** **

**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON,D.C. 20549**

 

**FORM 10-K**

 

----

 

| **ý**                                                                                                                                |   | **ANNUAL REPORT PURSUANT TO SECTION  13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**     |
|-------------------------------------------------------------------------------------------------------------------------------------------|--------|-----------------------------------------------------------------------------------------------|
|                                                                                                                                      |   |                                                                                          |
| **For the fiscal year ended December  31, 2002**                                                                                          |
|                                                                                                                                      |   |                                                                                          |
| **OR**                                                                                                                                    |
|                                                                                                                                      |   |                                                                                          |
| **o**                                                                                                                                     |   | **TRANSITION REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|                                                                                                                                      |   |                                                                                          |
| **For the transition period from           to          ** |
|                                                                                                                                      |   |                                                                                          |
| **Commission File Number 000-23541**                                                                                                      |

 

**NANOGEN,INC.**

(Exact name of Registrant as specified in its charter)

** **

| **Delaware**                                                     |   | **33-0489621**                        |
|------------------------------------------------------------------|--------|---------------------------------------|
| (State or other  jurisdiction of  incorporation or organization) |   | (I.R.S. Employer  Identification No.) |

** **

| **10398 Pacific Center Court, San  Diego, CA** |   | **92121**  |
|------------------------------------------------|--------|------------|
| (Address of  principal executive offices)      |   | (Zip code) |

 

**Registrant’stelephone number, including area code:**  (858) 410-4600

** **

**Securitiesregistered pursuant to Section 12(b) of the Act:**

**NONE**

** **

**Securitiesregistered pursuant to Section 12(g) of the Act:**

**CommonStock $0.001 par value**

**PreferredStock Purchase Rights**

**(Titleof Class)**

 

Indicate by check markwhether the registrant (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the registrant was required to filesuch reports), and (2) has been subject to such filing requirements for thepast 90 days.

 

YES    ý                 NO          o

 

Indicateby check mark if disclosure of delinquent filers pursuant to Item 405 ofRegulation S-K (Section 229.405 of this chapter) is not contained herein, andwill not be contained, to the best of registrant’s knowledge, in definitiveproxy or information statements incorporated by reference in Part III of thisForm 10-K or any amendment to this Form 10-K. o

 

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

 

YES    o                 NO     ý

 

Theaggregate market value of the voting stock held by non-affiliates of theregistrant based upon the closing sale price of the common stock on June 28,2002 (the last day of the registrant’s most recently completed second fiscalquarter), as reported on the Nasdaq National Market was approximately$20,142,311.  Shares of common stockheld by each executive officer and director and by each person (includingshares beneficially owned by Citigroup, Inc.) who own 10 percent or more of theoutstanding common stock have been excluded in such calculation as such personsmay be deemed to be affiliates.  Thisdetermination of affiliate status is not necessarily a conclusive determinationfor other purposes.

 

Thenumber of shares outstanding of the registrant’s common stock was 22,058,579 asof March 24, 2003.

 

DOCUMENTSINCORPORATED BY REFERENCE

 

Portions of theregistrant’s definitive proxy statement for its annual meeting of stockholdersto be held in 2003 are incorporated by reference in Items 10, 11, 12 and 13 ofPart III of this Form 10-K.

 

** **

----

 

**NANOGEN, INC.**

**FORM 10-K**

**INDEX**

** **

| **PART I**     |
|----------------|
| Item 1.        | Business |
|           |   |
| Item 2.        | Properties |
|           |   |
| Item 3.        | Legal Proceedings |
|           |   |
| Item 4.        | Submission of Matters to a Vote of Security  Holders |
|           |   |
| **PART II**    |
|           |   |
| Item 5.        | Market for Registrant’s Common Equity and  Related Stockholder Matters |
|           |   |
| Item 6.        | Selected Financial Data |
|           |   |
| Item 7.        | Management’s Discussion and Analysis of  Financial Condition and Results of Operations |
|           |   |
| Item 7A.       | Quantitative and Qualitative Disclosures About  Market Risk |
|           |   |
| Item 8.        | Financial Statements and Supplementary Data |
|           |   |
| Item 9.        | Change in and Disagreements with Accountants on  Accounting and  and Financial  Disclosure |
|           |   |
| **PART III**   |
|           |   |
| Item 10.       | Directors and Executive Officers of the  Registrant |
|           |   |
| Item 11.       | Executive Compensation |
|           |   |
| Item 12.       | Security Ownership of Certain Beneficial Owners  and Management and Related Stockholder Matters |
|           |   |
| Item 13.       | Certain Relationships and Related Transactions |
|           |   |
| Item 14.       | Controls and Procedures |
|           |   |
| **PART IV**    |
|           |   |
| Item 15.       | Exhibits, Financial Statement Schedules, and  Reports on Form 8-K |
|           |   |
| **SIGNATURES** |   |

 

i

----

 

**PART I**

 

**Item 1****.  Business**

 

**Forward Looking Statement**

 

This Form 10-K includesforward-looking statements about our business and results of operations thatare subject to risks and uncertainties that could cause our actual results tovary materially from those reflected in the forward-looking statements.  Words such as “believes,” “anticipates,”“plans,” “estimates,” “future,” “could,” “may,” “should,” “would,” “expect,”“envision,” “potentially,” variations of such words and similar expressions areintended to identify such forward-looking statements.  The forward-looking statements contained in this Form 10-Kinclude, but are not limited to, statements about matters including thefollowing:  (i) the development of themarkets and demand for our products and services; (ii) our product developmentplans, including the introduction of new products, and anticipated activitiesdesigned to pursue these plans, including collaborations and other corporatepartnering arrangements; (iii) our ability to generate substantial revenuesfrom sales of products and consumable cartridges and reagents and continuingrevenues from reagent rental agreements; (iv) the ability of our productplatform to affect the market and become an industry standard; (v) our abilityto generate license and other fee revenue in the future; (vi) the amounts weinvest in research and development activities in the future; (vii) futurelevels of operating expenses associated with our business; (viii) future levelsof interest income; (ix) any amounts we may be able to realize from theliquidation of our investments, including our investments in short-termsecurities; (x) operating results of joint ventures and other corporatepartnering arrangements; (xi) the amounts and timing of our contractualobligations and capital commitments and (xii) our future capital needs and ourability to fund those needs.  Factorsthat could cause or contribute to these differences include those discussedunder the caption “Factors that May Affect Results” and elsewhere in this Form10-K.  Readers are cautioned not toplace undue reliance on these forward-looking statements that speak only as ofthe date hereof.  We disclaim any intentor obligation to update these forward-looking statements.

 

Our internet address(presented as a textual reference only) is www.nanogen.com.  We make available through our website, freeof charge, an annual report on Form 10-K, quarterly reports on Form 10-Q,current reports on Form 8-K, and amendments to these reports filed with orfurnished to the SEC under Section 13(a) or 15(d) of the Securities ExchangeAct of 1934, as amended, as soon as reasonably practicable after we file themwith, or furnish them to, the SEC.

 

**Overview**

 

**Molecular Diagnostics Market**

 

Increased awareness ofthe role of genes in regulating the functions of living organisms has generateda worldwide effort to identify and sequence genes and genomes of manyorganisms, including the estimated three billion nucleotide pairs of the humangenome.  In June 2000, the effort led bythe Human Genome Project (sponsored by the Department of Energy and theNational Institutes of Health) resulted in a first complete draft of the humangenome sequence.  While it isanticipated that many years of additional research will be required tounderstand the specific functions and roles in disease of each of these genesand their patterns of interaction, this research, commonly referred to asgenomics, is leading to a new healthcare paradigm where disease is understoodat the molecular level.  It is believedthat the use of genomics will lead to the introduction of new therapies, the developmentof targeted therapeutics and an abundance of new screening tests that will, inturn, shift the focus of medicine to proactive from reactive.  Molecular diagnostic tools are integral torendering genetic information accessible to researchers and clinicians.

 

The market for moleculardiagnostics tools, assays and other products has been estimated by anindependent study conducted by industry experts Frost & Sullivan to beapproximately $1.9 billion in 2002 and is predicted to grow to

 

----

 

$3.1 billion by2005.  Of the $1.9 billion spent in2002, the Company believes that approximately seventy-five percent (75%) wasspent on infectious disease testing products for such diseases as Human ImmuneDeficiency Virus (“HIV”) and Hepatitis C Virus (“HCV”) and the remainingtwenty-five percent (25%) was spent for other products such as those used ingenetic testing.  As the moleculardiagnostics market grows, we expect human genetic testing to represent anincreasingly larger percentage of this annual amount.

 

The molecular diagnosticsmarket currently primarily consists of customers in (1) research institutionssuch as universities, research hospitals, private companies and governmentinstitutions, (2) high complexity CLIA (“Clinical Laboratory Improvements Act”)-certifiedclinical diagnostics laboratories and (3) clinical diagnostics laboratories inhospitals, private companies and government clinics.  Such customers are developing tests and assays to screen,predict, diagnose, treat or monitor individuals who have certain singlenucleotide polymorphisms (“SNP”), short tandem repeats (“STRs”), insertions,deletions or other genetic mutations that are correlated with various diseasestates.  Research customers normally developand perform assays that are designed to correlate various SNPs or othermutations with certain disease states. High complexity CLIA-certified laboratories, which are regulated underthe federal CLIA rules, normally develop and validate their own “home brew”tests or they may run assays purchased from platform manufacturers orothers.  In the development andvalidation of a “home brew” test, a laboratory may utilize Analyte SpecificReagents (“ASRs”).  ASRs are reagentsmanufactured under the good manufacturing practices regulations and are subjectto Food and Drug Administration (“FDA”) ASR regulations.  As such, ASRs do not require the filing of a510(k) or PreMarket Approval (“PMA”) application.  Clinical diagnostic laboratories normally run clinical assays tohelp physicians diagnose and treat various diseases and typically such assaysrequire a 510(k) or PMA application prior to being offered for sale ordistribution.

 

Molecular diagnosticscustomers are seeking a versatile, accurate, simple and cost-effective platformtechnology on which to develop, validate and run simple and complex researchand diagnostics tests and assays.  Whilethere are a number of platform technologies currently available to suchmolecular diagnostics customers, including those utilizing gel-based techniquessuch as Restriction Fragment Length Polymorphisms (“RFLP”), sequencing usingcapillary and gel-based techniques, dot-blot and glass slide based arrays,real-time PCR (polymerase chain reaction) methods and enzyme-based micro-wellassays, it is our understanding that these technologies do not consistentlymeet their basic customer requirements. These platforms lack the versatility to perform both simple and complexassays—customers are seeking a platform capable of developing, validating andrunning a broad menu of research, ASRs and clinical diagnostic tests.  The molecular diagnostics customers alsodemand a technology platform that consistently provides results at a levelapproaching 100% accuracy.  They alsoinsist on operational simplicity, so that the laboratory technicians of anyskill level may be used for its operation. Finally, they are seeking a cost-effective technology platform that willassist in optimizing its capital and labor costs.

 

We believe that thetechnology used to develop human genetic testing could also be applied in thefuture to other markets such as food, water and animal testing among otherfields.

 

**The Company**

 

Nanogen develops andcommercializes molecular diagnostics products and tests for the gene-basedtesting market for sale primarily in the United States, Europe and the PacificRim.  By integrating microelectronicsand molecular biology into a core proprietary technology platform, the Companyseeks to establish the unique, open-architecture design of its primaryproducts, the NanoChipâMolecular Biology Workstation and the NanoChipâ Cartridge(collectively, the “NanoChipâSystem”) as the standard platform for molecular identification andanalysis.  Nanogen also seeks to becomea leading supplier of molecular diagnostics testing products by developing ASRsand other commercial applications for the NanoChipâ System.  The Company continually conducts researchand development by itself and with its subsidiary and third parties, to improvethe NanoChipâSystem and to extend its technology to other applications such as biodefense,forensics and drug discovery (protein kinases).

 

Nanogen believes that itstechnology platform provides a key advantage over conventional manual andmechanical platforms in that it provides an accurate, simple, versatile andcost-effective integrated microelectronic system that is capable of improvingthe quality of molecular diagnostic testing while reducing the overall cost ofsuch testing.  At the heart of Nanogen’stechnology is a silicon chip called the NanoChipâ ElectronicMicroarray.  Each Electronic Microarrayhas 100 mircrolocations or test sites upon which genetic tests can beconducted.  DNA or RNA is moved andconcentrated by controlling the electric current at each test site, improvingaccuracy, speed

 

2

----

 

and flexibility. Thiselectronic concentration of molecules greatly accelerates molecular binding ateach test site.  In addition, ourtechnology allows the simultaneous analysis of multiple test results, or“multiplexing,” from a single sample. Current applications of the NanoChipâ ElectronicMicroarray include SNPs, STRs, insertions, deletions and other mutationanalyses.

 

Nanogen’s mission is todeliver high quality, innovative molecular diagnostics products andservices.  The Company’s currentcommercially available products include (1) the NanoChipâ MolecularBiology Workstation, an automated, multi-purpose instrument primarily used forDNA-based analyses, (2) the NanoChipâ Cartridge,which incorporates the NanoChipâElectronic Microarray and provides a flexible tool for the rapid identificationand precise analysis of biological test samples containing charged molecules,(3) various ASRs for detection of gene mutations associated with diseases suchas cystic fibrosis and hereditary hemochromotosis and (4) Nanogen’s AssayToolboxÔ, that is designed to help customers developtests on the NanoChipâSystem.  The Company also has severalother ASRs and applications of its proprietary technology under development.  The Company provides technical support andfield applications assistance to service and support its customers.

 

Nanogen is a Delawarecorporation and its stock is listed on the Nasdaq National Market under thesymbol “NGEN”.  Its corporate officesare located at 10398 Pacific Center Court, San Diego, California 92121.  Our main telephone number is 858-410-4600.

 

**Our Technology and Relevant Markets**

 

***Limitations of Current Molecular Diagnostic AssayTechnologies***

 

The initial technique forthe analysis of genetic variations was hybridization, which was first developedin the 1970s.  Hybridization relies onthe principle that a unique piece of DNA will bind, or hybridize, most stronglyto its exact complement.  Inhybridization, short, synthetic segments of DNA, also known as probes, are usedto locate and bind to their counterparts within a mixture of sample DNA orRNA.  Hybridization is often performedusing instrumentation that incorporates a detection medium that provides asignal to indicate whether the probe has hybridized to the sample DNA orRNA.  However, initial hybridizationtechniques had several limitations. Even minute changes in testing conditions,could dramatically affect the outcome of the hybridization reaction and,therefore, the reliability of test results.

 

Beginning in the 1980s,various techniques were invented with the objective of improving thereliability of hybridization.  However,these methods did not generally provide a signal that was sufficient to beeasily detectable.  Therefore, in orderto use these methods, it was necessary to first copy or amplify the segment ofDNA or RNA to be analyzed using a technique known as polymerase chain reaction,or PCR.  These initial techniques havesignificant limitations, including:

 

Highly ComplexProduct Development Process: Conventional methods frequently require trial and error testing tovalidate tests or product designs. Therefore, with conventional technologies, the process of developing atest, or product, for analyzing a specific genetic variation is highly complexand cannot be automated easily.

 

Inaccuracy:  Accuracy is essential to adequately detectand quantify genetic variations, which may involve the analysis of thousands ofgenetic variations per individual.  Conventionalmethods can result in one or more data points in 10 being incorrect.  These inaccuracies are magnified in testsfor multiple variations.  For example,in a test panel involving six genetic variations, the overall panel accuracyfor a technology having a 95% accuracy per result would be only 74%.  Accuracy is critical in moleculardiagnostics.

 

Difficulty ofUse:  Many of the conventional analysismethods involve multiple technical steps requiring human intervention, whichmake the analysis difficult to perform and challenging to automate.

 

Lack ofFlexibility:  Many of the conventionalanalysis methods use a passive array in which what is done to one site on thearray, must be done to all sites.  Thisresults in a lack of flexibility for the customer in using these technologiesas they cannot mix different assays on a single array or may not fully utilizeevery site on the array.

 

3

----

 

Limited ClinicalViability:  Because of the low degree ofaccuracy and difficulties associated with product development and use,conventional research methods have not been broadly applicable to clinicalsettings.

 

Lack of Menu:  Many of the existing methods of analysisrequire customers to purchase different instruments or technologies for eachanalysis performed.

 

Beyond thelimitations indicated above, in order to capture and expand the market forgenetic analysis, one must provide cost-effective and highly reliable tests.

 

Despite recent advancesin technology, many bioassays are too specialized or inflexible to be usedthroughout the various departments of a diagnostics or researchlaboratory.  Current bioassay tools weredesigned for large scale data generation and the automation of repetitioustasks such as very high throughput discovery. In addition, many of these systems are not useful in molecular, protein,enzyme, cell biology, and forensics laboratories. These technologies fallprimarily into three categories: high-density arrays; high throughputsequencing and SNP discovery tools; and gel-based methods.  While these technologies each have certainadvantages, they also have significant drawbacks that inhibit their broadapplicability across the life sciences market and in particular in themolecular diagnostics market.

 

***The Nanogen Microelectronic Solution***

 

Today, clinical andresearch laboratories use a number of different platforms to perform awide-range of different molecular tests. We are marketing the NanoChip® System based onour proprietary microelectronic technology. The Company believes that the NanoChip® System providesthe following eight major advantages:

 

**Accuracy**: Accuracy is critical in laboratory analysis.  To date, the NanoChip®System has been shown to be exceptionally accurate.  Additionally, the NanoChip®System embodies the technology that allows multiplexing capability.  This means that it allows two or more teststo be performed simultaneously, speeding results to the laboratory technician.  This capability has been critical indeveloping the ASRs for use in detecting the 25 mutations associated with thediagnosis of cystic fibrosis.

 

**Simplicity**.  The NanoChip®System is fully automated and once programmed and validated by the customer,has simple point and click software.  Itallows the laboratory technician to load samples and easily modify parametersto facilitate minimal hands on time.

 

**Versatility**:  One of the key attributes that positions the NanoChip® System as theplatform for molecular diagnostics is its unique, open architecture.  The flexible, addressable nature of theNanoChip® Cartridge enablesassay development from a variety of sources. We believe this is particularly important to customers in an emergingand rapidly growing market like molecular diagnostics, where new markers areconstantly being introduced.  Theability of a molecular laboratory to respond quickly to customers who request atest for a new marker without having to procure a new platform is key to theirsuccess.

 

**Profit Incentive**:   Nanogen’s focus is to offer a compelling value proposition toend users by providing laboratories an alternative to sending out their teststo third party laboratories.  WithNanogen products, these smaller laboratories should have the potential to earnadditional profits by handling tests within their own facilities.

 

**Fast Assay Design: ** Experimental design of tests and assays onthe NanoChip®System is relatively straightforward. Our customers can develop, program and validate assays in their ownlaboratories, allowing for faster turnaround times (i.e., days versus weeks)for solutions to complex analyses.

 

**Ease of use: ** Assays are easy to develop, validate andperform on our NanoChip®System.  Our fully automated Loaderallows the simultaneous programming and testing on up to four NanoChip® Cartridges.  A loaded Cartridge is inserted and thenanalyzed on the Nanogen Reader.  TheNanoChip® System alsoincludes proprietary software to automate testing operation.  All test design and development must bevalidated by the end user prior to reporting any results.  Data interpretation that is user defined isclear-cut and presented in a user-friendly format.

 

4

----

 

**Throughput**:  The NanoChip®System’s ability to program as many as 100 test sites per Cartridge (and up tofour Cartridges per run) allows for higher throughput than is achievable withmany competitive technologies.  Astesting volumes in molecular laboratories continue to grow, throughput isbecoming increasingly important.  Thisthroughput capacity permits highly efficient workflow for many biomedicalapplications in a variety of laboratory settings.  We believe that the NanoChip®System is scalable to eventually utilize a Cartridge with 400 test sites at atime.

 

**Cost effectiveness**:  The NanoChip® System has beendesigned to be a cost-effective solution for most molecular testing.  The NanoChip® System’s customfeatures allow users to employ their own reagents or Nanogen’s ASRs indesigning and validating assays for their specific purposes. Moreover, much of2002 was dedicated to developing a menu of ASRs that many laboratories performroutinely.  Consumables such as ASRsrepresent a significant revenue stream for companies providing successfulplatforms.  Walk-away automationconserves direct labor while improving the overall effectiveness of thelaboratory operation.  In addition, userdefinability allows important experiments to be done quickly, both acceleratingthe discovery process and simplifying the validation of important targets.

 

**Nanogen’s Core Technology**

 

Nanogen’s patentedmicroelectronics-based technology uses the natural positive or negative chargeof most biological molecules.  Applyingan electric current to individual test sites on the NanoChip® System enablesrapid movement and concentration of the molecules.  Nanogen’s technology involves electronically addressingbiotinylated DNA samples, hybridizing complementary DNA and applying stringencyto remove nonspecifically bound DNA after hybridization.  The NanoChip® System technologyprovides an open platform that allows customers to effectively develop,validate and run common assays as well as customize their own tests.

 

The NanoChip® System canintegrate in a single platform the following electronic operational features:

 

*Electronic addressing*

 

Electronic addressinginvolves placing charged molecules at specific test sites on a NanoChip® microarray.  When a biotinylated sample solution isintroduced onto the array, the negatively charged sample rapidly moves to theselected positively charged sites, where it is concentrated and bound to thestreptavidin in the permeation layer. The array is then washed and another sample can be added.  Site by site, row by row, an array ofsamples are assembled on the array. Such user-definable microchip arrays allow the customer to respondquickly to the ever evolving list of genes to be tested.

 

*Electronic concentration and hybridization*

 

In a standard SNP assay,following electronic addressing, red and green fluorescently-labeled reporterprobes are used to discriminate between wildtype, heterozygote and mutantDNA.  The ability of the NanoChip® technology tovery specifically control binding of samples to reporters is a key feature ofthe platform.

 

*Stringency control*

 

Stringency control enablesremoval of unbound and nonspecifically-bound DNA quickly and easily afterhybridization, providing quality control and ensuring that any bound pairs ofDNA are truly complimentary.  Nanogen’stechnology allows the customer to select electronic, thermal or chemicaltechniques, depending on the application, for precise, accurate stringencycontrol.  This provides extremely highdiscrimination and confidence in results.

 

*Electronic multiplexing*

 

The multiplexing featureis an extension of the open platform of the NanoChip® System.  The customer may analyze multiple genes froma single test site (representing one sample) or from multiple test sites(representing different samples).  Thecustomer also has the ability to electronically address multiplexed ampliconsto a single test site.

 

5

----

 

The ability to controlindividual test sites permits biochemically unrelated molecules to be usedsimultaneously on the same microchip array. Conventional DNA arrays do not have this feature—all process steps mustbe performed on an entire array. Nanogen’s microelectronic array technology delivers increasedversatility over conventional methods.

 

*Strand Displacement Amplification*

 

Strand DisplacementAmplification, or SDA, is a proprietary target amplification process wherebyvery low numbers of diagnostic targets in a test sample are enzymaticallyamplified to exponentially higher levels, greatly simplifying accuratedetection of these targets.  Becausethis process does not require thermal cycling, it is extremely fast, andcomplex instrumentation for thermal regulation is not required.  The Nanogen/Becton Dickinson Partnership wasgranted rights to Becton Dickinson’s patents relating to SDA in infectiousdisease diagnostics.  During 2000, werevised our relationship with Becton Dickinson.  Nanogen was granted rights to use SDA in the fields of *in vitro*human genetic testing and cancer diagnostics for use outside The Nanogen/BectonDickinson Partnership. We believe that SDA may be an important element in thedevelopment of sample-to-answer applications for our technology platform.  We also believe that SDA may potentiallyprovide our customers with operational benefits such as being easier to use aswell as cost advantages due to the high cost of the most common amplificationmethod.  Although the current NanoChip® System does notutilize SDA, we expect our next generation instrument to support SDAapplications.

 

***Commercialization Strategy: Platformation******Ô***

 

What is happening todayin molecular diagnostics closely mirrors the activities that occurred inclinical chemistry laboratories thirty years ago. The first clinical chemistrytests were done by hand—they were time intensive and required great skill–notunlike some of today’s molecular diagnostic assays.  Then single assay systems were developed that reduced hands-ontime and hastened the reporting of results to physicians.  When multiple assay systems were introduced,a series of assays could be performed simultaneously.  And finally clinical chemistry platforms were developed thatenabled all chemistry assays to be performed on one system, furtherstreamlining the laboratory.  The bottomline:  a transformation from manualassays to automated accurate systems that could perform multiple assayssimultaneously, increasing the reporting efficiency and reducing the time to areportable result.

 

Nanogen has focused oncapturing the market right from the start by creating an open moleculardiagnostics platform that we believe has the potential to become the goldstandard of the industry.  The processof consolidating a number of various molecular tests onto one platform is whatwe have termed “PlatformationTM”. Nanogen’s business strategy utilizes PlatformationTM along with a “razor/razorblade”approach to sales and distribution of our products.  The Company continually seeks to increase the installed base ofthe NanoChip®Systems and to establish our platform as a standard for the moleculardiagnostics industry in order to reap the benefits of the higher margin profitson consumables such as the NanoChip®Cartridges, ASRs and other products. The NanoChip®System’s open architecture facilitates development of molecular tests frommultiple sources, driving the growth in assay development far beyond whereNanogen could take it on its own.  Fromcustomers to development partners and licensing agreements, all act as aninspired research arm for NanoChip®assay development.

