** **

**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

 

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**FORM 10-Q**

 

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**(Mark One)**

 

**ý********QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OFTHE SECURITIES EXCHANGE ACT OF 1934**

 

**Forthe quarterly period ended September 30, 2005**

 

**OR**

 

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

 

**Forthe transition period from              to              **

 

**Commission File Number 000-51134**

 

**Favrille, Inc.**

(Exact name of registrant as specified in itscharter)

 

| **Delaware**                                                    | ** ** | **33-0892797**                        |
|-----------------------------------------------------------------|------------|---------------------------------------|
| (State or other  jurisdiction of incorporation or organization) |       | (I.R.S. Employer  Identification No.) |

 

| **10421  Pacific Center Court, Suite 150, San Diego, CA** |   | **92121**   |
|----------------------------------------------------------------|--------|-------------|
| (Address of principal  executive offices)                      |   | ( Zip Code) |

 

**(858) 526-8000**

(Registrant’s telephone number, including areacode)

 

**N/A**

(Former name, former address and former fiscalyear 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 of1934 during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject tosuch filing requirements for the past 90 days.   YES  ý    NO o

 

Indicateby check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2of the Exchange Act).                     YES o    NO ý

 

Indicateby check mark whether the registrant is shell company (as defined in Rule 12b-2of the Exchange Act).                      YES o    NO ý

 

Thenumber of shares of the Registrant’s common stock outstanding as of October31, 2005 was 20,324,884.

 

 

 

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**FAVRILLE,INC.**

**QUARTERLY REPORT ON FORM 10-Q FOR THE PERIOD ENDED SEPTEMBER 30, 2005TABLE OF CONTENTS**

 
| **PART I.**  | **FINANCIAL INFORMATION**                                                                                                                                                                                 |   | 3      |
|-------------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|--------|
| Item 1.           | Financial Statements                                                                                                                                                                                      |   | 3      |
|              | Balance  Sheets as of September 30, 2005 (Unaudited) and December 31, 2004                                                                                                                      |   | 3      |
|              | Statements of Operations (Unaudited) for  the three and nine months ended September 30, 2005 and 2004 and the  period from January 21, 2000 (inception) to September 30, 2005  (Unaudited) |   | 4      |
|              | Statements of Cash Flows (Unaudited) for  the nine months ended September 30, 2005 and 2004 and the period from January 21,  2000 (inception) to September 30, 2005 (Unaudited)            |   | 5      |
|              | Notes to Condensed Financial Statements (Unaudited)                                                                                                                                                       |   | 6      |
| Item 2.           | Management’s Discussion and Analysis of Financial Condition and  Results of Operations                                                                                                               |   | 9      |
| Item 3.           | Quantitative and Qualitative Disclosures About Market Risk                                                                                                                                                |   | 32     |
| Item 4.           | Controls and Procedures                                                                                                                                                                                   |   | 32     |
|              |                                                                                                                                                                                                      |   |   |
| **PART II.** | **OTHER  INFORMATION**                                                                                                                                                                                    |   | 32     |
| Item 1.           | Legal  Proceedings                                                                                                                                                                                        |   | 32     |
| Item 2.           | Unregistered Sales of Equity Securities and Use of Proceeds                                                                                                                                               |   | 32     |
| Item 6.           | Exhibits                                                                                                                                                                                                  |   | 33     |
|              |                                                                                                                                                                                                      |   |   |
| SIGNATURES        |                                                                                                                                                                                                      | 34     |

 

 

2

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**PART I — FINANCIAL INFORMATION**

 

**Item 1. Financial Statements.**

 

**FAVRILLE, INC.**

**(adevelopment stage company)**

**BALANCE SHEETS**

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

 
| ** **                                                                                                                                                                                                             | ** ** | **September 30, 2005** | ** ** | **December 31,  2004** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------|------------|-----------------------------|------------|
| ** **                                                                                                                                                                                                             | ** ** | **(unaudited)**             | ** ** | ** **                  | ** ** |
| **Assets**                                                                                                                                                                                                             |       |                        |       |                        |       |
| Current  assets:                                                                                                                                                                                                       |       |                        |       |                        |       |
| Cash and cash equivalents                                                                                                                                                                                              |       | $                           | 18,492     |                        | $          | 25,065 |   |
| Short-term investments                                                                                                                                                                                                 |       | 24,661                      |       | 1,493                       |       |
| Receivable from employees                                                                                                                                                                                              |       | 3                           |       | 4                           |       |
| Receivable, other                                                                                                                                                                                                      |       | 346                         |       | 15                          |       |
| Prepaid expenses and other current assets                                                                                                                                                                              |       | 646                         |       | 694                         |       |
| Total current assets                                                                                                                                                                                                   |       | 44,148                      |       | 27,271                      |       |
| Property and equipment, net                                                                                                                                                                                            |       | 8,911                       |       | 9,435                       |       |
| Restricted cash                                                                                                                                                                                                        |       | 1,550                       |       | 1,606                       |       |
| Other assets                                                                                                                                                                                                           |       | 626                         |       | 818                         |       |
| Total assets                                                                                                                                                                                                           |       | $                           | 55,235     |                        | $          | 39,130 |   |
| **Liabilities and stockholders’ equity (deficit)**                                                                                                                                                                |       |                        |       |                        |       |
| Current  liabilities:                                                                                                                                                                                                  |       |                        |       |                        |       |
| Accounts payable and accrued liabilities                                                                                                                                                                               |       | $                           | 3,480      |                        | $          | 2,603 |   |
| Current portion of debt                                                                                                                                                                                                |       | 3,111                       |       | 2,492                       |       |
| Total current liabilities                                                                                                                                                                                              |       | 6,591                       |       | 5,095                       |       |
| Debt, less current portion                                                                                                                                                                                             |       | 3,097                       |       | 4,224                       |       |
| Deferred rent                                                                                                                                                                                                          |       | 1,197                       |       | 793                         |       |
| Commitments and contingencies                                                                                                                                                                                          |       |                        |       |                        |       |
| Redeemable  convertible preferred stock, $0.001 par value:                                                                                                                                                             |       |                        |       |                        |       |
| Authorized shares, none at September 30, 2005 and 6,286,014 at  December 31, 2004; Issued and outstanding shares—none at  September 30, 2005 and 6,140,188 at December 31, 2004               |       | —                      |       | 43,672                      |       |
| Stockholders’  equity (deficit):                                                                                                                                                                                  |       |                        |       |                        |       |
| Preferred stock, $0.001 par value 5,000,000 shares authorized at  September 30, 2005 and none at December 31, 2004; no shares issued  and outstanding at September 30, 2005 and December 31, 2004  |       | —                      |       | —                      |       |
| Convertible  preferred stock, $0.001 par value:                                                                                                                                                                        |       |                        |       |                        |       |
| Authorized shares, none at September 30, 2005 and 7,013,387 at  December 31, 2004; Issued and outstanding shares-none at  September 30, 2005 and 5,505,330 at December 31, 2004                    |       | —                      |       | 6                           |       |
| Common  stock, $0.001 par value:                                                                                                                                                                                       |       |                        |       |                        |       |
| Authorized  shares, 75,000,000 at September 30, 2005 and 15,402,410 at December 31,  2004; Issued and outstanding shares—20,326,217 at September 30, 2005 and  1,838,714 at December 31, 2004 |       | 20                          |       | 2                           |       |
| Additional paid-in capital                                                                                                                                                                                             |       | 156,680                     |       | 73,324                      |       |
| Deferred stock-based compensation                                                                                                                                                                                      |       | (6,400                      | )          | (8,386                      | )          |
| Note receivable from stockholder                                                                                                                                                                                       |       | (96                         | )          | (96                         | )          |
| Accumulated other comprehensive loss                                                                                                                                                                                   |       | (44                         | )          | (2                          | )          |
| Deficit accumulated during the development stage                                                                                                                                                                       |       | (105,810                    | )          | (79,502                     | )          |
| Total stockholders’ equity (deficit)                                                                                                                                                                              |       | 44,350                      |       | (14,654                     | )          |
| Total liabilities and stockholders’ equity (deficit)                                                                                                                                                              |       | $                           | 55,235     |                        | $          | 39,130 |   |

 

See accompanying notes.

 

3

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**FAVRILLE, INC.(a development stage company)**

 

**STATEMENTS OF OPERATIONS(in thousands, except share and per share data)**

**Unaudited**

 
| ** **                                                                                              | ** ** | **Three Months ended September 30,** | ** ** | **Nine Months ended  September 30,** | ** ** | **Period from January 21, 2000  (inception) to September 30,** | ** ** |
|---------------------------------------------------------------------------------------------------------|------------|-------------------------------------------|------------|-------------------------------------------|------------|--------------------------------------------------------------------------|------------|
| ** **                                                                                              | ** ** | **2005**                                  | ** ** | **2004**                                  | ** ** | **2005**                                                                 | ** ** | **2004** | ** ** | **2005** | ** ** |
| Operating  expenses:                                                                                    |       |                                      |       |                                      |       |                                                                     |       |   |   |   |   |
| Research and development                                                                                |       | $                                         | 7,006      |                                      | $          | 4,885                                                                    |       | $ | 21,027 |   | $ | 12,877 |   | $ | 58,981 |   |
| General and administrative                                                                              |       | 1,176                                     |       | 1,656                                     |       | 3,783                                                                    |       | 3,519 |   | 14,239 |   |
| Amortization  of stock-based compensation:                                                              |       |                                      |       |                                      |       |                                                                     |       |   |   |   |   |
| Research and development                                                                                |       | 347                                       |       | 337                                       |       | 1,063                                                                    |       | 836 |   | 2,373 |   |
| General and administrative                                                                              |       | 358                                       |       | 352                                       |       | 1,096                                                                    |       | 838 |   | 2,357 |   |
| Total operating expenses                                                                                |       | 8,887                                     |       | 7,230                                     |       | 26,969                                                                   |       | 18,070 |   | 77,950 |   |
| Interest income                                                                                         |       | 524                                       |       | 116                                       |       | 1,229                                                                    |       | 229 |   | 2,146 |   |
| Interest expense                                                                                        |       | (166                                      | )          | (191                                      | )          | (555                                                                     | )          | (602 | ) | (1,859 | ) |
| Other income (expense)                                                                                  |       | 5                                         |       | 10                                        |       | (7                                                                       | )          | 12 |   | 13 |   |
| Total other income (expense), net                                                                       |       | 363                                       |       | (65                                       | )          | 667                                                                      |       | (361 | ) | 300 |   |
| Net loss                                                                                                |       | (8,524                                    | )          | (7,295                                    | )          | (26,302                                                                  | )          | (18,431 | ) | (77,650 | ) |
| Deemed dividend-beneficial conversion feature for Series C  redeemable convertible preferred stock |       | —                                    |       | —                                    |       | —                                                                   |       | (28,103 | ) | (28,103 | ) |
| Accretion of Series C redeemable convertible preferred stock  issuance costs                       |       | —                                    |       | (17                                       | )          | (6                                                                       | )          | (33 | ) | (57 | ) |
| Net loss applicable to common  stockholders                                                             |       | $                                         | (8,524     | )                                         | $          | (7,312                                                                   | )          | $ | (26,308 | ) | $ | (46,567 | ) | $ | (105,810 | ) |
| Historical  net loss per share:                                                                         |       |                                      |       |                                      |       |                                                                     |       |   |   |   |   |
| Basic and diluted                                                                                       |       | $                                         | (0.43      | )                                         | $          | (6.64                                                                    | )          | $ | (1.51 | ) | $ | (46.19 | ) |   |   |
| Weighted-average shares-basic and diluted                                                               |       | 19,913,038                                |       | 1,100,323                                 |       | 17,409,227                                                               |       | 1,008,098 |   |   |   |

 

See accompanying notes.

 

4

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**FAVRILLE, INC.(a development stage company)**

 

**STATEMENTS OF CASH FLOWS(in thousands)**

**Unaudited**

 
| ** **                                                                              | ** ** | **Nine Months ended  September 30,** | ** ** | **Period from January 21, 2000  (inception) to September 30,** | ** ** |
|-----------------------------------------------------------------------------------------|------------|-------------------------------------------|------------|--------------------------------------------------------------------------|------------|
| ** **                                                                              | ** ** | **2005**                                  | ** ** | **2004**                                                                 | ** ** | **2005** | ** ** |
| **Operating activities**                                                                |       |                                      |       |                                                                     |       |   |   |
| Net loss                                                                                |       | $                                         | (26,302    | )                                                                        | $          | (18,431 | ) | $ | (77,650 | ) |
| Adjustments  to reconcile net loss to net cash used in operating activities:            |       |                                      |       |                                                                     |       |   |   |
| Depreciation and amortization                                                           |       | 1,341                                     |       | 1,012                                                                    |       | 3,863 |   |
| Issuance of options and warrant related to consulting agreements                        |       | —                                    |       | 169                                                                      |       | 186 |   |
| Stock-based compensation                                                                |       | 2,159                                     |       | 1,674                                                                    |       | 4,749 |   |
| Non-cash interest expense                                                               |       | 28                                        |       | 47                                                                       |       | 168 |   |
| Issuance of restricted common stock for license                                         |       | —                                    |       | —                                                                   |       | 24 |   |
| Deferred rent                                                                           |       | 404                                       |       | 448                                                                      |       | 1,197 |   |
| Amortization of premium/discount on short-term investments                              |       | (3                                        | )          | —                                                                   |       | (5 | ) |
| Accrued interest on short-term investments                                              |       | (331                                      | )          | —                                                                   |       | (346 | ) |
| Unrealized loss on cash and cash equivalents                                            |       | —                                    |       | —                                                                   |       | (1 | ) |
| Changes in  operating assets and liabilities:                                           |       |                                      |       |                                                                     |       |   |   |
| Receivables                                                                             |       | 1                                         |       | 31                                                                       |       | (3 | ) |
| Prepaid expenses and other assets                                                       |       | 229                                       |       | (206                                                                     | )          | (1,009 | ) |
| Accounts payable and accrued liabilities                                                |       | 877                                       |       | 546                                                                      |       | 3,480 |   |
| Net cash used in operating activities                                                   |       | (21,597                                   | )          | (14,710                                                                  | )          | (65,347 | ) |
| **Investing activities**                                                                |       |                                      |       |                                                                     |       |   |   |
| Purchases of property and equipment                                                     |       | (806                                      | )          | (3,613                                                                   | )          | (12,747 | ) |
| Purchases of short-term investments                                                     |       | (23,206                                   | )          | —                                                                   |       | (24,699 | ) |
| Receivable, other                                                                       |       | —                                    |       | 207                                                                      |       | — |   |
| Other assets                                                                            |       | —                                    |       | —                                                                   |       | (70 | ) |
| Restricted cash                                                                         |       | —                                    |       | —                                                                   |       | (1,710 | ) |
| Sale of restricted cash                                                                 |       | 56                                        |       | 52                                                                       |       | 160 |   |
| Net cash used in investing activities                                                   |       | (23,956                                   | )          | (3,354                                                                   | )          | (39,066 | ) |
| **Financing activities**                                                                |       |                                      |       |                                                                     |       |   |   |
| Proceeds from debt                                                                      |       | 1,427                                     |       | 2,764                                                                    |       | 11,534 |   |
| Payments on debt                                                                        |       | (1,990                                    | )          | (1,533                                                                   | )          | (5,575 | ) |
| Issuance of preferred stock, net                                                        |       | —                                    |       | 43,618                                                                   |       | 76,144 |   |
| Deferred IPO issuances costs, net                                                       |       | —                                    |       | —                                                                   |       | — |   |
| Proceeds from issuance of convertible promissory note                                   |       | —                                    |       | —                                                                   |       | 650 |   |
| Issuance of common stock                                                                |       | 39,550                                    |       | 442                                                                      |       | 40,188 |   |
| Repurchase of restricted common stock                                                   |       | (7                                        | )          | (6                                                                       | )          | (36 | ) |
| Net cash provided by financing activities                                               |       | 38,980                                    |       | 45,285                                                                   |       | 122,905 |   |
| Net (decrease) increase in cash and cash equivalents                                    |       | (6,573                                    | )          | 27,221                                                                   |       | 18,492 |   |
| Cash and cash equivalents at beginning of period                                        |       | 25,065                                    |       | 5,610                                                                    |       | — |   |
| Cash and cash equivalents at end of period                                              |       | $                                         | 18,492     |                                                                     | $          | 32,831 |   | $ | 18,492 |   |
|                                                                                    |       |                                      |       |                                                                     |       |   |   |
| **Supplemental  schedule of noncash investing and financing activities:**          |       |                                      |       |                                                                     |       |   |   |
| Conversion of convertible preferred stock to common stock upon  initial public offering |       | $                                         | 43,678     |                                                                     | $          | — |   | $ | 43,678 |   |

 

See accompanying notes.

