**UNITEDSTATES**

**SECURITIESAND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

 

**FORM 10-Q**

 

**(MarkOne)**

 

|                                                        | **x**      | **QUARTERLY REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**  |
|--------------------------------------------------------|------------|---------------------------------------------------------------------------------------------------------|
| ** **                                             | ** ** | ** **                                                                                              |
| **For the quarterly period ended September 30,  2007** |
| ** **                                             | ** ** | ** **                                                                                              |
| **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 ofregistrant as specified in its charter)

 

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

 

**(609)452-3600**

(Registrant’stelephone number, including area code)

 

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

 

Indicate by check markwhether the registrant (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during thepreceding 12 months (or such shorter period that the registrant was required tofile such reports) and (2) has been subject to such filing requirementsfor the past 90 days.    Yes x     No o

 

Indicate by check mark whether the registrant is alarge accelerated filer, an accelerated filer, or a non-accelerated filer. Seedefinition of “accelerated filer and large accelerated filer” in Rule 12b-2 ofthe Exchange Act.

 

Large accelerated filer   o   Acceleratedfiler   o   Non-acceleratedfiler  x

 

Indicate by check markwhether the registrant is a shell company (as defined in Rule 12b-2 of theExchange Act).

Yes o    No x

 

Indicate the number ofshares outstanding of each of the issuer’s classes of common stock, as of the latestpracticable date:

 

| **Class**                      | ** ** | **Outstanding at October 31, 2007** |
|--------------------------------|------------|-------------------------------------|
| Common  Stock, $0.01 par value | ** ** | **29,615,353**                      |

 

 

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**PHARMACOPEIA, INC.**

 

**Form 10-Q**

 

**Table of Contents**

 
| **Item**          | ** **                                                                                  | ** **                                                                                             | ** ** | ** ** |
|-------------------|---------------------------------------------------------------------------------------------|--------------------------------------------------------------------------------------------------------|------------|------------|
|              |                                                                                        |                                                                                                   |       |
| PART I.      | FINANCIAL  INFORMATION                                                                      |                                                                                                   | 3          |
|              |                                                                                        |                                                                                                   |
| Item  1.          | Consolidated  Financial Statements (Unaudited):                                             | 3                                                                                                      |
|              |                                                                                        |                                                                                                   |       |
|              |                                                                                        | Consolidated  Balance Sheets as of September 30, 2007 and December 31, 2006                            | 3          |
|              |                                                                                        |                                                                                                   |       |
|              |                                                                                        | Consolidated Statements of Operations for the Three  and Nine Months Ended September 30, 2007 and 2006 | 4          |
|              |                                                                                        |                                                                                                   |       |
|              |                                                                                        | Consolidated Statements of Cash Flows for the Nine  Months Ended September 30, 2007 and 2006           | 5          |
|              |                                                                                        |                                                                                                   |       |
|              |                                                                                        | Notes to  Unaudited Consolidated Financial Statements                                                  | 6          |
|              |                                                                                        |                                                                                                   |
| Item 2.           | Management’s  Discussion and Analysis of Financial Condition and Results of Operations | 14                                                                                                     |
|              |                                                                                        |                                                                                                   |       |
| Item 3.           | Quantitative  and Qualitative Disclosures about Market Risk                                 | 25                                                                                                     |
|              |                                                                                        |                                                                                                   |       |
| Item 4.           | Controls and  Procedures                                                                    | 25                                                                                                     |
|              |                                                                                        |
| PART II.     | OTHER  INFORMATION                                                                          |                                                                                                   | 25         |
|              |                                                                                        |
| Item 1.           | Legal  Proceedings                                                                          | 25                                                                                                     |
|              |                                                                                        |                                                                                                   |       |
| Item 1A.          | Risk  Factors                                                                               | 25                                                                                                     |
|              |                                                                                        |                                                                                                   |       |
| Item 2.           | Unregistered  Sales of Equity Securities and Use of Proceeds                                | 27                                                                                                     |
|              |                                                                                        |                                                                                                   |       |
| Item 3.           | Defaults  upon Senior Securities                                                            | 27                                                                                                     |
|              |                                                                                        |                                                                                                   |
| Item 4.           | Submission  of Matters to a Vote of Security Holders                                        | 27                                                                                                     |
|              |                                                                                        |                                                                                                   |
| Item 5.           | Other  Information                                                                          | 28                                                                                                     |
|              |                                                                                        |                                                                                                   |
| Item 6.           | Exhibits                                                                                    | 28                                                                                                     |
|              |                                                                                        |                                                                                                   |
| Signatures        |                                                                                        | 29                                                                                                     |
|              |                                                                                        |                                                                                                   |
| Index to Exhibits |                                                                                        | 30                                                                                                     |
|                   |                                                                                             |                                                                                                        |            |            |  |  |  |

 

2

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**PART I - FINANCIAL INFORMATION**

 

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

 

**Pharmacopeia, Inc.Consolidated Balance Sheets**

**(Amounts in thousands, except share andper share data)**

** **
|                                                                                                                                | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                                                                                                          | ** ** | **2007**               | ** ** | **2006**              | ** ** |
| **ASSETS**                                                                                                                          |       |                   |       |                  |       |
| Current assets:                                                                                                                     |       |                   |       |                  |       |
| Cash and cash  equivalents                                                                                                          |       | $                      | 61,287     |                  | $          | 43,099 |   |
| Marketable  securities                                                                                                              |       | 20,068                 |       | 3,041                 |       |
| Accounts  receivable, net                                                                                                           |       | 1,013                  |       | 5,006                 |       |
| Prepaid expenses  and other current assets                                                                                          |       | 1,637                  |       | 1,498                 |       |
| Total current  assets                                                                                                               |       | 84,005                 |       | 52,644                |       |
|                                                                                                                                |       |                   |       |                  |       |
| Property and  equipment, net                                                                                                        |       | 12,946                 |       | 11,287                |       |
| Deferred  compensation plan assets                                                                                                  |       | 2,101                  |       | 2,022                 |       |
| Other assets                                                                                                                        |       | 144                    |       | 174                   |       |
| Total assets                                                                                                                        |       | $                      | 99,196     |                  | $          | 66,127 |   |
|                                                                                                                                |       |                   |       |                  |       |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                      |       |                   |       |                  |       |
| Current  liabilities:                                                                                                               |       |                   |       |                  |       |
| Accounts payable                                                                                                                    |       | $                      | 2,733      |                  | $          | 2,491 |   |
| Accrued  liabilities                                                                                                                |       | 4,499                  |       | 2,457                 |       |
| Deferred  revenue, current portion                                                                                                  |       | 16,563                 |       | 9,424                 |       |
| Notes payable,  current portion                                                                                                     |       | 573                    |       | —                |       |
| Warrant  liability                                                                                                                  |       | 5,503                  |       | 4,378                 |       |
| Total current  liabilities                                                                                                          |       | 29,871                 |       | 18,750                |       |
|                                                                                                                                |       |                   |       |                  |       |
| Deferred  revenue, long-term                                                                                                        |       | 23,990                 |       | 14,924                |       |
| Deferred  compensation plan liabilities                                                                                             |       | 2,101                  |       | 2,022                 |       |
| Notes payable,  long-term                                                                                                           |       | 1,624                  |       | —                |       |
|                                                                                                                                |       |                   |       |                  |       |
| Commitments and  contingencies                                                                                                      |       |                   |       |                  |       |
|                                                                                                                                |       |                   |       |                  |       |
| Stockholders’  equity:                                                                                                         |       |                   |       |                  |       |
| Preferred stock,  $.01 par value, 2,500,000 shares authorized, none issued and outstanding                                          |       | —                 |       | —                |       |
| Common stock,  $.01 par value, 50,000,000 shares authorized, 29,609,135 and 21,268,447  shares issued and outstanding, respectively |       | 296                    |       | 213                   |       |
| Additional  paid-in capital                                                                                                         |       | 121,056                |       | 81,362                |       |
| Accumulated  deficit                                                                                                                |       | (79,742                | )          | (51,137               | )          |
| Accumulated  other comprehensive loss                                                                                               |       | —                 |       | (7                    | )          |
| Total  stockholders’ equity                                                                                                    |       | 41,610                 |       | 30,431                |       |
| Total  liabilities and stockholders’ equity                                                                                    |       | $                      | 99,196     |                  | $          | 66,127 |   |

 

See accompanyingnotes to these unaudited consolidated financial statements

 

3

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**Pharmacopeia, Inc.Consolidated Statements of Operations**

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

** **
| ** **                                                   | ** ** | **For the Three Months** | ** ** | **For the Nine Months** | ** ** |
|--------------------------------------------------------------|------------|-----------------------------------------|------------|----------------------------------------|------------|
| ** **                                                   | ** ** | **Ended September 30,**       | ** ** | **Ended September 30,**      | ** ** |
| ** **                                                   | ** ** | **2007**                                | ** ** | **2006**                               | ** ** | **2007** | ** ** | **2006** | ** ** |
|                                                         |       |                                    |       |                                   |       |   |   |   |   |
| **Revenue**                                                  |       |                                    |       |                                   |       |   |   |   |   |
| Net revenue                                                  |       | $                                       | 5,089      |                                   | $          | 6,257 |   | $ | 16,395 |   | $ | 13,665 |   |
|                                                         |       |                                    |       |                                   |       |   |   |   |   |
| **Operating  Expenses**                                      |       |                                    |       |                                   |       |   |   |   |   |
| Collaborative  research and development expense              |       | 5,775                                   |       | 3,448                                  |       | 16,697 |   | 9,760 |   |
| Proprietary  research and development expense                |       | 9,514                                   |       | 5,801                                  |       | 21,965 |   | 17,561 |   |
| General and  administrative expense                          |       | 2,566                                   |       | 2,130                                  |       | 8,025 |   | 7,001 |   |
| Total operating  expenses                                    |       | 17,855                                  |       | 11,379                                 |       | 46,687 |   | 34,322 |   |
| Operating loss                                               |       | (12,766                                 | )          | (5,122                                 | )          | (30,292 | ) | (20,657 | ) |
| Interest and  other income                                   |       | 1,142                                   |       | 419                                    |       | 2,780 |   | 1,033 |   |
| Interest and  other expense                                  |       | (15                                     | )          | —                                 |       | (20 | ) | — |   |
| Change in  warrant liability                                 |       | (57                                     | )          | —                                 |       | (1,125 | ) | — |   |
| Restructuring  credits                                       |       | —                                  |       | —                                 |       | — |   | 88 |   |
| Loss before  income taxes                                    |       | (11,696                                 | )          | (4,703                                 | )          | (28,657 | ) | (19,536 | ) |
| (Benefit from)  provision for income taxes                   |       | —                                  |       | 9                                      |       | (52 | ) | 37 |   |
| Net loss                                                     |       | $                                       | (11,696    | )                                      | $          | (4,712 | ) | $ | (28,605 | ) | $ | (19,573 | ) |
|                                                         |       |                                    |       |                                   |       |   |   |   |   |
| Net loss per  share:                                         |       |                                    |       |                                   |       |   |   |   |   |
| - Basic and  diluted                                         |       | $                                       | (0.40      | )                                      | $          | (0.31 | ) | $ | (1.07 | ) | $ | (1.28 | ) |
|                                                         |       |                                    |       |                                   |       |   |   |   |   |
| Weighted average  number of common stock shares outstanding: |       |                                    |       |                                   |       |   |   |   |   |
| - Basic and  diluted                                         |       | 29,566,714                              |       | 15,297,476                             |       | 26,737,034 |   | 15,244,905 |   |

 

See accompanyingnotes to these unaudited consolidated financial statements

 

