successfully.***

 

Manyof our competitors have access to greater financial, technical, research,marketing, sales, distribution, service and other resources than we do.

 

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Moreover,the pharmaceutical and biotechnology industries are characterized by continuoustechnological innovation.  We anticipatethat we will face increased competition in the future as new companies enterthe market and our competitors make advanced technologies available.  Technological advances or entirely differentapproaches that we or one or more of our competitors develop may render ourproducts, services and expertise obsolete or uneconomical. Additionally, theexisting approaches of our competitors or new approaches or technologies thatour competitors develop may be more effective than those we develop.  We may not be able to compete successfullywith existing or future competitors.

 

***If we cannot manage the multiplerelationships and interests involved in our collaborative arrangements and drugdiscovery programs, our business, financial condition and results of operationsmay be materially adversely affected.***

 

Wemay need to successfully structure and manage multiple drug discovery programsand collaborative relationships, including maintaining confidentiality of theresearch being performed for multiple collaborators.  We may be unable to manage successfullyconflicts between competing drug development programs of third parties to whichwe offer services.  From time to time,more than one of our collaborators may want to perform research concerning thesame or molecularly similar disease targets.

 

Becauseof that, we may be required to reconcile our relationships with thosecollaborators, particularly if both want to establish exclusive relationshipswith us with respect to that target or if one collaborator has an existingarrangement with us and the other would like us to perform services regarding atarget restricted by that arrangement.

 

Further,if we are working with a collaborator regarding a particular target, another ofour collaborators may be researching the same target in one of its internalprograms of which we have no knowledge. As a result, potential conflicts involving us may arise due to thiscompetition between collaborators in a particular disease field of interest.

 

Conflictsalso may arise between our collaborators as to proprietary rights to particularcompounds in our libraries or as to proprietary rights to biological targetssuch as receptors or enzymes against which we screen compounds in ourlibraries.  The occurrence of conflicts,or the perception of conflicts, could have a material adverse effect on ourbusiness, financial condition and results of operations

 

***If we use hazardous materials in amanner that causes injury or violates laws, we may be liable for damages.***

 

Ouractivities involve the use of potentially harmful hazardous materials,chemicals and various radioactive compounds. These materials are utilized in the performance of our assaydevelopment, high-throughput screening and chemistry optimization services, andinclude common organic solvents, such as acetone, hexane, methylene chloride,acetonitrile, and isopropyl and methyl alcohol as well as common acids andbases.  The waste from utilization ofthese solvents and other materials is disposed of through licensed third-partycontractors.  Further, we utilize anextremely wide variety of chemicals in the performance of our assaydevelopment, screening and optimization services.  These chemicals, such as reagents, buffersand inorganic salts, typically are employed in extremely small amounts inconnection with the work performed in our laboratories.

 

Wecannot completely eliminate the risk of accidental contamination or injury fromthe use, storage, handling or disposal of these materials. In the event ofcontamination or injury, we could be held liable for damages that result.  We maintain insurance coverage againstenvironmental hazards arising from the storage and disposal of the materialsutilized in our business.  Although ourmanagement believes that such insurance has terms, including coverage limits,which are appropriate for our business, liabilities arising from the use,storage, handling or disposal of these materials could exceed our insurancecoverage as well as our resources.  Weare subject to federal, state and local laws and regulations governing the use,storage, handling and disposal of these materials and specified wasteproducts.  The cost of compliance withthese laws and regulations could be significant.  To our knowledge, we have not been, andcurrently are not, the subject of any governmental investigation concerning theviolation of these federal, state and local laws and regulations.  There can be no assurance that we will not bethe subject of future investigations by governmental authorities.

 

***We and our products are subject tostrict government regulation, which may limit the development of products by usor our collaborators.***

 

Regulationby governmental entities in the United States and other countries will be asignificant factor in the production and marketing of any pharmaceuticalproducts our customers or we may develop. The nature and the extent to which government regulation may apply toour customers and us will vary depending on the nature of the pharmaceuticalproducts, if any. Virtually all pharmaceutical products require regulatoryapproval prior to commercialization.

 

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Ifwe or our collaborators or licensees fail to obtain, or encounter delays inobtaining or maintaining, regulatory approvals, our financial results could beadversely affected.  Similar regulatoryprocedures are required in countries outside the United States.

 

Inaddition, new legislation related to health care could reduce the pricespharmaceutical and biotechnology companies can charge for drugs they sellwhich, in turn, could reduce the amounts that they have available forcollaborative relationships with us or for the purchase of our services.  If pharmaceutical and biotechnology companiesdecrease the resources they devote to the research and development of newdrugs, the number of collaborations we conclude and the amount of andprofitability of services we perform could be adversely impacted and ourrevenue and profitability reduced.  Ifprices that pharmaceutical and biotechnology companies can charge for drugsthey sell decrease, the royalties, if any, we receive from the sale of productswould also decrease, which would reduce our revenue and profitability.