 

5

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**FAVRILLE,INC.NOTES TO CONDENSEDFINANCIAL STATEMENTSSEPTEMBER 30, 2005UNAUDITED**

 

**1. Basis of Presentation**

 

The accompanying unaudited interim financial statements have beenprepared in accordance with U.S. generally accepted accounting principles andwith the rules and regulations of the Securities and Exchange Commissionrelated to a quarterly report on Form 10-Q. Accordingly, they do notinclude all of the information and disclosures required by U.S. generallyaccepted accounting principles for complete financial statements. The balancesheet at December 31, 2004 has been derived from the audited financialstatements at that date but does not include all information and footnotesrequired by U.S. generally accepted accounting principles for completefinancial statements. The interim financial statements reflect all adjustmentswhich, in the opinion of management, are necessary for a fair presentation ofthe financial condition and results of operations for the periods presented.Except as otherwise disclosed, all such adjustments are of a normal recurringnature.

 

Operating results for the three and nine months ended September 30,2005 are not necessarily indicative of the results that may be expected for theyear ending December 31, 2005. Thesefinancial statements should be read in conjunction with the financialstatements included in the Company’s Annual Report on Form 10-K for theyear ended December 31, 2004 and management’s discussion and analysis offinancial condition and results of operations included elsewhere herein.

 

The preparation of financial statements in conformity with U.S.generally accepted accounting principles requires management to make estimatesand assumptions that affect the reported amounts of assets and liabilities aswell as expenses during the reporting period. Actual results could differ fromthose estimates.

 

***Stock-BasedCompensation***

 

Favrille has a stock-based employee plan and anon-employee director compensation plan that are described more fully in Note 5to the Financial Statements included in the Company’s Annual Report on Form 10-Kfor the year ended December 31, 2004. Favrille accounts for these plansunder the recognition and measurement principles of Accounting Principles Board(“APB”) Opinion No. 25, *Accounting for StockIssued to Employees,* and related Interpretations. As of September 30,2005, no grants had been made from the non-employee director plan. No deferredcompensation was recorded related to options granted during the three-monthperiod ended September 30, 2005 and 2004. With respect to certain optionsgranted during the nine-month period ended September 30, 2005 and 2004,the Company has recorded deferred compensation of approximately $350,000 and$8.4 million, respectively, for the incremental difference at the grant datebetween the fair value per share determined by the Company’s Board of Directors(“Board”) and the deemed fair value per share solely for financial reportingpurposes.  Deferred stock-basedcompensation is recognized and amortized on a straight-line basis over thevesting period of the related options, generally four years.

 

In December 2002, the Financial Accounting Standards Board (“FASB”)issued Statement of Financial Accounting Standards (“SFAS”) No. 148,*Accounting for Stock-Based Compensation—Transitionand Disclosure—an amendment of SFAS No. 123*, *Accounting for Stock-Based Compensation*which provides alternative methods of transition for a voluntary change to thefair value based method of accounting for stock-based employee compensationfrom the intrinsic value-based method of accounting prescribed by APB Opinion No. 25.In addition, SFAS No. 148 amends the disclosure requirements of SFAS No. 123.The Company adopted the disclosure requirements of SFAS No. 148 effective December 31,2003.

 

Pro forma information regarding net loss is required by SFAS No. 123and has been determined as if the Company had accounted for its stock-basedemployee compensation under the fair value method prescribed in SFAS No. 123.The fair value of the options was estimated at the date of grant using theBlack-Scholes option pricing model with the following assumptions for the threeand nine months ended September 30, 2005 and 2004: weighted-average risk-freeinterest rates of 4.06% for the three-month period ended September 30,2005, and 4.25% and 2.79% for the nine-month periods ended September 30,2005 and 2004, respectively; dividend yields of 0%; expected volatility of 70%;and a weighted-average expected life of four years. There were no grantsawarded for the three-month period ended September 30, 2004.  For purposes of pro forma disclosures, theestimated fair value of the options is amortized to expense over the vestingperiod of the related options.

 

The following table illustrates the effect onnet loss and net loss per share if Favrille had applied the fair valuerecognition provisions of SFAS No. 123, to stock-based employeecompensation.

 

6

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| ** **                                                                                           | ** ** | **Three Months ended September 30,**  | ** ** | **Nine Months ended  September 30,** | ** ** |
|------------------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                                                           | ** ** | **2005**                                   | ** ** | **2004**                                  | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                                                                           | ** ** | **(in thousands, except per share  data)** | ** ** |
| Net loss applicable to common stockholders as reported                                               |       | $                                          | (8,524     | )                                         | $          | (7,312 | ) | $ | (26,308 | ) | $ | (46,567 | ) |
| Add: Stock-based employee compensation expense included in net loss                                  |       | 705                                        |       | 689                                       |       | 2,159 |   | 1,674 |   |
| Deduct: Stock-based employee compensation expense determined under  fair value method for all awards |       | (816                                       | )          | (659                                      | )          | (2,320 | ) | (1,710 | ) |
| Pro forma net loss applicable to common stockholders                                                 |       | $                                          | (8,635     | )                                         | $          | (7,282 | ) | $ | (26,469 | ) | $ | (46,603 | ) |
| Net loss per  share:                                                                                 |       |                                       |       |                                      |       |   |   |   |   |
| As reported—Basic and Diluted                                                                   |       | $                                          | (0.43      | )                                         | $          | (6.64 | ) | $ | (1.51 | ) | $ | (46.19 | ) |
| Pro forma—Basic and Diluted                                                                     |       | $                                          | (0.43      | )                                         | $          | (6.62 | ) | $ | (1.52 | ) | $ | (46.23 | ) |

 

***Net Loss per CommonShare***

 

Net loss per share is calculated inaccordance with SFAS No. 128, *EarningsPer Share,* and Staff Accounting Bulletin (SAB) No. 98. Basicloss per share is calculated using the weighted average number of common sharesoutstanding during each period, without consideration for common stockequivalents. Diluted loss per share includes the dilutive effect of commonequivalent shares outstanding for the period determined using thetreasury-stock method. For purposes of this calculation, common stock subjectto repurchase by the Company, preferred stock, options and warrants areconsidered to be common stock equivalents and are only included in thecalculation of diluted earnings per share when their effect is dilutive.

 

Pro forma net loss per share has beencalculated as described above. The pro forma shares used to compute basic anddiluted net loss per share represent the weighted-average common sharesoutstanding, reduced by the weighted-average unvested common shares subject torepurchase, and include the assumed automatic conversion of all outstandingshares of preferred stock that automatically converted into shares of commonstock upon the closing of our initial public offering  (“IPO”), in February 2005, using theas-if converted method as of January 1, 2004 or the date of issuance, iflater.

 
| ** **                                                                                              | ** ** | **Three Months ended  September 30,** | ** ** | **Nine Months ended  September 30,** | ** ** |
|---------------------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                                                              | ** ** | **2005**                                   | ** ** | **2004**                                  | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                                                                              | ** ** | **(in thousands, except per share  data)** | ** ** |
| **Historical:**                                                                                         |       |                                       |       |                                      |       |   |   |   |   |
| Numerator:                                                                                              |       |                                       |       |                                      |       |   |   |   |   |
| Net loss                                                                                                |       | $                                          | (8,524     | )                                         | $          | (7,295 | ) | $ | (26,302 | ) | $ | (18,431 | ) |
| Deemed dividend-beneficial conversion feature for Series C redeemable  convertible preferred stock |       | —                                     |       | —                                    |       | — |   | (28,103 | ) |
| Accretion of Series C redeemable convertible stock issuance  costs                                 |       | —                                     |       | (17                                       | )          | (6 | ) | (33 | ) |
| Net loss applicable to common stockholders                                                              |       | $                                          | (8,524     | )                                         | $          | (7,312 | ) | $ | (26,308 | ) | $ | (46,567 | ) |
| Denominator:                                                                                            |       |                                       |       |                                      |       |   |   |   |   |
| Weighted-average common shares                                                                          |       | 20,303,297                                 |       | 1,691,443                                 |       | 17,879,917 |   | 1,480,902 |   |
| Weighted-average unvested common shares subject to repurchase                                           |       | (390,259                                   | )          | (591,120                                  | )          | (470,690 | ) | (472,803 | ) |
| Denominator for basic and diluted earnings per share                                                    |       | 19,913,038                                 |       | 1,100,323                                 |       | 17,409,227 |   | 1,008,099 |   |
|                                                                                                    |       |                                       |       |                                      |       |   |   |   |   |
| Basic and diluted net loss per share                                                                    |       | $                                          | (0.43      | )                                         | $          | (6.64 | ) | $ | (1.51 | ) | $ | (46.19 | ) |
| **Pro  forma:**                                                                                         |       |                                       |       |                                      |       |   |   |   |   |
| Net loss applicable to common stockholders                                                              |       | $                                          | (8,524     | )                                         | $          | (7,312 | ) | $ | (26,308 | ) | $ | (46,567 | ) |
|                                                                                                    |       |                                       |       |                                      |       |   |   |   |   |
| Pro forma basic and diluted net loss per share                                                          |       | $                                          | (0.43      | )                                         | $          | (0.57 | ) | $ | (1.38 | ) | $ | (4.38 | ) |
|                                                                                                    |       |                                       |       |                                      |       |   |   |   |   |
| Shares used above                                                                                       |       | 19,913,038                                 |       | 1,100,323                                 |       | 17,409,227 |   | 1,008,099 |   |
| Pro forma adjustments to reflect weighted-average affect of conversion  of preferred stock              |       | —                                     |       | 11,645,522                                |       | 1,650,409 |   | 9,621,073 |   |
| Pro forma shares used to compute basic and diluted net loss per share                                   |       | 19,913,038                                 |       | 12,745,845                                |       | 19,059,636 |   | 10,629,172 |   |

 

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| ** **                                                                                                   | ** ** | **As of September 30,** | ** ** |
|--------------------------------------------------------------------------------------------------------------|------------|------------------------------|------------|
| ** **                                                                                                   | ** ** | **2005**                     | ** ** | **2004** | ** ** |
| **Historical  outstanding antidilutive securities not included in diluted net loss per  share calculation:** |       |                         |       |   |   |
| Common stock  equivalents:                                                                                   |       |                         |       |   |   |
| Redeemable convertible preferred stock                                                                       |       | —                       |       | 6,140,188 |   |
| Convertible preferred stock                                                                                  |       | —                       |       | 5,505,330 |   |
| Stock warrants                                                                                               |       | 29,831                       |       | 47,057 |   |
| Options to purchase common stock                                                                             |       | 1,481,200                    |       | 1,052,360 |   |
| Common stock subject to repurchase                                                                           |       | 355,216                      |       | 547,872 |   |
|                                                                                                         |       | 1,866,247                    |       | 13,292,807 |   |

 

**2. Comprehensive Loss**

 

Components of comprehensive loss were asfollows (in thousands):

 
| ** **                                          | ** ** | **Three Months ended September 30,** | ** ** | **Nine Months ended September 30,** | ** ** |
|-----------------------------------------------------|------------|-------------------------------------------|------------|------------------------------------------|------------|
| ** **                                          | ** ** | **2005**                                  | ** ** | **2004**                                 | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                                |       |                                      |       |                                     |       |   |   |   |   |
| Net loss                                            |       | $                                         | (8,524     | )                                        | $          | (7,295 | ) | $ | (26,302 | ) | $ | (18,431 | ) |
| Change in unrealized loss on short-term investments |       | (30                                       |  )    | —                                   |       | (42 | ) | — |   |
| Comprehensive loss                                  |       | $                                         | (8,554     | )                                        | $          | (7,295 | ) | $ | (26,344 | ) | $ | (18,431 | ) |

 

Accumulated other comprehensive loss totaled$44,000 and $2,000 at September 30, 2005 and December 31, 2004,respectively, and was attributed to unrealized losses on short-terminvestments.

 

**3. Stockholders’ Equity**

 

*Initial Public Offering*

 

On February 7, 2005, the Company completed an initial closing ofits IPO in which it sold 6,000,000 shares of common stock for proceeds of $37.7million, net of underwriting discounts and commissions and $1.4 million ofoffering expenses. In addition, on March 7, 2005, the Company completed anadditional closing of its IPO in which it sold an additional 285,000 shares ofcommon stock pursuant to the partial exercise by the underwriters of anover-allotment option which resulted in proceeds of $1.8 million, net ofunderwriting discounts and commissions.

 

*Authorized Capital Stock*

 

On February 7, 2005, the Company filed an amended and restatedcertificate of incorporation to provide for authorized capital stock of75,000,000 shares of common stock and 5,000,000 shares of undesignatedpreferred stock.