4

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** **

**Pharmacopeia, Inc.Consolidated Statements of Cash Flows**

**(Amountsin thousands)**

 
| ** **                                                                                | ** ** | **For the Nine Months** | ** ** |
|-------------------------------------------------------------------------------------------|------------|----------------------------------------|------------|
| ** **                                                                                | ** ** | **Ended September 30,**      | ** ** |
| ** **                                                                                | ** ** | **2007**                               | ** ** | **2006** | ** ** |
| ** **                                                                                | ** ** | **(unaudited)**                        | ** ** |
| CASH FLOWS FROM  OPERATING ACTIVITIES:                                                    |       |                                   |       |   |   |
| Net loss                                                                                  |       | $                                      | (28,605    | ) | $ | (19,573 | ) |
| Adjustments to  reconcile net loss to net cash (used in) provided by operating activities |       |                                   |       |   |   |
| Depreciation and  amortization                                                            |       | 1,690                                  |       | 1,406 |   |
| Change in  warrant liability                                                              |       | 1,125                                  |       | — |   |
| Contribution of  stock to 401(k) Plan                                                     |       | 342                                    |       | 311 |   |
| Share-based  compensation                                                                 |       | 1,604                                  |       | 1,418 |   |
| Restructuring  credits                                                                    |       | —                                 |       | (88 | ) |
| Gain on sale of  property and equipment                                                   |       | —                                 |       | (3 | ) |
| Changes in  assets and liabilities:                                                       |       |                                   |       |   |   |
| Accounts  receivable                                                                      |       | 3,993                                  |       | 248 |   |
| Prepaid expenses  and other current assets                                                |       | (139                                   | )          | (360 | ) |
| Other assets                                                                              |       | 30                                     |       | — |   |
| Accounts payable                                                                          |       | 242                                    |       | 1,608 |   |
| Accrued and  other liabilities                                                            |       | 2,043                                  |       | (1,134 | ) |
| Restructuring  reserve                                                                    |       | —                                 |       | (820 | ) |
| Deferred revenue                                                                          |       | 16,205                                 |       | 18,782 |   |
| Net cash (used  in) provided by operating activities                                      |       | (1,470                                 | )          | 1,795 |   |
| CASH FLOWS FROM  INVESTING ACTIVITIES:                                                    |       |                                   |       |   |   |
| Capital  expenditures                                                                     |       | (3,349                                 | )          | (2,172 | ) |
| Proceeds from  sale of property and equipment                                             |       | —                                 |       | 3 |   |
| Purchases of  marketable securities                                                       |       | (20,000                                | )          | (1,000 | ) |
| Proceeds from  sale and maturities of marketable securities                               |       | 2,980                                  |       | 14,766 |   |
| Net cash (used  in) provided by investing activities                                      |       | (20,369                                | )          | 11,597 |   |
| CASH FLOWS FROM  FINANCING ACTIVITIES:                                                    |       |                                   |       |   |   |
| Proceeds from  registered equity offering, net                                            |       | 37,070                                 |       | — |   |
| Proceeds from  exercise of stock options                                                  |       | 760                                    |       | 907 |   |
| Proceeds from  borrowings under line of credit, net                                       |       | 2,197                                  |       | — |   |
| Net cash  provided by financing activities                                                |       | 40,027                                 |       | 907 |   |
| Net increase in  cash and equivalents                                                     |       | 18,188                                 |       | 14,299 |   |
| Cash and  equivalents, beginning of period                                                |       | 43,099                                 |       | 11,680 |   |
| Cash and  equivalents, end of period                                                      |       | $                                      | 61,287     |   | $ | 25,979 |   |

 

See accompanying notes to theseunaudited consolidated financial statements

 

5

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**Pharmacopeia, Inc.Notes to Unaudited Consolidated Financial Statements**

 

**1.   Background and Basis of Presentation**

** **

Pharmacopeia, Inc. (Pharmacopeia or the Company) wasincorporated in 2002 as Pharmacopeia Drug Discovery, Inc., a wholly ownedsubsidiary of Accelrys, Inc. (Accelrys). On April 30, 2004 (the distribution date), Accelrys spun-off 100percent of the shares of Pharmacopeia Drug Discovery, Inc. in a pro ratatax-free distribution and distributed to its stockholders of record one shareof Pharmacopeia Drug Discovery, Inc. common stock for every two shares ofAccelrys common stock held.  A total of12,181,471 shares were distributed. Effective May 3, 2007, Pharmacopeia Drug Discovery, Inc. changed itsname to Pharmacopeia, Inc.

 

Pharmacopeia is aclinical development stage biopharmaceutical company dedicated to discoveringand developing novel small molecule therapeutics to address significant medicalneeds.  Using proprietary technologiesand processes, the Company seeks to identify, optimize and develop novel drugcandidates through its own internally-funded drug discovery and developmentprograms and in collaborations with major pharmaceutical and biotechnologycompanies.  The Company has a broadportfolio of clinical and preclinical candidates under development internallyor by partners, including seven compounds in Phase 2 or Phase 1 development,addressing multiple indications including hypertension, diabetic nephropathy,muscle wasting, inflammation and respiratory disease.  

 

The consolidated financial statementsinclude the accounts of the Company and its wholly owned subsidiaryPharmacopeia UK Holdings Limited (Pharmacopeia UK), which was formed in March2007. All significant intercompany accounts and transactions have beeneliminated in consolidation.

 

The accompanying unaudited consolidated financialstatements have been prepared in accordance with U. S. generally acceptedaccounting principles for interim financial information and with instructionsto Form 10-Q and Article 10 of Regulation S-X. Accordingly, theseunaudited consolidated financial statements do not include all of theinformation and disclosures required by U. S. generally accepted accountingprinciples for complete consolidated financial statements. In the opinion ofmanagement, all adjustments (of a normal recurring nature) considered necessaryfor a fair presentation of the consolidated financial statements have beenincluded. Interim results are not necessarily indicative of the results thatmay be expected for the year. The unaudited interim consolidated financialstatements should be read in conjunction with the financial statements andnotes thereto included in the Company’s Annual Report on Form 10-K for theyear ended December 31, 2006.

 

**2.**   **Significant Collaborations**

 

**Collaboration and LicenseAgreement with Cephalon**

 

In May 2006, the Companyentered into a Collaboration and License Agreement (the Cephalon Agreement)with Cephalon, Inc. (Cephalon) providing for the formation of a new drugdiscovery, development and commercialization alliance.  The Company received an up-front,non-refundable payment of $15.0 million in June 2006 to support the Company’sresearch efforts under the Cephalon Agreement.

 

As part of and during theinitial phase of the alliance, Cephalon is responsible for providing hit andlead compounds.  The Company and Cephalonwill then work collaboratively to advance the lead compounds to preclinicaldevelopment candidates.  The Company isprincipally responsible for medicinal chemistry research and Cephalon providesbiology support, including preclinical disease models, as required by theCephalon Agreement. The Company has agreed that, for a specified period, itwill not screen its compound library for other collaborators, or for its ownaccount, against any target it works on under the Cephalon Agreement.

 

Upon the nomination ofany preclinical development candidates by the alliance, Cephalon will beprimarily responsible for their development and commercialization.  The Company will retain an option to developcertain candidates from the alliance, subject to Cephalon’s agreeing to suchdevelopment.  For any preclinicaldevelopment candidate advanced under the alliance, the developing company willmake clinical, regulatory and sales milestone payments to the non-developingcompany.  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 Companyreceived a non-refundable payment of $15.0 million and is principallyresponsible for performing medicinal chemistry research. The revenue for thisresearch is recognized on a

 

6

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proportional performance basis, which is expected toapproximate straight-line recognition of revenue during the three-year term ofthe alliance.  Included in deferredrevenue at September 30, 2007 was approximately $8.3 million, related to theCephalon Agreement, of which $3.3 million was classified as long-term.  The Company’s revenue under theCephalon Agreement accounted for $1.3 million, or 25%, and $1.3 million, or20%, of net revenue for the three months ended September 30, 2007 and 2006,respectively. For the nine months ended September 30, 2007 and 2006, the Company’salliance with Cephalon accounted for approximately $3.8 million, or 23%, and$1.7 million, or 12%, of net revenue, respectively.  The research activities under the CephalonAgreement commenced in June 2006.

 

The Company and Cephaloneach have the right to terminate the Cephalon Agreement under certain specifiedcircumstances at any time during the term of the Cephalon Agreement.  In addition, Cephalon has the right to terminatethe Cephalon Agreement in its sole discretion, upon ninety days written noticeto the Company, during the three-year research phase of the alliance, whichphase may be extended by agreement of the parties.  No such termination shall require the Companyto refund to Cephalon any or all of the above funding.

 

One of the Company’sdirectors currently serves as the Chairman and Chief Executive Officer ofCephalon.

 

**Product Development andCommercialization Agreement with GSK**

 

In March 2006, the Company and SmithKlineBeecham Corporation and Glaxo Group Limited (together GSK) entered into aproduct development and commercialization agreement (the GSK Agreement). Underthe terms of the GSK Agreement, the Company may receive up to $15.0 million incash payments from GSK related to initial discovery activities to be conductedby the Company, including $5.0 million that the Company received in April 2006and $5.0 million that the Company received in June 2007. The remaining $5.0million will be payable to the Company upon its fulfillment of certainconditions related to the initial discovery activities to be conducted by theCompany. 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 toPhase 2 clinical “proof of concept” (a demonstration of efficacy in humans).

 

The GSK Agreement provides GSK anexclusive option, exercisable at defined points during the development processfor each program (up to the point of clinical proof of concept), to licensethat program. Upon licensing a program, GSK is obligated to conduct preclinicaldevelopment and/or clinical trials and commercialize pharmaceutical productsresulting from such licensed programs on a worldwide basis.  In addition to the cash payments above, theCompany is entitled to receive success-based milestone payments, starting inpreclinical research, from GSK for each drug development program under thealliance and the potential for double-digit royalties upon the successfulcommercialization by GSK of any product resulting therefrom. 

 

In the event that GSK does not exerciseits option to license a program, the Company will retain all rights to that programand may continue to develop the program and commercialize any productsresulting from the program, or it may elect to cease progressing theprogram and/or seek other partners for further development andcommercialization.  Should the Companydevelop or partner such a program and commercialize any products resulting fromthat program, the Company will be obligated to pay GSK success-based milestonepayments and royalties upon successful commercialization, if any.

 

The Company has agreed that, for a specifiedperiod, it will not screen its compound library for other collaborators, or forits own account, against any target it screens under the GSK Agreement.

 

Since theinception of the GSK Agreement, the Company has received $10.0 million ($5.0million in April 2006 and $5.0 million in June 2007) in connection with initialdiscovery and research activities the Company is obligated to perform under theGSK Agreement. The Company recorded deferred revenue of approximately $9.5million associated with these payments, net of the fair value of the warrantsdescribed below. In July 2007, the Company also received a non-refundable $500thousand milestone payment from GSK related to the identification of a leadcompound, which was also recorded as deferred revenue due to the Company’scontinuing performance obligations under the GSK Agreement. Included indeferred revenue as of September 30, 2007 was $8.5 million, of which $6.7million was classified as long-term. The Company recognizes revenue on aproportional performance basis as it performs the required discovery activitiesin an amount from time to time less than or equal to the non-refundable portionof payments received in connection with the GSK Agreement.  The Company’s revenue under the GSKAgreement accounted for $475 thousand and $93 thousand of net revenue for thethree months ended September 30, 2007 and 2006, respectively. For the ninemonths ended September 30, 2007 and 2006, the Company’s alliance with GSK accounted forapproximately $1.2

 

7

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million, and $145thousand of net revenue, respectively. The research activities under the GSK Agreement commenced in April 2006.

 

In connection with the GSK Agreement, theCompany issued two warrants to GSK for the purchase of up to anaggregate of 176,367 shares of its common stock at an exercise price of $5.67per share, which was a 25% premium over the trailing 30-day closing priceaverage preceding March 24, 2006. The warrants are exercisable at any time beforethe earlier to occur of (i) March 24, 2011 and (ii) theeffective date of certain types of terminations of the GSK Agreement. Thesewarrants were issued in a transaction not involving a public offering underSection 4(2) of the Securities Act of 1933, as amended. The fairvalue of the warrants at the time of the execution of the GSK Agreement wasdetermined to be $505 thousand. This amount was calculated using theBlack-Scholes 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 toterminate the GSK Agreement in its sole discretion under certain specifiedcircumstances at any time during the term of the GSK Agreement. In addition,the Company and GSK each have the right to terminate the GSK Agreement underother circumstances that are customary in these types of agreements.  If the Company exercises its discretionarytermination right at any time during the first five years of the term, under certaincircumstances, it could be required to refund to GSK a portion of the up to$15.0 million related to initial discovery activities to be conducted by theCompany referred to above.  The amount ofany such 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 instances where the deferred revenue would be amortizedbelow the amount that could be potentially refundable pursuant to the terms ofthe GSK Agreement.  Further, should GSK exercise its discretionarytermination rights, there are no provisions in the GSK Agreement that wouldrequire the Company to refund payments received relating to its performance ofinitial discovery activities or milestone payments received under the GSKAgreement

 

**Collaboration and LicenseAgreement with Organon**

 

InFebruary 2007, the Company entered into an amended and restated collaborationand license agreement (the Organon Agreement) with N.V. Organon (Organon), providingfor the formation of a new alliance to discover, develop and commercializetherapeutic products across a broad range of therapeutic indications.  The new alliance builds on the companies’past collaborations, including the February 2002 agreement between the Companyand Organon (the 2002 Collaboration).