 

*                **Because our internal programs are in discovery, there is a high risk that further development and testing will demonstrate that our programs are not suitable for commercialization.***

 

We have no products that have received regulatory approval for commercial sale.  Our programs must satisfy rigorous standards of safety and efficacy before the FDA and foreign regulatory authorities will approve them for commercial use.

 

We will need to conduct significant additional research, preclinical testing and clinical trials to demonstrate the safety and efficacy of our programs to the satisfaction of the FDA and foreign regulatory authorities to obtain product approval.

 

Discovery, preclinical testing and clinical development are long, expensive and uncertain processes.  It may take us several years to complete our testing, and failure can occur at any stage of testing.  Success in preclinical testing and early clinical trials does not ensure that later clinical trials will be successful.

 

We may suffer significant setbacks in advanced clinical trials, even after promising results in earlier trials.  We may not be able to enroll a sufficient number of patients to complete our clinical trials in a timely manner.  Based on results at any stage of clinical trials, we may decide to discontinue development of our product candidates.

 

We do not know whether any future clinical trials will demonstrate sufficient safety and efficacy necessary to obtain the requisite regulatory approvals or will result in marketable products.  Our failure to adequately demonstrate the safety and efficacy of our programs will prevent receipt of FDA and foreign regulatory approvals and, ultimately, commercialization of our programs.

 

***Failure to attract and retainskilled personnel could materially and adversely affect us.***

 

Weare a small company, and our success depends in part on the continued serviceof key scientific and management personnel, including our president and chiefexecutive officer Leslie J. Browne, Ph.D., and our ability to identify, hireand retain additional personnel.  Thereis intense competition for qualified personnel. Immigration laws may further restrict our ability to attract or hirequalified personnel.  We may not be ableto continue to attract and retain the personnel necessary for our growth anddevelopment.  Failure to attract andretain key personnel could have a material adverse effect on our business,financial condition and results of operations. Further, we are highly dependent on the principal members of ourscientific and management staff.  One ormore of these key employees could retire or otherwise leave our employ withinthe foreseeable future, and the loss of any of these people could have amaterial adverse effect on our business, financial condition and results ofoperations.  We do not, and do not intendto, maintain key person life insurance on the life of any employee.

 

***Some of our development andmarketing activities are, or will be, conducted by third parties.  If these third parties fail to perform theirfunctions satisfactorily, our revenue and earnings could be delayed, reduced oreliminated.***

 

Theultimate success of our business plan heavily depends upon the successfuldiscovery, development and commercialization of pharmaceutical products.  Our endeavors will result in commercializedpharmaceutical products, if at all, only after significant preclinical and clinicaldevelopment, requisite regulatory approvals, establishment of manufacturingcapabilities and successful marketing. We do not currently have the technology, facilities, personnel orexperience to accomplish all of these tasks on our own, and we will likely nothave all the necessary resources in the foreseeable future.  Therefore, we continue to depend heavily uponthe expertise and dedication of sufficient resources by partners to develop andcommercialize products primarily based on lead compounds discovered by us.  If a partner fails to develop orcommercialize a compound or product with respect to which it has rights fromus, we may not receive any future milestone payments or royalties associatedwith that compound or product.

 

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Similarly,while we are unaware of a specific reason that any of the following factorswill be experienced by our strategic collaborators, because we rely heavily onthem, our revenue could be adversely affected if our collaborators:

 

•                  fail to select a target or product candidatewe have identified for subsequent development;

 

•                  fail to gain the requisite regulatoryapprovals of product candidates;

 

•                  do not successfully commercialize productsbased on the compounds that we originate;

 

•                  do not conduct their collaborative activitiesin a timely manner;

 

•                  do not devote sufficient time or resources toour partnered programs or potential products;

 

•                  terminate their alliances or arrangementswith us;

 

•                  develop, either alone or with others,products that may compete with our product candidates;

 

•                  dispute our respective allocations of rightsto any products or technology developed during our collaborations; or

 

•                  merge with or are acquired by a third partythat seeks to terminate our collaboration.