 

*Convertible Preferred Stock*

 

Effective immediately prior to the initialclosing of the IPO in February 2005, shares of Series A, B, B-2 and Cconvertible preferred stock then outstanding were converted into an aggregateof 12,177,344 shares of the Company’s common stock.

 

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**Item 2. Management’s Discussion and Analysisof Financial Condition and Results of Operations.**

 

**Cautionary Note Regarding Forward-LookingStatements**

 

*This Form 10-Q contains certain forward-looking statementsincluding expectations of market conditions, challenges and plans, within themeaning of Section 21E of the Securities Exchange Act of 1934, as amended,and is subject to the Safe Harbor provisions created by that statute. The words“anticipate”, “expect”, “believe”, “plan”, “intend”, and similar expressionsare intended to identify such statements. Although the forward-lookingstatements in this Form 10-Q reflect the good faith judgment of ourmanagement, such statements are subject to various risks and uncertainties,including but not limited to those discussed herein and, in particular, underthe caption “Factors That May Affect Future Operating Results” beginningon page 14 and throughout our Annual Report on Form 10-K  for the year ended December 31, 2004.Actual results and the timing of selected events may differ materially fromthose anticipated in these forward-looking statements. We disclaim any duty toupdate any forward-looking statement to reflect events or circumstances thatoccur after the date on which such statement is made.*

 

**Overview**

 

Weare a biopharmaceutical company focused on the research, development andcommercialization of targeted immunotherapies for the treatment of cancer anddiseases of the immune system. We have developed a proprietary technology thatenables us to manufacture active immunotherapy products that are designed tostimulate a patient’s immune system to mount a specific and sustainedresponse to disease. Our lead product candidate, FavId, is an activeimmunotherapy for the treatment of B-cell non-Hodgkin’s lymphoma, or NHL. FavIdentered a pivotal Phase 3 clinical trial in follicular B-cell NHL in July 2004.As of August 9, 2005, 260 patients had been enrolled in the Phase 3 clinicaltrial. In addition, FavId has been evaluated in several multi-center,open-label Phase 2 clinical trials involving over 120 patients.

 

We believe FavId may be effective in treating other types of B-cellNHL. Five additional Phase 2 clinical trials of FavId are either ongoing orexpected to begin during 2005. One of these clinical trials is being conductedunder a separate physician-sponsored Investigational New Drug Application (“IND”)in the United States. A second of these is being conducted as aphysician-sponsored clinical trial in Switzerland. Moreover, we believe ouractive immunotherapy expertise and proprietary manufacturing technology willenable us to develop additional product candidates for other oncologyindications, such as T-cell lymphoma, and for autoimmune diseases, with aninitial focus on multiple sclerosis. We are currently developing a secondproduct candidate, FAV-201, for the treatment of T-cell lymphoma. We haveretained exclusive worldwide commercialization rights to all of our productcandidates.

 

We were incorporated in Delaware in January 2000. As of September 30,2005, we had not generated any revenues, and we had financed our operations andinternal growth through private placements of our preferred stock, equipmentand leasehold debt financings and the sale of common stock in our initialpublic offering (“IPO”) in February 2005. We are a development stagecompany and have incurred significant losses since our inception in 2000, as wehave devoted substantially all of our efforts to research and developmentactivities, including clinical trials. As of September 30, 2005, ouraccumulated deficit was approximately $105.8 million. We expect to incursubstantial and increasing losses for the next several years as we:

 

•continue to develop and prepare for the commercialization of our lead productcandidate, FavId;

•expand our research and development programs;

•expand our current manufacturing capabilities to support our operations; and

•acquire or in-license oncology products that are complementary to our own.

 

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**Financial Operations Overview**

 

***Research andDevelopment Expense.***Research and developmentexpense consists primarily of costs associated with clinical trials of ourproduct candidates, including the costs of manufacturing our productcandidates, compensation and other expenses related to research and developmentpersonnel, facilities costs and depreciation. We charge all research anddevelopment expenses to operations as they are incurred. Our research anddevelopment activities are primarily focused on the development of FavId. Wehave completed enrollment in two Phase 2 clinical trials and continue toevaluate the results. We initiated our pivotal Phase 3 clinical trial of FavIdfollowing Rituxan in patients with follicular B-cell NHL in July 2004. Weexpect to complete patient enrollment in the trial by the end of 2005 and anticipatean interim analysis of the secondary endpoint, response rate improvement (“RRI”),during the fourth quarter of 2006 and final analysis of the primary endpoint,time to disease progression (“TTP”), during the second half of 2007. Fiveadditional Phase 2 clinical trials of FavId are either ongoing or expected tobegin during 2005. One of these clinical trials is being conducted under aseparate physician-sponsored IND in the United States. A second of these isbeing conducted as a physician-sponsored clinical trial in Switzerland. Weestimate average enrollment periods of 12 to 24 months and evaluation periodsranging from six to 36 months for these Phase 2 clinical trials.

 

From inception through September 30, 2005, we incurred costs ofapproximately $59 million associated with the research and development ofFavId, which represents substantially all of our research and development coststo date. We expect our research and development costs to increase as we advanceFavId and new product candidates into later stages of clinical development.While difficult to predict, we estimate that research and development costsrequired to complete the development of and file a Biologics LicensingApplication (“BLA”) for FavId will be an additional $70 million. We are unableto estimate with any certainty the costs we will incur in the continueddevelopment of other product candidates for commercialization. On an ongoingbasis, we expect to expand our research and development activities to includeclinical development of FAV-201 and preclinical research of treatments forautoimmune diseases, primarily multiple sclerosis.

 

Clinical development timelines, likelihood of success and total costsvary widely. Although we are currently focused primarily on FavId, weanticipate that we will make determinations as to which research anddevelopment projects to pursue and how much funding to direct toward eachproject on an on-going basis in response to the scientific and clinical successof each product candidate.

 

At this time, due to the risks inherent in the clinical trial process,product candidate completion dates and costs vary significantly for eachproduct candidate and are difficult to estimate. The lengthy process of seekingregulatory approvals and the subsequent compliance with applicable regulationsrequire the expenditure of substantial resources. Any failure by us to obtain,or any delay in obtaining, regulatory approvals for our product candidatescould cause our research and development expenditures to increase and, in turn,have a material adverse effect on our results of operations. We cannot becertain when, or if, any cash flows from our current product candidates willcommence.

 

***General andAdministrative Expense.***General and administrativeexpenses consist primarily of compensation and other expenses related to ourcorporate administrative employees, legal fees and other professional servicesexpenses. We anticipate increases in general and administrative expenses as weadd personnel and continue to develop and prepare for commercialization of ourproduct candidates.

 

***Stock-BasedCompensation Expense.***Stock-based compensationexpense represents the amortization of deferred stock-based compensationresulting from options, granted prior to our IPO, that are consideredcompensatory because the deemed fair value of the underlying common stock forfinancial reporting purposes was greater than the exercise prices determined bythe board of directors on the date of grant.

 

***Interest Income.***Interestincome primarily consists of interest earned on our cash reserves, cashinvested in money market funds, government securities, corporate notes andbonds and certificates of deposit.

 

***Interest Expense.***Interestexpense represents interest on our debt, including capital leases.

 

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**Critical Accounting Policies and Estimates**

 

Thediscussion and analysis of our financial condition and results of operationsare based on our financial statements, which have been prepared in accordance withU.S. generally accepted accounting principles. The preparation of financialstatements requires us to make estimates and assumptions that affect thereported amounts of assets, liabilities, expenses and related disclosures.Actual results could differ from those estimates. We believe the followingaccounting policies to be critical to the judgments and estimates used in thepreparation of our financial statements:

 

***Deferred Tax Asset Valuation Allowance.***    Ourestimate for the valuation allowance for deferred tax assets requires us tomake significant estimates and judgments about our future operating results.Our ability to realize the deferred tax assets depends on our future taxableincome as well as limitations on utilization. A deferred tax asset must bereduced by a valuation allowance if it is more likely than not that someportion or all of the deferred tax asset will not be realized prior to itsexpiration. The projections of our operating results on which the establishmentof a valuation allowance is based involve significant estimates regardingfuture demand for our products, competitive conditions, product developmentefforts, approvals of regulatory agencies and product cost. We have recorded afull valuation allowance on our net deferred tax assets as of September 30,2005 and December 31, 2004, due to uncertainties related to our ability toutilize our deferred tax assets in the foreseeable future. These deferred taxassets primarily consist of certain net operating loss carryforwards and researchand development tax credits.

 

***Deferred Stock-Based Compensation.***    Inconnection with the grant of stock options during the three months ended September 30,2005 and 2004, we recorded no deferred stock-based compensation. In connectionwith the grant of stock options during the nine months ended September 30,2005 and 2004, we recorded deferred stock-based compensation of approximately $350,000and $8.4 million, respectively. Deferred stock-based compensation was reducedby amounts representing stock option cancellations and our repurchase ofunvested restricted stock related to employee terminations of approximately $28,000,$75,000, $176,000 and $88,000, during the three months ended September 30,2005 and 2004, and the nine months ended September 30, 2005 and 2004,respectively. These options were considered compensatory because the deemedfair value of the underlying common stock for financial reporting purposes wasgreater than the exercise prices determined by the board of directors on thedate of grant. The determination of the fair value prior to our IPO of theunderlying shares of common stock involves subjective judgment and theconsideration of a variety of factors, including the prices obtained in privateplacement transactions of other equity securities, and as a result the amountof the compensatory charge is not based on an objective measure such as thetrading price of the common stock since there was no public market for ourcommon stock prior to February 2, 2005. As of September 30, 2005, wehad an aggregate of $6.4 million of deferred stock-based compensation remainingto be amortized. This deferred stock-based compensation balance will beamortized as follows: an additional $703,000 in 2005; $2.8 million in2006; $2.3 million in 2007; and $571,000 in 2008. We are amortizing thedeferred compensation on a straight-line basis over the vesting period of therelated options, which is generally four years. The amount of stock-basedcompensation amortization actually recognized in future periods could decreaseif options for which accrued but unvested compensation has been recorded areforfeited.

 

**Results of Operations**

 

***Comparison of the Three Months Ended September 30,2005 to 2004***

 

***Research and Development****.    *Research and development expense increasedfrom approximately $4.9 million for the three months ended September 30,2004 to $7.0 million for the three months ended September 30, 2005. Theincrease of $2.1 million, or 43%, was due primarily to an increase ofapproximately $750,000 in expenses associated with clinical trial sitesand other third party vendors supporting the Phase 3 clinical trial; an increase of approximately $650,000associated with an increase in personnel from an average of 79 employees to 113employees to support our Phase 3 clinical trial; an increase of approximately $240,000 associated with rawmaterials and supplies for the manufacture of FavId for our Phase 3 clinical trial; and an increase ofapproximately $180,000 related to our manufacturing facility to support the productionof FavId.

 

***General andAdministrative****.    *General and administrative expense decreasedfrom approximately $1.7 million for the three months ended September 30,2004 to $1.2 million for the three months ended September 30, 2005. Thedecrease of $480,000, or 29%, primarily reflects a decrease of approximately$790,000 due to a non-recurring IPO related expenditure incurred in the threemonths ended September 30, 2004, which was partially offset by an increase ofapproximately $180,000 in directors and officers liability insurancepremiums and board of director’s fees incurred subsequent to our IPO; an increase of $170,000 associated with anincrease in personnel from an average of 13 employees to 19 employees; and anincrease of approximately $110,000 for services related to market researchstudies.

 

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***Amortization of Stock-Based Compensation***.    In connection with the grant of stockoptions, we recorded  no deferredstock-based compensation for the three months ended September 30, 2005 and2004, respectively. Deferred stock-based compensation was reduced by amountsrepresenting stock option cancellations and our repurchase of unvestedrestricted stock of approximately $28,000, and $75,000, respectively.The deferred stock-based compensation is being amortized on a straight-linebasis, as a non-cash charge to operations over the vesting period of theoptions. We recorded amortization of stock-based compensation of approximately $705,000and $689,000 for the three month periods ended September 30, 2005 and2004, respectively. We anticipate recording additional amortization of deferredstock-based compensation related to employee stock option grants ofapproximately $703,000, $2.8 million, $2.3 million and $571,000 for the yearsending December 31, 2005, 2006, 2007 and 2008, respectively.

 

***Interest Income****.  *Interest income increased from approximately $116,000 for the threemonths ended September 30, 2004 to approximately $524,000 for the threemonths ended September 30, 2005. The increase of $408,000, or 352%, wasprimarily a result of interest income attributable to the $43.6 million in netproceeds received from the sale of our Series C preferred stock in March andApril 2004 and the $39.5 million in net proceeds received from our IPO in February 2005.

 

***Comparison of the Nine Months Ended September 30,2005 to 2004***

 

***Research and Development****.    *Research and development expense increasedfrom approximately $12.9 million for the nine months ended September 30,2004 to approximately $21.0 million for the nine months ended September 30,2005. The increase of approximately $8.1 million, or 63%, was due primarily toan increase of approximately $2.3 million associated with raw materials andsupplies for the manufacture of FavId for our Phase 3 clinical trial; an increase of approximately $2.1 millionassociated with an increase in personnel from an average of 71 employees to 107employees to support our Phase 3 clinical trial; an increase of approximately$2.0 million in expenses associated with participating clinical sitesand other third party vendors supporting the Phase 3 clinical trial; an increase of approximately $880,000 inadditional outside services to support the manufacture of FavId; and an increaseof approximately $660,000 related to our manufacturing facility to support theproduction of FavId.

 

***General andAdministrative****.    *General and administrative expense increasedfrom approximately $3.5 million for the nine months ended September 30,2004 to approximately $3.8 million for the nine months ended September 30,2005. The increase of $264,000, or 8%, was primarily due to an increase of $480,000associated with an increase in personnel from an average of 11 employees to 16 employees;and an increase of approximately $480,000 in directors and officersliability insurance premiums and other fees incurred subsequent to ourIPO; which is partially offset by adecrease of approximately $790,000 due to a non-recurring IPO relatedexpenditure incurred in the three months ended September 30, 2004.

 

***Amortization of Stock-Based Compensation***.    In connection with the grant of stockoptions, we recorded deferred stock-based compensation of approximately$350,000 and $8.4 million for the nine months ended September 30, 2005 and2004, respectively. Deferred stock-based compensation was reduced by amountsrepresenting stock option cancellations and our repurchase of unvestedrestricted stock of approximately $176,000 and $88,000 for the nine monthsended September 30, 2005 and 2004, respectively. The deferredstock-based compensation is being amortized on a straight-line basis, as anon-cash charge to operations over the vesting period of the options. Werecorded amortization of stock-based compensation of approximately $2.2 millionand $1.7 million for the nine-month periods ended September 30, 2005 and2004, respectively. We anticipate recording additional amortization of deferredstock-based compensation related to employee stock option grants ofapproximately $703,000, $2.8 million, $2.3 million and $571,000 for the yearsending December 31, 2005, 2006, 2007 and 2008, respectively.