 

The NanoChip® System couldtransform molecular diagnostics, bringing to it the speed, efficiency andaccuracy of a robust platform.  As thismarket area grows and Nanogen’s market share increases, the NanoChip® System couldgenerate multiple revenue sources that will fuel next generation systems andthe growth of the Company.  Thus,PlatformationTM is not only the framework for tomorrow’s molecular diagnosticslaboratory; it is the foundation of Nanogen.

 

Nanogen’s strategy toestablish the NanoChipâ System asthe leading molecular diagnostics platform is five-fold.  First, the Company seeks to increase theinstalled base for the NanoChipâSystem for use in high complexity CLIA certified and research laboratoriesthrough direct sales, reagent rental and cost per test agreements as well asdevelopment site agreements.  Second,Nanogen seeks to continue to increase the breadth of its ASR menu on itsNanoChip® System.  We will determine on a case by case basiswhether or not to file with the FDA for approval or clearance to market itsfirst FDA-cleared product for sale to clinical diagnostics laboratories.  Third, Nanogen intends to develop otherproducts on its platform to facilitate customers’ development of their own“home brew”

 

6

----

 

tests on the System.  Fourth, the Company plans to makeimprovements to the NanoChipâ System andto increase the depth of other applications of the NanoChipâ ElectronicMicroarray technology for other uses. And fifth, Nanogen intends to continually seek out strategiccollaborations in order to strengthen our product menu, penetrate new markets,obtain new intellectual property and seek to enter the molecular diagnosticsprovider services market when appropriate.

 

*Increase Installed Base of NanoChip*â*Systems*

 

Nanogen seeks to increasethe installed base of its NanoChipâ MolecularBiology Workstation and to establish the NanoChipâ System asthe standard platform for the molecular diagnostics industry, in order to reapthe benefits of the higher margin profits on consumables, such as the NanoChipâ Cartridges,ASRs and other products.  The Companyhas provided its customers with three main types of commercial transactions toobtain the NanoChipâSystem:  outright sales, reagent rentalagreements and/or cost per test agreements (collectively, “reagent rentals”)and development site agreements.

 

Nanogen typically sellsits NanoChipâSystems directly to its customers through the Company’s sales representativesin the U.S. or Europe or through distributors in other countries throughout theworld.  As of December 31, 2002, theCompany had sold 45 NanoChipâSystems.

 

The sale of NanoChip® Systems is onlyone piece of the revenue stream. As is common with clinical instruments, theconsumables form a substantial revenue segment.  NanoChipâCartridges and those Cartridges and ASRs that are a part of each customerdeveloped and validated assay will normally be ordered by customers to meettheir testing demand.  Nanogenanticipates demand to grow rapidly for certain ASRs, such as those for thedetection of mutations in the CFTR gene that are associated with cysticfibrosis and the detection of mutations in the ApoE gene that are associatedwith Alzheimer’s disease.  While theremay always be customers who wish to purchase the NanoChip® System outright,it is our belief that there will be many more within the high complexityCLIA-certified clinical laboratory market that will want to amortize the costof the instrument over several years. These arrangements, called reagent rentals, have been the standard forthe clinical instruments industry for the past 40 years, fueling the growth ofindustry leaders such as Beckman-Coulter, Abbott and Roche.  Such agreements can span from three to fiveyears and involve establishing a minimum monthly consumables orderinglevel.  Based on that level and the termof the agreement, a premium is added to the cost of the consumables so that thetotal capital equipment cost of the NanoChip® System isrecouped by the end of the agreement. The advantage of reagent rental agreements for Nanogen is that it locksin a minimum revenue flow over the term of each agreement after a normallybrief validation period that normally varies from 30 to 90 days.  Nanogen believes that many of its customerswill increase their consumable ordering levels as new ASRs and ultimatelyFDA-cleared assays are made available. Because the customer’s set premium level will be incorporated into eachof these additional orders, Nanogen has the opportunity to obtain revenue overand above the cost of the original system during the life of theagreement.  As of December 31, 2002, theCompany had entered into 12 reagent rental agreements with customers, all ofwhich were signed in 2002 and all of which were contingent upon the acceptanceof the Company’s ASR for the CFTR gene.

 

The increased use ofreagent rental agreements is an indication of the Company’s strategy to targetmore commercial transactions with high volume high complexity CLIA-certifiedlaboratories.  High complexity CLIA-certifiedclinical reference laboratories are traditionally the “early adopters” of new,innovative systems that bring efficiency to labor intensive assays.  The Company’s success in reaching beyondthis core group into research hospitals and leading medical centers is atestament to the desire of these groups to enter into this testing segment.

 

The final type ofagreement whereby a customer may use and eventually purchase a NanoChipâ System, is adevelopment site agreement.  Thesedevelopment sites are normally with leading research organizations andlaboratories or companies that will provide us with certain rights tocommercialize the discoveries made using the our platform.  These relationships have been focused on thediscovery of the associations of specific genetic variations with major diseasestates, including cancer, hypertension, inflammation and cardiovasculardisease.  Our strategy is to offer ourresearch collaborators early access in exchange for the rights to commercializethe discoveries they make using it. These rights may enable us to offer new genetic products for clinicalresearch and clinical diagnostic applications if any are developed from thecollaboration. Pursuant to development site

 

7

----

 

agreements, Nanogeninstalls a NanoChipâ System at acustomer site for a period ranging typically from six to nine months duringwhich time the customer can test the System by developing, validating andrunning certain assays on the System. For the use of the System during this period, the Customer assigns toNanogen rights to improvements to the System and Nanogen and the customer agreeon certain Nanogen rights to any assays developed thereon.  Once the development site period hasterminated, the customer may then either return the System to the Company orpurchase it through a sale or a reagent rental transaction.  As of December 31, 2002, the Company hadentered into 32 development site agreements with customers and converted 10into commercial transactions that included 5 sales and 5 reagent rentaltransactions.

 

*Increase the Breadth of the ASR Menu on the NanoChip*â*  System to furtherPenetrate the Clinical Diagnostics Market*

 

The second of Nanogen’s five strategic goals is toincrease the breadth of the NanoChipâ System’s ASRmenu for commercial applications.  EachNanogen ASR includes specific reagents that enable the customer to develop,validate and perform a molecular test that determines the presence or absenceof certain gene mutations associated with certain disease states.  As part of Nanogen’s PlatformationTMstrategy, the Company seeks to increase the number of commercially availableASRs that it provides its customers so as to both increase the attractivenessof the NanoChipâSystem to seek to gain some of the higher profit margins normally associatedwith the sale of such consumables.

 

During 2002, Nanogen introduced its first commerciallyavailable ASRs, that for Factor V Leiden, a gene mutation associated with thedetection of thrombosis.  The Companyalso undertook great efforts to develop a number of other ASRs.  The Company internally developed and testedASRs for mutations in the CFTR gene associated with the diagnosis of cysticfibrosis, for the mutations in the HFE gene associated with hereditaryhemochromotosis and for a multiplexed Factor II/Factor V ASRs, all of which theCompany introduced commercially in the first quarter of 2003.

 

Also, during 2002, Nanogen entered into licenseagreements and began development work on either ASRs or research reagentsinvolving the following:  ASPA genemutations related to the diagnosis of Canavan disease (with the assistance ofNanogen Recognomics), the ApoE gene mutations associated with the diagnosis ofAlzheimer’s disease and for mutations in genes associated with the detection ofbeta thalasemia.  Nanogen has alsoacquired rights from a third party to certain content potentially related tothe diagnosis of epilepsy.  The Companyplans to introduce ASRs for detection of mutations in the ASPA gene associatedwith the diagnosis of Canavan disease, ASRs for ApoE and research reagents forthe detection of mutations associated with beta thalasemia in the secondquarter of 2003.

 

In addition, we expect to enter into more licensingand other collaborative agreements relating to securing rights to mutations togenes necessary to develop other ASRs.

 

In the future, wepresently intend to file with the FDA for clearance to market both the NanoChipâSystem and certain of our products for clinical diagnostics.  Nanogen is currently putting in place theinternal procedures and groundwork necessary to submit such products forclearance in the near future.   This maybe a costly and time consuming process.

 

*Developmentand Introduction of Research Products*

 

Nanogen’s third strategicgoal is to develop products on its platform that facilitate customers’development and validation of their own “home brew” tests on the NanoChipâ System.  In 2002, taking advantage of our openarchitecture system, we internally developed our Assay ToolboxÔproduct that provides research customers with the necessary tools and most ofthe reagents to develop and validate their own “home brew” tests on our Systemand take advantage of our open architecture system.  We commercially launched the Assay ToolboxÔproduct in the first quarter of 2003 and believe that this product will help usfurther our PlatformationTM goal.  Wealso intend to develop and commercialize other valuable products forcustomers.  While researchers want touse high throughput devices to discover genes and genetic mutations, they willwant to explore the function and impact of these genes and mutations with amore accurate and targeted technology. We seek to position the NanoChip®  System as such a

 

8

----

 

technology.  We intend to further pursue the genomics andbiomedical research markets by taking advantage of the open architecture designof our technology that allows end users to develop and validate diagnostictests to meet their individual research needs and help drive development ofnovel applications.

 

*Improve the NanoChip*â* System and increase the depth of other applications of theNanoChip*â*ElectronicMicroarray technology*.

 

Nanogen’s fourthstrategic goal is to develop improvements to the NanoChipâ System overtime through our engineering and advanced technology groups along with themanufacturer of the NanoChip®System, Hitachi High Technologies. Initially, improvements will be focused on cost reduction andthroughput.  In the long term, we wouldlike to develop sample-to-answer systems which integrate otherwisetime-consuming and labor-intensive sample preparation procedures on thedisposable cartridge.  The availabilityof this lab-on-a-chip technology would fulfill a substantial unmet need in bothacademic research and commercial sectors.

 

We also intend tocontinue the development of other technologies that may complement and improvethe NanoChipâSystem, utilize the NanoChipâElectronic Microarray technology or are designed and developed by our employees,subsidiaries or collaborators.  Suchproducts include those currently developed by Nanogen in the forensics,biodefense, and protein kinase as well as those developed by NanogenRecognomics in the fields of synthetic oligonucleotide chemistry and advancedmolecular biology.

 

*Continue to establish**strategic collaborations in order tostrengthen our product menu, penetrate new markets, obtain new intellectualproperty and enter the service market when appropriate*.

 

Our fifth strategic goalis to continue to enter into collaborations to expand applications of ourtechnology platform and to accelerate the commercialization of products inorder to strengthen our product menu, penetrate new markets, obtain newintellectual property and enter the molecular diagnostics service providermarket when appropriate.  We will pursueadditional collaborations in various forms, including research and developmentagreements, licensing agreements and joint ventures.  These collaborations permit integration of the technology andresources of our partners with our technology, while allowing Nanogen to pursuediagnostics and genomics opportunities outside the scope of thesecollaborations.

 

***Nanogen’s Current Products***

 

***NanoChip***®***System’s Components***

 

The Company is seeking toestablish the NanoChip®System as the standard platform for the detection of genetic mutations and todevelop applications for future clinical use. Nanogen markets its NanoChip®Molecular Biology Workstation to scientists and molecular diagnostics laboratories.  The heart of Nanogen’s offering is based onthree different components:  theWorkstation, Cartridges and software.

 

The NanoChip®  System consists of a consumable Cartridge containing a proprietarysemiconductor microchip, the NanoChip®Electronic Microarray, a fully automated instrument and imbedded software thatcan be programmed by the end-user to control all aspects of microchipoperations, processing, detection and reporting.  The System has been designed so that once programmed, theend-user need only insert of a consumable Cartridge containing a test sampleinto the instrument and all subsequent steps may be handled automatically undercomputer control.

 

***The NanoChip***®*** Cartridge***

 

The consumable NanoChip®  Cartridge consists of a proprietary semiconductormicrochip with electrical and fluidic connections to the instrument.  We expect that over time the consumablecartridge and microchip may be manufactured in high volumes at a low costrelative to many current technologies.

 

*Semiconductor microchip*

 

Our proprietary microchip(the “NanoChip®Electronic Microarray”) utilizes advances in the semiconductor industry and isdesigned and constructed using microlithography and fabricationtechniques.  The NanoChip®

 

9

----

 

Electronic Microarray ismounted within the consumable cartridge and is coated with a proprietarypermeation layer.  We have developedarrays of various sizes utilizing both passive and active CMOS microchips, aswell as flip chip assembly technologies. Our current production of consumablecartridges employs 100 different test sites on a single NanoChip® ElectronicMicroarray.  We are additionallydeveloping a cartridge that employees 400 different test sites on a singleNanoChip® Electronic Microarrayfor our next generation instrument.

 

*Permeation layer*

 

Our proprietarypermeation layer, which is critical to the proper functioning of our System, isthe interface between the surface of the microchip and the biological testenvironment.  The permeation layerisolates the biological materials from the electrochemical environment near theelectrode surface and provides the chemistry necessary for attachment of thesamples.

 

*Samples*

 

Samples areelectronically addressed to the desired microlocations and attached to thepermeation layer.  Because independentcontrol can be applied at any test site on our microchip, different samples canbe addressed on the same microchip, allowing multiple tests to be processed onthe same Cartridge.  Our open architectureapproach allows the customer to address their specific samples onto a microchipto perform individualized analyses.

 

***The NanoChip***®***Molecular Biology Workstation***

 

Our fully integratedNanoChip®  System consists of fourmajor subsystems: (1) a freestanding microchip Loader to perform electronicaddressing of blank microchips, (2) a highly sensitive, laser-basedfluorescence scanner that detects molecular binding, (3) a fluid handlingsubsystem that controls test sample application and washing steps, ((2) and (3)are, collectively referred to as, the “Reader”), and (4) computer hardware andsoftware that allow the operator to develop, validate and select protocols froma graphical user menu which controls all microchip operations, tabulates testresults and prints test reports based upon user-defined inputs.

 

*Microchip Loader*

 

Our System includes aCartridge/microchip Loader that will allow users to electronically addresstheir own samples to selected test sites on up to four chipssimultaneously.  In addition,hybridization can be performed on the Loader or on the Reader.  Multiple Loaders can operate concurrentlyunder the control of one System.

 

*Fluorescent array scanner*

 

The fluorescent scannercomponent of the System uses optoelectronic technology to reduce instrumentcost and size and eliminate the need for complicated array positioningmechanics.  In its presentconfiguration, the scanner is able to perform high sensitivity scans of arraysof 100 test sites in less than five minutes.

 

*Fluidics*

 

Within the fluorescentarray scanner component of the System, the fluidics function automates themovement of the reagents and test sample onto the consumable cartridge.  The fluidic subassembly of the instrumentincludes a panel of precision syringe pumps, a cartridge-mounted sampleassembly and fluidic connections between the instrument and the consumableCartridge.

* *

*Computer hardware and software system*

 

A multi-tasking operatingsystem and microprocessor control all aspects of the systems operations, includingbar-coded test selection, test operation, fluorescent signal detection andsignal processing, calculation of assay results and report generation.  The end-user must develop and validate theprotocols used by the software as well as define the parameters used tocalculate results and generate reports. Each of the individual array locations is separately controlled by themicroprocessor. Fluorescent signals emanating from positive test sites arescanned, monitored and quantified.

 

10

----

 

***NanoChip***®***Analysis Process***

 

*Cartridge*

 

The electronic microchipis mounted within a plastic molded Cartridge. The bar-coded cartridge is delivered in a ready-to-address format withno genetic sequences pre-attached.

 

*Electronic addressing*

 

Users design, create andvalidate their own genetic tests on the microelectronic chip with our automatedSystem.  A 96 well or 384 wellmicrotiter plate containing genetic sequences is placed in the Loader.  The System then automatically electronicallyaddresses the microchip with user-defined tests.

 

*Hybridization and stringency*

 

Users may add testsamples to the Cartridge and insert the Cartridge into the Reader.  The customer may then select to have theinstrument automatically perform hybridization and the appropriate stringencycontrol is selected by the user, chemical, thermal or electronic.  The electronically enhanced process speedsand improves the genetic analysis, allowing single-base accuracy.

 

*Simple-to-read output*

 

Within minutes ofinserting the bar-coded Cartridge for analysis, easy-to-read andeasy-to-interpret output is available based upon user-defined inputs.  Data can be automatically downloaded tonetwork systems and to standard software spreadsheet packages.   The entire electronic addressing and dataoutput process can be completed rapidly, allowing users to accelerate theirresearch process by creating new genetic tests based on previous experimentalresults.

 

**Applications Manager Software (“AMS”)**

 

Nanogen plans to offer bymid 2003 a separately priced software package designed to streamline routine orfrequent testing for the same genetic markers. AMS enables users to run protocols they’ve written and validated for theNanoChipâSystem in a simplified, menu driven, point-and-click fashion.  This supplemental software offers the easeof use required of those laboratories that run the same set of tests on aregular basis.  It was designed in responseto high complexity CLIA certified clinical laboratories that are frustrated by“research” orientation of the currently available software.  We believe that this software will provide asignificant competitive advantage for the NanoChipâ System.

 

***Analyte Specific Reagent (“ASRs”)***

 

ASRs are the specificreagents that permit either research or high complexity CLIA certifiedlaboratory customers to develop, validate and run certain SNP assays.  Under the ASRs model, we sell not onlyNanoChip®Cartridges, but also the specific reagents that can be used to develop,validate and perform DNA-based tests. We expect to further increase the potential revenue from each analysisperformed with the launch of the SDA method of amplification for use on ournext generation instrument.  We alsobelieve that by providing ASRs for tests that are in high demand, such as thosedeveloped for the CFTR gene mutation associated with the diagnosis of cysticfibrosis, we are in a better position to begin data collection on aprotocol-by-protocol basis for a potential FDA submission for certain kit-basedassays.  Such kit-based assays normallyinclude a protocol, ASRs, other reagents and performance claims and can be usedby a wider variety of customers to provide clinicians with results that theycan provide to their patients.

 

We currently have fourASRs that are commercially available for (1) Factor V Leiden launched in 2002,(2) Factor II/Factor V multiplex launched in the first quarter 2003, (3) CFTRlaunched in the first quarter 2003 and (4) HFE launched in the first quarter2003.  Below is a more detaileddescription of the ASRs:

 

11

----

 

**Factor V Leiden ASRs**

 

Nanogen’s Factor V (Leiden) ASRs determine if the G1691Amutation on Factor V (Leiden) gene is present in a sample by detecting thepresence of a certain characteristic gene polymorphism.  The Factor V (Leiden) ASRs consists ofactive reagents that CLIA-certified high complexity laboratories can usedeveloping and validating their tests to detect this mutation.  Factor V is a gene mutation associated withthrombosis.  Thrombosis is defined asthe formation, development or presence of a blood clot (thrombosis) in a bloodvessel or the heart.  Blood clots areassociated with heart attack, stroke, and other severe health complications.Complete blockage of the vessel can lead to an embolism.  Mutations in the Factor V (Leiden) gene havebeen linked to thrombotic events.

 

**Factor II/Factor V Multiplex ASRs**

 

Nanogen offers ASRs for the detection of two geneticmutations associated with thrombosis: the G1691A mutation on the Factor V(Leiden) gene and the G20210A mutation on the Factor II (Prothrombin)gene.  CLIA certified high complexitylaboratories may use the reagents to create and validate laboratory developedtests for detection of these two mutations. Currently, Nanogen is the only provider of the Factor V (Leiden) andFactor II (Prothrombin) mutations in a multiplexed format.

 

Nanogen’s Factor II/Factor V ASRs are multiplexed ASRsmeaning that the customer can develop and validate multiple Factor II and FactorV gene mutations from a single test site (representing one sample) or frommultiple test sites (representing different samples).  The customer also has the ability to electronically addressmultiplexed amplicons to a single test site. The ability to control individual test sites permits biochemicallyunrelated molecules to be used simultaneously on the same microchip array.  Conventional DNA arrays do not have thisfeature; all process steps must be performed on an entire array.  Nanogen’s Factor II/Factor V ASRs are aprime example of how our unique microelectronic array technology deliversincreased versatility over conventional methods.

 

**CFTR ASRs**

 

Nanogen’s CFTR ASRs offer the customer the ability todevelop and validate a test for the detection of the ****25 CFTRmutations recommended by American College of Medical Genetics “ACMG”)/****AmericanCollege of Obstetrics and Gynecology (“ACOG”) as part of a high complexityCLIA-certified laboratory “homebrew” assay.

 

These mutations areassociated with the diagnosis of cystic fibrosis.  Our ASRs are based upon the first molecular based testrecommended for nationwide screening of healthy individuals.  In early 2003, we completed beta-sitetesting of our set of ASRs for use in developing and validating tests for themutations in the CFTR gene, which are associated with the diagnosis of cysticfibrosis, and commenced a controlled release of the product to market.   Many people carry a single cystic fibrosisgene mutation, and they do not experience any significant health problems.  In the general population, approximately 1in 31 Americans carries the gene mutations. This is the reason ACOG announced that the Standard of Medical Care includesscreening women contemplating pregnancy for cystic fibrosis.  To meet the standard of medical care, aphysician must at least offer screening to each woman contemplatingpregnancy.  However, the disease canonly occur in babies with two carrier parents. If initial screening of the prospective mother is positive for the CFTRmutation, then further testing of the prospective father is warranted.  When both parents are carriers, they have a25% chance with every pregnancy of passing two copies of the defective gene totheir child.  The current recommendationfrom ACOG is for a 25-mutation screen. We believe that the ACOG recommendations may drive a significantincrease in genetic testing for gene mutations associated with cystic fibrosis.

 

***HFE ASRs***

 

Nanogen offers ASRs for the development and validationof a test to detect the three mutations associated with hereditaryhemochromatosis (HH).  Reagents includeoligonucleotides for the detection of nucleotides corresponding to the C282Y,H63D, and S65C mutations of the HFE gene. CLIA-certified high complexity laboratories may use the reagents tocreate and validate laboratory developed tests (LDT) for HFE.  Currently, Nanogen’s HFE ASRs are the onlyASRs for use in developing and validating a test  for the three mutations in the HFE gene.

 

12

----

 

Hereditary hemochromatosis is an autosomal recessivedisorder characterized by unusually high levels of iron in the blood due topolymorphisms in the HFE gene.  Excessiron accumulates over a period of years in the patients’ major organsystems.  Clinical indications of HHinclude type II diabetes (also known as “bronze” diabetes), heart disease,arthritis, and liver disease.

 

**Other Current Products**

 

**Assay ToolBox**Ô

 

The Nanogen Assay ToolBoxTM is a collection of general purposereagents and accessories used to facilitate assay and protocol development andvalidation on the NanoChip® platform.  The Assay ToolBoxTM components, together with oligos availablefrom third party vendors, may be used to facilitate development and validationof laboratory developed tests by CLIA-certified high complexity laboratories orresearch laboratories.  The unique,open-architecture of the NanoChip® Electronic Microarray andinstrumentation enables researchers to define, select and build their own testpanels.  Customers may be required toobtain third party licenses to the specific gene mutations for the assays thatthey seek to develop or validate.

 

***Products and Applications in Research and Development***

 

We seek to furtherdevelop the NanoChip®  System, integrating new features andbroadening the applications of the currently marketed System, includingenhancing chip design and capabilities to simplify instrument design.  Our scientists will investigate newopportunities and develop and validate new protocols, ASRs and products for useon the NanoChip®  System, while customers may create andvalidate new “home brew” assays by taking advantage of the flexible format ofthe System.

 

We also intend to pursuenew opportunities utilizing electronics beyond the current microchipconcept.  For example, futuretechnologies may include integration of sample processing and DNAamplification.  The NanoChip®  System may be designed to provide analysisof other charged molecules and antigen-antibody, enzyme substrate,cell-receptor, and cell-separation techniques. The NanoChip®  System eventually may also become a portablelab on a chip for use in the field, away from the laboratory bench.

 

Below is a brief descriptionof some of future products and application currently in research anddevelopment at either the Company or with one of its collaborators.

 

**Next Generation NanoChip**â**System**

 

As part of the NanogenHitachi collaboration, we have been working on improvements to the currentNanoChipâSystem and the development of a next generation NanoChipâ System.  We believe our next generation NanoChip® System must bemore compact and less costly to access smaller hospital laboratories and othercustomers for molecular-based testing.

 

**Additional Potential ASRs and other Products**

 

*ASRs for mutations in the ASPA Gene related to Canavandisease*

 

During 2002, Nanogenentered into a non-exclusive license agreement with a third party that providedit with rights to develop ASRs for certain mutations in the ASPA geneassociated with Canavan disease, a disease that has highest prevalence in theAshkenazi Jewish community.  Thiscommunity has historically been very proactive in the United States inadvocating that its members undergo genetic testing prior to havingchildren.  The ASPA mutation detectiontest is a key member of a panel of multiple tests frequently used in anAshkenazi Jewish genetic disease screening panel.  Cystic fibrosis also is a key part of this panel and Nanogenoffers the ASRs to enable customers to develop and validate an assay to testfor the specific mutations associated with the diagnosis of cysticfibrosis.  Strategically, the ASPA ASRsare important as they provide patent licensure to the end user which hashistorically been a challenge for individual laboratories to obtain.  This will allow many labs who are currentlysending out this test to bring it in-house. Moreover, those labs that currently test internally typically run a“home brew” assay which most report as highly cumbersome.  These ASRs will simplify and streamlinetheir testing for this important gene.

 

13

----

 

During 2002, Nanogen andits subsidiary, Recognomics, jointly worked on developing and validating theASRs and Nanogen currently has transferred the ASRs to an alpha test site.  Nanogen currently expects to release theASRs in the second quarter of 2003.

