**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

**FORM 1O-Q**

 
| **(Mark One)**                                        |
|-------------------------------------------------------|
| **ý**                                            | **QUARTERLY  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE  ACT OF 1934** |
|                                                  |
| **For the quarterly period ended June 30, 2005** |
|                                                  |
| **Or**                                                |
|                                                  |
| **o**                                                 | **TRANSITION  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE  ACT OF 1934** |
|                                                  |
| **Commission File Number: 0-50523**                   |

 

**PHARMACOPEIA DRUG DISCOVERY, INC.**

(Exact name of registrant 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’s telephone number, including area code)                           |
|                                                                                |
| **Not Applicable**                                                                  |
| (Former name, former address and former fiscal year, if changed since  last report) |

 

Indicateby check mark whether the registrant (1) has filed all reports required tobe filed by Section 13 or 15(d) of the Securities Exchange Act of 1934during the preceding 12 months (or such shorter period that the registrant wasrequired to file such reports) and (2) has been subject to such filingrequirements for the past 90 days.    Yes ý     Noo

 

Indicateby check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2of the Exchange Act). Yes o    Noý

 

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

 
| **Class**                     | ** ** | **Outstanding  at August 1, 2005** |
|-------------------------------|------------|-----------------------------------------|
| Common Stock, $0.01 par value |       | 14,938,271                              |

 

 

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**PHARMACOPEIA DRUG DISCOVERY, INC.**

 

**Form 10-Q**

 

**Table of Contents**

 
| **Item**           | ** ** | ** **                                                                                      | ** ** | ** ** |
|--------------------|------------|-------------------------------------------------------------------------------------------------|------------|------------|
|               |       |                                                                                            |       |       |
| PART I.       |       | FINANCIAL INFORMATION                                                                           |       | 1          |
|               |       |                                                                                            |       |       |
| Item 1.            |       | Financial  Statements (Unaudited):                                                              |       | 1          |
|               |       |                                                                                            |       |       |
|               |       | Balance  Sheets as of June 30, 2005 and December 31, 2004                             |       | 1          |
|               |       |                                                                                            |       |       |
|               |       | Statements of Operations for the Three Months and Six Months Ended June 30,  2005 and 2004 |       | 2          |
|               |       |                                                                                            |       |       |
|               |       | Statements of Cash Flows for the Six Months Ended June 30, 2005  and 2004                  |       | 3          |
|               |       |                                                                                            |       |       |
|               |       | Notes to Unaudited Financial Statements                                                         |       | 4          |
|               |       |                                                                                            |       |       |
| Item 2.            |       | Management’s  Discussion and Analysis of Financial Condition and Results of Operations     |       | 8          |
|               |       |                                                                                            |       |       |
|               |       | Certain Risks Related to Our Business                                                           |       | 16         |
|               |       |                                                                                            |       |       |
| Item 3.            |       | Quantitative  and Qualitative Disclosures about Market Risk                                     |       | 27         |
|               |       |                                                                                            |       |       |
| Item 4.            |       | Controls  and Procedures                                                                        |       | 27         |
|               |       |                                                                                            |       |       |
| PART II.      |       | OTHER INFORMATION                                                                               |       | 27         |
|               |       |                                                                                            |       |       |
| Item 1.            |       | Legal  Proceedings                                                                              |       | 27         |
|               |       |                                                                                            |       |       |
| Item 2.            |       | Unregistered  Sales of Equity Securities and Use of Proceeds                                    |       | 28         |
|               |       |                                                                                            |       |       |
| Item 3.            |       | Defaults  upon Senior Securities                                                                |       | 28         |
|               |       |                                                                                            |       |       |
| Item 4.            |       | Submission  of Matters to a Vote of Security Holders                                            |       | 28         |
|               |       |                                                                                            |       |       |
| Item 5.            |       | Other  Information                                                                              |       | 28         |
|               |       |                                                                                            |       |       |
| Item 6.            |       | Exhibits                                                                                        |       | 28         |
|               |       |                                                                                            |
| Signatures         |       | 30                                                                                              |
|               |       |                                                                                            |
| Index  of Exhibits |       | 31                                                                                              |

 

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**PART I****-FINANCIAL INFORMATION**

 

**Item 1****.  Unaudited Financial Statements**

 

**PharmacopeiaDrug Discovery, Inc.**

**Balance Sheets**

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

 
| ** **                                                                                                                          | ** ** | **June 30,** | ** ** | **December 31,** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------|------------|-----------------------|------------|
| ** **                                                                                                                          | ** ** | **2005**          | ** ** | **2004**              | ** ** |
| ** **                                                                                                                          | ** ** | **(unaudited)**   | ** ** | ** **            | ** ** |
| **ASSETS**                                                                                                                          |       |              |       |                  |       |
| Current assets:                                                                                                                     |       |              |       |                  |       |
| Cash and cash equivalents                                                                                                           |       | $                 | 13,601     |                  | $          | 20,173 |   |
| Marketable securities                                                                                                               |       | 19,114            |       | 20,712                |       |
| Accounts receivable                                                                                                                 |       | 650               |       | 1,062                 |       |
| Prepaid expenses and other current assets                                                                                           |       | 777               |       | 1,062                 |       |
| Total current assets                                                                                                                |       | 34,142            |       | 43,009                |       |
|                                                                                                                                |       |              |       |                  |       |
| Property and equipment, net                                                                                                         |       | 10,986            |       | 11,725                |       |
| Deferred compensation assets due from  Accelrys, Inc.                                                                          |       | —            |       | 2,140                 |       |
| Deferred compensation plan                                                                                                          |       | 2,061             |       | —                |       |
| Other assets                                                                                                                        |       | 173               |       | 131                   |       |
| Total assets                                                                                                                        |       | $                 | 47,362     |                  | $          | 57,005 |   |
|                                                                                                                                |       |              |       |                  |       |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                      |       |              |       |                  |       |
| Current liabilities:                                                                                                                |       |              |       |                  |       |
| Accounts payable                                                                                                                    |       | $                 | 1,921      |                  | $          | 1,414 |   |
| Accrued liabilities                                                                                                                 |       | 2,636             |       | 2,874                 |       |
| Restructuring reserve, current portion                                                                                              |       | 2,083             |       | 2,462                 |       |
| Deferred revenue, current portion                                                                                                   |       | 3,604             |       | 3,501                 |       |
| Total current liabilities                                                                                                           |       | 10,244            |       | 10,251                |       |
|                                                                                                                                |       |              |       |                  |       |
| Deferred compensation plan                                                                                                          |       | 2,061             |       | 2,140                 |       |
| Restructuring reserve, long-term                                                                                                    |       | —            |       | 906                   |       |
|                                                                                                                                |       |              |       |                  |       |
| Commitments and contingencies                                                                                                       |       | —            |       | —                |       |
|                                                                                                                                |       |              |       |                  |       |
| Stockholders’ equity:                                                                                                          |       |              |       |                  |       |
| Preferred stock, $.01 par value, 2,500,000  shares authorized, none issued and outstanding                                          |       | —            |       | —                |       |
| Common stock, $.01 par value, 50,000,000  shares authorized, 12,468,271 and 12,354,695 shares issued and outstanding,  respectively |       | 125               |       | 123                   |       |
| Additional paid-in capital                                                                                                          |       | 50,920            |       | 50,263                |       |
| Accumulated deficit                                                                                                                 |       | (15,585           | )          | (6,235                | )          |
| Accumulated other comprehensive loss                                                                                                |       | (200              | )          | (175                  | )          |
| Deferred compensation                                                                                                               |       | (203              | )          | (268                  | )          |
| Total stockholders’ equity                                                                                                     |       | 35,057            |       | 43,708                |       |
| Total liabilities and stockholders’ equity                                                                                     |       | $                 | 47,362     |                  | $          | 57,005 |   |

 

See accompanying notes to these unaudited financial statements.

 

1

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**PharmacopeiaDrug Discovery, Inc.**

**Statementsof Operations**

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

 
| ** **                                            | ** ** | **For the Three Months** | ** ** | **For the Six Months**  | ** ** |
|-------------------------------------------------------|------------|--------------------------|------------|-------------------------|------------|
| ** **                                            | ** ** | **Ended June 30,**  | ** ** | **Ended June 30,** | ** ** |
| ** **                                            | ** ** | **2005**                 | ** ** | **2004**                | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                            | ** ** | **(unaudited)**          | ** ** | **(unaudited)**         | ** ** |
| Net revenue                                           |       | $                        | 5,231      |                    | $          | 5,107 |   | $ | 10,922 |   | $ | 10,476 |   |
|                                                  |       |                     |       |                    |       |   |   |   |   |
| Collaborative research and development  expense       |       | 4,616                    |       | 4,985                   |       | 10,242 |   | 10,535 |   |
| Proprietary research and development  expense         |       | 2,455                    |       | 1,385                   |       | 4,696 |   | 2,774 |   |
| Sales, general and administrative expense             |       | 3,163                    |       | 2,244                   |       | 5,826 |   | 4,663 |   |
| Restructuring and other charges                       |       | —                   |       | —                  |       | — |   | 5,947 |   |
| Interest and other income, net                        |       | (297                     | )          | (56                     | )          | (506 | ) | (59 | ) |
|                                                  |       | 9,937                    |       | 8,558                   |       | 20,258 |   | 23,860 |   |
| Loss before income taxes                              |       | (4,706                   | )          | (3,451                  | )          | (9,336 | ) | (13,384 | ) |
| Provision for income taxes                            |       | 4                        |       | 10                      |       | 14 |   | 13 |   |
| Net loss                                              |       | $                        | (4,710     | )                       | $          | (3,461 | ) | $ | (9,350 | ) | $ | (13,397 | ) |
|                                                  |       |                     |       |                    |       |   |   |   |   |
| Net loss per share:                                   |       |                     |       |                    |       |   |   |   |   |
| •  Basic and diluted                             |       | $                        | (0.38      | )                       | $          | (0.28 | ) | $ | (0.75 | ) | $ | (1.10 | ) |
|                                                  |       |                     |       |                    |       |   |   |   |   |
| Weighted average number of common stock  outstanding: |       |                     |       |                    |       |   |   |   |   |
| •  Basic and diluted                             |       | 12,427,767               |       | 12,179,890              |       | 12,390,660 |   | 12,167,821 |   |

 

See accompanying notes to these unauditedfinancial statements.

 

2

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**PharmacopeiaDrug Discovery, Inc.**

**Statements of Cash Flows**

**(Amounts inthousands)**

 
| ** **                                                                  | ** ** | **For the Six Months**  | ** ** |
|-----------------------------------------------------------------------------|------------|-------------------------|------------|
| ** **                                                                  | ** ** | **Ended June 30,** | ** ** |
| ** **                                                                  | ** ** | **2005**                | ** ** | **2004** | ** ** |
| ** **                                                                  | ** ** | **(unaudited)**         | ** ** |
| CASH FLOWS FROM OPERATING ACTIVITIES:                                       | ** ** | ** **              | ** ** | ** ** | ** ** |
| Net loss                                                                    |       | $                       | (9,350     | ) | $ | (13,397 | ) |
| Adjustments to reconcile net loss to net  cash used in operating activities |       |                    |       |   |   |
| Depreciation and amortization                                               |       | 1,175                   |       | 906 |   |
| Contibution of stock to 401(k) Plan                                         |       | 203                     |       | 65 |   |
| Amortization of deferred compensation                                       |       | 65                      |       | 34 |   |
| Accelerated vesting of options                                              |       | 191                     |       | — |   |
| Changes in assets and liabilities:                                          |       |                    |       |   |   |
| Accounts receivable                                                         |       | 412                     |       | 531 |   |
| Prepaid expenses and other current assets                                   |       | 285                     |       | (40 | ) |
| Other assets                                                                |       | (42                     | )          | — |   |
| Accounts payable                                                            |       | 507                     |       | (1,586 | ) |
| Accrued liabilities                                                         |       | (238                    | )          | 358 |   |
| Restructuring reserve                                                       |       | (1,285                  | )          | 4,956 |   |
| Deferred revenue                                                            |       | 103                     |       | 54 |   |
| Net cash used in operating activities                                       |       | (7,974                  | )          | (8,119 | ) |
| CASH FLOWS FROM INVESTING ACTIVITIES:                                       |       |                    |       |   |   |
| Capital expenditures, net                                                   |       | (436                    | )          | (5,629 | ) |
| Purchases of marketable securities                                          |       | (5,525                  | )          | (6,171 | ) |
| Proceeds from sales/maturities of  marketable securities                    |       | 7,098                   |       | 19,187 |   |
| Net cash provided by investing activities                                   |       | 1,137                   |       | 7,387 |   |
| CASH FLOWS FROM FINANCING ACTIVITIES:                                       |       |                    |       |   |   |
| Proceeds from issuance of common stock                                      |       | 218                     |       | 192 |   |
| Investment by Accelrys, Inc.                                           |       | 47                      |       | 13,467 |   |
| Net cash provided by financing activities                                   |       | 265                     |       | 13,659 |   |
| Net (decrease) increase in cash and  equivalents                            |       | (6,572                  | )          | 12,927 |   |
| Cash and equivalents, beginning of period                                   |       | 20,173                  |       | 524 |   |
| Cash and equivalents, end of period                                         |       | $                       | 13,601     |   | $ | 13,451 |   |
|                                                                        |       |                    |       |   |   |
| SUPPLEMENTAL SCHEDULE OF CASH FLOW  INFORMATION:                       |       |                    |       |   |   |
| Cash paid during the period for:                                            |       |                    |       |   |   |
| Interest                                                                    |       | $                       | —     |   | $ | — |   |
| Income tax                                                                  |       | $                       | 57         |   | $ | 3 |   |

 

See accompanying notes to these unaudited financial statements.