 

***Interest Income****.  *Interest income increased from approximately $229,000 for the ninemonths ended September 30, 2004 to approximately $1.2 million for the ninemonths ended September 30, 2005. The increase of $1.0 million, or 437%,was primarily a result of interest income attributable to the $43.6 million innet proceeds received from the sale of our Series C preferred stock in March andApril 2004 and the $39.5 million in net proceeds received from our IPO in February 2005.

 

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**Liquidity and Capital Resources**

 

***Sources of Liquidity***

 

We have historically funded our operations primarily through the saleof our equity securities and equipment and leasehold debt financing. As of September 30,2005, we had received proceeds from the sale of preferred stock ofapproximately $76.8 million, net of stock offering costs of approximately$686,000, and proceeds from the sale of common stock in our IPO ofapproximately $39.5 million, net of underwriters’ discounts and commissions andapproximately $1.4 million of offering costs. As of September 30, 2005, wehad financed the purchase of equipment and leasehold improvements through debttotaling approximately $11.5 million, of which approximately $6.2 millionwas outstanding at that date. These obligations are secured by certainpurchased equipment and leasehold improvements and are due in monthly installmentsthrough January 2009. They bear interest at effective rates ranging fromapproximately 5.18% to 21.67% and include terminal payments at the end ofcertain of the loans ranging from 7.50% to 12.75%. The debt agreements subjectus to certain non-financial covenants. As of September 30, 2005, we werein compliance with the terms of the debt agreements.

 

As of September 30,2005, we had cash, cash equivalents and short-term investments of approximately$43.2 million, as compared to approximately $26.6 million at December 31,2004, an increase of approximately $16.6 million. The increase resultedprimarily from the $39.5 million in net proceeds received from our IPOduring the first quarter of 2005, partially offset by net cash used to fundongoing operations.

 

Netcash used in operating activities was approximately $21.6 millionfor the nine-month period ended September 30, 2005, reflecting the netloss occurred for this period of approximately $26.3 million, offsetprimarily by non-cash charges for stock-based compensation of $2.2 million,depreciation and amortization of $1.3 million, deferred rent of $404,000,and an increase in accounts payable and accrued liabilities of $877,000;which was offset by accrued interest income of $331,000.   Net cash used in operating activities wasapproximately $14.7 million for the nine-month period ended September 30,2004 reflecting the net loss occurred for this period of approximately $18.4 million,offset primarily by non-cash charges for stock-based compensation of $1.7million, depreciation and amortization of $1.0 million, an increase in accountspayable and accrued liabilities of $546,000, and deferred rent of $448,000. 

 

Netcash used in investing activities for the nine-month period ended September 30,2005 was approximately $24.0 million, reflecting the purchase of $23.2million in short-term investments and the purchase of approximately $806,000 ofproperty and equipment. Net cash used in investing activities for the nine-monthperiod ended September 30, 2004 was approximately $3.4 million,reflecting primarily the purchase of approximately $3.6 million of property andequipment, partially offset by amount received from our landlord as areimbursement of costs associated with tenant improvements expenditures.

 

Netcash provided by financing activities for the nine-month period ended September 30,2005 was approximately $39.0 million, reflecting primarily the netproceeds from our IPO during the first quarter of 2005 of approximately$39.5 million.  Net cash provided byfinancing activities for the nine-month period ended September 30, 2004was approximately $45.3 million, reflecting primarily the net proceedsfrom the sale of our Series C preferred stock in March and April 2004and net proceeds of debt financing of approximately $1.2 million.

 

***Funding Requirements***

 

Our futurecapital uses and requirements depend on numerous forward-looking factors. Thesefactors include but are not limited to the following:

 

•magnitude and cost of our product development efforts and other research anddevelopment activities;

 

•rate of progress toward obtaining regulatory approval for our productcandidates;

 

•costs of filing, prosecuting, defending and enforcing our patent claims andother intellectual property rights;

 

•our ability to establish and maintain collaborative, licensing or otherarrangements for the development, sale, marketing or distribution of ourproduct candidates and the terms of those arrangements;

 

•effects of competing technological and market developments;

 

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• the costof expansion of our current facility for commercial production or theconstruction of a large separate commercial-scale production facility; and

 

• thesuccess of the commercialization of FavId.

 

Until we cangenerate significant cash from our operations, we expect to continue to fundour operations with existing cash resources that were primarily generated fromthe proceeds of offerings of our equity securities and from equipment andleasehold improvement debt financing. In addition, we may finance future cashneeds through the sale of other equity securities, strategic collaborationagreements and debt financing. However, we may not be successful in obtainingcollaboration agreements, or in receiving milestone or royalty payments underthose agreements. In addition, we cannot be sure that our existing cash andcash equivalents will be adequate or that additional financing will beavailable when needed or that, if available, financing will be obtained onterms favorable to us or our stockholders. Having insufficient funds mayrequire us to delay, scale back or eliminate some or all of our research ordevelopment programs or to relinquish greater or all rights to productcandidates at an earlier stage of development or on less favorable terms thanwe would otherwise choose. Failure to obtain adequate financing may alsoadversely affect our ability to operate as a going concern. If we raiseadditional funds by issuing equity securities, substantial dilution to existingstockholders would likely result. If we raise additional funds by incurringdebt financing, the terms of the debt may involve significant cash paymentobligations as well as covenants and specific financial ratios that mayrestrict our ability to operate our business.

 

As of September 30, 2005, we do not believe that we have investedin any variable interest entities. We do not have any relationships withunconsolidated entities or financial partnerships, such as entities oftenreferred to as structured finance or special purpose entities, which would havebeen established for the purpose of facilitating off-balance sheet arrangementsor other contractually narrow or limited purposes. In addition, we do notengage in trading activities involving non-exchange traded contracts. As such,we are not materially exposed to any financing, liquidity, market or creditrisk that could arise if we had engaged in these relationships.

 

**Factors that May Affect Future OperatingResults**

 

*You should consider carefully the riskfactors described below, together with the other information contained in thisreport. If any of the following risks actually occur, our business, financialcondition, results of operations and future growth prospects would likely bematerially and adversely affected. In these circumstances, the market price ofour common stock could decline, and you may lose all or part of your investmentin our common stock.*

 

**RisksRelated to the Development of Our Product Candidates**

 

**We are dependent on the success of our leadproduct candidate, FavId, and we cannot be certain that it will becommercialized.**

 

We have expended significant time, money and effort in the developmentof our lead product candidate, FavId, which is still in clinical development,has not yet received regulatory approval and may never be commercialized. Inorder to commercialize FavId, we will need to demonstrate to the FDA and otherregulatory agencies that it satisfies rigorous standards of safety andeffectiveness. We initiated a pivotal Phase 3 clinical trial of FavId followingRituxan for the treatment of follicular B-cell NHL in July 2004.

 

We are also evaluating FavId for use in other B-cell NHL indications.However, even if we were to receive regulatory approval of FavId for thetreatment of indolent B-cell NHL or the other indications we are exploring, ourability to successfully commercialize FavId could be jeopardized by theemergence of a competitive product that exhibits greater efficacy, longerduration of response or other benefits. In addition, because our initialregulatory and marketing strategy contemplates the administration of FavId topatients following treatment with Rituxan, the commercial opportunity for FavIdmay be limited by the degree to which oncologists continue to use Rituxan totreat indolent B-cell NHL. Furthermore, to the extent FavId fails to gainmarket acceptance for its initial indication, it may be more difficult for usto generate sufficient credibility with physicians and patients to commercializeFavId for other indications.

 

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Other than FavId, we have only two other product development programs,which are at significantly earlier stages of development. We are currentlypreparing to file an IND for a product candidate, FAV-201, from one of theseprograms in patients with T-cell lymphoma. During the fourth quarter of 2005,we intend to initiate preclinical studies to assess the applicability of ourtechnology to autoimmune diseases, with an initial focus on multiple sclerosis.We cannot be certain that we will be able to successfully develop any productcandidate from these development programs. We cannot be certain that theclinical development of FavId or any other product candidate in preclinicaltesting or clinical trials will be successful, that it will receive theregulatory approvals required to commercialize it, or that any of our otherresearch programs will yield a product candidate suitable for entry intoclinical trials. If we are unable to commercialize FavId or our other productcandidates, we may be unable to generate sufficient revenues to attain ormaintain profitability, our ability to raise additional capital will beimpaired and our stock price may be negatively affected.

 

**Failure to obtain product approvals by theFDA could harm our business.**

 

We are subject to rigorous and extensive regulation by the FDA. In theUnited States, our biologic product candidates, currently in the preclinicaland clinical stages of development, cannot be marketed until they are approvedby the FDA. Obtaining FDA approval involves the submission of the results ofpreclinical studies and clinical trials, among other information, of theproduct candidates. We may not be able to obtain FDA approval, and, even if weare able to do so, the approval process typically takes many years and requiresthe commitment of substantial effort and financial resources. The FDA candelay, limit or deny approval of a biologic product candidate for many reasons,including:

 

• the FDAmay not find that the biologic product candidate is sufficiently safe oreffective;

 

• FDAofficials may interpret data from preclinical testing and clinical trialsdifferently than we do; and

 

• the FDAmay not find our manufacturing processes or facilities satisfactory.

 

In addition, the specific active immunotherapy technology on whichFavId is based is a relatively new form of cancer therapy that presents novelissues for the FDA to consider, which may make the regulatory process especiallydifficult.

 

We cannot assure you that any of our product candidates in developmentwill be approved in the United States in a timely fashion, or at all. Failureto obtain regulatory approval of our product candidates in a timely fashionwould prevent or delay us from marketing or selling any products and,therefore, from generating revenues from their sale. If this occurs, we may beunable to generate sufficient revenues to attain or maintain profitability, ourability to raise additional capital will be impaired and our stock price may benegatively affected. In addition, both before and after approval, we aresubject to numerous FDA requirements covering, among other things, testing,manufacturing, quality control, labeling, advertising, promotion and export ofbiologics. Failure to comply with the law, including statutes and regulations,administered by the FDA, could result in, among others, any of the followingactions:

 

• warningletters;

 

• fines andother civil penalties;

 

•unanticipated expenditures;

 

• delays inapproving or refusal to approve a product candidate;

 

• productrecall or seizure;

 

•interruption of production;

 

• operatingrestrictions;

 

•injunctions; and

 

• criminalprosecution.

 

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**Before we can seek regulatory approval of anyof our product candidates, we must successfully complete clinical trials, whichare uncertain.**

 

Conducting clinical trials is a lengthy, time-consuming and expensiveprocess, and the results of these trials are inherently uncertain. We havecompleted enrollment of patients in several Phase 2 clinical trials of FavIdinvolving over 120 indolent B-cell NHL patients and are currently conductingfollow-up evaluation of those patients. We initiated a pivotal Phase 3 clinicaltrial of FavId for the treatment of follicular B-cell NHL in July 2004. Weexpect to complete enrollment of our target of 342 evaluable patients by yearend or soon thereafter and anticipate an analysis of the secondary endpoint,RRI, during the fourth quarter of 2006 and final analysis of the primaryendpoint, TTP, during the second half of 2007. Five additional Phase 2clinical trials of FavId are either ongoing or expected to begin during 2005.One of these clinical trials is being conducted under a separatephysician-sponsored IND in the United States. A second of these is beingconducted as a physician-sponsored clinical trial in Switzerland. Sponsorshipfor a physician-sponsored IND of an ongoing Phase 2 clinical trial wasassumed in August 2004. We are also developing our preclinical candidete FAV-201for the treatment of T-cell lymphoma and we are currently preparing to file anIND.

 

We have received a Special Protocol Assessment, or SPA, from the FDAfor our Phase 3 clinical trial. In the SPA process, the FDA reviewed thedesign, size and planned analysis of our Phase 3 clinical trial and providedcomments regarding the trial’s adequacy to form a basis with respect toeffectiveness for approval of a Biologics Licensing Application, or BLA, if thetrial meets its predetermined objectives. The FDA’s written agreement isbinding, except in limited circumstances, such as when a substantial scientificissue essential to determining the safety or effectiveness of a productcandidate is identified after the Phase 3 clinical trial is commenced. Despitehaving received an SPA, we may be required to conduct an additional Phase 3clinical trial of FavId for the treatment of indolent B-cell NHL before we canapply for regulatory approval. Although the FDA typically requires successfulresults in two Phase 3 clinical trials to support marketing approval, the FDAhas, on several occasions, approved products based on a single Phase 3 clinicaltrial that demonstrates a high level of statistical significance where there isan unmet need for a life-threatening condition. We currently plan to seek FDAapproval of FavId based on our ongoing Phase 3 clinical trial alone. Inthe event that the FDA requires the results of a second Phase 3 clinical trialbefore accepting a BLA or before granting marketing approval of FavId, ourlaunch of FavId would be delayed, possibly by several years, and we would incursignificant costs in conducting the additional trial.

 

Completion of necessary clinical trials may take several years or more.Our commencement and rate of completion of clinical trials may be delayed bymany factors, including:

 

•ineffectiveness of the product candidate, or perceptions by physicians that theproduct candidate is not safe or effective for a particular indication;

 

• inabilityto manufacture sufficient quantities of the product candidate for use inclinical trials;

 

• delay orfailure in obtaining approval of our clinical trial protocols from the FDA;

 

• slowerthan expected rate of patient recruitment and enrollment;

 

• inabilityto adequately follow and monitor patients after treatment;

 

•difficulty in managing multiple clinical sites;

 

•unforeseen safety issues; and

 

•government or regulatory delays.

 

Even if we achieve positive interim results in clinical trials, theseresults do not necessarily predict final results, and positive results in earlytrials may not be indicative of success in later trials. A number of companiesin the pharmaceutical industry have suffered significant setbacks in advancedclinical trials, even after promising results in earlier trials. Negative orinconclusive results or adverse medical events during a clinical trial couldcause us to repeat or terminate a clinical trial or require us to conductadditional trials. Our clinical trials may be suspended at any time for avariety of reasons, including if the FDA or we believe the patientsparticipating in our trials are exposed to unacceptable health risks or if theFDA finds deficiencies in the conduct of these trials.

 

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Failures or perceived failures in our clinical trials will directlydelay our product development and regulatory approval process, damage ourbusiness prospects, make it difficult for us to establish collaboration andpartnership relationships, and negatively affect our reputation and competitiveposition in the pharmaceutical community.