 

*ApoE ASRs*

 

In 2002, Nanogen non-exclusively licensed rights todevelop and commercialize ASRs relating to ApoE gene mutations linked to thedetection of Alzheimer’s disease.  TheASRs are currently in beta site testing and Nanogen expects to release the ASRsin the second quarter of 2003.  Like theASPA ASRs, strategically, the ApoE ASRs are important as they provide patentlicensure to the end user which has historically been a challenge forindividual laboratories to obtain.  Thiswill allow many labs who are currently sending out this test to bring itin-house.  Since those labs that currentlytest internally typically run a “home brew” assay that most report as highlycumbersome, the ApoE ASRs will simplify and streamline their testing for thisimportant gene.

 

ASRs for Genes related toepilepsy

 

In 2002, Nanogen enteredinto a development site agreement with Bionomics, an Australian company thatprovides for an option to the exclusive commercial rights for certain genemutations believed to relate to epilepsy. Bionomics is currently in the initial stage of validating its hypothesisand developing a test for these mutations. Since this research is in the early stage of development, no definitivetime table has been set for the release of any of such ASRs.

 

Beta thalassema researchreagents

 

Nanogen has been workingwith a company in Europe to jointly develop a product for the detection ofcertain genes associated with the diagnosis of beta thalassimia, a disease thatis most prevalent in the Mediterranean regions of Europe.  These research reagents will be initiallymarketed through the European company as an alternative method for testing betathalassemia in newborns.  Nanogenexpects to release these research reagents in the second quarter of 2003.

 

**Advanced Technology and Research and Development**

 

Besides the continueddevelopment of the NanoChipâ System, ASRsand other similar products, we are currently conducting research anddevelopment into a number of other applications of our technology.

 

*Developing Advanced Technologies and Point-of-CareApplications***.**

 

In the long term, we planto develop sample-to-answer systems which integrate otherwise time-consumingand labor-intensive sample preparation procedures on the disposable cartridgethrough the use of active microelectronics. The availability of this lab-on-a-chip technology would fulfill asubstantial unmet need in both academic research and commercial sectors.

 

*****Nanogen Recognomics*****

 

Nanogen Recognomics, ajoint venture of Nanogen and Aventis Research & Technologies, combines theNanoChip®technology and Aventis R&T ́s intellectual property and expertise insynthetic oligonucleotide chemistry and advanced molecular biology to developnew products and applications for the NanoChip® System. Besidesassisting us in the development of ASRs for the detection of genes associatedwith Canavan disease, their current research efforts include genetic-based invitro human detection, diagnostics, screening and monitoring applications,including research into novel oligonucleotide chemistries.

 

*****Biodefense*****

 

Nanogen began work onbiodefense-related technology for the United States Government in 1995.  The work has expanded to include threecurrent government grants to support biowarfare detection efforts (one ongoingDARPA grant and two DUST grants).

 

14

----

 

Specific developmentefforts include a prototype portable field-based detection device and anintegrated micro-laboratory and assay protocol to analyze simulated biowarfaretargets.  Also under development areassays aimed at detection of specific biowarfare agents and infectious diseasesand a self-contained portable system capable of performing on-chip non-PCRamplification and detection of potential biowarfare threats.

 

*****Forensics*****

 

STRs are the geneticsequences chosen by the U.S. government and various foreign governments topopulate their national criminal identification databases.  Some foreign researchers and governments arealso beginning to examine certain SNPs to develop such databases.  These databases are intended to providenationwide tools for identifying repeat criminals by comparing a given piece ofevidence or sample from a suspect with the sequences stored in thedatabase.  Currently, we have fouroverseas development sites working on forensic applications.  We believe our NanoChip®  System may be useful in human identitytesting.

 

Our researchcollaborations in the area of forensic applications include identity testingand have allowed us to further develop existing technology and explore newtechnology.  Prior and current grantsfrom the National Institute of Justice have involved sponsored research forforensic applications, such as the development of a portable system for humanidentification at the crime scene and the development of on-chip non-PCRamplification.

 

*Kinase*

 

Working with Aventis,Nanogen has developed an electronic, fluorescent kinase assay and instrumentfor use in drug discovery.  The assay isconfigured for 384-well microtiter plates and uses no antibodies orradioactivity.  While particularlyattractive for serine/threonine kinases, the electronic assay can also beapplied to phosphatases and proteases.

 

The assay principleinvolves kinase phosphorylation to invert the charge of a fluorophore-labeledpeptide substrate, followed by electrophoresis to separate the phosphorylatedand unphosphorylated peptides.  Theintensity of the fluorescence is quantitatively read on a conventional platereader and directly related to the effectiveness of the inhibitor.

 

Nanogen has placedElectroCaptureTM HTS workstations in beta-site locations.  Direct comparisons with fluorescencepolarization, homogeneous time-resolved fluorescence and radioactive filterbinding assays have been presented by Eli Lilly & Company and Aventis atseveral drug discovery conferences.  Theprimary advantages our electronic technology identified by our collaboratorsare assay simplicity and low fluorescence compound interference.  We have developed a proprietary method toquickly identify specific fluorophore labeled proprietary substrates for kinaseand orphan kinases that are assay-ready. By combining the substrateidentification method with our electronic assay, we believe that high-qualityscreening results can be generated for a large fraction of the kinases andphosphatases in the human genome.  Wewill be identifying the on-going business strategy for the optimum commercialimpact of this technology.  Nanogen doesnot plan to commercialize the kinase technology on its own, but will identifythird party collaborators to commercialize it.

 

**Other Potential Applications**

 

As the Human GenomeProject opportunity and other public and private genetic sequencing effortsyield increasing amounts of genetic information, we believe that the demand forgenetic predisposition testing will continue to grow.  Because many important genetic diseases are ideally suited todiagnosis in multiplexed arrays, we believe that our technology platform couldcontribute significantly to the expansion of testing in this area.  While our development efforts in this areawith respect to specific genetic tests are still at an early stage, our coretechnology platform for other diagnostic applications may be well suited forthese opportunities.

 

*Infectious diseases*

 

We believe we have thepotential to apply our technology in the field of infectious diseasediagnostics to develop automated tests to replace the manual and time-intensiveprocedures used in hospitals and reference laboratories.  The role of the clinical microbiologylaboratory is to detect, identify and determine antibiotic sensitivity ofdisease

 

15

----

 

causingmicroorganisms.  To accomplish thistask, colonies of microorganisms from patient specimens are grown, or cultured,in various growth media.  Followingcolony growth, various direct and indirect techniques are utilized to determinethe identity and, as required, the sensitivity of the microorganism to specificantibiotics.  Using currently availabletechnologies, the entire process may take days or weeks to complete.  In the meantime, a patient requiringimmediate therapy, must often be treated by the clinician based upon the bestclinical facts available at that time. Upon receipt of the diagnostic analysis from the laboratory, the initialpatient treatment protocol may need to be modified in order to treat thepatient more effectively.

 

Current culture-basedmethods detect a single microorganism at one time.  Because a particular infectious episode may be caused by one ofmany microorganisms or several microorganisms together, multiple tests may berequired to determine the correct diagnosis. “Single tube” (one at a time) DNA probe diagnostics, which were firstintroduced to the marketplace in the mid-1980’s, have been unsuccessful in displacingculture based diagnostic tests in part due to their inability to identifyseveral organisms simultaneously.  Ourtechnology addresses these shortcomings by allowing the simultaneous analysisof multiple microorganisms from a single patient sample.  We believe our technology and integrated systemmay speed the time-to-result for diagnostic tests and offer our customers theopportunity to lower their costs and improve productivity by automating all ora significant portion of their labor-intensive testing.

 

*Drug discovery applications*

 

We believe we have apowerful tool, the ElectroCaptureTM workstation,  which will help clarify appropriate pathways for therapeuticintervention, identify and evaluate lead compounds and simultaneously assessthe efficacy and toxicology of these compounds in model systems. It isestimated that the pre-clinical drug discovery process takes an average of sixand one-half years.  Consequently, webelieve there is a significant demand for improved tools that accelerate thedrug discovery process.

 

We believe the microelectronicarray format and independent test site control of our System are well suitedfor applications in drug discovery. In addition, we believe the use ofelectronics beyond the microchip format may provide a valuable tool for thehigh throughput screening of compounds. One such application is the high throughput screening of drug candidatesacting on protein kinases.  Proteinkinases are particularly important in signal transduction pathways and arethought to be key elements in many forms of cancer.  Our electronic, fluorescent tests are free of antibodies and havethe potential of improving the cost and quality of the screening process.  We will be identifying the ongoing businessstrategy for the optimum commercialization of this technology.

 

*Pharmacogenomics*

 

We believe that theability of our technology to screen simultaneously for various DNA sequencesand the ability to differentiate between SNPs has potentially wideapplicability to the field of genetic testing in general and pharmacogenomicsin particular.  Pharmacogenomics is thescience of individualizing therapy based on genetic differences among patients.

 

Our NanoChip®  System may provide pharmaceutical andbiotechnology companies with the ability to identify important geneticvariations early in the drug development process.  We believe our System may help stratify patients during clinicaltrials and identify those receiving the maximum benefit from treatment.

 

**Collaborative Alliances**

 

We intend to continue toenter into collaborations to expand applications of our technology platform andto accelerate the commercialization of products.  We will pursue additional collaborations in various forms,including research and development agreements, licensing agreements and jointventures. These collaborations permit integration of the technology andresources of our partners with our technology, while allowing Nanogen to pursuediagnostics, drug discovery and genomics opportunities outside the scope ofthese collaborations.

 

We are currently involvedin two material corporate collaborations. In July 2001, we formed a company with Aventis named Nanogen RecognomicsGmbH.  In January 2000, we entered intoa manufacturing, development and

 

16

----

 

distribution agreementwith Hitachi, Ltd.  In July 2000, weentered into an additional agreement with Hitachi, Ltd., Nissei Sangyo Co. Ltd.and Hitachi Instruments Service Co. Ltd. of Japan (collectively, “Hitachi”) todevelop, manufacture and distribute additional potential products based on theparties’ proprietary technologies, potentially including, among other things,reduced-size instruments for genetic testing, integrated amplification andpoint-of-care detection.  We aredirectly involved with marketing our first product line to the biomedicalresearch and genomics market and clinical diagnostics labs.  Additionally, we may distribute products inJapan and select Asian markets through the distribution arm of Hitachi HighTechnologies.

 

***Aventis/Nanogen Recognomics***

 

In December 1997, weentered into a Letter Agreement with Aventis for an exclusive research anddevelopment collaboration relating to new drug discovery tools andimmunodiagnostics research.  Inconnection with the Letter Agreement, we entered into a definitiveCollaborative Research and Development Agreement with an effective date ofJanuary 1, 1998.  The term of thisoriginal collaboration agreement expired at the end of 2000.  In September 1999 we entered into anadditional collaboration agreement with Aventis that involved two new researchand development programs focused on gene expression arrays and on anelectronics-based high throughput screening system.  We retain full commercialization rights for any productsresulting from these new projects, while Aventis retains the right to use thetechnology for internal research and development.  The September 1999 agreement expired at the end of 2001.  We do not expect to receive additionalfunding for these projects.

 

In July 2001, we formed acompany with Aventis named Nanogen Recognomics GmbH.  This company may allow us to benefit from the development of newtechnological advances for our platform while still focusing on our near-termgoal of entry into molecular diagnostics. Nanogen Recognomics adds intellectual property and expertise insynthetic oligonucleotide chemistry and advanced molecular biology to Nanogen.

 

As described earlierherein, Nanogen Recognomics combines the NanoChip® technology andAventis R&T ́s intellectual property and expertise in syntheticoligonucleotide chemistry and advanced molecular biology to develop newproducts and applications for the NanoChip®System.  These current research effortsinclude genetic-based in vitro human detection, diagnostics, screening andmonitoring applications, including research into novel oligonucleotidechemistries.

 

***Hitachi***

 

In January 2000, weexecuted an agreement with Hitachi, Ltd. for the full-scale commercialmanufacturing and distribution of the NanoChip® Molecular BiologyWorkstation in specified research markets. Hitachi, Ltd.’s Instrument Groupprovides technology and technical support to aid in the manufacturing of theNanoChip® Molecular BiologyWorkstation’s components.

 

Under this agreement,Hitachi, Ltd. has the right to be the sole distributor of Hitachi, Ltd.produced NanoChip®Molecular Biology Workstations in Japan. Hitachi, Ltd. also has thenon-exclusive right to distribute NanoChip®Cartridges in Japan.  We retained theright to distribute, directly or through others, Hitachi, Ltd. producedNanoChip® Molecular BiologyWorkstations outside of Japan.  Inaddition, we currently develop and manufacture the NanoChip® Cartridges fordistribution worldwide.  We also retainthe right to form other manufacturing and distribution agreements.

 

In July 2000, we executeda ten-year agreement with Hitachi, Ltd., Nissei Sangyo Co. Ltd. and HitachiInstruments Service Co. Ltd. of Japan (collectively, “Hitachi”) to develop,manufacture and distribute products based on the parties’ proprietary technologies,potentially including, among other things, reduced-size instruments for genetictesting, integrated amplification and point-of-care detection.  The agreement provides that the parties willjointly determine which projects to prioritize over the term of theagreement.  The agreement may beterminated before its expiration by either party after July 26, 2003, subjectto certain conditions.  The agreementexpands on the existing agreement executed by us and Hitachi in January2000.  Hitachi has the right to be theexclusive distributor of collaboration products in Japan and, based upon theattainment of minimum sales targets to be mutually agreed upon, in other Asiancountries.  We retain the exclusiveright to distribute collaboration products outside of these countries.

 

17

----

 

***Government Grants***

 

In 2002, we continuedwork under a number of biodefense-related technology grants for the UnitedStates Government.  The work hasexpanded to include three current government grants to support biowarfaredetection efforts (one ongoing DARPA grant and two DUST grants)  In the latter part of 2002, we received anadditional $1.7 million grant from the National Institute of Justice (“NIJ”) tocontinue an earlier NIJ grant for the development of a forensics detectionsystem for the identification of certain relevant SNPs and STRs and we receiveda grant from the National Institute of Health for $162,000 for the developmentof a sample preparation system for the detection of certain biological agents.

 

Specific developmentefforts include a prototype portable field-based detection device and anintegrated micro-laboratory and assay protocol to analyze simulated biowarfaretargets.  Also under development areassays aimed at detection of specific biowarfare agents and infectious diseasesand a self-contained portable system capable of performing on-chip non-PCRamplification and detection of potential biowarfare threats.

 

We believe that theactions we are taking to develop our product platform for use in moleculardiagnostics are directly portable and complementary to what we are doing in thebiowarfare arena for the U.S. Army.  Asa result, we believe that our government and commercial programs complement oneanother.

 

**Proprietary Technology and Patents**

 

Asof December 31, 2002, we have forty-seven issued U.S. patents and thirty-sixforeign patents and a number of pending patent applications filed in the U.S.and abroad.  In addition to pursuingpatents and patent applications relating to our platform technology, we haveand may enter into other license arrangements to obtain rights to third-partyintellectual property where appropriate.

 

Ouror our licensors’ patent applications may not be issued.  Issued patents may not be found valid ifchallenged. In addition, intellectual property rights licensed by us may not besuccessfully integrated into commercial products. Others may independentlydevelop similar technologies or duplicate any technology developed by us.  Because of the extensive time required fordevelopment, testing, and regulatory review of a potential product, it ispossible that, before any of our products can be commercialized, any relatedpatent may expire or remain in existence for only a short period followingcommercialization, thus reducing any advantage of the patent, which couldadversely affect our ability to protect future product development and,consequently, our business, financial condition and results of operations.

 

Weseek to protect our inventions through filing U.S. patents and foreigncounterpart applications in selected other countries.  Because patent applications in the U.S. are maintained in secrecyfor at least eighteen months after the applications are filed and sincepublication of discoveries in the scientific or patent literature often lagsbehind actual discoveries, we cannot be certain that we were the first to makethe inventions covered by each of our issued or pending patent applications orthat we were the first to file for protection of inventions set forth in suchpatent applications.  Our planned orpotential products may be covered by third-party patents or other intellectualproperty rights, in which case continued development and marketing of theproducts would require a license. Required licenses may not be available to us on commercially acceptableterms, if at all. If we do not obtain these licenses, we could encounter delaysin product introductions while we attempt to design around the patents, orcould find that the development, manufacture or sale of products requiringthese licenses is foreclosed.

 

We are aware of U.S. and European patents and patentapplications owned by Oxford Gene Technology (“OGT”). We have opposed oneallowed European Patent that had broad claims to array technology for analyzinga predetermined polynucleotide sequence. OGT’s position with respect to the opposed patent is that the claimsrelate to what it terms the “diagnostic mode.” Those claims have now been narrowed before the Opposition Division tothe point that, if these claims remain final before the European Patent Office,we believe they would not be infringed by our technology.  In the Oral Proceedings before theOpposition Division on November 13, 14, and 15, 2001, the Division determinedthat the claims’ language must be limited to arrays with ‘smooth, impermeable’surfaces.  The case is currently onappeal.  If the decision of theOpposition Division is successfully appealed by OGT and the original claims arereinstated, or if an application relating to arrays issued in another countrywith claims as broad as

 

18

----

theoriginal European patent, we could be subject to infringement accusations thatcould delay or preclude sales of some or all of our anticipated diagnosticproducts.

 

Inaddition to the patent litigation with Oxford Gene Technologies described inItem 3 herein, other litigation may be necessary to defend against or assertclaims of infringement, to enforce patents issued to us, to protect tradesecrets or know-how owned by us or to determine the scope and validity of theproprietary rights of others.  Inaddition, interference proceedings declared by the U.S. Patent and TrademarkOffice may be necessary to determine the priority of inventions with respect toour patent applications.  Litigation orinterference proceedings could result in substantial costs to and diversion ofour effort, and could have a material adverse effect on our business, financialcondition, and results of operations. Any such efforts may not be successful.

 

Wemay rely on trade secrets to protect our technology.  Trade secrets are difficult to protect.  We seek to protect our proprietary technology and processes byconfidentiality agreements with our employees and certain consultants andcontractors.  These agreements may bebreached, we may not have adequate remedies for any breach and our tradesecrets may otherwise become known or be independently discovered by competitors.  To the extent that our employees or ourconsultants or contractors use intellectual property owned by others in theirwork for us, disputes may also arise as to the rights in related or resultingknow-how and inventions.

 

**Manufacturing**

 

In January 2000, weformed a collaboration with Hitachi for the manufacture of our NanoChip®  Molecular Biology Workstationinstruments.  In July 2000, we executeda ten-year agreement with Hitachi, Ltd., Nissei Sangyo Co. Ltd. and HitachiInstruments Service Co. Ltd. of Japan to develop, manufacture and distributeproducts based on the parties’ proprietary technologies.  

 

For the manufacture ofthe NanoChip®  Cartridge, we perform many of theproprietary assembly steps in-house.  Webelieve our technology allows for large-scale microchip production at a relativelylow cost.  We believe that theimplementation of this scalability and low cost will help promote the rapidacceptance of our proprietary semiconductor-based platform technology as anindustry standard.  However, achievingthese efficiencies will require substantial commercial volumes and there can beno assurance we will be successful in generating sufficient demand to scale upmanufacturing capacity to levels that will allow our products to be pricedcompetitively.

 

**Sales and Marketing**

 

We began commercializingthe NanoChip®  Molecular Biology Workstation during thelatter part of 2000. Since then, we have built a commercial structure thatallows us to sell directly in certain markets, while selling throughdistributors and partners in other markets. We began selling our first ASRs for Factor V Leiden in Spring of 2002.

 

Our commercialorganization includes direct sales representatives and sales management,customer support personnel, field support personnel and marketing.  We began selling our product to customers inthe United States, Canada, Mexico and several European countries.  Hitachi’s distribution company, Hitachi HighTechnologies, began distributing our product in Japan during the latter part of2000 as well.  We expect to augment ourcommercial selling process by adding additional distributor partners in othercountries.  To support the commercialefforts in Europe, in August 2000 we established Nanogen Europe B.V., a companywith limited liability, in The Netherlands. This wholly-owned subsidiary operates as our primary European sales andmarketing office.  In San Diego, we aresupporting world-wide field activities with a customer applicationslaboratory.  This laboratory is used toassist in early customer demonstrations, protocol development and system andapplications training.

 

**Competition**

 

As we developapplications of our technology, we expect to encounter intense competition froma number of companies that offer products competing in our targetedapplications.  The molecular diagnostictest market, in particular, is highly competitive, and we expect the intensityof competition to increase.  Weanticipate that our competitors will include health care companies thatmanufacture laboratory-based tests and analyzers, diagnostic and pharmaceuticalcompanies, as well as companies developing drug discovery technologies.  To the extent we are successful indeveloping products in these areas, we will face competition from establishedand development-stage companies both in the United States and abroad.

 

19

----

 

In many instances, ourcompetitors have substantially greater financial, technical, research, andother resources and larger, more established marketing, sales, distribution andservice organizations than we. Moreover, competitors may offer broader product lines and have greatername recognition than we, and may offer discounts as a competitive tactic.  In addition, several development stagecompanies are making or developing products that compete with our potentialproducts.  There can be no assurancethat our competitors will not succeed in developing or marketing technologiesor products that are more effective or commercially attractive than ourpotential products, or that would render our technologies and productsobsolete.  Also, we may not have thefinancial resources, technical expertise or marketing, distribution or supportcapabilities to compete successfully in the future.  Our success will depend in large part on our ability to maintaina competitive position with respect to our technologies.  Rapid technological development by othersmay also result in competing products or technologies.

 

**Government Regulation**

 

Currently our NanoChip® System isregistered for general purpose use in the U.S. and distributed for research usein Europe.  The ASRs under developmentand commercially available are manufactured and distributed in the U.S.pursuant to 21CFR 864.4020.  Futureshort term plans include distribution of these reagents for research use inEurope with eventual CE marking of test systems under the European IVDMDDregulations.

 

For our initial commercial markets, the biomedicalresearch market and the high complexity CLIA certified laboratory market, we donot anticipate the need for FDA or other regulatory clearances for our NanoChip® System andcertain ASRs prior to marketing.  Wehave not applied for FDA or other regulatory clearances with respect to any ofour products under development.  Weanticipate, however, that the manufacturing, labeling, distribution andmarketing of some or all of the diagnostic products we may develop andcommercialize in the future will be subject to regulation in the U.S. and inother countries.  In addition toclinical diagnostic markets, we also may pursue forensic, agricultural,environmental, laboratory and industrial applications for our products whichmay be subject to different government regulation.  Aspects of our manufacturing and marketing activities may also besubject to federal, state and local regulation by various governmentalauthorities.

 

In the U.S., the FDA regulates, as medical devices,most diagnostic tests and *in vitro* reagents that are marketed asfinished test kits and equipment. Pursuant to the Federal Food, Drug, andCosmetic Act, and the regulations promulgated thereunder, the FDA regulates thepreclinical and clinical testing, design, manufacture, labeling, distributionand promotion of medical devices.  Wewill not be able to commence marketing or commercial sales in the U.S. of ournew medical devices that fall within the FDA’s jurisdiction until we receiveclearance or approval from the FDA, which can be a lengthy, expensive, anduncertain process.  Noncompliance withapplicable requirements can result in, among other things, administrative orjudicially imposed sanctions such as injunctions, civil penalties, recall orseizure of products, total or partial suspension of production, failure of thegovernment to grant premarket clearance or premarket approval for devices, withdrawalof marketing clearances or approvals, or criminal prosecution.

 

In the U.S., medical devices are generally classifiedinto one of three classes (i.e., Class I, II or III) on the basis of thecontrols deemed necessary by the FDA to reasonably ensure their safety andeffectiveness. Class I devices are subject to general controls (e.g., labeling,Medical Device Reporting and adherence to Quality System Regulation, orQSR).  Class II devices are subject togeneral and special controls (e.g., performance standards, premarketnotification, postmarket surveillance, patient registries and FDAguidelines).  Generally, Class IIIdevices are new devices which must receive premarket approval by the FDA toensure their safety and effectiveness (e.g., life-sustaining, life-supporting,and implantable devices or new devices which have been found not to besubstantially equivalent to legally marketed devices).  Before a device can be introduced in themarket, the manufacturer must generally obtain FDA clearance of a 510(k)notification or approval of a PMA application. Our products will vary significantly in the degree of regulatoryapprovals required. We believe that certain of our products labeled forresearch, genomics, drug discovery and industrial applications will not requireregulatory approvals or clearance.  Some*in vitro*diagnosticproducts will require 510(k) approvals, while other diagnostic and genetictesting products will require PMA approvals.

 

A 510(k) clearance will generally only be granted ifthe information submitted to the FDA establishes that the device is“substantially equivalent” to a legally marketed predicate device.  For any devices that are cleared through

 

20

----

 

the 510(k) process, significant modifications or enhancements in thedesign or intended use that could significantly affect safety or effectivenesswill require new 510(k) submissions.  Itgenerally takes at least three to six months or more from submission to obtain510(k) premarket clearance, but the process may take longer if FDA requestsmore data or research.