 

3

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**PharmacopeiaDrug Discovery, Inc.**

**Notes to Unaudited****Financial Statements**

 

**1.  Background and Basis of Presentation**

 

Pharmacopeia Drug Discovery, Inc.(“Pharmacopeia” or the “Company”) was incorporated on May 31, 2002 as awholly owned subsidiary of Accelrys, Inc. (“Accelrys”), formerlyPharmacopeia, Inc.  On April 30,2004, Accelrys spun-off 100 percent of the shares of Pharmacopeia in a pro ratatax-free distribution and distributed to its stockholders of record one shareof Pharmacopeia common stock for every two shares of Accelrys common stockheld. A total of 12,181,471 shares were distributed.

 

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

 

In connection with thedistribution, Accelrys and the Company entered into a series of agreements,including a master separation and distribution agreement, a transition servicesagreement, a tax sharing and indemnification agreement and other agreements,which govern the ongoing relationship between the two companies.

 

Pharmacopeia creates and deliverstherapeutics to address significant medical needs. Using proprietarytechnologies and processes, Pharmacopeia identifies, optimizes, and developsnovel drug candidates through its own internally funded drug discovery programsand in collaboration with major pharmaceutical and biotechnology companies.  These internal programs are primarily focusedon immunobiology and immunological diseases. Pharmacopeia’s later stage portfoliocurrently comprises multiple partnered programs that have been advanced intohuman clinical trials, with further programs in late-stage pre-clinicaldevelopment.  Additionally, Pharmacopeiahas four lead internal programs in advanced preclinical optimization andmultiple partnered programs in discovery.

 

For periods prior to thedistribution date, Pharmacopeia’s financial statements were derived from thefinancial statements and accounting records of Accelrys using the historicalresults of operations and historical basis of the assets and liabilities of theCompany’s business. For periods prior to the distribution date, such financialstatements included allocations of certain Accelrys corporate headquarterassets, liabilities and expenses relating to the Company’s business that havebeen transferred to the Company from Accelrys. General corporate overhead wasallocated based on the Company’s revenue as a percentage of Accelrys totalrevenue. General corporate overhead primarily includes salaries and expensesfor executive management, finance, legal, human resources, information servicesand investor relations, and was $131 thousand for the quarter ended June 30,2004 and $668 thousand for the six months ended June 30, 2004. These costsare included in sales, general and administrative expenses in the accompanyingstatements of operations.  Managementbelieves the assumptions underlying such financial statements are reasonable. Thefinancial statements included herein may not necessarily reflect the Company’sresults of operations, financial position and cash flows in the future or whatits results of operations, financial position and cash flows would have beenhad the Company been a stand-alone company during the periods presented.

 

The accompanying unauditedfinancial statements have been prepared in accordance with U. S. generallyaccepted accounting principles for interim financial information and withinstructions to Form 10-Q and Article 10 of Regulation S-X.  Accordingly, these unaudited financialstatements do not include all of the information and disclosures required by U.S. generally accepted accounting principles for complete financial statements. Inthe opinion of management, all adjustments (consisting of normal recurringaccruals) considered necessary for a fair presentation of the financialstatements have been included.  Interimresults are not necessarily indicative of the results that may be expected forthe year. The unaudited interim financial statements should be read inconjunction with the financial statements and notes thereto included in theCompany’s Annual Report on Form 10-K for the year ended December 31,2004.

 

**2.Significant Collaborations**

 

For the quarters ended June 30,2005 and 2004, the Company’s research collaborations with Schering-Ploughaccounted for 49% and 57%, respectively, of revenue.  For the six months ended June 30, 2005and 2004, the Company’s research collaborations with Schering-Plough accountedfor 57% and 63%, respectively, of revenue. In the third quarter of 2003, the Company entered into new drugdiscovery collaborations with Schering-Plough, which continued certain existingprograms and implemented a number

 

4

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of new activities. The 2003agreements continue the Company’s collaboration with Schering-Plough through August 2006.  Under the 2003 agreements the Company receives researchfunding on a full-time employee (FTE)basis which is recognized as revenue as services are performed.  Schering-Ploughwas obligated to fund a specified number of the Company’s FTEs in the firstyear.  Subsequently, Schering-Ploughdecided to focus on optimization programs and terminated the Company’sscreening activities on Schering-Plough’s behalf. This decision resulted in anapproximately 11% reduction of the number of the Company’s FTEs whomSchering-Plough was obligated to fund.  Schering-Ploughreduced its FTE funding by an additional 41% (or approximately $1.1 million percalendar quarter) effective August 2005. The Company may receive milestone payments upon thesuccessful achievement of preclinical and clinical milestones. Milestonepayments will be recognized as revenue to the extent that milestones areachieved. Upon any successful commercialization of most products resulting fromthis relationship, the Company will be entitled to receive royalties on salesof those products.  Discussions have been initiated regarding thepossible extension or modification of the 2003 agreements.  There can be no assurance that the 2003agreements will be extended beyond August 2006 or that funding will bemaintained at reduced August 2005 levels beyond August 2006 either inthe aggregate or on an FTE basis.

 

For the quarters ended June 30,2005 and 2004, the Company’s research collaborations with N.V. Organon (“Organon”)accounted for 29% and 18%, respectively, of revenue.  For the six months ended June 30, 2005and 2004, the Company’s research collaborations with N.V. Organon (“Organon”)accounted for 25% and 17%, respectively, of revenue.  The principal agreement with Organon, enteredinto in February 2002, has a stated term of five years; however, Organonhas the right to terminate the agreement in December 2005 if Pharmacopeia failsto (i) deliver to Organon a cumulative total of three lead compound seriesand (ii) show demonstrated progress towards one additional lead compoundseries.  The Company has delivered toOrganon three such lead compound series. If Organon so terminates the research collaboration with theCompany on or prior to December 31, 2005, Organon will be permitted totake a credit of up to $1.2 million with respect to certain milestone paymentsthat may become due under the agreement after December 31, 2005 fromOrganon to the Company.  Under this agreement, Pharmacopeia receivesresearch funding to conduct its drug discovery activities to identify andoptimize new drug candidates for multiple therapeutic targets provided byOrganon. This revenue is recognized on a straight-line basis over the term ofthe collaboration. The Company may receive milestone payments upon thesuccessful achievement of preclinical and clinical milestones. These milestonepayments will be recognized as revenue to the extent that milestones areachieved. Upon successful commercialization of any product resulting from thisrelationship, Pharmacopeia will be entitled to receive royalties on sales ofthat product.

 

**3.  Net Loss Per Share**

 

The Company computes net income(loss) per share in accordance with Statement of Financial Accounting Standard No. 128,“Earnings Per Share” (“SFAS 128”).  Underthe provisions of SFAS 128, basic net income (loss) per share is computed bydividing the net income (loss) for the period by the weighted-average number ofcommon shares outstanding during the period. Diluted net income (loss) per share is computed by dividing the netincome (loss) for the period by the weighted-average number of common anddilutive common equivalent shares outstanding during the period.  Diluted earnings per share include thepotentially dilutive effect of outstanding stock options, or other dilutivesecurities. Shares outstanding for the Company for the period prior to thedistribution are calculated based on the 12,181,471 shares distributed in thespin-off, adjusted for unvested restricted shares (see note 1). The Company hasa net loss for the periods presented; accordingly, the inclusion of commonstock equivalents for outstanding stock options would be anti-dilutive and,therefore, the weighted-average shares used to calculate both basic and dilutedloss per share are the same.

 

**4.  Segment Information**

 

The Company classifies its businessoperations in one operating segment.  Allof the Company’s revenues are generated from this segment.  In the quarters ended June 30, 2005 and2004, approximately 47% and 40%, respectively, of the Company’s revenue fromcustomers was derived from within the United States, 52% and 51%, respectively,was derived from Europe, and 1% and 9%, respectively, was derived from Asia.  In the six months ended June 30, 2005and 2004, approximately 46% and 42%, respectively, of the Company’s revenuefrom customers was derived from within the United States, 53% and 52%,respectively, was derived from Europe, and 1% and 6%, respectively, was derivedfrom Asia.

 

**5.  Stock-Based Compensation**

 

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

 

5

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at the time of the distribution ofthe exercise price per share to the market value per share.

 

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

 

In December 2004, the FASB issued Statement of FinancialAccounting Standards (SFAS) No 123 (revised 2004), “Share-Based Payment” (SFAS No. 123R),which replaces SFAS No. 123 and supersedes APB 25.  SFAS No. 123R requires all share-basedpayments to employees, including grants of employee stock options, to be recognizedin the financial statements based on their fair values. The pro formadisclosures previously permitted under SFAS No. 123 no longer will be analternative to financial statement recognition. Under SFAS No. 123R, the Company must determine the appropriatefair value model to be used for valuing share-based payments, the amortizationmethod for compensation cost, and the transition method to be used at date ofadoption. The permitted transition methods include either retrospective orprospective adoption. Under the retrospective option, prior periods may berestated either as of the beginning of the year of adoption or for all periodspresented. The prospective method requires that compensation expense berecorded for all unvested stock options at the beginning of the first quarterof adoption of SFAS No. 123R, while the retrospective methods would recordcompensation expense for all unvested stock options beginning with the firstperiod presented. The Company is currently evaluating the requirements of SFAS No. 123Rand expects that adoption of SFAS No. 123R will have a material impact onthe Company’s results of operations. The Company has not yet determined themethod of adoption or the effect of adopting SFAS No. 123R and it has notdetermined whether the adoption will result in amounts that are similar to thecurrent pro forma disclosures under SFAS No. 123.

 

On April 14, 2005, the Securities and Exchange Commissionannounced the adoption of a new rule that amends the compliance dates forSFAS No. 123R.  The new rule allowscompanies to implement SFAS No. 123R at the beginning of their next fiscalperiod, therefore, the Company will need to be in compliance with SFAS No. 123Rcommencing with its fiscal year beginning January 1, 2006.  The Commission’s new rule does notchange the accounting required by SFAS No. 123R; it changes only the datesfor compliance with the standard.

 

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

 
| ** **                                                                                                                                    | ** ** | **Six Months Ended June 30,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------------|------------|
| ** **                                                                                                                                    | ** ** | **2005**                           | ** ** | **2004** | ** ** |
| Net loss:                                                                                                                                     |       |                               |       |   |   |
| As reported                                                                                                                                   |       | $                                  | (9,350     | ) | $ | (13,397 | ) |
|                                                                                                                                          |       |                               |       |   |   |
| Add: Stock-based employee compensation  expense included in reported net loss                                                                 |       | 256                                |       | $ | 34 |   |
| Deduct: Total stock-based employee  compensation expense determined under fair value based method for all awards,  net of related tax effects |       | (1,099                             | )          | $ | (1,051 | ) |
| Pro forma                                                                                                                                     |       | $                                  | (10,193    | ) | $ | (14,414 | ) |
| Basic and diluted net loss per common  share:                                                                                                 |       |                               |       |   |   |
| As reported                                                                                                                                   |       | $                                  | (0.75      | ) | $ | (1.10 | ) |
| Pro forma                                                                                                                                     |       | $                                  | (0.82      | ) | $ | (1.18 | ) |

 

The fair value of each optiongranted during 2005 and 2004 is estimated on the date of grant using the Black-Scholesoption-pricing model with the following assumptions:

 
| ** **              | ** ** | **2005** | ** ** | **2004** | ** ** |
|-------------------------|------------|----------|------------|----------|------------|
| Dividend yield          |       | 0.00     | %          | 0.00     | %          |
| Expected volatility     |       | 75.00    | %          | 85.24    | %          |
| Risk-free interest rate |       | 3.86     | %          | 4.35     | %          |
| Expected life (years)   |       | 5.0      |       | 5.8      |       |

 

6

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**6.  Restructuring**

 

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

 

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

 
| ** **                        | ** ** | **Costs to  Exit Leased  Facility** | ** ** |
|-----------------------------------|------------|-------------------------------------|------------|
| Balance at December 31, 2004 |       | $                                   | 3,368      |   |
| Lease payments                    |       | (1,285                              | )          |
| Balance at June 30, 2005     |       | $                                   | 2,083      |   |

 

**7**.  Commitments and Contingencies

** **

On August 23, 2004, Columbia University Scienceand Technology Ventures provided the Company with a notice of material breachof the License Agreement (the “Original Agreement”) dated July 16, 1993and as amended October 6, 1995 among the Company, the Trustees of ColumbiaUniversity in the City of New York (“Columbia”) and Cold Spring HarborLaboratory (“Cold Spring”) arising from an alleged underpayment by the Companyof certain royalties under the Original Agreement.  Pursuant to theterms of the Original Agreement, the Company, Columbia and Cold Spring enteredinto good faith negotiations in an effort to resolve the dispute.