 

**Failure to enroll patients in our clinicaltrials may cause delays in developing FavId or any other product candidate.**

 

We may encounter delays in development and commercialization, or failto obtain marketing approval, of FavId or any other product candidate that wemay develop if we are unable to enroll enough patients to complete clinicaltrials. Our ability to enroll sufficient numbers of patients in our clinicaltrials depends on many factors, including the size of the patient population,the nature of the protocol, the proximity of patients to clinical sites, theeligibility criteria for the trial and competing clinical trials. We have fromtime to time experienced slower-than-expected patient enrollment in ourclinical trials. Delays in planned patient enrollment may result in increasedcosts and harm our ability to complete our clinical trials and obtain regulatoryapproval.

 

**The development of FavId requires thecontinued availability of two FDA-approved drugs: GM-CSF and Rituxan.**

 

Administration of FavId requires an adjuvant to enhance the immuneresponse. An adjuvant is a substance that is used to enhance the immuneresponse. We use a white blood cell growth factor known as GM-CSF, which iscommercially available solely from Berlex Laboratories, Inc., as anadjuvant for FavId. We currently rely on purchase orders to purchase GM-CSF foruse in our clinical trials and do not have a supply agreement with Berlex.GM-CSF is an FDA-approved and commercially available drug that may be purchasedby physicians. Our current strategy for the initial commercialization of FavIdinvolves the administration of FavId following treatment with Rituxan. Rituxanis a passive immunotherapy for patients with NHL, which is also FDA-approvedand is commercially available solely from Genentech, Inc. and Biogen IdecInc. We currently rely on physicians to order and administer Rituxan to patientsprior to the administration of FavId in our registration trial. If GM-CSF orRituxan were to become unavailable as a result of regulatory actions, supplyconstraints or other reasons, our ability to continue the clinical developmentof FavId would be jeopardized.

 

**RisksRelated to Our Financial Results and Need for Financing**

 

**We have incurred significant operating lossessince inception and anticipate that we will continue to incur substantiallosses and negative cash flow from operations for the foreseeable future.**

 

We are a development stage company with a limited operating history. Wehave financed our operations through private placements of preferred stock, aninitial public offering of our common stock, and equipment and leasehold debtfinancing. We have incurred losses in each year since our inception in 2000. Netlosses were $8.5 million and $26.3 million for the three- and nine- monthperiods ended September 30, 2005, respectively; $7.3 million and $18.4million for the three- and nine- month periods ended September 30, 2004,respectively; and $26.0 million, $13.3 million, $7.2 million,$3.8 million and $1.0 million for 2004, 2003, 2002, 2001 and 2000,respectively. As of September 30, 2005, we had an accumulated deficit of$105.8 million. These losses, among other things, have had and will continue tohave an adverse effect on our stockholders’ equity and working capital. Weexpect to incur substantial operating losses for at least the next severalyears. This is due primarily to the expansion of our clinical trials andresearch and development programs and, to a lesser extent, general andadministrative expenses. We also have substantial lease and debt obligationsrelated to our manufacturing and headquarters facilities impacting ouroperating expenses. We expect that our losses will fluctuate from quarter toquarter and that these fluctuations may be substantial. We cannot guaranteethat we will successfully develop, manufacture, commercialize or market anyproducts. As a result, we cannot guarantee that we will ever achieve or sustainproduct revenues or profitability.

 

**We currently have no source of revenue andmay never become profitable.**

 

Our ability to become profitable will depend upon our ability togenerate revenue. To date, FavId has not generated any revenue, and we do notknow when or if FavId will generate revenue. Our ability to generate revenuedepends on a number of factors, including our ability to:

 

•successfully complete clinical trials for FavId;

 

• obtainregulatory approval for FavId, including regulatory approval for our commercialscale manufacturing facility and process;

 

•manufacture commercial quantities of FavId at acceptable cost levels; and

 

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•successfully market and sell FavId.

 

We do not anticipate that we will generate revenues until 2008, at theearliest. Further, we do not expect to achieve profitability for at leastseveral years after generating material revenues. If we are unable to generaterevenue, we will not become profitable, and we may be unable to continue ouroperations.

 

**We will need substantial additional funds tocontinue operations, which we may not be able to raise on favorable terms, orat all.**

 

We will need substantial additional funds for existing and plannedpreclinical studies and clinical trials, to continue research and developmentactivities, for lease and debt obligations related to our manufacturing andheadquarter facilities, and to establish manufacturing and marketingcapabilities for any products we may develop. In addition, because we do notexpect to generate revenues from the sale of our product candidates for severalyears, or at all, we will also need to raise additional capital to fund ouroperations.

 

We anticipate our cash, cash equivalents and short-term investments tobe in the range of $33 million to $34 million at December 31, 2005. We willneed to raise additional funds in order to commercialize FavId, including thecompletion of the construction and qualification of a commercial scalemanufacturing facility. Our forecast of the period of time through which ourfinancial resources will be adequate to support our operations is aforward-looking statement and involves risks and uncertainties, and actualresults could vary as a result of a number of factors, including the factorsdiscussed elsewhere in this “Factors that May Affect Future OperatingResults” section of this report. We have based this estimate onassumptions that may prove to be wrong, and we could utilize our availablecapital resources sooner than we currently expect.

 

Our future capital requirements or the adequacy of our available fundswill depend on many factors, including, but not limited to:

 

• magnitudeand cost of our product development efforts and other research and developmentactivities;

 

• rate ofprogress toward obtaining regulatory approval for our product candidates;

 

• costs offiling, prosecuting, defending and enforcing our patent claims and otherintellectual property rights;

 

• ourability to establish and maintain collaborative, licensing or otherarrangements for the development, sale, marketing or distribution of ourproduct candidates and the terms of those arrangements;

 

• effectsof competing technological and market developments;.

 

• the cost of expansion of our currentfacility for commercial production or the construction of a large separatecommercial-scale production facility; and

 

• thesuccess of the commercialization of FavId.

 

Future capital requirements will also depend on the extent to which weacquire or invest in businesses, products and technologies, but we currentlyhave no commitments or agreements relating to any of these types oftransactions.

 

We may seek to access the public or private equity markets wheneverconditions are favorable, even if we do not have an immediate need foradditional capital at that time. Additional funding may not be available to us,and, if available, may not be on acceptable terms. If we raise additional fundsby issuing equity securities, stockholders will incur immediate dilution. Ifadequate funds are not available to us, we may be required to delay, reduce thescope of, or eliminate one or more of our research, development and clinicalactivities. Alternatively, we may need to seek funds through arrangements withcollaborative partners or others that require us to relinquish rights totechnologies or product candidates that we would otherwise seek to develop orcommercialize ourselves. Any of these events could have a material adverseeffect on our business, results of operations, financial condition or cashflow.

 

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**We are recording non-cash compensationexpense that may result in an increase of our net losses for a given period.**

 

Stock-based compensation represents an expense associated with therecognition of the difference between the deemed fair value of common stock atthe time of an option grant or stock issuance and the option exercise price orprice paid for the stock. Stock-based compensation is amortized over thevesting period of the option or issuance. As of September 30, 2005,deferred stock-based compensation related to option grants to our employees andnon-employee directors totaled $6.4 million, which is being amortized toexpense on a straight-line basis as the options or stock are earned, generallyover a period of four years. Options granted to consultants, if any, forcompensation purposes, must be remeasured at each reporting date during thevesting period. The remeasurement and the corresponding effect on the relatedexpense may result in an increase in net losses for a given period.

 

**OtherRisks Related to Our Business and Industry**

 

**We currently depend on single sourcesuppliers for critical raw materials for manufacturing. The loss of thesesuppliers could delay our clinical trials or prevent or delay commercializationof FavId.**

 

We currently depend on single source suppliers for critical rawmaterials used in the manufacture of FavId. In particular, our manufacturingprocess for FavId requires a foreign protein derived from shellfish that isknown as keyhole limpet hemocyanin, or KLH. We purchase KLH from biosynArzneimittel GmbH, or biosyn, which is currently the only supplier of KLH thathas submitted the required filing, known as a drug master file, to the FDA. In November 2004,we entered into an eight-year supply and license agreement with biosyn underwhich biosyn has agreed to supply us with KLH and we have committed to annualKLH purchase requirements. An additional aggregate of up to $300,000 will bedue upon the achievement of certain milestones, the timing of which is notknown at this time. Either party may terminate the supply agreement upon abreach by the other party that is not cured within 60 days or other eventsrelating to insolvency or bankruptcy. If we identify another supplier of KLH ofsuitable quality for our purposes, we will not be able to use the supplier as asecond source of KLH for the commercial manufacture of FavId unless the KLH istested to be comparable to the existing KLH.

 

In addition, we depend on a single source supplier for the cell growthmedia we use to produce FavId. We purchase this material from ExpressionSystems LLC, which in turn obtains several of the components used in the cellgrowth media from sole suppliers. We currently rely on purchase orders toobtain this material and do not have a supply agreement with ExpressionSystems. We intend to qualify a second source for the cell growth media but maynot be able to do so.

 

Establishing additional or replacement suppliers for these materialsmay take a substantial amount of time. In addition, we may have difficultyobtaining similar materials from other suppliers that are acceptable to theFDA. If we have to switch to a replacement supplier, we may face additionalregulatory delays and the manufacture and delivery of FavId, or any otherproduct candidates that we may develop, could be interrupted for an extendedperiod of time, which may delay completion of our clinical trials or commercialization.If we are unable to obtain adequate amounts of these materials, our clinicaltrials will be delayed. In addition, we will be required to obtain regulatoryclearance from the FDA to use different materials that may not be as safe or aseffective. As a result, regulatory approval of FavId, or any other productcandidates that we may develop, may not be received at all.

 

**We rely on third parties to conduct ourclinical trials. If these third parties do not successfully carry out theircontractual duties or meet expected deadlines, we may be delayed or may not beable to obtain regulatory approval for or commercialize FavId or any otherproduct candidates that we may develop.**

 

Our pivotal Phase 3 clinical trial of FavId for the treatment offollicular B-cell NHL is being conducted at 65 or more sites in the UnitedStates and will require at least 342 evaluable patients. Two clinical trials ofFavId are being conducted under the direction of a physician sponsor, ratherthan under our supervision. We do not have the ability to independently conductclinical trials for FavId, or any other product candidate that we may develop,and we must rely on third parties, such as medical institutions and clinicalinvestigators, including physician sponsors, to conduct our clinical trials. Inparticular, we will rely on these parties to recruit and enroll patients in ourclinical trials. We also rely on third-party couriers to transport patienttissue samples and FavId. If any of the third parties upon whom we rely to conductour clinical trials or transport patient tissue samples and immunotherapies donot comply with applicable laws, successfully carry out their obligations ormeet expected deadlines, and need to be replaced, our clinical trials may beextended, delayed or terminated.

 

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If the quality or accuracy of the clinical data obtained by medicalinstitutions and clinical investigators, including physician sponsors, iscompromised due to their failure to adhere to applicable laws or our clinicalprotocols or for other reasons, we may not be able to obtain regulatoryapproval for or successfully commercialize FavId, or any other productcandidates that we may develop. If any of our relationships with any of these organizationsor individuals terminates, we believe that we would be able to enter intoarrangements with alternative third parties. However, replacing any of thesethird parties would delay our clinical trials and could jeopardize our abilityto commercialize FavId and our other product candidates on a timely basis, orat all.

 

**Even if we obtain regulatory approval, wewill continue to be subject to extensive government regulation that may causeus to delay the introduction of our products or withdraw our products from themarket.**

 

Even if we obtain regulatory approval for FavId or our other productcandidates, we will still be subject to extensive regulation. These regulationswill impact many aspects of our operations, including production, recordkeeping, quality control, adverse event reporting, storage, labeling,advertising, promotion and personnel. In addition, the later discovery ofpreviously unknown problems may result in restrictions of the productcandidates, including their withdrawal from the market. Furthermore, regulatoryapproval may subject us to ongoing requirements for post-marketing studies. Ifwe or any third party that we involve in our operations fail to comply with anycontinuing regulations, we may be subject to, among other things, productseizures, recalls, fines or other civil penalties, injunctions, suspensions orrevocations of marketing licenses, operating restrictions and criminalprosecution.

 

**Before we can obtain marketing approval foror commercially distribute FavId, we must have a commercial-scale facility forthe manufacture of FavId.  In addition,the FDA and the California Department of Health Services must find ourmanufacturing facility and process satisfactory.**

 

Our manufacturing methods, equipment and processes must comply with theFDA’s current Good Manufacturing Practices, or cGMP, requirements. We may alsoneed to perform extensive audits of vendors, contract laboratories andsuppliers. The cGMP requirements govern, among other things, record keeping,production processes and controls, personnel and quality control. We have onlyundertaken initial steps towards achieving compliance with these regulatoryrequirements. Additional steps will require expenditure of significant time,money and effort. We cannot predict the likelihood that the FDA will find ourfacility satisfactory, even if we believe that we have taken the necessarysteps to achieve compliance. If we fail to comply with these requirements orfail to pass a pre-approval inspection of our manufacturing facility inconnection with an application to obtain marketing approval for FavId oranother product candidate, we would not receive regulatory approval, and wewould be subject to possible regulatory action.

 

We manufacture FavId for our ongoing Phase 3 and for the plannedand ongoing Phase 1/2 clinical trials at our facility in San Diego. We currentlylease approximately 80,000 square feet of space in a facility in SanDiego, California under long-term lease agreements, including approximately17,000 square feet of space that we began leasing in August 2005.  This space is used for our corporateheadquarters and manufacturing and laboratory facilities.  Our manufacturing facility consists ofapproximately 26,000 square feet of space in the facility. Our manufacturingfacility is subject to the licensing requirements of the California Departmentof Health Services. Our facility was inspected and licensed by the CaliforniaDepartment of Health Services. Our facility is subject to re-inspection at anytime. Failure to maintain a license from the California Department of HealthServices or to meet the inspection criteria of the California Department ofHealth Services would disrupt our manufacturing processes and prevent us fromsupplying FavId to patients. If an inspection by the California Department ofHealth Services indicates that there are deficiencies in our manufacturingprocess, we could be required to take remedial actions at potentiallysignificant expense, and our facility may be temporarily or permanently closed.

 

We will need to either expand and qualify our current facility orconstruct and qualify a commercial scale manufacturing facility in order tocommercialize FavId or any other product candidates that we may develop. Webelieve our current facility, as expanded in August 2005,could be used to manufacture FavId for initial commercial launch. We cannotassure you that we would be able to meet commercial demand for FavId in thisfacility.  Additionally, we may require alarger production facility to meet the demand for FavId if it is approved.  We would need to raise additional debt orequity capital to finance either facility. Such financing may not be available or, if available, may not beobtained on terms favorable to us or our stockholders.

 

Preparing a facility for commercial manufacturing may involveunanticipated delays and the costs of complying with FDA regulations may besignificant. In addition, any material changes we make to the manufacturingprocess after approval may require approval by the FDA and state regulatoryauthorities. Obtaining these approvals is a lengthy, involved process, and wemay experience delays that could limit our ability to manufacture commercialquantities, increase our costs and adversely affect our business.

