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** **

 

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**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

 

**FORM 10-Q**

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

 

**CommissionFile Number: 0-50523**

 

**PHARMACOPEIA, INC.**

(Exact name of registrant asspecified in its charter)

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

 

**(609)452-3600**

(Registrant’s telephone number,including area code)

 

 

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

 

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

 

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

 

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

 

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

 

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

 

| **Class**                     | ** ** | **Outstanding  at July 28, 2008** |
|-------------------------------|------------|----------------------------------------|
| Common Stock, $0.01 par value |       | **29,745,100**                         |

 

 

 

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**PHARMACOPEIA,INC.**

 

**Form 10-Q**

 

**Tableof Contents**

 
| **Item**           | ** **        | ** **                                                                                            | ** ** | ** ** | ** ** |
|--------------------|-------------------|-------------------------------------------------------------------------------------------------------|------------|------------|------------|
| ** **         | ** **        | ** **                                                                                            | ** ** | ** ** |
| PART I.       |              | FINANCIAL INFORMATION                                                                                 |       | 3          |
|               |              |                                                                                                  |       |       |
| Item 1.            |              | Consolidated Financial Statements (Unaudited):                                                        |       | 3          |
|               |              |                                                                                                  |       |       |
|               |              | Consolidated Balance Sheets as of  June 30, 2008 and December 31, 2007                      |       | 3          |
|               |              |                                                                                                  |       |       |
|               |              | Consolidated Statements of Operations for  the Three and Six Months Ended June 30, 2008 and 2007 |       | 4          |
|               |              |                                                                                                  |       |       |
|               |              | Consolidated Statements of Cash Flows for  the Six Months Ended June 30, 2008 and 2007           |       | 5          |
|               |              |                                                                                                  |       |       |
|               |              | Notes to  Unaudited Consolidated Financial Statements                                                 |       | 6          |
|               |              |                                                                                                  |       |       |
| Item 2.            |              | Management’s Discussion and Analysis of  Financial Condition and Results of Operations           |       | 20         |
|               |              |                                                                                                  |       |       |
| Item 3.            |              | Quantitative and Qualitative Disclosures  about Market Risk                                           |       | 34         |
|               |              |                                                                                                  |       |       |
| Item 4.            |              | Controls and Procedures                                                                               |       | 34         |
|               |              |                                                                                                  |       |       |
| PART II.      | OTHER INFORMATION |                                                                                                  | 35         |
|               |              |                                                                                                  |       |       |
| Item 1.            |              | Legal Proceedings                                                                                     |       | 35         |
|               |              |                                                                                                  |       |       |
| Item 1A.           |              | Risk Factors                                                                                          |       | 35         |
|               |              |                                                                                                  |       |       |
| Item 2.            |              | Unregistered Sales of Equity Securities and  Use of Proceeds                                          |       | 39         |
|               |              |                                                                                                  |       |       |
| Item 3.            |              | Defaults upon Senior Securities                                                                       |       | 39         |
|               |              |                                                                                                  |       |       |
| Item 4.            |              | Submission of Matters to a Vote of Security  Holders                                                  |       | 39         |
|               |              |                                                                                                  |       |       |
| Item 5.            |              | Other Information                                                                                     |       | 39         |
|               |              |                                                                                                  |       |       |
| Item 6.            |              | Exhibits                                                                                              |       | 40         |
|               |              |                                                                                                  |       |       |
| Signatures         |              | 41                                                                                                    |
|               |              |                                                                                                  |
| Index to  Exhibits |              | 42                                                                                                    |

 

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**PART I - FINANCIALINFORMATION**

 

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

 

**Pharmacopeia, Inc.**

**Consolidated Balance Sheets**

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

 
| ** **                                                                                                                           | ** ** | **June 30,** | ** ** | **December 31,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------|------------|-----------------------|------------|
| ** **                                                                                                                           | ** ** | **2008**          | ** ** | **2007**              | ** ** |
| **ASSETS**                                                                                                                           | ** ** | ** **        | ** ** | ** **            | ** ** |
| Current assets:                                                                                                                      | ** ** | ** **        | ** ** | ** **            | ** ** |
| Cash and cash equivalents                                                                                                            |       | $                 | 30,955     |                  | $          | 30,186 |   |
| Marketable securities                                                                                                                |       | 13,485            |       | 41,129                |       |
| Accounts receivable, net                                                                                                             |       | 1,000             |       | —                |       |
| Prepaid expenses and other current assets                                                                                            |       | 1,396             |       | 2,026                 |       |
| Total current assets                                                                                                                 |       | 46,836            |       | 73,341                |       |
|                                                                                                                                 |       |              |       |                  |       |
| Property and equipment, net                                                                                                          |       | 14,860            |       | 14,840                |       |
| Deferred compensation plan assets                                                                                                    |       | 1,838             |       | 2,073                 |       |
| Other assets                                                                                                                         |       | 144               |       | 144                   |       |
| Total assets                                                                                                                         |       | $                 | 63,678     |                  | $          | 90,398 |   |
|                                                                                                                                 |       |              |       |                  |       |
| **LIABILITIES AND STOCKHOLDERS’ (DEFICIT)  EQUITY**                                                                             |       |              |       |                  |       |
| Current liabilities:                                                                                                                 |       |              |       |                  |       |
| Accounts payable                                                                                                                     |       | $                 | 2,506      |                  | $          | 2,871 |   |
| Accrued and other liabilities                                                                                                        |       | 8,440             |       | 6,928                 |       |
| Deferred revenue, current portion                                                                                                    |       | 21,042            |       | 22,398                |       |
| Notes payable, current portion                                                                                                       |       | 1,228             |       | 1,069                 |       |
| Warrant liability                                                                                                                    |       | 2,744             |       | 4,205                 |       |
| Total current liabilities                                                                                                            |       | 35,960            |       | 37,471                |       |
|                                                                                                                                 |       |              |       |                  |       |
| Deferred revenue, long-term                                                                                                          |       | 25,192            |       | 24,769                |       |
| Deferred compensation plan liabilities                                                                                               |       | 1,838             |       | 2,073                 |       |
| Notes payable, long-term                                                                                                             |       | 2,749             |       | 3,001                 |       |
| Other liabilities, long-term                                                                                                         |       | 348               |       | —                |       |
|                                                                                                                                 |       |              |       |                  |       |
| Commitments and contingencies                                                                                                        |       |              |       |                  |       |
|                                                                                                                                 |       |              |       |                  |       |
| Stockholders’ (deficit) equity:                                                                                                 |       |              |       |                  |       |
| Preferred stock, $.01 par value, 2,500,000  shares authorized, none issued and outstanding                                           |       | —            |       | —                |       |
| Common stock, $.01 par value, 100,000,000  shares authorized, 29,710,100 and 29,630,931 shares issued and outstanding,  respectively |       | 297               |       | 296                   |       |
| Additional paid-in capital                                                                                                           |       | 123,608           |       | 121,785               |       |
| Accumulated deficit                                                                                                                  |       | (126,314          | )          | (98,997               | )          |
| Total stockholders’ (deficit) equity                                                                                            |       | (2,409            | )          | 23,084                |       |
| Total liabilities and stockholders’  (deficit) equity                                                                           |       | $                 | 63,678     |                  | $          | 90,398 |   |

 

See accompanying notes to theseunaudited consolidated financial statements

 

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**Pharmacopeia, Inc.**

**ConsolidatedStatements of Operations**

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

** **
| ** **                                                   | ** ** | **For the Three Months** | ** ** | **For the Six Months** | ** ** |
|--------------------------------------------------------------|------------|-----------------------------------------|------------|---------------------------------------|------------|
| ** **                                                   | ** ** | **Ended June 30,**            | ** ** | **Ended June 30,**          | ** ** |
| ** **                                                   | ** ** | **2008**                                | ** ** | **2007**                              | ** ** | **2008** | ** ** | **2007** | ** ** |
| **Revenue**                                                  | ** ** | ** **                              | ** ** | ** **                            | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net revenue                                                  |       | $                                       | 5,882      |                                  | $          | 4,957 |   | $ | 12,086 |   | $ | 11,306 |   |
|                                                         |       |                                    |       |                                  |       |   |   |   |   |
| **Operating Expenses**                                       |       |                                    |       |                                  |       |   |   |   |   |
| Collaborative research and development  expense              |       | 7,215                                   |       | 5,685                                 |       | 15,135 |   | 10,922 |   |
| Proprietary research and development  expense                |       | 9,188                                   |       | 5,033                                 |       | 17,952 |   | 12,451 |   |
| General and administrative expense                           |       | 4,077                                   |       | 2,771                                 |       | 7,464 |   | 5,459 |   |
| Restructuring expense                                        |       | 1,695                                   |       | —                                |       | 1,695 |   | — |   |
| Total operating expenses                                     |       | 22,175                                  |       | 13,489                                |       | 42,246 |   | 28,832 |   |
| Operating loss                                               |       | (16,293                                 | )          | (8,532                                | )          | (30,160 | ) | (17,526 | ) |
| Other income                                                 |       | 700                                     |       | —                                |       | 700 |   | 94 |   |
| Interest income                                              |       | 244                                     |       | 942                                   |       | 887 |   | 1,544 |   |
| Interest and other expense, net                              |       | (103                                    | )          | (5                                    | )          | (203 | ) | (5 | ) |
| (Increase) decrease in warrant liability                     |       | (145                                    | )          | 638                                   |       | 1,461 |   | (1,068 | ) |
| Loss before income taxes                                     |       | (15,597                                 | )          | (6,957                                | )          | (27,315 | ) | (16,961 | ) |
| Provision for (benefit from) income taxes                    |       | 2                                       |       | (52                                   | )          | 2 |   | (52 | ) |
| Net loss                                                     |       | $                                       | (15,599    | )                                     | $          | (6,905 | ) | $ | (27,317 | ) | $ | (16,909 | ) |
|                                                         |       |                                    |       |                                  |       |   |   |   |   |
| Net loss per share:                                          |       |                                    |       |                                  |       |   |   |   |   |
| - Basic and diluted                                          |       | $                                       | (0.53      | )                                     | $          | (0.26 | ) | $ | (0.92 | ) | $ | (0.63 | ) |
|                                                         |       |                                    |       |                                  |       |   |   |   |   |
| Weighted average number of common stock  shares outstanding: |       |                                    |       |                                  |       |   |   |   |   |
| - Basic and diluted                                          |       | 29,688,920                              |       | 26,336,997                            |       | 29,688,000 |   | 26,716,303 |   |

 

See accompanying notes to theseunaudited consolidated financial statements

 

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**Pharmacopeia, Inc.**

**ConsolidatedStatements of Cash Flows**

**(Amounts in thousands)**

 
| ** **                                                                                                              | ** ** | **For the Six Months** |
|-------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------|
| ** **                                                                                                              | ** ** | **Ended June 30,**          | ** ** |
| ** **                                                                                                              | ** ** | **2008**                              | ** ** | **2007** | ** ** |
| ** **                                                                                                              | ** ** | ** **                            | ** ** | ** ** | ** ** |
| CASH FLOWS FROM OPERATING ACTIVITIES:                                                                                   | ** ** | ** **                            | ** ** | ** ** | ** ** |
| Net loss                                                                                                                |       | $                                     | (27,317 | ) | $ | (16,909 | ) |
| Adjustments to reconcile net loss to net  cash (used in) provided by operating activities Depreciation and amortization |       | 1,414                                 |   | 1,073 |   |
| Change in warrant liability                                                                                             |       | (1,461                                | ) | 1,068 |   |
| Contribution of stock to 401(k) Plan                                                                               |       | 292                                   |   | 235 |   |
| Share-based compensation                                                                                                |       | 1,524                                 |   | 1,048 |   |
| Changes in assets and liabilities:                                                                                      |       |                                  |   |   |   |
| Accounts receivable                                                                                                     |       | (1,000                                | ) | 5,000 |   |
| Prepaid expenses and other current assets                                                                               |       | 978                                   |   | 32 |   |
| Accounts payable                                                                                                        |       | (365                                  | ) | 908 |   |
| Accrued and other liabilities                                                                                           |       | 1,860                                 |   | 229 |   |
| Deferred revenue                                                                                                        |       | (933                                  | ) | 17,293 |   |
| Net cash (used in) provided by operating activities                                                                     |       | (25,008                               | ) | 9,977 |   |
| CASH FLOWS FROM INVESTING ACTIVITIES:                                                                                   |       |                                  |   |   |   |
| Capital expenditures                                                                                                    |       | (1,434                                | ) | (1,673 | ) |
| Purchases of marketable securities                                                                                      |       | (13,454                               | ) | — |   |
| Proceeds from sale and maturities of  marketable securities                                                             |       | 40,750                                |   | 2,020 |   |
| Net cash provided by investing activities                                                                               |       | 25,862                                |   | 347 |   |
| CASH FLOWS FROM FINANCING ACTIVITIES:                                                                                   |       |                                  |   |   |   |
| Proceeds from registered equity offering,  net                                                                          |       | —                                |   | 37,070 |   |
| Proceeds from issuance of common stock  related to compensation plans                                                   |       | 8                                     |   | 630 |   |
| Proceeds from borrowings under notes  payable                                                                           |       | 416                                   |   | 553 |   |
| Repayments under notes payable                                                                                          |       | (509                                  | ) | (14 | ) |
| Net cash (used in) provided by financing activities                                                                     |       | (85                                   | ) | 38,239 |   |
| Net increase in cash and equivalents                                                                                    |       | 769                                   |   | 48,563 |   |
| Cash and equivalents, beginning of period                                                                               |       | 30,186                                |   | 43,099 |   |
| Cash and equivalents, end of period                                                                                     |       | $                                     | 30,955 |   | $ | 91,662 |   |

 

See accompanying notes to these unauditedconsolidated financial statements

 

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**Pharmacopeia, Inc.**

 

**Notes to Unaudited Consolidated Financial Statements**

 

**1. Background and Basis of Presentation**

 

Pharmacopeia, Inc. (Pharmacopeia or the Company) was incorporatedin 2002 as Pharmacopeia Drug Discovery, Inc., a wholly owned subsidiary ofAccelrys, Inc. (Accelrys). On April 30, 2004 (the distribution date),Accelrys spun-off 100 percent of the shares of Pharmacopeia Drug Discovery, Inc.in a pro rata tax-free distribution and distributed to its stockholders ofrecord one share of Pharmacopeia Drug Discovery, Inc. common stock forevery two shares of Accelrys common stock held. Effective May 3, 2007,Pharmacopeia Drug Discovery, Inc. changed its name to Pharmacopeia, Inc.

 

Pharmacopeia is a clinical development stage biopharmaceutical companydedicated to discovering and developing novel small molecule therapeutics toaddress significant medical needs. The Company’s strategy is to retain therights to product candidates at least to clinical validation, and to continuedevelopment on its own to New Drug Application (NDA) filing andcommercialization for selected indications. The Company has a broad portfolioof clinical and preclinical candidates under development internally or bypartners.

 

The consolidated financial statements include the accounts of theCompany and its wholly-owned subsidiary Pharmacopeia UK Holdings Limited(Pharmacopeia UK), which was formed in March 2007. All significantintercompany accounts and transactions have been eliminated in consolidation.

 

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

 

**2. Significant Accounting Policies**

 

**Use of Estimates**

 

The preparation of financial statements in conformity with U.Sgenerally accepted accounting principles requires management to make estimatesand assumptions that affect the reported amounts of assets, liabilities,revenues and expenses, and the disclosure of contingent assets and liabilities.Actual future results could differ from those estimates.

 

**Revenue Recognition**

 

Contract revenue is generally recognized either (i) on a proportionalperformance basis for contracts specifying payment for services over a givenperiod, or (ii) as services are performed under the agreement forcontracts specifying payment on a full-time employee basis.

 

Revenue earned related to up-front product and technology license feesis recognized in accordance with Staff Accounting Bulletin (SAB) 104 issued bythe Securities and Exchange Commission (SEC) and Emerging Issue Task Force(EITF) No. 00-21, “Revenue Arrangements with Multiple Deliverables” (EITF00-21) issued by the Financial Accounting Standards Board (FASB). Accordingly,amounts received under multiple-element arrangements requiring ongoing servicesor performance by us are recognized over the period of such services orperformance.

 

Revenue from milestones is recognized when earned, as evidenced bywritten acknowledgement from the collaborator, provided that (i) themilestone event is substantive, its achievability was not reasonably assured atthe inception of the agreement, and the Company has no further performanceobligations relating to that event, and (ii) collectibility is reasonablyassured. If these criteria are not met, the milestone payment is recognizedover the remaining period of our performance obligations under the arrangement.Royalties are recognized as earned in accordance with the terms of variousresearch and collaboration agreements.

 

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**Share-based Compensation**

 

Effective January 1, 2006, the Company adopted the fair valuerecognition provisions of SFAS No. 123 (revised 2004) “Share-BasedPayments” (SFAS 123R), using the modified-prospective transition method. Thisstatement, which is a revision to SFAS 123, supersedes AccountingPrinciples Board Opinion No. 25 “Accounting for Stock Issued to Employees”(APB 25) and amends SFAS No. 95, “Statement of Cash Flows.” Underthis transition method, compensation cost recognized includes compensationcosts for all share-based payments granted prior to, but not yet vested as of December 31,2005 based on the grant date fair value estimated in accordance with theoriginal provisions of SFAS 123, and compensation cost for all share-basedpayments granted subsequent to December 31, 2005 based on the grant datefair value estimated in accordance with the provisions of SFAS 123R.