 

In accordance with FASB Statement No. 5, “Accountingfor Contingencies” and FASB Interpretation No. 14, “Reasonable Estimationof the Amount of a Loss”, the Company accrued and recognized as operatingexpense a charge of $1.0 million in the year ended December 31, 2004 forthe probable outcome of the resolution.

 

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

 

Under the Agreement, the Company has an exclusivelicense for technology used in its proprietary combinatorial chemistry encodingtechnology, Encoded Combinatorial Libraries on Polymeric Support, orECLiPS®.  The Agreement obligates the Company to pay a minimum annuallicense fee of $100 thousand to Columbia and Cold Spring.  The term of theAgreement is the later of (i) 20 years from July 16, 1993 or (ii) theexpiration of the last patent relating to the technology, at which time theCompany will have a fully paid license to the technology.  The licensegranted to the Company under the Agreement can be terminated by Columbia andCold Spring (i) upon 30 days written notice to the Company if the Companymaterially breaches the Agreement and the Company fails to cure such materialbreach in accordance with the Agreement or (ii) if the Company commits anyact of bankruptcy, becomes insolvent, files a petition under any bankruptcy or insolvencyact or has any such petition filed against it that is not dismissed within 60days.  The Company is obligated to pay royalties to Columbia and ColdSpring based upon net sales of pharmaceutical products the Company develops aswell as a percentage of all other payments (such as milestones and royalties)the Company receives from customers in cases in which the Company has utilizedthe technology licensed from Columbia and Cold Spring.

 

**8.  Subsequent Event – Sale of Securities**

 

On July 28, 2005, the Company entered into purchase agreements to sell an aggregate 2,470,000 shares of newly issued common stock (the “Shares”) to institutional investors (collectively, the “Purchasers”) at a price of $3.43 per share (the “Private Placement”).  On August 1, 2005, the Company sold the Shares and realized gross proceeds of approximately $8.47 million from the Private Placement.  The Company expects net proceeds of approximately $7.63 million from the Private Placement after deducting fees payable to the placement agent and other transaction expenses.

 

Pursuant to the purchase agreements executed in connection with the Private Placement, the Company agreed to file a

 

7

 

registration statement on Form S-3 with the Securities and Exchange Commission (the “Commission”) as soon as reasonably practicable, but in no event later than 10 days after the closing of the Private Placement, to register the resale of the Shares.  The Company also agreed to use its best efforts, subject to the receipt of necessary information from the Purchasers, to cause the Commission to declare the registration statement effective within 60 days after the closing of the Private Placement if the registration statement receives no Commission review or 120 days after the closing of the Private Placement if the registration statement receives Commission review (the “Required Effectiveness Date”).  In addition, the Company agreed to use its best efforts, subject to receipt of necessary information from the Purchasers, to keep the registration statement effective until the earliest of (i) 2 years after the effective date of the registration statement or (ii)  the date on which the Shares become eligible for resale pursuant to Rule 144(k) under the Securities Act of 1933, as amended (the “Securities Act”) (the “Effectiveness Period”).

 

If (i) the registration statement is not filed on or prior to 10 days after the closing of the Private Placement or the Company fails to file with the Commission a request for acceleration in accordance with Rule 461 promulgated under the Securities Act, within 5 trading days after the date that the Company is notified by the Commission that the registration statement will not be “reviewed,” or will not be subject to further review, (ii) the registration statement filed is not declared effective by the Commission by the Required Effectiveness Date, or (iii) after the registration statement is filed with and declared effective by the Commission, such registration statement ceases to be effective as to all the Shares to which it is required to relate at any time prior to the expiration of the Effectiveness Period without being succeeded within 10 trading days by an amendment to such registration statement or by a subsequent registration statement filed with and declared effective by the Commission, or (iv) the Company’s common stock is not listed or quoted, or is suspended from trading on, the Nasdaq National Market or the facilities of any national securities exchange on which the common stock is then traded for a period of 3 trading days (any such failure or breach being referred to as an “Event,” and the date on which such Event occurs being referred to as “Event Date”), then: (x) on each such Event Date the Company shall pay to each Purchaser an amount in cash, as partial liquidated damages and not as a penalty, equal to 1.0% of the aggregate purchase price paid by such Purchaser pursuant to the purchase agreements; and (y) on each monthly anniversary of each such Event Date thereof (if the applicable Event shall not have been cured by such date) until the applicable Event is cured, the Company shall pay to each Purchaser an amount in cash, as partial liquidated damages and not as a penalty, equal to 1.0% of the aggregate purchase price paid by such Purchaser pursuant to the purchase agreements.  The purchase agreements provide that such payments shall not constitute the Purchasers’ exclusive remedy for such events.  If the Company fails to pay any such liquidated damages in full within 7 days after the date payable, the Company will pay interest thereon at a rate of 10.0% per annum (or such lesser maximum amount that is permitted to be paid by applicable law) to the Purchasers, accruing daily from the date such liquidated damages are due until such amounts, plus all such interest thereon, are paid in full.

 

**Item 2**.Management’s Discussion and Analysis of Financial Condition and Results OfOperations.

** **

Forward-LookingStatements

 

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

 

•                  our intentions regardingthe establishment and continuation of drug discovery and development collaborationswith leading pharmaceutical and biotechnology organizations, in particular, thecontinuation and funding level of such continuation of our existing collaborationswith Schering-Plough and N.V. Organon;

 

•                  our ability tobuild our pipeline of novel drug candidates, both through our owninternally-funded drug discovery programs and third party collaborations;

 

•                  our ability toraise additional capital;

 

•                  our expectationsregarding the potential benefits to us of our separation from Accelrys, ourformer parent;

 

•                  our anticipatedoperating results, financial condition, liquidity and capital resources;

 

8

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•                  our expectationsconcerning the development priorities of our collaborative partners, and theirability to successfully develop compounds;

 

•                  our expectationsconcerning the legal protections afforded by U.S. and international patentlaws;

 

•                  our beliefs asto the trends and opportunities impacting us and our history;

 

•                  our estimates ofthe market opportunity for our product candidates;

 

•                  our ability toacquire or invest in complementary businesses or technologies, or to in-licensepotential product candidates; and

 

•                  the distributionbeing tax-free to Accelrys and its stockholders for federal income tax purposesand under section 355 of the Internal Revenue Code of 1986, as amended.

 

In some cases,you can identify forward-looking statements by terminology, such as “expects,” “anticipates,”“intends,” “plans,” “believes,” “seeks,” “estimates,” or the negative of suchterms or other similar expressions. Factors that could cause or contribute to differences in results andoutcomes include, without limitation, those discussed elsewhere in this Reportin Item 2.  “Management’s Discussion andAnalysis of Financial Condition and Results of Operations” (including a subsection thereofentitled “Certain Risks Related to Our Business”) and discussed in our otherSecurities and Exchange Commission (“SEC”) filings.

 

We urge you tocarefully read and consider the disclosures found in these filings, all ofwhich are available in the SEC EDGAR database at www.sec.gov.  You are urged not to place undue reliance onany such forward-looking statements, any of which may turn out to be wrong dueto inaccurate assumptions, unknown risks, uncertainties or other factors.  We undertake no obligation to (and expresslydisclaim any such obligation to) revise or update the statements made herein orthe risk factors that may relate thereto whether as a result of newinformation, future events or otherwise.

 

**TheCompany**

** **

**Overview**

** **

Wecreate and deliver therapeutics to address significant medical needs.  Using proprietary technologies and processes,we identify, optimize and develop novel drug candidates through our owninternally-funded drug discovery programs and in collaboration with majorpharmaceutical and biotechnology companies. These internal programs are focused on immunobiology and immunological diseases.  Our later stage portfolio currently comprisesmultiple partnered programs that have been advanced into human clinical trials,with further programs in late-stage pre-clinical development.  Additionally, we have four lead internalprograms in advanced preclinical optimization and multiple partnered programsin discovery.

 

Weconduct proprietary research focused on immunobiology and immunologicaldiseases to discover novel drug candidates with commercial potential. Incontrast to our collaboration business, we fully fund these programs ourselves.Consequently we retain all intellectual property and ownership rights in anycompounds discovered. At an appropriate point, we may determine to license oneor more of these compounds to a third party (usually a larger pharmaceutical orbiotechnology organization). Out-licensing at an appropriate point in thecompound’s development would enable us to take advantage of the additionalresources, expertise and technologies of the licensee company in order tofurther the development of the compound and would provide us with up-front feesand milestone payments, as well as recurring royalty payments if thesecompounds are developed into new commercial drugs. Out-licensing would convertour proprietary programs into collaborative partnerships, typically onfavorable terms for us due to the reduction in the risk for the partner and theinvestment that we have made advancing the program to the stage at which it islicensed.

 

Wechose to focus our internally-funded drug discovery programs on immunobiologyand immunological diseases such as rheumatoid arthritis, psoriasis and otherinflammatory diseases for several reasons:

 

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

 

9

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

 

•                  The global market for immunosuppressanttherapy for transplant patients alone is in excess of $4 billion per year, and webelieve a drug developed to meet the needs of such patients is likely to alsooffer medical benefit and commercial opportunity in other chronic diseases withsimilar underlying etiologies.

 

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

 

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

 

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

 

Inaddition to our proprietary research, we have drug discovery collaborationswith leading pharmaceutical companies and biotechnology companies.  In contrast to many of our partneringefforts in the past (with the key exceptions of our relationships withSchering-Plough and Organon), we now seek to establish alliances that are broadin scope and multi-year in term to deliver compounds that are further developedthan in our previous collaborations; ideally compounds that are clinicalcandidates, as opposed to hits or leads. We intend to deliver later-stage compounds, which are of greater value andwe will seek to retain a larger share of ownership (as represented by increasedroyalties on net sales that may result from the program advancing to themarket) in those compounds.

 

Wecontribute the following to our collaborative drug discovery programs:

 

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

 

•                  pharmacological results *in vitro*and*in vivo* generated by us or through theuse of contract research organizations;

 

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

 

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

 

Todate, our collaborative drug discovery efforts have resulted in theidentification of four clinical compounds, which are under development by ourcollaborators.  We initially identifiedp38 kinase inhibitor lead compounds in 1997 and entered into a collaborativepartnering agreement with Bristol-Myers Squibb in 1999.  This collaboration resulted in a compoundthat entered clinical trials in August 2003.  A second compound discovered in ourlaboratories, aimed at an allergic asthma indication, was the basis of acollaboration with Daiichi Pharmaceutical Co. and resulted in a drug candidatethat entered clinical trials in November 2003.  A third clinical compound, which also targetsa respiratory indication, was developed in collaboration with Schering-Plough andcommenced clinical trials in December 2003.  The Schering-Plough relationship alsoproduced a second compound, our fourth clinical candidate, which enteredclinical trials in March 2004 for an inflammation indication.  Associated with these development programs,we have received milestone payments from each of Bristol-Myers Squibb, Daiichiand Schering-Plough and, to the extent the compounds successfully progressthrough clinical development, we will be entitled to receive additionalmilestone payments.  We are also entitled under the agreements with eachof these partners to receive royalties on the commercial sale, if any, of mostnew drugs resulting from these collaborations. However, numerous additional studies are required to fully assess thepotential of these clinical candidates, which are proprietary to Pharmacopeia,to reach the marketplace, and the results from preclinical studies and clinicalstudies conducted to date with these compounds are not necessarily indicativeof the results that may be obtained in future clinical studies.   In addition to the compounds in the clinic,six more programs are at various stages of preclinical development, the pointat which compounds are tested for safety in animals prior to filing anInvestigational New Drug application and their introduction into humans duringPhase I of clinical development.