 

***We are subject to risks associatedwith the operation of an international business***

 

Inthe nine months ended September 30, 2005, approximately 57% of ourrevenue was derived from customers outside the United States.  During that period, approximately 56% of ourrevenue was derived from customers in Europe, and approximately 1% was derivedfrom customers in the Asia/Pacific region. We anticipate that international revenue will continue to account for asignificant percentage of our overall revenue. While we are unaware of a specific reason that any of the followingfactors will have a material impact on our revenue, our internationaloperations are subject to the risk factors inherent in the conduct ofinternational business, including:

 

•                  unexpected changes in regulatoryrequirements;

 

•                  longer payment cycles;

 

•                  import and export license requirements;

 

•                  tariffs and other barriers;

 

•                  political and economic instability;

 

•                  limited intellectual property protection;

 

•                  difficulties in collecting trade receivables;

 

•                  difficulties in staffing and managing foreignjoint venture operations; and

 

•                  potentially adverse tax consequences.

 

Wemay not be able to sustain or increase our international revenue.  Any of the foregoing factors may have amaterial adverse effect on our international operations and, therefore, ourbusiness, financial condition and results of operations.

 

***We may not realize revenue from ourbusiness development efforts.***

 

Ourcollaborative relationships involve lengthy negotiation cycles, often requiringus to expend considerable financial and personnel resources without anyassurance that revenue will be recognized.

 

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Thesecycles typically are long for a number of reasons.  Factors include the strategic nature of ourpartnerships, the size of many such transactions, the confidential andproprietary nature of the biological targets against which we screen ourchemical compound libraries, and the unique terms typically found in each ofthe transactions.  As a result, we mayexpend substantial funds and effort to negotiate agreements for collaborativearrangements, but may ultimately be unable to complete the transaction andrecognize revenue.  In thesecircumstances, our business, financial condition and results of operations willbe adversely affected.

 

***Our operations may be interrupted bythe occurrence of a natural disaster or other catastrophic event at our primaryfacilities.***

 

Wedepend on our laboratories and equipment for the continued operation of ourbusiness.  Our research and developmentoperations and administrative functions are primarily conducted at ourfacilities in the Princeton, New Jersey area. Although we have contingency plans in effect for natural disasters orother catastrophic events, catastrophic events could still disrupt ouroperations.  Even though we carrybusiness interruption insurance policies, we may suffer losses as a result ofbusiness interruptions that exceed the coverage available under our insurancepolicies.  Any natural disaster orcatastrophic event in our facilities or the areas in which they are locatedcould have a significant negative impact on our operations.

 

***Because we do not intend to paydividends, you will benefit from an investment in our common stock only if itappreciates in value.***

 

Wehave never declared or paid any cash dividend on common stock.  We currently intend to retain our futureearnings, if any, to finance the expansion of our business and do not expect topay any cash dividends in the foreseeable future.  As a result, the success of your investmentin our common stock will depend entirely upon any future appreciation in itsvalue.  There is no guarantee that ourcommon stock will appreciate in value or even maintain its price.

 

***Anti-takeover provisions underSection 203 of the Delaware General Corporation Law, provisions in ouramended and restated certificate of incorporation and amended and restatedbylaws, and our adoption of a stockholder rights plan may render more difficultthe accomplishment of mergers or the assumption of control by a principalstockholder, making more difficult the removal of management.***

 

Section 203of the Delaware General Corporation Law may delay or deter attempts to securecontrol of our company without the consent of our management.  In general, Section 203 prohibits apublicly-held Delaware corporation from engaging in a business combination withan interested stockholder for a period of three years following the date theperson becomes an interested stockholder, unless certain conditions are met.

 

Ouramended and restated certificate of incorporation and amended and restatedbylaws contain several provisions that could delay or make more difficult theacquisition of our company through a hostile tender offer, open marketpurchases, proxy contest, merger or other takeover attempt that a stockholdermight consider in his or her best interest, including those attempts that mightresult in a premium over the market price of our common stock.  Such provisions include the issuance ofpreferred stock without approval of the holders of our common stock, theclassification of our board of directors, the election and removal ofdirectors, restrictions on the ability of stockholders to take action without ameeting, restrictions on stockholders’ ability to call a special meeting andadvance notice procedures regarding any proposal of stockholder business to bediscussed at a stockholders meeting.

 

Wehave adopted a stockholder rights plan, which is triggered upon commencement orannouncement of a hostile tender offer or when any one person or group acquires15% or more of our common stock.  Therights plan, once triggered, enables stockholders to purchase our common stock,and the stock of the entity acquiring us, at reduced prices.  These provisions of our governing documents,stockholder rights plan and Delaware law could have the effect of delaying,deferring or preventing a change of control, including without limitation aproxy contest, making more difficult the acquisition of a substantial block ofour common stock.  The provisions couldalso limit the price that investors might be willing to pay in the future forshares of our common stock.  Further, theexistence of these anti-takeover measures may cause potential bidders to lookelsewhere, rather than initiating acquisition discussions with us.