 

Under SFAS 123R, the Company uses the Black-Scholes option-pricingmodel to estimate the fair value of the share-based awards as of the grantdate. The Black-Scholes model, by its design, is highly complex and dependentupon key data inputs estimated by management. The primary data inputs with thegreatest degree of judgment are the estimated lives of the share-based awards andthe estimated volatility of the Company’s stock price. The Black-Scholes modelis sensitive to changes in these two data inputs. Beginning in fiscal year2006, the Company calculated the estimated life of stock options granted usinga “simplified” method, which is based on the average of the vesting term andthe actual term of the option, as a result of guidance from the SEC ascontained in SAB 107 permitting the initial use of this method through2007. In December 2007, the SEC issued SAB 110, which becameeffective January 1, 2008, expressing the expectation that companiesshould be employing information from internal or external sources aboutemployee stock option exercise behavior when developing estimates of expectedterm as they relate to stock option valuations. SAB 110 states that theSEC will continue to accept the use of the “simplified” method beyond December 31,2007 under certain circumstances. The Company evaluated the exercise behaviorof its employees for stock options granted since its spin-off from Accelrys in April 2004and determined that the exercise history was an inadequate measure of theexpected term of its stock options. Therefore, the Company has continued its use of the simplified method asprescribed in SAB 107. Expected stock price volatility is typically based onthe daily historical trading data from an appropriate point in time through thelast day of the applicable period. Because the Company’s historical tradingdata only dates back to May 3, 2004, the first trading date after itsspin-off from Accelrys, the Company has estimated expected volatility using ananalysis of the stock price volatility of comparable companies in its industry.

 

**Warrant Liability**

 

The Company, in accounting for its warrants, follows EITF No. 00-19,“Accounting for Derivative Financial Instruments Indexed to, and PotentiallySettled in, a Company’s Own Stock” (EITF 00-19) which provides guidance fordistinguishing between permanent equity, temporary equity and assets andliabilities. Under EITF 00-19, to qualify as permanent equity, an equityderivative, including warrants, must permit the Company to settle inunregistered shares. Under securities law, if the warrants were issued inconnection with a public offering and have a cash settlement feature at theholder’s option, the Company does not have the ability to settle inunregistered shares. Therefore, the warrants cannot be classified as permanentequity and are instead classified as a liability. The approximately 1,450,000warrants that the Company issued as part of its equity financing in October 2006meet this criteria, and their fair value has been recorded as a liability inthe accompanying balance sheets. Other warrants the Company had previouslyissued qualify as permanent equity and do not require remeasurement.

 

The Company records its warrant liabilities at fair value using aBlack-Scholes option-pricing model and remeasures at each reporting date untilthe warrants are exercised or have expired. Changes in the fair value of thewarrants are reported in the statements of operations as income or expense. Thefair value of the warrants is subject to significant fluctuation based onchanges in the Company’s stock price, expected volatility, expected life, therisk-free interest rate and dividend yield. The market price for the Company’scommon stock has been and may continue to be volatile. Consequently, futurefluctuations in the price of the Company’s common stock may cause significantincreases or decreases in the fair value of the warrants issued in October 2006.

 

**Research and Development Expense**

 

Collaborative research and development expense consists of the labor,material, equipment and allocated facilities cost of the Company’s scientificstaff who are working pursuant to the Company’s collaborative agreements. Fromtime to time, collaborative research and development expense includes costsrelated to research efforts in excess of those required under certaincollaborative agreements. Management has the discretion to set the scope of suchexcess efforts and may increase or decrease the level of such efforts dependingon the Company’s strategic priorities.

 

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

 

All research and development costs are charged tooperations as incurred.

 

**Preclinical Study and Clinical Trial Accruals**

 

Substantial portions ofthe Company’s preclinical studies and all of the Company’s clinical trials havebeen performed by third-party laboratories, contract research organizations, orother vendors (collectively CROs).  Some CROs bill monthly for servicesperformed, while others bill based upon milestone achievement.  TheCompany accrues for each of the significant agreements it has with CROs on amonthly basis.  For preclinical studies,accruals are estimated based upon the percentage of work completed and thecontract milestones achieved.  For clinical studies, accruals are estimatedbased upon a percentage of work completed, the number of patients enrolled andthe duration of the study.  The Company monitors patient enrollment, theprogress of clinical studies and related activities to the extent possiblethrough internal reviews of data reported to it by the CROs, correspondencewith the CROs and clinical site visits.  The Company’s estimates aredependent upon the timelines and accuracy of the data provided by its CROsregarding the status of each program and total program spending. The Companyperiodically evaluates its estimates to determine if adjustments are necessaryor appropriate based on information it receives concerning changingcircumstances, and conditions or events that may affect such estimates. No material adjustments to preclinical study and clinical trial accruedexpenses have been recognized to date.

 

**Accounting for Uncertain Tax Positions**

 

The Company adopted the provisions of FASB Interpretation No. 48, “Accountingfor Uncertainty in Income Taxes—an interpretation of FAS Statement No. 109”(FIN 48). FIN 48 applies to all uncertain tax positions accounted forin accordance with SFAS No. 109, “Accounting for Income Taxes” and isintended to result in increased relevance and comparability in financialreporting of income taxes and to provide more information about the uncertaintyin income tax assets and liabilities. The Company will recognize potentialinterest and penalties related to income tax positions as a component of thebenefit or provision for income taxes on the consolidated statements of operationsin any future periods in which the Company must record a liability. Because theCompany has not recorded such a liability at June 30, 2008, there is noimpact to the Company’s effective tax rate. The Company does not anticipatethat total unrecognized tax benefits will significantly change during the nexttwelve months.

 

**Concentrations of Risk**

 

See Note 3 and Note 4 to the Unaudited Consolidated FinancialStatements regarding Concentrations of Risk as they relate to the Company’srevenue concentrations.

 

**Net Loss Per Share**

 

The Company computes net loss per share in accordance with SFAS No. 128,“Earnings Per Share” (SFAS 128). Under the provisions of SFAS 128,basic net loss per share is computed by dividing the net loss for the period bythe weighted-average number of common shares outstanding during the period.Diluted net loss per share is computed by dividing the net loss for the periodby the weighted-average number of common and dilutive common equivalent sharesoutstanding during the period. The Company had a net loss for the periods presented;accordingly, the inclusion of common stock equivalents for outstanding stockoptions would be anti-dilutive and, therefore, the weighted average shares usedto calculate both basic and diluted earnings per share are the same.

 

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**Recent Accounting Pronouncements**

 

*Fair ValueMeasurements*

 

InSeptember 2006, the FASB issued SFAS No. 157, “Fair ValueMeasurements” (SFAS 157). SFAS 157 establishes a framework formeasuring fair value in accordance with generally accepted accountingprinciples and expands disclosures about fair value measurements. The statement defines fair value as theexit price that would be received to sell an asset or paid to transfer aliability.   Fair value is a market-basedmeasurement that should be determined using assumptions that marketparticipants would use in pricing an asset or liability.  The statement establishes a three-levelhierarchy to prioritize the inputs used in measuring fair value.  The levels are described in the table belowwith Level 1 having the highest priority and Level 3 having the lowest.

 

In February 2008, the FASB issued FASB Staff Position (FSP) 157-bwhich delayed the effective date of SFAS 157 for one year for allnonfinancial assets and nonfinancial liabilities, except those that arerecognized or disclosed at fair value in the financial statements on arecurring basis (at least annually). SFAS 157 and FSP 157-b are effectivefor financial statements issued for fiscal years beginning after November 15,2007. The Company has elected a partial deferral of Statement 157 under theprovisions of FSP 157-b and, effective January 1, 2008, the Companyadopted SFAS 157 for those assets and liabilities that are remeasured atfair value on a recurring basis. This partial adoption of SFAS 157 did not havea material effect on the Company’s consolidated financial statements as of andfor the three and six months ended June 30, 2008.

 

The following tableprovides a summary of the assets and liabilities that are measured at fairvalue on a recurring basis as of June 30, 2008:

 
| ** **                               | ** ** | ** **                  | ** ** | **Basis of Fair Value Measurements**                    | ** ** |
|------------------------------------------|------------|-----------------------------|------------|-----------------------------------------------------------------------------|------------|
| ** **                               | ** ** | **As of**              | ** ** | **Quoted prices  in active  markets for  identical  assets** | ** ** | **Significant  other  observable  inputs** | ** ** | **Significant  unobservable  inputs** | ** ** |
| ** **                               | ** ** | **June 30, 2008** | ** ** | **Level 1**                                                            | ** ** | **Level 2** | ** ** | **Level 3** | ** ** |
| **Assets**                               |       |                        |       |                                                                        |       |   |   |   |   |
| Cash and cash equivalents                |       | $                           | 30,955     |                                                                        | $          | 30,955 |   | $ | — |   | $ | — |   |
| Marketable securities                    |       | 13,485                      |       | 13,485                                                                      |       | — |   | — |   |
| Deferred compensation plan assets        |       | 1,838                       |       | 1,838                                                                       |       | — |   | — |   |
|                                     |       |                        |       |                                                                        |       |   |   |   |   |
| Total assets measured at fair value      |       | $                           | 46,278     |                                                                        | $          | 46,278 |   | $ | — |   | $ | — |   |
|                                     |       |                        |       |                                                                        |       |   |   |   |   |
| Percentage of total assets               |       | 73                          | %          | 73                                                                          | %          | — |   | — |   |
|                                     |       |                        |       |                                                                        |       |   |   |   |   |
| **Liabilities**                          |       |                        |       |                                                                        |       |   |   |   |   |
| Warrant liability                        |       | $                           | 2,744      |                                                                        | $          | — |   | $ | 2,744 |   | $ | — |   |
| Deferred compensation plan liabilities   |       | 1,838                       |       | —                                                                      |       | 1,838 |   | — |   |
|                                     |       |                        |       |                                                                        |       |   |   |   |   |
| Total liabilities measured at fair value |       | $                           | 4,582      |                                                                        | $          | — |   | $ | 4,582 |   | $ | — |   |
|                                     |       |                        |       |                                                                        |       |   |   |   |   |
| Percentage of total liabilities          |       | 7                           | %          | —                                                                      |       | 7 | % | — |   |

 

As noted above, the fair value of the Company’s cash, cash equivalents,marketable securities, and deferred compensation plan assets are determinedusing quoted market prices in active markets. The fair value of the deferredcompensation plan liabilities is based upon significant observable inputs suchas the fair value of the underlying securities of the deferred compensationplan and the Company’s credit risk. The fair value of the warrant liability isdetermined using the Black-Scholes option-pricing model, which uses certainsignificant observable inputs, including stock price (quoted market prices inactive market), warrant exercise price (defined in warrant agreement), expectedlife of warrant (defined in warrant agreement), dividend yields (determined bythe Company), and risk-free interest rate (quoted market prices based onexpected life assumption). The only input in the Black-Scholes option-pricingmodel that

 

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isnot readily observable is the expected stock price volatility. Because theCompany’s historical trading data only dates back to May 3, 2004, thefirst trading date after its spin-off from Accelrys, the Company estimates itsexpected volatility using an analysis of the stock price volatility ofcomparable companies in its industry. The fair value of the warrant liabilityis subject to significant fluctuations and has ranged from approximately $2.7million as of June 30, 2008 to approximately $5.4 million as of June 30,2007. These fluctuations have primarily resulted from fluctuations in themarket price of the Company’s common stock, which ranged from $3.65 per shareto $5.55 per share at the Company’s quarterly remeasurement dates since June 30,2007. Changes in the warrant liability are recorded in the statement ofoperations as income (decreases) or expense (increases).

 

*Fair ValueOption for Financial Assets and Liabilities*

 

In February 2007, the FASB issued SFAS No. 159, “The FairValue Option for Financial Assets and Liabilities Including an Amendment ofFASB Statement No. 115” (SFAS 159). SFAS 159 permits reportingentities to choose to measure eligible financial assets or liabilities, whichinclude marketable securities available-for-sale and equity method investments,at fair value at specified election dates, or according to a pre-existingpolicy for specific types of eligible items. Unrealized gains and losses forwhich the fair value option has been elected are reported in earnings.SFAS 159 is effective for fiscal years beginning after November 15,2007. The Company’s adoption of SFAS 159, which was effective January 1,2008, did not have any impact on its consolidated financial statements as ofand for the six months ended June 30, 2008.

 

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

 

In June 2007, the EITF of the FASB reached a consensus on Issue No. 07-3,“Accounting for Nonrefundable Advance Payments for Goods or Services Receivedfor Use in Future Research and Development Activities” (EITF 07-3).EITF 07-3 requires that non-refundable advance payments for goods orservices that will be used or rendered for future research and developmentactivities be deferred and capitalized. As the related goods are delivered orthe services are performed, or when the goods or services are no longerexpected to be provided, the deferred amounts would be recognized as anexpense. EITF 07-3 is effective for financial statements issued for fiscalyears beginning after December 15, 2007. The Company’s adoption ofEITF 07-3, which was effective January 1, 2008, did not have amaterial effect on its consolidated financial statements as of and for the sixmonths ended June 30, 2008.

 

*Business Combinations*

 

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

 

**3. License Agreements with Bristol-Myers Squibb (DARA programand SARM program)**

 

**DARALicense Agreement**

 

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

 

Under the terms of the DARA License Agreement, in lieu of an up-frontcash payment, the Company is providing BMS a set of compound libraries, over aperiod of approximately three years following the execution of the DARA LicenseAgreement. In the event the Company fails to deliver such compound libraries toBMS, the Company would be required to make cash payments to BMS on a pro ratabasis of up to $0.8 million as of June 30, 2008; however, the Companyexpects to complete its delivery of these compound libraries by the end of2008.

 

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In March 2006, the Company estimated that the fair value of thecompound library services to be provided to BMS was approximately$2.0 million. In accordance with SFAS 2 “Accounting for Research andDevelopment Costs,” the Company recorded a non-cash charge of $2.0 millionto proprietary research and development expense related to the acquisition ofthe license to the DARA program during the year ended December 31, 2006. TheCompany also recorded deferred revenue of approximately $2.0 million during theyear ended December 31, 2006, which represented the estimated fair value of thecompound library services it is to provide to BMS under the DARA  License Agreement.  As of June 30, 2008, the Company had increasedits estimate of the fair value of the compound library services it is providingto BMS to approximately $2.2 million. The increase related to an increase in costs associated with providingsuch services.  Included in deferredrevenue as of June 30, 2008 was approximately $1.0 million, all ofwhich was classified as deferred revenue, current portion. During the three andsix month periods ended June 30, 2008, the Company recognizedapproximately $151 thousand and $429 thousand, respectively, of revenue inconnection with these compound library services.  During the three and six month periods ended June 30,2007, the Company did not recognize any revenue in connection with these compoundlibrary services.

 

In 2007, the Company paid $3.0 million in milestone payments to BMS forthe achievement of certain clinical and regulatory events, which was recordedas proprietary research and development expense during the year ended December 31,2007. The Company is obligated to pay BMS additional milestone payments uponthe achievement, if any, of further successive clinical and regulatory eventsin the United States and certain other jurisdictions, and royalties on sales ofproducts, if any, resulting from the DARA program. BMS has a limited right offirst negotiation in the event that the Company desires to license compoundsthat are the subject of the DARA License Agreement to a third party other thanBMS.

 

**SARMLicense Agreement**

 

In October 2007, the Company entered into an agreement to acquirethe development and commercialization rights to its SARM program from BMS (theSARM License Agreement), including PS178990, a product candidate inPhase 1 clinical development for which it intends to conduct furtherclinical trials. In consideration for the licenses to the SARM program, theCompany entered into a discovery collaboration agreement with BMS (theDiscovery Collaboration Agreement) to provide a portion of the Company’smedicinal chemistry resources to a BMS discovery program unrelated to the SARMprogram for a period up to three years.

 

The Company estimated that the fair value of the medicinal chemistryresources to be provided to BMS is approximately $9.2 million. Inaccordance with SFAS 2, the Company recorded a non-cash charge of$9.2 million to proprietary research and development expense related tothe acquisition of the license to the SARM program during the year ended December 31,2007. The Company also recorded deferred revenue of approximately $9.2 millionduring the year ended December 31, 2007, which represented the estimatedfair value of the medicinal chemistry resources the Company is to provide toBMS under the Discovery Collaboration Agreement.  As of June 30, 2008, included indeferred revenue was approximately $7.7 million, of which $4.6 million wasclassified as long-term. For the three and six month periods months ended June 30,2008, the Company recognized revenue of approximately $0.8 million, or 13% ofnet revenue, and approximately $1.5 million, or 13% of net revenue, respectively,in connection with the medicinal chemistry resources it provided to BMS.

 

In addition, the Company will pay BMS milestone payments associatedwith submission and approval of a therapeutic product for marketing and astepped royalty on net sales of therapeutic products, if any, resulting fromthe SARM program. BMS has a limited right of first negotiation in the eventthat the Company desires to license compounds that are the subject of the SARMLicense Agreement to a third party other than BMS.

 

**4. Significant Collaborations**

 

**ProductDevelopment and Commercialization Agreement with GSK**

 

In March 2006, the Company and SmithKline Beecham Corporation andGlaxo Group Limited (together GSK) entered into a product development andcommercialization agreement (the GSK Agreement). The Company’s role in thealliance with GSK is to (i) identify and (ii) advance molecules inchosen therapeutic programs to development stage and (iii) subject tocertain provisions in the GSK Agreement, further develop the candidates toclinical demonstration of efficacy in humans. The Company has agreed that itwill not screen its compound library for other collaborators, or for its ownaccount, against any target it screens under the GSK Agreement for a specifiedperiod.

 

The GSK Agreement provides GSK an exclusive option, exercisable atdefined points during the development process for each program (up to the pointof clinical demonstration of efficacy in humans), to license that program. Uponlicensing a program, GSK is obligated to conduct preclinical development and/orclinical trials and commercialize pharmaceutical products, if any,  resulting from such licensed programs on aworldwide basis. In addition to the cash payments above, the Company isentitled to receive success-based milestone payments, starting in preclinicalresearch, from

 

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GSKfor each drug development program under the alliance and the potential fordouble-digit royalties upon the successful commercialization by GSK of anyproduct resulting therefrom.