 

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**We may experience difficulties inmanufacturing FavId or any other product candidates that we may develop, whichcould prevent us from completing our ongoing clinical trials andcommercializing these product candidates.**

 

Manufacturing FavId is a complex, multi-step process that requires usto expend significant time, money and effort in production, record keeping andquality systems to assure that FavId will meet product specifications and otherregulatory requirements. To date, we have manufactured FavId only for use inPhase 2 and Phase 3 clinical trials and have no experience in manufacturingFavId for the commercial quantities that might be required if we receiveregulatory approval. In particular, we cannot be sure that we will be able tomanufacture FavId at a cost that would enable commercial use. We may experienceany of the following problems in our efforts to manufacture our productcandidates for our expanding clinical trials or on a commercial scale:

 

• failureto obtain a sufficient supply of key raw materials;

 

•difficulties in completing the development and validation of the specializedassays required to ensure the consistency of our product candidates, includingFavId;

 

•difficulties in obtaining adequate tumor samples from treating physicians andhospitals;

 

•difficulties in manufacturing FavId for multiple patients simultaneously;

 

•difficulties in the timely shipping of tumor samples to us or in the shippingof FavId to the treating physicians due to errors by third-party couriers,transportation restrictions or other reasons;

 

• failureto ensure adequate quality control and assurance in the manufacturing processas we increase the production quantities of FavId;

 

•difficulties in establishing and effectively managing a commercial-scalemanufacturing facility;

 

• failureto comply with regulatory requirements, such as FDA regulations andenvironmental laws;

 

•significant changes in regulatory requirements;

 

• damage toor destruction of our manufacturing facility or equipment; and

 

• shortagesof qualified personnel.

 

In addition, because our manufacturing process only begins upon ourreceipt of a patient’s tumor biopsy, we cannot produce inventory reserves ofour product candidate to be stored in anticipation of any of these potentialmanufacturing problems. The failure to produce an adequate supply of FavIdcould delay our clinical trials and, in turn, delay submission of a BLA forFavId and commercial launch. Similarly, any difficulties we experience in themanufacture and supply of other product candidates, such as FAV-201, woulddelay the clinical trials of those product candidates.

 

**If our manufacturing facility is damaged ordestroyed, our ability to manufacture products will be significantly affected,which could delay or prevent completion of our clinical trials andcommercialization of FavId or any other product candidates that we may develop.**

 

We currently rely on the availability and condition of ourmanufacturing facility in San Diego to manufacture FavId. We lease the propertywhere this facility is located under a lease agreement that expires August 31,2018, but may be extended at our option for two additional five-year periods.After that time, we may not be able to negotiate a new lease for our facility.If the facility or our equipment in the facility is damaged or destroyed, wewill not be able to quickly or inexpensively replace our manufacturingcapacity. This would significantly affect our ability to complete clinical trialsof, and to manufacture and commercialize, FavId, or any other productcandidates that we may develop.

 

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In addition, our facilities have been subject to electrical blackoutsas a result of a shortage of available electrical power. Although we haveback-up emergency power generators to cover energy needs for key supportsystems, a lengthy outage could disrupt the operations of our facilities andclinical trials. While we carry business interruption insurance, this insurancemay not be adequate. Any significant business interruption could cause delaysin our product development and harm our business.

 

**If we do not develop a sufficient sales andmarketing force or enter into agreements with third parties to sell and marketFavId, we may not be able to successfully commercialize our products, whichwould limit our ability to earn product revenues.**

 

We plan to retain exclusive worldwide rights to FavId for oncologyindications at least through the completion of our BLA filing with the FDA forapproval to market FavId in the United States. If we are successful inobtaining BLA approval or foreign marketing approval for FavId, we will need toestablish sales and marketing capabilities. In the United States, we plan to dothis either by establishing our own sales force or by entering into aco-promotion arrangement with a sales and distribution partner. Outside of theUnited States, we plan to establish strategic collaborations for thedevelopment and marketing of FavId.

 

We do not presently possess the resources or experience necessary tomarket FavId or our other product candidates ourselves, and we currently haveno arrangements for the promotion or distribution of our product candidates.Our future commercial success will depend on our ability to establish our ownsales and marketing infrastructure or to collaborate with third parties thathave greater sales and marketing experience and resources. Developing effectiveinternal sales and marketing capabilities, which would include the hiring of asales force, would require a significant amount of our financial resources andtime.

 

We may be unable to establish and manage an effective sales force in atimely or cost-effective manner, or at all, and any sales force we do establishmay not be capable of generating demand for FavId or any other productcandidate we may develop. In addition, if we cannot enter into co-promotionarrangements in the United States, or other strategic collaborations for thedevelopment and marketing of FavId in other countries, in a timely manner andon acceptable terms, we may not be able to successfully commercialize FavId orany other product candidate that we may develop.

 

To the extent that we enter into arrangements with third parties toperform sales, marketing and distribution services, our product revenues arelikely to be lower than if we directly marketed and sold FavId, or any otherproduct candidates that we may develop. If we are unable to establish adequatesales, marketing and distribution capabilities, independently or with others,we will not be able to generate product revenue and will not become profitable.

 

**If physicians and patients do not use any ofour products that may be approved, our ability to generate revenue in thefuture will be limited.**

 

If approved, FavId and other product candidates that we may develop maynot gain market acceptance among physicians, healthcare payors, patients andthe medical community. Demand for any approved product that we may develop willdepend on many factors, including:

 

• ourability to provide acceptable evidence of safety and efficacy;

 

•convenience and ease of administration;

 

•availability of alternative treatments;

 

• costeffectiveness;

 

•continuing widespread use of Rituxan to treat our initial target diseasemarket;

 

•effectiveness of our regulatory and marketing strategies;

 

•prevalence and severity of adverse side effects;

 

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• publicityconcerning our products or competitive products; and

 

**•** our ability toobtain third-party coverage or reimbursement.

 

Furthermore, to the extent FavId fails to gain market acceptance forits initial indication, it may be more difficult for us to generate sufficientcredibility with physicians and patients to commercialize FavId for otherindications.

 

**If we are unable to obtain acceptable pricesor adequate coverage and reimbursement from third-party payors for FavId, orany other product candidates that we may develop, our revenues and prospectsfor profitability will suffer.**

 

Our ability to commercialize FavId, or any other product candidatesthat we may develop, depends on the extent to which coverage and reimbursementfor FavId, or any other product candidates that we may develop, will be availablefrom:

 

**•** governmentalpayors, such as Medicare and Medicaid;

 

• privatehealth insurers, including managed care organizations; and

 

• otherthird-party payors.

 

Many patients will not be capable of paying for FavId, or any otherproduct candidates that we may develop, themselves and will rely on third-partypayors to pay for their medical needs. The federal and state governments,insurance companies, managed care organizations and other third-party payorsare actively seeking to contain or reduce costs of health care in the UnitedStates and exert increasing influence on decisions regarding the use of, andreimbursement levels for, particular treatments. Such third-party payors,including Medicare, are scrutinizing newly approved medical products andservices and may not cover or may limit coverage and reimbursement for ourproduct candidates. In particular, third-party payors may limit the indicationsfor which they will reimburse patients who use FavId, or any other productcandidates that we may develop. Cost-control initiatives could cause us todecrease the price we might establish for FavId, or any other productcandidates that we may develop, which would result in lower product revenues.If the prices for FavId, or any other product candidates that we may develop,decrease or if governmental and other third-party payors do not provideadequate coverage and reimbursement levels for FavId, or any other productcandidates that we may develop, our revenue and prospects for profitabilitywill suffer.

 

**If we are unable to establish or managestrategic collaborations in the future, our revenue and product development maybe limited.**

 

Our strategy may include reliance on strategic collaborations forco-promotion of FavId in the United States. In addition, we expect to rely onstrategic collaborators for commercialization of FavId outside of the UnitedStates and, to an even greater extent, for worldwide development andcommercialization of product candidates and programs for chronic autoimmunediseases, such as multiple sclerosis. To date, we have not entered into anyagreements with third parties for any of these services and do not plan toestablish a collaboration for FavId until at least completion of a BLA filing.

 

Establishing strategic collaborations is difficult and time-consuming.Our discussions with potential collaborators may not lead to the establishmentof new collaborations on favorable terms, or at all. For example, potentialpartners may reject collaborations based upon their assessment of ourfinancial, regulatory or intellectual property position. If we successfullyestablish new collaborations, these relationships may never result in thesuccessful development or commercialization of our product candidates or thegeneration of sales revenue. To the extent that we enter into co-promotion orother collaborative arrangements, our product revenues are likely to be lowerthan if we directly marketed and sold any products that we may develop.

 

Management of any collaborative relationship we may establish in thefuture will require:

 

•significant time and effort from our management team;

 

•coordination of our research and development programs with the research anddevelopment priorities of our collaborators; and

 

• effectiveallocation of our resources to multiple projects.

 

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If we enter into development or commercialization collaborations, oursuccess will in part depend on the performance of our corporate collaborators.We will not directly control the amount or timing of resources devoted by ourcorporate collaborators to activities related to our product candidates. Ourcorporate collaborators may not commit sufficient resources to our research anddevelopment programs or the commercialization, marketing or distribution of ourproduct candidates. If any corporate collaborator fails to commit sufficientresources, our preclinical or clinical development related to the collaborationcould be delayed or terminated. Also, our collaborators may pursue developmentor commercialization of other products, product candidates or alternativetechnologies in preference to our product candidates. Finally, ourcollaborators may terminate our relationships, and we may be unable toestablish additional corporate collaborations in the future on acceptableterms, or at all.

 

**Our efforts to discover, develop andcommercialize new product candidates beyond FavId are at an early stage and aresubject to a high risk of failure.**

 

Our strategy is focused on the research, development andcommercialization of targeted immunotherapies for the treatment of cancer andother diseases of the immune system. The process of successfully developingproduct candidates is very time-consuming, expensive and unpredictable. We haveonly recently begun to direct significant effort toward the development ofproduct candidates in addition to FavId, such as FAV-201 for T-cell lymphomaand a preclinical product candidate for the treatment of multiple sclerosis. Wedo not know whether our planned preclinical studies or clinical trials forthese other product candidates will begin on time or be completed on schedule,or at all. In addition, we do not know whether these clinical trials willresult in marketable products. Typically, there is a high rate of attrition forproduct candidates in preclinical and clinical trials. We do not anticipatethat any of our product candidates will reach the market for at least severalyears.

 

We may not identify, develop or commercialize any additional new productcandidates from our proprietary active immunotherapy technology. Our ability todevelop successfully any of these product candidates depends on our ability todemonstrate safety and efficacy in humans through extensive preclinical testingand clinical trials and to obtain regulatory approval from the FDA and otherregulatory authorities. Development of our product candidates will also dependsubstantially upon the availability of funding for our research and developmentprograms.

 

**If our competitors develop and marketproducts that are more effective than our existing product candidates or otherswe may develop, or obtain marketing approval before we do, our commercialopportunity may be reduced or eliminated.**

 

The development and commercialization of new pharmaceutical productsfor the treatment of cancer and autoimmune diseases is competitive, and we willface competition from numerous sources, including major pharmaceuticalcompanies, specialty pharmaceutical companies and biotechnology companies worldwide.Many of our competitors have substantially greater financial and technicalresources and development, production and marketing capabilities than we do. Inaddition, many of these companies have more experience than we do inpreclinical testing, clinical trials and manufacturing of biologictherapeutics, as well as in obtaining FDA and foreign regulatory approvals. Wewill also compete with academic institutions, governmental agencies and privateorganizations that are conducting research in the fields of cancer andautoimmune disease. Competition among these entities to recruit and retainhighly qualified scientific, technical and professional personnel andconsultants is also intense.

 

We are aware of a number of companies that are developing active immunotherapiesto treat B-cell NHL. Genitope Corporation is evaluating its idiotypeimmunotherapy product candidate in a Phase 3 clinical trial in patients withfollicular B-cell NHL who are in remission following prior treatment withchemotherapy. Antigenics, Inc. completed a Phase 2 clinical trialevaluating its active immunotherapy candidate in indolent NHL patients. The NCIis also conducting a Phase 3 clinical trial of an active idiotype immunotherapyin collaboration with Accentia Biopharmaceuticals.

 

Several companies are engaged in the development and commercializationof passive immunotherapy products for the treatment of B-cell NHL that maycompete with FavId. Genentech and Biogen Idec are co-marketing Rituxan for thetreatment of relapsed or refractory, indolent B-cell NHL. Biogen Idec has alsoreceived FDA approval to market Zevalin, its passive radioimmunotherapyproduct. GlaxoSmithKline plc has received FDA approval to market Bexxar, apassive radioimmunotherapy product.

 

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The most recent advances in the treatment of B-cell NHL have involvedthe combination of existing products and changes to approved schedules anddoses, particularly for Rituxan. Numerous clinical trials reported in recentyears have indicated that additional doses of Rituxan and maintenance dosing ofRituxan can improve TTP in patients who respond to therapy. Combinationtherapies involving chemotherapeutic or immunostimulatory drugs in combinationwith Rituxan at various doses and schedules may provide patients with anincrease in TTP over that expected with Rituxan alone. Accordingly, we may facecompetition as a result of developments in this area.

 

We expect that our ability to compete effectively will depend upon ourability to:

 

•successfully and rapidly complete clinical trials and obtain all requisiteregulatory approvals in a cost-effective manner;

 

• reliablyand cost-effectively manufacture sufficient quantities of our products;

 

• maintaina proprietary position for our manufacturing process and other technology;

 

• price ourproducts competitively;

 

• obtainappropriate reimbursement approvals for our products;

 

• establishan adequate sales and marketing force for our products; and

 

• attractand retain key personnel.

 

In addition, our ability to compete effectively will depend on therelative efficacy and safety of other active immunotherapy products approvedfor sale as compared to our own products.

 

**We are subject to new legislation, regulatoryproposals and managed care initiatives that may increase our costs ofcompliance and adversely affect our ability to market our products, obtaincollaborators and raise capital.**

 

There have been a number of legislative and regulatory proposals aimedat changing the healthcare system and pharmaceutical industry, includingreductions in the cost of prescription products and changes in the levels atwhich consumers and healthcare providers are reimbursed for purchases ofpharmaceutical products. For example, the Prescription Drug and MedicareImprovement Act of 2003 was recently enacted. This legislation provides a newMedicare prescription drug benefit beginning in 2006 and mandates otherreforms. Although we cannot predict the full effects on our business of theimplementation of this new legislation, it is possible that the new benefit,which will be managed by private health insurers, pharmacy benefit managers andother managed care organizations, will result in decreased reimbursement forprescription drugs, which may further exacerbate industry-wide pressure toreduce the prices charged for prescription drugs. This could harm our abilityto market our products and generate revenues.