 

Preclinicaland clinical development of drug candidates is a long, expensive and uncertainprocess.  Our candidates are at an early

 

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stage,as none of our compounds are contained in products that have receivedregulatory approval for commercial sale.  All of our compounds, includingour partnered clinical candidates, face the substantial risks of failureinherent in developing drugs.  At any stage of the clinical developmentprocess, our collaborators, or we, may decide to discontinue development of ourproduct candidates.  We do not expect that our product candidates will becommercially available for many years, if ever.  Therefore, we continue topursue the discovery and initial development of product candidates using ourintegrated technology platform in both our internal and collaborative programsto implement our strategy of seeking to reduce the cost and time incurred bythe pharmaceutical industry in developing drug candidates.  To date, wehave not identified a therapeutic candidate that has been developed into acommercial drug and, although we have received license and milestone fees, wemay never receive any royalty payments, or any additional license and milestonefees, under our current or any future collaborations.

 

Fromtime to time we have considered, and we will continue to consider in thefuture, if and when any appropriate opportunities become available, strategicinitiatives intended to further the development of our business.  We believe that there are opportunities toexpand our product pipeline through the acquisition or in-licensing of, orinvestment in, product development candidates, and we intend to continue toexplore and evaluate those opportunities.

 

OnApril 30, 2004, Accelrys, then our sole stockholder, distributed alloutstanding shares of our common stock to the holders of common stock ofAccelrys.  We thereafter began operations as an independent, separatelytraded and publicly held company.  The distribution was made withoutpayment of any consideration or the exchange of any shares by Accelrysstockholders.  In the distribution, Accelrys stockholders received oneshare of our common stock for every two shares of Accelrys common stock held ofrecord.  The stock traded as when issued from April 20, 2004 through April 30,2004 and began regular trading on The NASDAQ National Market on May 3,2004 under the trading symbol “PCOP.”

 

**Liquidityand Capital Resources**

** **

Prior to the distribution we had funded ouractivities primarily through Accelrys’ consolidated operations, including revenuederived from collaborative partnerships, and milestone payments. Accelryscontributed cash, cash equivalents and marketable securities such that uponconsummation of the distribution on April 30, 2004, we had a cash, cashequivalents and marketable securities balance aggregating $46.5 million.

 

As of June 30,2005, we had cash, cash equivalents and marketable securities of $32.7 millioncompared to $40.9 million at December 31, 2004, representing 69% and 72%of our total assets, respectively. We invest excess cash in highly liquidinvestment-grade marketable securities, including corporate bonds and UnitedStates government and agency securities.

 

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

 
| ** **                                | ** ** | **Six months ended**    | ** ** |
|-------------------------------------------|------------|-------------------------|------------|
| ** **                                | ** ** | **June 30,**       | ** ** |
| ** **                                | ** ** | **2005**                | ** ** | **2004** | ** ** |
| ** **                                | ** ** | **(in thousands of $)** | ** ** |
| Net loss                                  |       | $                       | (9,350     | ) | $ | (13,397 | ) |
| Adjustments for noncash operating items   |       | 1,634                   |       | 1,005 |   |
|                                      |       |                    |       |   |   |
| Net cash operating loss                   |       | (7,716                  | )          | (12,392 | ) |
| Net change in assets and liabilities      |       | (258                    | )          | 4,273 |   |
|                                      |       |                    |       |   |   |
| Net cash used in operating activities     |       | $                       | (7,974     | ) | $ | (8,119 | ) |
|                                      |       |                    |       |   |   |
| Net cash provided by investing activities |       | $                       | 1,137      |   | $ | 7,387 |   |
|                                      |       |                    |       |   |   |
| Net cash provided by financing activities |       | $                       | 265        |   | $ | 13,659 |   |

 

**Netcash used in operating activities**

 

Net operating cashoutflows for the six months ended June 30, 2005 have resulted primarilyfrom our operating loss due to an increase in the funding of our internal drugdiscovery efforts, the payment of restructuring expenses related to the 2004

 

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consolidation ofour facilities and the payment to Columbia of $500 thousand in connection withthe settlement of our dispute.  Our cashflows from operating activities for the six months ended June 30, 2005included a $750 thousand payment from Allergan received as a result of ourgrant to Allergan of an option to license compounds from us.

 

**Net cashprovided by investing activities**

** **

Net cash providedby investing activities for the six months ended June 30, 2005 relatesprimarily to the net sales and maturities of marketable securities.

 

**Net cashprovided by financing activities**

** **

Net cash providedby financing activities for the six months ended June 30, 2005 consists ofa capital contribution made to us by Accelrys and proceeds from the issuance ofcommon stock in connection with our employee stock option and stock purchase plans.

 

**Liquidity andCapital Resources Outlook**

 

We expect to continue to use ourcapital to fund operating losses. We expect that our research and developmentexpenditures will increase in the future as we increase our internal drugdiscovery efforts.  Conducting our owndrug discovery research is a key component of our business model.

 

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

 

On July 28, 2005, we entered into purchase agreements to sell an aggregate 2,470,000 shares of newly issued common stock (the “Shares”) to institutional investors (collectively, the “Purchasers”) at a price of $3.43 per share (the “Private Placement”).  On August 1, 2005, we sold the Shares and realized gross proceeds of approximately $8.47 million from the Private Placement.  We expect net proceeds of approximately $7.63 million from the Private Placement after deducting fees payable to the placement agent and other transaction expenses.

 

Pursuant to the purchase agreements executed in connection with the Private Placement, the Company agreed to file a registration statement on Form S-3 with the Securities and Exchange Commission (the “Commission”) as soon as reasonably practicable, but in no event later than 10 days after the closing of the Private Placement to register the resale of the Shares.  The Company also agreed to use its best efforts, subject to the receipt of necessary information from the Purchasers, to cause the Commission to declare the registration statement effective within 60 days after the closing of the Private Placement if the registration statement receives no Commission review or 120 days after the closing of the Private Placement if the registration statement receives Commission review (the “Required Effectiveness Date”).  In addition, the Company agreed to use its best efforts, subject to receipt of necessary information from the Purchasers, to keep the registration statement effective until the earliest of (i) 2 years after the effective date of the registration statement or (ii)  the date on which the Shares become eligible for resale pursuant to Rule 144(k) under the Securities Act of 1933, as amended (the “Securities Act”) (the “Effectiveness Period”).

 

If (i) the registration statement is not filed on or prior to 10 days after the closing of the Private Placement or the Company fails to file with the Commission a request for acceleration in accordance with Rule 461 promulgated under the Securities Act, within 5 trading days after the date that the Company is notified by the Commission that the registration statement will not be “reviewed,” or will not be subject to further review, (ii) the registration statement filed is not declared effective by the Commission by the Required Effectiveness Date, or (iii) after the registration statement is filed with and declared effective by the Commission, such registration statement ceases to be effective as to all the Shares to which it is required to relate at any time prior to the expiration of the Effectiveness Period without being succeeded within 10 trading days by an amendment to such registration statement or by a subsequent registration statement filed with and declared effective by the Commission, or (iv) the Company’s common stock is not listed or quoted, or is suspended from trading on, the Nasdaq National Market or the facilities of any national securities exchange on which the common stock is then traded for a period of 3 trading days (any such failure or breach being referred to as an “Event,” and the date on which such Event occurs being referred to as “Event Date”), then: (x) on each such Event Date the Company shall pay to each Purchaser an amount in cash, as partial liquidated damages and not as a penalty, equal to 1.0% of the aggregate purchase price paid by such Purchaser pursuant to the purchase agreements; and (y) on each monthly anniversary of each such Event Date thereof (if the applicable Event shall not have been cured by such date) until the applicable Event is cured, the Company shall pay to each Purchaser an amount in cash, as partial liquidated damages and not as a penalty, equal to 1.0% of the aggregate purchase price paid by such Purchaser pursuant to the purchase agreements.  The purchase agreements provide

 

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that such payments shall not constitute the Purchasers’ exclusive remedy for such events.  If the Company fails to pay any such liquidated damages in full within 7 days after the date payable, the Company will pay interest thereon at a rate of 10.0% per annum (or such lesser maximum amount that is permitted to be paid by applicable law) to the Purchasers, accruing daily from the date such liquidated damages are due until such amounts, plus all such interest thereon, are paid in full.

 

We are obligated to pay approximately $2.1 million in costs inconnection with a leased facility we vacated in the first quarter of 2004. Thelease on this facility expires in April 2006.  We are also obligated to pay approximately$500 thousand in June 2006 in connection with the settlement of ourdispute with Columbia and Cold Spring.

 

We anticipate that ourcapital resources will be adequate to fund our operations at their currentlevels at least through 2006. However,there can be no assurance that changes will not occur that would consumeavailable capital resources before then. Our capital requirements depend onnumerous factors, including our ability to continue and extend existing collaborativeagreements and to enter into additional arrangements.  Approximately 78% and 75% of our revenue forthe three months ended June 30, 2005 and 2004, respectively, was generatedfrom our collaborations with Schering Plough and N.V. Organon.  Approximately 82% and 80% of our revenue forthe six months ended June 30, 2005 and 2004, respectively, was generatedfrom our collaborations with Schering Plough and N.V. Organon.  The collaborations with Schering Plough arescheduled to expire in August 2006, and Schering-Plough reduced by 41% (orapproximately $1.1 million per calendar quarter) its FTE funding under the 2003agreements effective August 2005. The principal agreement withOrganon, entered into in February 2002, has a stated term of five years;however, Organon has the right to terminate the agreement in December 2005if we fail to (i) deliver to Organon a cumulative total of three leadcompound series and (ii) show demonstrated progress towards one additionallead compound series.  We have deliveredto Organon three such lead compound series, and management believes we havedemonstrated progress towards one additional lead compound series.  If Organon so terminates the researchcollaboration with us on or prior to December 31, 2005, Organon will bepermitted to take a credit of up to $1.2 million with respect to certainmilestone payments that may become due under the agreement after December 31,2005 from Organon to us. In addition, ourcapital requirements depend on competing technological and market developments,changes in our existing collaborative relationships, the cost of filing,prosecuting, defending, and enforcing patent claims and other intellectualproperty rights and the outcome of related litigation, the purchase ofadditional capital equipment, acquisitions of other businesses or technologies,and the progress of our customers’ milestone and royalty producing activities.Prior to exhausting our current capital resources, we will need to raiseadditional funds to finance our operating activities or enter into strategicinitiatives intended to further the development of our business. There can beno assurance that additional funding, if necessary, will be available onfavorable terms, if at all.  Ourforecasts of the period of time through which our financial resources will beadequate to support our operations are forward-looking information, and actualresults could vary.  The factorsdescribed earlier in this paragraph will impact our future capital requirementsand the adequacy of our available funds.

 

**Results of Operations**

 

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

** **

Our net revenue increased 2% to $5.2 millionin the quarter ended June 30, 2005 compared to $5.1 million in the quarterended June 30, 2004.  Net revenueconsists of the funding of our collaborative research activities, as well asour receipt of milestones, success fees and license revenue if and as ourdiscoveries progress through our collaborators’ development processes.  Net revenue for the three months ended June 30,2005 and 2004 is summarized as follows:

 
| ** **                     | ** ** | **For the Three Months** | ** ** |
|--------------------------------|------------|--------------------------|------------|
| ** **                     | ** ** | **Ended June 30,**  | ** ** |
| ** **                     | ** ** | **2005**                 | ** ** | **2004** | ** ** |
| ** **                     | ** ** | **(in thousands of $)**  | ** ** |
|                           |       |                     |       |   |   |
| Collaborative research funding |       | $                        | 4,548      |   | $ | 5,032 |   |
| Milestones and success fees    |       | 500                      |       | — |   |
| License revenue                |       | 183                      |       | 75 |   |
|                           |       | $                        | 5,231      |   | $ | 5,107 |   |

 

Schering-Plough accounted for 49% and 57% ofour net revenue in the three months ended June 30, 2005 and 2004,respectively.  N.V. Organon accounted for29% and 18% of our net revenue in the three months ended June 30, 2005 and2004, respectively.  N.V. Organon accountedfor 100% of the milestone payments and success fees that we received in thethree months ended June

 

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30, 2005. The decrease in collaborative research funding was largely due toreduced funding from our collaboration with Schering Plough.