 

In the event that GSK does not exercise its option to license aprogram, the Company will retain all rights to that program and may continue todevelop the program and commercialize any products resulting from the program,or it may elect to cease progressing the program and/or seek other partners forfurther development and commercialization. Should the Company develop orpartner such a program and commercialize any products resulting from thatprogram, the Company will be obligated to pay GSK success-based milestonepayments and royalties upon successful commercialization, if any.

 

Since the inception of the GSK Agreement, the Company has received$15.0 million in connection with initial discovery activities the Companyis obligated to perform under the GSK Agreement, including $5.0 million itreceived in March 2008. The Company recorded deferred revenue ofapproximately $14.5 million associated with these payments, net of thefair value of the warrants described below. The Company has also earned non-refundablemilestone payments totaling $2.5 million from GSK related to theidentification of five lead compounds, including a $500 thousand payment invoicedin June 2008. These milestone payments were also recorded as deferredrevenue due to the Company’s continuing performance obligations under the GSKAgreement. Included in deferred revenue as of June 30, 2008 wasapproximately $12.8 million, of which approximately $7.8 million wasclassified as long-term. The Company recognizes revenue on a proportionalperformance basis as it performs the required discovery activities in an amountfrom time to time less than or equal to the non-refundable portion of paymentsreceived in connection with the GSK Agreement. The Company’s revenue under theGSK Agreement accounted for approximately $1.1 million, or 19% of netrevenue, and approximately $0.5 million, or 9% of net revenue, for thethree months ended June 30, 2008 and 2007, respectively.  The Company’s revenue under the GSK Agreementaccounted for approximately $2.3 million, or 19% of net revenue, andapproximately $0.7 million, or 6% of net revenue, for the six months endedJune 30, 2008 and 2007, respectively. The initial research term of the GSK Agreement expires in March 2011.

 

In connection with the GSK Agreement, the Company issued two warrantsto GSK for the purchase of up to an aggregate of 176,367 shares of its commonstock at an exercise price of $5.67 per share, which was a 25% premium over thetrailing 30-day closing price average preceding March 24, 2006. Thewarrants are exercisable at any time before the earlier to occur of (i) March 24,2011 and (ii) the effective date of certain types of termination of theGSK Agreement. These warrants were issued in a transaction not involving apublic offering under Section 4(2) of the Securities Act of 1933, asamended. The fair value of the warrants at the time of the execution of the GSKAgreement was determined to be $505 thousand. This amount was calculatedusing the Black-Scholes option-pricing model with the following assumptions:80% volatility; expected term of 5 years; 4.66% risk-free rate; and 0%dividend.

 

The Company and GSK each have the right to terminate the GSK Agreementin its sole discretion under certain specified circumstances at any time duringthe term of the GSK Agreement. In addition, the Company and GSK each have theright to terminate the GSK Agreement under other circumstances that arecustomary in these types of agreements. If the Company exercises itsdiscretionary termination right at any time during the first five years of theterm, under certain circumstances, it could be required to refund to GSK aportion of the $15.0 million it has received related to initial discoveryactivities to be conducted by the Company referred to above. The amount of anysuch refund will be calculated based upon when during the term of the GSKAgreement that termination occurs and the amount of research funding theCompany had received prior to such termination. However, there are no instanceswhere the deferred revenue would be amortized below the amount that could bepotentially refundable pursuant to the terms of the GSK Agreement. Further,should GSK exercise its discretionary termination rights, there are noprovisions in the GSK Agreement that would require the Company to refundpayments received relating to its performance of initial discovery activitiesor milestone payments received under the GSK Agreement.

 

**Researchand License Agreement with Wyeth**

 

In December 2006, the Company entered into a research and licenseagreement (the Wyeth Agreement) with Wyeth, acting through its WyethPharmaceuticals Division, providing for the formation of a new alliance basedon the Company’s Janus Kinase-3 (JAK3) inhibitor program. The alliance’s goalis to identify, develop and commercialize therapeutic products for thetreatment of certain immunological conditions in humans.

 

The companies each have certain exclusive rights to develop andcommercialize products resulting from the JAK3 program and the alliance. The Companyretains the right to develop and commercialize therapeutic products for thetreatment of dermatological and ocular diseases employing topicaladministration, and Wyeth has the right to develop human therapeutic productsfor all other indications and routes of delivery. Under the terms of the WyethAgreement, the Company has received an up-front non-refundable$5.0 million cash payment, and approximately $5.3 million inquarterly research funding. The Company may also receive an additional$3.9 million, over the remaining portion of the three-year research

 

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termthat began in January 2007. In addition, the Company may receive up to$175.0 million if Wyeth achieves preclinical and clinical development andregulatory and commercialization milestones, as well as double-digit royaltieson the net sales of any products commercialized by Wyeth under the alliance. Eachcompany is responsible for all development, regulatory, manufacturing andcommercialization activities for any products it develops and commercializes inits field.

 

The revenue for this research is recognized on a proportionalperformance basis, which is expected to approximate straight-line recognitionof revenue over the initial three year term of the alliance. For the threemonths ended June 30, 2008 and 2007, the Company recognized revenue of approximately$1.2 million, or 20% of net revenue, and approximately $1.2 million, or24% of net revenue, respectively, under the Wyeth Agreement. For the six monthsended June 30, 2008 and 2007, the Company recognized approximately$2.4 million, or 20% of net revenue, and approximately $2.3 million, or21% of net revenue, respectively, under the Wyeth Agreement.  As of June 30, 2008, approximately $3.8 millionwas recorded in deferred revenue, of which approximately $1.0 million wasclassified as long-term.

 

Pharmacopeia and Wyeth each have the right to terminate the WyethAgreement under certain specified circumstances at any time during the term ofthe Wyeth Agreement. In addition, Wyeth has the right, upon six months’ priorwritten notice provided to the Company, to terminate the research collaborationand/or the Wyeth Agreement in its entirety or in part. Such right totermination would not apply to Wyeth’s obligations with respect to any programdeveloped by the collaboration and licensed by Wyeth. No termination willrequire the Company to refund to Wyeth any or all of the cash paymentsdescribed above.

 

**Collaborationand License Agreement with Cephalon**

 

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

 

Cephalon is responsible for identifying hit and lead compounds, and theCompany and Cephalon will then work collaboratively to advance the leadcompounds to clinical candidates. The Company is principally responsible formedicinal chemistry research and Cephalon provides biology support, includingpreclinical disease models, as required by the Cephalon Agreement. The Companyhas agreed that, for a specified period, it will not screen its compoundlibrary for other collaborators, or for its own account, against any target itworks on under the Cephalon Agreement.

 

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

 

As stated above, under the Cephalon Agreement, the Company received anon-refundable payment of $15.0 million and is principally responsible forperforming medicinal chemistry research. The revenue for this research isrecognized on a proportional performance basis, which is expected toapproximate straight-line recognition of revenue over the initial three yearterm of the alliance. Included in deferred revenue at June 30, 2008 wasapproximately $4.6 million related to the Cephalon Agreement, all of whichwas classified as deferred revenue, current portion. The Company recognized revenueof approximately $1.3 million, or 21% of net revenue, and $1.3 million, or25% of net revenue, for the three month period ended June 30, 2008, and2007, respectively, under the Cephalon Agreement. For the six months ended June 30,2008 and 2007, the Company recognized approximately $2.5 million, or 21%of net revenue, and approximately $2.5 million, or 22% of net revenue,respectively, under the Cephalon Agreement. The initial research term of the Cephalon Agreement expires inMay 2009.

 

The Company and Cephalon each have the right to terminate the CephalonAgreement under certain specified circumstances at any time during the term ofthe Cephalon Agreement. In addition, Cephalon has the right to terminate theCephalon Agreement in its sole discretion, upon ninety days written notice tothe Company, during the initial three-year phase of the alliance, which phasemay be extended by agreement of the parties. No such termination shall requirethe Company to refund to Cephalon any or all of the above research and developmentfunding.

 

One of the Company’s directors currently serves as the Chairman andChief Executive Officer of Cephalon.

 

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**Collaborationand License Agreement with Schering-Plough**

 

In February 2007, the Company entered into an amended and restatedcollaboration and license agreement  with N.V.Organon (Organon), providing for the formation of a new alliance to discover,develop and commercialize therapeutic products across a broad range oftherapeutic indications. The new alliance followed the companies’ pastcollaborations, including the February 2002 agreement between the Companyand Organon (the 2002 Collaboration). In November 2007, Organon wasacquired by, and is now a part of, Schering-Plough. The Company refers to the February 2007agreement with Organon as the 2007 Schering-Plough Agreement.

 

Since inception of the 2007 Schering-Plough Agreement, the Company hasreceived an up-front payment of $15.0 million, $1.0 million for thetransfer of rights to certain programs from the 2002 Collaboration, and$6.0 million in quarterly research funding. The 2007 Schering-PloughAgreement provides that the Company may also receive up to an additional$4.0 million per year in quarterly research funding over the remainingportion of the five-year research term of the alliance, which began in February 2007.The 2007 Schering-Plough Agreement also provides that the Company waives itsrights to receive further compensation (e.g., future milestone and royaltypayments) with respect to programs resulting from lead series identified by theCompany and delivered to Organon under the 2002 Collaboration and certain otherprograms from earlier agreements.

 

The 2007 Schering-Plough Agreement provides the Company the option topurchase the right to co-develop and co-commercialize certain therapeuticcandidates discovered through the alliance. For therapeutic candidates theCompany does not elect to co-develop and co-commercialize, Schering-Plough willretain exclusive development and commercialization rights, and the Company willreceive milestone payments as a result of Schering-Plough’s successfuladvancement, if any, of each candidate through clinical development, and up todouble-digit royalties based on commercialization of any resultingpharmaceutical products.

 

The revenue associated with the research the Company performs under the2007 Schering-Plough Agreement is recognized on a proportional performancebasis. The Company has received $22.0 million in connection with the 2007Schering-Plough Agreement which the Company recorded as deferred revenue. Includedin deferred revenue as of June 30, 2008 was approximately$16.3 million related to the 2007 Schering-Plough Agreement, of whichapproximately $11.8 million was classified as deferred revenue, long-term.For the three months ended June 30, 2008 and 2007, the Company recognizedrevenue of approximately $1.3 million, or 22% of net revenue,  and approximately $0.9 million, or 17% of netrevenue, respectively, in connection with the 2007 Schering-PloughAgreement.  For the six months ended June 30,2008, the Company recognized revenue of approximately $2.8 million, or 23%of net revenue in connection with the 2007 Schering-Plough Agreement. For thesix months ended June 30, 2007, the Company recognized approximately $1.4million, or 13% of net revenue, under the 2007 Schering-Plough Agreement andthe 2002 Collaboration, the research term of which ended February 2007.

 

Both Pharmacopeia and Schering-Plough have the right to terminate the2007 Schering-Plough Agreement under certain specified circumstances at anytime during the term of the 2007 Schering-Plough Agreement. In addition, theCompany and Schering-Plough each have the right to terminate the 2007Schering-Plough Agreement under other circumstances that are customary in thesetypes of agreements. Further, each party has the right, upon six months priorwritten notice provided to the other party at any time beginning two andone-half years after February 8, 2007, to terminate the research portionof the alliance and/or the 2007 Schering-Plough Agreement. Such a terminationof the research portion of the alliance by Schering-Plough would not apply toSchering-Plough’s obligations with respect to any program developed by thealliance that Schering-Plough is advancing or to therapeutic candidates withrespect to which the Company has previously exercised its option to purchasethe right to co-develop and co-commercialize. Should Schering-Plough exerciseits discretionary termination right, there are no provisions in the 2007Schering-Plough Agreement that would require the Company to refund paymentsreceived under the 2007 Schering-Plough Agreement. If the Company exercises itsdiscretionary termination right, under certain circumstances, it could besubject to a termination fee of $5.0 million. Whether or not the Companyis subject to the termination fee is based upon when during the term of the2007 Schering-Plough Agreement the Company’s discretionary termination right isexercised. However, until such time as the Company is no longer subject to thetermination fee, there will be no instances where the deferred revenueassociated with the 2007 Schering-Plough Agreement would be amortized below$5.0 million.

 

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

 

Separate from the 2007 Schering-Plough Agreement, in April 2007the Company completed its research activities under its other agreements withSchering-Plough. Under the terms of the Company’s agreements withSchering-Plough in which the Company’s research activities have ceased, the cessationof those research activities did not affect other areas of thosecollaborations, including the ongoing Phase 2 and 

 

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Phase 1 clinical trialsand multiple preclinical programs that Schering-Plough is conducting. TheCompany continues to be entitled to payments resulting from the successfulachievement by Schering-Plough, if any, of clinical milestones, as well asroyalty payments from sales, if any, of products resulting from compoundsalready delivered by the Company and accepted by Schering-Plough under thosecollaborations.

 

For the three and six months ended June 30, 2008, the Company didnot recognize any revenue under its collaborations with Schering-Plough inwhich its research activities ceased in April 2007.  For the three and six months ended June 30,2007, the Company recognized revenue of approximately $1.1 million, or 21%of net revenue, including $1.0 million in milestone revenue, andapproximately $2.8 million, or 25% of net revenue, including $2.0 millionin milestone revenue, related to those collaborations.

 

**Other Items**

 

In the three and six months ended June 30, 2008, the Companyrecognized approximately $0.9 million, or 16%, and  approximately $2.0 million, or 16%, of netrevenue, in connection with its Discovery Collaboration Agreement and DARALicense Agreement with BMS. There was no revenue recognized in the three andsix months ended June 30, 2007 in connection with its DiscoveryCollaboration Agreement with BMS.  SeeNote 3 above for further discussion of the Company’s Discovery CollaborationAgreement and DARA License Agreement with BMS.

 

Except as disclosed above, no other collaborator accounted for morethan 10% of the Company’s total revenue in the three months ended June 30,2008.

 

In the six months ended June 30, 2007, as part of itscollaboration with Biovitrum, the Company recognized revenue of approximately$1.1 million, including $1.0 million in milestone revenue for delivering anadvanced lead compound that Biovitrum accepted. This revenue accounted for 10% of net revenue for the six months ended June 30,2007.  There was no revenue recognizedduring the three months ended June 30, 2007 under the Company’scollaboration with Biovitrum.

 

**5. Business Segment and Geographical Information**

 

The Company classifies its business operations in one operatingsegment. All of the Company’s revenues are generated from this segment. Revenuewas derived from collaborators located in the following geographic regions:

 
| ** **            | ** ** | **Three months ended June 30,** | ** ** | **Six months ended June 30,** | ** ** |
|-----------------------|------------|--------------------------------------|------------|------------------------------------|------------|
| ** **            | ** ** | **2008**                             | ** ** | **2007**                           | ** ** | **2008** | ** ** | **2007** | ** ** |
| Customers located in: |       |                                 |       |                               |       |   |   |   |   |
| United States         |       | 78                                   | %          | 72                                 | %          | 77 | % | 66 | % |
| Europe                |       | 22                                   | %          | 28                                 | %          | 23 | % | 34 | % |

 

**6****. Share-based Compensation**

 

The fair value of the Company’s equity awards were estimated at thedate of grant using the Black-Scholes option-pricing model with the following rangesof assumptions:

 

**Black-Scholes Assumptions**

 
| ** **              | ** ** | **2008**  | ** ** | **2007**    | ** ** |
|-------------------------|------------|-----------|------------|-------------|------------|
| Dividend yield          |       | 0         | %          | 0           | %          |
| Expected volatility     |       | 75.00     | %          | 80.00-90.00 | %          |
| Risk-free interest rate |       | 3.04-3.18 | %          | 4.51-4.60   | %          |
| Expected life (years)   |       | 6.25      |       | 6.25        |       |

 

For the three months ended June 30, 2008 and 2007, totalshare-based compensation costs related to stock options were approximately$618 thousand, and $526 thousand, respectively.  For the three months ended June 30,2008, the Company also incurred share based compensation costs related torestricted stock unit awards of approximately $263 thousand, 

 

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which included approximately$135 thousand relating to the accelerated vesting of certain restricted stockunit awards of a former executive of the Company in June 2008. There wasno such expense during the three months ended June 30, 2007. In addition,during the three months ended June 30, 2008 and 2007, the Company incurredshare-based compensation costs of approximately $2 thousand and$9 thousand, respectively, relating to stock options granted toconsultants.

 

For the six months ended June 30, 2008 and 2007, total share-basedcompensation costs related to stock options were approximately $1.3 million and$1.0 million, respectively.  For the sixmonths ended June 30, 2008 and 2007, the Company also incurred share basedcompensation costs related to restricted stock unit awards of approximately$263 thousand, which included approximately $135 thousand relating to theaccelerated vesting of certain restricted stock unit awards of a formerexecutive of the Company in June 2008, and $13 thousand, respectively. Inaddition, during the six months ended June 30, 2008 and 2007, the Companyincurred share-based compensation costs of approximately $7 thousand and$19 thousand, respectively, relating to stock options granted toconsultants.

 

As of June 30, 2008, there was approximately $5.2 million ofunrecognized compensation costs, net of estimated forfeitures, related toshare-based payments which are expected to be recognized over a weightedaverage period of 2.6 years. The cash proceeds from options exercisedduring the three months ended June 30, 2008 and 2007 were approximately $4thousand and $113 thousand, respectively. The cash proceeds from optionsexercised during the six months ended June 30, 2008 and 2007 wereapproximately $8 thousand and $630 thousand, respectively.

 

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

 

In December 2006, the Company entered into a loan and securityagreement (the Line of Credit) with a lending institution. The Line of Creditis intended to provide the Company with funding, in exchange for a securityinterest in certain of the Company’s equipment. The Line of Credit provides upto a total of $5.0 million in funding in the form of term loans, from timeto time through December 2008. Term loans secured by laboratory equipmenthave a fixed term of 48 months. Term loans secured by all other collateralcategories have a fixed term of 36 months.