 

***If we engage inan acquisition or business combination, we will incur a variety of risks thatcould adversely affect our business operations or our stockholders.***

 

From time to time we have considered, and we willcontinue to consider in the future, if and when any appropriate opportunitiesbecome available, strategic business initiatives intended to further thedevelopment of our business.

 

27

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These initiatives may include acquiring businesses,technologies or products or entering into a business combination with anothercompany.  If we do pursue such astrategy, we could, among other things:

 

•      issue equity securities that would dilute ourcurrent stockholders’ percentage ownership; 

 

•      incur substantial debt that may place strainson our operations; 

 

            •      spend substantial operational, financial andmanagement resources in integrating new businesses, technologies and products;

#####  

•      assume substantial actual or contingentliabilities; or 

 

•      merge with, or otherwise enter into abusiness combination with, another company in which our stockholders wouldreceive cash or shares of the other company or a combination of both on termsthat our stockholders may not deem desirable. 

 

We are not in a position to predict what, if any,collaborations, alliances or other transactions may result or how, when or ifthese activities would have a material effect on us or the development of ourbusiness.

 

**RISKS RELATED TO ESTABLISHING OUR COMPANY AS INDEPENDENT FROMACCELRYS**

 

***We have agreed to certainrestrictions to preserve the tax treatment of the distribution, which willreduce our strategic and operating flexibility.***

 

Accelrysobtained an opinion from Dechert LLP, its counsel, to the effect that thedistribution qualifies as a transaction that is generally tax-free underSections 355 and/or 368(a)(1)(D) of the Internal Revenue Code of 1986, asamended (the “Code”). Current tax law generally creates a presumption that thedistribution would be taxable to Accelrys but not to its stockholders if weengage in, or enter into an agreement to engage in, a transaction that wouldresult in a 50 percent or greater change by vote or by value in our stockownership during the four-year period beginning on the date that begins twoyears before the distribution date, unless it is established that thetransaction is not pursuant to a plan or series of transactions related to thedistribution.

 

TemporaryU.S. Treasury regulations currently in effect generally provide that whether anacquisition transaction and a distribution are part of a plan is determinedbased on all of the facts and circumstances, including but not limited to thosespecific factors listed in the regulations. In addition, the regulations provide several “safe harbors” foracquisition transactions that are not considered to be part of a plan.

 

Weand Accelrys have entered into a tax sharing agreement under which we have madecertain covenants to each other in connection with the distribution that we maynot take certain actions without first obtaining an unqualified opinion ofcounsel or an Internal Revenue Service ruling that such actions will not causethe distribution to become taxable.  Pursuant to these covenants,generally (1) we will, for two years after the distribution date, continuethe active conduct of the drug discovery business; (2) we will notrepurchase our stock except in certain circumstances permitted by the InternalRevenue Service; (3) we will not take any actions inconsistent with therepresentations made in connection with the issuance by Dechert LLP of itsopinion with respect to the distribution; and (4) we will not take or failto take any other action that would result in any tax being imposed on thedistribution.  Accelrys may seek an injunction to enforce these covenants.

 

Theserestrictions could substantially limit our strategic and operationalflexibility, including our ability to finance our operations by issuing equitysecurities, to make acquisitions using equity securities, to repurchase ourequity securities, to raise money by selling assets, or to enter into businesscombination transactions.

 

***We have agreed to indemnify Accelrysfor taxes and related losses resulting from any actions we take that cause thedistribution to fail to qualify as a tax-free transaction.***

 

Wehave agreed to indemnify Accelrys for any taxes and related losses (includingany applicable interest and penalties, all related accounting, legal and otherprofessional fees, all related court costs and all costs, expenses and damagesassociated with related stockholder litigation or controversies and any amountpaid in respect of the liability of stockholders) resulting from a breach ofany of the covenants described above.  Furthermore, we will be responsiblefor taxes that may be imposed upon Accelrys pursuant tosection 355(e) of the Code in connection with a transaction thatresults in a change in control of us, even though we will have obtained anInternal Revenue Service ruling or an unqualified opinion of counsel prior tothe transaction.  The amount of any indemnification payments could besubstantial.

 

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Theamount of Accelrys taxes for which we are agreeing to indemnify Accelrys willbe based on the excess of the aggregate fair market value of our stock as ofthe distribution date over Accelrys tax basis in our stock.