 

Collaborativeresearch and development expense includes the labor, material, equipment andallocated facilities cost of our scientific staff that is working oncollaborative partnerships. Collaborative research and development expenses decreased 7% to $4.6million for the three months ended June 30, 2005, compared to $5.0 millionfor the three months ended June 30, 2004. This decrease was due to decreased resources allocated to ourcollaborative partnerships.

 

Proprietaryresearch and development expense includes labor, material, equipment andallocated facilities cost of scientific staff working on self-funded internaldrug discovery programs. Our internal drug discovery projects are focused onthe creation of new small molecule therapeutics using proprietary technologiesand our proprietary collection of compounds to identify and optimize novel drugcandidates. Because of the speculative nature of these internal drug discoveryprojects, it is not possible to estimate completion dates, or estimated costsof completion. Additionally, from time to time, depending on requirements undercollaborative partnership work, certain staff and other research anddevelopment resources may be temporarily redirected to collaborativepartnership work which redirection may also delay or impact the cost ofinternal drug discovery projects. Consistent with our strategy to increase ourinvestment in internal drug discovery programs, proprietary research anddevelopment expenses increased 77% to $2.5 million for the three months ended June 30,2005 compared to $1.4 million for the three months ended June 30, 2004.

 

Sales,general and administrative expense increased by 41% to $3.2 million for thethree months ended June 30, 2005 compared to $2.2 million for the threemonths ended June 30, 2004.  The increase in sales, general andadministrative expense is primarily attributable to the severance payableto the Company’s former Chief Operating Officer.  In connection with our severance cash paymentobligations we recorded a charge of approximately $770 thousand in the quarterending June 30, 2005.  In addition, werecorded a non-cash charge of approximately $191 thousand related to theaccelerated vesting of stock options. Also contributing to the increase were additional costs associated with our being an independent company,including salary and expenses for executive management, finance, legal, humanresources, information services, investor relations, and corporategovernance.  This was offset by themoving costs incurred in connection with the consolidation of ourfacilities.  Prior to the distribution,general corporate overhead had been allocated based on our revenue as apercentage of Accelrys’ total revenue.

 

Interestand other income, net increased to $297 thousand for the three months ended June 30,2005 compared to $56 thousand for the three months ended June 30, 2004. This increase is due to higher cash balances and yields.

 

Werecorded an income tax provision of $4 thousand and $10 thousand for the threemonths ended June 30, 2005 and 2004, respectively, related to minimumstate income taxes.

 

Asa result of the net revenues and expenses described above, we generated a netloss of $4.7 million ($0.38 per basic and diluted share) for the three monthsended June 30, 2005, compared to a net loss of $3.5 million ($0.28 perbasic and diluted share) for the three months ended June 30, 2004.

 

**Six months ended June 30,2005 and 2004**

** **

Our net revenue increased 4% to $10.9 millionin the six months ended June 30, 2005 compared to $10.5 million in the sixmonths ended June 30, 2004.  Netrevenue consists of the funding of our collaborative research activities, aswell as our receipt of milestones, success fees and license revenue if and asour discoveries progress through our collaborators’ development processes.  Net revenue for the six months ended June 30,2005 and 2004 is summarized as follows:

 
| ** **                     | ** ** | **For the Six Months**  | ** ** |
|--------------------------------|------------|-------------------------|------------|
| ** **                     | ** ** | **Ended June 30,** | ** ** |
| ** **                     | ** ** | **2005**                | ** ** | **2004** | ** ** |
| ** **                     | ** ** | **(in thousands of $)** | ** ** |
|                           |       |                    |       |   |   |
| Collaborative research funding |       | $                       | 9,056      |   | $ | 9,339 |   |
| Milestones and success fees    |       | 1,500                   |       | 1,000 |   |
| License revenue                |       | 366                     |       | 137 |   |
|                           |       | $                       | 10,922     |   | $ | 10,476 |   |

 

Schering-Plough accounted for 57% and 63% ofour net revenue in the six months ended June 30, 2005 and 2004,respectively.

 

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N.V. Organon accounted for 25% and 17% of ournet revenue in the six months ended June 30, 2005 and 2004,respectively.  Schering-Plough and N.V.Organon accounted for 100% of the milestone payments and success fees that wereceived for the six months ended June 30, 2005 and 2004.  The decrease in collaborative researchfunding was due to reduced funding from our collaboration with Schering-Plough.

 

Collaborativeresearch and development expense includes the labor, material, equipment andallocated facilities cost of our scientific staff that are working oncollaborative partnerships. Collaborative research and development expenses decreased 3% to $10.2million in the six months ended June 30, 2005 compared to $10.5 million inthe six months ended June 30, 2004. This decrease was due to decreased resources allocated to ourcollaborative partnerships.

 

Proprietaryresearch and development expense includes labor, material, equipment andallocated facilities cost of scientific staff working on self-funded internaldrug discovery programs. Our internal drug discovery projects are focused onthe creation of new small molecule therapeutics using proprietary technologiesand our proprietary collection of compounds to identify and optimize novel drugcandidates. Because of the speculative nature of these internal drug discoveryprojects, it is not possible to estimate completion dates, or estimated costsof completion. Additionally, from time to time, depending on requirements undercollaborative partnership work, certain staff and other research anddevelopment resources may be temporarily redirected to collaborativepartnership work, which redirection may also delay or impact the cost ofinternal drug discovery projects. Consistent with our strategy to increase ourinvestment in internal drug discovery programs, proprietary research anddevelopment expenses increased 69% to $4.7 million in the six months ended June 30,2005 compared to $2.8 million in the six months ended June 30, 2004.

 

Sales,general and administrative expense increased by 25% to $5.8 million in the sixmonths ended June 30, 2005 compared to $4.7 million in the six monthsended June 30, 2004.  The increase in sales, general andadministrative expense is primarily attributable to the severance payableto the Company’s former Chief Operating Officer.  In connection with our severance cash paymentobligations we recorded a charge of approximately $770 thousand in the quarterending June 30, 2005.  In addition, werecorded a non-cash charge of approximately $191 thousand related to theaccelerated vesting of stock options. Also contributing to the increase were additional costs associated with our being an independent company,including salary and expenses for executive management, finance, legal, humanresources, information services, investor relations, and corporate governance.This was offset by the moving costs incurred in the six months ended June 30,2004, in connection with the consolidation of our facilities.  Prior to the distribution, general corporateoverhead had been allocated based on our revenue as a percentage of Accelrys’total revenue.

 

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

 

Interestand other income, net increased to $506 thousand in the six months ended June 30,2005 compared to $59 thousand in the six months ended June 30, 2004. This increase is due to higher cash balances and yields.

 

Werecorded an income tax provision of $14 thousand and $13 thousand in the sixmonths ended June 30, 2005 and 2004, respectively, related to minimumstate income taxes.

 

Asa result of the net revenues and expenses described above, we generated a netloss of $9.4 million ($0.75 per basic and diluted share) in the six monthsended June 30, 2005, compared to a net loss of $13.4 million ($1.10 perbasic and diluted share) in the six months ended June 30, 2004.

 

**Contractual Obligations**

 

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

 

**Net Loss Outlook**

 

We have had net losses in recent years and weexpect to incur losses in future periods. Our net loss is highly dependent onthe continued funding and success of our research and development programs withour existing collaborators.  One suchcollaborator, Schering-Plough, has exercised its right to reduce by 41% (orapproximately $1.1 million per calendar quarter) its

 

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funding of our FTEs effective August 2005.  The principal agreement withOrganon, entered into in February 2002, has a stated term of five years;however, Organon has the right to terminate the agreement in December 2005if we fail to (i) deliver to Organon a cumulative total of three leadcompound series and (ii) show demonstrated progress towards one additionallead compound series.  We have deliveredto Organon three such lead compound series, and management believes we havedemonstrated progress towards one additional lead compound series.  If Organon so terminates the researchcollaboration with us on or prior to December 31, 2005, Organon will bepermitted to take a credit of up to $1.2 million with respect to certainmilestone payments that may become due under the agreement after December 31,2005 from Organon to us.  On a quarterly basis, our future operatingresults are likely to be highly volatile because they depend upon our receiptof milestone payments from our collaborators. We may not receive milestonepayments on a regular basis or at all. In addition, our ability to achieveprofitability will be significantly impacted by the increased level ofinvestment we have determined to make in our internal proprietary programs inthe future as well as the results of those programs. We believe that we mayincur higher sales, general and administrative costs than the historicalamounts reflected in the financial statements since we are now operating as anindependent public company. There is no assurance that we will ever achieveprofitable operations, or that profitable operations, if achieved, could besustained on a continuing basis.

 

**Critical Accounting Policies**

 

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

 

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

 

Revenue earned related to up-front product and technology license feesis recognized in accordance with Staff Accounting Bulletin 104 issued by theSEC. Accordingly, amounts received under multiple-element arrangementsrequiring ongoing services or performance by us are recognized over the periodof such services or performance.

 

Revenue from milestones are recognized when earned, as evidenced bywritten acknowledgement from the collaborator, provided that (i) themilestone event is substantive and its achievability was not reasonably assuredat the inception of the agreement, and (ii) our performance obligationafter the milestone achievement will continue to be funded by the collaboratorat a comparable level to before the milestone achievement. If both of thesecriteria are not met, the milestone payment is recognized over the remainingminimum period of our performance obligations under the arrangement. Royaltiesare recognized as earned in accordance with the terms of various research andcollaboration agreements.

 

*Long-Lived Assets-*Wereview long-lived assets, including leasehold improvements, property andequipment, and acquired technology rights, for impairment whenever events orchanges in business circumstances indicate that the carrying amount of theassets may not be fully recoverable. This requires us to estimate future cashflows related to these assets. Actual results could differ from theseestimates, which may affect the carrying amount of assets and the actualamortization expense. As of June 30, 2005, we had long-lived assets with anet book value of $11.0 million.

 

**Certain Risks Related to Our Business**

** **

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

 

**RISKS RELATED TO OUR BUSINESS AND INDUSTRY**

 

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

 

Duringthe six months ended June 30, 2005, we earned approximately $8.9 million,or 82% of our revenue, under our research collaboration agreements with twocollaborators, Schering-Plough and N.V. Organon.  During the six months ended June 30,2005, we earned approximately $6.2 million, or 57% of our revenue, under ourresearch collaboration agreements with Schering-Plough, one of ourlongest-standing collaborative partners. In the third quarter of 2003, weentered into new drug discovery collaborations with Schering-Plough, whichcontinued certain existing programs and implemented a number of new activities.

 

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The2003 agreements continue our collaboration with Schering-Plough through August 2006.  Under the 2003 agreements, wereceive research funding on an FTE basis which is recognized as revenue asservices are performed.  Schering-Ploughwas obligated to fund a specified number of our FTEs in the first year of theagreements.  Subsequently, Schering-Plough decided to focus onoptimization programs and terminated our screening activities onSchering-Plough’s behalf. This decision resulted in an approximately 11%reduction of the number of our FTEs whom Schering-Plough was obligated to fund.  Schering-Plough has reduced its FTE fundingby an additional 41% (or approximately $1.1 million per calendar quarter)effective August 2005.  Wemay receive milestone payments upon the successful achievement of preclinicaland clinical milestones. Milestone payments will be recognized as revenue tothe extent that milestones are achieved. Upon successful commercialization ofmost products resulting from this relationship, we will be entitled to receiveroyalties on sales of those products.   Discussions have been initiated regarding thepossible extension or modification of the 2003 agreements.  There can be no assurance that the 2003agreements will be extended beyond August 2006 or that funding will bemaintained at reduced August 2005 levels beyond August 2006 either inthe aggregate or on an FTE basis.  Inlight of the significance to us of the Schering-Plough relationship, theexpiration or termination of our collaborative agreements or our failure toextend, modify or replace the 2003 agreements would have a material adverseeffect on our business as it is currently conducted, our financial conditionand other results of operations because of the resulting decrease in ourrevenue.

 

Duringthe six months ended June 30, 2005, we earned approximately $2.7 million,or 25% of our revenue, under our research collaboration agreements with N.V.Organon, our second largest collaborator. The principal agreement with Organon,entered into in February 2002, has a stated term of five years; however,Organon has the right to terminate the agreement in December 2005 if we failto (i) deliver Organon a cumulative total of three lead compound seriesand (ii) show demonstrated progress towards one additional lead compoundseries.   We have already delivered toOrganon three such lead compound series, and management believes we havedemonstrated progress towards one additional lead compound series.  If Organon so terminates the researchcollaboration with us on or prior to December 31, 2005, Organon will bepermitted to take a credit of up to $1.2 million with respect to certainmilestone payments that may become due under the agreement after December 31,2005 from Organon to us.  There can be no assurance that Organon willagree with management’s belief that we have demonstrated progress towards oneadditional lead compound series by December 2005. The termination of thisagreement would have a material adverse effect on our business as it iscurrently conducted, our financial condition and other results of operationsbecause of the resulting decrease in our revenue.