 

Under the OrganonAgreement, the Company received an up-front payment of $15.0 million in March2007 and is entitled to receive up to $4.0 million per year($20.0 million aggregate) in research funding over the five-year term ofthe research portion of the alliance.  The Organon Agreement also providesthat the Company waives its rights to receive further compensation (e.g. futuremilestone and royalty payments) with respect to programs resulting from leadseries identified by the Company and delivered to Organon under the 2002Collaboration and certain other programs from earlier agreements.  In June 2007, the Company received anadditional $1.0 million relating to the transfer to Organon of rights tocertain other research programs that the Company worked on under the 2002collaboration. 

 

The Organon Agreementprovides Pharmacopeia the option to purchase the right to co-develop andco-commercialize certain therapeutic candidates discovered through thealliance. For therapeutic candidates the Company does not elect to co-developand co-commercialize, Organon will retain exclusive development andcommercialization rights, and the Company will receive milestone payments as aresult of Organon’s successful advancement, if any, of each candidate throughclinical development, and up to double-digit royalties based oncommercialization of any resulting pharmaceutical products.

 

Since February 2007, theCompany has received $19.0 million in connection with the Organon Agreement(the $15.0 million up-front payment, $1.0 million for the transfer of rights tocertain programs from the 2002 Collaboration, and three quarterly researchpayments of $1.0 million each), which the Company recorded as deferred revenue.Included in deferred revenue as of September 30, 2007 was approximately $17.1million related to the Organon Agreement, of which approximately $11.2 millionwas classified in deferred revenue, long-term. The Company recognizes revenueon a proportional performance basis as it performs research activities asprovided in the Organon Agreement. For the three and nine months endedSeptember 30, 2007, the Company recognized approximately $1.0 million, or 20%,and $1.9 million, or 12%, respectively, of revenue in connection with theOrganon Agreement. 

 

Under the 2002 Collaboration, the Company had receivedquarterly research funding to conduct its drug discovery activities to identifyand optimize new drug candidates for multiple therapeutic targets provided byOrganon. Funding received in advance was recorded as deferred revenue.

 

8

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Researchfunding from the 2002 Collaboration was recognized as revenue on a proportionalperformance basis, which approximated straight-line recognition over the termof the agreement.The research term of the 2002 Collaboration ended in February2007, and therefore the Company did not recognize any revenue from the 2002Collaboration in the three months ended September 30, 2007.  

 

Under the Organon Agreement and the 2002 Collaboration, theCompany recognized approximately $1.0 million, or 20%, and $2.9 million, or46%, respectively, of net revenue for the three months ended September 30, 2007and 2006, including $2.0 million in milestones and success fees in the threemonths ended September 30, 2006. For the nine months ended September 30, 2007and 2006, the Company recognized approximately $2.4 million, or 15%, and $4.6million, or 34%, respectively, of net revenue for the period under thesecollaborations, including $2.0 million in milestones and success fees in thenine months ended September 30, 2006.

 

BothPharmacopeia and Organon have the right to terminate the Organon Agreementunder certain specified circumstances at any time during the term of theOrganon Agreement.   In addition, the Company and Organon eachhave the right to terminate the Organon Agreement under other circumstancesthat are customary in these types of agreements. Further, each party has theright, upon six months prior written notice provided to the other party at anytime beginning two and one-half years after February 8, 2007, to terminate theresearch portion of the alliance and/or the Organon Agreement. Such a terminationof the research portion of the alliance by Organon would not apply to Organon’sobligations with respect to any program developed by the alliance that Organonis advancing or to therapeutic candidates with respect to which the Company haspreviously exercised its option to purchase the right to co-develop andco-commercialize. Should Organon exercise its discretionary termination right,there are no provisions in the Organon Agreement that would require the Companyto refund payments received under the Organon Agreement. If Pharmacopeiaexercises its discretionary termination right, under certain circumstances, itcould be subject to a termination fee of $5.0 million. Whether or not theCompany is subject to the termination fee is based upon when during the term ofthe Organon Agreement the Company’s discretionary termination right isexercised. There will, however, be no instances where the deferred revenueassociated with the Organon Agreement would be amortized below $5.0 millionuntil such time as the Company is no longer subject to the termination fee.

 

**Research and License Agreementwith Wyeth**

 

InDecember 2006, Pharmacopeia entered into a research and license agreement (theWyeth Agreement) with Wyeth, acting through its Wyeth Pharmaceuticals Division,providing for the formation of a new alliance based on the Company’s JanusKinase-3 (JAK3) inhibitor program.  The alliance’s goal is to identify, develop and commercializetherapeutic products for the treatment of certain immunological conditions inhumans.

 

The companies each havecertain exclusive rights to develop and commercialize products resulting fromthe JAK3 program and the alliance.  Pharmacopeia retains the right todevelop and commercialize therapeutic products for the treatment of dermatologicaland ocular diseases employing topical administration and Wyeth has the right todevelop human therapeutic products for all other indications and routes ofdelivery.  Under the terms of the Wyeth Agreement, in addition to anup-front non-refundable $5.0 million cash payment that the Company received inJanuary 2007, the Company may also receive, over the three-year research termthat began in January 2007, up to $9.0 million in research funding.  Inaddition, the Company may receive up to $175.0 million if Wyeth achievespreclinical and clinical development and regulatory and commercializationmilestones, as well as double-digit royalties on the net sales of any productscommercialized by Wyeth under the alliance. Each company is responsible for alldevelopment, regulatory, manufacturing and commercialization activities for theproducts it develops and commercializes in its field.

 

In January 2007, theCompany received the $5.0 million up-front non-refundable payment, which hadbeen recorded as deferred revenue in December 2006. The revenuefor this research is recognized on a proportional performance basis, which isexpected to approximate straight-line recognition of revenue over the initialthree year term of the alliance. For the three and nine months ended September 30,2007, the Company recognized approximately $1.2 million, or 23%, and $3.5million, or 21%, of net revenue for each respective period under the WyethAgreement.  As of September 30, 2007,approximately $4.5 million was recorded in deferred revenue, of which $2.1million was classified as long-term.  Theresearch term under the Wyeth Agreement commenced in January 2007. TheCompany may receive milestone payments upon the successful achievement, if any,of preclinical and clinical milestones. 

 

Pharmacopeiaand Wyeth each have the right to terminate the Wyeth Agreement under certainspecified circumstances at any time during the term of the WyethAgreement.  In addition, Wyeth has the right, upon six months’ priorwritten notice provided to the Company at any time after December 22, 2007, toterminate the research collaboration and/or the Wyeth Agreement in its entiretyor in part.  Such right to termination would not apply to Wyeth’sobligations with respect to any

 

9

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program developed by thecollaboration and licensed by Wyeth. No termination will require the Company torefund to Wyeth any or all of the cash payments described above.

 

**Collaboration and LicenseAgreements with Schering-Plough**

 

In April 2007, theCompany’s research activities under its collaborations with ScheringCorporation and Schering-Plough Ltd. (together Schering-Plough) were completed.Under the terms of the Company’s agreements with Schering-Plough, the cessationof the Company’s research activities does not affect other areas of thecollaborations, including the ongoing Phase 2 and 1 clinical trials andmultiple preclinical programs that Schering-Plough is conducting. The Companywill continue 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 thecollaborations. For the three months ended September 30, 2007 and 2006, theCompany’s collaborations with Schering-Plough accounted for approximately $1.0million, or 20%, and $1.7 million, or 28%, respectively, of net revenue in theperiod, including $1.0 million in milestone revenue earned in each respectiveperiod. For the nine months ended September 30, 2007 and 2006, the Company’scollaborations with Schering-Plough accounted for approximately $3.8 million,or 23%, and $5.8 million, or 43%, respectively, of net revenue in the period,including $3.0 million and $2.0 million in milestone revenue in 2007 and 2006,respectively. 

 

**Other Items**

 

No other collaboratoraccounted for more than 10% of total revenue in the three or nine month periodsended September 30, 2007 and 2006.

 

**3.****  ****License Agreement withBristol-Myers Squibb (DARA)**

** **

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 lead and backup DARA developmentcandidates. 

 

Under the terms of the DARA License Agreement, in lieu of anup-front cash payment, the Company is providing BMS a set of compoundlibraries, over a period of approximately three years following the executionof the agreement. In the event the Company fails to deliver the aforementionedlibraries to BMS, the Company would be required to make cash payments to BMS ona pro rata basis of up to $1.9 million as of September 30, 2007.  

 

The Company estimated that the fair value of the compound libraryservices to be provided to BMS is approximately $2.0 million. In accordancewith Statement of Financial Accounting Standard (SFAS) No. 2 “Accounting forResearch and Development Costs,” the Company recorded a non-cash charge of $2.0million to proprietary research and development expense related to theacquisition of the license to the DARA program during the three months endedMarch 31, 2006. The Company also recorded deferred revenue for the estimatedfair value of the compound library services to be provided. Included in deferredrevenue as of September 30, 2007 was approximately $1.8 million, of whichapproximately $0.6 million was classified as long-term.

 

During the three months ended September 30, 2007, the Companyinitiated a Phase 2a clinical trial with its product candidate PS433540, which,under the terms of the DARA License Agreement, triggered a $2.0 millionmilestone payment to BMS that was paid in September 2007. For the nine monthsended September 30, 2007, the Company paid BMS $3.0 million in milestone fees relatedto the achievement of clinical events by PS433540. The Company is obligated topay BMS additional milestone payments upon the achievement, if any, of furthersuccessive clinical and regulatory events in the United States and certainother jurisdictions, and royalties on sales of products, if any, resulting fromthe DARA program.

 

**4.**   **Net Loss Per Share**

 

The Company computes netloss per share in accordance with SFAS No. 128, “Earnings Per Share” (SFAS128). Under the provisions of SFAS 128, basic net loss per share is computed bydividing the net loss for the period by the weighted-average number of commonshares outstanding during the period. Diluted net loss per share is computed bydividing the net loss for the period by the weighted-average number of commonand dilutive common equivalent shares outstanding during the period. TheCompany had a net loss for the periods presented; accordingly, the inclusion ofcommon stock equivalents for outstanding stock options would be anti-dilutiveand, therefore, the weighted average shares used to calculate both basic anddiluted earnings per share are the same.

 

10

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**5.**   **Segment Information**

 

The Companyclassifies its business operations in one operating segment. All of the Company’srevenues are generated from this segment. Revenue was derived from customerslocated in the following geographic regions:

 
| ** **             | ** ** | **Three months ended** | ** ** | **Nine months ended** | ** ** |
|------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **             | ** ** | **September 30,**           | ** ** | **September 30,**          | ** ** |
| ** **             | ** ** | **2007**                         | ** ** | **2006**                        | ** ** | **2007** | ** ** | **2006** | ** ** |
| Customers located  in: |       |                             |       |                            |       |   |   |   |   |
| United States          |       | 70                               | %          | 39                              | %          | 67 | % | 41 | % |
| Europe                 |       | 30                               | %          | 61                              | %          | 33 | % | 59 | % |

 

**6.**   **Share-Based Compensation**

 

Effective January 1, 2006, the Company adopted thefair value recognition provisions of SFAS No. 123 (revised 2004), “Share-BasedPayment” (SFAS 123R), using the modified-prospective transition method. Thisstatement is a revision to SFAS 123, supersedes Accounting Principles BoardOpinion No. 25, “Accounting for Stock Issued to Employees” (APB 25) andamends SFAS No. 95, “Statement of Cash Flows.”  Under this transition method, compensationcost recognized includes compensation costs for all share-based paymentsgranted prior to, but not yet vested as of December 31, 2005 based on the grantdate fair value estimated in accordance with the original provisions of SFAS123, and compensation cost for all share-based payments granted subsequent toDecember 31, 2005 based on the grant date fair value estimated in accordancewith provisions of SFAS 123R.

 

The fair value of theseequity awards was estimated at the date of grant using the Black-Scholes optionpricing model with the following weighted average assumption ranges for thenine months ended September 30, 2007 and 2006, respectively:

 
| ** **               | ** ** | **2007**  | ** ** | **2006**  | ** ** |
|--------------------------|------------|-----------|------------|-----------|------------|
| Dividend yield           |       | 0         | %          | 0         | %          |
| Expected  volatility     |       | 80-90     | %          | 80-90     | %          |
| Risk-free  interest rate |       | 4.39-4.60 | %          | 4.66-5.06 | %          |
| Expected life  (years)   |       | 6.25      |       | 6.25      |       |

 

For the three monthsended September 30, 2007 and 2006, total share-based compensation costsassociated with the adoption of SFAS 123R was approximately $548 thousand and$471 thousand, respectively. In addition to the expense incurred related tostock option grants to employees, for the three months ended September 30, 2007the Company also incurred share-based compensation costs of approximately $8thousand related to stock options granted to consultants. For the three monthsended September 30, 2006, the Company incurred share-based compensation costsof approximately $21 thousand related to the vesting of restricted stock grantsto employees. These grants fully vested in March 2007 and thus, there was norelated expense in the three months ended September 30, 2007.