 

As of June 30, 2008, the aggregate balance of term loansoriginated under the Line of Credit was approximately $4.0 million, ofwhich approximately $2.7 million was classified as notes payable,long-term. Interest rates on these term loans range from 10.08% to 10.28%.Additionally, the Company had approximately $0.3 million available forborrowings under the Line of Credit as of June 30, 2008.

 

**8. Warrant Liability**

 

In connection with its October 2006financing, the Company issued approximately 1,450,000 warrants to purchase itscommon stock. Under EITF 00-19, to qualify as permanentequity, an equity derivative must permit the issuer to settle in unregisteredshares. Under securities law, if the warrants were issued in connection with apublic offering and have a cash settlement feature at the holder’s option, acompany does not have the ability to settle in unregistered shares. Therefore,the warrants cannot be classified as permanent equity and are insteadclassified as a liability. The warrants that the Company issued as part of itsequity financing in October 2006 meet this criteria, and have beenrecorded as a liability in the accompanying balance sheet. The fair value ofthe warrants was determined as of October 18, 2006, and the Companyrecorded a liability relating to the issuance of the warrants of approximately$4.5 million. Equity derivatives not qualifying for permanent equityaccounting are recorded at fair value on the measurement date, and areremeasured at each reporting date until the warrants are exercised or haveexpired. Changes in the fair value of the warrants are reported in thestatement of operations as income or expense.

 

AtJune 30, 2008, the fair value of the warrants increased to approximately$2.7 million from approximately $2.6 million at March 31, 2008. As aresult of this increase, the Company recorded approximately $0.1 million inexpense in the statement of operations for the three months ended June 30,2008. At June 30, 2007, the fair value of the warrants had decreased toapproximately $5.4 million from approximately $6.1 million at March 31,2007. As a result of this decrease, the Company recorded approximately $638thousand in expense in the statement of operations for the three months ended June 30,2007.

 

Forthe six months ended June 30, 2008, the fair value of the warrantsdecreased to approximately $2.7 million from approximately $4.2 million asof December 31, 2007. As a result of this decrease, the Company recordedapproximately $1.5 million in income in the statement of operations for thesix months ended June 30, 2008. At June 30, 2007, the fair value ofthe warrants had increased to approximately $5.4 million fromapproximately $4.4 million as of December 31, 2006. As a 

 

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result of this increase, the Company recordedapproximately $1.1 million in expense in the statement of operations forthe six months ended June 30, 2007.

 

The fair value of the warrants was calculated using the Black-Scholesoption-pricing model with the following assumptions at the respectivemeasurement dates:

 

| ** **              | ** ** | **June 30,** | ** ** | **December 31,** | ** ** |
|-------------------------|------------|-------------------|------------|-----------------------|------------|
| ** **              | ** ** | **2008**          | ** ** | **2007**              | ** ** |
| Dividend yield          |       | 0                 | %          | 0                     | %          |
| Expected volatility     |       | 75.00             | %          | 80.00                 | %          |
| Risk-free interest rate |       | 3.13              | %          | 3.45                  | %          |
| Expected life (years)   |       | 3.80              |       | 4.30                  |       |
| Stock Price             |       | $                 | 3.83       |                  | $          | 4.77 |   |
| Exercise Price          |       | $                 | 5.14       |                  | $          | 5.14 |   |

 

**9. Commitments and Contingencies**

 

**DARALicense Agreement with BMS**

 

Under the terms of the DARA License Agreement, in lieu of an up-frontcash payment, the Company is providing BMS a set of compound libraries, over aperiod of approximately three years following the execution of the agreement.As of June 30, 2008, the Company had approximately $1.0 million ofdeferred revenue related to compound libraries that the Company will provideafter June 30, 2008. In the event the Company fails to deliver theaforementioned compound libraries to BMS, the Company would be required to makecash payments on a pro rata basis of up to approximately $0.8 million;however, the Company expects to complete its delivery of these compoundlibraries by the end of 2008.

 

In addition, the Company will pay BMS milestone payments upon theachievement of successive clinical and regulatory events in the United Statesand certain other jurisdictions, and royalties on sales of products, if any,resulting from the DARA program.

 

**SARMLicense Agreement with BMS**

 

In consideration for the licenses to the SARM program, in October 2007,the Company also entered into the Discovery Collaboration Agreement with BMS.The Discovery Collaboration Agreement provides that the Company will apply aportion of its medicinal chemistry resources to a BMS discovery program that isunrelated to the SARM program for up to three years. The Company recordeddeferred revenue of $9.2 million, which approximates the fair value of thechemistry resources that the Company is to provide to BMS.  As of June 30, 2008, the Company hadapproximately $7.7 million of deferred revenue related to services that itis to provide under the Discovery Collaboration Agreement after June 30,2008.

 

In addition, the Company will pay BMS milestone payments associatedwith submission and approval of a therapeutic product for marketing and astepped royalty on net sales of therapeutic products, if any, resulting fromthe SARM program

 

**ProductDevelopment and Commercialization Agreement with GSK**

 

Under the GSK Agreement, the Company and GSK each have the right toterminate the GSK Agreement in its sole discretion under certain specifiedcircumstances at any time during the term of the GSK Agreement. In addition,the Company and GSK each have the right to terminate the GSK Agreement undercircumstances that are customary in these types of agreements. If the Company exercisesits discretionary termination right at any time during the first five years ofthe term, under certain circumstances, it could be required to refund to GSK aportion of the $15.0 million it has received related to initial discoveryactivities to be conducted by the Company. The amount of any such refund willbe calculated based upon when during the term of the GSK Agreement thattermination occurs. However, there are no instances where the deferred revenuewould be amortized below the amount that could be potentially refundablepursuant to the terms of the GSK Agreement. Further, should GSK exercise itsdiscretionary termination rights, there are no provisions in the GSK Agreementthat would require the Company to refund payments received relating to itsperformance of initial discovery activities under the GSK Agreement.

 

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The Company’s role in the alliance is to (i) identify and (ii) advancemolecules in chosen therapeutic programs to development stage and (iii) subjectto certain provisions in the GSK Agreement, further develop the candidates toclinical demonstration of efficacy in humans. As of June 30, 2008, theCompany had approximately $12.8 million of deferred revenue related toservices that are to be provided under the GSK Agreement by the Company after June 30,2008.

 

**Researchand License Agreement with Wyeth**

 

Under the Wyeth Agreement, the Company has received an up-front,non-refundable payment of $5.0 million and approximately $5.3 millionin quarterly research funding since January 2007 to support the Company’sresearch efforts. As of June 30, 2008, the Company had approximately$3.8 million of deferred revenue related to services that the Company isto provide under the Wyeth Agreement.

 

**Collaborationand License Agreement with Cephalon**

 

Under the Cephalon Agreement, the Company received an up-front,non-refundable payment of $15.0 million in June 2006 to support theCompany’s research efforts. The Company is principally responsible forperforming medicinal chemistry research over the alliance term. As of June 30,2008, the Company had approximately $4.6 million of deferred revenuerelated to services that are to be provided under the Cephalon Agreement by theCompany after June 30, 2008.

 

**Collaborationand License Agreement with Schering-Plough**

 

Under the 2007 Schering-Plough Agreement, the Company has received$22.0 million (the $15.0 million up-front payment, $1.0 millionfor the transfer of rights to certain programs from the 2002 Collaboration, and$6.0 million in quarterly research funding) since February 2007 to supportits research efforts. As of June 30, 2008, the Company had approximately $16.3 millionof deferred revenue related to services it is to provide under the 2007Schering-Plough Agreement after June 30, 2008.

 

In addition, if the Company exercises its discretionary terminationright, under certain circumstances, the Company could be subject to atermination fee of $5.0 million. Whether or not the Company is subject tothe termination fee is based upon when during the term of the 2007Schering-Plough Agreement the Company exercise its discretionary terminationright. However, until such time as the Company is no longer subject to thetermination fee, there will be no instances where the deferred revenueassociated with the 2007 Schering-Plough Agreement would be amortized below$5.0 million.

 

**Milestoneand Royalty Commitments**

 

Under the terms of certain agreements to which the Company is a party,it is possible that the Company may become obligated to pay aggregate milestonepayments totaling up to $267 million upon the achievement of successiveclinical and regulatory events and royalties on sales of products, if any,resulting from programs for which the Company has development responsibilityunder such agreements. The Company will not be responsible for the payment offuture milestone and/or royalty payments in the event that development of sucha program is discontinued. Preclinical and clinical development of drugcandidates is a long, expensive and uncertain process. At any stage of thepreclinical or clinical development process, the Company may decide todiscontinue the development of its product candidates. To date, none of thecompounds to which the Company holds complete or partial rights has reached thestage of commercial product. The Company expects that its product candidateswill not be commercially available for many years, if ever.

 

**ProductManufacturing Contracts**

 

The Company has entered into contracts with third parties related tothe manufacturing of materials that are to be used in connection with theCompany’s clinical trials for PS433540. The termination provisions for thesecontracts are such that, as of June 30, 2008, the Company had aggregatecommitments thereunder totaling approximately $2.6 million, which areexpected to be fulfilled during the year ended December 31, 2008.

 

**10. Restructuring Costs**

 

*Restructuring Costs*

 

InMay 2008, the Company’s Board of Directors committed to a restructuringplan intended to reduce the Company’s operating expenses by focusing itsefforts on, and allocating a greater share of its resources to, the Company’s 

 

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clinical and later-stagediscovery programs. In implementing the restructuring plan, the Company reducedits workforce by twenty-three positions during the quarter, twenty positions ofwhich were eliminated effective May 30, 2008. The elimination of theremaining three positions will have been completed by July 31, 2008. Inaddition, the Company streamlined its facilities.  As a result of the restructuring plan, theCompany recorded a restructuring charge of approximately $1.7 million duringthe three months ended June 30, 2008.

 

Thefollowing table summarizes the activity and balance of the restructuringreserve as of June 30, 2008 (in thousands):

 
| ** **                    | ** ** | **Severance Cost for  Involuntary Employee  Terminations** | ** **  | **Costs to Exit Leased  Facility** | ** ** | **Total** | ** ** |
|-------------------------------|------------|------------------------------------------------------------|-------------|------------------------------------|------------|-----------|------------|
| Restructuring charges         |       | $                                                          |  1,202 |                               | $          |  493 |       | $ |  1,695 |   |
| Utilization of Reserves:      |       |                                                       |        |                               |       |      |       |
| Cash payments                 |       | (529                                                       | )           | —                             |       | (529      | )          |
| Equity compensation           |       | (135                                                       | )           | —                             |       | (135      | )          |
| Balance at June 30, 2008 |       | $                                                          | 538         |                               | $          | 493       |       | $ | 1,031 |   |

 

Restructuring costsrelated to the Company’s facilities are comprised of the difference between theremaining lease obligations of the abandoned operating leases, which runthrough the year 2016, and the Company’s estimate of potential future subleaseincome, discounted to present value.

 

Included in Accrued andother liabilities as of June 30, 2008 was approximately $683 thousandrelating to the current portion of the restructuring reserve. Included in Otherliabilities, long-term was approximately $348 thousand relating to thelong-term portion of the restructuring reserve.

 

See Note 13 to theUnaudited Consolidated Financial Statements regarding additional restructuringcharges the Company expects to incur subsequent to June 30, 2008.

 

**11. Severance Costs**

 

In April 2008, theCompany recorded a charge of approximately $0.9 million in connection with aseparation agreement between the Company and its former President and ChiefExecutive Officer. In addition, the Company also recorded approximately $0.1million in severance costs in connection with a severance agreement between theCompany and its former Senior Vice President, Business Development. Theseseverance costs were unrelated to the May 2008 restructuring plan and wererecorded as general and administrative expense in the Company’s Statements ofOperations during the three months ended June 30, 2008.

 

**12. Related Party Transactions**

 

A member of Pharmacopeia’s board of directors currently serves as theChairman and Chief Executive Officer of Cephalon. In June 2006, theCompany received an up-front non-refundable $15.0 million payment tosupport the Company’s research efforts under the Cephalon Agreement.  For the three and six month periods ended June 30,2008, the Company recognized revenue under the Cephalon Agreement ofapproximately $1.3 million or, 21% of net revenue, and $2.5 million, or21% of net revenue, respectively. For the three and six month period ended June 30,2007, the Company recognized revenue of approximately $1.3 million, or 25% ofnet revenue, and $2.5 million, or 22% of net revenue, respectively.

 

A member of Pharmacopeia’s clinical advisory board is affiliated with aCRO that the Company has contracted with to conduct one of its clinical trials.For the three and six months periods ended June 30, 2008, the Companyincurred expense of approximately $0.3 million and $1.1 million, respectively,related to the clinical trial this CRO is conducting. There was no such expensein the corresponding periods in 2007.

 

**13. Subsequent Event**

 

On July 31, 2008, the Company announced that as part of its ongoing effort to focus its resources on progressing its assets in clinical development, it expects to further reduce its workforce in the third quarter of 2008. This reduction in force will be in addition to the restructuring plan the Company committed to in May 2008 and as described in Note 10 to the Unaudited 

 

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Consolidated Financial Statements.The Company expects to record a restructuring charge in the three months ending September 30, 2008, the amount of which has not yet been determined.

 

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

** **

**FORWARD-LOOKING STATEMENTS**

 

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

 

·                  our plans to developPS433540, a Phase 2 product candidate from our DARA program; the medicalindications for which we intend to pursue development of PS433540; and ourexisting and proposed Phase 2 and Phase 1 clinical studies withrespect to PS433540, including our announcement of the reduction of the numberof subjects in our ongoing Phase 2b clinical trial (Study 006);

 

·                  our ability to raiseadditional funds;

 

·                  our ability to implement ourrestructuring plans intended to reduce our operating expenses by focusing ourefforts on, and allocating a greater share of our resources to, our clinicaland later-stage discovery programs;

 

·                  our estimates of the marketopportunity for our product candidates, including PS433540, PS178990 andPS031291;

 

·                  the expiration of theinitial research terms of our alliances with Cephalon and Wyeth in May andDecember 2009, respectively;

 

·                  our plans to developPS178990, a Phase 1 product candidate from our SARM program, and PS031291, a preclinicaldevelopment product candidate from our chemokine receptor CCR1 program;

 

·                  our ability to successfullyperform under our agreements with BMS, GSK, Wyeth, Cephalon andSchering-Plough;

 

·                  our ability to build ourpipeline of novel drug candidates through our own internally-funded drugdiscovery and development programs, third party collaborations, in-licensingand acquisitions;

 

·                  our expectations concerningthe development priorities of our collaborators, their ability to successfullydevelop compounds and our receipt of milestones and royalties;

 

·                  our anticipated operatingresults, financial condition, liquidity and capital resources;

 

·                  our expectations concerningthe legal protections afforded by U.S. and international patent laws;

 

·                  our ability to pursue thedevelopment of new compounds and other business matters without infringing thepatent rights of others;

 

·                  our ability to acquire orinvest in complementary businesses or technologies; and

 

·                  additional competition andchanges in economic conditions.

 

In some cases, youcan identify forward-looking statements by terminology, such as “goals,” or “expects,”“anticipates,” “intends,” “plans,” “believes,” “seeks,” “estimates,” or thenegative of such terms or other similar expressions. You are urged not to placeundue reliance on any such forward-looking statements, any of which may turnout to be wrong due to inaccurate assumptions, unknown risks, uncertainties orother factors.  Factors that could causeor contribute to differences in results and outcomes from those in ourforward-looking statements include, without limitation, those discussedelsewhere in this Report in Part II, Item 1A “Risk Factors” and in this Part I,Item 2, as well as those discussed in our other Securities and ExchangeCommission (SEC) filings.

 

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We urge you tocarefully read and consider the disclosures found in our SEC filings, all ofwhich are available in the SEC EDGAR database at *www.sec.gov*.  Weundertake no obligation to (and expressly disclaim any such obligation to)revise or update the statements made herein or the risk factors that may relatethereto whether as a result of new information, future events or otherwise.

 

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

 

**The Company**

** **

**Overview**

 

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

 

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

 

There is considerablepreclinical and initial clinical data suggesting that simultaneously blockingthe actions of both angiotensin and endothelin by co-administration, comparedto either agent alone, may provide significantly improved treatment options fordiabetic nephropathy and several cardiovascular diseases. We believe PS433540can be developed as a potential treatment for renal and cardiovasculardiseases. We intend to focus our future development of PS433540 on theindication of diabetic nephropathy, which we believe represents the bestopportunity for us to pursue with our available financial resources.  In addition, we are considering opportunitiesto partner the development of PS433540 for various indications, includingdiabetic nephropathy and various forms of cardiovascular disease.

 

In May 2008, weannounced that Study 008, a Phase 2a clinical trial of PS433540 in subjectswith Stage I and Stage II hypertension, showed statistically significant bloodpressure reductions.  Study 008 met itsprimary endpoint by showing a statistically significant reduction in mean24-hour systolic ambulatory blood pressure over placebo.  Study 008 also showed statisticallysignificant improvements over placebo in mean 24-hour diastolic ambulatoryblood pressure as well as seated blood pressure.  In this double-blind, placebo-controlledstudy, patients treated with 200 mg of PS433540 once daily experienced a12/9mmHg drop in mean 24-hour systolic and diastolic blood pressure and thosetreated with 500 mg experienced a 15/10mmHg drop in mean 24-hour systolic anddiastolic blood pressure. These reductions were highly statisticallysignificant vs. placebo (P<0.001). Mean seated office systolic and diastolicblood pressure, the typical blood pressure measure, was also evaluated, withobserved blood pressure drops of 17/11mmHg with the 200 mg dose and 17/10mmHgwith the 500 mg dose (P<0.001 vs. placebo). Once-daily treatment with 200 or 500 mg of PS433540 was well tolerated.Most of the adverse events reported were mild or moderate in severity and includedheadaches and minor musculoskeletal and respiratory complaints. All of theseevents occurred with similar frequency in the three treatment groups. There wasone case of peripheral edema in the placebo arm and one case of peripheraledema in one of the treated arms. There were no increases in liver enzymesabove 2 times the upper limit of normal. On average, liver enzyme levels tendedto decrease from baseline in the treated arms. There were no serious adverseevents in subjects treated with PS433540. Three subjects discontinued therapyfor adverse events, all of whom were in the placebo group.