 

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

 

Drugdevelopment is a highly uncertain process. Our approach and technology maynever result in a commercial drug. None of our compounds are contained inproducts that have received regulatory approval for commercial sale, andcurrently we have only four candidates with respect to which our collaboratorshave initiated clinical trials (i.e., human testing). All of our therapeuticcandidates, including these clinical candidates, face the substantial risks offailure inherent in the drug development process. Any potential pharmaceuticalproduct emanating from one of our internal or collaborative programs mustsatisfy rigorous standards of safety and efficacy before the United States Foodand Drug Administration (FDA) and foreign regulatory authorities will approvethem for commercial use. To satisfy these standards, significant additionalresearch, preclinical studies (i.e., animal testing) and clinical trials willbe required.

 

Preclinicaland clinical development of drug candidates is a long, expensive and uncertainprocess. Failure can occur at any stage of testing. Success in preclinicaltesting does not ensure that clinical trials will be successful. Based onresults at any stage of product development, our development collaborators orwe may decide to discontinue development of our product candidates.

 

Ourproduct candidates and research programs are in the early stages of developmentand require significant, time-consuming and costly research and development,testing and regulatory approvals. We do not expect that our product candidateswill be commercially available for many years, if ever. In addition, we pursuethe discovery and initial development of product candidates using ourintegrated drug discovery technology platform in both our internal andcollaborative programs to implement our strategy of reducing the cost and timeincurred by the pharmaceutical industry in developing drug candidates. To date,we have not identified a therapeutic candidate that has been developed into acommercial drug. It is uncertain whether we will achieve these goals at all.

 

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

 

Weanticipate that our capital resources, including our existing cash, cashequivalents and marketable securities as of June 30, 2005 of approximately$32.7 million, will be adequate to fund our operations at their current levels atleast through 2006. However, changes may occur that would cause us to consumeavailable capital resources before that time. On July 28, 2005, we

 

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enteredinto purchase agreements to sell an aggregate 2,470,000 shares of newly issuedcommon stock (the “Shares”) to institutional investors at a price of $3.43 pershare (the “Private Placement”).  On August 1,2005, we sold the Shares and realized gross proceeds of approximately $8.47million from the Private Placement.  Weexpect net proceeds of approximately $7.63 million from the Private Placementafter deducting fees payable to the placement agent and other transactionexpenses.  While we are unaware of a specific reason that any factor will have amaterial impact on our capital requirements, examples of relevant factorsinclude:

 

•                  changes in our existing collaborativerelationships, including the revenues we receive in connection with thoserelationships;

 

•                  our internal proprietary drug discoveryactivities;

 

•                  acquisitions of other businesses ortechnologies;

 

•                  the costs associated with our drug discovery anddevelopment activities;

 

•                  penalties we may be required to pay the purchasersin the Private Placement if we fail to comply with certain covenants andobligations related to that transaction;

 

•                  competing technological and marketdevelopments;

 

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

 

•                  the purchase of additional capital equipment;and

 

•                  the progress of our milestone and royaltyproducing activities.

 

Ifwe determine that we must raise additional capital, the capital could be raisedthrough public or private financings involving debt or equity. However,additional capital may not be available on favorable terms, or at all. Ifadequate 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.

 

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

 

Ourrevenue depends to a large extent on research and development expenditures bythe pharmaceutical and biotechnology industries. Our capabilities includeaspects of the drug discovery and development process that pharmaceuticalcompanies have traditionally performed internally. Although there is a historyamong pharmaceutical and biotechnology companies of outsourcing drug researchand development functions, this practice may not continue.

 

Thewillingness of these companies to expand or continue collaborations to enhancetheir research and development activities is based on certain factors that arebeyond our control. While we are unaware of a specific reason that any of thefollowing factors will have a material impact on the willingness of current orpotential collaborators to expand or continue collaborations, examples ofrelevant factors include collaborators’ changing spending priorities amongvarious types of research activities, their ability to hire and retainqualified scientists, their approach regarding expenditures during recessionaryperiods and their policies regarding the balance of research expendituresversus cost containment. Also, general economic downturns in our customers’industries or any decrease in our customers’ research and developmentexpenditures could harm our operations, as could increased popularity ofmanagement theories, which counsel against outsourcing of critical businessfunctions. Continued consolidation in the pharmaceutical and biotechnologyindustries may further decrease the number of potential collaborators for us.In addition, the popularity of scientific thinking that disfavors expensiveproducts, such as large diverse libraries, could negatively impact our business.Any decrease in drug discovery spending by pharmaceutical and biotechnologycompanies could cause our revenue to decline.

 

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

 

•                        discover and develop high-quality drugcandidates;

 

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

 

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

 

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

 

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

 

Ourcollaborators, Bristol-Myers Squibb Company, Daiichi Pharmaceutical Co. andSchering-Plough Corporation, currently are performing clinical trials ofprospective pharmaceutical products containing our proprietary compounds. Ineach case, the collaborator is responsible for the development of thesepotential products, the level of resources devoted to such development and thedecision as to when, or whether, such development should cease. Numerousadditional studies are necessary to support the further development of these productcandidates. Results from preclinical studies conducted to date on these productcandidates are not necessarily indicative of the results that may be obtainedin clinical studies. Results from additional studies could cause ourcollaborators to discontinue or limit development of these product candidates.There can be no assurance that Bristol-Myers Squibb, Daiichi or Schering-Ploughwill continue to develop these programs. In addition, our collaborators maypursue alternative technologies or drug candidates, either on their own or incollaboration with others, that compete with our clinical candidates. If ourcollaborators do not continue their development efforts or if such efforts donot result in positive clinical results, we will not receive additionalmilestone and royalty payments from those efforts, and the market price of ourcommon stock will be materially and adversely affected.

 

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

 

Themarket price for our common stock has been highly volatile and may continue tobe highly volatile in the future.  During the quarter ended June 30,2005 the closing price was $4.05 per share at its low point in June 2005and $5.32 per share at its high point in April 2005.  Our quarterlyoperating results, changes in general conditions in the economy or thefinancial markets, and other developments affecting our competitors or us couldcause the market price of our common stock to fluctuate substantially.  Inrecent years, the stock market has experienced significant price and volumefluctuations.

 

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

 

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

 

•                  reduction, termination or expiration of ourcollaborations;

 

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

 

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

 

•                  developments concerning proprietary rights,including patents;

 

•                  litigation;

 

•                  economic and other external factors or otherdisasters or crises;

 

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

 

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•                  changes in financial estimates prepared bysecurities analysts; and

 

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

 

***Disputes may arise between ourcollaborative partners and us as to royalties and milestones to which we areentitled.***

 

Thecompound basis for drugs developed by a customer may be a derivative oroptimized version of the compound screened or optimized by us. While ourexisting collaborative agreements provide that we will receive milestonepayments and royalties with respect to certain products developed from certainderivative compounds, there can be no assurance that disputes will not ariseover the application of payment provisions to such products. There can be noassurance that current or future collaborative partners will not pursuealternative technologies, or develop alternative products either on their ownor in collaboration with others, including our competitors, as a means fordeveloping treatments based on the targets which are the subject of thecollaborative arrangements with us.

 

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

 

Oneof our business strategies is to expand our proprietary pipeline of drugcandidates and to then enter into collaborations for the development of thesedrug candidates that will allow us to earn milestone, royalty and/or licensepayments. Our proprietary drug discovery program is in its early stage ofdevelopment and is unproven. Although we have expended, and continue to expend,time and money on internal research and development programs, we may beunsuccessful in creating valuable proprietary drug candidates that would enableus to form additional collaborations and receive milestone, royalty and/orlicense payments.

 

Ourcollaborations and internal programs may not result in the discovery ofpotential drug candidates that will be safe or effective. Although we havereceived license and milestone fees to date, we may never receive any royaltypayments, or any additional license and milestone fees, under our current orany future collaborations. Our receipt of any future milestone, royalty orlicense payments depends on many factors, including whether our collaboratorsdesire to or are able to continue to pursue a potential drug candidate and theultimate commercial success of the drug. Development and commercialization ofpotential drug candidates depend not only on the achievement of researchobjectives by our collaborators and us, but also on each collaborator’sfinancial, competitive, marketing and strategic considerations and regulationin the United States and other countries. If unforeseen complications arise inthe development or commercialization of the potential drug candidates by ourcollaborators, we may not realize milestone, royalty or license payments.

 

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

 

Manyof our competitors have access to greater financial, technical, research,marketing, sales, distribution, service and other resources than we do.Moreover, the pharmaceutical and biotechnology industries are characterized bycontinuous technological innovation. We anticipate that we will face increasedcompetition in the future as new companies enter the market and our competitorsmake advanced technologies available. Technological advances or entirelydifferent approaches that we or one or more of our competitors develop mayrender our products, services and expertise obsolete or uneconomical.Additionally, the existing approaches of our competitors or new approaches ortechnologies that our competitors develop may be more effective than those wedevelop. We may not be able to compete successfully with existing or futurecompetitors.

 

Inaddition, due to improvements in global communications, combined with thesupply of lower cost Ph.D. level scientific talent in offshore locations suchas China, India and Eastern Europe, we face the growing threat of competitionfor our services.

 

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

 

Wemay need to successfully structure and manage multiple drug discovery programsand collaborative relationships, including maintaining confidentiality of theresearch being performed for multiple collaborators. We may be unable to managesuccessfully conflicts between competing drug development programs of thirdparties to which we offer services. From time to time, more than one of ourcollaborators may want to perform research concerning the same or molecularlysimilar disease targets. Because of that, we may be required to reconcile ourrelationships with those collaborators, particularly if both want to establishexclusive

 

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relationshipswith us with respect to that target or if one collaborator has an existingarrangement with us and the other would like us to perform services regarding atarget restricted by that arrangement. Further, if we are working with acollaborator regarding a particular target, another of our collaborators may beresearching the same target in one of its internal programs of which we have noknowledge. As a result, potential conflicts involving us may arise due to thiscompetition between collaborators in a particular disease field of interest.Conflicts also may arise between our collaborators as to proprietary rights toparticular compounds in our libraries or as to proprietary rights to biologicaltargets such as receptors or enzymes against which we screen compounds in ourlibraries. The occurrence of conflicts, or the perception of conflicts, couldhave a material adverse effect on our business, financial condition and resultsof operations.

 

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

 

Ouractivities involve the use of potentially harmful hazardous materials,chemicals and various radioactive compounds. These materials are utilized inthe performance of our assay development, high-throughput screening andchemistry optimization services, and include common organic solvents, such asacetone, hexane, methylene chloride, acetonitrile, and isopropyl and methylalcohol as well as common acids and bases. The waste from utilization of these solventsand other materials is disposed of through licensed third-party contractors.Further, we utilize an extremely wide variety of chemicals in the performanceof our assay development, screening and optimization services. These chemicals,such as reagents, buffers and inorganic salts, typically are employed inextremely small amounts in connection with the work performed in ourlaboratories.

 

Wecannot completely eliminate the risk of accidental contamination or injury fromthe use, storage, handling or disposal of these materials. In the event ofcontamination or injury, we could be held liable for damages that result. Wemaintain insurance coverage against environmental hazards arising from thestorage and disposal of the materials utilized in our business. Although ourmanagement believes that such insurance has terms, including coverage limits,which are appropriate for our business, liabilities arising from the use,storage, handling or disposal of these materials could exceed our insurancecoverage as well as our resources. We are subject to federal, state and locallaws and regulations governing the use, storage, handling and disposal of thesematerials and specified waste products. The cost of compliance with these lawsand regulations could be significant. To our knowledge, we have not been, andcurrently are not, the subject of any governmental investigation concerning theviolation of these federal, state and local laws and regulations. There can beno assurance that we will not be the subject of future investigations bygovernmental authorities.

 

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

 

Regulationby governmental entities in the United States and other countries will be asignificant factor in the production and marketing of any pharmaceuticalproducts our customers or we may develop. The nature and the extent to whichgovernment regulation may apply to our customers and us will vary depending onthe nature of the pharmaceutical products, if any. Virtually all pharmaceuticalproducts require regulatory approval prior to commercialization. If we or ourcollaborators or licensees fail to obtain, or encounter delays in obtaining ormaintaining, regulatory approvals, our financial results could be adverselyaffected. Similar regulatory procedures are required in countries outside theUnited States.