 

For the nine months endedSeptember 30, 2007 and 2006, total share-based compensation costs associatedwith the adoption of SFAS 123R was approximately $1.6 million and $1.4 million,respectively. In addition to the expense incurred related to stock optiongrants to employees, the Company also incurred share-based compensation costsof approximately $13 thousand and $63 thousand related to the vesting ofrestricted stock grants to employees for the nine months ended September 30,2007 and 2006, respectively, and approximately $27 thousand related to stockoptions granted to consultants for the nine months ended September 30, 2007.

 

As of September 30, 2007,there was approximately $4.6 million of unrecognized compensation costs, net ofestimated forfeitures, related to share-based payments that are expected to berecognized over a weighted average period of 2.8 years.  Cash proceeds from stock options exercisedduring the three months ended September 30, 2007 and 2006 was approximately$130 thousand and $1 thousand, respectively. Cash proceeds from stock optionsexercised during the nine months ended September 30, 2007 and 2006 wasapproximately $760 thousand and $907 thousand, respectively.

 

**7.  WarrantLiability**

** **

In connection withits October 2006 financing, the Company issued approximately 1,450,000 warrantsto purchase Pharmacopeia common stock. The Company follows Emerging Issues TaskForce (EITF) No. 00-19, “Accounting for Derivative Financial InstrumentsIndexed to, and Potentially Settled in, a Company’s Own Stock” (EITF 00-19) in

 

11

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accounting for itswarrants, which provides guidance for distinguishing between permanent equity,temporary equity and assets and liabilities. Under EITF 00-19, to qualify aspermanent equity, an equity derivative, including warrants, must permit theCompany to settle in unregistered shares. Under securities law, if the warrantswere issued in connection with a public offering and have a cash settlementfeature at the holder’s option, the Company does not have the ability to settlein unregistered shares. Therefore, the warrants cannot be classified aspermanent equity and are instead classified as a liability. The approximately1,450,000 warrants that the Company issued as part of its equity financing inOctober 2006 meet this criteria and their fair value has been recorded as aliability in the accompanying balance sheets. Other warrants the Company hadpreviously issued qualify as permanent equity and do not require remeasurement.

 

The Companyrecords its warrant liabilities at fair value using a Black-Scholesoption-pricing model and remeasures 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 inthe Company’s stock price, expected volatility, expected life, the risk-freeinterest rate and dividend yield. As of September 30, 2007, the fair value ofthe warrant liability increased to approximately $5.5 million fromapproximately $5.4 million as of June 30, 2007, and as such, approximately $0.1million was recorded as non-operating expense in the three months endedSeptember 30, 2007. For the nine months ended September 30, 2007, the netincrease in warrant liability was approximately $1.1 million, which wasrecorded as non-operating expense for the period. The assumptions used in theBlack-Scholes option-pricing model as of September 30, 2007 and December 31,2006, respectively, were as follows:

 
| ** **               | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|--------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **               | ** ** | **2007**               | ** ** | **2006**              | ** ** |
| Dividend yield           |       | 0                      | %          | 0                     | %          |
| Expected  volatility     |       | 80.00                  | %          | 90.00                 | %          |
| Risk-free  interest rate |       | 4.23                   | %          | 4.70                  | %          |
| Expected life  (years)   |       | 4.55                   |       | 5.30                  |       |
| Stock Price              |       | $                      | 5.72       |                  | $          | 4.26 |   |
| Exercise Price           |       | $                      | 5.14       |                  | $          | 5.14 |   |

 

**8**.   Commitments andContingencies

** **

**Product Development and Commercialization Agreementwith GSK**

** **

Under the terms of theGSK Agreement, the Company and GSKeach have the right to terminate the GSK Agreement in its sole discretion undercertain specified circumstances at any time during the term of the GSKAgreement. In addition, the Company and GSK each have the right to terminatethe GSK Agreement under circumstances that are customary in these types ofagreements.  If the Company exercises 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 up to $15.0 million related to initial discovery activities tobe conducted by the Company under the GSK Agreement. The amount of any suchrefund will be calculated based upon when during the term of the GSK Agreementthat termination occurs and the amount of research funding the Company hadreceived prior to such termination. However, there are no instances where the deferred revenue would beamortized below the amount that could be potentially refundable pursuant to theterms 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 or milestone payments under the GSKAgreement.

 

The Company’s role in the alliance is to(i) identify and (ii) advance molecules in chosen therapeutic programs todevelopment stage and (iii) subject to certain provisions in the GSK Agreement,further develop the candidates to Phase 2 clinical “proof of concept” (ademonstration of efficacy in humans). As of September 30, 2007, the Company hadapproximately $8.5 million of deferred revenue related to services that are tobe provided to GSK by the Company subsequent to September 30, 2007.

 

**DARA License Agreement with BMS**

** **

Under the terms of theDARA License Agreement with BMS, in lieu of an up-front cash payment, theCompany is providing BMS a set of compound libraries, over a period ofapproximately three years following the execution of the agreement.  The Company recorded deferred revenue of $2.0million for the estimated fair value of the compound library services to beprovided. As of September 30, 2007 the balance of this deferred revenue wasapproximately $1.8 million. In the event the Company fails to deliver theaforementioned libraries to BMS, the Company would be required to make cashpayments on a pro rata basis of up to approximately $1.9 million as ofSeptember 30, 2007.

 

12

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In addition, the Companywill pay BMS milestone payments upon the achievement, if any, of successiveclinical and regulatory events in the United States and certain otherjurisdictions, and royalties on sales of products, if any, resulting from theDARA program.

 

**Collaboration and LicenseAgreement with Cephalon**

** **

Under the CephalonAgreement, the Company received an up-front, non-refundable payment of $15.0million in June 2006 to support the Company’s research efforts.  The Company is principally responsible forperforming medicinal chemistry research over the alliance term, as required bythe Cephalon Agreement. As of September 30, 2007, the Company had approximately$8.3 million of deferred revenue related to services that are to be provided toCephalon by the Company subsequent to September 30, 2007.

 

**Collaboration and LicenseAgreement with Organon**

** **

Under the OrganonAgreement, the Company has received $19.0 million (the $15.0 million up-front payment,$1.0 million for the transfer of rights to certain programs from the 2002Collaboration, and three quarterly research payments of $1.0 million each) since February 2007 to support theCompany’s research efforts.  As ofSeptember 30, 2007, the Company had approximately $17.1 million of deferredrevenue related to services that are to be provided to Organon by the Companysubsequent to September 30, 2007.

 

In addition, if theCompany exercises its discretionary termination right, under certaincircumstances, it could be subject to a termination fee of $5.0 million.Whether or not the Company is subject to the termination fee is based upon whenduring the term of the Organon Agreement the Company exercises itsdiscretionary termination right. There will, however, be no instances where thedeferred revenue associated with the Organon Agreement would be amortized below$5.0 million until such time as the Company is no longer subject to thetermination fee.

 

**Research and License Agreementwith Wyeth**

** **

Under the WyethAgreement, the Company received an up-front, non-refundable payment of $5.0million in January 2007 to support the Company’s research efforts.  As of September 30, 2007, the Company hadapproximately $4.5 million of deferred revenue related to services that are tobe provided to Wyeth by the Company subsequent to September 30, 2007.

 

**Milestone and Royalty Commitments**

** **

Under the terms ofcertain agreements to which the Company was a party as of September 30, 2007,it is possible that the Company may become obligated to pay aggregate milestonepayments totaling up to $235 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 willnot be responsible for the payment of future milestone and/or royalty paymentsin the event that development of such a program is discontinued.  Preclinical and clinical development of drugcandidates is a long, expensive and uncertain process.  At any stage of the preclinical or clinicaldevelopment process, the Company may decide to discontinue the development ofits product candidates.  To date, none ofthe compounds to which the Company holds complete or partial rights has reachedthe stage of commercial product.  TheCompany expects that its product candidates will not be commercially availablefor many years, if ever.

 

**9**.   RelatedParty Transaction

** **

In May 2006, the Companyentered into the Cephalon Agreement.One of the Company’s directorscurrently serves as the Chairman and Chief Executive Officer of Cephalon.During the three month period ended September 30, 2007 and 2006, the Company’salliance with Cephalon accounted for $1.3 million, or 25%, and $1.3 million, or20%, respectively, of the Company’s revenue. For the nine month period ended September 30, 2007 and 2006, the Company’salliance with Cephalon accounted for $3.8 million, or 23%, and $1.7 million, or12%, respectively, of the Company’s revenue. 

 

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

** **

In December 2006, theCompany entered into a Loan and Security Agreement (the Line of Credit) with alending institution (the Lender). The Line of Credit is intended to provide theCompany with funding, in exchange for a security interest in certain of theCompany’s equipment.  The Line of Creditprovides up to a total of $5.0 million in funding in the

 

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form of term loans, from time to time through December2008.  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 September 30, 2007,the aggregate balance of loans originated under the Line of Credit wasapproximately $2.2 million, of which $1.6 million is classified as notespayable, long-term. Interest rates on these loans range from 10.08% to 10.28%.Additionally, the Company had approximately $2.7 million available forborrowings under the Line of Credit as of September 30, 2007.

 

**11.   Reclassifications**

** **

Certain accounts in theconsolidated balance sheet as of December 31, 2006 and the consolidatedstatement of cash flows for the nine months ended September 30, 2006 have beenreclassified for comparative purposes to conform with the presentation of theunaudited consolidated financial statements as of and for the nine months endedSeptember 30, 2007.

 

**12.**   New Accounting Pronouncements

** **

**Fair Value Measurements**

 

In September 2006, theFinancial Accounting Standards Board (FASB) issued SFAS No. 157, “Fair ValueMeasurements,” (SFAS 157). SFAS 157 establishes a framework for measuring fairvalue in accordance with generally accepted accounting principles and expandsdisclosures about fair value measurements. SFAS 157 is effective for fiscalyears beginning after November 15, 2007 and interim periods within those fiscalyears. The Company is currently evaluating the impact that SFAS 157 will haveon its consolidated financial statements.

 

**Fair Value Option for Financial Assets and Liabilities**

** **

In February 2007, theFASB 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 159is effective for fiscal years beginning after November 15, 2007. The Company iscurrently evaluating the impact that SFAS 159 will have on its consolidatedfinancial statements.

 

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

 

The EITF has an issuecurrently under consideration that may impact the Company.  EITF 07-3, “Accounting for Non-Refundable Advance Payments for Goods or Servicesto Be Used in Future Research and Development Activities”, is focused onwhether non-refundable advance payments for goods that will be used or servicesthat will be performed in future research and development activities should beaccounted for as research and development costs or deferred and capitalizeduntil the goods have been delivered or the related services have been rendered.The Company will continue to monitor the development of this EITF and evaluatethe impact on its consolidated financial statements.

 

**13.   Subsequent Event**

In October 2007, theCompany entered into a license agreement (the SARM License Agreement) with BMSproviding the Company exclusive worldwide development and commercializationrights to a selective androgen receptor modulator (SARM) program (the SARMProgram).  The SARM Program has a leadcompound (PS178990) in Phase 1 clinical development and back-up compounds.  The SARM License Agreement provides that theCompany will pay BMS milestone payments associated with submission and approvalof a product for marketing, and a stepped royalty on net sales of products, ifany, resulting from the SARM Program.  

** **

In consideration for thelicenses to the SARM Program, in October 2007, the Company also entered into adiscovery collaboration agreement (the Discovery Collaboration Agreement) withBMS.  The Discovery CollaborationAgreement provides that the Company will apply a portion of its medicinalchemistry resources to a BMS discovery program that is unrelated to the SARMProgram for up to three years. In addition, the Company will pay BMS milestonepayments associated with submission and approval of a therapeutic product formarketing and a stepped royalty on net sales of therapeutic products, if any,resulting from the SARM development program. The Company estimates that thefair value of the medicinal chemistry resources the Company is to provide toBMS under the Discovery Collaboration Agreement is approximately $9.5 millionto $10.0 million. In accordance with SFAS No. 2 “Accounting forResearch and Development Costs,” the Company expects to record a non-cashcharge to earnings in the range of approximately $9.5 million to$10.0 million in the fourth quarter of 2007. The Company also expects torecord deferred revenue for the estimated fair value of the chemistry resourcesto be provided BMS under the Discovery Collaboration Agreement.