 

In July 2008, weannounced a reduction from 375 to approximately 250 subjects expected to bestudied in Study 006, a Phase 2b clinical trial of PS433540 which is designedto further evaluate safety and efficacy of PS433540 in subjects withStage I and Stage II hypertension. Our decision to reduce the number of subjects in Study 006 was madeafter fully evaluating the efficacy and safety data reported from Study 008.  Study 006 will study 200 mg and 400 mg dosesof PS433540 versus placebo and will also compare efficacy and safety data ofPS433540 with that of irbesartan.  Webelieve the reduction in number of subjects will allow us to begin a Phase 2clinical trial focusing on the indication of diabetic nephropathy sooner thanotherwise would have been possible. Although data from Study 006 remains blinded, the safety profile we haveobserved to date in Study 006 is similar to that which we observed with respectto Study 008, as discussed above.  Todate, there have been no serious adverse events in Study 006. We expect Study006 to be completed in the fourth quarter of 2008.

 

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InOctober 2007, we entered into an additional license agreement with BMSproviding us exclusive worldwide development and commercialization rights to aselective androgen receptor modulator (SARM) program (the SARM program).PS178990, the lead compound in the SARM program, is in Phase 1 clinicaldevelopment. PS178990 is a non-steroidal SARM that was designed to provide thebenefits of testosterone to patients without unwanted side effects on theprostate. BMS completed a Phase 1 single ascending dose study withPS178990.

 

InFebruary 2008, we announced the nomination of PS031291 as a preclinicaldevelopment compound from our internal chemokine receptor CCR1 program.PS031291 is a potent and highly selective antagonist at the chemokine receptorCCR1, which has been implicated in playing a significant role in multipleinflammatory and autoimmune disease processes. We believe PS031291 may possesssignificant potential in the treatment of various inflammatory diseasesincluding rheumatoid arthritis. We initiated good laboratory practice (oftenreferred to as GLP) toxicology studies on PS031291 in the second quarter of2008.

 

Wealso have certain other agreements with leading pharmaceutical andbiotechnology companies, including Schering-Plough, BMS and Celgene Corporation(Celgene), where we have completed our research activities and the partner isnow responsible for the development of potential therapeutic products. Ourcollaborative research efforts with Schering Plough, BMS and Celgene haveresulted in a portfolio that includes two partnered programs currently inPhase 2 clinical trials targeting chronic obstructive pulmonary disease(COPD), psoriasis and asthma in the first instance and psoriasis, rheumatoidarthritis and atherosclerosis in the second instance, as well as five partneredprograms in active Phase 1 clinical trials targeting oncology,inflammatory, metabolic and respiratory diseases. Associated with theseclinical development programs, we have received milestone payments fromSchering-Plough, BMS and Celgene and, to the extent the compounds successfullyprogress through clinical development and registration, we will be entitled toreceive additional milestone payments. We are also entitled to receiveroyalties on the commercial sale, if any, of drugs resulting from thesecollaborations. However, numerous additional studies are required to fullyassess the potential of these clinical candidates before they reach themarketplace, and the results from preclinical and clinical studies conducted todate with these compounds are not necessarily indicative of the results thatmay be obtained in future clinical studies.

 

Inaddition to the compounds in clinical development, another of our partneredprograms is in preclinical development, the point at which compounds are testedfor safety in animals and are subjected to other studies required prior totesting compounds in humans.

 

Inaddition to our proprietary research and development, we currently have collaborationsunder which we are actively performing research and development activities withleading pharmaceutical and biotechnology companies, including GSK, Wyeth,Cephalon and Schering-Plough. While the nature of our collaborativerelationships vary with each of these companies, we retain certain developmentand/or commercialization rights under the terms of each agreement.

 

Clinicaland preclinical development of product drug candidates is a long, expensive anduncertain process that requires us to raise funds from time to time to supportour internal development programs. We need to raise funds from one or acombination of approaches, which could include public and/or private financing,sale and/or partnering of one or more of our internal programs, and partneringof our internal drug discovery capabilities. We continue to pursue thediscovery and development of product candidates in both our internal andcollaborative programs. The product candidates described above are at earlystages and none have received regulatory approval for commercial sale. All ofthe compounds face the substantial risk of failure inherent in drug discoveryand development. At any stage of the clinical development process, we or ourcollaborators may decide to discontinue development of our product candidates.To date, none of the compounds in which we hold complete or partial rights hasreached the stage of a commercial product and, although we have receivedlicense and milestone fees, we may never receive any sales revenues, royaltypayments or any additional license and milestone fees, under our current or anyfuture collaborations. We do not expect that our product candidates will becommercially available for many years, if ever.

 

Fromtime to time we have considered, and we will continue to consider, sometimeswith the assistance of professional banking and consulting firms, strategicinitiatives intended to further the development of our business and enhanceshareholder value.  We are alsoconsidering partnering opportunities or other strategic relationships withrespect to the development of PS433540 for various indications, includingdiabetic nephropathy and various forms of cardiovascular disease.  In addition, we consider opportunities toexpand our product pipeline through the acquisition or in-licensing of, orinvestment in, product development candidates.

 

**RecentDevelopments**

 

OnApril 10, 2008, we announced that Leslie J. Browne, Ph.D., our formerPresident, Chief Executive Officer, and member of our Board of Directorsresigned, effective April 9, 2008. We also announced that the Chairman ofour Board of 

 

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Directors, Joseph A. Mollica, Ph.D. willserve as Interim President and Chief Executive Officer until a permanentsuccessor is appointed. We have retained a national executive search firm andour search for a permanent successor is in progress.

 

Inconnection with a separation agreement we entered into with Dr. Browne, werecorded a charge of approximately $0.9 million in the three months ending June 30,2008.

 

OnApril 30, 2008, at our 2008 annual stockholders meeting, our stockholdersapproved an amendment to our Amended and Restated Certificate of Incorporationto increase the number of authorized shares of our common stock from 50,000,000to 100,000,000. Also on April 30, 2008, our Board of Directors approved anincrease in the number of shares designated as Series A Junior ParticipatingPreferred Stock from 5,000 to 10,000.

 

InMay 2008, our Board of Directors committed to a restructuring planintended to reduce our operating expenses by focusing our efforts on, andallocating a greater share of our resources to, our clinical and later-stagediscovery programs. In implementing the restructuring plan, we reduced ourworkforce by twenty-three positions during the second quarter of 2008, twentypositions of which were eliminated effective May 30, 2008. The eliminationof the remaining three positions will be completed by July 31, 2008. Inaddition, we streamlined our facilities. As a result of the restructuring plan, we recorded a restructuringcharge of approximately $1.7 million during the three months ended June 30,2008.

 

On July 31, 2008, we announced that as part of our ongoing effort to focus our resources on progressing our assets in clinical development, we expect to further reduce our workforce in the third quarter of 2008. This reduction in force will be in addition to the restructuring plan the Company committed to in May 2008  We expect to record a restructuring charge in the three months ending September 30, 2008, the amount of which has not yet been determined.

 

**Liquidity and Capital Resources**

 

As of June 30, 2008, we had cash, cash equivalents and marketablesecurities of $44.4 million compared to $71.3 million at December 31,2007, representing 70% and 79% of our total assets, respectively. We makeinvestments in highly liquid investment-grade marketable securities, includingcorporate bonds, and United States government and agency securities. As of June 30,2008, our investment portfolio did not include any auction ratesecurities.   In addition, as of June 30,2008, we had deferred revenue of $46.2 million related to cash payments andlicenses to certain product candidates that we have received under ouralliances and license agreements in exchange for research and developmentactivities that are to be performed by us subsequent to June 30, 2008.

 

The following is a summary of selected cash flow information for thesix months ended June 30, 2008 and 2007:

 

| ** **                                          | ** ** | **Six months ended June 30,** | ** ** |
|-----------------------------------------------------|------------|------------------------------------|------------|
| ** **                                          | ** ** | **2008**                           | ** ** | **2007** | ** ** |
| Net loss                                            |       | $                                  | (27,317    | ) | $ | (16,909 | ) |
| Adjustments for noncash operating items             |       | 1,769                              |       | 3,424 |   |
|                                                |       |                               |       |   |   |
| Net cash operating loss                             |       | (25,548                            | )          | (13,485 | ) |
| Net change in assets and liabilities                |       | 540                                |       | 23,462 |   |
|                                                |       |                               |       |   |   |
| Net cash (used in) provided by operating activities |       | $                                  | (25,008    | ) | $ | 9,977 |   |
|                                                |       |                               |       |   |   |
| Net cash provided by investing activities           |       | $                                  | 25,862     |   | $ | 347 |   |
|                                                |       |                               |       |   |   |
| Net cash (used in) provided by financing activities |       | $                                  | (85        | ) | $ | 38,239 |   |

 

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

 

Net cash used in operating activities for the six months ended June 30,2008 was primarily due to cash used to fund both our proprietary internal drugresearch and development efforts, including our Phase 2 and Phase 1clinical trials for PS433540, and the fulfillment of our research anddevelopment performance obligations under our collaborations. We also paidapproximately $1.5 million in severance payments related to the implementationof our restructuring plan and the separation of our former President and ChiefExecutive Officer. The net cash used in operating activities was offset by the 

 

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receipt of a$5.0 million payment received in March 2008 relating to additionalresearch funding under the GSK Agreement. Absent the receipt of the $5.0 million from GSK, our net cash usedin operating activities would have been approximately $30.0 million duringthe six months ended June 30, 2008.

 

**Net cash provided by investing activities**

 

Net cash provided by investing activities for the six months ended June 30,2008 related primarily to the maturity of marketable securities offset bycapital expenditures related to our facilities and capital expenditures forresearch and development and information technology equipment and software.

 

**Net cash provided by financing activities**

 

Net cash used in financingactivities for the six months ended June 30, 2008 consisted primarily ofrepayments of the loans originated under our Line of Credit, net of borrowingsduring the period.

 

**Liquidity and Capital Resources Outlook**

 

As of June 30, 2008, we had cash, cash equivalents and marketablesecurities of approximately $44.4 million. In addition, as of June 30,2008, we had deferred revenue of approximately $46.2 million related tocash payments and licenses to certain product candidates that we have receivedunder our alliances and licenses agreements in exchange for research anddevelopment activities that are to be performed by us subsequent to June 30,2008. Our cash used in operating activities for the six months ended June 30,2008 was approximately $25.0 million, which included $5.0 million inresearch funding from GSK. Excluding this receipt, our cash used in operatingactivities would have been approximately $30.0 million for the six monthsended June 30, 2008.  We  intend to manage our research and developmentand other expenditures in a manner consistent with our available capitalresources. Clinical and preclinical development of drug candidates is a long,expensive and uncertain process that requires us to raise funds from time totime to support our internal development programs. In order to progressPS433540 and PS178990 in clinical development, we need to raise funds from oneor a combination of approaches, which could include public and/or privatefinancing, sale and/or partnering of one or more of our internal programs, andpartnering of our internal drug discovery capabilities.

 

Conducting our own drug research and development is a key component ofour business model. We are currently conducting Phase 2 and Phase 1clinical trials for PS433540, our lead product candidate from our DARA programthat we are developing internally. In May 2008, we announced positiveresults from Study 008, a Phase 2a clinical trial of PS433540 in subjectswith Stage I and Stage II hypertension. After fully evaluating theefficacy and safety data reported in Study 008, we decided to reduce the numberof subjects in Study 006, a Phase 2b clinical trial we are conducting tofurther evaluate safety and efficacy of PS433540 in subjects with Stage Iand Stage II hypertension. This reduction will allow us to begin a Phase 2clinical trial focusing on the indication of diabetic nephropathy sooner thanotherwise would have been possible. We are also considering opportunities topartner the development of PS433540 for various indications, including diabeticnephropathy and various forms of cardiovascular disease.

 

In October 2007, we acquired the development and commercializationrights to the SARM program from BMS, including PS178990, a product candidate inPhase 1 clinical development for which we intend to conduct furtherclinical trials. In consideration for the licenses to the SARM program, weentered into the Discovery Collaboration Agreement with BMS to provide aportion of our medicinal chemistry resources to a BMS discovery programunrelated to the SARM program for a period of up to three years. Additionally, progressingthe SARM program, specifically our product candidate PS178990, through clinicaltrials is expected to further increase our proprietary research and developmentcosts.

 

As part of our collaborative agreements with GSK, Wyeth, Cephalon andSchering-Plough, we have received up-front cash payments. In connection withthese agreements and the Discovery Collaboration Agreement with BMS, we areobligated to perform significant research and development activities overmultiple years and as such, expect to incur significant costs performing suchactivities. The following table provides the period over which these researchand development activities are to be provided, as well as the deferred revenuecurrently recorded for each agreement as of June 30, 2008:

 

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| **Collaborative Agreement**           | ** ** | **Expiration of   Initial Research Term** | ** ** | **Deferred Revenue   as of   June 30, 2008** | ** ** |
|---------------------------------------|------------|-------------------------------------------|------------|---------------------------------------------------|------------|
|                                  |       |                                      |       |                                              |       |
| 2007 Schering-Plough Agreement        |       | February 2012                        |       | $                                                 | 16,262     |   |
| GSK Agreement                         |       | March 2011                           |       | 12,799                                            |       |
| BMS Discovery Collaboration Agreement |       | December 2010                        |       | 7,688                                             |       |
| Cephalon Agreement                    |       | May 2009                             |       | 4,583                                             |       |
| Wyeth Agreement                       |       | December 2009                        |       | 3,781                                             |       |
| Other                                 |       | June 2009(1)                         |       | 1,121                                             |       |
|                                  |       |                                      |       | $                                                 | 46,234     |   |

 

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(1) June 2009 represents the latest expiration of agreementsin this category.

 

Since February 2007, under the 2007 Schering-Plough Agreement, wehave received $22.0 million (a $15.0 million up-front payment,$1.0 million for the transfer of rights to certain programs from the 2002Collaboration, and $6.0 million in quarterly research funding). We may receiveup to an additional $14.0 million of research and development funding overthe remaining portion of the five-year research term, which began in February 2007.

 

Since January 2007, we have received approximately $10.3 millionin connection with our research and license agreement with Wyeth (a$5.0 million up-front payment and approximately $5.3 million inquarterly research funding). We may receive an additional $3.9 million ofresearch and development funding over the remaining portion of the three-yearresearch term, which began in January 2007.

 

As of June 30, 2008, we had borrowings associated with our Line ofCredit of approximately $4.0 million, which have repayment terms rangingfrom 36 to 48 months, including approximately $1.2 million that isclassified as current. We had approximately $0.3 million available forborrowings under our Line of Credit as of June 30, 2008.

 

On July 31, 2008, we announced that as part of our ongoing effort to focus our resources on progressing our assets in clinical development, we expect to further reduce our workforce in the third quarter of 2008. This reduction in force is in addition to the restructuring plan the Company committed to in May 2008. While this reduction in force is expected to increase our cash outlay during the remainder of the year, the reduction is expected to reduce our operating expenditures in the future.

 

We anticipate that our capital resources will be adequate to fund ouroperations at their current levels at least through March 31, 2009.  We intend to manage our expenditures in amanner consistent with our available capital resources. However, there can beno assurance that changes will not occur that would consume available capitalresources before then.

 

Our capital requirements depend on competing technological and marketdevelopments, changes in our existing collaborative relationships, progress ofPS433540 and PS178990 in clinical trials, 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 toexhausting our current capital resources, we will need to raise additionalfunds or enter into strategic initiatives intended to further the developmentof our business in order to finance our operating activities and to satisfy ourcommitments to our corporate partners and our other contractual obligations.There can be no assurance that additional funding, if necessary, will beavailable to us on favorable terms, if at all. Our forecasts of the period oftime through which our financial resources will be adequate to support ouroperations are forward-looking information and actual results could vary. Thefactors described earlier in this section will impact our future capitalrequirements and the adequacy of our available funds.

 

**Results of Operations**

 

This section should be read in conjunction with the discussion aboveunder “Liquidity and Capital Resources.”

 

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

 

Our net revenue increased 19% to $5.9 million in the three monthsended June 30, 2008 compared to $5.0 million in the three monthsended June 30, 2007. Net revenue consists of revenue recorded inconnection with research and development efforts we perform under our variouscollaborative agreements, as well as our earning of milestones, success feesand license revenue if and as the compounds we and our collaborators haveidentified progress through our collaborators’ development processes. Netrevenue for the three months ended June 30, 2008 and 2007 is summarized asfollows:

 

| ** **                                   | ** ** | **For the three months ended June 30,** | ** ** |
|----------------------------------------------|------------|----------------------------------------------|------------|
| ** **                                   | ** ** | **2008**                                     | ** ** | **2007** | ** ** |
|                                         |       |                                         |       |   |   |
| Collaborative research revenue               |       | $                                            | 5,793      |   | $ | 3,806 |   |
| Milestones, success fees and license revenue |       | 89                                           |       | 1,151 |   |
|                                         |       | $                                            | 5,882      |   | $ | 4,957 |   |

 

Revenuerecognized from our collaborative relationships for the three months ended June 30,2008 and 2007, respectively, was as follows:

 

| ** **         | ** ** | **For the three months ended June 30,** | ** ** |
|--------------------|------------|----------------------------------------------|------------|
| ** **         | ** ** | **2008**                                     | ** ** | **% of   Total   Revenue** | ** ** | **2007** | ** ** | **% of   Total  Revenue** | ** ** | **Change** | ** ** |
|               |       |                                         |       |   |   |   |   |   |   |   |   |
| Schering-Plough(1) |       | $                                            | 1,281      |   | 22 | % | $ | 1,918 |   | 39 | % | $ | (637 | ) |
| Cephalon           |       | 1,250                                        |       | 21 | % | 1,250 |   | 25 | % | — |   |
| Wyeth              |       | 1,197                                        |       | 20 | % | 1,167 |   | 24 | % | 30 |   |
| GSK                |       | 1,145                                        |       | 19 | % | 468 |   | 9 | % | 677 |   |
| BMS                |       | 920                                          |       | 16 | % | — |   | 0 | % | 920 |   |
| Other              |       | 89                                           |       | 2 | % | 154 |   | 3 | % | (65 | ) |
| Total Revenue      |       | $                                            | 5,882      |   | 100 | % | $ | 4,957 |   | 100 | % | $ | 925 |   |

 

----

(1) Revenue from our collaborations with Schering-Plough includesnet revenue of approximately $1.3 million recognized under the 2007Schering-Plough Agreement during the three months ended June 30, 2008.During the three months ended June 30, 2007, revenue from ourcollaborations with Schering-Plough consisted of net revenue of approximately$0.9 million recognized under the 2007 Schering-Plough Agreement and $1.0million in milestone revenue recognized under those collaborations withSchering-Plough in which our research activities ceased in April 2007.