 

***We may be required to indemnifyAccelrys, or may not be able to collect on indemnification rights fromAccelrys.***

 

Underthe terms of the master separation and distribution agreement and the taxsharing and indemnification agreement that we entered into with Accelrys, weand Accelrys agreed to indemnify one another from and after the distributionwith respect to the indebtedness, liabilities and obligations retained by ourrespective companies.  These indemnification obligations could besignificant.  Our ability to satisfy any such indemnification obligationswill depend upon the future financial strength of our company.  We cannotdetermine whether we will have to indemnify Accelrys for any substantialobligations.

 

Wealso cannot assure you that, if Accelrys becomes obligated to indemnify us forany substantial obligations, Accelrys will have the ability to satisfy thoseobligations.  Any payment by Accelrys or us pursuant to theseindemnification provisions could have a material adverse effect on itsbusiness.  Any failure by Accelrys or us to satisfy its indemnificationobligations could have a material adverse effect on the other company’sbusiness.

 

**CERTAIN RISKS RELATED TO INTELLECTUAL PROPERTY**

 

***Positions taken by the U.S. Patentand Trademark Office or non-U.S. patent and trademark officials may preclude usfrom obtaining sufficient or timely protection for our intellectual property.***

 

Thepatent positions of pharmaceutical and biotechnology companies are uncertainand involve complex legal and factual questions.  The coverage claimed in a patent applicationcan be significantly reduced before the patent is issued.  There is a significant risk that the scope ofa patent may not be sufficient to prevent third parties from marketing otherproducts or technologies with the same functionality of our products andtechnologies.  Consequently, some or allof our patent applications may not issue into patents, and any issued patentsmay provide ineffective remedies or be challenged or circumvented.

 

***Third parties may have filed patentapplications of which we may or may not have knowledge, and which may adverselyaffect our business.***

 

Patentapplications in the United States are maintained in secrecy for 18 months fromfiling or until a patent issues.  Undercertain circumstances, patent applications are never published but remain insecrecy until issuance.  As a result,others may have filed patent applications for products or technology covered byone or more pending patent applications upon which we are relying.  If applications covering similar technologieswere to be filed before our applications, our patent applications may not begranted.  There may be third-partypatents, patent applications and other intellectual property or informationrelevant to our chemical compositions and other technologies that are not knownto us, that block us or compete with our chemical compositions or othertechnologies, or limit the scope of patent protection available to us.  Moreover, from time to time, patents mayissue which block or compete with our chemical compositions or othertechnologies, or limit the scope of patent protection available to us.  Litigation may be necessary to enforcepatents issued to us or to determine the scope and validity of the intellectualproperty rights of third parties.

 

***We may not be able to protectadequately the trade secrets and confidential information that we disclose toour employees.***

 

Werely upon trade secrets, technical know-how and continuing technologicalinnovation to develop and maintain our competitive position.  Competitors through their independentdiscovery (or improper means, such as unauthorized disclosure or industrialespionage) may come to know our proprietary information.  We generally require employees andconsultants to execute confidentiality and assignment-of-inventionsagreements.  These agreements typicallyprovide that all materials and confidential information developed by or madeknown to the employee or consultant during his, her or its relationship with usare to be kept confidential, and that all inventions arising out of theemployee’s relationship with us are our exclusive property.  Our employees and consultants may breachthese agreements, and in some instances we may not have an adequateremedy.  Additionally, in some instances,we may have failed to require that employees and consultants executeconfidentiality and assignment-of-inventions agreements.

 

***Foreign laws may not afford ussufficient protections for our intellectual property, and we may not seekpatent protection outside the United States.***

 

Webelieve that our success depends, in part, upon our ability to obtaininternational protection for our intellectual property.

 

29

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However,the laws of some foreign countries may not be as comprehensive as those of theUnited States and may not be sufficient to protect our proprietary rightsabroad.  In addition, we may decide notto pursue patent protection outside the United States, because of cost andconfidentiality concerns.  Accordingly,our international competitors could obtain foreign patent protection for, andmarket overseas, products and technologies for which we are seeking U.S. patentprotection and may be able to use these products and technologies to competeagainst us.

 

***We may not be able to adequatelydefend our intellectual property from third party infringement, and third partychallenges to our intellectual property may adversely affect our rights and becostly and time consuming.***

 

Someof our competitors have, or are affiliated with companies having, substantiallygreater resources than we have, and those competitors may be able to sustainthe costs of complex patent litigation to a greater degree and for longerperiods of time than us.  Uncertaintiesresulting from the initiation and continuation of any patent or relatedlitigation could have a material adverse effect on our ability to compete inthe marketplace pending resolution of the disputed matters.  If our competitors prepare and file patentapplications in the United States that claim technology also claimed by us, wemay have to participate in interference proceedings declared by the U.S. Patentand Trademark Office to determine the priority of invention, which could resultin substantial costs to us, even if the outcome is favorable to us.  Similarly, opposition proceedings may occuroverseas, which may result in the loss or narrowing of the scope of claims orlegal rights.  Such proceedings will atleast result in delay in the issuance of enforceable claims.  An adverse outcome could subject us tosignificant liabilities to third parties and require us to license disputedrights from third parties or cease using the technology.