 

The Premarket Approval (“PMA”) application process ismore expensive, uncertain, and lengthy than the 510(k) clearance process.  A PMA must prove the safety andeffectiveness of the device to the FDA’s satisfaction, which typically requiresextensive data, including but not limited to, technical, preclinical, clinicaltrials, manufacturing and labeling to demonstrate the safety and effectivenessof the device.  Although clinicalinvestigations of most devices are subject to the investigational deviceexemption requirements, clinical investigations of non significant risk *in vitro*diagnostic tests, such as our products and products under development, areexempt from the investigational device exemption requirements, including theneed to obtain the FDA’s prior approval. We believe our diagnostics are non significant risk devices because thetesting is noninvasive, does not require an invasive sampling procedure thatpresents a significant risk, does not introduce energy into the subject, and isnot used as a diagnostic procedure without confirmation by another medicallyestablished test or procedure.  Inaddition, the *in vitro* diagnostic tests must be labeled for research useonly or investigational use only, and distribution and due diligence controlsmust be established by the company to assure that IVDs distributed for researchor clinical investigation are used only for those purposes.

 

The FDA may determine that we must adhere to the morecostly, lengthy, and uncertain PMA approval process for our potential products.Significant modifications to the design, labeling or manufacturing process ofan approved device may require approval by the FDA of a PMA supplement..

 

After a PMA is accepted for filing, the FDA begins itsreview of the submitted information, which generally takes between one and twoyears.  During this review period, theFDA may request additional information or clarification of information alreadyprovided, as well as conduct a preapproval inspection of the manufacturingfacility.  If we are not in compliancewith Quality System Regulations (“QSRs”) applicable to manufacturing, we willnot receive PMA approval. Also during the review period, an advisory panel of expertsfrom outside the FDA will be convened to review and evaluate the applicationand provide recommendations to the FDA as to the approvability of thedevice.  We may not be able to obtainnecessary approvals on a timely basis, if at all, and delays in obtaining orfailure to obtain such approvals, the loss of previously obtained approvals, orfailure to comply with existing or future regulatory requirements could have amaterial adverse effect on our business, financial condition and results ofoperations.

 

Manufacturers of medical devices for marketing in theU.S. are required to adhere to the QSR requirements (formerly GoodManufacturing Practices), which include testing, control and documentationrequirements. Manufacturers must also comply with Medical Device Reportingrequirements that a manufacturer report to the FDA any incident in which itsproduct may have caused or contributed to a death or serious injury, or inwhich its product malfunctioned and would be likely to cause or contribute to adeath or serious injury upon recurrence. Labeling and promotional activitiesare subject to scrutiny by the FDA and, in certain circumstances, by theFederal Trade Commission. FDA enforcement policy prohibits the marketing ofapproved medical devices for unapproved uses.

 

We may become subject to routine inspection by the FDAand certain state agencies for compliance with QSR requirements, medical devicereporting requirements and other applicable regulations.  The QSR requirements include design controlsthat will likely increase the cost of compliance.  We may incur significant costs to comply with laws andregulations in the future and these laws and regulations may have a materialadverse effect upon our business, financial condition and results of operation.

 

Any of our customers using our potential futurediagnostic devices for clinical use in the U.S. may be regulated under theCLIA.  CLIA is intended to ensure thequality and reliability of clinical laboratories in the U.S. by mandatingspecific standards in the areas of personnel qualification, administration,participation in proficiency testing, patient test management, quality control,quality assurance and inspections. The regulations promulgated under CLIAestablish three levels of diagnostic tests (“waived,” “moderately complex” and“highly complex”), and the standards applicable to a clinical laboratory dependon the level of the tests it performs. CLIA requirements may prevent someclinical laboratories from using our diagnostic products.  Therefore, CLIA regulations and future

 

21

----

 

administrative interpretations of CLIA may have a material adverseimpact on us by limiting the potential market for our products.

 

There can be no assurance that new legislation willnot impose additional costs or lengthen review times for our products.

 

Additionally, should we develop food pathogenproducts, they will be subject to the regulations of various domestic andforeign government agencies which regulate food safety and food adulteration,including the U.S. Department of Agriculture.

 

**Employees**

 

Asof December 31, 2002, we had 195 full-time employees, of whom 37 hold Ph.D.degrees and 17 hold other advanced degrees. Approximately 81 are involved in research and development, 40 inoperations, manufacturing and quality assurance, 40 in sales and marketing, and34 in finance, legal and other administrative functions. Our success willdepend in large part upon our ability to attract and retain employees.  We face competition in this regard fromother companies, research and academic institutions, government entities andother organizations. None of our employees are covered by a collectivebargaining agreement.

 

**Factors That May Affect Results**

 

***Our products may not be successfullydeveloped or commercialized, which would harm us and force us to curtail orcease operations.***

 

We are at an early stage of development.  As of March 2003, we had only a limitedproduct offering that includes our NanoChip® System, NanoChip® Cartridge, fourASRs and one other product.  All of ourother platforms and ASRs and other potential products are underdevelopment.  Our NanoChip® System, ASRs orour other products may not be successfully developed or commercialized on atimely basis, or at all.  If we areunable, for technological or other reasons, to complete the development,introduction or scale-up of manufacturing of our new products, or if ourproducts do not achieve a significant level of market acceptance, we would beforced to curtail or cease operations.

 

As of December 31, 2002 we have sold a total of 45NanoChip®Systems.  We also placed instruments atvarious customer sites under development site agreements whereby title of theNanoChip® Molecular BiologyWorkstation did not pass to the customer and therefore no revenue wasrecognized.

 

We are also party to transactions known as reagentrentals and cost-per-test agreements. As of December 31, 2002, we entered into three reagent rental agreementsand nine cost-per-test agreements for 2002. Under these types of transactions, we place a Workstation at a customersite with no upfront cost to the customer. The value of the instrument is typically recaptured through a contractedstream of future reagent sales, sold at a premium to cover the cost of thesystem.  The nine cost-per-testtransactions entered into in 2002 require customer acceptance of our CFTR ASRsas a pre-condition to this commitment which we released in the first quarter of2003.  These reagent rentals and costper test agreements might have an adverse impact on our short-term instrumentsales revenue and cash flow as the revenues and cash received under theseagreements are over the life of the contract, as reagents are shipped to thecustomer. Our success will depend upon our ability to continue to overcomesignificant technological challenges and successfully introduce our productsinto the marketplace.  A number ofapplications envisioned by us may require significant enhancements to our basictechnology platform.  There can be noassurance that we can successfully develop such enhancements.

 

As of December 31, 2002, we have receivedapproximately $388,000 in revenue from the sale of our NanoChip® Cartridges.  Also, as of December 31, 2002, we have notyet recognized any revenue from the sale of our ASRs.

 

***Lack of market acceptance of our technology would harm us.***

 

Although we have developed a number of products asdiscussed above, we may not be able to further develop these products or todevelop other commercially viable products. Even if we develop a product it may not be

 

22

----

 

accepted in the marketplace.  Ifwe are unable to achieve market acceptance, we will not be able to generatesufficient product revenue to become profitable.  We may also be forced to carry greater inventories of ourproducts for longer periods than we may have anticipated.  If we are unable to sell the inventory of ourproducts in a timely fashion and at anticipated price levels, we may not becomeprofitable.  In addition, we may have totake accounting charges and reduce the value of our product inventory to itsnet realizable value.  Market acceptancewill depend on many factors, including our ability to:

 

•                  convince prospective strategic partnersand customers that our technology is an attractive alternative to othertechnologies;

 

•                  manufacture products in sufficientquantities with acceptable quality and at an acceptable cost; and

 

•                  sell, place and service sufficientquantities of our products.

 

In addition, our technology platform could be harmedby limited funding available for product and technology acquisitions by ourcustomers, internal obstacles to customer approvals of purchases of ourproducts and market conditions in general.

 

***Commercialization of some of our potentialproducts depends on collaborations with others.  If our collaborators are not successful or if we are unable tofind collaborators in the future, we may not be able to develop these products.***

 

Our strategy for the research, development andcommercialization of some of our products requires us to enter into contractualarrangements with corporate collaborators, joint venture partners, licensors,licensees and others.  Our success dependsin part upon the performance by these collaboration partners and potentialcollaboration partners of their responsibilities under these arrangements.  Some collaborators may not perform theirobligations as we expect, and we may not derive any revenue or other benefitsfrom these arrangements.

 

We have collaborative agreements with a developer andmanufacturer of instrumentation products and we formed a new company with theresearch and development subsidiary of a pharmaceutical company.  We do not know whether these collaborationswill successfully develop and market any products under our respectiveagreements.  Moreover, some of ourcollaborators are also researching competing technologies targeted by ourcollaborative programs.  We may beunsuccessful in entering into other collaborative arrangements to develop andcommercialize our products.  Inaddition, disputes may arise over ownership rights to intellectual property,know-how or technologies developed with our collaborators.

 

We currently have agreements with Hitachi thatcontemplate the commercialization of products resulting from the agreementsbetween the parties.  In addition, wehave a manufacturing and distribution agreement with Hitachi.  In June 2001, we formed a company, NanogenRecognomics GmbH, with Aventis Research and Technologies & Co. KG, in whichwe own 60% of the stock of Nanogen Recognomics and Aventis R&T owns theremaining 40%.  Nanogen Recognomicsseeks to combine our NanoChip® technology andAventis R & T’s intellectual property and expertise in synthetic oligonucleotidechemistry and advanced molecular biology to develop new products andapplications for the NanoChip®System.  These collaborations may not besuccessful.

 

***We have a history of net losses.  We expect to continue to incur net lossesand we may not achieve or maintain profitability.***

 

From our inception to December 31, 2002, we haveincurred cumulative net losses totaling approximately $145.7 million.  Moreover, our negative cash flow and lossesfrom operations will continue for the foreseeable future.  We may never generate sufficient productrevenue to become profitable.  We alsoexpect to have quarter-to-quarter fluctuations in revenues, expenses andlosses, which fluctuations could be significant.  The amount and timing of product revenue recognition and cashflow may depend on whether potential customers for the NanoChip® System choose toenter into sales, reagent rentals, cost-per-test or development sitetransactions.

 

23

----

 

To develop and sell our products successfully, we mayneed to increase our spending levels in research and development, as well as inselling, marketing and administration. We may have to incur these increased spending levels before knowing whetherour products can be sold successfully.

 

***We will need additional capital in thefuture.  If additional capital is notavailable, we may have to curtail or cease operations.***

 

We will need to raise more money to continue theresearch and development necessary to further develop our current products tobring our products to market and to further our manufacturing and marketingcapabilities.  We may seek additionalfunds through public and private stock offerings, arrangements with corporatepartners, borrowings under lease lines of credit or other sources.  If we cannot raise more money, we will haveto reduce our capital expenditures, scale back our development of new products,reduce our workforce and seek to license to others products or technologies thatwe otherwise would seek to commercialize ourselves.  The amount of money we will need will depend on many factors,including among others:

 

•                  the progress of our research anddevelopment programs;

 

•                  the commercial arrangements we mayestablish;

 

•                  the time and costs involved in:

 

•                  scaling up our manufacturingcapabilities;

 

•                  meeting regulatory requirements,including meeting necessary Quality System Regulations or QSRs and obtainingnecessary regulatory clearances or approvals;

 

•                  filing, prosecuting, defending andenforcing patent claims and litigation; and

 

•                  the scope and results of our futureclinical trials, if any.

 

Additional capital may not be available on termsacceptable to us, or at all.  Anyadditional equity financing would likely be dilutive to stockholders, and debtfinancing, if available, may include restrictive covenants and requiresignificant collateral.

 

***Competing technologies may adversely affectus.***

 

We expect to encounter intense competition from anumber of companies that offer products in our targeted application areas.  We anticipate that our competitors in theseareas will include:

 

•                  health care and other companies thatmanufacture laboratory-based tests and analyzers;

 

•                  diagnostic and pharmaceutical companies;

 

•                  companies developing drug discoverytechnologies; and

 

•                  companies developing molecular diagnostictests.

 

If we are successful in developing products in theseareas, we will face competition from established companies and numerousdevelopment-stage companies that continually enter these markets. In many instances,our competitors have substantially greater financial, technical, research andother resources and larger, more established marketing, sales, distribution andservice organizations than us. Moreover, these competitors may offer broader product lines and havegreater name recognition than us and may offer discounts as a competitivetactic.

 

In addition, several development-stage companies arecurrently making or developing products that compete with or will compete withour potential products.  Our competitorsmay succeed in developing, obtaining FDA

 

24

----

 

approval or marketing technologies or products that are more effectiveor commercially attractive than our current or potential products, or that renderour technologies and current or potential products obsolete.

 

As these companies develop their technologies, theymay develop proprietary positions that may prevent us from successfullycommercializing products.

 

Also, we may not have the financial resources,technical expertise or marketing, distribution or support capabilities tocompete successfully in the future.

 

***The uncertainty of patent and proprietarytechnology protection may adversely affect us.***

 

Our success will depend in part on obtaining andmaintaining meaningful patent protection on our inventions, technologies anddiscoveries.  Our ability to competeeffectively will depend on our ability to develop and maintain proprietaryaspects of our technology, and to operate without infringing the proprietaryrights of others, or to obtain rights to third-party proprietary rights, ifnecessary.  Our pending patentapplications may not result in the issuance of patents.  Our patent applications may not havepriority over others’ applications, and even if issued, our patents may notoffer protection against competitors with similar technologies.  Any patents issued to us may be challenged,invalidated or circumvented, and the rights created thereunder may not affordus a competitive advantage.

 

We also rely upontrade secrets, technical know-how and continuing inventions to develop andmaintain our competitive position. Others may independently develop substantially equivalent proprietaryinformation and techniques or otherwise gain access to our trade secrets ordisclose our technology and we may not be able to meaningfully protect ourtrade secrets, or be capable of protecting our rights to our tradesecrets.  We seek to protect ourtechnology and patents, in part, by confidentiality agreements with ouremployees and contractors.  Ouremployees may breach their existing Proprietary Information, Inventions, andDispute Resolution Agreements and these agreements may not protect ourintellectual property.  This could havea material adverse effect on us.

 

***Our products could infringe on theintellectual property rights of others, which may subject us to futurelitigation and cause us to be unable to license technology from third parties.***

 

Our commercial success also depends in part on usneither infringing valid, enforceable patents or proprietary rights of thirdparties, nor breaching any licenses that may relate to our technologies andproducts. We are aware of other third-party patents that may relate to ourtechnology.  It is possible that we mayunintentionally infringe these patents or other patents or proprietary rightsof third parties.  We may in the futurereceive notices claiming infringement from third parties as well as invitationsto take licenses under third-party patents. Any legal action against us or our collaborative partners claimingdamages and seeking to enjoin commercial activities relating to our productsand processes affected by third-party rights may require us or ourcollaborative partners to obtain licenses in order to continue to manufactureor market the affected products and processes. In addition, these actions may subject us to potential liability fordamages.  We or our collaborativepartners may not prevail in an action and any license required under a patentmay not be made available on commercially acceptable terms, or at all.

 

There are many U.S. and foreign patents and patentapplications held by third parties in our areas of interest, and we believethat, there may be significant other litigation in the industry regardingpatent and other intellectual property rights. Additional litigation could result in substantial costs and thediversion of management’s efforts regardless of the result of the litigation.  Additionally, the defense and prosecution ofinterference proceedings before the U.S. Patent and Trademark Office, or USPTO,and related administrative proceedings would result in substantial expense tous and significant diversion of effort by our technical and managementpersonnel.  We may in the future becomesubject to USPTO interference proceedings to determine the priority ofinventions.  In addition, laws of someforeign countries do not protect intellectual property to the same extent as dolaws in the U.S., which may subject us to additional difficulties in protectingour intellectual property in those countries.

 

We are aware of U.S. and European patents and patentapplications owned by Oxford Gene Technology (“OGT”). We have opposed oneallowed European Patent that had broad claims to array technology for analyzinga predetermined polynucleotide sequence. OGT’s position with respect to theopposed patent is that the claims relate to what it terms the “diagnosticmode.” Those claims have now been narrowed before the Opposition Division tothe point that, if these claims remain final before the European Patent Office,we believe they would not be infringed by our

 

25

----

 

technology. In the Oral Proceedings before the OppositionDivision on November 13, 14, and 15, 2001, the Division determined that theclaims’ language must be limited to arrays with ‘smooth, impermeable’ surfaces.The case is currently on appeal. If the decision of the Opposition Division issuccessfully appealed by OGT and the original claims are reinstated, or if anapplication relating to arrays issued in another country with claims as broadas the original European patent, we could be subject to infringementaccusations that could delay or preclude sales of some or all of ouranticipated diagnostic products.

 

***We are involved in intellectual property litigationthat may be costly, time-consuming and may impact our competitive position.***

 

In December 2002, Oxford Gene Technologies (“OGT”)filed a complaint against the Company in the United States District Court forthe District of Delaware claiming that Nanogen infringes U.S. Patent No.  6,054,270 (the “‘270 Patent”) entitled“Analytical Polynucleotide Sequences”. Nanogen denies that it infringes the ‘270 Patent.  Although it is Nanogen’s position that OGT’sassertions of infringement have no merit, neither the outcome of the litigationnor the amount and range of potential fees can yet be assessed.  No assurances can be given that the Companywill prevail in the lawsuit or that it can successfully defend itself againstthe claim and the Company may not prevail in the action, which could have amaterial adverse effect on the Company.

 

***The regulatory approval process isexpensive, time consuming, uncertain and may prevent us from obtaining requiredapprovals for the commercialization of our products.***

 

The manufacturing, labeling, distribution andmarketing of any diagnostic products we may develop will be subject toregulation in the U.S. and other countries. These regulations could subject us to several problems such as:

 

•                  failure to obtain necessary regulatoryapprovals or clearances for our products on a timely basis, or at all;

 

•                  delays in receipt of or failure toreceive approvals or clearances;

 

•                  the loss of previously received approvalsor clearances;

 

•                  limitations on intended uses imposed as acondition of approvals or clearances; or

 

•                  failure to comply with existing or futureregulatory requirements.

 

In the U.S., the FDA regulates as medical devices mosttest systems, kits and reagents that are marketed for human *in vitro*diagnosticuse.  Pursuant to the Federal Food,Drug, and Cosmetic Act, the FDA regulates the preclinical and clinical testing,design, safety, effectiveness, manufacture, labeling, distribution andpromotion of medical devices.  We willnot be able to commence marketing or commercial sales in the U.S. of theseproducts until we receive an exemption, clearance or approval from the FDA,which can be a lengthy, expensive and uncertain process.  We have not applied for FDA or otherregulatory approvals with respect to any of our current products or productsunder development.  We may experiencedifficulties that could delay or prevent the successful development,introduction and marketing of proposed products.  Regulatory clearance or approval of any proposed products may notbe granted by the FDA or foreign regulatory authorities on a timely basis, ifat all. Noncompliance with applicable FDA requirements can result in:

 

•                  criminal prosecution, civil penalties,other administrative sanctions or judicially imposed sanctions, such asinjunctions;

 

•       recall or seizure of products;

 

•       total or partial suspension ofproduction; and

 

•       failure of the government to grantpremarket clearance or premarket approval for devices or withdrawal ofmarketing clearances or approvals once granted.

 

26

----

 

The FDA also has the authority to request the recall,repair, replacement or refund of the cost of any regulated device that mayeventually be manufactured or distributed by us.  Any devices manufactured or distributed by us pursuant to FDAclearance or approvals are subject to thorough and continuing regulation by theFDA and certain state agencies, including the California Department of HealthServices.

 

***Our dependence on suppliers for materialscould impair our ability to manufacture our products.***

 

Outside vendors provide key components and rawmaterials used by us and Hitachi in the manufacture of our products.  Although we believe that alternative sourcesfor these components and raw materials are available, any supply interruptionin a limited or sole source component or raw material would harm our andHitachi’s ability to manufacture our products until a new source of supply isidentified and qualified, including qualification under applicable FDAregulations.  In addition, anuncorrected defect or supplier’s variation in a component or raw material,either unknown to us or Hitachi or incompatible with our or Hitachi’smanufacturing processes, could harm our or Hitachi’s ability to manufactureproducts.  We or Hitachi may not be ableto find a sufficient alternative supplier in a reasonable time period, or oncommercially reasonable terms, if at all. If we or Hitachi fail to obtain a supplier for the manufacture ofcomponents of our potential products, we may be forced to curtail or ceaseoperations.

 

***We may not be able to manufacture productson a commercial scale.***

 

Hitachi manufactures our NanoChip® System, and wemanufacture our NanoChip®Cartridges, our ASRs and most of our other products.  We and Hitachi rely on subcontractors to manufacture the limitedquantities of microchips and other components we require for use by and sale toour customers, as well as for internal and collaborative purposes.Manufacturing, supply and quality control problems may arise as we or Hitachieither alone, together or with subcontractors, attempt to further scale upmanufacturing procedures or to manufacture new products.  We or Hitachi may not be able to scale-up ina timely manner or at a commercially reasonable cost.  Problems could lead to delays or pose a threat to the ultimatecommercialization of our products and cause us to fail.

 

We or Hitachi or any of our contract manufacturerscould encounter manufacturing difficulties, including those relating to:

 

•                  the ability to scale up manufacturingcapacity;

 

•                  production yields;

 

•                  quality control and assurance; or

 

•                  shortages of components or qualifiedpersonnel.

 

Our manufacturing facilities and those of Hitachi andany other of our contract manufacturers are or will be subject to periodicregulatory inspections by the FDA and other federal, state and internationalregulatory agencies and these facilities are or may become subject to QualitySystem Regulation, or QSR, requirements of the FDA.  If we, Hitachi or our third-party manufacturers, fail to maintainfacilities in accordance with QSR regulations, other international qualitystandards or other regulatory requirements then the manufacture process couldbe suspended or terminated which would harm us.

 

***Lead times for obtaining materials andcomponents for our products and the manufacturing and introduction of ourproducts may vary significantly which could lead to excess inventory levels aswell as shortages of critical components and products if our supply and demandforecasts are inaccurate.***

 

We anticipate that our products, including our ASRsand most of our other products will be manufactured and introduced by us andthird parties, if any, based on forecasted demand and will seek to purchasecomponents and materials in anticipation of the actual receipt of purchaseorders from our customers.  Lead timesfor materials and components to be included in our products vary significantlyand may depend on factors such as the business practices of each specificsupplier and the terms of the particular contracts, as well as the overallmarket demand for such materials and components at any given time.  Also, we often rely on our own and thirdparty forecasted

 

27

----

 

demand for various products and the accuracy of such forecasts maydepend on a number of factors, including but not limited to, government reportsand recommendations for certain genetic testing, regulatory burdens,competitive products, the nature and effectiveness of our products, the timingand extent of the introduction of our products into the marketplace and otherfactors.  If the forecasts areinaccurate, we could experience fluctuations in excess inventory of ourproducts, or shortages of critical components or products, either of whichcould cause our business to suffer.

 

***We currently rely on one manufacturer ofour Workstation and for certain future generations of the Workstation and otherhardware products, and only we manufacture our NanoChip***®***Cartridges, and our ASRs and most of our other products, which maydelay the manufacture and shipment of our products to customers.***

*** ***

We have signed an exclusive manufacturing agreement withHitachi to manufacture our NanoChip® Workstation and a collaboration agreement to exclusively manufacturecertain of our other second generation Workstations and other hardware productsto be developed, subject to certain terms and conditions in each agreement.  We have retained exclusive rights pursuantto each agreement to manufacture the NanoChip® Cartridges.  Pursuant to themanufacturing agreement and the collaboration agreement, each party isobligated to provide the other with certain notice periods if such partydetermines to curtail or terminate the manufacturing relationship.  Nevertheless, while alternativemanufacturers of our Workstation and other products currently exist, a lengthyprocess would be required to negotiate and begin work under a manufacturingagreement with a new manufacturer which could disrupt our manufacturing processand harm our business.

 

***The number of our sales and marketingemployees may not result in corresponding numbers of sales or placements of theNanoChip***®***System or sale of ASRs or other Nanogen products.***

 

At December 31, 2002, we had 40 total employees in ourworldwide sales and marketing group.  InJuly 2000, we incorporated a subsidiary, Nanogen Europe B.V. in The Netherlandsas our European sales office.  AtDecember 31, 2002, this office employed 11 European-based sales executives andsupport personnel in the United Kingdom, Germany and The Netherlands..

 

Developing, training and monitoring this sales andmarketing force has required and will further require capital and timeexpenditures by Nanogen and certain of its employees.  The size of our sales and marketing force may not result incorresponding numbers of sales or placements of the NanoChip® System norincreased product revenues associated with such sales or placements or our ASRsor other products.  Nanogen may berequired to increase or decrease the size of this sales and marketing force asdeemed necessary and such increases or decreases in staff will requireadditional capital and time expenditures by Nanogen and its employees.

 

***Failure to expand our international salesas we intend would reduce our ability to become profitable***.

 

We expect that a portion of our sales will be madeoutside the United States.  A successfulinternational effort will require us to develop relationships withinternational customers and partners. We may not be able to identify, attract or retain suitable internationalcustomers and distribution partners.  Asa result, we may be unsuccessful in our international expansion efforts.  Furthermore, expansion into internationalmarkets will require us to continue to establish and expand foreign sales andmarketing efforts, hire additional sales and marketing personnel and maintaingood relations with our foreign customers and distribution partners.

 

International operations involve a number of risks nottypically present in domestic operations, including:

 

•                  currency fluctuation risks;

 

•       changes in regulatory requirements;

 

•       costs and risks of deploying the NanoChip® System, ASRs and other products inforeign countries;

 

•       licenses, tariffs and other tradebarriers;

 

•       political and economic instability,including the war on terrorism;

 

28

----

 

•                  difficulties in staffing and managingforeign offices;

 

•       costs and difficulties in establishingand maintaining foreign distribution partnerships;

 

•       potentially adverse tax consequences; and

 

•       the burden of complying with a widevariety of complex foreign laws and treaties.