 

The increase in collaborative research revenue in the three monthsended June 30, 2008 was largely due to increased research revenue from our2007 Schering-Plough Agreement and our agreements with GSK and BMS offset bylower milestone revenue from our collaborations with Schering-Plough in whichour research activities ceased in April 2007.

 

Collaborative research and development expense includes the labor,material, equipment and allocated facilities cost of our scientific staff thatis working on collaborative partnerships. Collaborative research anddevelopment expenses increased 27% to $7.2 million in the three monthsended June 30, 2008 compared to $5.7 million in the three monthsended June 30, 2007. This increase primarily related to an increase inresources allocated to our alliances with GSK, Schering-Plough, specificallyunder our 2007 Schering-Plough Agreement and resources allocated to ourDiscovery Collaboration Agreement with BMS. Share-based compensation costsassociated with our adoption of SFAS 123R for the three months ended June 30,2008 and 2007 were approximately $200 thousand and $138 thousand,respectively.

 

Proprietary research and development expense includes research anddevelopment acquisition costs, clinical trial and preclinical study costs, andlabor, material, equipment and allocated facilities cost of scientific staffworking on self-funded internal drug discovery and development programs. Ourmost advanced internal program is our DARA program. The most advanced compoundin our DARA program is our lead product candidate PS433540, which is in Phase 2clinical trials. 

 

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Welicensed our DARA program from BMS in March 2006. In addition, wein-licensed our SARM program from BMS in October 2007. The most advancedcompound in our SARM program is our product candidate PS178990, which is inPhase 1 clinical development. Proprietary research and developmentexpenses increased 83% to $9.2 million in the three months ended June 30,2008 compared to $5.0 million in the three months ended June 30,2007. This increase was primarily attributable to costs relating to clinicaltrials for PS433540 and toxicology studies for PS178990 offset by decreasedcosts related to our CCR1 program. Share-based compensation costs associatedwith our adoption of SFAS 123R for the three months ended June 30,2008 and 2007 were approximately $114 thousand and $76 thousand,respectively. Because of the speculative nature of these internal drug discoveryand development projects, it is not possible to estimate completion dates orcosts of completion. Additionally, from time to time, 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 and development projects.

 

General and administrative expense increased by 47% to$4.1 million in the three months ended June 30, 2008 compared to$2.8 million in the three months ended June 30, 2007. The increase ingeneral and administrative expense was primarily attributable to $1.0 millionin severance costs in connection with the separations of our former Presidentand Chief Executive Officer and our former Senior Vice President, BusinessDevelopment. Also contributing to the increase were increases in patentprosecution and other legal costs, and compensation costs during the threemonths ended June 30, 2008. Share-based compensation costs associated withour adoption of SFAS 123R for the three months ended June 30, 2008and 2007 were approximately $432 thousand and $312 thousand,respectively.

 

Restructuring expense relates to costs associated with a restructuringplan our Board of Directors committed to during the three months ended June 30,2008.  These costs consisted ofapproximately $1.2 million in severance costs, including approximately $0.1million in share-based compensation costs related to the accelerated vesting ofrestricted stock units, and approximately $0.5 million related to abandoningcertain facility leases.  There was nosuch restructuring expense in the three months ending June 30, 2007.

 

Other income for the three months ended June 30, 2008 consisted of $700thousand we received in connection with the assignment of certain intellectualproperty to a collaborator in which our research activities had ceased. Therewere no amounts recognized as other income for the three months ended June 30,2007.

 

Interest income decreased to $244 thousand in the three monthsended June 30, 2008 compared to $942 thousand in the three months ended June 30,2007. This decrease was primarily due to lower yields on our cash, cashequivalents, and marketable securities balances during the three months ended June 30,2008 as compared to the three months ended June 30, 2007.

 

Interest and other expense, net increased to $103 thousand in thethree months ended June 30, 2008 compared to $5 thousand in the threemonths ended June 30, 2007.  Thisincrease related to our increased borrowing balances under our line of creditduring the period.  As of June 30,2008 and 2007, the aggregate balance of loans originated under the Line ofCredit was approximately $4.0 million and $0.5 million, respectively.

 

Non-operating expense associated with the increase in warrant liabilitywas $145 thousand for the three months ended June 30, 2008. This increaserepresents the change in the fair value of the warrants that were issued inconnection with our equity financing in October 2006, from March 31,2008 to June 30, 2008.  For thethree months ended June 30, 2007 non-operating income associated with adecrease in warrant liability totaled approximately $638 thousand.  This increase represents the change in thefair value of the warrants that were issued in connection with our equityfinancing in October 2006, from March 31, 2007 to June 30, 2007.The fair value of the warrants was determined using the Black-Scholesoption-pricing model and is remeasured at each reporting period.

 

We recorded an income tax provision of $2 thousand for the three monthsended June 30, 2008, which related to minimum state income taxes.   For the three months ended June 30,2007, we recorded an income tax benefit of approximately $52 thousand whichrepresented an adjustment to our estimated 2006 tax provision to reflect actualminimum state income taxes due.

 

As a result of the net revenues and expenses described above, wegenerated a net loss of $15.6 million ($0.53 per basic and diluted share)in the three months ended June 30, 2008, compared to a net loss of$6.9 million ($0.26 per basic and diluted share) in the three months endedJune 30, 2007.

 

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**Six Months Ended June 30, 2008 and 2007**

 

Our net revenue increased 7% to $12.1 million in the six monthsended June 30, 2008 compared to $11.3 million in the six months endedJune 30, 2007. Net revenue consists of revenue recorded in connection withresearch and development efforts we perform under our various collaborativeagreements, as well as our earning of milestones, success fees and licenserevenue if and as the compounds we and our collaborators have identifiedprogress through our collaborators’ development processes. Net revenue for thesix months ended June 30, 2008 and 2007 is summarized as follows:

 

| ** **                                   | ** ** | **For the six months ended June 30,** | ** ** |
|----------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                   | ** ** | **2008**                                   | ** ** | **2007** | ** ** |
|                                         |       |                                       |       |   |   |
| Collaborative research revenue               |       | $                                          | 11,895     |   | $ | 7,838 |   |
| Milestones, success fees and license revenue |       | 191                                        |       | 3,468 |   |
|                                         |       | $                                          | 12,086     |   | $ | 11,306 |   |

 

Revenuerecognized from our collaborative relationships for the six months ended June 30,2008 and 2007, respectively was as follows:

 

| ** **         | ** ** | **For the six months ended June 30,** | ** ** |
|--------------------|------------|--------------------------------------------|------------|
| ** **         | ** ** | **2008**                                   | ** ** | **% of   Total  Revenue** | ** ** | **2007** | ** ** | **% of   Total   Revenue** | ** ** | **Change** | ** ** |
|               |       |                                       |       |   |   |   |   |   |   |   |   |
| Schering-Plough(1) |       | $                                          | 2,766      |   | 23 | % | $ | 4,198 |   | 37 | % | $ | (1,432 | ) |
| Cephalon           |       | 2,500                                      |       | 21 | % | 2,500 |   | 22 | % | — |   |
| Wyeth              |       | 2,395                                      |       | 20 | % | 2,333 |   | 21 | % | 62 |   |
| GSK                |       | 2,268                                      |       | 19 | % | 706 |   | 6 | % | 1,562 |   |
| BMS                |       | 1,966                                      |       | 16 | % | — |   | 0 | % | 1,966 |   |
| Biovitrum(2)       |       | —                                     |       | 0 | % | 1,096 |   | 10 | % | (1,096 | ) |
| Other              |       | 191                                        |       | 1 | % | 473 |   | 4 | % | (282 | ) |
| Total Revenue      |       | $                                          | 12,086     |   | 100 | % | $ | 11,306 |   | 100 | % | $ | 780 |   |

 

----

(1) Revenue from our collaborations with Schering-Plough includednet revenue of approximately $2.8 million recognized under the 2007Schering-Plough Agreement during the six months ended June 30, 2008.During the six months ended June 30, 2007, revenue from our collaborationswith Schering-Plough included net revenue of approximately $0.9 millionrecognized under our 2007 Schering-Plough Agreement, $0.5 million of netrevenue recognized under our 2002 Collaboration and approximately $2.8 millionof net revenue, including $2.0 million in milestone revenue, recognized underthose collaborations with Schering-Plough in which our research activitiesceased in April 2007.

 

(2) Revenue from our Biovitrum collaborations included$1.0 million in milestone revenue for the six months ended June 30,2007.

 

The increase in collaborative research revenue in the six months ended June 30,2008 was largely due to increased research revenue from our 2007Schering-Plough Agreement and our agreements with GSK and BMS offset by lowermilestone revenue from our collaborations with Schering-Plough in which ourresearch activities ceased in April 2007 and Biovitrum.

 

Collaborative research and development expense includes the labor,material, equipment and allocated facilities cost of our scientific staff thatis working on collaborative partnerships. Collaborative research anddevelopment expenses increased 39% to $15.1 million in the six monthsended June 30, 2008 compared to $10.9 million in the six months endedJune 30, 2007. This increase primarily related to an increase in resourcesallocated to our alliances with GSK, and Schering-Plough, specifically underour 2007 Schering-Plough Agreement, and resources allocated to our DiscoveryCollaboration 

 

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Agreement with BMS. Thisincrease was offset by decreased resources allocated to those collaborationswith Schering-Plough in which we completed our research activities in April 2007.Share-based compensation costs associated with SFAS 123R for the sixmonths ended June 30, 2008 and 2007 were approximately $396 thousandand $263 thousand, respectively.

 

Proprietary research and development expense includes research anddevelopment acquisition costs, clinical trial and preclinical study costs, andlabor, material, equipment and allocated facilities cost of scientific staffworking on self-funded internal drug discovery and development programs. Ourmost advanced internal program is our DARA program. The most advanced compoundin our DARA program is our lead product candidate PS433540, which is inPhase 2 clinical trials. We licensed our DARA program from BMS in March 2006.In addition, we in-licensed our SARM program from BMS in October 2007. Themost advanced compound in our SARM program is our product candidate PS178990,which is in Phase 1 clinical development. Proprietary research anddevelopment expenses increased 44% to $18.0 million in the six monthsended June 30, 2008 compared to $12.5 million in the six months endedJune 30, 2007. This increase was primarily attributable to costs relatingto clinical trials for PS433540 and toxicology studies for PS178990 offset bydecreased costs on our CCR1 program. Share-based compensation costs associatedwith SFAS 123R for the six months ended June 30, 2008 and 2007 wereapproximately $193 thousand and $149 thousand, respectively. Becauseof the speculative nature of these internal drug discovery and developmentprojects, it is not possible to estimate completion dates or costs ofcompletion. Additionally, from time to time, certain staff and other researchand development resources may be temporarily redirected from one project toanother, which redirection may also delay or impact the cost of internal drugdiscovery and development projects.

 

General and administrative expense increased by 37% to$7.5 million in the six months ended June 30, 2008 compared to$5.5 million in the six months ended June 30, 2007. The increase ingeneral and administrative expense was primarily attributable to $1.0 millionin severance costs in connection with the separations of our former Presidentand Chief Executive Officer and our former Senior Vice President, BusinessDevelopment. Also contributing to the increase were increases in patentprosecution and other legal costs, and compensation costs during the six monthsended June 30, 2008. Share-based compensation costs associated withSFAS 123R for the six months ended June 30, 2008 and 2007 wereapproximately $792 thousand and $604 thousand, respectively.

 

Restructuring expense relates to costs associated with a restructuringplan our Board of Directors committed to during the six months ended June 30,2008.  These costs consisted ofapproximately $1.2 million in severance costs, including approximately $0.1million in share-based compensation costs related to the accelerated vesting ofrestricted stock units, and approximately $0.2 million related to abandoningcertain facility leases.  There was nosuch restructuring expense in the six months ending June 30, 2007.

 

Other income for the six months ended June 30, 2008 consisted of $700thousand we received in connection with the assignment of certain intellectualproperty to a collaborator in which our research activities had ceased. Otherincome for the six months ended June 30, 2007 related to $94 thousand in proceedsfrom an insurance claim.

 

Interest income decreased to approximately $0.9 million in the sixmonths ended June 30, 2008 compared to approximately $1.5 million in thesix months ended June 30, 2007. This decrease was primarily due to loweryields on our cash, cash equivalents, and marketable securities balances duringthe six months ended June 30, 2008 as compared to the six months ended June 30,2007.

 

Interest and other expense, net increased to $203 thousand in thesix months ended June 30, 2008, compared to $5 thousand in the six monthsended June 30, 2007.  The increaserelated to our increased borrowing balance under our line of credit during theperiod.  As of June 30, 2008 and2007, the aggregate balance of loans originated under the Line of Credit wasapproximately $4.0 million and $0.5 million, respectively.

 

Non-operating income associated with the decrease in warrant liabilitywas approximately $1.5 million for the six months ended June 30, 2008.This decrease represents the change in the fair value of the warrants that wereissued in connection with our equity financing in October 2006, from December 31,2007 to June 30, 2008.  For the sixmonths ended June 30, 2007 non-operating expense associated with theincrease in warrant liability totaled approximately $1.1 million.  This increase represents the change in thefair value of the warrants that were issued in connection with our equityfinancing in October 2006, from December 31, 2006 to June 30,2007. The fair value of the warrants was determined using the Black-Scholesoption-pricing model and is remeasured at each reporting period.

 

We recorded an income tax provision of $2 thousand for the six monthsended June 30, 2008, which related to minimum state income taxes.   For the six months ended June 30, 2007,we recorded an income tax benefit of approximately $52 thousand whichrepresented an adjustment to our estimated 2006 tax provision to reflect actualtaxes due.

 

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As a result of the net revenues and expenses described above, wegenerated a net loss of $27.3 million ($0.92 per basic and diluted share)in the six months ended June 30, 2008, compared to a net loss of$16.9 million ($0.63 per basic and diluted share) in the six months ended June 30,2007.

 

**Net Loss Outlook**

 

We have had net losses in recent years and we expect to incur losses infuture periods.  These losses may increasecompared to prior periods. Our efforts to progress the DARA and SARM programsthrough clinical trials represent significant expenditures. However we intendto manage all of our expenditures in a manner consistent with our availablecapital resources.

 

The amount of our net loss is highly dependent on the continued fundingand success of our research and development programs with our existingcollaborators.  The initial researchterms of our alliances with Cephalon and Wyeth are scheduled to end in May and December 2009,respectively.  Cephalon and Wyethrepresented 22% and 19%, respectively, of our total revenue during the sixmonths ended June 30, 2008.  Weexpect to record revenue from these alliances through the end of the initialresearch terms, at which time our research activities under these alliancescould cease.  We are uncertain whether wewill extend or replace these alliances. Failure to earn additional research and milestone payments under ourcurrent alliances and alliances we may seek to enter into after the end ofthese initial research terms would have a material adverse effect on ourfinancial condition and our results of operations.  If we fail to earnadequate additional research and milestone payments, we may be required tocurtail operations significantly or to obtain funds by entering intoarrangements with collaborative partners or others that may require us torelinquish rights to certain of our technologies, products or potential marketsthat we would not otherwise relinquish.

 

On July 31, 2008, we announced that as part of our ongoing effortto focus our resources on progressing our assets in clinical development, weexpect to further reduce our workforce in the third quarter of 2008. We expect torecord a restructuring charge in the three months ending September 30, 2008,the amount of which has not yet been determined. This charge is expected to increaseour net loss in the third quarter of 2008.

 

Our adoption of SFAS 123R, which was effective January 1,2006, increased our compensation costs and will continue to have a significantimpact on our results of operations. Changes in the fair value of the warrantswe issued in October 2006 are reported in the statements of operations asincome or expense. As such, changes to the market price of our common stock orto the assumptions used in calculating the fair value of the warrants may causesignificant increases or decreases to our results of operations. However,neither the impact of share-based compensation costs, nor the impact of changesin the fair value of the warrant liability will have an impact on our cashflows.

 

There is no assurance that we will ever achieve profitable operations,or that profitable operations, if achieved, could be sustained on a continuingbasis.

 

**Critical Accounting Policies and Estimates**

 

The preparation of our financial statements and disclosures involve theuse of judgments and estimates. We believe the following critical accountingpolicies which we follow involve significant judgments and use estimates.

 

*RevenueRecognition*

 

Contract revenue is generally recognized either (i) on aproportional performance basis, for contracts specifying payment for servicesover a given period, or (ii) as services are performed under the agreementfor contracts specifying payment on a full-time employee basis.

 

Revenue earned related to up-front product and technology license feesis recognized in accordance with SAB 104 issued by the SEC and EITF 00-21issued by the FASB. Accordingly, amounts received under multiple-elementarrangements requiring ongoing services or performance by us are recognizedover the period of such services or performance.