 

Inaddition, new legislation related to health care could reduce the pricespharmaceutical and biotechnology companies can charge for drugs they sellwhich, in turn, could reduce the amounts that they have available forcollaborative relationships with us or for the purchase of our services. Ifpharmaceutical and biotechnology companies decrease the resources they devoteto the research and development of new drugs, the number of collaborations weconclude and the amount of and profitability of services we perform could beadversely impacted and our revenue and profitability reduced. If prices thatpharmaceutical and biotechnology companies can charge for drugs they selldecrease, the royalties, if any, we receive from the sale of products wouldalso decrease, which would reduce our revenue and profitability.

 

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

 

Duringthe six month period ended June 30, 2005, we had a net loss ofapproximately $9.4 million.  For thefiscal years ended December 31, 2004, 2003 and 2002, we had net losses ofapproximately $17.4 million, $2.8 million and $2.1 million, respectively.

 

Thenet loss for the fiscal year ended December 31, 2004 includedrestructuring and other charges of $5.9 million.  The net loss for the sixmonths ended June 30, 2005 was due to increased corporate overhead costs,severance and our increased focus on internal research and development.  Continuing net losses may limit our ability tofund our operations, and we may not generate income from operations in thefuture.

 

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Ona quarterly basis, our future operating results are likely to be highlyvolatile depending upon our receipt of milestone payments from ourcollaborators. We may not receive milestone payments on a regular basis or atall. Our ability to achieve profitability, if ever, will be significantlyimpacted by the level of investment we determine to make in our internalproprietary programs in the future as well as the results of those programs.

 

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

 

Weare a small company, and our success depends in part on the continued serviceof key scientific, business development and management personnel, including ourpresident and chief executive officer Leslie J. Browne, Ph.D., and our abilityto identify, hire and retain additional personnel. There is intense competitionfor qualified personnel. In particular, we believe that there is a shortage ofscientists qualified to work in drug discovery. There is significantcompetition among drug discovery and development companies to hire suchscientists. Immigration laws may further restrict our ability to attract orhire qualified personnel. We may not be able to continue to attract and retainthe personnel necessary for our growth and development. Failure to attract andretain key personnel could have a material adverse effect on our business,financial condition and results of operations. Further, we are highly dependenton the principal members of our scientific, business development and managementstaff. One or more of these key employees could retire or otherwise leave ouremploy within the foreseeable future, and the loss of any of these people couldhave a material adverse effect on our business, financial condition and resultsof operations. We do not, and do not intend to, maintain key person lifeinsurance on the life of any employee.

 

***Some of our development andmarketing activities are, or will be, conducted by third parties. If thesethird parties fail to perform their functions satisfactorily, our revenue andearnings could be delayed, reduced or eliminated.***

 

Theultimate success of our business plan heavily depends upon the successfuldiscovery, development and commercialization of pharmaceutical products. Ourendeavors will result in commercialized pharmaceutical products, if at all,only after significant preclinical and clinical development, requisiteregulatory approvals, establishment of manufacturing capabilities andsuccessful marketing. We do not currently have the technology, facilities, personnelor experience to accomplish all of these tasks on our own, and we will likelynot have all the necessary resources in the foreseeable future. Therefore, wecontinue to depend heavily upon the expertise and dedication of sufficientresources by collaborative partners to develop and commercialize productsprimarily based on lead compounds discovered by us. If a collaborative partnerfails to develop or commercialize a compound or product with respect to whichit has rights from us, we may not receive any future milestone payments orroyalties associated with that compound or product. Similarly, while we areunaware of a specific reason that any of the following factors will beexperienced by our strategic collaborators, because we rely heavily on them,our revenue could be adversely affected if our collaborators:

 

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

 

•                  fail to gain the requisite regulatoryapprovals of product candidates;

 

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

 

•                  do not conduct their collaborative activitiesin a timely manner;

 

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

 

•                  terminate their alliances or arrangementswith us;

 

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

 

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

 

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

 

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

 

Inthe six months ended June 30, 2005, approximately 54% of our revenue wasderived from customers outside the United States. During that period, approximately53% of our revenue was derived from customers in Europe, and approximately 1%was derived

 

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fromcustomers in the Asia/Pacific region. We anticipate that international revenuewill continue to account for a significant percentage of our overall revenue.While we are unaware of a specific reason that any of the following factorswill have a material impact on our revenue, our international operations aresubject to the risk factors inherent in the conduct of international business,including:

 

•                  unexpected changes in regulatoryrequirements;

 

•                  longer payment cycles;

 

•                  import and export license requirements;

 

•                  tariffs and other barriers;

 

•                  political and economic instability;

 

•                  limited intellectual property protection;

 

•                  difficulties in collecting trade receivables;

 

•                  difficulties in staffing and managing foreignjoint venture operations; and

 

•                  potentially adverse tax consequences.

 

Wemay not be able to sustain or increase our international revenue. Any of theforegoing factors may have a material adverse effect on our internationaloperations and, therefore, our business, financial condition and results ofoperations.

 

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

 

Ourcollaborative relationships involve lengthy negotiation cycles, often requiringus to expend considerable financial and personnel resources without anyassurance that revenue will be recognized. These cycles typically are long fora number of reasons. Factors include the strategic nature of our partnerships,the size of many such transactions, the confidential and proprietary nature ofthe biological targets against which we screen our chemical compound libraries,and the unique terms typically found in each of the transactions. As a result,we may expend substantial funds and effort to negotiate agreements forcollaborative arrangements, but may ultimately be unable to complete thetransaction and recognize revenue. In these circumstances, our business,financial condition and results of operations will be adversely affected.

 

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

 

Wedepend on our laboratories and equipment for the continued operation of ourbusiness. Our research and development operations and administrative functionsare primarily conducted at our facilities in the Princeton, New Jersey area.Although we have contingency plans in effect for natural disasters or othercatastrophic events, catastrophic events could still disrupt our operations.Even though we carry business interruption insurance policies, we may sufferlosses as a result of business interruptions that exceed the coverage availableunder our insurance policies. Any natural disaster or catastrophic event in ourfacilities or the areas in which they are located could have a significantnegative impact on our operations.

 

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

 

Wehave never declared or paid any cash dividend on common stock. We currentlyintend to retain our future earnings, if any, to finance the expansion of ourbusiness and do not expect to pay any cash dividends in the foreseeable future.As a result, the success of your investment in our common stock will dependentirely upon any future appreciation in its value. There is no guarantee thatour common stock will appreciate in value or even maintain its price.

 

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***Anti-takeover provisions under Section 203of the Delaware General Corporation Law, provisions in our amended and restatedcertificate of incorporation and amended and restated bylaws, and our adoptionof a stockholder rights plan may render more difficult the accomplishment ofmergers or the assumption of control by a principal stockholder, making moredifficult the removal of management.***

 

Section 203of the Delaware General Corporation Law may delay or deter attempts to securecontrol of our company without the consent of our management. In general, Section 203prohibits a publicly-held Delaware corporation from engaging in a businesscombination with an interested stockholder for a period of three yearsfollowing the date the person becomes an interested stockholder, unless certainconditions are met.

 

Ouramended and restated certificate of incorporation and amended and restatedbylaws contain several provisions that could delay or make more difficult theacquisition of our company through a hostile tender offer, open marketpurchases, proxy contest, merger or other takeover attempt that a stockholdermight consider in his or her best interest, including those attempts that mightresult in a premium over the market price of our common stock. Such provisionsinclude the issuance of preferred stock without approval of the holders of ourcommon stock, the classification of our board of directors, the election andremoval of directors, restrictions on the ability of stockholders to takeaction without a meeting, restrictions on stockholders’ ability to call aspecial meeting and advance notice procedures regarding any proposal ofstockholder business to be discussed at a stockholders meeting.

 

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

 

***If we choose to acquire new andcomplementary businesses, products or technologies instead of developing themourselves, we may be unable to complete these acquisitions or to successfullyintegrate an acquired business or technology in a cost-effective andnon-disruptive manner.***

 

Fromtime to time, we may choose to acquire complementary businesses, products ortechnologies instead of developing them ourselves. We do not know if we will beable to complete any acquisitions, or whether we will be able to successfullyintegrate any acquired businesses, operate them profitably or retain their keyemployees. Integrating any business, product or technology we acquire could beexpensive and time-consuming, disrupt our ongoing business and distract companymanagement. In addition, in order to finance any acquisition, we might need toraise additional funds through public or private equity or debt financings. Inthat event, we could be forced to obtain financing on less than favorable termsand, in the case of equity financing, on terms that may result in dilution toour stockholders. lf we are unable to integrate any acquired entities, productsor technologies effectively, our business will suffer. In addition, undercertain circumstances, amortization of assets or charges resulting from thecosts of acquisitions could harm our business and operating results.

 

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

 

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

 

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

 

TemporaryU.S. Treasury regulations currently in effect generally provide that whether anacquisition transaction and a distribution are part of a plan is determinedbased on all of the facts and circumstances, including but not limited to thosespecific

 

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factorslisted in the regulations. In addition, the regulations provide several “safeharbors” for acquisition transactions that are not considered to be part of aplan.

 

Weand Accelrys have entered into a tax sharing agreement under which we have madecertain covenants to each other in connection with the distribution that we maynot take certain actions without first obtaining an unqualified opinion ofcounsel or an Internal Revenue Service ruling that such actions will not causethe distribution to become taxable.  Pursuant to these covenants,generally (1) we will, for two years after the distribution date, continuethe active conduct of the drug discovery business; (2) we will notrepurchase our stock except in certain circumstances permitted by the InternalRevenue Service; (3) we will not take any actions inconsistent with therepresentations made in connection with the issuance by Dechert LLP of itsopinion with respect to the distribution; and (4) we will not take or failto take any other action that would result in any tax being imposed on thedistribution.  Accelrys may seek an injunction to enforce thesecovenants.  These restrictions could substantially limit our strategic andoperational flexibility, including our ability to finance our operations byissuing equity securities, to make acquisitions using equity securities, torepurchase our equity securities, to raise money by selling assets, or to enterinto business combination transactions.

 

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

 

Wehave agreed to indemnify Accelrys for any taxes and related losses (includingany applicable interest and penalties, all related accounting, legal and otherprofessional fees, all related court costs and all costs, expenses and damagesassociated with related stockholder litigation or controversies and any amountpaid in respect of the liability of stockholders) resulting from a breach ofany of the covenants described above.  Furthermore, we will be responsiblefor taxes that may be imposed upon Accelrys pursuant to section 355(e) ofthe Code in connection with a transaction that results in a change in controlof us, even though we will have obtained an Internal Revenue Service ruling oran unqualified opinion of counsel prior to the transaction.  The amount ofany indemnification payments could be substantial.  The amount of Accelrystaxes for which we are agreeing to indemnify Accelrys will be based on theexcess of the aggregate fair market value of our stock as of the distributiondate over Accelrys tax basis in our stock.

 

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

 

Underthe terms of the master separation and distribution agreement and the taxsharing and indemnification agreement that we entered into with Accelrys, weand Accelrys agreed to indemnify one another from and after the distributionwith respect to the indebtedness, liabilities and obligations retained by ourrespective companies.  These indemnification obligations could besignificant.  Our ability to satisfy any such indemnification obligationswill depend upon the future financial strength of our company.  We cannotdetermine whether we will have to indemnify Accelrys for any substantialobligations.  We also cannot assure you that, if Accelrys becomesobligated to indemnify us for any substantial obligations, Accelrys will havethe ability to satisfy those obligations.  Any payment by Accelrys or uspursuant to these indemnification provisions could have a material adverseeffect on its business.  Any failure by Accelrys or us to satisfy itsindemnification obligations could have a material adverse effect on the othercompany’s business.

 

**CERTAIN RISKS RELATED TO INTELLECTUAL PROPERTY**

 

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

 

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

 

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

 

Patentapplications in the United States are maintained in secrecy for 18 months fromfiling or until a patent issues. Under certain circumstances, patentapplications are never published but remain in secrecy until issuance. As aresult, others may have filed patent applications for products or technologycovered by one or more pending patent applications upon which we are relying.If

 

25

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applicationscovering similar technologies were to be filed before our applications, ourpatent applications may not be granted. There may be third-party patents,patent applications and other intellectual property or information relevant toour chemical compositions and other technologies that are not known to us, thatblock us or compete with our chemical compositions or other technologies, orlimit the scope of patent protection available to us. Moreover, from time totime, patents may issue which block or compete with our chemical compositionsor other technologies, or limit the scope of patent protection available to us.Litigation may be necessary to enforce patents issued to us or to determine thescope and validity of the intellectual property rights of third parties.