 

Our international sales and marketing efforts willalso be subject to the risks associated with the imposition of legislation andregulations relating to the import or export of high technology products.  We cannot predict whether tariffs orrestrictions upon the importation or exportation of our products will beimplemented by the United States or other countries.

 

We may lose money when we exchange foreign currencyreceived from international sales into U.S. dollars.  A portion of our business is expected to be conducted incurrencies other than the U.S. dollar. We recognize foreign currency gains or losses arising from ouroperations in the period incurred.  As aresult, currency fluctuations between the US dollar and the currencies in whichwe do business will cause foreign currency transaction gains and losses.  We cannot predict the effects of exchangerate fluctuations upon our future operating results because of the number ofcurrencies involved, the variability of currency exposure and the potentialvolatility of currency exchange rates. We currently do not engage in foreign exchange hedging transactions tomanage our foreign currency exposure.

 

***We may have significant product liabilityexposure.***

 

We face an inherent business risk of exposure toproduct liability and other claims in the event that our technologies orproducts are alleged to have caused harm. These risks are inherent in the testing, manufacturing and marketing ofour products.  Any potential product liabilityclaims could exceed the amount of our insurance coverage or may be excludedfrom coverage under the terms of the policy. Our insurance may not be renewed at a cost and level of coveragecomparable to that then in effect.

 

***If we lose our key personnel or are unableto attract and retain additional personnel, we may not be able to pursuecollaborations or develop our own products.***

 

We are highly dependent on the principal members ofour scientific, manufacturing, marketing, administrative, management andexecutive personnel, the loss of whose services might significantly delay orprevent the achievement of our objectives. We face competition from other companies, academic institutions,government entities and other organizations in attracting and retainingpersonnel.  For the year ended December31, 2002, the rate of turnover at all levels of the Company was 39%.  For the years ended December 31, 2001 and2000 the turnover rates of the Company were 31% and 19%, respectively. Turnoverat these rates may, and if they continue, will adversely affect the Company.

 

In October 2002, the Company reduced its workforce byapproximately 10% and incurred severance charges of approximately $290,000during the fourth quarter of fiscal 2002 related to this event.  Continued layoffs could have an adverseeffect on the Company.

 

***Health care reform and restrictions onreimbursement may limit our returns on potential products.***

 

Our ability to earn sufficient returns on our productswill depend in part on the extent to which reimbursement for our products andrelated treatments will be available from:

 

•                  government health administrationauthorities;

 

•       private health coverage insurers;

 

•       managed care organizations; and

 

29

----

 

•                  other organizations.

 

If appropriate reimbursement cannot be obtained, we couldbe prevented from successfully commercializing our potential products.

 

There are efforts by governmental and third partypayors to contain or reduce the costs of health care through variousmeans.  We expect that there willcontinue to be a number of legislative proposals to implement governmentcontrols.  The announcement of proposalsor reforms could impair our ability to raise capital.  The adoption of proposals or reforms could impair our business.

 

Additionally, third party payors are increasinglychallenging the price of medical products and services.  If purchasers or users of our products arenot able to obtain adequate reimbursement for the cost of using our products,they may forego or reduce their use. Significant uncertainty exists as to the reimbursement status of newlyapproved health care products, and whether adequate third party coverage willbe available.

 

***If ethical and other concerns surroundingthe use of genetic information become widespread, we may have less demand forour products.***

 

Genetic testing has raised ethical issues regardingconfidentiality and the appropriate uses of the resulting information.  For these reasons, governmental authoritiesmay call for limits on or regulation of the use of genetic testing or prohibittesting for genetic predisposition to certain conditions, particularly forthose that have no known cure.  Any ofthese scenarios could reduce the potential markets for our products, whichcould seriously harm our business, financial condition and results of operations.

 

***We use hazardous materials in ourbusiness.  Any claims relating toimproper handling, storage or disposal of these materials could be timeconsuming and costly.***

 

Our research and development processes involve thecontrolled storage, use and disposal of hazardous materials including, but notlimited to, biological hazardous materials and radioactive compounds.  We are subject to federal, state and localregulations governing the use, manufacture, storage, handling and disposal ofmaterials and waste products.  Althoughwe believe that our safety procedures for handling and disposing of thesehazardous materials comply with the standards prescribed by law and regulation,the risk of accidental contamination or injury from hazardous materials cannotbe completely eliminated.  In the eventof an accident, we could be held liable for any damages that result, and anyliability could exceed the limits or fall outside the coverage of ourinsurance.  We may not be able tomaintain insurance on acceptable terms, or at all.  We could be required to incur significant costs to comply withcurrent or future environmental laws and regulations.

 

***Our stock price could continue to be highlyvolatile and our stockholders may not be able to resell their shares at or abovethe price they paid for them.***

 

The market price of our common stock, like that ofmany other life sciences companies, has been highly volatile and is likely tocontinue to be highly volatile.  Thefollowing factors, among others, could have a significant impact on the marketprice of our common stock:

 

•                  the results of our premarket studies andclinical trials or those of our collaborators or competitors or for DNA testingin general;

 

•      evidence of the safety or efficacy of ourpotential products or the products of our competitors;

 

•      the announcement by us or our competitorsof technological innovations or new products;

 

•      the announcement by us of acquisitions bycustomers of our NanoChip® System, ASRs or our other products;

 

•      announcements by us of government grantsor contracts or of failure to obtain such government grants or contracts;

 

30

----

 

•                  announcements by us of involvement inlitigation;

 

•      developments concerning our patents orother proprietary rights or those of our competitors, including otherlitigation or patent office proceedings;

 

•      loss of key board, executive, managementor other personnel or the increase or decrease in size of our sales andmarketing staff;

 

•      governmental regulatory actions or thefailure to gain necessary clearances or approvals;

 

•      the ability to obtain necessary licenses;

 

•      changes or announcements in reimbursementpolicies;

 

•      developments with our subsidiaries andcollaborators;

 

•      changes in or announcements relating toacquisition programs for our products, including the expiration or continuationof our development site agreements;

 

•      period-to-period fluctuations in sales,inventories and our operating results;

 

•      market conditions for life science stocksand other stocks in general;

 

•      purchases by the Company pursuant to thestock repurchase program;

 

•      changes in estimates of our performance bysecurities analysts and the loss of coverage by one or more securitiesanalysts;

 

•      the announcement by us of any stockrepurchase plan, any purchases made thereunder by us and any cessation of theprogram by us;

 

•      changes in the United States war onterrorism and other geopolitical and military situations in which the countryis involved; and

 

•      changes in the price of petroleum, heatingoil and any other raw materials that the Company uses at its facilities.

 

***Our anti-takeover provisions coulddiscourage potential takeover attempts and make attempts by stockholders tochange management more difficult.***

 

The approval of two-thirds of our voting stock isrequired to approve some transactions and to take some stockholder actions,including the calling of a special meeting of stockholders and the amendment ofany of the anti-takeover provisions contained in our certificate ofincorporation.  Further, pursuant to theterms of our stockholder rights plan adopted in November 1998, as amended, wehave distributed a dividend of one right for each outstanding share of commonstock.  These rights will causesubstantial dilution to the ownership of a person or group that attempts toacquire us on terms not approved in advance by our board of directors and mayhave the effect of deterring unsolicited takeover attempts.

 

***If we make any acquisitions, we will incura variety of costs and may never realize the anticipated benefits.***

 

If appropriate opportunities become available, we mayattempt to acquire businesses, technologies, services or products that webelieve are a strategic fit with our business. We currently have no commitments or agreements with respect to anymaterial acquisitions.  If we doundertake any transaction of this sort, the process of integrating an acquiredbusiness, technology, service or product may result in operating difficultiesand expenditures and may absorb significant management attention that wouldotherwise be available for ongoing development of our business.  Moreover, we may never realize theanticipated benefits of any acquisition. Future acquisitions could result in

 

31

----

 

potentially dilutive issuances of equity securities, theincurrence of debt, contingent liabilities and/or amortization expenses relatedto certain intangible assets and increased operating expenses, which couldadversely affect our results of operations and financial condition.

 

**Item 2****.  Properties**

 

AtDecember 31, 2002, we occupied the indicated square footage in the leasedfacilities described below:

 
| **Number of  Buildings** |   | **Location**          |   | **Total Square Footage** |   | **Primary Use**                                                                                                                                           |
|--------------------------|--------|-----------------------|--------|--------------------------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------|
| 1                        |   | San Diego, California |   | 44,000                   |   | Administrative  offices, research and development, sales and marketing and manufacturing for  a term ending on March 31, 2010 (with an option to extend). |
| 1                        |   | Helmond, Netherlands  |   | 2,900                    |   | Administrative offices and sales and marketing.                                                                                                           |
| 1                        |   | Frankfurt, Germany    |   | 9,500                    |   | Administrative offices and research and development.                                                                                                      |

 

Ourleases expire at varying dates through 2010 not including renewals that wouldbe at our option.  We believe that ourfacilities will be suitable and adequate for the present purposes, and that theproductive capacity in such facilities is substantially being utilized.  In the future, we may need to purchase,build or lease additional facilities to meet the requirements projected in ourlong-term business plan.

 

**Item 3****.  Legal Proceedings**

 

In December, 2002, Oxford Gene Technologies (“OGT”)filed a complaint against the Company in the United States District Court forthe District of Delaware claiming that Nanogen infringes U.S. Patent No.  6,054,270 (the “‘270 Patent”) entitled“Analytical Polynucleotide Sequences”. Nanogen denies that it infringes the ‘279 Patent.  Although it is Nanogen’s position that OGT’sassertions of infringement have no merit, neither the outcome of the litigationnor the amount and range of potential fees can yet be assessed.  No assurances can be given that the Companywill prevail in the lawsuit or that it can successfully defend itself againstthe claim and the Company may not prevail in the action, which could have amaterial adverse effect on the Company.

 

**Item 4****.  Submission of Matters to a vote of SecurityHolders**

 

Therewere no matters submitted to a vote of security holders during the quarterended December 31, 2002.

 

**PART II**

 

**Item 5****.  Market for the Registrant’s Common Equityand Related Stockholder Matters**

 

Market Information

 

Ourcommon stock trades on the National Association of Securities Dealers AutomatedQuotation (“Nasdaq”) National Market under the symbol “NGEN.”  The following table sets forth the range ofhigh and low sales prices as reported for our common stock by Nasdaq for theperiods indicated:

 

32

----

 
|                           |   | **High** |   | **Low** |   |
|--------------------------------|--------|----------|--------|---------|--------|
| Year ended December 31,  2001: |   |     |   |    |   |
|                           |   |     |   |    |   |
| 1st Quarter                    |   | $        | 13.44  |    | $      | 5.13 |   |
| 2nd Quarter                    |   | $        | 10.60  |    | $      | 5.40 |   |
| 3rd Quarter                    |   | $        | 7.50   |    | $      | 3.00 |   |
| 4th Quarter                    |   | $        | 10.13  |    | $      | 4.54 |   |
|                           |   |     |   |    |   |
| Year ended December 31, 2002:  |   |     |   |    |   |
| 1st Quarter                    |   | $        | 6.34   |    | $      | 3.95 |   |
| 2nd Quarter                    |   | $        | 4.74   |    | $      | 2.49 |   |
| 3rd Quarter                    |   | $        | 3.67   |    | $      | 1.50 |   |
| 4th Quarter                    |   | $        | 2.23   |    | $      | 1.22 |   |

 

As of March 24,2003 there were approximately 218 shareholders of record of our commonstock.  We have not paid any cashdividends to date and do not anticipate any being paid in the foreseeablefuture.

 

33

----

 

**Item 6****.  Selected Financial Data**

 

Theselected financial data set forth below with respect to our consolidatedfinancial statements has been derived from the audited financial statements.The data set forth below should be read in conjunction with “Management’sDiscussion and Analysis of Financial Condition and Results of Operations” andour financial statements and notes thereto appearing elsewhere herein:

 
|                                                                              |   | **Years Ended December 31,**                       |    |
|-----------------------------------------------------------------------------------|--------|----------------------------------------------------|---------|
|                                                                              |   | **2002**                                           |    | **2001** |   | **2000** |   | **1999** |   | **1998** |   |
|                                                                              |   | **(in thousands, except per share  amounts)** |    |
| **Consolidated  Statement of Operations Data:**                                   |   |                                               |    |   |   |   |   |   |   |   |   |
| Revenues:                                                                         |   |                                               |    |   |   |   |   |   |   |   |   |
| Product  sales                                                                    |   | $                                                  | 3,384   |   | $ | 2,245 |   | $ | 919 |   | $ | — |   | $ | — |   |
| License  fees                                                                     |   | 10,844                                             |    | — |   | — |   | — |   | — |   |
| Sponsored  research                                                               |   | 1,355                                              |    | 7,457 |   | 8,457 |   | 5,688 |   | 5,461 |   |
| Contract  and grant                                                               |   | 1,596                                              |    | 1,467 |   | 1,856 |   | 2,431 |   | 2,172 |   |
| Total  revenues                                                                   |   | 17,179                                             |    | 11,169 |   | 11,232 |   | 8,119 |   | 7,633 |   |
| Operating  expenses:                                                              |   |                                               |    |   |   |   |   |   |   |   |   |
| Cost  of product sales                                                            |   | 2,466                                              |    | 1,606 |   | 599 |   | — |   | — |   |
| Research  and development                                                         |   | 21,020                                             |    | 18,597 |   | 18,905 |   | 25,284 |   | 23,002 |   |
| Selling,  general and administrative                                              |   | 20,540                                             |    | 22,032 |   | 15,267 |   | 9,097 |   | 6,420 |   |
| Litigation  and settlement of patent matters                                      |   | (165                                               | )       | 6,900 |   | — |   | — |   | — |   |
| Acquired  in-process technology                                                   |   | —                                             |    | — |   | — |   | — |   | 1,193 |   |
| Total  operating expenses                                                         |   | 43,861                                             |    | 49,135 |   | 34,771 |   | 34,381 |   | 30,615 |   |
| Loss  from operations                                                             |   | (26,682                                            | )       | (37,966 | ) | (23,539 | ) | (26,262 | ) | (22,982 | ) |
|                                                                              |   |                                               |    |   |   |   |   |   |   |   |   |
| Interest  income, net                                                             |   | 2,119                                              |    | 4,390 |   | 5,257 |   | 2,059 |   | 2,650 |   |
| Minority  interest in loss of consolidated subsidiary                             |   | 2,156                                              |    | 907 |   | — |   | — |   | — |   |
| Other  income (loss)                                                              |   | 161                                                |    | 168 |   | — |   | (996 | ) | (610 | ) |
| Net  loss                                                                         |   | $                                                  | (22,246 | ) | $ | (32,501 | ) | $ | (18,282 | ) | $ | (25,199 | ) | $ | (20,942 | ) |
|                                                                              |   |                                               |    |   |   |   |   |   |   |   |   |
| Net  loss per share — basic and diluted                                      |   | $                                                  | (1.02   | ) | $ | (1.54 | ) | $ | (0.92 | ) | $ | (1.39 | ) | $ | (1.60 | ) |
| Number  of shares used in computing net   Loss per share — basic and diluted |   | 21,722                                             |    | 21,091 |   | 19,944 |   | 18,069 |   | 13,097 |   |
|                                                                              |   |                                               |    |   |   |   |   |   |   |   |   |
| **Consolidated  Balance Sheet Data:**                                             |   |                                               |    |   |   |   |   |   |   |   |   |
| Cash,  cash equivalents and short-term investments                                |   | $                                                  | 52,729  |   | $ | 67,524 |   | $ | 95,089 |   | $ | 41,021 |   | $ | 62,245 |   |
| Working  capital                                                                  |   | 53,050                                             |    | 71,516 |   | 92,700 |   | 33,508 |   | 57,701 |   |
| Total  assets                                                                     |   | 71,360                                             |    | 90,091 |   | 111,168 |   | 50,785 |   | 72,704 |   |
| Other  long term liabilities and capital lease obligations, less current portion  |   | 4,219                                              |    | 3,430 |   | 2,065 |   | 2,831 |   | 4,176 |   |
| Accumulated  deficit                                                              |   | (145,659                                           | )       | (123,413 | ) | (90,912 | ) | (72,630 | ) | (47,431 | ) |
| Total  stockholders’ equity                                                  |   | 57,393                                             |    | 74,929 |   | 101,414 |   | 38,121 |   | 61,051 |   |

 

**Item 7****.  Management’s Discussion and Analysis ofFinancial Condition and Results of Operations**

 

This Form 10-K includes forward-looking statementsabout our business and results of operations that are subject to risks anduncertainties that could cause our actual results to vary materially from thosereflected in the forward-looking statements. Words such as “believes,” “anticipates,” “plans,” “estimates,” “future,”“could,” “may,” “should,” “expect,” “envision,” “potentially,” “eventually,”and variations of such words and similar expressions are intended to identifysuch forward-looking statements.  Theforward-looking statements contained in this Form 10-K include, but are notlimited to, statements about matters including the following:  (i) the development of the markets anddemand for our products and services; (ii) our product development plans,including the introduction of new products, and anticipated activities designedto pursue these plans, including collaborations and other corporate partneringarrangements; (iii) our ability to generate substantial revenues from sales ofproducts and consumable cartridges and reagents and continuing revenues fromreagent rental agreements; (iv) the ability of our product platform to affectthe market and become an industry standard; (v) our ability to generate licenseand other fee revenue in the future; (vi) the amounts we invest in research anddevelopment activities in the future; (vii) future levels of operating expensesassociated with our business; (viii) future levels of interest income; (ix) anyamounts we may be able to realize from the liquidation of our investments,including our investments in short-term securities;

 

34

----

 

(x) operating results of joint ventures and other corporate partneringarrangements; (xi) the amounts and timing of our contractual obligations andcapital commitments and (xii) our future capital needs and our ability to fundthose needs.  Factors that could causeor contribute to these differences include those discussed previously under thecaption “Factors that May Affect Results” and elsewhere in this Form 10-K.  Readers are cautioned not to place unduereliance on these forward-looking statements which speak only as of the datehereof.  We disclaim any intent orobligation to update these forward-looking statements.

 

**Overview**

 

It is our goal to becomea leading provider of molecular diagnostic tests.  We integrate advanced microelectronics and molecular biology intoa core technology platform with potentially broad and diverse commercial applications.  Our primary areas of focus have been ingenomics and biomedical research, medical diagnostics, forensics and drugdiscovery.  The Company’s currentcommercially available products include (1) the NanoChipâ MolecularBiology Workstation, an automated, multi-purpose instrument primarily used forDNA-based analyses, (2) the NanoChipâ Cartridge,which incorporates the NanoChipâElectronic Microarray and provides a flexible tool for the rapid identificationand precise analysis of biological test samples containing charged molecules,(3) various ASRs for gene mutations associated with diseases such as cysticfibrosis and hereditary hemochromotosis and (4) Assay ToolboxÔ,a product designed to help customers develop their own assays on the NanoChipâ System.  The Company also has several other ASRs andapplications of its proprietary technology under development.  The Company provides technical support andfield applications assistance to its customers.

 

Since commencing operations in 1993, we have appliedsubstantially all of our resources to our research and developmentprograms.  We have incurred losses sinceinception and, as of December 31, 2002, had an accumulated deficit of $145.7million.  We expect to continue to incursignificant losses over at least the next few years as we attempt to furthercommercialize our products as well as expand the menu of applications for ourcurrent products.

 

We introduced ourfirst two products into the marketplace in 2000.  While we recognized revenue from product sales during the yearsended December 31, 2002, 2001, and 2000, our main sources of revenues duringthese fiscal years and in 1999 were payments under our sponsored researchagreements, contracts and grants and, in 2002, a license fee valued at $10.8million received from a litigation settlement with CombiMatrix Corp.  Webelieve that in future periods, however, our revenue base will shift to beingmore product driven as certain research collaboration agreements expire and newproducts are introduced to the marketplace. We believe our future operating results may be subject to quarterlyfluctuations due to a variety of factors, including, but not limited to, marketacceptance of the NanoChip®System and potential products under development, the type of acquisitionprogram our potential customers may choose, whether and when new products aresuccessfully developed and introduced by us or our competitors, and theachievement of milestones under our collaborative agreements with Hitachi andvarious government agencies.  Therecognition of revenue under contracts, grants and sponsored researchagreements will be subject to significant fluctuations in both timing andamount and therefore our results of operations for any period may not becomparable to the results of operations for any other period.  The terms of our contracts and grants andsponsored research arrangements vary, but can generally be categorized asfollows:

 

AventisDevelopment Program—In December 1997, we entered into a Letter Agreement withAventis for an exclusive research and development collaboration relating to newdrug discovery tools and immunodiagnostics research.  In connection with the Letter Agreement, we entered into adefinitive Collaborative Research and Development agreement with an effectivedate of January 1, 1998.  All projectmilestones were completed and the term of this collaboration agreement expiredat the end of 2000.  In September 1999,we entered into a collaboration agreement with Aventis that involved tworesearch and development programs focused on gene expression tools utilizingelectronic bioarrays and on the development of high throughput screening toolsfor protein kinase development.  Weretained full commercialization rights for any products resulting from thesenew projects, while Aventis retained the right to use the technology forinternal research and development. All project milestones established underthese arrangements were completed as of fiscal year end 2001 at which time theagreements had expired. Under these programs, we demonstrated quantitative,multiplexed and reliable gene expression monitoring on our electronicmicroarray system.  Additionally, wedelivered an electronic hybridization-based gene expression prototype detectionsystem as well as a prototype system for analyzing protein kinases.  The protein kinase prototype system was soldduring the fourth quarter of 2001 to an affiliate of Aventis.  As of December 31, 2002, we

 

35

----

 

had incurred anaggregate of $14.7 million in direct and indirect research and developmentcosts under these collaboration efforts. We do not expect to receive additional funding for these projects.

 

HitachiDevelopment Program—In July 2000, we entered into a 10-year agreement withHitachi to develop, manufacture and distribute products based on the parties’proprietary technologies, potentially including, among other things,reduced-size instruments for genetic testing, integrated amplification andpoint-of-care detection.  Thearrangement provides that the parties will jointly determine which projects toprioritize over the term of the agreement. Hitachi has the right to be theexclusive distributor of collaboration products in Japan and, based upon theattainment of minimum sales targets to be mutually agreed upon, in other Asiancountries.  We retain the exclusiveright to distribute collaboration products outside of these countries.  Either party, subject to certainrestrictions, may terminate the agreement before its expiration.  Pursuant to the terms of the agreement,Hitachi and the Company each may contribute up to $28.5 million in cash overthe 10-year period.  At a minimum, theCompany is required to contribute on an annual basis funding for its owngeneral technology development in an amount equal to or greater than paymentsmade by Hitachi to the Company for that year. The Company received $2.8 million ($125,000 of which is a prepayment for2003 research and development activities), $2.3 million, and $1.0 million fromHitachi during the years ended December 31, 2002, 2001, and 2000,respectively.  In addition, the Companyis liable to repay fifty percent of all funding provided by Hitachi over anindefinite period of time.  Paymentamounts are determined as a percentage of the Company’s gross NanoChip® Cartridge salesuntil the liability is paid in full. The Company has completed theidentification of requirements phase of the project as of December 31, 2001 andanticipates completion of a prototype by the middle of 2003.  As of December 31, 2002, we had incurred anaggregate of $4.6 million in direct research and development costs in additionto other related general technology development costs that exceed $1.4 millionsince the beginning of this project in July 2000.  Our failure to achieve established milestones under thiscollaboration could have a material adverse effect on funding available underthis agreement, relations with Hitachi and our business, financial condition orresults of operations.

 

DARPA Grants—InSeptember 1998, the Company was awarded a contract by the Space and NavalWarfare Systems Center San Diego (“SSC San Diego”) for the Defense AdvancedResearch Projects Agency (“DARPA”) in an amount totaling approximately $2.4million over a two-year period.  Thegoal of the contract is to develop and refine electronically driven samplepreparation protocols on specifically designed microelectronic chips. Thecontract was completed in January 2001 and all milestones have beenachieved.  In August 2000, a secondDARPA contract was granted to Nanogen in an amount totaling approximately $1.6million over a two-year period which was subsequently reduced to $1.4 millionin 2002.  The contract is focused ondeveloping an electronic sample preparation chip for the detection ofbiowarfare agents from blood samples. The contract was completed in November 2002 and all milestones have beencompleted.  As of December 31, 2002, wehave incurred an aggregate of $3.6 million in direct and indirect research anddevelopment costs since the beginning of these contracts.

 

USAMRAACooperative Agreements—The Company received funding from two cooperativeresearch agreements with the U.S. Army Medical Research AcquisitionActivity.  The first agreement, enteredinto in October 2000, is focused on developing technology to identifybiological warfare compounds if used in combat against U.S. troops.  The second cooperative agreement, enteredinto in October 2001, is to continue the development of miniaturized electronicdevices for isolation and detection of biological warfare and infectiousdisease agents.  In conjunction with theagreements, funding provided by the agency is matched dollar-for-dollar withNanogen funds.  As of December 31, 2002,we have incurred an aggregate of $2.1 million in direct and indirect researchand development costs since the beginning of these collaboration efforts.