 

Revenue from milestones is recognized when earned, as evidenced bywritten acknowledgement from the collaborator, provided that (i) themilestone event is substantive, its achievability was not reasonably assured atthe inception of the agreement, and we have no further performance obligationsrelating to that event, and (ii) collectibility is reasonably assured. Ifthese criteria are not met, the milestone payment is recognized over theremaining minimum period of our performance obligations under the arrangement.Royalties are recognized as earned in accordance with the terms of variousresearch and collaboration agreements.

 

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*Share-basedCompensation*

 

Effective January 1, 2006, we adopted the fair value recognitionprovisions of SFAS 123R, using the modified-prospective transition method.This statement is a revision to SFAS 123, supersedes APB 25 andamends SFAS No. 95, “Statement of Cash Flows.” Under this transitionmethod, compensation cost recognized includes compensation cost for allshare-based payments granted prior to, but not yet vested as of December 31,2005 based on the grant date fair value estimated in accordance with theoriginal provisions of SFAS 123, and compensation cost for all share-basedpayments granted subsequent to December 31, 2005 based on the grant datefair value estimated in accordance with provisions of SFAS 123R

 

Under SFAS 123R, we use the Black-Scholes option pricing model toestimate the fair value of the share-based awards as of the grant date. TheBlack-Scholes model, by its design, is highly complex and dependent upon keydata inputs estimated by management. The primary data inputs with the greatestdegree of judgment are the estimated lives of the share-based awards and theestimated volatility of our stock price. The Black-Scholes model is sensitiveto changes in these two data inputs. Beginning in fiscal year 2006, wecalculated the estimated life of stock options granted using a “simplified”method, which is based on the average of the vesting term and the actual termof the option, as a result of guidance from the SEC as contained inSAB 107 permitting the initial use of this method through 2007. In December 2007,the SEC issued SAB 110, which became effective January 1, 2008,expressing the expectation that companies should be employing information frominternal or external sources about employee stock option exercise behavior whendeveloping estimates of expected term as they relate to stock optionvaluations. SAB 110 states that the SEC will continue to accept the use ofthe “simplified” method, under certain circumstances, beyond December 31,2007. We evaluated the exercise behavior of our employees for stock optionsgranted since our spin-off from Accelrys in April 2004 and determined thatthe exercise history was an inadequate measure of the expected term of ourstock options. Therefore, we have continued our use of the simplified method asprescribed in SAB 107. Expected stock price volatility is typically based onthe daily historical trading data from an appropriate point in time through thelast day of the applicable period. Because our historical trading data onlydates back to May 3, 2004, the first trading date after our spin-off fromAccelrys, Inc., we estimate expected volatility using an analysis of thestock price volatility of companies comparable to ours in our industry.

 

*WarrantLiability*

 

We follow EITF 00-19 in accounting for our warrants which providesguidance for distinguishing between permanent equity, temporary equity andassets and liabilities. Under EITF 00-19, to qualify as permanent equity,the equity derivative must permit us to settle in unregistered shares. Undersecurities law, if the warrants were issued in connection with a publicoffering and have a cash settlement feature at the holder’s option, we do nothave the ability to settle in unregistered shares. Therefore, the warrantscannot be classified as permanent equity and are instead classified as aliability. The approximately 1,450,000 warrants that we issued as part of ourequity financing in October 2006 meet this criteria, and have beenrecorded as a liability in the accompanying balance sheets. Other warrants wehad previously issued qualify as permanent equity and do not requireremeasurement.

 

We record our warrant liabilities at fair value using a Black-Scholesoption-pricing model and remeasure at each reporting date until the warrantsare exercised or have expired. Changes in the fair value of the warrants arereported in the statements of operations as income or expense. The fair valueof the warrants could be subject to significant fluctuation based on changes inour stock price, expected volatility, expected life, the risk-free interestrate and dividend yield. The market price for our common stock has been and maycontinue to be volatile. Consequently, future fluctuations in the price of ourcommon stock may cause significant increases or decreases in the fair value ofthe warrants issued in October 2006.

 

*Long-LivedAssets*

 

We review long-lived assets, including leasehold improvements, propertyand equipment, and acquired technology rights, for impairment whenever eventsor changes in business circumstances indicate that the carrying amount of theassets may not be fully recoverable. This requires us to estimate future cashflows related to these assets. Actual results could differ from theseestimates, which may affect the carrying amount of assets and the actualamortization expense. As of June 30, 2008, we had long-lived assets with anet book value of $14.9 million.

 

*Accountingfor Uncertain Tax Positions*

 

We have adopted the provisions of FASB Interpretation No. 48, “Accountingfor Uncertainty in Income Taxes—an interpretation of FAS Statement No. 109”(FIN 48). FIN 48 applies to all uncertain tax positions accounted forin accordance with SFAS No. 109, “Accounting for Income Taxes” and isintended to result in increased relevance and comparability in 

 

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financial reporting ofincome taxes and to provide more information about the uncertainty in incometax assets and liabilities. We will recognize potential interest and penaltiesrelated to income tax positions as a component of the benefit or provision forincome taxes on the consolidated statements of operations in any future periodsin which we must record a liability. Because we have not recorded a liabilityat June 30, 2008, there is no impact to our effective tax rate. We do notanticipate that total unrecognized tax benefits will significantly changeduring the next twelve months.

 

**Recent Accounting Pronouncements**

 

*Fair ValueMeasurements*

 

InSeptember 2006, the FASB issued SFAS No. 157, “Fair Value Measurements”(SFAS 157). SFAS 157 establishes a framework for measuring fair valuein accordance with generally accepted accounting principles and expandsdisclosures about fair value measurements. The statement defines fair value as the exit pricethat would be received to sell an asset or paid to transfer a liability.   Fair value is a market-based measurementthat should be determined using assumptions that market participants would usein pricing an asset or liability.  Thestatement establishes a three-level hierarchy to prioritize the inputs used inmeasuring fair value.  The levels aredescribed in the table below with Level 1 having the highest priority and Level3 having the lowest.

 

In February 2008, the FASB issued FASB Staff Position (FSP) 157-bwhich delayed the effective date of SFAS 157 for one year for allnonfinancial assets and nonfinancial liabilities, except those that arerecognized or disclosed at fair value in the financial statements on arecurring basis (at least annually). SFAS 157 and FSP 157-b are effectivefor financial statements issued for fiscal years beginning after November 15,2007. We have elected a partial deferral of Statement 157 under the provisionsof FSP 157-b and, effective January 1, 2008, the Company adoptedSFAS 157 for those assets and liabilities that are remeasured at fairvalue on a recurring basis. Our partial adoption of SFAS 157 did not have amaterial effect on our consolidated financial statements as of and for the sixmonths ended June 30, 2008.

 

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The followingtable provides a summary of the assets and liabilities that are measured atfair value on a recurring basis as of June 30, 2008.

 
| ** **                               | ** ** | **Basis of Fair Value Measurements** | ** **   |
|------------------------------------------|------------|--------------------------------------|--------------|
| ** **                               | ** ** | **As of**                            | ** **   | **Quoted prices   in active   markets for   identical   assets** | ** ** | **Significant   other   observable   inputs** | ** ** | **Significant  unobservable  inputs** | ** ** |
| ** **                               | ** ** | **June 30, 2008**               | ** **   | **Level 1** | ** ** | **Level 2** | ** ** | **Level 3** | ** ** |
| **Assets**                               | ** ** | ** **                           | ** **   | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Cash and cash equivalents                |       | $                                    |  30,955 |   | $ |  30,955 |   | $ |  — |   | $ |  — |   |
| Marketable securities                    |       | 13,485                               |         | 13,485 |   | — |   | — |   |
| Deferred compensation plan assets        |       | 1,838                                |         | 1,838 |   | — |   | — |   |
|                                     |       |                                 |         |   |   |   |   |   |   |
| Total assets measured at fair value      |       | $                                    |  46,278 |   | $ |  46,278 |   | $ |  — |   | $ |  — |   |
|                                     |       |                                 |         |   |   |   |   |   |   |
| Percentage of total assets               |       | 73                                   | %            | 73 | % | — |   | — |   |
|                                     |       |                                 |         |   |   |   |   |   |   |
| **Liabilities**                          | ** ** | ** **                           | ** **   | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Warrant liability                        |       | $                                    |  2,744  |   | $ | — |   | $ |  2,744 |   | $ |  — |   |
| Deferred compensation plan liabilities   |       | 1,838                                |         |   |   | 1,838 |   | — |   |
|                                     |       |                                 |         | — |   |   |   |   |   |
| Total liabilities measured at fair value |       | $                                    |  4,582  |   | $ | — |   | $ | 4,582 |   | $ |  — |   |
|                                     |       |                                 |         |   |   |   |   |   |   |
| Percentage of total liabilities          |       | 7                                    | %            | — |   | 7 | % | — |   |

 

As noted above, the fair value of our cash, cash equivalents,marketable securities and deferred compensation plan assets are determinedusing quoted market prices in active markets. The fair value of the deferredcompensation plan liabilities is based upon significant observable inputs suchas the fair value of the underlying securities of the deferred compensationplan and our credit risk. The fair value of the warrant liability is determinedusing the Black-Scholes option-pricing model, which uses certain significantobservable inputs, including stock price (quoted market prices in activemarket), warrant exercise price (defined in warrant agreement), expected lifeof warrant (defined in warrant agreement), dividend yields (determined by us),and risk-free interest rate (quoted market prices based on expected lifeassumption). The only input in the Black-Scholes option-pricing model that isnot readily observable is the expected stock price volatility. Because ourhistorical trading data only dates back to May 3, 2004, the first tradingdate after our spin-off from Accelrys, Inc., we estimate our expectedvolatility using an analysis of the stock price volatility of comparablecompanies in our industry. The fair value of the warrant liability is subjectto significant fluctuations and has ranged from approximately $2.7 million asof June 30, 2008 to approximately $5.5 million as of June 30, 2007.These fluctuations have primarily resulted from fluctuations in the marketprice of our common stock, which ranged from $3.65 per share to $5.55 per shareat our quarterly remeasurement dates since June 30, 2007. Changes in thewarrant liability are recorded in the statement of operations as income(decreases) or expense (increases).

 

*Fair ValueOption for Financial Assets and Liabilities*

 

InFebruary 2007, the FASB issued SFAS No. 159, “The Fair Value Optionfor Financial Assets and Liabilities Including an Amendment of FASB Statement No. 115”(SFAS 159). SFAS 159 permits reporting entities to choose to measureeligible financial assets or liabilities, which include marketable securitiesavailable-for-sale and equity method investments, at fair value at specifiedelection dates, or according to a pre-existing policy for specific types ofeligible items. Unrealized gains and losses for which the fair value option hasbeen elected are reported in earnings. SFAS 159 is effective for fiscalyears beginning after November 15, 2007. Our adoption of SFAS 159, whichwas effective January 1, 2008, did not have any impact on our consolidatedfinancial statements as of and for the six months ended June 30, 2008.

 

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

 

In June 2007, the EITF of the FASB reached a consensus on Issue No. 07-3,“Accounting for Nonrefundable Advance Payments for Goods or Services Receivedfor Use in Future Research and Development Activities” (EITF 07-3).EITF 07-3 requires that non-refundable advance payments for goods orservices that will be used or rendered for future research and developmentactivities should be deferred and capitalized. As the related goods aredelivered or the services are performed, or when the goods or services are nolonger expected to be provided, the deferred amounts would be recognized as anexpense. EITF 07-3 is effective for financial statements issued for fiscalyears beginning after December 15, 2007. Our adoption of EITF 07-3,which was effective January 1, 2008, did not have a material effect on ourconsolidated financial statements as of and for the six months ended June 30,2008.

 

*Business Combinations*

 

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

 

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

 

The recent decline in themarket value of certain securities backed by residential mortgage loans has ledto a large liquidity crisis effecting the broader U.S. housing market, thefinancial services industry and global financial markets. Investors in manyindustry sectors have experienced substantial decreases in asset valuations anduncertain market liquidity. Furthermore, credit rating authorities have, inmany cases, been slow to respond to the rapid changes in the underlying valueof certain securities and pervasive market illiquidity of these securities.

 

As a result, this “creditcrisis” may have a potential impact on the determination of the fair value offinancial instruments or possibly require impairments in the future should thevalue of certain investments suffer a decline in value which is determined tobe other than temporary. Our cash, cash equivalents and marketable securitiesportfolio currently consists of United States treasury bills and money marketfunds. As such, we believe the impairment risk to our portfolio is minimal.

 

Our exposure to market risks associated with changes in interest ratesrelates primarily to the increase or decrease in the amount of interest incomeearned on our investment portfolio since we have minimal debt. We ensure thesafety and preservation of invested funds by limiting default risks, marketrisk and reinvestment risk. We mitigate default risk by investing in investmentgrade securities. A hypothetical 100 basis point adverse move in interest ratesalong the entire interest rate yield curve would not have materially affectedthe fair value of our interest sensitive financial instruments at June 30,2008.

 

We do not use derivative financial instruments for trading orspeculative purposes. However, we regularly make investments in overnightrepurchase agreements that are subject to changes in short-term interest rates.We believe that the market risk arising from holding these financialinstruments is minimal.

 

Our international revenue is generally denominated in United StatesDollars, and is, therefore, not exposed to changes in foreign currency exchangerates. Additionally, certain of our preclinical and clinical developmentcontracts are denominated in foreign currencies. We believe that the foreigncurrency risk arising from these contracts to be minimal.

 

**Item 4. Controls and Procedures**

 

For the three months ended June 30, 2008, our management carried outan evaluation, under the supervision and with the participation of our InterimPresident and Chief Executive Officer and our Executive Vice President, ChiefFinancial Officer and Treasurer (our principal financial officer and chiefaccounting officer), of the effectiveness of our disclosure controls and

 

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procedures pursuant to Rules 13a-15 and15d-15 under the Securities Exchange Act of 1934, or the Exchange Act, as ofthe end of the period covered by this report. Based upon this evaluation, ourInterim President and Chief Executive Officer and our Executive Vice President,Chief Financial Officer and Treasurer concluded that as of June 30, 2008, our disclosure controlsand procedures were effective to ensure that the information required to bedisclosed by us in reports filed under the Exchange Act was recorded,processed, summarized and reported within the time periods specified in the rules andforms of the SEC. Our management, including our Interim President and ChiefExecutive Officer and our Executive Vice President, Chief Financial Officer andTreasurer, does not expect that our disclosure controls or our internalcontrols will prevent all errors and all fraud. A control system, no matter howwell designed and operated, cannot provide assurance that the objectives of thecontrol system are met, and no evaluation of controls can provide absoluteassurance that all control issues and instances of fraud, if any, within acompany have been detected.

 

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

 

**PART II. OTHER INFORMATION**

 

**Item 1.****   ****LegalProceedings**

 

We arenot currently a party to any legal proceedings the negative outcome of whichwould have a material adverse effect on our business, financial condition orresults of operations.

 

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

 

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

 

**RISKS RELATED TO OUR BUSINESS AND INDUSTRY**

 

***If we are unable to raise additionalcapital or if we consume cash more quickly than expected, we will be forced tocurtail operations.***

 

As of June 30, 2008, we had cash, cash equivalents and marketablesecurities of approximately $44.4 million. In addition, as of June 30,2008, we had deferred revenue of approximately $46.2 million representingcash payments we have received under our alliances and licenses to certainproduct candidate that we have acquired in exchange for research anddevelopment activities that are to be performed by us subsequent to June 30,2008. Our cash used in operating activities for the six months ended June 30,2008 was approximately $25.0 million, which includes $5.0 million inresearch funding we received from GSK. Absent this receipt of the $5.0 millionfrom GSK, our net cash used in operating activities would have beenapproximately $30.0 million for the six months ended June 30, 2008.Clinical and preclinical development of drug candidates is a long, expensiveand uncertain process that requires us to raise funds from time to time tosupport our internal development programs. In order to progess PS433540 andPS178990 in clinical development and to satisfy our commitments to ourcorporate partners and our other contractual obligations, we need to raisefunds from one or a combination of approaches, which could include publicand/or private financing, sale and/or partnering of one or more of our internalprograms, and partnering of our internal drug discovery capabilities.  Capital could be raised through public orprivate financings involving debt or common stock or other classes of ourequity. Additional issuances of equity securities will further dilute ourexisting stockholders’ percentage ownership.

 

We believe that our capital resources will be adequate to fund ouroperations at their current levels at least through March 31, 2009.  We intend to manage our expenditures in amanner consistent with our available capital resources.  However, there can be no assurance thatchanges will not occur that would consume available capital resources beforethen.

 

Examples of relevant potential changes that could impact our capitalresources include:

 

·                  the costs associated withour drug research and development activities, including the costs associatedwith our Phase 2 and Phase 1 clinical development programs for ourproduct candidates PS433540 and PS178990 and additional costs we may incur ifour development programs are delayed or are more expensive to implement than wecurrently anticipate;

 

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·                  changes in existingcollaborative relationships, including the funding we receive in connectionwith those relationships;

 

·                  the progress of ourmilestone and royalty producing activities;

 

·                  acquisitions of otherbusinesses or technologies;

 

·                  the purchase of additionalcapital equipment;

 

·                  cash refunds we may berequired to make to GSK if, prior to March 24, 2011, we exercise ourdiscretionary termination right under the GSK Agreement;

 

·                  cash payments we may berequired to make to Schering-Plough relating to a termination fee if, prior to August 2010,we exercise our discretionary termination right under the 2007 Schering-PloughAgreement;

 

·                  cash payments we may berequired to make to BMS if we fail to deliver certain compound libraries underthe license agreement for the DARA program;

 

·                  competing technological andmarket developments; and

 

·                  the cost of filing,prosecuting, defending and enforcing patent claims and other intellectualproperty rights, and the outcome of related litigation.