** **

**Item 2. Management’s Discussion and Analysis ofFinancial Condition and Results of Operations.**

** **

**FORWARD-LOOKING STATEMENTS**

** **

This Report on Form 10-Q containsforward-looking statements regarding us and our business, financial condition,results of operations and prospects within the meaning of the PrivateSecurities Litigation Reform Act of 1995.  Such

 

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forward-looking statements include thosethat express plans, anticipation, intent, contingency, goals, targets or futuredevelopment and/or otherwise are not statements of historical fact.  Theseforward-looking statements are based on our current expectations andprojections about future events and they are subject to risks and uncertaintiesknown and unknown that could cause actual results and developments to differ materiallyfrom those expressed or implied in such statements.  These forward-lookingstatements include statements about the following:

 

•                  our plansto develop PS433540, a Phase 2 product candidate from our DARA program;

 

•                  ourexisting and proposed Phase 2 and Phase 1 clinical studies with respectto PS433540, including timing and expected outcomes of such studies;

 

•                  our plansto develop PS178990, a Phase 1 product candidate from our SARM program;

 

•                  ourestimates of the market opportunity for our product candidates, includingPS433540 and PS178990;

 

•                  our plansto record a non-cash charge to earnings in the range of approximately $9.5million to $10.0 million in the fourth quarter of 2007 in connection with ouracquisition of our SARM program from BMS;

 

•                  our abilityto successfully perform under our agreements with BMS, Cephalon, GSK, Organonand Wyeth;

 

•                  our ability tobuild our pipeline of novel drug candidates through our own internally-fundeddrug discovery and development programs, third party collaborations andin-licensing;

 

•                  our abilityto raise additional capital;

 

•                  our expectationsconcerning the development priorities of our collaborators, their ability tosuccessfully develop compounds and our receipt of milestones and royalties;

 

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

 

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

 

•                  our ability topursue the development of new compounds and other business matters withoutinfringing the patent rights of others;

 

•                  our abilityto acquire or invest in complementary businesses or technologies; and

 

•                  additionalcompetition and changes in economic conditions.

 

In some cases, you can identifyforward-looking statements by terminology, such as “goals,” or “expects,” “anticipates,”“intends,” “plans,” “believes,” “seeks,” “estimates,” or the negative of suchterms or other similar expressions.  You are urged not to place unduereliance on any such forward-looking statements, any of which may turn out tobe wrong due to inaccurate assumptions, unknown risks, uncertainties or otherfactors.  Factors that could cause orcontribute 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 PartI, Item 2, as well as those discussed in our other Securities and ExchangeCommission (SEC) filings.

 

We urge you to carefully read and considerthe disclosures found in these filings, all of which are available in the SECEDGAR 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 following discussionsshould be read in conjunction with the section of this Report entitled “RiskFactors”.

 

**TheCompany**

** **

**Overview**

** **

We are a clinicaldevelopment stage biopharmaceutical company dedicated to discovering anddeveloping novel small molecule therapeutics to address significant medicalneeds.  Using proprietary technologiesand processes, we seek to

 

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identify, optimize and develop novel drug candidatesthrough our own internally-funded drug discovery and development programs andin collaborations with major pharmaceutical and biotechnology companies.  We have a broad portfolio of clinical andpreclinical candidates under development internally or by partners, includingseven compounds in Phase 2 or Phase 1 development, addressing multipleindications including hypertension, diabetic nephropathy, muscle wasting,inflammation and respiratory disease.  

 

PS433540, a product candidate we aredeveloping internally, is in Phase 2 clinical development.  PS433540 is a Dual-Acting angiotensin andendothelin Receptor Antagonist (DARA) that we in-licensed from BMS and that isbeing developed as a potential treatment for cardiovascular diseases, includinghypertension and diabetic nephropathy. The DARA License Agreement with BMS provides us with an exclusivelicense under certain BMS patents with respect to worldwide development andcommercialization of PS433540, as well as certain other compounds discovered byBMS that possess DARA activity.  Webelieve that PS433540 administered as a single agent has the potential to havea superior efficacy profile to monotherapy with an angiotensin receptor blockerfor the potential treatment of hypertension and diabetic nephropathy.  

 

In September 2007, we announced results of a Phase 1trial that showed PS433540 (DARA) blocked the blood pressure raising effect ofangiotensin II (AII) in healthy volunteers who had received AII.   We also recently announced that basedon initial results from the Phase 1 multiple ascending dose (MAD) study ofPS433540, no safety or tolerability issues were observed with any of the dosesunder evaluation, including the extension to a 1,000 mg dose.  

 

In October 2007, we entered into the SARM License Agreement with BMS providingus exclusive worldwide development and commercialization rights to a selectiveandrogen receptor modulator (SARM) program (the SARM Program).  The SARM Program has a lead compound(PS178990) in Phase 1 clinical development and back-up compounds.  PS178990 is a non-steroidal SARM that wasdesigned to provide the benefits of testosterone to patients without unwantedside effects on the prostate.  BMS hascompleted a Phase 1 single ascending dose study with PS178990.  The SARM Program has a broad portfolio ofpending patent applications in the United States and other jurisdictions that,if granted, would provide intellectual property coverage to the SARM Program atleast through the year 2023.  TheSARM License Agreement provides that we will pay BMS milestone paymentsassociated with submission and approval of a product for marketing, and astepped royalty on net sales of products, if any, resulting from the SARMProgram.  In consideration for thelicenses to the SARM Program, in October 2007, we also entered into a discoverycollaboration agreement (the Discovery Collaboration Agreement) with BMS.  The Discovery Collaboration Agreement providesthat we will apply a portion of our medicinal chemistry resources to a BMSdiscovery program that is unrelated to the SARM Program for up to three years.

 

We have concentrated ourinternal discovery programs primarily on diseases related to immunoregulation. Immunoregulatory indications could include rheumatoid arthritis, psoriasis,inflammatory bowel disease, multiple sclerosis and others. This focus builds onour expertise in the area, and also takes advantage of attractive commercialopportunities we believe exist. Our internal discovery efforts includedeveloping CCR1 antagonists to treat inflammatory diseases including rheumatoidarthritis and multiple sclerosis as well as programs directed at generatingJAK3 inhibitors for topical use in dermatological and ocular diseases. We havepartnered our JAK3 Inhibitors program with Wyeth for all indications and routesof delivery other than topical administration for dermatological and oculardiseases. We also have a discovery program focused on A2a antagonists to treatParkinson’s disease.  We fully fund ourinternal discovery programs and retain intellectual property and ownershiprights to any compounds discovered. At an appropriate point, we may license oneor more of these compounds or programs to a partner.

 

In addition to ourproprietary research and development, we currently have collaborations underwhich we are actively performing research and development activities withleading pharmaceutical and biotechnology companies, including Cephalon,GlaxoSmithKline, Organon and Wyeth. While the nature of our collaborative relationships vary with each ofthese companies, we retain certain development and/or commercialization rightsunder the terms of each agreement. We also have certain other agreements withleading pharmaceutical and biotechnology companies, including Schering-Plough andBMS, where we have completed our research activities and the partner is nowresponsible for the development of potential therapeutic products. Our collaborativeresearch efforts with Schering-Plough and BMS have resulted in a portfolio thatincludes two partnered programs currently in Phase 2 clinical trials targetingchronic obstructive pulmonary disease (COPD) and psoriasis, and three partneredprograms in active Phase 1 clinical trials targeting oncology, inflammatory andrespiratory diseases.

 

Associated with theseclinical development programs, we have received milestone payments fromSchering-Plough and BMS and, to the extent the compounds successfully progressthrough clinical development and registration, we will be entitled to receiveadditional milestone payments. We are also entitled to receive royalties on thecommercial sale, if any, of drugs resulting from these collaborations. However,numerous additional studies are required to fully assess the potential of theseclinical candidates before they reach the marketplace, and the results frompreclinical studies and clinical studies

 

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conducted to date with these compounds are notnecessarily indicative of the results that may be obtained in future clinicalstudies.

 

In addition to thecompounds in clinical development, three more partnered programs are at variousstages of preclinical development, the point at which compounds are tested forsafety in animals and are subjected to other studies required prior to testingcompounds in humans.

 

Preclinical and clinicaldevelopment of drug candidates is a long, expensive and uncertain process. Wecontinue to pursue the discovery and development of product candidates in bothour internal and collaborative programs. The drug candidates described aboveare at early stages and none have received regulatory approval for commercialsale. All of the compounds face the substantial risk of failure inherent indrug discovery and development. At any stage of the clinical developmentprocess, we or our collaborators may decide to discontinue development of ourproduct candidates. To date, none of the compounds in which we hold complete orpartial rights has reached the stage of a commercial product and, although wehave received license and milestone fees, we may never receive any salesrevenues, royalty payments or any additional license and milestone fees, underour current or any future collaborations. We do not expect that our productcandidates will be commercially available for many years, if ever.

 

From time to timewe have considered, and we will continue to consider strategic initiativesintended to further the development of our business. In addition, we consideropportunities to expand our product pipeline through the acquisition orin-licensing of, or investment in, product development candidates, and weintend to continue to explore those opportunities.

 

**Liquidity and Capital Resources**

** **

As of September 30, 2007, we had cash, cash equivalents andmarketable securities of $81.4 million compared to $46.1 million at December31, 2006, representing 82% and 70% of our total assets, respectively. We makeinvestments in highly liquid investment-grade marketable securities, includingcorporate bonds and United States government and agency securities. As ofSeptember 30, 2007, we had deferred revenue of approximately $40.6 millionrelating to research and development activities that are to be provided by ussubsequent to September 30, 2007, of which approximately $24.0 million wasclassified as long-term. The following is a summary of selected cash flowinformation for the nine months ended September 30, 2007 and 2006 (inthousands):

 
| ** **                                           | ** ** | **Nine months ended September 30,** | ** ** |
|------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                           | ** ** | **2007**                                                | ** ** | **2006** | ** ** |
| Net loss                                             |       | $                                                       | (28,605    | ) | $ | (19,573 | ) |
| Adjustments for  noncash operating items             |       | 4,761                                                   |       | 3,044 |   |
|                                                 |       |                                                    |       |   |   |
| Net cash  operating loss                             |       | (23,844                                                 | )          | (16,529 | ) |
| Net change in  assets and liabilities                |       | 22,374                                                  |       | 18,324 |   |
|                                                 |       |                                                    |       |   |   |
| Net cash (used  in) provided by operating activities |       | $                                                       | (1,470     | ) | $ | 1,795 |   |
|                                                 |       |                                                    |       |   |   |
| Net cash (used  in) provided by investing activities |       | $                                                       | (20,369    | ) | $ | 11,597 |   |
|                                                 |       |                                                    |       |   |   |
| Net cash  provided by financing activities           |       | $                                                       | 40,027     |   | $ | 907 |   |

 

**Net cash (used in) provided by operatingactivities**

 

Net cash used in operating activities for the nine monthsended September 30, 2007 was primarily due to cash used to fund both ourproprietary internal drug research and development efforts, including our Phase2 and Phase 1 clinical trials for PS433540, and the fulfillment of our researchand development performance obligations under our collaborations, offset by thereceipts of a $5.0 million up-front non-refundable payment received in January2007 relating to the Wyeth Agreement, a $15.0 million up-front non-refundablepayment received in March 2007 in connection with the Organon Agreement, and a$5.0 million payment received in June 2007 related to the second tranche ofresearch funding under the GSK Agreement. Absent the receipt of the $25.0 million from Wyeth, Organon and GSK, ournet cash used in operating activities would have been approximately $26.5million.

 

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Net cash provided by operating activities for the ninemonths ended September 30, 2006 was primarily due to the receipts of a $5.0million up-front payment received in April 2006 relating to the GSK Agreementand a $15.0 million up-front non-refundable payment received in June 2006relating to the Cephalon Agreement, offset by cash used to fund both ourproprietary internal drug research and preclinical development efforts and thefulfillment of our research and development performance obligations under ourcollaborations, as well as the payment of restructuring expenses related to the2004 consolidation of our facilities. Absent the receipt of the $20.0 millionfrom GSK and Cephalon, our net cash used in operating activities would havebeen approximately $18.2 million.

 

**Net cash (used in) provided by investingactivities**

 

Net cash used in investing activities for the nine monthsended September 30, 2007 related primarily to the purchase of marketablesecurities. Net cash used in investing activities also included capitalexpenditures related to the expansion of our facilities and purchases relatedto laboratory and information technology equipment and software, partiallyoffset by net proceeds from the sales and maturities of marketable securities. Netcash provided by investing activities for the nine months ended September 30,2006 related primarily to the net sales and maturities of marketablesecurities, partially offset by capital expenditures for laboratory andinformation technology equipment and software.