 

NIJ Grant—TheNational Institute of Justice, U.S. Department of Justice, provides funding forthe development of a chip based genetic detector for rapid DNA-basedidentification of individuals. All milestones contemplated under Phase IV, thefinal phase of this multi-year grant, were completed in 2002.  In July 2002, the Company was awarded aPhase V grant of $1.7 million over a two-year period; efforts in Phase V couldresult in protocols and reagents suitable for beta-testing in crime labs.  As of December 31, 2002, we have incurred anaggregate of $2.6 million in direct research and development costs since thebeginning of this multi-year grant.

 

NIH Grant—TheNational Institute of Health, U.S. Department of Health and Human Services,provides funding for the development of a compact centrifugalmicrofluidics-based analyzer.  TheCompany received the award in July 2002 for approximately $162,000 extendingover 14 months.  As of December 31,2002, we have incurred an aggregate of $25,000 in direct and indirect researchand development cost since the beginning of the contract.

 

36

----

 

Combinedsponsored research, contract and grant revenue has declined during the fiscalyears ended 2002 from our experience in 2001 and 2000.  Revenues for 2002 consisted of $1.6 millionfrom government contracts and grant revenue funding and $1.4 million fromsponsored research, all pertaining to the development program entered into inJuly 2000 with Hitachi.  Revenues duringyears 2001 and 2000 were primarily derived from sponsored research and contractand grant funding.  The decline incombined revenue associated with sponsored research, contract and grantsbetween 2000 and 2002 is the result of the Company’s strategic shift away fromsuch sponsored research revenue and more towards product revenue.  The Company is shifting from primarilysponsored research funding to product revenues as sales and marketing effortsincrease the installed base of our NanoChip® MolecularBiology Workstation and as programs from research and developmentcollaborations expire.  We offer ourproducts to customers under several different types of acquisition programs,some of which pass title of the instrument to the customer and some of which donot pass title to the customer.  One ofthese acquisition programs is through development site agreements, where titledoes not pass to the customer, however, these agreements may provide for thepotential development of content for use on the NanoChip®System.  As internal and externalcontent development expand the capabilities of the NanoChip® System, theCompany believes that consumable sales, including NanoChip® Cartridgesales and eventually ASRs and FDA-cleared or approved kits will account for anincreasing portion of our product revenues.

 

Fiscalyear 2002 included a number of highlights. An important milestone for theCompany was the release of the ASRs for the detection of the 25 mutations ofthe CFTR gene most commonly associated with cystic fibrosis, to our firstcustomer site for evaluation.  TheCompany announced a worldwide, non-exclusive licensing agreement with Bio-RadLaboratories Inc. for the two most common gene mutations associated with thediagnosis of hereditary hemochromatosis (HH), a disorder resulting in excessiveiron build-up in tissues and major organs of the body.  The Company also announced in 2002 licenseagreements or collaboration agreements for rights to commercialize mutations inthe ApoE gene from Athena Diagnostics that are associated with Alzheimersdisease, for mutations in the ASPA gene associated with the diagnosis ofCanavan disease and with Bionomics Limited, an Australian company, formutations to certain genes associated with the diagnosis of epilepsy.  During 2002, the Company introduced itsfirst ASRs for Factor V Leiden.  In thefirst quarter 2003, the Company introduced three additional ASRs for the CFTRgene associated with cystic fibrosis, for the HFE gene associated withhereditary hemochromotosis, and multiplexed ASRs for Factor II (Prothrombin)and Factor V (Leiden), genes associated with thrombosis.  In March 2003, the Company also introduced aproduct the Assay ToolBoxTM a product that is designed to assist researchinstitutions conduct their own “home brew” assays on the System.  Under the ASRs model, we will continue tosell blank Cartridges in addition to the reagents necessary to perform these testson the NanoChip® System.

 

***Critical Accounting Policies and Estimates***

 

Weprepare our financial statements in conformity with United States generallyaccepted accounting principals.  Theseaccounting principals require management to make certain judgments andassumptions that affect the reported amounts of assets and liabilities and thedisclosure of contingent assets and liabilities at the date of the financialstatements and the reported amounts of revenues and expenses during thereporting period.  On an on-going basis,we evaluate our estimates and judgments, including those related to bad debts,inventories, investments, intangible assets, service obligations, contingenciesand litigation.  We base our estimatesand judgments on historical experience and on various other factors that we believeto be reasonable under the circumstances. Actual results may differ from theseestimates under different assumptions or conditions.

 

We believe the following critical accounting policies,among others, affect our more significant judgments and estimates used in thepreparation of our consolidated financial statements:

 

*Revenuerecognition*

 

We generate product revenue by the sale of ourcommercial products and services under various sales programs to the end useror through distribution channels.  We recognizerevenue in accordance with Staff Accounting Bulletin 101 “Revenue Recognitionin Financial Statements” and record revenues as follows:

 

We offer our NanoChip® Molecular BiologyWorkstations under various commercial programs such as: direct sale, reagentrental programs and cost-per-test agreements. We also offer our Workstations to customers under

 

37

----

 

development site programs that may result in one of the abovecommercial transactions.  We sell ourWorkstations direct to the end user and to distributors. Revenue from the saleof consumables is recognized upon shipment (f.o.b. shipping point) as we do notsell consumables with a right of return.

 

Revenue from the direct sale of NanoChip® Molecular BiologyWorkstations is recognized following receipt of a purchase order, shipment(f.o.b. shipping point) of product, and transfer of title when sold directly tothe end user or to a distributor.  Intransactions where a right-of-return exists, revenue is deferred untilacceptance has occurred and the period for the right-of-return has lapsed.  The NanoChip® Molecular BiologyWorkstation is sold with a one year warranty contract.  The fair value of the warranty is recordedas deferred revenue and recognized ratably over the warranty period included inthe customer contract.  The fair valueof the warranty is based on the renewal price paid by the same customer.  This renewal price for the maintenancecontract is consistent for all customers. We provide for the estimated cost of product warranty at the timerevenue is recognized.

 

We also recognize revenue from the sale of ourNanoChip®System under reagent rental and cost-per-test transactions whereby customerspay a premium for our consumable products (NanoChip® Cartridges orASRs) over a number of years that is intended to cover the sales price of theNanoChip® Workstation,consumables and warranty.  Under areagent rental transaction, the customer commits to purchasing a fixed numberof consumable products on a periodic basis for a specified period of time (i.e.a certain number of cartridges for a certain number of years).  Revenue for the Workstation, consumables andwarranty under reagent rental transactions is recognized as consumable productsare shipped, over a period of generally two to five years, depending on thespecific customer arrangement as they may vary by customer.  We reclassify the recorded value of theWorkstation from inventory to fixed assets, recognizing the depreciationexpense as cost of sales ratably over the period of the arrangement.  Under a cost-per-reportable transaction, thecustomer agrees to purchase a certain number of consumable products on aperiodic basis determined by the customer’s volume of reported test results (tothird parties) from the use of our consumable products.  We recognize revenue under this type oftransaction at the time we receive evidence of the customer’s test resultsreported to third parties.  Under thesearrangements, we provide product warranty coverage for the Workstation over theperiod of the contract.  Under both ofthese sale transactions, the fair value of the warranty is recognized ratablyover the warranty period included in the customer contract.  The cost of sales related to the consumablesis recorded in line with the revenue (i.e. as consumables are shipped orconsumed, depending on the terms of the contract).

 

We also place our NanoChip® Molecular BiologyWorkstations at customer sites under programs, such as development sitearrangements, where title of the NanoChip®Workstation does not transfer to the customer. No revenues are recognized at the time of placement under theseagreements.  These arrangements are fora period normally between six and nine months for the purpose of developingcontent and optimizing assays that may result in the creation or enhancement ofintellectual property that we may license in the future. In addition, a primaryintent of the program is for the customer to purchase the NanoChip® Workstationduring the period of the arrangement or at its expiration.  We provide a warranty for these NanoChip®  Workstations as well as insure them duringthe development site period.  Warrantyexpense is recorded ratably over the period of the arrangement within selling,general, and administrative (SG&A) expenses.  Development site customers are normally required to purchase anyconsumables to be used on the instrument from us during the development siteperiod.  We classify this inventory asconsignment inventory and include this within finished goods.  We record a reserve for the refurbishmentcosts, recorded within SG&A, for each unit included in consignmentinventory for the purpose of resale in the event the unit is returned underthis arrangement.  In addition, we haverecorded a reserve related to the older production units that may be deemedobsolete or sold to the customer at a discount due to the age of the unitduring the development site period. Transactions under these types of programsdo not result in the recognition of revenue, however, if the customer opts topurchase the NanoChip®Workstation at any time, sales revenue is recognized upon receipt of a purchaseorder.  Cost of sales for theWorkstation is provided for at the time revenue is recognized.

 

Workstations sold to distributors are sold outrightwith title transferring at point of shipment (i.e., f.o.b. shipping point)without a right of return. Workstations are sold at a discount to the standardsales price (but not below the cost of manufacturing the instrument) andwithout warranty coverage.

 

38

----

 

Sales revenue is subject to fluctuation due to thetype of acquisition program our customers may choose.  Sponsored research and contract and grant revenue are generallyrecorded as the costs and expenses to perform the research are incurred.  Under certain arrangements revenue isrecorded ratably over the term of the arrangement as funding is provided forcontractually on a scheduled basis. Payments received in advance under these arrangements are recorded asdeferred revenue until the expenses are incurred.  Continuation of certain sponsored research and contracts andgrants are dependent upon our achieving specific contractual milestones.

 

License fees include nonrefundable fees generated fromthe licensing of the Company’s technology. Revenue is recognized immediately when the Company has no furtherobligation to perform and collections are reasonably assured.

 

*Baddebt*

 

We maintain allowances for doubtful accounts forestimated losses resulting from the inability of our customers to make requiredpayments. We record additions to our reserve based on specific analysis of eachcustomer’s balance due us.  If thefinancial condition of our customers were to deteriorate, resulting in animpairment of their ability to make payments, additional allowances would berequired.

* *

*Inventory*

 

We reduce the carrying value of our inventory,including NanoChip®Molecular Biology Workstations placed under development site arrangements, forestimated obsolescence or non-marketability after considering future purchasecommitments and based upon assumptions about future demand and marketconditions. If actual future demand or market conditions are less favorablethan those projected by us, additional inventory write-downs may be required.

* *

*IntangibleAssets*

 

We have intangible assets related to acquiredtechnology rights.  The determination ofrelated estimated useful lives and whether or not these assets are impairedinvolves significant judgments.  Changesin strategy and/or market conditions could significantly impact these judgmentsand require adjustments to recorded asset balances.

** **

**Results of Operations**

 

***Years ended December 31, 2002, 2001 and 2000***

 

*Revenues*

 

For the year ended December 31, 2002, product salesrevenue totaled $3.4 million compared to $2.2 million for the year endedDecember 31, 2001.  Product salesprimarily consists of revenue recognized from the sale of our NanoChip® Molecular BiologyWorkstations and NanoChip®Cartridges. We sold twenty-four NanoChip®Systems in 2002 compared to thirteen and eight during 2001 and 2000,respectively. In addition, we sold two NanoChip® Systems in eachof 2001 and 2000 under sponsored research programs. All revenue recorded inconnection with sales of our NanoChip®Systems resulted from outright sales transactions where title of the instrumentpassed to the customer.  We offer ourproducts to customers under several different types of acquisition programs,some of which pass title of the instrument to the customer and some of which donot pass title to the customer. As of December 31, 2002, we had an installedbase of 85 instruments, which consists of 45 outright sales and 40 placementsunder non-title transfer transactions. Our sales revenue may vary from year to year due to, among other things,the types of acquisition programs our potential customers may choose.

 

For the year ended December 31, 2002, license feescontributed $10.8 million to revenue as the result of a litigation settlementwith CombiMatrix (see Note 4 of Notes to Financial Statements).  The amount recorded was based on the fairvalue of the CombiMatrix shares received in the settlement.  These fees were non-recurring and we do notanticipate recognizing significant license fees in 2003.  There were no license fee revenues earnedfor 2001 or 2000.

 

39

----

 

For the year ended December 31, 2002, revenue fromsponsored research totaled $1.4 million compared to $7.5 million and$8.5 million for the years ended December 31, 2001 and 2000, respectively.Sponsored research revenue in 2002 consisted of revenue earned in connectionwith our development program entered into in July 2000 with Hitachi totaling$1.4 million in 2002.  We expect theHitachi funding to continue at approximately the same level in 2003.

 

Sponsored researchrevenue for 2001 and 2000 included the following:

 
| ·                        | Revenue earned in connection with our research and  development agreement entered into in January 1998 and September 1999 with  Aventis totaling $6.4 million and $7.7 million for 2001 and 2000,  respectively, which included the sale of 2 NanoChip® Molecular  Biology Workstations in each year. |
|----------------------------------------------------------------------------------------------------------------------------------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| ·                        | Revenue earned in connection with the joint venture  agreement with Becton Dickinson, as amended in September 2000, totaling  $300,000 for 2000.                                                                                                                                                           |
| ·                        | Revenue earned in connection with our development  program entered into in July 2000 with Hitachi totaling $1.1 million for 2001  and $417,000 for 2000.                                                                                                                                                   |

 

All project milestones established under the researchand development agreement entered into in September 1999 with Aventis werecompleted as of fiscal year end 2001 at which time the agreements haveexpired.  We do not expect to receiveadditional funding from Aventis or Becton Dickinson under the projectsmentioned above.

 

We fund some of our research and development effortsthrough contracts and grants awarded by various federal agencies. Revenues arerecognized under these contracts and grants as expenses are incurred.

 

Continuation of sponsored research agreements,contracts and grants is dependent upon us achieving specific contractualmilestones.  The recognition of revenueunder sponsored research agreements and contracts and grants may vary fromquarter to quarter and may result in significant fluctuations in operatingresults from year to year.

 

*Cost of sales and gross margins*

 

Cost of sales totaled $2.5 million in 2002 compared to$1.6 million and $599,000 in 2001 and 2000, respectively. Gross margins onproduct sales revenue were 27% in 2002 compared to 28% and 35% in 2001 and2000, respectively.  Cost of salesduring the years ended December 31, 2002 and 2001 were adversely impacted byunderabsorbed overhead costs due to underutilized capacity.  The cost per unit of our products remainedhigh, as our volume of production relative to the available capacity remainedlow.  In 2002 and 2001, cost of saleswas further impacted by a reserve for obsolete inventory.  Gross margins in 2002 were also unfavorablyimpacted due to manufacturing scrap as a result of lower yields on new productsreleased into production.  Incomparison, during the year ended December 31, 2000, a portion of sales revenuerelated to prototypes and therefore did not have the related cost of salesrecorded in the period sold as these costs had been expensed as research anddevelopment costs in prior years.  As weare still in the early stages of commercialization, we expect to continue toincur significant costs associated with excess production capacity within ourmanufacturing facility in 2003.  Inaddition to underabsorbed overhead costs, cost of sales was further impacted bya reserve for obsolete inventory totaling $28,000, $109,000, and $176,000 forthe years ended December 31, 2002, 2001, and 2000, respectively.  This reserve relates primarily to excessinstrument parts in our inventory that could potentially become obsolete priorto their consumption.  If necessary,these parts will be used as replacement parts for Nanogen Systems located bothinternally and at customer sites.  Grossmargins during these periods were further impacted by sales of NanoChip® Workstations tocertain customers under various discount programs and by sales to distributors,which are generally at a discount. Gross margins in future periods may additionally be impaired by minimumproduct royalties or potential adjustments made to reflect the impairment ofintangible assets related to products sold.

 

*Research and development expenses*

 

Research and development expenses totaled $21.0million, $18.6 million and $18.9 million for the years ended December 31, 2002,2001, and 2000, respectively.  Theincrease in research and development expenses from 2001 to 2002 is primarilythe result of costs incurred by our majority-owned subsidiary, NanogenRecognomics GmbH, which began operations in the third quarter of 2001.  The majority-owned subsidiary recordedlosses of $2.2 million in 2002 compared to $907,000 in 2001.  Additionally, research and development costsincreased from the prior year, in part, as a result of the termination of acollaboration agreement resulting in a loss of $452,000 in 2002.  The loss represented the remaining carryingvalue of acquired technology rights originally obtained in 1999.  Research and development expenses includedthe following during the years 2002, 2001, and 2000: costs of salaries andbenefits for scientific, engineering and operations personnel; costs associatedwith improving and refining our current products as well as development ofpotential new products and protocols; lab supplies, consulting, travel,facilities, and other expenditures associated with our research and productdevelopment activities.

 

40

----

 

Research and development expenses decreased from 2000to 2001 as the number of personnel working directly in research and developmentrelated activities within our U.S. operations decreased by approximately 10% asa result of a reallocation of personnel to operations.  We anticipate that we will continue toinvest in research and product development at approximately the same level as2002 for the foreseeable future.

 

*Selling, general and administrative expenses*

 

Selling, general and administrative expenses totaled$20.5 million in 2002 compared to $22.0 million in 2001 and $15.3 million in2000.  The decline in expenses between2001 and 2002 is primarily the result of curtailed spending associated with thelaunch of products and reduced personnel costs.  The increase from 2000 to 2001 is primarily due to costsassociated with the expansion and development of our sales and marketingorganization, the expansion of activities related to marketing and selling ourproducts, and increased legal fees associated with enhancing and maintainingour intellectual property portfolio. Selling, general and administrative expenses are expected to continue atthe current level for the foreseeable future as we continue to market and sellour current and potential future products.

 

 *Litigation and Settlement of Patent Matter*

 

The net benefit for litigation and settlement of apatent matter totaled $165,000 for the year ended December 31, 2002 and netexpenses totaled $6.9 million for the year ended December 31, 2001.  There were no litigation and settlement ofpatent matter expenses incurred during 2000 that were material.

 

In July 2001, the Company entered into a settlementagreement with Motorola, Genometrix, and MIT concluding the declaratoryjudgment action by the Company against Motorola, Genometrix and MIT and Motorola’scounterclaim against the Company. In connection with the settlement, theCompany has secured a license from Motorola to certain claims of the disputedpatent. In exchange, the Company made a one-time payment of $2.5 million incash and issued 416,666 shares of the Company’s common stock (valued atapproximately $2.5 million based upon a per share price of $6.00, the fairmarket value on the date of settlement) to the parties involved.  The settlement does not include anycross-licensing provisions of the Company’s technology to Motorola, Genometrixor MIT.  The lawsuit and thecounterclaim have now been dismissed. Costs incurred during 2001 primarilyconsist of the settlement fee of $5.0 million in addition to legalfees incurred related to the litigation process.   Costs associated with the litigation and settlement of thismatter totaled approximately $6.3 million for the year ended December 31,2001.  There were no costs incurredduring 2002 or 2000.

 

In September 2002, the Company entered into a settlementagreement with CombiMatrix Corp. (“CombiMatrix”) and Dr. Donald Montgomeryconcluding pending litigation in the U.S. District Court for the SouthernDistrict of California.  Pursuant to thesettlement agreement, Nanogen agreed to drop its claims against CombiMatrix andDr. Montgomery that include certain causes of action relating to U.S. patentNos. 6,093,302 and 6,280,595 (the “patented technology”) that were assigned byDr. Montgomery, an ex-Nanogen employee, to CombiMatrix in 1995 and assertions relatingto other matters.  In exchange,CombiMatrix agreed to pay $1.0 million as a reimbursement of legal costs; issue4,016,346 shares of CombiMatrix tracking common stock that as of December 18,2002 became publicly tradable on the Nasdaq National Market, which representsseventeen and one-half percent (17.5%) of its outstanding common stock; andmake royalty payments of twelve and one-half percent (12.5%) on sales ofproducts by either CombiMatrix or its affiliates that incorporate the patentedtechnology.  Also, as part of thesettlement agreement, CombiMatrix and Dr. Montgomery agreed to drop theircounterclaims against Nanogen and CombiMatrix retained sole ownership of thepatented technology.  The 4,016,346shares of CombiMatrix tracking common stock were initially valued at $10.8million based on the initial offering price and has been recorded as licensefee revenue for the year ended December 31, 2002. The net benefit and costsassociated with the litigation and settlement of the CombiMatrix and Dr.Montgomery litigation patent matter totaled approximately $165,000 and $578,000for the years ended December 31, 2002 and 2001, respectively.  The benefit of $165,000 for the year endedDecember 31, 2002 is net of the settlement receivable of $1.0 millionfrom CombiMatrix.  There were no costsrelating to this matter in 2000 that were material. 

 

41

----

 

*Interest income, net*

 

We had net interest income of $2.1 million in 2002compared to $4.4 million and $5.3 million, in 2001 and 2000, respectively. Theyear to year decrease in net interest income is a result of lower average cashand investment balances as well as lower yields on outstanding cash andinvestment balances during 2002 when compared to 2001 and 2000. Based on thecontinued consumption of cash and short-term investments to augment operatingactivities, we expect net interest income to decline during in 2003.

 

*Otherincome*

 

Other income totaled $161,000 for the year endedDecember 31, 2002 compared to $168,000 for the year ended December 31, 2001.For both years, other income primarily consists of gains realized from the saleof short-term investments during the respective years.   We do not anticipate realizing significantgains from the sale of short-term securities in 2003.  In February 2003, the Company sold 3,000,000 shares ofCombiMatrix common stock for net proceeds totaling $4.5 million and recognizeda realized loss of approximately $3.6 million.

 

*Minorityinterest in loss of consolidated subsidiary*

 

We had losses relating to our majority-ownedsubsidiary, Nanogen Recognomics GmbH, of $2.2 million in 2002 compared to$907,000 in 2001. The losses increased from 2001 to 2002 as operations for thesubsidiary began in the third quarter of 2001. We expect to experience continued losses with the majority-ownedsubsidiary similar to levels incurred during 2002.  These losses are funded by the investment from minority interestinvestors and are therefore offset against the minority interest balance in therespective balance sheet.

 

**Liquidity and capital resources**

 

At December 31, 2002, we had $52.7 million in cash,cash equivalents and short-term investments, compared to $67.5 million atDecember 31, 2001.  This decrease isprimarily due to cash used in operations ofapproximately $28.5 million offset by securities received from theCombiMatrix settlement during 2002 with a value of $14.6 million as of December31, 2002.  While the CombiMatrixsecurities are included in this category, there is significant risk associatedwith market value fluctuations in this investment and we expect to receivesubstantially less than $14.6 million from the sale of these securities.  In February 2003, the Company sold 3,000,000shares of CombiMatrix common stock for net proceeds totaling $4.5 million andrecognized a realized loss of approximately $3.6 million.

 

Net cash used in operating activities was $28.5million, $33.1 million, and $19.8 million for 2002, 2001, and 2000,respectively.  The decline in cash usedin operating activities from 2001 to 2002 was primarily due to paymentsreceived from receivables. Cash used for operations during 2002, 2001, and 2000was primarily related to costs associated with commercializing our productsincluding the expansion, development and support of our sales and marketingorganization; the procurement of inventory pursuant to our manufacturingarrangement with Hitachi, Ltd; support of our continuing research anddevelopment efforts; legal fees relating to establishing, maintaining anddefending our intellectual property portfolio; and the costs associated withpatent litigation.

 

Net cash provided by investing activities totaled$26.5 million in 2002 compared to cash used in investing activities of $17.1million and $44.5 million for 2001 and 2000, respectively.  Cash provided by investing activities in2002 related to proceeds received from the sale of short-term investments.  Cash used for investing activities during2001 and 2000 primarily related to the purchase of short-term securities in aneffort to maximize our return while preserving our cash balance.  During the year ended December 31, 2000, wepaid $5.1 million to acquire rights to technologies in order to enable us tofurther develop and commercialize our products.

 

Net cash provided by financing activities was$353,000, $5.2 million and $78.6 million for 2002, 2001 and 2000,respectively.  Cash provided byfinancing activities in 2002 primarily related to proceeds received from a developmentpartner totaling $1.4 million, release of restricted cash balances ofapproximately $235,000 and lease proceeds of $222,000 which were primarilyoffset by payments on capital lease obligations totaling $1.5 million. Cashprovided by financing activities in 2001 primarily related to the fundstotaling $4.8 million provided by Aventis for the operations of NanogenRecognomics as well as funding provided by Hitachi under the July 2000 researchand development agreement. Cash provided by financing activities in 2000primarily related to proceeds received pursuant to our follow-on publicoffering of common stock in March 2000.

 

We fund much of our equipment acquisitions andleasehold improvements through capital leasing facilities. During 2002,equipment and leasehold improvement financing funded $400,000 compared to $1.1million and

 

42

----

 

$944,000 during 2001 and 2000, respectively.  We anticipate that we will continue to use capital equipmentleasing or debt facilities to fund much of our equipment acquisitions andleasehold improvements. As of December 31, 2002, we had approximately $1.0million of available funding under our equipment lease lines.