 

**We depend on attracting and retaining keyscientific and management personnel to advance our technology, and the loss ofthese personnel could impair the development of our products.**

 

Our success depends on our continued ability to attract, retain andmotivate highly qualified management, clinical and scientific personnel and onour ability to develop and maintain important relationships with leadingacademic institutions, clinicians and scientists. We are highly dependent uponour senior management and scientific staff, particularly John P. Longenecker,Ph.D., our President and Chief Executive Officer, and Daniel P. Gold, Ph.D.,one of our co-founders and our Chief Scientific Officer. The loss of servicesof Dr. Longenecker or Dr. Gold, or one or more of our other membersof senior management, could delay or prevent the successful completion of our pivotalPhase 3 clinical trial or the commercialization of FavId. Although we haveemployment agreements with each of our executives, their employment with us is “atwill,” and each executive can terminate his or her agreement with us at anytime. We do not carry “key person” insurance covering members of seniormanagement, other than Drs. Longenecker and Gold. This insurance may notcontinue to be available on commercially reasonable terms and may proveinadequate to compensate us for the loss of their services.

 

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The competition for qualified personnel in the biotechnology field isintense. In particular, our manufacturing process depends on our ability toattract and retain qualified manufacturing and quality control personnel. Wewill need to hire additional personnel as we continue to expand ourmanufacturing, research and development activities. We may not be able toattract and retain quality personnel on acceptable terms given the competitionfor such personnel among biotechnology, pharmaceutical and other companies. Weare not aware of any key personnel planning to retire or terminate theiremployment in the near future.

 

**We will need to increase the size of ourorganization, and we may experience difficulties in managing growth.**

 

As of September 30, 2005, we had 133 employees. Of these, 113 employeeswere in research and development comprised of 78 in manufacturing, qualitycontrol and quality assurance, 30 in research and process development, and fivemembers of senior management.  Of theremaining employees, two were members of senior management and 18 were inadministration. We will need to expand our financial, managerial, operationaland other resources in order to continue our clinical trials and commercializeFavId, FAV-201, or any other product candidates that we may develop. Futuregrowth will impose significant added responsibilities on our management team,including the need to identify, recruit, maintain and integrate additionalemployees. Our ability to commercialize FavId, FAV-201, or any other productcandidates that we may develop, and our future financial performance ingeneral, will depend in part on our ability to manage any future growtheffectively. In order to meet these challenges, we will need to:

 

• manageour clinical trials effectively;

 

• manageour research and development efforts effectively;

 

• developour administrative, accounting and management information systems and controls;and

 

• hire,train and integrate additional management, administrative, manufacturing andsales and marketing personnel.

 

We may not be able to accomplish these tasks, and our failure toaccomplish any of them could harm our business or future prospects.

 

**If we use biological and hazardous materialsin a manner that causes injury or violates laws, we may be liable for damages.**

 

Our research and development and manufacturing activities involve theuse of biological and hazardous materials that could be dangerous to humanhealth, safety or the environment. Although we believe our safety proceduresfor handling and disposing of these materials comply with federal, state andlocal laws and regulations, we cannot entirely eliminate the risk of accidentalinjury or contamination from the use, storage, handling or disposal of thesematerials. In the event of contamination or injury, we could be held liable forany resulting damages, and any liability could exceed our resources. Wecurrently maintain property and casualty insurance coverage which covers liabilityfor hazardous and controlled materials. However, this insurance coverage maynot be sufficient to cover our liability and we may not be able to obtainsufficient coverage in the future at a reasonable cost. In addition, we mayincur significant costs complying with both existing and future environmentallaws and regulations. In particular, we are subject to regulation by theOccupational Safety and Health Administration, or OSHA, and the EnvironmentalProtection Agency, or EPA, and to regulation under the Toxic Substances ControlAct and the Resource Conservation and Recovery Act. OSHA, the EPA or otheragencies may adopt regulations that adversely affect our research anddevelopment programs.

 

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**We face a risk of product liability claimsand may not be able to obtain adequate insurance.**

 

Our business exposes us to potential liability risks that may arisefrom the clinical testing of our product candidates and the manufacture andsale of any approved products. These risks will exist even with respect tothose product candidates that are approved for commercial sale by the FDA andmanufactured in facilities regulated by the FDA. Any product liability claim orseries of claims brought against us could significantly harm our business by,among other things, reducing demand for our products, injuring our reputationand creating significant adverse media attention and costly litigation.Plaintiffs have received substantial damage awards in some jurisdictions againstpharmaceutical companies based upon claims for injuries allegedly caused by theuse of their products. Any judgment against us that is in excess of ourinsurance policy limits would have to be paid from our cash reserves, whichwould reduce our capital resources. We currently maintain clinical trialinsurance , which covers liability for up to 561 patients in our clinicaltrials. Although we believe our current insurance coverage is adequate, wecannot be certain that it will be sufficient. Furthermore, we cannot be certainthat our current insurance coverage will continue to be available, or thatincreased coverage, which will be necessary if we are able to commercialize ourproducts, will be available in the future on reasonable terms, or at all. Further,we may not have sufficient capital resources to pay a judgment, in which caseour creditors could levy claims against our assets, including our intellectualproperty.

 

**We could be negatively impacted by futureinterpretation or implementation of federal and state fraud and abuse laws,including anti-kickback laws and other federal and state anti-referral laws.**

 

If we are able to commercialize FavId or any other product candidatesthat we may develop, we will be subject to various federal and state laws pertainingto healthcare fraud and abuse, including anti-kickback laws and physicianself-referral laws. Violations of these laws are punishable by criminal andcivil sanctions, including, in some instances, imprisonment and exclusion fromparticipation in federal and state healthcare programs, including Medicare,Medicaid and Veterans Administration health programs. Because of thefar-reaching nature of these laws, we may be required to alter one or more ofour practices to be in compliance with these laws. Healthcare fraud and abuseregulations are complex, and even minor, inadvertent irregularities canpotentially give rise to claims that a statute or prohibition has beenviolated. Any violations of these laws, or any action against us for violationof these laws, even if we successfully defend against it, could result in amaterial adverse effect on our business, financial condition and results ofoperations. If there is a change in law, regulation or administrative orjudicial interpretations, we may have to change our business practices or ourexisting business practices could be challenged as unlawful, which could have amaterial adverse effect on our business, financial condition and results ofoperations. In addition, some allegations under these laws have been claimed toviolate the False Claims Act, discussed in more detail below.

 

In addition, if we are able to commercialize FavId or any other productcandidates that we may develop, we could become subject to false claimslitigation under federal statutes, which can lead to civil money penalties,criminal fines and imprisonment, and exclusion from participation in Medicare,Medicaid and other federal and state healthcare programs. These false claimsstatutes include the False Claims Act, which allows any person to bring suit onbehalf of the federal government alleging the submission of false or fraudulentclaims, or causing to present such false or fraudulent claims, under federalprograms or contracts claims or other violations of the statute and to share inany amounts paid by the entity to the government in fines or settlement. Thesesuits against biotechnology companies have increased significantly in recentyears and have increased the risk that a healthcare company will have to defenda false claim action, pay fines or be excluded from the Medicare, Medicaid orother federal and state healthcare programs as a result of an investigationarising out of such action. We cannot assure you that we will not becomesubject to such litigation or, if we are not successful in defending againstsuch actions, that such actions will not have a material adverse effect on ourbusiness, financial condition and results of operations. In addition, we cannotassure you that the costs of defending claims or allegations under the FalseClaims Act will not have a material adverse effect on our business, financialcondition and results of operations.

 

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** **

**RisksRelated to Our Intellectual Property and Potential Litigation**

 

**If we are unable to obtain and maintainprotection for our intellectual property, the value of our technology andproducts may be adversely affected.**

 

Our business and competitive positions are dependent upon our abilityto protect our proprietary technology. Our success will depend in large part onour ability to obtain and maintain patent protection for our product andtechnologies, preserve trade secrets and operate without infringing theintellectual property right of others. Because of the substantial length oftime and expense associated with development of new products, we, along withthe rest of the biopharmaceutical industry, place considerable importance onobtaining and maintaining patent protection for new technologies, products andprocesses. The patent positions of pharmaceutical, biopharmaceutical andbiotechnology companies, including us, are generally uncertain and involvecomplex legal and factual questions. Our patent applications may not protectour technologies and products because, among other things:

 

• there isno guarantee that any of our pending patent applications will result in issuedpatents;

• we maydevelop additional proprietary technologies that are not patentable;

• there isno guarantee that any patents issued to us, our collaborators or our licensorswill provide a basis for a commercially viable product;

• there isno guarantee that any patents issued to us or our collaborators or ourlicensors will provide us with any competitive advantage;

• there isno guarantee that any patents issued to us or our collaborators or ourlicensors will not be challenged, circumvented or invalidated by third parties;and

• there isno guarantee that any patents previously issued to others or issued in thefuture will not have an adverse effect on our ability to do business.

 

We attempt to protect our intellectual property position by filingUnited States patent applications related to our proprietary technology,inventions and improvements that are important to the development of ourbusiness. Currently we own one issued U.S. Patent and four pending UnitedStates patent applications covering methods of treating immune system diseases,including B-cell and T-cell lymphomas, using our proprietary immunotherapyproduction methods, as well as methods for combining the idiotypeimmunotherapies with other therapies that are used to treat diseases of theimmune system.

 

We also have 22 patent applications pending outside of the UnitedStates, and have received notices that four of these applications will issue aspatents. Limitations on patent protection in some countries outside the UnitedStates, and the differences in what constitutes patentable subject matter inthese countries, may limit the protection we have under patents issued to usoutside of the United States. In addition, laws of foreign countries may notprotect our intellectual property to the same extent as would laws of theUnited States. In determining whether or not to seek a patent or to license anypatent in a particular foreign country, we weigh the relevant costs andbenefits, and consider, among other things, the market potential of our productcandidates in the jurisdiction, and the scope and enforceability of patentprotection afforded by the law of the jurisdiction. Failure to obtain adequatepatent protection for our proprietary product candidates and technology wouldimpair our ability to be commercially competitive in these markets.

 

Although we believe our issued patent, as well as our patentapplications if they issue as patents, will provide a competitive advantage, wemay not be able to develop additional patentable products or processes.  Further, we may not be able to obtain patentsfrom any of the pending applications. Even if patent claims are allowed, theclaims may not issue, or in the event of issuance, may not be sufficient toprotect our technology. In addition, any patents or patent rights we obtain maybe circumvented, challenged or invalidated by our competitors.

 

**We are not able to prevent others, includingpotential competitors, from using certain types of patient-specific idiotypeprotein-KLH conjugates, like those we use in our lead product candidate, FavId,for the treatment of indolent B-cell NHL.**

 

Certain types of patient-specific idiotype-KLH conjugates, comprisingsingle idiotype proteins, and their use for the treatment of indolent B-cellNHL are in the public domain and therefore cannot be patented. Consequently, wemay only be able to seek patent protection for methods of treating immunesystem diseases, including B-cell and T-cell lymphomas, using our proprietaryimmunotherapy production methods for making idiotype protein conjugates andcompositions comprising such conjugates, as well as methods for combining theidiotype or T-cell receptor-based immunotherapies with other therapies that areused to treat diseases of the immune system. As a result, we may not be able toprevent other companies using different manufacturing processes from developingactive immunotherapies that directly compete with FavId.

 

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**We may have to engage in costly litigation toenforce our proprietary rights or to defend challenges to our intellectualproperty by our competitors, which may harm our business, results ofoperations, financial condition and cash flow.**

 

The pharmaceutical field is characterized by a large number of patentfilings involving complex legal and factual questions, and, therefore, wecannot predict with certainty whether our patents will be enforceable. Competitorsmay have filed applications for or have been issued patents and may obtainadditional patents and proprietary rights related to products or processes thatcompete with or are similar to ours. We may not be aware of all of the patentspotentially adverse to our interests that may have been issued to others.Litigation may be necessary to protect our patent position, and we cannot becertain that we will have the required resources to pursue litigation orotherwise to protect our patent rights. In addition, our efforts to protect ourpatents may not be successful.

 

**Our ability to market our products may beimpaired by the intellectual property rights of third parties.**

 

Our commercial success will depend in part on not infringing thepatents or proprietary rights of third parties. We are aware of competingintellectual property relating to active idiotype immunotherapies for cancer.Competitors or third parties may be issued, or may currently hold, patents thatmay cover subject matter that we use in developing the technology required tobring our product candidates to market, that we use in producing our productcandidates, or that we use in treating patients with our product candidates. Inaddition, from time to time we receive correspondence inviting us to licensepatents from third parties. While we currently believe we have freedom tooperate in these areas, others may challenge our position in the future. Therehas been, and we believe that there will continue to be, significant litigationin the pharmaceutical industry regarding patent and other intellectual propertyrights.

 

While we believe that our pre-commercialization activities fall withinthe scope of an available exemption against patent infringement provided by35 U.S.C. §271(e), and that our subsequent manufacture of our commercialproducts will also not require the license of any of these patents, claims maybe brought against us in the future based on these or other patents held byothers. As our product candidates progress toward commercialization,competitors or other parties may assert that we infringe on their patents orproprietary rights.

 

In particular, we are aware of the following third party patents:

 

•                                          Genentechand City of Hope National Medical Center hold patent rights related to theexpression of recombinant antibodies;

•                                          Genitopeholds patent rights relating to immunotherapy using idiotype proteins producedusing T-lymphoid cells for the treatment of B-Cell lymphoma;

•                                          ScheringCorp. holds patent rights relating to the use of GM-CSF as a vaccine adjuvantfor use against infectious diseases.

 

The first patent listed above was issued to Genentech in 2001. We do not believe that this patent covers our technology, andwe note that in May 2005, a third party filed a request for reexaminationof this patent with the U.S. Patent and Trademark Office, requesting that theclaims of this patent be reexamined as to their patentability. If wedecide to attempt to obtain a license for this patent, we cannot guarantee thatwe would be able to obtain such a license on commercially reasonable terms, orat all.

 

Additionally, because patent prosecution can proceed in secret prior toissuance of a patent, third parties may obtain other patents with claims ofunknown scope relating to our product candidates, prior to the issuance ofpatents, which they could attempt to assert against us. Further, as we developour products, we may infringe the current patents of third parties or patentsthat may issue in the future.  Thirdparties could bring legal actions against us claiming damages and seeking toenjoin clinical testing, manufacturing and marketing of the affected product orproducts. If we become involved in any litigation, it could consume asubstantial portion of our resources, regardless of the outcome of thelitigation. If any of these actions are successful, in addition to anypotential liability for damages, we could be required to obtain a license tocontinue to manufacture or market the affected product, in which case we may berequired to pay substantial royalties or grant cross-licenses to our patents.However, there can be no assurance that any such license will be available onacceptable terms or at all. To enforce patents issued to us or to determine thescope and validity of other parties’ proprietary rights, we may also becomeinvolved in litigation or in interference proceedings declared by the UnitedStates Patent and Trademark Office, which could result in substantial costs tous, regardless of the outcome of the litigation, or an adverse decision as tothe priority of our inventions. Ultimately, we could be prevented fromcommercializing a product, or forced to cease some aspect of our businessoperations, as a result of patent infringement claims, which could harm ourbusiness.