 

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

 

Werely upon trade secrets, technical know-how and continuing technologicalinnovation to develop and maintain our competitive position. Competitorsthrough their independent discovery (or improper means, such as unauthorizeddisclosure or industrial espionage) may come to know our proprietaryinformation. We generally require employees and consultants to executeconfidentiality and assignment-of-inventions agreements. These agreementstypically provide that all materials and confidential information developed byor made known to the employee or consultant during his, her or its relationshipwith us are to be kept confidential, and that all inventions arising out of theemployee’s relationship with us are our exclusive property. Our employees andconsultants may breach these agreements, and in some instances we may not havean adequate remedy. Additionally, in some instances, we may have failed torequire that employees and consultants execute confidentiality andassignment-of-inventions agreements.

 

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

 

Webelieve that our success depends, in part, upon our ability to obtaininternational protection for our intellectual property. However, the laws ofsome foreign countries may not be as comprehensive as those of the UnitedStates and may not be sufficient to protect our proprietary rights abroad. Inaddition, we may decide not to pursue patent protection outside the UnitedStates, because of cost and confidentiality concerns. Accordingly, ourinternational competitors could obtain foreign patent protection for, andmarket overseas, products and technologies for which we are seeking U.S. patentprotection and may be able to use these products and technologies to competeagainst us.

 

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

 

Someof our competitors have, or are affiliated with companies having, substantiallygreater resources than we have, and those competitors may be able to sustainthe costs of complex patent litigation to a greater degree and for longerperiods of time than us. Uncertainties resulting from the initiation andcontinuation of any patent or related litigation could have a material adverseeffect on our ability to compete in the marketplace pending resolution of thedisputed matters. If our competitors prepare and file patent applications inthe United States that claim technology also claimed by us, we may have toparticipate in interference proceedings declared by the U.S. Patent andTrademark Office to determine the priority of invention, which could result insubstantial costs to us, even if the outcome is favorable to us. Similarly,opposition proceedings may occur overseas, which may result in the loss ornarrowing of the scope of claims or legal rights. Such proceedings will atleast result in delay in the issuance of enforceable claims. An adverse outcomecould subject us to significant liabilities to third parties and require us tolicense disputed rights from third parties or cease using the technology.

 

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

 

Evenif patents are issued to us, these patents may not sufficiently protect ourinterest in our chemical compositions or other technologies because the scopeof protection provided by any patents issued to or licensed by us are subjectto the uncertainty inherent in patent law. Third parties may be able to designaround these patents or develop unique products providing effects similar toour products. In addition, others may discover uses for our chemicalcompositions or technologies other than those uses covered in our patents, andthese other uses may be separately patentable. A number of pharmaceutical andbiotechnology companies, and research and academic institutions, have developedtechnologies, filed patent applications or received patents on varioustechnologies that may be related to our business. Some of these technologies,patent applications or patents may conflict with our technologies, patentapplications or patents. These conflicts could also limit the scope of patents,if any, that we may be able to obtain, or result in the denial of our patentapplications. We are not currently aware of any such patent

 

26

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applicationsor patents that could have a material adverse effect on our business.

 

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

 

Thirdparties may claim infringement by us of their intellectual property rights. Inaddition, to the extent our employees are involved in research areas similar tothose areas in which they were involved at their former employers, we may besubject to claims that one of our employees, or we, have inadvertently orotherwise used or disclosed the alleged trade secrets or other proprietaryinformation of a former employer. From time to time, we have received lettersclaiming or suggesting that our products or activities may infringe third partypatents or other intellectual property rights. Our products may infringe patentor other intellectual property rights of third parties. A number of patents mayhave been issued or may be issued in the future that could cover certainaspects of our technology and that could prevent us from using technology thatwe use or expect to use. We may be required to seek licenses for, or otherwiseacquire rights to, technology as a result of claims of infringement. We may notpossess proper ownership or access rights to the intellectual property we use.Third parties or other companies may bring infringement suits against us. Anyclaims, with or without merit, could be time consuming to defend, result incostly litigation, divert management’s attention and resources or require us toenter into royalty or licensing agreements. Royalty or licensing agreements, ifrequired, may not be available on terms acceptable to us, if at all. In the eventof a successful claim of product infringement against us, our failure orinability to license or design around the infringed technology could have amaterial adverse effect on our business, financial condition and results ofoperations. We are not currently involved in actions of this type that arematerial to our business.

 

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

 

Our international sales generally are denominated inUnited States Dollars, and are, therefore, not exposed to changes in foreigncurrency exchange rates.

 

We do not use derivative financial instruments fortrading or speculative purposes.  Ourexposure to market risks associated with changes in interest rates relatesprimarily to the increase or decrease in the amount of interest income earnedon our investment portfolio since we have no debt.  We ensure the safety and preservation ofinvested funds by limiting default risks, market risk and reinvestmentrisk.  We mitigate default risk byinvesting in investment grade securities. A hypothetical 100 basis point adverse move in interest rates along theentire interest rate yield curve would not materially affect the fair value ofour interest sensitive financial instruments at June 30, 2005.

 

**Item 4.****Controls and Procedures**

 

Forthe quarterly period ended June 30, 2005, our management carried out anevaluation, under the supervision and with the participation of our Presidentand Chief Executive Officer, Chief Financial Officer (our principal financialofficer) and our Vice President, Finance (our chief accounting officer), of theeffectiveness of our disclosure controls and procedures pursuant to Rules 13a-15and 15d-15 under the Securities Exchange Act of 1934, or the Exchange Act, asof the end of the period covered by this report.  Based upon this evaluation, our President andChief Executive Officer, Chief Financial Officer and Vice President, Financeconcluded that as of June 30, 2005, our disclosure controls and proceduresare effective to ensure that the information required to be disclosed by us inreports filed under the Exchange Act is recorded, processed, summarized andreported within the time periods specified in the rules and forms of theSEC.  Our management, including ourPresident and Chief Executive Officer, Chief Financial Officer and VicePresident, Finance, does not expect that our disclosure controls or ourinternal controls will prevent all errors and all fraud.  A control system, no matter how well designedand operated, cannot provide assurance that the objectives of the controlsystem are met, and no evaluation of controls can provide absolute assurancethat all control issues and instances of fraud, if any, within a company havebeen detected.

 

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

 

**PART II.****  OTHER INFORMATION**

 

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

 

Presently,we are not party to any litigation.

 

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**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.**

 

On May 5, 2005, we held our Annual Meeting ofStockholders in Princeton, New Jersey. The following matters were submitted to a vote of security holders.

 

Our stockholders voted to elect the following membersof our Board of Directors for terms of three years each:

 

| **Nominee**                    | ** ** | **In Favor** | ** ** | **Against** | ** ** | **Abstain** | ** ** |
|--------------------------------|------------|--------------|------------|-------------|------------|-------------|------------|
| Frank Baldino, Jr., Ph.D. |       | 8,083,637    |       | 3,578,282   |       | —      |       |
| Leslie J. Browne, Ph.D.        |       | 9,282,795    |       | 2,379,124   |       | —      |       |
| Gary E. Costley, Ph.D.         |       | 10,802,862   |       | 859,057     |       | —      |       |

 

Our directors whose terms of office continued afterthe meeting include two Class II directors whose term expires in 2006,Paul A. Bartlett, Ph.D. and Joseph A. Mollica, Ph.D., and three Class IIIdirectors whose term expires in 2007, Steven J. Burakoff, M.D., James J. Marinoand Bruce A. Peacock.

 

Our stockholders voted as follows to ratify theappointment of Ernst & Young LLP as our independent certified publicaccountants for the fiscal year ending December 31, 2005: 11,630,103shares were voted in favor of ratification, 30,937 shares were voted againstratification, and 878 shares abstained from voting.

 

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

 

None.

 

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

 
| **Exhibits.** | ** ** | ** **                                                                                                                                                                                                                                                   |
|---------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|          |       |                                                                                                                                                                                                                                                         |
| 10.1          |       | License Agreement, amended and restated as of July 1, 2003,  among The Trustees of Columbia University in the City of New York, Cold  Spring Harbor Laboratory and Pharmacopeia Drug Discovery, Inc. (1) (2)                                  |
|          |       |                                                                                                                                                                                                                                                         |
| 31.1          |       | Certification  of the Principal Executive Officer of Pharmacopeia Drug Discovery, Inc.  pursuant to Rule 13a-l4 of the Securities Exchange Act of 1934, as  amended, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of  2002(1) |
|          |       |                                                                                                                                                                                                                                                         |
| 31.2          |       | Certification  of the Principal Financial Officer of Pharmacopeia Drug Discovery, Inc.  pursuant to Rule 13a-14 of the Securities Exchange Act of 1934, as  amended, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of  2002(1) |
|          |       |                                                                                                                                                                                                                                                         |
| 31.3          |       | Certification  of the Chief Accounting Officer of Pharmacopeia Drug Discovery, Inc.  pursuant to Rule 13a-14 of the Securities Exchange Act of 1934, as  amended, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of  2002(1)    |
|          |       |                                                                                                                                                                                                                                                         |
| 32.1          |       | Certification  of the Chief Executive Officer of Pharmacopeia Drug Discovery, Inc.  pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906  of the Sarbanes-Oxley Act of 2002(1)                                              |
|          |       |                                                                                                                                                                                                                                                         |
| 32.2          |       | Certification  of the Principal Financial Officer of Pharmacopeia Drug Discovery, Inc.  pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906  of the Sarbanes-Oxley Act of 2002(1)                                          |
|          |       |                                                                                                                                                                                                                                                         |
| 32.3          |       | Certification  of the Chief Accounting Officer of Pharmacopeia Drug Discovery, Inc.  pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906  of the Sarbanes-Oxley Act of 2002(1)                                             |

 

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(1)                                  Filed herewith.

 

(2)                                  Confidential treatment has been requested forportions of this exhibit.  These portionshave been omitted and submitted separately to the Securities and ExchangeCommission.

 

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**SIGNATURES**

 

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

 
|                                  | PHARMACOPEIA  DRUG  DISCOVERY, INC. |
|---------------------------------------|-------------------------------------|
|                                  |                                |
| Date:  August 5,  2005 | By:                                 | /s/  Leslie J. Browne, Ph.D. |
|                                  |                                | Leslie  J. Browne, Ph.D. |
|                                  |                                | President  and Chief Executive  Officer |
|                                  |                                |   |
|                                  | By:                                 | /s/  Michio Soga |
|                                  |                                | Michio  Soga |
|                                  |                                | Executive  Vice President and |
|                                  |                                | Chief  Financial Officer |
|                                  |                                | (Principal  Financial Officer) |
|                                  |                                |
|                                  | By:                                 | /s/  Brian M. Posner |
|                                  |                                | Brian  M. Posner |
|                                  |                                | Vice  President, Finance |
|                                  |                                | (Chief  Accounting Officer) |

 

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**PHARMACOPEIA DRUG DISCOVERY, INC.**

 

**INDEX TO EXHIBITS**

 
| **No.**    | ** ** | **EXHIBIT**                                                                                                                                                                                                            |
|------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| ** ** | ** ** | ** **                                                                                                                                                                                                             |
| 10.1       |       | License Agreement, amended and restated as of July 1, 2003,  among The Trustees of Columbia University in the City of New York, Cold  Spring Harbor Laboratory and Pharmacopeia Drug Discovery, Inc. (1) (2) |
|       |       |                                                                                                                                                                                                                   |
| 31.1       |       | Section 302  Certification of the Principal Executive Officer (1)                                                                                                                                                 |
|       |       |                                                                                                                                                                                                                   |
| 31.2       |       | Section 302  Certification of the Principal Financial Officer (1)                                                                                                                                                 |
|       |       |                                                                                                                                                                                                                   |
| 31.3       |       | Section 302  Certification of the Chief Accounting Officer (1)                                                                                                                                                    |
|       |       |                                                                                                                                                                                                                   |
| 32.1       |       | Section 906  Certification of the Chief Executive Officer (1)                                                                                                                                                     |
|       |       |                                                                                                                                                                                                                   |
| 32.2       |       | Section 906  Certification of the Principal Financial Officer (1)                                                                                                                                                 |
|       |       |                                                                                                                                                                                                                   |
| 32.3       |       | Section 906  Certification of the Chief Accounting Officer (1)                                                                                                                                                    |

 

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| (1)    | Filed herewith.                                                                                                                                                                      |
|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |                                                                                                                                                                                 |
| (2)    | Confidential treatment has been requested for portions of this  exhibit.  These portions have been  omitted and submitted separately to the Securities and Exchange Commission. |

 

 

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