 

The following illustrates, on a comprehensive basis,all recorded liabilities on the consolidated balance sheets as included hereinand contractual commitments associated with operating leases, purchasecommitments and funding commitments under research and developmentcollaborations as of December 31, 2002 (in thousands):

 
|                                                   |   | **Payments  Due by Period** |   |
|--------------------------------------------------------|--------|-----------------------------|--------|
| **Contractual Obligations & Other Commitments**    |   | **Total**                   |   | **Less Than  1  year** |   | **1 - 2  years** |   | **3 – 5  years** |   | **Thereafter** |   |
| Capital  lease obligations                             |   | $                           | 1,939  |   | 845 |   | 1,055 |   | 39 |   | $ | — |   |
| Other  long term liabilities (a)                       |   | 3,084                       |   | — |   | — |   | — |   | 3,084 |   |
| Operating  leases                                      |   | 8,448                       |   | 1,028 |   | 2,268 |   | 3,570 |   | 1,582 |   |
| Purchase  commitments (b)                              |   | 2,600                       |   | 2,600 |   | — |   | — |   | — |   |
| Research  and development funding commitments (c)      |   | 26,075                      |   | 4,100 |   | 4,100 |   | 10,375 |   | 7,500 |   |
| Standby  letters of credit (d)                         |   | 63                          |   | — |   | — |   | — |   | 63 |   |
| Total  contractual obligations & other commitments |   | $                           | 42,209 |   | $ | 8,573 |   | $ | 7,423 |   | $ | 13,984 |   | $ | 12,229 |   |
|                                                        |        |                             |        |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

----

(a)        In connection with the agreement enteredinto with Hitachi in July 2000, we are required to repay fifty percent of thetotal contributions made by Hitachi. Payment amounts are determined as a percentage of our gross NanoChip® Cartridge salesuntil the liability is paid in full. This liability is non-interest bearing and will survive any terminationof the agreement among the parties until it is paid. We have received a totalof $6 million since July 2000 under this arrangement.

(b)        Our manufacturing agreement withHitachi, Ltd. (“Hitachi”) requires that we provide annual purchase commitmentsto Hitachi for NanoChip®Workstations.  As of December 31, 2002,we had commitments to purchase approximately $2.4 million in NanoChip® Workstationsthrough June 30, 2003.  The requirementof future purchase commitments will be determined based on product demand andinventory levels. In connection with the service agreement established withHitachi in October 2000, as amended in December 2001, we have committed toprovide Hitachi with a minimum of $200,000 in payments for maintenance serviceprovided in fiscal 2003.

(c)        We are required to contribute on anannual basis funding for its own general technology development in an amountequal to or greater than payments made by Hitachi under the research anddevelopment agreement established in July 2000. Amounts included in the tableabove assume Hitachi will make all scheduled payments under this arrangementtotaling $28.5 million since inception of the agreement in fiscal 2000.  In connection with the formation of NanogenRecognomics in fiscal 2001, we are required to spend an aggregate of $5.5million, at a rate of $1.1 million per year beginning April 1, 2001, for ourown general technology development which benefits the commercialization anddevelopment of potential Nanogen Recognomics’ products.

(d)        Payments are not required under thestandby letters of credit and expire at various dates and therefore the tableabove does not reflect payment information over the five year period.

 

The Company is a party to development site agreementswith various entities whereby the Company may be obligated to pay license feesor royalties for any customer owned or licensed intellectual property used todevelop any Nanogen commercial products. None of these agreements individually are considered material.

 

We expect that our existing capital resources,combined with anticipated revenues from potential product sales, reagentrentals, leases or other types of acquisition programs for the NanoChip® System, sponsoredresearch agreements, contracts and grants will be sufficient to support ourplanned operations through at least the next eighteen months.  This estimate of the period for which weexpect our available sources of liquidity to be sufficient to meet our capitalrequirements is a forward-looking statement that involves risks anduncertainties, and actual results may differ materially.  Our future liquidity and capital fundingrequirements will depend on numerous factors including, but not limited to,commercial success of our products, or lack thereof, of our current products,the extent to which our products under development are successfully developedand gain market acceptance, the timing of regulatory actions regarding ourpotential products, the costs and timing of expansion of sales, marketing andmanufacturing

 

43

----

 

activities, prosecution and enforcement of patents important to ourbusiness and any litigation related thereto, the results of clinical trials,competitive developments, and our ability to maintain existing collaborationsand to enter into additional collaborative arrangements.  We have incurred negative cash flow fromoperations since inception and do not expect to generate positive cash flow tofund our operations for at least the next several years.  We may need to raise additional capital tofund our research and development programs, to scale-up manufacturingactivities and expand our sales and marketing efforts to support thecommercialization of our products under development.  Additional capital may not be available on terms acceptable tous, or at all.  If adequate funds arenot available, we may be required to curtail our operations significantly or toobtain funds through entering into collaborative agreements or otherarrangements on unfavorable terms.  Ourfailure to raise capital on acceptable terms when needed could have a materialadverse effect on our business, financial condition or results of operations.

 

**Net operating loss carryforwards**

 

As of December 31, 2002, we had federal and state netoperating loss, or NOL, carryforwards of approximately $127.0 million and $24.1million, respectively, and $4.8 million and $3.4 million of research anddevelopment, or R&D, tax credits available to offset future federal andstate income taxes, respectively. The federal and state NOL carryforwards aresubject to alternative minimum tax limitations and to examination by the taxauthorities.  The federal tax losscarryforwards will begin expiring in 2006, unless previously utilized, and thestate tax loss carryforwards will begin to expire in 2004, unless previouslyutilized.  The federal and state R&Dtax credit carryforwards will begin expiring in 2007 unless previouslyutilized.  Our initial public offeringcombined with the concurrent private placement, which occurred in April 1998,may be perceived as a “change of ownership” under federal income taxregulations.  We also experienced a“change of ownership” in 1995 and 1997. As such, we may be limited in the amount of NOLs incurred prior to ourinitial public offering, which may be utilized to offset future taxableincome.  Similar limitations may alsoapply to utilization of R&D tax credits to offset taxes payable. However,we do not believe such limitations will have a material impact on our abilityto utilize the NOLs.  See Note 9 of Notesto Financial Statements.

 

**Item 7A****.  Quantitative and Qualitative DisclosuresAbout Market Risk**

 

We invest our excess cash in short-term,interest-bearing investment-grade securities that are typically held for theduration of the term of the respective instrument.  We have not utilized derivative financial instruments, derivativecommodity instruments or other market risk sensitive instruments, positions ortransactions in any material fashion. Accordingly, we believe that, while the instruments we hold are subjectto changes in the financial standing of the issuer of such securities, we arenot subject to any material risks arising from changes in interest rates,foreign currency exchange rates, commodity prices, equity prices or othermarket changes that affect market risk sensitive instruments.  Recent downgrading of issuers of suchsecurities we believe, have had no material impact on our investment portfolio.

 

The functional currency for our Netherlands and Germansubsidiaries is the U.S. dollar and euro, respectively. The German subsidiary’saccounts are translated from the euro to the U.S. dollar using the currentexchange rate in effect at the balance sheet date for balance sheet accounts,and using the average exchange rate during the period for revenues and expenseaccounts.  The effects of translationare recorded in accumulated other comprehensive income in the consolidatedfinancial statements included herein. In certain instances, our subsidiaries conduct business with customersand vendors in euros or in other local European currencies.  Exchange gains and losses arising from thesetransactions are recorded using the actual exchange rate differences on thedate of the transaction.  We have nottaken any action to reduce our exposure to changes in foreign currency exchangerates, such as options or futures contracts, with respect to transactions withour European customers and vendors.  Thenet tangible assets of our foreign subsidiaries, excluding intercompanybalances, was $5.1 million at December 31, 2002.

 

**Item 8****.  Financial Statements and Supplementary Data**

 

Refer to the Index on Page F-1 of the Financial Reportincluded herein.

 

**Item 9****.  Changes in and Disagreements withAccountants on Accounting and Financial Disclosure**

 

None.

 

44

----

 

**PARTIII**

 

**Item 10****.  Directors and Executive Officers of theRegistrant**

 

Information regarding Directors is incorporated byreference to the section entitled “Election of Directors” in the Nanogen, Inc.definitive Proxy Statement to be filed with the Securities and ExchangeCommission in connection with the Annual Meeting of Stockholders to be held onJune 12, 2003 (the “Proxy Statement”). Information regarding Executive Officers is incorporated by reference tothe Proxy Statement under the heading “Executive Officers.”  Information regarding Section 16(a)reporting compliance is incorporated by reference to the Proxy Statement underthe heading “Section 16(a) Beneficial Ownership Reporting Compliance.”  In January 2003, the Board of Directors ofthe Company approved an Ethics Policy for all employees of the Companyincluding the Company’s senior executives and financial management.

 

**Item 11****.  Executive Compensation**

 

The information required by this item is incorporatedby reference to the Proxy Statement under the heading “Compensation ofExecutive Officers and Directors.”

 

# **Item 12**.  Security Ownership of Certain BeneficialOwners and Management and Related Stockholder Matters

 

The information required by this item is incorporatedby reference to the Proxy Statement under the heading “Security Ownership ofCertain Beneficial Owners and Management” and “Equity Compensation PlanInformation”.

 

# **Item 13**.  Certain Relationships and RelatedTransactions

 

The information required by this item is incorporatedby reference to the Proxy Statement under the heading “Certain Transactions.”

 

# **Item 14.**  Controls and Procedures

 

Within 90 days prior to the date of this report, anevaluation was carried out under the supervision and with the participation ofNanogen’s management, including the Chief Executive Officer and Chief FinancialOfficer, of the effectiveness of the design and operation of Nanogen’sdisclosure controls and procedures (as defined in Rule 13a-14(c) under theSecurities Exchange Act of 1934, as amended (the “Exchange Act”)).  Based on that evaluation, the ChiefExecutive Office and Chief Financial Officer have concluded that Nanogen’sdisclosure controls and procedures are effective to ensure that informationrequired to be disclosed by Nanogen in reports that it files or submits underthe Exchange Act is recorded, processed, summarized and reported within thetime periods specified in Securities and Exchange Commission rules andforms.  A control system, however, no matterhow well designed and operated, cannot provide absolute assurances that theobjectives of the controls system are met, and no evaluation of controls canprovide absolute assurances that all control issues and instances of fraud, ifany, within any company have been detected. Subsequent to the date of that evaluation, there were no significantchanges to Nanogen’s internal controls or in other factors that couldsignificantly affect these controls, including any corrective actions withregard to significant deficiencies or material weaknesses.

 

45

----

 

**PARTIV**

 

**Item 15****.  Exhibits, Financial Statement Schedules andReports on Form 8-K**

 

(a)(1) FinancialStatements:

 

Our financial statements are included herein asrequired under Item 8 of this Annual Report on Form 10-K.  See Index on page F-1.

 

(2)  Financial Statement Schedules

 

Financial statementschedules have been omitted since they are either not required, not applicable,or the information is otherwise included.

 

(3)  Exhibits

 
| **Exhibit  Number** |   | **Description of Document**                                                                                                                                                                                    |
|---------------------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                |   |                                                                                                                                                                                                           |
| 3.(i)1***(3)***     |   | Restated Certificate of  Incorporation. (3.(i)1)                                                                                                                                                               |
| 3.(i)2***(3)***     |   | Certificate of  Designations, as filed with the Delaware Secretary of State on November 23,  1998. (3.(ii)2)                                                                                                   |
| 3.(ii)***(11)***    |   | Amended and Restated  Bylaws of Registrant. (3.(ii)1).                                                                                                                                                         |
| 4.1***(1)***        |   | Form of Common Stock  Certificate. (4.1)                                                                                                                                                                       |
| 4.2***(2)***        |   | Rights Agreement dated  as of November 17, 1998, between Registrant and BankBoston. N.A                                                                                                                        |
| 4.3***(8)***        |   | Amendment No. 1 to  Rights Agreement, dated as of December 11, 2000 between Registrant and  FleetBoston, N.A.                                                                                                  |
| 10.1***(11)(A)***   |   | 1997 Stock Incentive  Plan of Nanogen, Inc. (“1997 Plan”), as amended. (10.7)                                                                                                                        |
| 10.2***(6)(A)***    |   | Form of Incentive Stock  Option Agreement under the 1997 Plan, as amended. (10.2)                                                                                                                              |
| 10.3***(6)(A)***    |   | Form of Nonqualified  Stock Option Agreement under the 1997 Plan, as amended. (10.3)                                                                                                                           |
| 10.4***(10)(A)***   |   | Nanogen, Inc. Employee  Stock Purchase Plan, as amended.                                                                                                                                                       |
| 10.5***(13)(A)***   |   | Nanogen, Inc. 2002  Stock Bonus Plan                                                                                                                                                                           |
| 10.6***(1)(A)***    |   | Form of Indemnification  Agreement between Registrant and its directors and executive officers.  (10.7)                                                                                                   |
| 10.7***(7)***       |   | Warrant to Purchase  Common Stock between Registrant and Aventis Research and Technologies  Verwaltungs, GmbH, dated September 22, 2000. (10.9)                                                                |
| 10.8***(12)***      |   | Warrant to Purchase  Common Stock between Registrant and Genetic Technologies Limited, dated June  3, 2002 (10.9)                                                                                              |
| 10.9***(5)(+)***    |   | Reader, Loader and  Cassette Low Cost Engineering and Manufacturing Agreement by and between  Registrant and Hitachi, Ltd. dated as of December 15, 1999.                                                      |
| 10.10***(7)(+)***   |   | First Amendment to  Reader, Loader and Cassette Low Cost Engineering and Manufacturing Agreement  between Registrant and Hitachi, Ltd., dated July 26, 2000. (10.7)                                            |
| 10.11***(7)(+)***   |   | Collaboration Agreement  between Registrant and Hitachi, Ltd., Nissei Sangyo Co. Ltd. And Hitachi  Instruments Service Co. Ltd., (collectively, the “Hitachi Parties”), dated  July 26, 2000. (10.6) |
| 10.12***(7)***      |   | Common Stock Purchase  Agreement between Registrant and the Hitachi Parties, dated July 26, 2000.  (10.8)                                                                                                      |

 

46

----

 
| 10.13***(1)***      |   | Amended and Restated  Investors’ Rights Agreement between Registrant and certain security holders  set forth therein, dated as of May 5, 1997, as amended.  (10.18)                                                                     |
|---------------------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.14***(1)***      |   | Master Lease Agreement  between Registrant and Mellon US Leasing, dated September 11, 1997.  (10.19)                                                                                                                                         |
| 10.153***(1)***     |   | Master Lease Agreement  between Registrant and LMP Properties, Ltd., dated June 29, 1994 as amended  on March 14, 2001.  (10.20)                                                                                                             |
| 10.16***(1)***      |   | Lease Agreement between  Registrant and Lease Management Services, Inc., dated April 26, 1994, as  amended on December 13, 1994 and June 13, 1996.  (10.21)                                                                                  |
| 10.17***(1)(A)***   |   | Form of Promissory Note  between Registrant and certain of its executive officers, dated August 22,  1996.  (10.23)                                                                                                                          |
| 10.18***(1)(A)***   |   | Form of Promissory Note  between Registrant and certain of its executive officers, dated June 30,  1995.  (10.24)                                                                                                                            |
| 10.19***(1)(A)***   |   | Form of Performance  Stock Option Agreement.  (10.26)                                                                                                                                                                                        |
| 10.20***(11)(A)***  |   | Amended and Restated  Employment Agreement between Registrant and Howard C. Birndorf, dated as of  June 3, 2001. (10.2)                                                                                                                           |
| 10.21***(A)***      |   | Separation Agreement  between Registrant and Kieran T. Gallahue, dated as of January 2, 2003                                                                                                                                                      |
| 10.22***(A)***      |   | Separation Agreement  between Registrant and Dr. Vance R. White, dated as of December 11, 2002                                                                                                                                                    |
| 10.23***(A)***      |   | Employment Agreement  between Registrant and Ira Marks, dated January 24, 2003                                                                                                                                                                    |
| 10.24(***A)***      |   | Employment Agreement  between Registrant and Bruce A. Huebner, dated December 1, 2002                                                                                                                                                             |
| 10.25***(A)***      |   | Employment Agreement  between Registrant and William Franzblau, dated January 24, 2003                                                                                                                                                            |
| 10.26***(A)***      |   | Employment Agreement  between Registrant and David Macdonald, dated January 24, 2003                                                                                                                                                              |
| 10.27***(A)***      |   | Employment Agreement  between Registrant and Graham Lidgard, dated******January 24,******2003                                                                                                                                                     |
| 10.28***(11)(A***)  |   | Amended and Restated  Employment Agreement between Registrant and Gerard A. Wills, dated as of  April 27, 2001. (10.5)                                                                                                                            |
| 10.29***(12)(A)***  |   | Severance Agreement  between Registrant and Joseph Turgeon, dated May 21, 2002 (10.4)                                                                                                                                                             |
| 10.30***(A)***      |   | Indemnification  Agreement between Registrant and Bruce A. Huebner, dated effective as of  December 1, 2002                                                                                                                                       |
| 10.31***(A)***      |   | Indemnification  Agreement between Registrant and Graham Lidgard, dated effective as of  January 24, 2003                                                                                                                                         |
| 10.32**(**9**)**(+) |   | Cooperation and  Shareholders’ Agreement among Aventis Research & Technologies GmbH &  Co. KG (“Aventis R&T”), Registrant and Nanogen Recognomics GmbH (“Nanogen  Recognomics”), dated June 29, 2001 (10.3). |
| 10.33**(9)(A)(+)**  |   | Contribution Agreement  among Aventis R&T, Registrant and Nanogen Recognomics, dated June 27,  2001 (10.4).                                                                                                                                   |
| 10.34**(11)(+)**    |   | Settlement Agreement between  Motorola, Inc., Genometrix, Inc., the Massachusetts Institute of Technology  and Registrant, dated July 20, 2001. (10.6)                                                                                            |
| 10.35***(14)***     |   | Settlement Agreement  between CombiMatrix Corporation, Dr. Donald Montgomery, Acacia Research  Corporation and Registrant, dated September 30, 2002                                                                                               |
| 10.36***(4)***      |   | Master Loan and  Security Agreement between Registrant and Transamerica Business Credit  Corporation, dated June 14, 1999.                                                                                                                        |
| 23.1                |   | Consent of Ernst &  Young LLP, independent auditors.                                                                                                                                                                                          |
| 99.1                |   | Chief Executive Officer  and Chief Financial Officer Certification Letters, dated March 28, 2003                                                                                                                                                  |
| 99.2                |   | Nanogen, Inc. Ethics  Policy                                                                                                                                                                                                                      |

 

47

----

 

----

***(1)***     Incorporated by reference to Registrant’sRegistration Statement on Form S-1 (File No. 333-42791).  Parenthetical references following thedescription of each document relate to the exhibit number under which suchexhibit was initially filed.

***(2)    ***Incorporatedby reference to Exhibit 4.2 to the Registrant’s Registration Statement on Form8-A, filed on November 24, 1998.

***(3)    ***Incorporatedby reference to Registrant’s Annual Report on Form 10-K for the year endedDecember 31, 1998.  Parentheticalreferences following the description of each document relate to the exhibitnumber under which such exhibit was initially filed.

***(4)    ***Incorporatedby reference to Exhibit 10.38 to the Registrant’s Annual Report on Form 10-Kfor the year ended December 31, 1999.  

***(5)    ***Incorporatedby reference to Exhibit 10.1 to the Registrant’s Quarterly Report on Form 10-Qfor the quarter ended March 31, 2000.

***(6)    ***Incorporatedby reference to the Registrant’s Form S-8 filed on June 15, 2000.  Parenthetical references following thedescription of each document relate to the exhibit number under which suchexhibit was initially filed.

***(7)    ***Incorporatedby reference to the Registrant’s Quarterly Report on Form 10-Q for the quarterended September 30, 2000.  Parentheticalreferences following the description of each document relate to the exhibitnumber under which such exhibit was initially filed.

***(8)    ***Incorporatedby reference to Exhibit 10.1 to the Registrant’s Form 8-K filed on December 12,2000.

***(9*)*    ***Incorporatedby reference to the Registrant’s Quarterly Report on Form 10-Q for the quarterended June 30, 2001.  Parentheticalreferences following the description of each document relate to the exhibitnumber under which such exhibit was initially filed.

**(10)*  ***Incorporatedby reference to Exhibit 10.1 to the Registrant’s Form S-8 filed on June 20,2001.  Parenthetical references followingthe description of each document relate to the exhibit number under which suchexhibit was initially filed.

**(11)*  ***Incorporatedby reference to the Registrant’s Quarterly Report on Form 10-Q for the quarterended September 30, 2001.  Parentheticalreferences following the description of each document relate to the exhibitnumber under which such exhibit was initially filed.

**(12)*  ***Incorporatedby reference to the Registrant’s Quarterly Report on Form 10-Q for the quarterended June 30, 2002.  Parenthetical referencesfollowing the description of each document relate to the exhibit number underwhich such exhibit was initially filed.

**(13)*  ***Incorporatedby reference to Exhibit 10.1 to the Registrant’s Form S-8 filed on August 16,2002.

**(14)*  ***Incorporatedby reference to Exhibit 10.1 to the Registrant’s Quarterly Report on Form 10-Qfor the quarter ended September 31, 2002.

***(A)   ***Indicatesmanagement compensatory plan or arrangement.

***(+)    ***Confidentialtreatment has been requested for certain portions of these agreements.

 

(b)      Reports on Form 8-K

 

On November 21, 2002, wefiled a report on Form 8-K announcing that Bruce A. Huebner had been named theCompany’s President and Chief Operating Officer, effective December 2,2002.  The Company also announced the resignationsof Kieran T. Gallahue, our then current President, and Randy White, Phd., ourthen current Chief Executive Officer and a director of the Company.  We also announced that effective December 2,2002, Howard C. Birndorf, the Company’s then Chairman of the Board andExecutive Chairman, would then also assume the position of Chief ExecutiveOfficer.

 

48

----

 

**SIGNATURES**

 

Pursuant to the requirements of Section 13 or 15(d) ofthe Securities Exchange Act of 1934, the registrant has duly caused this reportto be signed on its behalf by the undersigned, thereunto duly authorized.

 
|                       |   | NANOGEN, INC. |
|----------------------------|--------|---------------|
|                       |   |          |   |
|                       |   |          |   |
| Date:  March 28, 2003 |   | By:           | /s/    HOWARD C. BIRNDORF |
|                       |   |          | Howard C. Birndorf |
|                       |   |          | Chairman of the Board, |
|                       |   |          | Executive Chairman and  Chief Executive Officer |

 

Pursuant to therequirements to the Securities Exchange Act of 1934, this report has beensigned below by the following persons on behalf of the registrant and in thecapacities and on the dates indicated.

 
| **Signature**                                       |   | **Title** |                                      | **Date** |
|-----------------------------------------------------|--------|-----------|-------------------------------------------|----------|
|                                                |   |      |                                      |     |
| /s/    HOWARD  C. BIRNDORF      |   |      | Chairman of the Board,                    |     | March 28, 2003 |
| Howard C.  Birndorf                                 |   |      | Executive Chairman and  Chief             |     |   |
|                                                |   |      | Executive Officer                         |     |   |
|                                                |   |      | (Principal Executive  Officer)            |     |   |
|                                                |   |      |                                      |     |   |
| /s/    GERARD  A. WILLS         |   |      | Vice President, Chief  Financial Officer, |     | March 28, 2003 |
| Gerard A. Wills                                     |   |      | and Treasurer                             |     |   |
|                                                |   |      | (Principal Financial  and                 |     |   |
|                                                |   |      | Accounting Officer)                       |     |   |
|                                                |   |      |                                      |     |   |
| /s/    VAL  BUONAIUTO           |   |      | Director                                  |     | March 28, 2003 |
| Val Buonaiuto                                       |   |      |                                      |     |   |
|                                                |   |      |                                      |     |   |
| /s/    DAVID  G. LUDVIGSON      |   |      | Director                                  |     | March 28, 2003 |
| David G.  Ludvigson                                 |   |      |                                      |     |   |
|                                                |   |      |                                      |     |   |
| /s/    STELIOS  B. PAPADOPOULOS |   |      | Director                                  |     | March 28, 2003 |
| Stelios B. Papadopoulos                             |   |      |                                      |     |   |
|                                                |   |      |                                      |     |   |
| /s/    ROBERT  E. WHALEN        |   |      | Director                                  |     | March 28, 2003 |
| Robert E. Whalen                                    |   |      |                                      |     |   |

 

49

----

 

**Chief Executive Officer Certification**

 

I, Howard C. Birndorf,Chairman of the Board and Executive Chairman of Nanogen, Inc. certify that:

 

(1)           I have reviewed this Annual Report onForm 10-K of Nanogen, Inc. (the “registrant”);

 

(2)           Based on my knowledge, this AnnualReport does not contain any untrue statement of a material fact or omit tostate a material fact necessary to make the statements made, in light of thecircumstances under which such statements were made, not misleading withrespect to the period covered by this Annual Report;

 

(3)           Based on my knowledge, the financialstatements, and other financial information included in this Annual Report,fairly present in all material respects the financial condition, results ofoperations and cash flows of the registrant as of, and for, the periodspresented in this Annual Report;

 

(4)           The registrant’s other certifyingofficers and I are responsible for establishing and maintaining disclosurecontrols and procedures (as such term is defined in Exchange Act Rules 13a-14and 15d-14) for the registrant and have:

 

(i)       designed such disclosurecontrols and procedures to ensure that material information relating to theregistrant, including its consolidated subsidiaries, is made known to us byothers within those entities, particularly during the period in which thisAnnual Report is being prepared;

 

(ii)       evaluated the effectivenessof the registrant’s disclosure controls and procedures as of a date within 90days prior to the filing date of this Annual Report (the “Evaluation Date”);and

 

(iii)          presented in this Annual Report ourconclusions about the effectiveness of the disclosure controls and proceduresbased on our evaluation as of the Evaluation Date;

 

(5)           The registrant’s other certifyingofficers and I have disclosed, based on our most recent evaluation, to theregistrant’s auditors and the audit committee of the board of directors (orpersons fulfilling the equivalent function):