 

***A patent issued to us may not besufficiently broad to protect adequately our rights in intellectual property towhich the patent relates.***

 

Evenif patents are issued to us, these patents may not sufficiently protect ourinterest in our chemical compositions or other technologies because the scopeof protection provided by any patents issued to or licensed by us are subjectto the uncertainty inherent in patent law. Third parties may be able to design around these patents or developunique products providing effects similar to our products.  In addition, others may discover uses for ourchemical compositions or technologies other than those uses covered in ourpatents, and these other uses may be separately patentable.  A number of pharmaceutical and biotechnologycompanies, and research and academic institutions, have developed technologies,filed patent applications or received patents on various technologies that maybe related to our business.  Some ofthese technologies, patent applications or patents may conflict with ourtechnologies, patent applications or patents. These conflicts could also limit the scope of patents, if any, that wemay be able to obtain, or result in the denial of our patent applications. Weare not currently aware of any such patent applications or patents that couldhave a material adverse effect on our business.

 

***We may be subject to claims ofinfringement by third parties.***

 

Thirdparties may claim infringement by us of their intellectual propertyrights.  In addition, to the extent ouremployees are involved in research areas similar to those areas in which theywere involved at their former employers, we may be subject to claims that oneof our employees, or we, have inadvertently or otherwise used or disclosed thealleged trade secrets or other proprietary information of a formeremployer.  From time to time, we havereceived letters claiming or suggesting that our products or activities mayinfringe third party patents or other intellectual property rights.  Our products may infringe patent or otherintellectual property rights of third parties. A number of patents may have been issued or may be issued in the futurethat could cover certain aspects of our technology and that could prevent usfrom using technology that we use or expect to use.  We may be required to seek licenses for, orotherwise acquire rights to, technology as a result of claims ofinfringement.  We may not possess properownership or access rights to the intellectual property we use.  Third parties or other companies may bringinfringement suits against us.  Anyclaims, with or without merit, could be time consuming to defend, result incostly litigation, divert management’s attention and resources or require us toenter into royalty or licensing agreements. Royalty or licensing agreements, if required, may not be available onterms acceptable to us, if at all.  In theevent of a successful claim of product infringement against us, our failure orinability to license or design around the infringed technology could have amaterial adverse effect on our business, financial condition and results ofoperations.  We are not currentlyinvolved in actions of this type that are material to our business.

 

**Item 3. Quantitative and Qualitative Disclosures aboutMarket Risk**

 

Ourinternational sales generally are denominated in United States Dollars, andare, therefore, not exposed to changes in foreign currency exchange rates.

 

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We donot use derivative financial instruments for trading or speculativepurposes.  Our exposure to market risksassociated with changes in interest rates relates primarily to the increase ordecrease in the amount of interest income earned on our investment portfoliosince we have no debt.  We ensure thesafety and preservation of invested funds by limiting default risks, marketrisk and reinvestment risk.  We mitigatedefault risk by investing in investment grade securities.  A hypothetical 100 basis point adverse movein interest rates along the entire interest rate yield curve would notmaterially affect the fair value of our interest sensitive financialinstruments at September 30, 2005.

 

**Item 4. Controls andProcedures**

 

Forthe quarterly period ended September 30, 2005, our management carried out anevaluation, under the supervision and with the participation of our Presidentand Chief Executive Officer, Chief Financial Officer (our principal financialofficer) and Vice President, Finance (our chief accounting officer), of theeffectiveness of our disclosure controls and procedures pursuant toRules 13a-15 and 15d-15 under the Securities Exchange Act of 1934, or theExchange Act, as of the end of the period covered by this report.  Based upon this evaluation, our President andChief Executive Officer, Chief Financial Officer and Vice President, Financeconcluded that as of September 30,2005, our disclosure controls and procedures are effective to ensure that theinformation required to be disclosed by us in reports filed under the ExchangeAct is recorded, processed, summarized and reported within the time periodsspecified in the rules and forms of the SEC.  Our management, including our President andChief Executive Officer, Chief Financial Officer and Vice President, Finance,does not expect that our disclosure controls or our internal controls willprevent all errors and all fraud.  Acontrol system, no matter how well designed and operated, cannot provideassurance that the objectives of the control system are met, and no evaluationof controls can provide absolute assurance that all control issues andinstances of fraud, if any, within a company have been detected.