 

**Net cash provided by financingactivities**

** **

In May 2007, weissued and sold approximately 8.1 million shares of our common stock at apurchase price per share of $5.00 as part of a public underwrittenoffering.  The aggregate gross proceeds of the transaction wereapproximately $40.3 million. The proceeds we received from the transaction, netof transaction costs, were approximately $37.1 million.  The shares ofcommon stock were sold through a prospectus supplement pursuant to one of oureffective shelf registration statements.

 

Net cash provided by financing activities for the ninemonths ended September 30, 2007 also included proceeds, net of repayments, ofapproximately $2.2 million received from loans originated under our Line ofCredit and proceeds from the issuance of common stock in connection withexercises of stock options. Net cash provided by financing activities for thenine months ended September 30, 2006 related to proceeds from the issuance ofcommon stock in connection with exercises of stock options.

** **

**Contractual Obligations**

 

In September 2007,we amended one of our facilities leases, adding approximately 16,000 squarefeet of office and laboratory space in Cranbury, New Jersey. The term of thelease for this additional space coincides with our current facilities leases,which expire in the year 2016. Minimum lease payments associated with thislease amendment are currently approximately $310 thousand per year, and mayincrease subject to certain tenant improvement provisions contained in theamendment. Lease payments for some of the additional space are expected tocommence in the fourth quarter of 2007, and for the remainder of the additionalspace in the first quarter of 2008.

 

For furtherdiscussion of our contractual obligations, see “Item 7. Management’s Discussionand Analysis of Financial Condition and Results of Operations” in our report onForm 10-K for the year ended December 31, 2006. For other newcontractual obligations as September 30, 2007 and thereafter, see also thefollowing items described in the notes to the unaudited consolidated financialstatements contained herein:

 

•                  theCollaboration and License Agreement with Organon described in Note 2;

 

•                  ourcommitments and contingencies described in Note 8; and

 

•                  eachof the SARM License Agreement and Discovery Collaboration Agreement with BMSdescribed in Note 13.

 

**Liquidity and Capital Resources Outlook**

 

**Weexpect to continue to use our capital to fund our operations. We expect thatour research and development expenditures will continue to increase in thefuture as we increase our internal drug research and development efforts.Preclinical development studies and clinical trials are significant,time-consuming and costly processes. Conducting our own drug research and developmentis a key component of our business model. We are currently conducting Phase 2and Phase 1 clinical trials for PS433540, a product candidate from our DARAprogram that we are developing internally.**We initated a Phase 2a proof of concept study in hypertension in thethird quarter of 2007 and plan to initiate a second Phase 2 clinical trial inthe first half of 2008. Conducting these Phase 2 clinical trials, in additionto other Phase 1 clinical trials that will need to be conducted, willsignificantly increase our proprietary research and development costs.

** **

In October 2007, we acquired thedevelopment and commercialization rights to the SARM Program from BMS,including PS178990, a product candidate in Phase 1 clinical development forwhich we intend to conduct further clinical trials. In consideration for thelicenses to the SARM Program, we entered into the Discovery Collaboration Agreementwith BMS to provide a portion of our medicinal chemistry resources to a BMSdiscovery program unrelated to the SARM Program for a period up to three years.Progressing the SARM Program, specifically our product candidate PS178990,through clinical trials is expected to further increase our proprietaryresearch and development costs.

 

**Inaddition, as part of our other collaborative agreements with Cephalon, GSK,Organon and Wyeth, we have received up-front payments. In connection with theseagreements, we are obligated to perform significant research and developmentactivities over multiple years and as such, expect to incur significant costsperforming such activities.**

** **

**As of September 30, 2007, we hadapproximately $2.7 million available for borrowings under our line of credit.We expect that we will continue to draw on this line of credit for capitalexpenditures in the future.**

** **

We anticipate that ourcapital resources will be adequate to fund our operations at their currentlevels at least through December 31, 2008. However, there can be no assurancethat changes will not occur that would consume available capital resourcesbefore then.

 

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Our capital requirementsdepend on competing technological and market developments, changes in ourexisting collaborative relationships, progress of PS433540 and PS178990 in clinicaltrials, the cost of filing, prosecuting, defending, and enforcing patent claimsand other intellectual property rights and the outcome of related litigation,the purchase of additional capital equipment, acquisitions of other businessesor technologies, and the progress of our collaborators’ milestone and royaltyproducing activities. We will need to raise additional funds to finance ouroperating activities or enter into strategic initiatives intended to furtherthe development of our business. There can be no assurance that additionalfunding, if necessary, will be available to us on favorable terms, if at all.Our forecasts of the period of time through which our financial resources willbe adequate to support our operations are forward-looking information andactual results could vary. The factors described earlier in this section willimpact our future capital requirements and the adequacy of our available funds.

 

**Resultsof Operations**

 

This sectionshould be read in conjunction with the discussion under “Liquidity and CapitalResources”.

 

**Three months ended September 30, 2007 and 2006**

** **

Our net revenue decreased 19% to $5.1 million in the three months ended September 30, 2007 compared to $6.3 million in the three monthsended September 30,2006. Net revenue consists ofrevenue recorded in connection with research and development efforts we performunder our various collaboration agreements, as well as our earning ofmilestones, success fees and license revenue if and as our discoveries progressthrough our collaborators’ development processes. Net revenue for the threemonths ended September30, 2007 and 2006 is summarized asfollows (in thousands):

 
| ** **                                    | ** ** | **For the three months ended September 30,** | ** ** |
|-----------------------------------------------|------------|----------------------------------------------|------------|
| ** **                                    | ** ** | **2007**                                     | ** ** | **2006** | ** ** |
|                                          |       |                                         |       |   |   |
| Collaborative  research revenue               |       | $                                            | 3,916      |   | $ | 3,132 |   |
| Milestones,  success fees and license revenue |       | 1,173                                        |       | 3,125 |   |
|                                          |       | $                                            | 5,089      |   | $ | 6,257 |   |

 

Cephalon accounted for approximately $1.3 million of our net revenue ineach of the three months ended September 30, 2007 and 2006, or 25% and 20%,respectively. Wyeth accounted for approximately $1.2 million or 23%, of our netrevenue in the three months ended September 30, 2007. Our alliance with Wyethcommenced in January 2007 and therefore there was no corresponding revenue inthe three months ended September 30, 2006. Organon accounted for approximately$1.0 million, or 20%, and approximately $2.9 million, or 46%, of our netrevenue in the three months ended September 30, 2007 and 2006, respectively,including $2.0 million of milestone and success fees revenue in the threemonths ended September 30, 2006. Schering-Plough accounted for $1.0 million, or20%, and approximately $1.8 million, or 28%, of our net revenue in the threemonths ended September30, 2007 and 2006, respectively,including $1.0 million of our milestone and success fees revenue recorded ineach of the three months ended September 30, 2007 and 2006.

 

The increase in collaborative research revenue in the three months endedSeptember 30, 2007 versus the prior year period was largely due to increasedresearch revenue recognized from our alliances with Wyeth, Organon and GSK,offset by the completion of our research activities under our collaborationswith Schering-Plough in April 2007.

 

The decrease in milestones, success fees and license revenue related to$1.0 million in milestone revenue earned in the three months ended September30, 2007 ($1.0 million from our Schering-Plough collaborations), compared to$3.0 million in milestone revenue ($2.0 million from our 2002 Organon Collaboration,and $1.0 million from our Schering-Plough collaborations) earned in the threemonths ended September 30, 2006.

 

Collaborativeresearch and development expense includes the labor, material, equipment andallocated facilities cost of our scientific staff that is working oncollaborative partnerships. Collaborative research and development expensesincreased 67% to $5.8 million in the three months ended September 30, 2007compared to $3.4 million in the three months ended September 30, 2006. This increaserelated primarily to an increase in resources allocated to our alliances withGSK and Wyeth. In December 2006, we entered into the Wyeth Agreement in whichwe licensed certain rights to our JAK3 program to Wyeth. Prior to January 2007,the resources that were deployed on the JAK3 program were accounted for inproprietary research and development expense. Resources deployed on our JAK3program, as they relate to programs for employing 

 

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topical administrationfor ocular and dermatological diseases, have been and will continue to beaccounted for in proprietary research and development as we retain all rightsto these programs. This increase was offset by the re-allocation of resourcesfrom our collaborations with Schering-Plough, the research activities of whichwere completed in April 2007. Share-based compensation costs associated withour adoption of SFAS 123R for the three months ended September 30, 2007 and2006 were $153 thousand and $91 thousand, respectively.

 

Proprietaryresearch and development expense includes research and development acquisitioncosts, labor, material, equipment and allocated facilities cost of scientificstaff working on self-funded internal drug discovery and development programs. Our mostadvanced internal program is our DARA program, which is in Phase 2 clinicaltrials. We licensed our DARA program from BMS in March 2006. In addition, wecurrently have several internal programs in advanced preclinical discovery.Proprietary research and development expenses increased 64% to $9.5 million inthe three months ended September 30, 2007 compared to $5.8 million in the threemonths ended September 30, 2006. This increase related primarily to costs forPhase 1 and Phase 2 clinical trials for PS433540, including a milestone paymentof $2.0 million made to BMS for the initiation of the Phase 2 clinical trials,and costs expended on our CCR1 discovery program. This increase was offset by adecrease in costs related to our JAK3 program and a reduction in resourcesallocated to our Adenosine A2a program. As previously mentioned, certainaspects of our JAK3 program were partnered with Wyeth in December 2006. Themajority of the costs related to this program, previously incurred in proprietaryresearch and development expense in prior periods, are now categorized ascollaborative research and development. Share-based compensation costsassociated with our adoption of SFAS 123R for the three months ended September30, 2007 and 2006 were $84 thousand and $102 thousand, respectively. Because ofthe 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 andadministrative expense increased by 20% to $2.6 million in the three monthsended September30, 2007 compared to $2.1 million in the three months ended September30, 2006.  The increase in general and administrative expense wasprimarily attributable to increased consulting and recruiting costs during thethree months ending September 30, 2007. Share-based compensation costsassociated with our adoption of SFAS 123R for the three months ended September30, 2007 and 2006 were $311 thousand and $279 thousand, respectively.

 

Interest and otherincome, net increased to $1.1 million in the three months ended September 30, 2007compared to $419 thousand in the three months ended September 30, 2006.  Thisincrease was primarily due to higher yields on our increased cash, cashequivalents, and marketable securities balances during the three months endedSeptember 30, 2007 as compared to the three months ended September 30, 2006.

 

Interest expenseof approximately $15 thousand was incurred in the three months ended September30, 2007, and related to our borrowings under our Line of Credit during theperiod. During the corresponding period in 2006, we did not have a creditfacility.

 

The expenseassociated with the increase in warrant liability represents the change in thefair value of the warrants that were issued in connection with our equityfinancing in October 2006, from June 30, 2007 to September 30, 2007. The fairvalue of the warrants was determined using the Black-Scholes option-pricingmodel and is remeasured at each reporting period.

 

 We recorded no income tax provision for thethree months ended September30, 2007 as the minimum state income taxes that we previously weresubject to no longer apply due to state legislative changes. For the threemonths ended September 30, 2006, we recorded an income tax provision of $9thousand related to these minimum state income taxes.

 

As a result of thenet revenues and expenses described above, we generated a net loss of $11.7million ($0.40 per basic and diluted share) in the three months ended September 30, 2007,compared to a net loss of $4.7 million ($0.31 per basic and diluted share) inthe three months ended September30, 2006.