 

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**If we are not able to protect and controlunpatented trade secrets, know-how and other technological innovation, we maysuffer competitive harm.**

 

We also rely on trade secrets to protect our technology, particularlywhen we do not believe that patent protection is appropriate or available.However, trade secrets are difficult to protect. We attempt to protect ourtrade secrets by requiring each of our employees, consultants and advisors toexecute a non-disclosure and assignment of invention agreement before beginninghis or her employment, consulting or advisory relationship with us. We cannotguarantee that these agreements will provide meaningful protection, that theseagreements will not be breached, that we will have an adequate remedy for anysuch breach, or that our trade secrets will not otherwise become known orindependently developed by a third party. Our trade secrets, or those of ourfuture collaborators, may become known or may be independently discovered byothers, which could adversely affect the competitive position of our productcandidates.

 

**RisksRelated to the Securities Markets and Ownership of Our Common Stock**

 

**There has been no prior public market for ourcommon stock, and the price of our common stock may be volatile and coulddecline significantly.**

 

Until our IPO in February 2005, there was no public market for ourcommon stock, and despite our IPO, an active public market for these shares maynot develop or be sustained. Our stock price has traded in the range of $7.50 -$3.31 from the commencement of our IPO on February 2, 2005 to October 31,2005.

 

The stock market in general has been experiencing dramatic fluctuationsthat have often been unrelated to the operating performance of companies. Themarket prices for securities of biotechnology companies in general have beenhighly volatile and may continue to be highly volatile in the future. Ifmarket-based or industry-based volatility continues, the trading price of ourcommon stock could decline significantly, independent of our actual operatingperformance, and you could lose all or part of your investment. The marketprice of our common stock could fluctuate significantly as a result of severalfactors, including:

 

•announcements of technological innovations or new products by us or ourcompetitors;

 

•announcement of FDA approval or non-approval of FavId or any other productcandidates that we may develop, or delays in the FDA review process;

 

• actionstaken by regulatory agencies with respect to FavId and FAV-201, or any otherproduct candidates that we may develop, or our clinical trials, manufacturingprocess or sales and marketing activities;

 

•regulatory developments in the United States and foreign countries;

 

• successof our research efforts and clinical trials;

 

• anyintellectual property infringement lawsuit in which we may become involved;

 

•announcements concerning our competitors, or the biotechnology orbiopharmaceutical industries in general;

 

• actual oranticipated fluctuations in our operating results;

 

• changesin financial estimates or recommendations by securities analysts;

 

• sales oflarge blocks of our common stock;

 

• sales ofour common stock by our executive officers, directors and significantstockholders;

 

• changesin accounting principles; and

 

• loss ofany of our key scientific or management personnel.

 

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Specifically, you may not be able to resell your shares at or above theprice you paid for such shares. In addition, class action litigation has oftenbeen instituted against companies whose securities have experienced periods ofvolatility in market price. Any such litigation brought against us could resultin substantial costs and a diversion of management’s attention and resources,which could hurt our business, operating results and financial condition.

 

**Concentration of ownership among our existingofficers, directors and principal stockholders may prevent other stockholdersfrom influencing significant corporate decisions and depress our stock price.**

 

As of September 30, 2005, our officers, directors and thosestockholders owning at least five percent of our outstanding capital stocktogether beneficially held approximately 71.5% of our outstanding common stockon an as-converted basis. If some or all of these officers, directors andprincipal stockholders act together, they will be able to exert a significantdegree of influence over our management and affairs and over matters requiringstockholder approval, including the election of directors, the merger,consolidation or sale of all or substantially all of our assets, and any othersignificant corporate transaction. The interests of this concentration ofownership may not always coincide with our interests or the interests of ourother stockholders. For instance, officers, directors and principalstockholders, acting together, could cause us to enter into transactions oragreements that we would not otherwise consider. Similarly, this concentration ofownership may have the effect of delaying or preventing a change in control ofus otherwise favored by our other stockholders. This concentration of ownershipalso could depress our stock price.

 

**Provisions in our amended and restatedcertificate of incorporation and amended and restated bylaws and applicableDelaware law may prevent or discourage third parties or our stockholders fromattempting to replace our management or influencing significant decisions.**

 

Provisions in our amended and restated certificate of incorporation andamended and restated bylaws may have the effect of delaying or preventing achange in control of us or our management, even if doing so would be beneficialto our stockholders. These provisions include:

 

• dividingour board of directors into three classes serving staggered three-year terms;

 

•authorizing our board of directors to issue preferred stock without stockholderapproval;

 

•prohibiting cumulative voting in the election of directors;

 

•prohibiting stockholder actions by written consent;

 

• limitingthe persons who may call special meetings of stockholders;

 

•prohibiting our stockholders from making certain changes to our certificate ofincorporation or bylaws except with 66.7% stockholder approval; and

 

• requiringadvance notice for raising business matters or nominating directors atstockholders’ meetings.

 

We are also subject to provisions of the Delaware corporation law that,in general, prohibit any business combination with a beneficial owner of 15% ormore of our common stock for five years unless the holder’s acquisition of ourstock was approved in advance by our board of directors. Together, thesecharter and statutory provisions could make the removal of management moredifficult and may discourage transactions that otherwise could involve paymentof a premium over prevailing market prices for our common stock.

 

**Because we do not intend to pay any cashdividends on our shares of common stock, our stockholders will not be able toreceive a return on their shares unless they sell them.**

 

We have never paid or declared any cash dividends on our capital stockand intend to retain any future earnings to finance the development andexpansion of our business. The payment of dividends by us on our common stockis limited by our debt agreements. We do not anticipate paying any cashdividends on our common stock in the foreseeable future. Unless we paydividends, our stockholders will not be able to receive a return on theirshares unless they sell them.

 

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**We may incur increased costs as a result ofrecently enacted and proposed changes in laws and regulations.**

 

Recently enacted and proposed changes in the laws and regulationsaffecting public companies, including the provisions of the Sarbanes-Oxley Actof 2002 and rules related to corporate governance and other matterssubsequently adopted by the SEC and the Nasdaq Stock Market, could result inincreased costs to us. The new rules and any related regulations that maybe proposed in the future could make it more difficult or more costly for us toobtain certain types of insurance, including directors’ and officers’ liabilityinsurance, and we may be forced to accept reduced policy limits and coverage orincur substantially higher costs to obtain the same or similar coverage. Theimpact of these events could also make it more difficult for us to attract andretain qualified persons to serve on our board of directors, our boardcommittees or as executive officers. We are presently evaluating and monitoringdevelopments with respect to new and proposed rules and cannot predict orestimate the amount of the additional costs we may incur or the timing of suchcosts.

 

**Item 3. Quantitative and QualitativeDisclosures about Market Risk.**

 

The primary objective of our investment activities is to preserveprincipal while maximizing income without significantly increasing risk. Someof the securities in which we invest may be subject to market risk. This meansthat a change in prevailing interest rates may cause the market value of theinvestment to fluctuate. To minimize this risk, we may maintain our portfolioof cash equivalents and short-term investments in a variety of securities,including commercial paper, money market funds and direct or guaranteedobligations of the United States government. The risk associated withfluctuating interest rates is limited to our investment portfolio and we do notbelieve that a 1% change in interest rates would have a significant impact onour interest income. As of September 30, 2005, all of our short-terminvestments were government agency securities, corporate notes and bonds, andour cash equivalents were held in checking accounts and money market funds.

 

**Item 4. Controls and Procedures.**

 

As of the end of the period covered by this report, we carried out anevaluation, under the supervision and with the participation of our ChiefExecutive Officer and Chief Financial Officer, of the effectiveness of ourdisclosure controls and procedures pursuant to Rule 13a-15 of theSecurities Exchange Act of 1934, as amended, or Exchange Act. Based upon thatevaluation, our Chief Executive Officer and Chief Financial Officer concludedthat, as of the end of the period covered by this report, our disclosurecontrols and procedures were effective to cause material information requiredto be disclosed by the Company in the reports that we file or submit under theExchange Act to be recorded, processed, summarized and reported within the timeperiods specified in the Securities and Commission’s rules and forms.

 

During the three months ended September 30, 2005, there were nochanges in our internal control over financial reporting which materiallyaffected, or are reasonably likely to materially affect, our internal controlover financial reporting.

 

**PART II - OTHER INFORMATION.**

 

**Item 1.  Legal Proceedings.**

 

Weare currently not a party to any material legal proceeding. We may be subjectto various claims and legal actions arising in the ordinary course of businessfrom time to time.

 

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

 

Ourinitial public offering of our common stock, par value $0.001, was effectedthrough a Registration Statement on Form S-1 (File No. 333-114299) thatwas declared effective by the Securities and Exchange Commission on February 2,2005.  The Registration Statement covered the offer and sale of up to6,900,000 shares of our common stock for an aggregate offering price of $48.3million.  Our initial public offering commenced on February 2,2005.  On February 7, 2005, 6,000,000 shares of our common stock weresold for an aggregate offering price of $42.0 million.  On March 7,2005, 285,000 shares of our common stock were sold for an aggregate offeringprice of $2.0 upon the partial exercise of the underwriters’ over-allotmentoption.  Our initial public offering terminated following the sale of allof the securities registered on the registration statement and the expirationof the underwriters’ over-allotment option.  Our initial public offeringresulted in aggregate proceeds to us of approximately $39.5 million, netof underwriting discounts and commissions of approximately $3.1 million andoffering expenses of approximately $1.4 million, through a syndicate ofunderwriters managed by Bear, Stearns & Co. Inc., CIBC World MarketsCorp., Needham & Company, Inc. and A.G. Edwards & Sons, Inc.

 

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Nooffering expenses were paid directly or indirectly to any of our directors orofficers (or their associates) or person owning ten percent or more of anyclass of our equity securities or to any other affiliates.  All offeringexpenses were paid directly to others.

 

Asof September 30, 2005, we had invested the $40.9 million in gross proceedsfrom the offering, net of underwriting discounts and commissions, in governmentagency securities, corporate bonds and notes and money market funds. Through September 30, 2005, we have used approximately $4.2 million of thenet proceeds from our initial public offering to fund $1.7 million of salariesexpense, $1.0 million of payments to third-party vendor related to our pivotalPhase 3 clinical trial, $700,000 in raw materials and supplies to manufactureFavId, $500,000 for facility lease expense, and $500,000 to principal  payments on our debt obligations.

 

The foregoing payments were direct payments made to third parties whowere not our directors of officers (of their associates), persons owning tenpercent or more of any class of our equity securities or any other affiliate,except that the proceeds used for salaries expense inculded regularcompensation for officers and directors. The use of proceeds does not represent a material change from the use ofproceeds described in the prospectus we filed pursuant to Rule 424(b)(4) of theSecurities Act of 1933, as amended, with the Securities and Exchange Commissionon February 3, 2005.

 

**Item 6.  Exhibits.**

 

Theexhibits listed on the accompanying index to exhibits are filed or incorporatedby reference (as stated therein) as part of this Quarterly Report on Form 10-Q.

 
| **Exhibit  Number** | ** ** | **Description of Document**                                                                                                                                  |
|---------------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------|
| ** **          | ** ** | ** **                                                                                                                                                   |
| 3.1                 |       | Registrant’s Amended and Restated  Certificate of Incorporation.(1)                                                                                     |
|                |       |                                                                                                                                                         |
| 3.2                 |       | Registrant’s Amended and Restated  Bylaws.(1)                                                                                                           |
|                |       |                                                                                                                                                         |
| 4.1                 |       | Form of Common Stock Certificate of  Registrant.(1)                                                                                                     |
|                |       |                                                                                                                                                         |
| 4.2                 |       | Amended and Restated Investor Rights  Agreement dated March 26, 2004 between the Registrant and certain of its  stockholders.(1)                        |
|                |       |                                                                                                                                                         |
| 4.3                 |       | Amendment No. 1 to Amended and  Restated Investor Rights Agreement dated April 6, 2004 between the  Registrant and certain of its stockholders.(1) |
|                |       |                                                                                                                                                         |
| 10.1                |       | 2005 Non-employee Director’s Stock Option Plan.                                                                                                         |
|                |       |                                                                                                                                                         |
| 10.2                |       | 2005 Non-employee Director’s Stock Option Plan Form of Stock Option  Agreement                                                                          |
|                |       |                                                                                                                                                         |
| 10.3                |       | 2005 Non-employee Director’s Stock Option Plan Form of Stock Option  Grant Notice (Initial Grant).                                                      |
|                |       |                                                                                                                                                         |
| 10.4                |       | 2005 Non-employee Director’s Stock Option Plan Form of Stock Option  Grant Notice (Annual Grant).                                                       |
|                |       |                                                                                                                                                         |
| 10.5                |       | Amended and Restated Office Lease dated October 31, 2005 between the  Registrant and Kilroy Realty, L.P.                                                     |
|                |       |                                                                                                                                                         |
| 31.1                |       | Certification of Chief Executive Officer  pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.                                                    |
|                |       |                                                                                                                                                         |
| 31.2                |       | Certification of Chief Financial Officer  pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.                                                    |
|                |       |                                                                                                                                                         |
| 32.1                |       | Certification of Chief Executive Officer,  pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.                                                   |
|                |       |                                                                                                                                                         |
| 32.2                |       | Certification of Chief Financial Officer,  pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.                                                   |
|                     |            |                                                                                                                                                              |  |

 

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(1)          Previously filed as an Exhibit toFavrille, Inc.’s Registration Statement on Form S-1 (File No. 333-114299),as amended, and incorporated by reference herein.

 

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**Favrille, Inc.**

 

**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 thereuntoduly authorized.

 
| Dated: November 14, 2005 |                                                                                                    |
|--------------------------|---------------------------------------------------------------------------------------------------------|
|                     |                                                                                                    |
|                     | Favrille, Inc.                                                                                     |
|                     |                                                                                                    |
|                     |                                                                                                    |
|                     | /s/ Tamara A. Seymour                                                                                   |
|                     |                                                                                                    |
|                     | Tamara A. Seymour                                                                                       |
|                     |                                                                                                    |
|                     | Chief Financial Officer                                                                                 |
|                     |                                                                                                    |
|                     | (On behalf of the registrant and as the  registrant’s  Principal Financial and Accounting Officer) |

 

 

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