 

Additionally,our President and Chief Executive Officer, Chief Financial Officer and VicePresident, Finance determined that there were no changes in our internalcontrol over financial reporting during the quarterly period ended September 30, 2005, that have materially affected,or are reasonably likely to materially affect, our internal control overfinancial reporting.

 

**PART II.  OTHER INFORMATION**

 

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

 

Presently,we are not party to any litigation.

 

**Item 2.****          ****Unregistered Sales of EquitySecurities and Use of Proceeds**

 

On July 28, 2005, we entered into purchase agreements to sell an aggregate 2,470,000 shares of newly issued common stock (the “Shares”) to institutional investors (collectively, the “Purchasers”) at a price of $3.43 per share pursuant to the exemption from registration provided by Section 4(2) of the Securities Act of 1933 in connection with a transaction by an issuer not involving any public offering (the “Private Placement”).  On August 1, 2005, we sold the Shares and realized gross proceeds of approximately $8.5 million from the Private Placement.  We realized net proceeds of approximately $7.7 million from the Private Placement after deducting fees payable to the placement agent and other transaction expenses.

 

Pursuant to the purchase agreements executed in connection with the Private Placement, we filed a registration statement on Form S-3 with the Securities and Exchange Commission to register the resale of the Shares.  The registration statement on Form S-3 was declared effective on August 26, 2005.  In addition, we agreed to use our best efforts, subject to receipt of necessary information from the Purchasers, to keep the registration statement effective until the earlier of (i) 2 years after the effective date of the registration statement or (ii) the date on which the Shares become eligible for resale pursuant to Rule 144(k) under the Securities Act of 1933, as amended.

 

We expected to use the proceeds from the Purchasers in the PrivatePlacement to advance our internal programs towards the filing of theInvestigational New Drug applications.

** **

**Item 3.**           **Defaultsupon Senior Securities**

 

None.

 

**Item 4.****          ****Submission of Matters to aVote of Security Holders.**

 

None.

 

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

 

OnNovember 3, 2005, the Company entered into a letter agreement (the “CostalasAmendment”) amending the Severance Agreement, dated as of December 2, 2004,between the Company and Stephen C. Costalas, Executive Vice President andGeneral Counsel of the Company.  TheCostalas Amendment provides that the Company will make a “gross-up payment” toMr. Costalas in the event that certain severance payments to him in connectionwith a change in control of the Company become subject to the excise taximposed by Section 4999 of the Internal Revenue Code.  The Company will make such a payment to Mr.Costalas if such severance payments exceed the applicable Internal RevenueService “safe harbor” multiple by 10% or more. The Costalas Amendment states that if such severance payments exceed the“safe harbor” multiple by less than 10%, Mr. Costalas will have his severancebenefits cut back so as not to incur any excise taxes.

 

OnNovember 3, 2005, the Company entered into a letter agreement (the “DeLorbeAmendment”) amending the Severance Agreement, dated as of August 26, 2005,between the Company and William J. DeLorbe, Executive Vice President, HumanResources of the Company.  The DeLorbeAmendment provides that the Company will make a “gross-up payment” to Dr.DeLorbe in the event that certain severance payments to him in connection witha change in control of the Company become subject to the excise tax imposed bySection 4999 of the Internal Revenue Code. The Company will make such a payment to Dr. DeLorbe if such severancepayments exceed the applicable Internal Revenue Service “safe harbor” multipleby 10% or more.  The DeLorbe Amendmentstates that if such severance payments exceed the “safe harbor” multiple byless than 10%, Dr. DeLorbe will have his severance benefits cut back so as notto incur any excise taxes.

 

OnNovember 3, 2005, the Company entered into a letter agreement (the “FloydAmendment”) amending the Severance Agreement, dated as of January 7, 2005,between the Company and David M. Floyd, Executive Vice President and ChiefScientific Officer of the Company.  TheFloyd Amendment provides that the Company will make a “gross-up payment” to Dr.Floyd in the event that certain severance payments to him in connection with achange in control of the Company become subject to the excise tax imposed bySection 4999 of the Internal Revenue Code. The Company will make such a payment to Dr. Floyd if such severancepayments exceed the applicable Internal Revenue Service “safe harbor” multipleby 10% or more.  The Floyd Amendmentstates that if such severance payments exceed the “safe harbor” multiple byless than 10%, Dr. Floyd will have his severance benefits cut back so as not toincur any excise taxes.