 

**Nine months ended September 30, 2007 and 2006**

** **

Our net revenue increased 20% to $16.4 million in the nine months ended September 30, 2007 compared to $13.7 million in the nine monthsended September 30,2006. Net revenue consists ofrevenue recognized in connection with research and development efforts weperform under our various collaboration agreements, as well as our earning ofmilestones, success fees and license revenue if and as our discoveries progressthrough our collaborators’ development processes. Net revenue for the ninemonths ended September30, 2007 and 2006 is summarized asfollows (in thousands):

 

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| ** **                                    | ** ** | **For the nine months ended September 30,** | ** ** |
|-----------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                    | ** ** | **2007**                                    | ** ** | **2006** | ** ** |
|                                          |       |                                        |       |   |   |
| Collaborative  research revenue               |       | $                                           | 11,750     |   | $ | 9,290 |   |
| Milestones,  success fees and license revenue |       | 4,645                                       |       | 4,375 |   |
|                                          |       | $                                           | 16,395     |   | $ | 13,665 |   |

 

Cephalon accounted for approximately $3.8 million, or 23%, andapproximately $1.7 million, or 12%, of our net revenue in the nine months endedSeptember 30, 2007 and 2006, respectively. Our alliance with Cephalon commencedin May 2006. Wyeth accounted for approximately $3.5 million, or 21%, of our netrevenue in the nine months ended September 30, 2007. Our alliance with Wyethcommenced in January 2007 and therefore there was no corresponding revenue inthe nine months ended September 30, 2006. Organon accounted for approximately$2.4 million, or 15%, and approximately $4.6 million, or 34%, of our netrevenue in the nine months ended September 30, 2007 and 2006, respectively,including $2.0 million of milestone and success fees revenue in the nine monthsended September 30, 2006. Schering-Plough accounted for approximately $3.8million, or 23%, and approximately $5.8 million, or 43%, of our net revenue inthe nine months ended September30, 2007 and 2006, respectively,including $3.0 million and  $2.0 millionof our milestone and success fees revenue recorded in each respective period.

 

The increase in collaborative research revenue in the nine months endedSeptember 30, 2007 was largely due to our alliances with Cephalon, Wyeth andGSK, partially offset decreased research revenue that resulted from thecompletion of our research activities under our collaborations withSchering-Plough in April 2007.

 

Collaborativeresearch and development expense includes the labor, material, equipment andallocated facilities cost of our scientific staff that is working oncollaborative partnerships. Collaborative research and development expensesincreased 71% to $16.7 million in the nine months ended September 30, 2007compared to $9.8 million in the nine months ended September 30, 2006. This increaseprimarily related to an increase in resources allocated to our alliances withGSK, Cephalon and Wyeth. In December 2006, we entered into the Wyeth agreementunder which we licensed certain rights to our JAK3 program to Wyeth. Prior toJanuary 2007, the resources that were deployed on the JAK3 program wereaccounted for in proprietary research and development expense. Resourcesdeployed on our JAK3 program, as they relate to programs for employing topicaladministration for ocular and dermatological diseases, have been and willcontinue to be accounted for in proprietary research and development as weretain all rights to these programs. This increase was offset by decreased resources allocated to ourcollaborations with Schering-Plough that resulted from the completion of ourresearch activities in April 2007. Share-based compensation costsassociated with our adoption of SFAS 123R for the nine months ended September30, 2007 and 2006 were $416 thousand and $250 thousand, respectively.

 

Proprietaryresearch and development expense includes research and development acquisitioncosts, labor, material, equipment and allocated facilities cost of scientificstaff working on self-funded internal drug discovery and development programs. Our mostadvanced internal program is our DARA program, which is in Phase 2 clinicaltrials. We licensed our DARA program from BMS in March 2006. In addition, wecurrently have several internal programs in advanced preclinical discovery.Proprietary research and development expenses increased 25% to $22.0 million inthe nine months ended September 30, 2007 compared to $17.6 million in the ninemonths ended September 30, 2006***.***Thisincrease was primarily attributable to costs relating to clinical trials forPS433540, including milestone payments of $1.0 million and $2.0 million made toBMS for the initiation of Phase 1 and Phase 2 clinical trials, respectively.The increase in proprietary research and development expense also related toincreased costs expended on our CCR1 discovery program. The increase was offsetby a decrease in costs related to our JAK3 program. As previously mentioned,certain aspects of our JAK3 program were partnered with Wyeth in December 2006.The majority of the costs related to this program, previously incurred inproprietary research and development expense in prior periods, are nowcategorized as collaborative research and development. Share-based compensationcosts associated with our adoption of SFAS 123R for the nine months endedSeptember 30, 2007 and 2006 were $234 thousand and $287 thousand, respectively.Because of the speculative nature of these internal drug discovery anddevelopment projects, it is not possible to estimate completion dates or costsof 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 administrativeexpense increased by 15% to $8.0 million in the nine months ended September 30, 2007compared to $7.0 million in the nine months ended September 30, 2006.  Theincrease in general and administrative expense was attributable to increasedconsulting, recruiting and share-based compensation costs during the ninemonths ended 

 

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September 30, 2007. Share-basedcompensation costs associated with our adoption of SFAS 123R for the ninemonths ended September 30, 2007 and 2006 were $915 thousand and $741 thousand,respectively.

 

Interest and otherincome, net increased to $2.8 million in the nine months ended September 30, 2007compared to $1.0 million in the nine months ended September 30, 2006.  This increasewas primarily due to higher yields on our increased cash, cash equivalents, andmarketable securities balances during the nine months ended September 30, 2007as compared to the nine months ended September 30, 2006.

 

Interest expenseof approximately $20 thousand was incurred in the nine months ended September30, 2007, and related to our borrowings under our Line of Credit during theperiod. During the corresponding period in 2006, we did not have a creditfacility.

 

The expenseassociated with the increase in warrant liability 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 September 30, 2007. Thefair value of the warrants was determined using the Black-Scholesoption-pricing model and is remeasured at each reporting period.

 

Increase in taxbenefit represents an adjustment to our estimated provision, to reflect actualminimum taxes due. We recorded no income tax provision for the nine months endedSeptember30, 2007 as the minimum state income taxes that we previously weresubject to no longer apply due to state legislative changes. For the ninemonths ended September 30, 2006, we recorded an income tax provision of $37thousand related to these minimum state income taxes.

 

As a result of thenet revenues and expenses described above, we generated a net loss of $28.6million ($1.07  per basic and dilutedshare) in the nine months ended September 30, 2007, compared to a net loss of $19.6million ($1.28 per basic and diluted share) in the nine months ended September30, 2006.

 

**Net Loss Outlook**

 

Wehave had net losses in recent years and we expect to incur losses in futureperiods. These losses are expected to increase as compared to prior periods asa result of the increased level of investment we plan to make in our internalproprietary programs in the future. Our internal proprietary research anddevelopment costs are expected to continue to increase due to our efforts toprogress the DARA and SARM programs through clinical trials.

 

In connection with theacquisition of the licenses to the SARM Program in October 2007, we alsoentered into the Discovery Collaboration Agreement with BMS, which providesthat we will apply a portion of our medicinal chemistry resources to a BMSdiscovery program that is unrelated to the SARM Program for up to three years.  We expect to record a non-cash charge toearnings in the range of approximately $9.5 million to $10.0 million in thefourth quarter of 2007. The amount of this charge approximates the fair valueof the chemistry resources we are to provide to BMS under the DiscoveryCollaboration Agreement.

 

Ournet loss is highly dependent on the continued funding and success of ourresearch and development programs with our existing collaborators. Ourcollaborations with Schering-Plough ceased in April 2007. We will continue tobe entitled to payments resulting from the successful achievement bySchering-Plough, if any, of clinical milestones as well as royalty paymentsfrom sales, if any, of products resulting from compounds already delivered byus and accepted by Schering-Plough under the collaborations.

 

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Our adoption of SFAS123R, which was effective January 1, 2006, increased our compensation costs andwill continue to have a significant impact on our results of operations. Changesin the fair value of the warrants we issued in October 2006 are reported in thestatements of operations as income or expense. As such, changes to the marketprice of our common stock or to the assumptions used in calculating the fairvalue of the warrants may cause significant increases or decreases to ourresults of operations. However, neither the impact of share-based compensationcosts, nor the impact of changes in the fair value of the warrant liabilitywill have an impact on our cash flows.

 

Thereis no assurance that we will ever achieve profitable operations, or thatprofitable operations, if achieved, could be sustained on a continuing basis.

 

**Critical Accounting Policies and Estimates**

** **

The preparation of ourfinancial statements and disclosures involve the use of judgments and estimates.We believe the following critical accounting policies which we follow involvesignificant judgments and use estimates.

 

*Revenue Recognition*

 

Contract revenue isgenerally recognized either (i) on a proportional performance basis, forcontracts specifying payment for services over a given period, or (ii) asservices are performed under the agreement for contracts specifying payment ona full-time employee basis.

 

Revenue earned related toup-front product and technology license fees is recognized in accordance withStaff Accounting Bulletin 104 issued by the SEC and EITF Issue 00-21, “RevenueArrangements with Multiple Deliverables” issued by the 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 milestonesis recognized when earned, as evidenced by written acknowledgement from thecollaborator, provided that (i) the milestone event is substantive, itsachievability was not reasonably assured at the inception of the agreement, andwe have no further performance obligations relating to that event, and(ii) collectibility is reasonably assured. If these criteria are not met,the milestone payment is recognized over the remaining period of ourperformance obligations under the arrangement. Royalties are recognized asearned in accordance with the terms of various research and collaborationagreements.

 

*Share-based Compensation*

 

Effective January 1,2006, we adopted the fair value recognition provisions of SFAS 123R, using themodified-prospective transition method. This statement is a revision to SFAS123, supersedes APB 25 and amends SFAS No. 95, “Statement of Cash Flows.”  Under this transition method, compensationcost recognized includes compensation costs for all share-based paymentsgranted prior to, but not yet vested as of December 31, 2005 based on the grantdate fair value estimated in accordance with the original provisions of SFAS123, and compensation cost for all share-based payments granted subsequent toDecember 31, 2005 based on the grant date fair value estimated in accordancewith provisions of SFAS 123R.

 

Under SFAS 123R, we usethe Black-Scholes option pricing model to estimate the fair value of theshare-based awards as of the grant date. The Black-Scholes model, by itsdesign, is highly complex and dependent upon key data inputs estimated bymanagement. The primary data inputs with the greatest degree of judgment arethe estimated lives of the share-based awards and the estimated volatility ofour stock price. The Black-Scholes model is sensitive to changes in these twodata inputs. Beginning in fiscal year 2006, we calculated the estimated life ofstock options granted using a “simplified” method, which is based on theaverage of the vesting term and the actual term of the option, as a result ofguidance from the SEC as contained in Staff Accounting Bulletin No. 107permitting the initial use of this method through 2007. Typically, expectedstock price volatility is based on the daily historical trading data from anappropriate point in time through the last day of the applicable period.Because our historical trading data only dates back to May 3, 2004, the date ofour spin-off from Accelrys, we determine our expected volatility using ananalysis of the stock price volatility of companies comparable to ours in ourindustry.

 

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*WarrantLiability*

 

We follow EITF00-19 in accounting for our warrants, 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 us 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 approximately 1,450,000 warrants that we issuedas part of our equity financing in October 2006 meet this criteria, and theirfair value has been recorded as a liability in the accompanying balance sheets.Other warrants we had previously issued qualify as permanent equity and do notrequire remeasurement.

 

We record ourwarrant liabilities at fair value using a Black-Scholes option-pricing modeland remeasure at each reporting date until the warrants are exercised or haveexpired. Changes in the fair value of the warrants are reported in thestatements of operations as income or expense. The fair value of the warrantscould be subject to significant fluctuation based on changes in our stockprice, expected volatility, expected life, the risk-free interest rate anddividend yield. The market price for our common stock has been and may continueto be volatile. Consequently, future fluctuations in the price of our commonstock may cause significant increases or decreases in the fair value of thewarrants issued in October 2006.

 

*Long-Lived Assets*

 

We review long-livedassets, including leasehold improvements, property and equipment, and acquiredtechnology rights, for impairment whenever events or changes in businesscircumstances indicate that the carrying amount of the assets may not be fullyrecoverable. This requires us to estimate future cash flows related to theseassets. Actual results could differ from these estimates, which may affect thecarrying amount of assets and the actual amortization expense. As of September30, 2007, we had long-lived assets with a net book value of $12.9 million.

 

*Accounting for Uncertain Tax Positions*

 

In June 2006, the FASBissued Interpretation No. 48, “Accounting for Uncertainty in Tax Positions – anInterpretation of FASB Statement No. 109” (FIN 48).  FIN 48 appliesto all open tax positions accounted for in accordance with SFAS No. 109, “Accountingfor Income Taxes” and is intended to result in increased relevance andcomparability in financial reporting of income taxes and to provide moreinformation about the uncertainty in income tax assets and liabilities. Weadopted FIN 48, effective January 1, 2007, and have concluded that we had nosignificant open tax positions as of September 30, 2007, and thus, suchadoption has had no impact on our income tax assets and liabilities.

 

**New Accounting Pronouncements**

 

*Fair Value Measurements*

 

In September 2006, theFASB issued SFAS No. 157, “Fair Value Measurements,” (SFAS 157). SFAS 157establishes a framework for measuring fair value in accordance with generallyaccepted accounting principles and expands disclosures about fair valuemeasurements. SFAS 157 is effective for fiscal years beginning after November15, 2007, and interim periods within those fiscal years. We are currentlyevaluating the impact that SFAS 157 will have on our consolidated financialstatements.