 

Failure to earn additional research funding and milestone paymentsunder our current alliances and alliances we may seek to enter into after theend of the initial research terms of our alliances with Cephalon and Wyethwould have a material adverse effect on our business as it is currentlyconducted, our financial condition and our results of operations.  If wefail to earn adequate additional research and milestone payments, we may berequired 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 potential marketsthat we would not otherwise relinquish.

 

As of July 28, 2008, there were approximately 4,529,000 stockoptions and 232,000 restricted stock units outstanding granted under ourvarious equity compensation plans and approximately 1,626,000 warrantsoutstanding, which includes approximately 176,000 warrants issued in connectionwith the GSK Agreement and approximately 1,450,000 warrants issued inconnection with our October 2006 financing transaction. These equityinstruments represent approximately 21% of our shares outstanding at July 28,2008. The significant dilution represented by our outstanding warrants andequity compensation awards may make it more difficult for us to raiseadditional capital.

 

Additional capital may not be available on favorable terms, or at all.We may curtail operations, perhaps significantly.  If adequate funds are not available, we mayobtain funds by entering into arrangements with partners or others that mayrequire us to relinquish rights to certain of our technologies, products orpotential markets that we would not otherwise relinquish.

 

***Because PS433540 is in Phase 2clinical development and PS178990 is in Phase 1 clinical development,there is a high risk that further development and testing will demonstrate thatneither compound is suitable for commercialization. In addition, because weexclusively licensed each of PS433540 and PS178990 from BMS, any dispute withBMS may adversely affect our ability to develop and commercialize those productcandidates.***

 

Wehave no products that have received regulatory approval for commercial sale.PS433540 is in Phase 2 clinical development and PS178990 is inPhase 1 clinical development. We face the substantial risks of failureinherent in developing drugs based on new technologies.

 

BothPS433540 and PS178990 must satisfy rigorous standards of safety and efficacybefore the FDA and foreign regulatory authorities will approve either productcandidate for commercial use. In May 2008, we announced that Study 008with PS433540 showed statistically significant blood pressure reductions insubjects with mild to moderate hypertension. Further Phase 2 clinical trials with PS433540, however, may notdemonstrate that it is safe or efficacious with respect to diabeticnephropathy, the principal clinical indication for which we seek to develop it,or other clinical indications.  Inaddition, Phase 1 clinical trials with PS178990 may not demonstrate thatthe product candidate is sufficiently safe to warrant its continueddevelopment. We will need to conduct significant additional clinical trials todemonstrate the safety and efficacy of PS433540 and PS178990 to thesatisfaction of the FDA and foreign regulatory authorities to obtain productapproval.

 

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Clinicaldevelopment is a long, expensive and uncertain process. It may take us manyyears to complete clinical trials, and failure can occur at any stage of trials.Success in preclinical testing and early clinical trials does not ensure thatlater clinical trials will be successful. We may suffer significant setbacks inadvanced clinical trials, even after promising results in earlier trials. Wemay not be able to enroll a sufficient number of patients to complete ourclinical trials in a timely manner. Based on results at any stage ofpreclinical testing or clinical trials, we may decide to discontinuedevelopment of PS433540 and PS178990.

 

Wedo not know whether any future clinical trials of PS433540 or PS178990 willdemonstrate sufficient safety and efficacy necessary to obtain the requisiteregulatory approvals or will result in marketable products. Our failure toadequately demonstrate the safety and efficacy of PS433540 or PS178990 in theirrespective development programs will prevent receipt of FDA and foreignregulatory approvals and, ultimately, commercialization.

 

Ifthere is any dispute between us and BMS regarding our rights under the DARALicense Agreement, our ability to develop and commercialize PS433540 may beadversely affected. Any loss of our rights from BMS could delay or completelyterminate our product development efforts for PS433540 and other DARA compoundslicensed from BMS.

 

Similarly,if there is any dispute between us and BMS regarding our rights under the SARMLicense Agreement and/or performance under the Discovery CollaborationAgreement, our ability to develop and commercialize PS178990 may be adverselyaffected. Any loss of our rights from BMS could delay or completely terminateour product development efforts for PS178990 and other SARM compounds licensedfrom BMS.

 

***Our development of PS433540 may beadversely impacted if our clinical trials show certain adverse effects reportedby other companies in connection with clinical trials of their ERA and ARBproduct candidates.***

 

Abnormalliver function test (LFT) results, which are indicative of potential livertoxicity, have been reported by other companies as complications in theirclinical trials of ERA product candidates. Approval of PS433540 may be delayedor ultimately blocked by such concerns. If the results of any of our PS433540clinical trials indicate abnormal LFTs, we may not receive regulatory approvalto market the product candidate and our product candidate, if approved formarketing, may not be able to compete with other products. There can be noassurance that the lack of LFT abnormalities experienced with respect toPS433540 to date will be confirmed by subsequent clinical trial results.

 

Asdeveloped by other companies, ERAs have been teratogenic in animals. Ifapproved for marketing, we assume that PS433450 will be subject to a black boxwarning regarding teratogenicity and therefore may not be able to compete withother products that do not have a similar warning.

 

Priorclinical trials by other companies have also indicated that the ERA therapeuticclass may cause peripheral edema (fluid retention) in some patients.Consequently, if similar adverse effects are experienced with PS433540 then itmay not be successfully developed as a treatment for heart failure or for usein patients at risk for heart failure and may therefore have a more limitedmarket potential than antihypertensives that are approved for the treatment ofheart failure.

 

***Our development of PS178990 may beadversely impacted if our clinical trials show certain adverse effects reportedin connection with testosterone and other anabolic steroids.***

 

Testosteroneand other anabolic steroids may cause serious unwanted side effects, includingliver toxicity, stimulation of prostate cancer growth in men andmasculinization in women. Approval of PS178990 may be delayed or ultimatelyblocked by such concerns. If the results of any of our PS178990 clinical trialsindicate such stimulation of prostate cancer growth, we may not receiveregulatory approval to market the product candidate and our product candidate,if approved for marketing, may not be able to compete with other products.

 

***We had net losses in recent years and our future profitability isuncertain.***

 

During the six months ended June 30, 2008, we had a net loss ofapproximately $27.3 million. In addition, during the year ended December 31,2007, we had a net loss of approximately $47.9 million. The net losses forthese periods was primarily due to costs incurred in our internal productdevelopment efforts, including the costs of developing PS433540, which iscurrently in Phase 2 clinical trials, and the research and development ofour other product candidates. The net loss for the six months endedJune 30, 2008 included a restructuring charge of approximately$1.7 million. The net loss for the year ended December 31, 2007included a non-cash charge of $9.2 million to proprietary research anddevelopment expense related to the acquisition of our SARM program.

 

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We expect to incur losses in future periods and these losses may increaseas compared to prior periods. Our efforts to progress the DARA Program and SARMProgram through clinical trials represent significant expenditures. However, weintend to manage all of our expenditures in a manner consistent with ouravailable resources. 

 

On July 31, 2008, we announced that as part of our ongoing effortsto focus our resources on progressing our assets in clinical development, weexpect to further reduce our workforce in the third quarter of 2008. We expectto record a restructuring charge in the three months ended September 30,2008, the amount of which has not yet been determined. This charge is expectedto increase our net loss in the third quarter of 2008.

 

Our adoption of SFAS 123R, which was effective January 1, 2006,increased our compensation costs and will continue to have a significant impacton our results of operations. In addition, under EITF 00-19, the accountingtreatment of the warrants that we issued in our October 2006 equityfinancing may have a significant impact on our results of operations, dependingon the volatility of the market price of our common stock and the assumptionsused in calculating the fair value of the warrants.

 

On a quarterly basis, our future operating results are likely to behighly volatile depending upon our receipt, if any, of milestone payments fromour collaborators. We may not receive milestone payments on a regular basis orat all. Our ability to achieve profitability, if ever, will be significantlyimpacted by the level of investment we plan to make in our internal proprietaryprograms in the future, as well as the results of those programs.

 

Continuing net losses may limit our ability to fund our operations andwe may not generate income from operations in the future.

 

***If third parties do not manufacturePS433540 in sufficient quantities and at an acceptable cost, clinicaldevelopment of PS433540 would be delayed.***

 

We do not currently own or operate manufacturing facilities, and werely, and expect to continue to rely, on third parties for the production ofclinical quantities of our product candidates. Our current and anticipatedfuture dependence upon others for the manufacture of our product candidates mayadversely affect our future profit margins and our ability to develop productcandidates and commercialize any product candidates on a timely and competitivebasis.

 

We have relied on third party vendors for the manufacture of clinicalquantities of PS433540, and we are currently assessing our manufacturing needsfor additional clinical trial supply of PS433540 as we review our clinicalstrategy for PS433540. We will evaluate whether to continue to rely on themanufacturing capabilities of our current third party vendors or whether someor all of the manufacturing process should be transferred to other contractmanufacturers as we plan for our additional clinical trials. If our currentsupply of PS433540 becomes unusable, if our PS433540 supply is not sufficientto complete our clinical trials, or if we are unsuccessful in identifying acontract manufacturer or negotiating a manufacturing agreement on a timelybasis and at an acceptable cost for our additional clinical trials, we couldexperience a delay in receiving an adequate supply of PS433540.

 

We may not be able to maintain or renew our existing or any otherthird-party manufacturing arrangements on acceptable terms, if at all. If weare unable to continue relationships for PS433540, or to do so at an acceptablecost, or if these or other suppliers fail to meet our requirements for PS433540for any reason, we would be required to obtain alternate suppliers. Anyinability to obtain alternate suppliers, including an inability to obtainapproval from the FDA of an alternate supplier, would delay or prevent theclinical development of these product candidates.

 

***Failure to attract and retain skilled personnel, including apermanent chief executive officer, could materially and adversely affect us.***

 

We are a small company,and our success depends in part on the continued service of key management andscientific personnel and our ability to identify, hire and retain additionalpersonnel.  Our former president andchief executive officer resigned effective April 9, 2008.  We are currently engaged in a search for hissuccessor, and the Chairman of our Board of Directors is serving as InterimPresident and Chief Executive Officer while we undertake that search.  Failure to identify and hire a permanentsuccessor to our former president and chief executive officer could have amaterial adverse effect on our business, financial condition and results ofoperations.

 

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

 

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

 

**None.**

** **

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

 

None.

 

**Item 4.****   ****Submissionof Matters to a Vote of Security Holders**

 

On April 30, 2008,we held our Annual Meeting of Stockholders in Cranbury, New Jersey.  Thefollowing matters were submitted to a vote of security holders:

 

Our stockholders voted toelect the following Class I members of our Board of Directors for terms ofthree years each:

 

| ** **                     | ** ** | ** **         | ** ** | **Votes**    | ** ** |
|--------------------------------|------------|--------------------|------------|--------------|------------|
| **Nominee**                    | ** ** | **Votes For** | ** ** | **Withheld** | ** ** |
| Frank Baldino, Jr. Ph. D. |       | 19,891,063         |       | 4,564,958    |       |
| Dennis H. Langer, M.D., J.D.   |       | 22,171,923         |       | 2,284,098    |       |

 

Our directors whose termsof office continued after the meeting include three Class II directorswhose term expires in 2009, Carol A. Ammon, Paul A. Bartlett, Ph.D. and JosephA. Mollica, Ph.D., and three Class III directors whose term expires in2010, Steven J. Burakoff, M.D., Bruce A. Peacock and Martin H. Soeters.

 

Our stockholders voted asfollows to ratify the appointment of Ernst & Young LLP as ourindependent external auditors for the fiscal year ending December 31,2008: 24,421,452 shares were voted in favor of ratification, 33,263 shares werevoted against ratification, 1,305 shares abstained from voting, and there wereno broker non-votes.

 

Ourstockholders voted as follows to approved an amendment to our Amended andRestated Certificate of Incorporation to increase the number of authorizedshares of our common stock from 50,000,000 to 100,000,000.  21,599,788 shares were voted in favor of theamendment, 2,849,973 shares were voted against the amendment, 6,257 sharesabstained from voting, and there were no broker non-votes.

 

Our stockholders voted asfollows to approve the Amended and Restated 2004 Stock Incentive Plan (the “Plan”)which increased the number of shares available for issuance there under:14,238,197 shares were voted in favor of the Plan, 4,211,304 shares were votes againstthe Plan, 11,593 shares abstained from voting, and 5,994,928 shares were brokernon-votes.

 

**Item 5.****   ****OtherInformation**

 

None.

 

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

 
| **Exhibits.** | ** ** | ** **                                                                                                                                                                                                                                                                         |
|---------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| ** **    | ** ** | ** **                                                                                                                                                                                                                                                                         |
| 10.1          | ** ** | Amended and Restated 2004  Stock Incentive Plan. (1)(2)                                                                                                                                                                                                                            |
|          | ** ** |                                                                                                                                                                                                                                                                               |
| 10.2          | ** ** | Amendment No. 1 to Amended  and Restated 2004 Stock Incentive Plan. (1)(2)                                                                                                                                                                                                         |
|          | ** ** |                                                                                                                                                                                                                                                                               |
| 10.3          |       | Amendment No. 2 to  Amended and Restated 2004 Stock Incentive Plan. (1)(2)                                                                                                                                                                                                    |
|          |       |                                                                                                                                                                                                                                                                               |
| 10.4          |       | Form of Restricted  Stock Unit Agreement. (1)(2)                                                                                                                                                                                                                              |
|          |       |                                                                                                                                                                                                                                                                               |
| 31.1          |       | Certification of the  Principal Executive Officer of Pharmacopeia, Inc. pursuant to  Rule 13a-l4(a) of the Securities Exchange Act of 1934, as amended,  as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002(1)                               |
|          |       |                                                                                                                                                                                                                                                                               |
| 31.2          |       | Certification of the  Principal Financial Officer and Chief Accounting Officer of  Pharmacopeia, Inc. pursuant to Rule 13a-14(a) of the  Securities Exchange Act of 1934, as amended, as adopted pursuant to  Section 302 of the Sarbanes-Oxley Act of 2002(1) |
|          |       |                                                                                                                                                                                                                                                                               |
| 32.1          |       | Certification of the  Principal Executive Officer of Pharmacopeia, Inc. pursuant to 18 U.S.C.  Section 1350, as adopted pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002(1)                                                                               |
|          |       |                                                                                                                                                                                                                                                                               |
| 32.2          |       | Certification of the  Principal Financial Officer and Chief Accounting Officer of  Pharmacopeia, Inc. pursuant to 18 U.S.C. Section 1350, as adopted  pursuant to Section 906 of the Sarbanes-Oxley Act of 2002(1)                                                  |

 

----

(1)             Filedherewith.

(2)             Compensationplan or arrangement in which directors and executive officers are eligible toparticipate.

 

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**SIGNATURES**

 

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

 
|                                      | PHARMACOPEIA, INC. |
|--------------------------------------|--------------------|
|                                 |               |   |
| Date:  July 31,  2008 | By:                | /s/ Joseph A. Mollica,  Ph.D. |
|                                 |               | Joseph A. Mollica,  Ph.D. |
|                                 |               | Chairman of the Board  and Interim President   and Chief Executive Officer |
|                                 |               |   |
|                                 |               | (Principal Executive  Officer) |
|                                 |               |   |
|                                 | By:                | /s/ Brian M. Posner |
|                                 |               | Brian M. Posner |
|                                 |               | Executive Vice President, |
|                                 |               | Chief Financial Officer  and Treasurer |
|                                 |               | (Principal Financial  Officer and Chief  Accounting Officer) |
|                                      |                    |  |  |

 

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**PHARMACOPEIA,INC.**

 

**INDEX TOEXHIBITS**

 
| **Exhibits.** | ** ** | ** **                                                                                                                                                                                                                                                                         |
|---------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| ** **    | ** ** | ** **                                                                                                                                                                                                                                                                         |
| 10.1          | ** ** | Amended and Restated 2004  Stock Incentive Plan. (1)(2)                                                                                                                                                                                                                            |
|          | ** ** |                                                                                                                                                                                                                                                                               |
| 10.2          | ** ** | Amendment No. 1 to Amended  and Restated 2004 Stock Incentive Plan. (1)(2)                                                                                                                                                                                                         |
|          | ** ** |                                                                                                                                                                                                                                                                               |
| 10.3          |       | Amendment No. 2 to  Amended and Restated 2004 Stock Incentive Plan. (1)(2)                                                                                                                                                                                                    |
|          |       |                                                                                                                                                                                                                                                                               |
| 10.4          |       | Form of Restricted  Stock Unit Agreement. (1)(2)                                                                                                                                                                                                                              |
|          |       |                                                                                                                                                                                                                                                                               |
| 31.1          |       | Certification of the  Principal Executive Officer of Pharmacopeia, Inc. pursuant to  Rule 13a-l4(a) of the Securities Exchange Act of 1934, as amended,  as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002(1)                               |
|          |       |                                                                                                                                                                                                                                                                               |
| 31.2          |       | Certification of the  Principal Financial Officer and Chief Accounting Officer of  Pharmacopeia, Inc. pursuant to Rule 13a-14(a) of the  Securities Exchange Act of 1934, as amended, as adopted pursuant to  Section 302 of the Sarbanes-Oxley Act of 2002(1) |
|          |       |                                                                                                                                                                                                                                                                               |
| 32.1          |       | Certification of the  Principal Executive Officer of Pharmacopeia, Inc. pursuant to 18 U.S.C.  Section 1350, as adopted pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002(1)                                                                               |
|          |       |                                                                                                                                                                                                                                                                               |
| 32.2          |       | Certification of the  Principal Financial Officer and Chief Accounting Officer of  Pharmacopeia, Inc. pursuant to 18 U.S.C. Section 1350, as adopted  pursuant to Section 906 of the Sarbanes-Oxley Act of 2002(1)                                                  |

 

----

(1)             Filedherewith.

(2)             Compensationplan or arrangement in which directors and executive officers are eligible toparticipate.

 

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