 

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**Item 6.****          ****Exhibits**

 
| **Exhibits.** | ** ** | ** **                                                                                                                                                                                                                                                   |
|---------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|          |       |                                                                                                                                                                                                                                                         |
| 10.1          |       | Amendment,  dated November 3, 2005, to Severance Agreement, dated December 2, 2004  between Pharmacopeia Drug Discovery, Inc. and Stephen C. Costalas (1)                                                                                                    |
|          |       |                                                                                                                                                                                                                                                         |
| 10.2          |       | Amendment,  dated November 3, 2005, to Severance Agreement, dated August 26, 2005 between  Pharmacopeia Drug Discovery, Inc. and William J. DeLorbe (1)                                                                                                      |
|          |       |                                                                                                                                                                                                                                                         |
| 10.3          |       | Amendment,  dated November 3, 2005, to Severance Agreement, dated January 7, 2005 between  Pharmacopeia Drug Discovery, Inc. and David M. Floyd (1)                                                                                                          |
|          |       |                                                                                                                                                                                                                                                         |
| 31.1          |       | Certification  of the Principal Executive Officer of Pharmacopeia Drug Discovery, Inc.  pursuant to Rule 13a-l4 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 of Pharmacopeia Drug Discovery, Inc.  pursuant to Rule 13a-14 of the Securities Exchange Act of 1934, as  amended, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of  2002(1) |
|          |       |                                                                                                                                                                                                                                                         |
| 31.3          |       | Certification  of the Chief Accounting Officer of Pharmacopeia Drug Discovery, Inc.  pursuant to Rule 13a-14 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 Chief Executive Officer of Pharmacopeia Drug Discovery, 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 of Pharmacopeia Drug Discovery, Inc.  pursuant to 18 U.S.C. Section 1350, as adopted pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002(1)                                          |
|          |       |                                                                                                                                                                                                                                                         |
| 32.3          |       | Certification  of the Chief Accounting Officer of Pharmacopeia Drug Discovery, 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)                                  Filed herewith.

 

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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  DRUG  DISCOVERY, INC. |
|------------------------------------|-------------------------------------|
|                               |                                |
| Date:  November  4, 2005 | By:                                 | /s/  Leslie J. Browne, Ph.D. |
|                               |                                | Leslie  J. Browne, Ph.D. |
|                               |                                | President  and Chief Executive Officer |
|                               |                                |
|                               | By:                                 | /s/  Michio Soga |
|                               |                                | Michio  Soga |
|                               |                                | Executive  Vice President and |
|                               |                                | Chief  Financial Officer |
|                               |                                | (Principal  Financial Officer) |
|                               |                                |
|                               | By:                                 | /s/  Brian M. Posner |
|                               |                                | Brian  M. Posner |
|                               |                                | Vice  President, Finance |
|                               |                                | (Chief  Accounting Officer) |

 

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**PHARMACOPEIA DRUG DISCOVERY, INC.**

 

**INDEX TO EXHIBITS**

 
| **No.**    | ** ** | **EXHIBIT**                                                                                                                                               |
|------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------|
| ** ** | ** ** | ** **                                                                                                                                                |
| 10.1       |       | Amendment,  dated November 3, 2005, to Severance Agreement, dated December 2, 2004  between Pharmacopeia Drug Discovery, Inc. and Stephen C. Costalas (1) |
|       |       |                                                                                                                                                      |
| 10.2       |       | Amendment,  dated November 3, 2005, to Severance Agreement, dated August 26, 2005 between  Pharmacopeia Drug Discovery, Inc. and William J. DeLorbe (1)   |
|       |       |                                                                                                                                                      |
| 10.3       |       | Amendment,  dated November 3, 2005, to Severance Agreement, dated January 7, 2005 between  Pharmacopeia Drug Discovery, Inc. and David M. Floyd (1)       |
|       |       |                                                                                                                                                      |
| 31.1       |       | Section 302  Certification of the Principal Executive Officer (1)                                                                                    |
|       |       |                                                                                                                                                      |
| 31.2       |       | Section 302  Certification of the Principal Financial Officer (1)                                                                                    |
|       |       |                                                                                                                                                      |
| 31.3       |       | Section 302  Certification of the Chief Accounting Officer (1)                                                                                       |
|       |       |                                                                                                                                                      |
| 32.1       |       | Section 906  Certification of the Chief Executive Officer (1)                                                                                        |
|       |       |                                                                                                                                                      |
| 32.2       |       | Section 906  Certification of the Principal Financial Officer (1)                                                                                    |
|       |       |                                                                                                                                                      |
| 32.3       |       | Section 906  Certification of the Chief Accounting Officer (1)                                                                                       |

 

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| (1) | Filed herewith. |
|-----|-----------------|

 

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