* *

*Fair Value Option for Financial Assets and Liabilities*

 

In February 2007, theFASB 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 159is effective for fiscal years beginning after November 15, 2007. We arecurrently evaluating the impact that SFAS 159 will have on our consolidatedfinancial statements.

 

*Non-Refundable Advance Payments for Goods or Services to BeUsed in Future Research and Development Activities*

 

The EITF has an issuecurrently under consideration that may impact us. EITF 07-3, “Accounting for Non-Refundable AdvancePayments for Goods or Services to Be Used in Future Research and DevelopmentActivities”, is focused on whether non-refundable advance payments forgoods that will be used or services that will be performed in future researchand 

 

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development activities should be accounted for asresearch and development costs or deferred and capitalized until the goods havebeen delivered or the related services have been rendered. We will continue tomonitor the development of this EITF and evaluate the impact on ourconsolidated financial statements.

 

**Item 3. Quantitative and Qualitative Disclosures about Market Risk**

 

Our international salesgenerally are denominated in United States Dollars, and are, therefore, notexposed to changes in foreign currency exchange rates.

 

We do not use derivativefinancial instruments for trading or speculative purposes. However, weregularly invest excess cash in overnight repurchase agreements that aresubject to changes in short-term interest rates. We believe that the marketrisk arising from holding these financial instruments is minimal.

 

Our exposure to marketrisks associated with changes in interest rates relates primarily to theincrease or decrease in the amount of interest income earned on our investmentportfolio since we have minimal debt. We ensure the safety and preservation ofinvested funds by limiting default risks, market risk and reinvestment risk. Wemitigate default risk by investing in investment grade securities. Ahypothetical 100 basis point adverse move in interest rates along the entireinterest rate yield curve would not have materially affected the fair value ofour interest sensitive financial instruments as of September 30, 2007.

 

**Item4. Controls and Procedures**

 

For the threemonths ended September30, 2007, our management carried out an evaluation, under thesupervision and with the participation of our President and Chief ExecutiveOfficer and our Executive Vice President, Chief Financial Officer and Treasurer(our principal financial officer and chief accounting officer), of theeffectiveness of our disclosure controls and procedures pursuant toRules 13a-15 and 15d-15 under the Securities Exchange Act of 1934, or theExchange Act, as of the end of the period covered by this report. Based uponthis evaluation, our President and Chief Executive Officer and our ExecutiveVice President, Chief Financial Officer and Treasurer concluded that as of September 30, 2007,our disclosure controls and procedures were effective to ensure that theinformation required to be disclosed by us in reports filed under the ExchangeAct was recorded, processed, summarized and reported within the time periodsspecified in the rules and forms of the SEC. Our management, including ourPresident and Chief Executive Officer and our Executive Vice President, ChiefFinancial Officer and Treasurer, does not expect that our disclosure controlsor our internal controls will prevent all errors and all fraud. A controlsystem, no matter how well designed and operated, cannot provide assurance thatthe objectives of the control system are met, and no evaluation of controls canprovide absolute assurance that all control issues and instances of fraud, ifany, within a company have been detected.

 

Additionally, ourPresident and Chief Executive Officer and our Executive Vice President, ChiefFinancial Officer and Treasurer determined that there were no changes in ourinternal control over financial reporting during the three month period ended September 30, 2007,that have materially affected, or are reasonably likely to materially affect,our internal control over financial reporting.

 

**PART II. OTHER INFORMATION**

 

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

 

We are notcurrently a party to any legal proceedings the negative outcome of which wouldhave a material adverse effect on our business, financial condition or resultsof operations.

 

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

 

Our performance and financialresults are subject to risks and uncertainties, including, but not limited to,the specific risks disclosed in Item 1A. Risk Factors in our Annual Report onForm 10-K for the year ended December 31, 2006. Except as noted below, therehave been no material changes to the risk factors disclosed in the Form 10-K.

 

**RISKSRELATED TO OUR BUSINESS AND INDUSTRY**

 

***If we consume cash more quickly than expected, and if we areunable to raise additional capital, we may be forced to curtail operations.***

 

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As of September30, 2007, we had cash, cash equivalents and marketable securities aggregating$81.4 million. Also as of September 30, 2007, we had deferred revenue ofapproximately $40.6 million relating to research and development activitiesthat are to be provided by us subsequent to September 30, 2007. In addition, inconnection with the acquisition of the SARM Program, we expect to recordadditional deferred revenue in the range of approximately $9.5 million to $10.0million in the fourth quarter of 2007, which represents the estimated fairvalue of the chemistry resources we are to provide BMS under the DiscoveryCollaboration Agreement.  We anticipatethat our capital resources on hand as of September 30, 2007 will be adequate tofund our operations at their current levels at least through December 31,2008.  However, changes may occur thatwould cause us to consume available capital resources before that time.Examples of relevant potential changes that could impact our capital resourcesinclude:

 

•                  thecosts associated with our drug research and development activities, includingthe costs associated with our Phase 2 and Phase 1 clinical developmentprograms for our product candidates PS433540 and PS178990 and additional costswe may incur if our development programs are delayed or are more expensive toimplement than we currently anticipate;

 

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

 

•                  theprogress of our milestone and royalty producing activities;

 

•                  acquisitionsof other businesses or technologies;

 

•                  thepurchase of additional capital equipment and construction of additionallaboratory space;

 

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

 

•                  cashpayments we may be required to make to BMS if we fail to deliver certaincompound libraries under the DARA License Agreement;

 

•                  cashpayments we may be required to make to Organon relating to a termination feeif, prior to August 2010, we exercise our discretionary termination right underthe Organon Agreement;

 

•                  competingtechnological and market developments; and

 

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

 

In May 2007, weraised capital through a public underwritten offering of common stock. Ourissuance of approximately 8.1 million shares of common stock in connection withthis financing resulted in significant dilution in the percentage ownership ofour stockholders that owned stock prior to the financing. It is likely that wewill raise capital in the future. The capital could be raised through public orprivate financings involving debt or common stock or other classes of ourequity. Further issuances of equity securities will further dilute ourstockholders’ percentage ownership. As of September 30, 2007, there were approximately4,198,000 stock options outstanding granted under our various equitycompensation plans, and approximately 1,626,000 warrants outstanding, whichincludes approximately 176,000 warrants issued in connection with the GSKAgreement and approximately 1,450,000 warrants issued in connection with ourOctober 2006 financing transaction. These equity instruments representapproximately 20% of our shares outstanding at September 30, 2007. Thesignificant dilution represented by our outstanding warrants and equitycompensation awards may make it more difficult for us to raise additionalcapital. Additional capital may not be available on favorable terms, or at all.If adequate funds are not available, we may be required to curtail operationssignificantly or to obtain funds by entering into arrangements withcollaborative partners or others that may require us to relinquish rights tocertain of our technologies, products or potential markets that we would nototherwise relinquish.

 

***Because PS433540 is in Phase 2 clinical development andPS178990 is in Phase 1 clinical development, there is a high risk that furtherdevelopment and testing will demonstrate that neither compound is suitable forcommercialization. In addition, because we exclusively licensed each ofPS433540 and PS178990 from BMS, any dispute with BMS may adversely affect ourability to develop and commercialize those product candidates.***

 

We have no products thathave received regulatory approval for commercial sale. PS433540 is in Phase 2clinical development and PS178990 is in Phase 1 clinical development. We facethe substantial risks of failure inherent in developing drugs based on newtechnologies.

 

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Both PS433540 andPS178990 must satisfy rigorous standards of safety and efficacy before the FDAand foreign regulatory authorities will approve either product candidate forcommercial use. Phase 1 clinical trials with PS178990 may not demonstrate that theproduct candidate is sufficiently safe to warrant our continued development ofit, and Phase 2 clinical trials with PS433540 may not demonstrate that it isefficacious with respect to the clinical indications for which we seek todevelop it. We will need to conduct significant additional clinical trialsto demonstrate the safety and efficacy of PS433540 and PS178990 to thesatisfaction of the FDA and foreign regulatory authorities to obtain productapproval.

 

Clinical development is along, expensive and uncertain process. It may take us many years to completeclinical trials, and failure can occur at any stage of trials. Success inpreclinical testing and early clinical trials does not ensure that laterclinical 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.

 

We do not know whetherany future clinical trials of PS433540 or PS178990 will demonstrate sufficientsafety and efficacy necessary to obtain the requisite regulatory approvals orwill result in marketable products. Our failure to adequately demonstrate thesafety and efficacy of PS433540 or PS178990 in their respective developmentprograms will prevent receipt of FDA and foreign regulatory approvals and,ultimately, commercialization.

 

If there is any disputebetween us and BMS regarding our rights under the DARA License Agreement, ourability to develop and commercialize PS433540 may be adversely affected. Anyloss of our rights from BMS could delay or completely terminate our productdevelopment efforts for PS433540 and other DARA compounds licensed 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.

 

***We had net losses in recent years and our future profitabilityis uncertain.***

 

During the ninemonths ended September 30, 2007, we had a net loss of approximately $28.6million.  The net loss was primarily due to costs incurred in our internalproduct development efforts, including the costs of developing our DARA programand the research and development of our other product candidates.

 

In connection withthe acquisition of the SARM program, we expect to record a non-cash charge toearnings in the range of approximately $9.5 million to $10.0 million in the fourthquarter of 2007. The amount of this charge approximates the fair value of thechemistry resources we are to provide to BMS under the Discovery CollaborationAgreement.

 

We expect to incur losses in future periods and these losses are expectedto increase as compared to prior periods as a result of the increased level ofinvestment we plan to make in our internal programs, including our DARA programand our newly acquired SARM program, in the future.

 

Our adoption ofSFAS 123R, which was effective January 1, 2006, increased our compensationcosts and will continue to have a significant impact on our results ofoperations. In addition, under EITF 00-19, the accounting treatment of thewarrants that we issued in our October 2006 equity financing may have asignificant impact on our results of operations, depending on the volatility ofthe market price of our common stock and the assumptions used in calculatingthe fair value of the warrants.

 

On a quarterlybasis, our future operating results are likely to be highly volatile dependingupon our receipt of milestone payments from our collaborators. We may notreceive milestone payments on a regular basis or at all. Our ability to achieveprofitability, if ever, will be significantly impacted by the level of investmentwe plan to make in our internal proprietary programs in the future, as well asthe results of those programs.

 

Continuing net losses maylimit our ability to fund our operations and we may not generate income fromoperations in the future.

 

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

 

**None.**

** **

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

 

None.

 

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

 

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None.

 

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

 

None.

 

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

 
| Exhibits.  | ** ** | ** **                                                                                                                                                                                                                                                                    |
|------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| ** ** | ** ** | ** **                                                                                                                                                                                                                                                                    |
| 10.1       |       | Amendment to Lease  dated September 10, 2007 between Eastpark at 8A and Pharmacopeia, Inc. (1)                                                                                                                                                                                |
|       |       |                                                                                                                                                                                                                                                                          |
| 10.2       |       | Amendment to Lease  dated April 18, 2007 between Eastpark at 8A and Pharmacopeia, Inc. (1)                                                                                                                                                                                    |
|       |       |                                                                                                                                                                                                                                                                          |
| 10.3       |       | Form of Stock Option  Agreement (1) (2)                                                                                                                                                                                                                                       |
|       |       |                                                                                                                                                                                                                                                                          |
| 10.4       |       | Amendment No. 1 to 2007  Incentive Compensation Plan (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)                                             |

 

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(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:  November  5, 2007 | By:                | /s/ Leslie J. Browne,  Ph.D. |
|                               |               | Leslie J. Browne, Ph.D. |
|                               |               | President, Chief  Executive Officer   and Director |
|                               |               | (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       |       | Amendment to Lease  dated September 10, 2007 between Eastpark at 8A and Pharmacopeia, Inc. (1)                                                                                                                                                                                 |
|       |       |                                                                                                                                                                                                                                                                           |
| 10.2       |       | Amendment to Lease  dated April 18, 2007 between Eastpark at 8A and Pharmacopeia, Inc. (1)                                                                                                                                                                                     |
|       |       |                                                                                                                                                                                                                                                                           |
| 10.3       |       | Form of Stock Option  Agreement (1) (2)                                                                                                                                                                                                                                        |
|       |       |                                                                                                                                                                                                                                                                           |
| 10.4       |       | Amendment No. 1 to 2007  Incentive Compensation Plan (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)                                             |

 

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(1)          Filedherewith.

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

 

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