 

(i)       all significantdeficiencies in the design or operation of internal controls which couldadversely affect the registrant’s ability to record, process, summarize andreport financial data and have identified for the registrant’s auditors anymaterial weaknesses in internal controls; and

 

(ii)           any fraud, whether or not material,that involves management or other employees who have a significant role in theregistrant’s internal controls; and

 

(6)           The registrant’s other certifyingofficers and I have indicated in this Annual Report whether or not there weresignificant changes in internal controls or in other factors that couldsignificantly affect internal controls subsequent to the date of our mostrecent evaluation, including any corrective actions with regard to significantdeficiencies and material weaknesses.

 
| Dated:  March 28, 2003          |   |   |
|--------------------------------------|--------|--------|
|                                 |   |
| /s/ Howard C. Birndorf               |   |
| Howard C. Birndorf                   |   |
| Chairman of the Board  and           |   |
| Executive Chairman of  Nanogen, Inc. |   |
| (Principal Executive  Officer)       |   |

 

50

----

 

**Chief Financial Officer Certification**

 

I, Gerard A. Wills, VicePresident, Chief Financial Officer and Treasurer of Nanogen, Inc. certify that:

 

(1)           I have reviewed this Annual Report onForm 10-K of Nanogen, Inc. (the “registrant”);

 

(2)           Based on my knowledge, this AnnualReport does not contain any untrue statement of a material fact or omit tostate a material fact necessary to make the statements made, in light of thecircumstances under which such statements were made, not misleading withrespect to the period covered by this Annual Report;

 

(3)           Based on my knowledge, the financialstatements, and other financial information included in this Annual Report,fairly present in all material respects the financial condition, results ofoperations and cash flows of the registrant as of, and for, the periodspresented in this Annual Report;

 

(4)           The registrant’s other certifyingofficers and I are responsible for establishing and maintaining disclosurecontrols and procedures (as such term is defined in Exchange Act Rules 13a-14and 15d-14) for the registrant and have:

 

(iii)      designed such disclosurecontrols and procedures to ensure that material information relating to theregistrant, including its consolidated subsidiaries, is made known to us byothers within those entities, particularly during the period in which thisAnnual Report is being prepared;

 

(iv)      evaluated the effectivenessof the registrant’s disclosure controls and procedures as of a date within 90days prior to the filing date of this Annual Report (the “Evaluation Date”);and

 

(iii)          presented in this Annual Report ourconclusions about the effectiveness of the disclosure controls and proceduresbased on our evaluation as of the Evaluation Date;

 

(5)           The registrant’s other certifyingofficers and I have disclosed, based on our most recent evaluation, to theregistrant’s auditors and the audit committee of the board of directors (orpersons fulfilling the equivalent function):

 

(ii)       all significantdeficiencies in the design or operation of internal controls which couldadversely affect the registrant’s ability to record, process, summarize andreport financial data and have identified for the registrant’s auditors anymaterial weaknesses in internal controls; and

 

(ii)           any fraud, whether or not material,that involves management or other employees who have a significant role in theregistrant’s internal controls; and

 

(6)           The registrant’s other certifyingofficers and I have indicated in this Annual Report whether or not there weresignificant changes in internal controls or in other factors that couldsignificantly affect internal controls subsequent to the date of our mostrecent evaluation, including any corrective actions with regard to significantdeficiencies and material weaknesses.

 
| Dated March 28, 2003                          |
|-----------------------------------------------|
|                                          |
| /s/ Gerard A. Wills                           |   |
| Gerard A. Wills                               |
| Vice President, Chief  Financial Officer and  |
| Treasurer of Nanogen,  Inc.                   |
| (Principal Financial  and Accounting Officer) |

 

51

----

 

**NANOGEN,INC.**

**INDEX TO CONSOLIDATED FINANCIALSTATEMENTS**

 
| Report  of Ernst & Young LLP, Independent Auditors |
|--------------------------------------------------------|
|                                                   |
| Consolidated Balance Sheets                            |
|                                                   |
| Consolidated  Statements of Operations                 |
|                                                   |
| Consolidated  Statements of Stockholders’ Equity  |
|                                                   |
| Consolidated  Statements of Cash Flows                 |
|                                                   |
| Notes to  Consolidated Financial Statements            |

 

F-1

----

 

**REPORTOF ERNST & YOUNG LLP, INDEPENDENT AUDITORS**

 

The Board of Directorsand Stockholders

Nanogen, Inc.

 

We have audited theaccompanying consolidated balance sheets of Nanogen, Inc., as of December 31,2002 and 2001, and the related consolidated statements of operations,stockholders’ equity, and cash flows for each of the three years in the periodended December 31, 2002.  Thesefinancial statements are the responsibility of the Company’s management.  Our responsibility is to express an opinionon these financial statements based on our audits.

 

We conducted our auditsin accordance with auditing standards generally accepted in the UnitedStates.  Those standards require that weplan and perform the audit to obtain reasonable assurance about whether thefinancial statements are free of material misstatement.  An audit includes examining, on a testbasis, evidence supporting the amounts and disclosures in the financialstatements.  An audit also includesassessing the accounting principles used and significant estimates made bymanagement, as well as evaluating the overall financial statementpresentation.  We believe that ouraudits provide a reasonable basis for our opinion.

 

In our opinion, thefinancial statements referred to above present fairly, in all materialrespects, the consolidated financial position of Nanogen, Inc. at December 31,2002 and 2001 and the consolidated results of its operations and its cash flowsfor each of the three years in the period ended December 31, 2002, inconformity with accounting principles generally accepted in the United States.

 
|                           | /s/ ERNST & YOUNG  LLP |   |
|--------------------------------|----------------------------|--------|
|                           |                       |
| San Diego, California          |                       |
| January 24, 2003               |                       |
| except Note 15 as to  which    |                       |
| the date is February  27, 2003 |                       |

 

F-2

----

 

**NANOGEN, INC.**

 

**CONSOLIDATED BALANCE SHEETS**

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

** **
|                                                                                                                                                                                               |   | **December  31,** |   |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|-------------------|--------|
|                                                                                                                                                                                               |   | **2002**          |   | **2001** |   |
| ASSETS                                                                                                                                                                                             |   |              |   |   |   |
| Current  assets:                                                                                                                                                                                   |   |              |   |   |   |
| Cash  and cash equivalents                                                                                                                                                                         |   | $                 | 9,353  |   | $ | 10,455 |   |
| Short-term  investments                                                                                                                                                                            |   | 43,376            |   | 57,069 |   |
| Receivables,  net                                                                                                                                                                                  |   | 1,754             |   | 4,380 |   |
| Inventories,  net                                                                                                                                                                                  |   | 4,717             |   | 4,688 |   |
| Other  current assets                                                                                                                                                                              |   | 1,781             |   | 2,473 |   |
| Total current assets                                                                                                                                                                               |   | 60,981            |   | 79,065 |   |
|                                                                                                                                                                                               |   |              |   |   |   |
| Property  and equipment, net                                                                                                                                                                       |   | 4,982             |   | 5,386 |   |
| Acquired  technology rights, net                                                                                                                                                                   |   | 4,544             |   | 4,183 |   |
| Other  assets, net                                                                                                                                                                                 |   | 789               |   | 1,158 |   |
| Restricted  cash                                                                                                                                                                                   |   | 64                |   | 299 |   |
|                                                                                                                                                                                               |   | $                 | 71,360 |   | $ | 90,091 |   |
|                                                                                                                                                                                               |   |              |   |   |   |
| LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                                                                                                          |   |              |   |   |   |
|                                                                                                                                                                                               |   |              |   |   |   |
| Current  liabilities:                                                                                                                                                                              |   |              |   |   |   |
| Accounts  payable                                                                                                                                                                                  |   | $                 | 753    |   | $ | 1,051 |   |
| Accrued  liabilities                                                                                                                                                                               |   | 5,901             |   | 4,916 |   |
| Deferred  revenue                                                                                                                                                                                  |   | 472               |   | 522 |   |
| Current  portion of capital lease obligations                                                                                                                                                      |   | 805               |   | 1,060 |   |
| Total  current liabilities                                                                                                                                                                         |   | 7,931             |   | 7,549 |   |
|                                                                                                                                                                                               |   |              |   |   |   |
| Capital  lease obligations, less current portion                                                                                                                                                   |   | 1,134             |   | 1,755 |   |
| Other  long-term liabilities                                                                                                                                                                       |   | 3,085             |   | 1,675 |   |
| Total  long-term liabilities                                                                                                                                                                       |   | 4,219             |   | 3,430 |   |
|                                                                                                                                                                                               |   |              |   |   |   |
| Minority  interest in consolidated subsidiary                                                                                                                                                      |   | 1,817             |   | 4,183 |   |
|                                                                                                                                                                                               |   |              |   |   |   |
| Commitments  and contingencies                                                                                                                                                                     |   |              |   |   |   |
|                                                                                                                                                                                               |   |              |   |   |   |
| Stockholders’  equity:                                                                                                                                                                        |   |              |   |   |   |
| Convertible  preferred stock, $0.001 par value, 5,000,000 shares authorized at December  31, 2002 and 2001; no shares issued and outstanding at December 31, 2002 and  2001                        |   | —            |   | — |   |
| Common  stock, $0.001 par value, 50,000,000 shares authorized at December 31, 2002  and 2001; 21,981,115 and 21,616,172 shares issued and outstanding at December  31, 2002 and 2001, respectively |   | 22                |   | 22 |   |
| Additional  paid-in capital                                                                                                                                                                        |   | 199,483           |   | 198,387 |   |
| Accumulated  other comprehensive income                                                                                                                                                            |   | 4,926             |   | 1,253 |   |
| Deferred  compensation                                                                                                                                                                             |   | (156              | )      | (336 | ) |
| Notes  receivable from officers                                                                                                                                                                    |   | (513              | )      | (984 | ) |
| Accumulated  deficit                                                                                                                                                                               |   | (145,659          | )      | (123,413 | ) |
| Treasury  stock, at cost                                                                                                                                                                           |   | (710              | )      | — |   |
| 366,857  and no shares at December 31, 2002 and 2001, respectively                                                                                                                                 |   |              |   |   |   |
| Total  stockholders’ equity                                                                                                                                                              |   | 57,393            |   | 74,929 |   |
|                                                                                                                                                                                               |   | $                 | 71,360 |   | $ | 90,091 |   |

 

See accompanyingnotes.

 

F-3

----

 

**NANOGEN, INC.**

 

**CONSOLIDATED STATEMENTS OF OPERATIONS**

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

 
|                                                                            |   | **Years  Ended December 31,** |    |
|---------------------------------------------------------------------------------|--------|-------------------------------|---------|
|                                                                            |   | **2002**                      |    | **2001** |   | **2000** |   |
| Revenues:                                                                       |   |                          |    |   |   |   |   |
| Product  sales                                                                  |   | $                             | 3,384   |   | $ | 2,245 |   | $ | 919 |   |
| License  fees                                                                   |   | 10,844                        |    | — |   | — |   |
| Sponsored  research                                                             |   | 1,355                         |    | 7,457 |   | 8,457 |   |
| Contract  and grant                                                             |   | 1,596                         |    | 1,467 |   | 1,856 |   |
| Total  revenues                                                                 |   | 17,179                        |    | 11,169 |   | 11,232 |   |
|                                                                            |   |                          |    |   |   |   |   |
| Operating  expenses:                                                            |   |                          |    |   |   |   |   |
| Cost  of product sales                                                          |   | 2,466                         |    | 1,606 |   | 599 |   |
| Research  and development                                                       |   | 21,020                        |    | 18,597 |   | 18,905 |   |
| Selling,  general and administrative                                            |   | 20,540                        |    | 22,032 |   | 15,267 |   |
| Litigation  and settlement of patent matters                                    |   | (165                          | )       | 6,900 |   | — |   |
| Total  operating expenses                                                       |   | 43,861                        |    | 49,135 |   | 34,771 |   |
|                                                                            |   |                          |    |   |   |   |   |
| Loss  from operations                                                           |   | (26,682                       | )       | (37,966 | ) | (23,539 | )  |
|                                                                            |   |                          |    |   |   |   |   |
| Interest  income, net                                                           |   | 2,119                         |    | 4,390 |   | 5,257 |   |
| Other  income                                                                   |   | 161                           |    | 168 |   | — |   |
| Minority  interest in loss of consolidated subsidiary                           |   | 2,156                         |    | 907 |   | — |   |
| Net  loss                                                                       |   | $                             | (22,246 | ) | $ | (32,501 | ) | $ | (18,282 | )  |
|                                                                            |   |                          |    |   |   |   |   |
| Net  loss per share – basic and diluted                                    |   | $                             | (1.02   | ) | $ | (1.54 | ) | $ | (0.92 | )  |
| Number  of shares used in computing net loss per share – basic and diluted |   | 21,722                        |    | 21,091 |   | 19,944 |   |

 

See accompanyingnotes.

 

F-4

----

 

**NANOGEN, INC.**

 

**CONSOLIDATED STATEMENTS OF STOCKHOLDERS’EQUITY**

**(in thousands)**
|                                                                                  |   |       |   |   |   | **Additional  Paid-in  Capital** |   | **Treasury  Stock** |   | **Accumulated  Other  Comprehensive  Income** |   | **Deferred  Compensation** |   | **Notes  Receivable  From  Officers** |   | **Accumulated  Deficit** |   | **Total  Stockholders’  Equity** |   |
|---------------------------------------------------------------------------------------|--------|------------|--------|--------|--------|----------------------------------|--------|---------------------|--------|-----------------------------------------------|--------|----------------------------|--------|---------------------------------------|--------|--------------------------|--------|---------------------------------------|--------|
| **Common  Stock**                                                                     |
| **Shares**                                                                            |   | **Amount** |   |
|                                                                                  |   |       |   |   |   |                             |   |                |   |                                          |   |                       |   |                                  |   |                     |   |                                  |   |
| Balance at December 31, 1999                                                          |   | 18,991     |   | $      | 19     |                             | $      | 113,574             |   | $                                             | — |                       | $      | —                                |   | $                        | (1,473 | )                                     | $      | (1,369 | ) | $ | (72,630 | ) | $ | 38,121 |   |
| Components of comprehensive loss:                                                     |   |       |   |   |   |                             |   |                |   |                                          |   |                       |   |                                  |   |                     |   |                                  |   |
| Net loss                                                                              |   | —     |   | — |   | —                           |   | —              |   | —                                        |   | —                     |   | —                                |   | (18,282                  | )      | (18,282                               | )      |
| Unrealized gain on short-term investments                                             |   | —     |   | — |   | —                           |   | —              |   | 270                                           |   | —                     |   | —                                |   | —                   |   | 270                                   |   |
| Total comprehensive loss                                                              |   |       |   |   |   |                             |   |                |   |                                          |   |                       |   |                                  |   |                     |   | (18,012                               | )      |
| Issuance of common stock                                                              |   | 462        |   | — |   | 1,835                            |   | —              |   | —                                        |   | —                     |   | —                                |   | —                   |   | 1,835                                 |   |
| Repurchase of common stock                                                            |   | (58        | )      | — |   | (437                             | )      | —              |   | —                                        |   | 201                        |   | —                                |   | —                   |   | (236                                  | )      |
| Sale of common stock under secondary public  offering, net of expenses                |   | 1,500      |   | 2      |   | 76,538                           |   | —              |   | —                                        |   | —                     |   | —                                |   | —                   |   | 76,540                                |   |
| Sale of common stock in private placement                                             |   | 75         |   | — |   | 2,000                            |   | —              |   | —                                        |   | —                     |   | —                                |   | —                   |   | 2,000                                 |   |
| Cancellation of notes receivable related to  unvested restricted stock                |   | (57        | )      | — |   | (51                              | )      | —              |   | —                                        |   | —                     |   | 56                                    |   | —                   |   | 5                                     |   |
| Stock based compensation expense                                                      |   | —     |   | — |   | —                           |   | —              |   | —                                        |   | 947                        |   | —                                |   | —                   |   | 947                                   |   |
| Payments received and accrued interest on notes  receivable from officers             |   | —     |   | — |   | —                           |   | —              |   | —                                        |   | —                     |   | 214                                   |   | —                   |   | 214                                   |   |
| Balance at December 31, 2000                                                          |   | 20,913     |   | 21     |   | 193,459                          |   |                |   | 270                                           |   | (325                       | )      | (1,099                                | )      | (90,912                  | )      | 101,414                               |   |
| Components of comprehensive loss:                                                     |   |       |   |   |   |                             |   |                |   |                                          |   |                       |   |                                  |   |                     |   |                                  |   |
| Net loss                                                                              |   | —     |   | — |   | —                           |   | —              |   | —                                        |   | —                     |   | —                                |   | (32,501                  | )      | (32,501                               | )      |
| Unrealized gain on short-term investments                                             |   | —     |   | — |   | —                           |   | —              |   | 892                                           |   | —                     |   | —                                |   | —                   |   | 892                                   |   |
| Cumulative currency translation adjustment                                            |   | —     |   | — |   | —                           |   | —              |   | 91                                            |   | —                     |   | —                                |   | —                   |   | 91                                    |   |
| Total comprehensive loss                                                              |   |       |   |   |   |                             |   |                |   |                                          |   |                       |   |                                  |   |                     |   | (31,518                               | )      |
| Issuance of common stock                                                              |   | 330        |   | — |   | 1,248                            |   | —              |   | —                                        |   | —                     |   | —                                |   | —                   |   | 1,248                                 |   |
| Repurchase of common stock                                                            |   | (47        | )      | — |   | (282                             | )      | —              |   | —                                        |   | 11                         |   | —                                |   | —                   |   | (271                                  | )      |
| Issuance of common stock in settlement of  litigation and patent matter               |   | 417        |   | 1      |   | 2,500                            |   | —              |   | —                                        |   | —                     |   | —                                |   | —                   |   | 2,501                                 |   |
| Issuance of warrant to development partner                                            |   | —     |   | — |   | 1,200                            |   | —              |   | —                                        |   | —                     |   | —                                |   | —                   |   | 1,200                                 |   |
| Issuance of common stock in connection with  defined benefit plan, net of forfeitures |   | 25         |   | — |   | 297                              |   | —              |   | —                                        |   | (284                       | )      | —                                |   | —                   |   | 13                                    |   |
| Stock based compensation expense                                                      |   | —     |   | — |   | —                           |   | —              |   | —                                        |   | 367                        |   | —                                |   | —                   |   | 367                                   |   |
| Options issued to consultants                                                         |   | —     |   | — |   | 105                              |   | —              |   | —                                        |   | (105                       | )      | —                                |   | —                   |   | —                                |   |
| Payments received and accrued interest on notes  receivable from officers             |   | (22        | )      | — |   | (140                             | )      | —              |   | —                                        |   | —                     |   | 115                                   |   | —                   |   | (25                                   | )      |
| Balance at December 31, 2001                                                          |   | 21,616     |   | 22     |   | 198,387                          |   | —              |   | 1,253                                         |   | (336                       | )      | (984                                  | )      | (123,413                 | )      | 74,929                                |   |
| Components of comprehensive loss:                                                     |   |       |   |   |   |                             |   |                |   |                                          |   |                       |   |                                  |   |                     |   |                                  |   |
| Net loss                                                                              |   | —     |   | — |   | —                           |   | —              |   | —                                        |   | —                     |   | —                                |   | (22,246                  | )      | (22,246                               | )      |
| Unrealized gain on short-term investments                                             |   | —     |   | — |   | —                           |   | —              |   | 2,909                                         |   | —                     |   | —                                |   | —                   |   | 2,909                                 |   |
| Cumulative currency translation adjustment                                            |   | —     |   | — |   | —                           |   | —              |   | 764                                           |   | —                     |   | —                                |   | —                   |   | 764                                   |   |
| Total comprehensive loss                                                              |   | —     |   | — |   | —                           |   | —              |   | —                                        |   | —                     |   | —                                |   | —                   |   | (18,573                               | )      |
| Issuance of common stock                                                              |   | 82         |   | — |   | 177                              |   | —              |   | —                                        |   | —                     |   | —                                |   | —                   |   | 177                                   |   |
| Issuance of warrant for technology rights                                             |   | —     |   | — |   | 122                              |   | —              |   | —                                        |   | —                     |   | —                                |   | —                   |   | 122                                   |   |
| Issuance of common stock for technology rights                                        |   | 254        |   | — |   | 750                              |   | —              |   | —                                        |   | —                     |   | —                                |   | —                   |   | 750                                   |   |
| Accrued interest on notes receivable from officers                                    |   | —     |   | — |   | —                           |   | —              |   | —                                        |   | —                     |   | (58                                   | )      | —                   |   | (58                                   | )      |
| Acquisition of common stock                                                           |   | —     |   | — |   | —                           |   | (47                 | )      | —                                        |   | —                     |   | —                                |   | —                   |   | (47                                   | )      |
| Acquisition of common stock from officer                                              |   | —     |   | — |   | —                           |   | (663                | )      | —                                        |   | —                     |   | 529                                   |   | —                   |   | (134                                  | )      |
| Issuance of common stock in connection with  defined benefit plan, net of forfeitures |   | 29         |   | — |   | 138                              |   | —              |   | —                                        |   | 21                         |   | —                                |   | —                   |   | 159                                   |   |
| Stock based compensation expense                                                      |   | —     |   | — |   | (133                             | )      | —              |   | —                                        |   | 201                        |   | —                                |   | —                   |   | 68                                    |   |
| Options issued to consultants                                                         |   | —     |   | — |   | 42                               |   | —              |   | —                                        |   | (42                        | )      | —                                |   | —                   |   | —                                |   |
| Balance at December 31, 2002                                                          |   | 21,981     |   | $      | 22     |                             | $      | 199,483             |   | $                                             | (710   | )                          | $      | 4,926                                 |   | $                        | (156   | )                                     | $      | (513 | ) | $ | (145,659 | ) | $ | 57,393 |   |

 

See accompanyingnotes.

 

F-5

----

 

**NANOGEN, INC.**

 

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

**(in thousands)**

** **
|                                                                                                         |   | **Years  Ended December 31,** |    |
|--------------------------------------------------------------------------------------------------------------|--------|-------------------------------|---------|
|                                                                                                         |   | **2002**                      |    | **2001** |   | **2000** |   |
| **Operating  activities:**                                                                                   |   |                          |    |   |   |   |   |
| Net  loss                                                                                                    |   | $                             | (22,246 | ) | $ | (32,501 | ) | $ | (18,282 | ) |
| Adjustments  to reconcile net loss to net cash used in operating activities:                                 |   |                          |    |   |   |   |   |
| Issuance  of common stock pursuant to litigation settlement                                                  |   | —                        |    | 2,500 |   | — |   |
| Minority  interest in loss of consolidated subsidiary                                                        |   | (2,156                        | )       | (907 | ) | — |   |
| Depreciation  and amortization                                                                               |   | 4,088                         |    | 3,475 |   | 2,553 |   |
| Asset  impairment and other non-cash charges                                                                 |   | 452                           |    | — |   | — |   |
| Amortization  (accretion) related to short-term investments                                                  |   | 99                            |    | (53 | ) | 29 |   |
| Stock-based  compensation expense                                                                            |   | 68                            |    | 367 |   | 947 |   |
| Interest  capitalized on notes receivable from officers                                                      |   | (58                           | )       | (63 | ) | (57 | ) |
| Gain  on sale of short-term investments                                                                      |   | (197                          | )       | (116 | ) | — |   |
| Common  stock received for upfront licensing fees                                                            |   | (10,844                       | )       | — |   | — |   |
| Changes  in operating assets and liabilities:                                                                |   |                          |    |   |   |   |   |
| Receivables                                                                                                  |   | 2,626                         |    | (3,058 | ) | (735 | ) |
| Inventories                                                                                                  |   | (1,440                        | )       | (2,398 | ) | (2,289 | ) |
| Other  assets                                                                                                |   | 581                           |    | (919 | ) | 47 |   |
| Accounts  payable                                                                                            |   | (298                          | )       | (172 | ) | 625 |   |
| Accrued  liabilities                                                                                         |   | 923                           |    | 610 |   | 369 |   |
| Deferred  revenue                                                                                            |   | (50                           | )       | 162 |   | (3,013 | ) |
| Net  cash used in operating activities                                                                       |   | (28,452                       | )       | (33,073 | ) | (19,806 | ) |
|                                                                                                         |   |                          |    |   |   |   |   |
| **Investing  activities:**                                                                                   |   |                          |    |   |   |   |   |
| Purchase  of short-term investments                                                                          |   | (16,661                       | )       | (26,941 | ) | (39,461 | ) |
| Proceeds  from sale of short-term investments                                                                |   | 44,205                        |    | 10,692 |   | — |   |
| Purchase  of technology rights                                                                               |   | (884                          | )       | (150 | ) | (5,000 | ) |
| Purchase  of equipment                                                                                       |   | (135                          | )       | (652 | ) | (59 | ) |
| Net  cash provided by (used in) investing activities                                                         |   | 26,525                        |    | (17,051 | ) | (44,520 | ) |
|                                                                                                         |   |                          |    |   |   |   |   |
| **Financing  activities:**                                                                                   |   |                          |    |   |   |   |   |
| Proceeds  from minority interest shareholder                                                                 |   | —                        |    | 4,794 |   | — |   |
| Proceeds  from development partner                                                                           |   | 1,371                         |    | 1,125 |   | 500 |   |
| Proceeds  (payments) from restricted cash balances                                                           |   | 235                           |    | (135 | ) | 55 |   |
| Proceeds  from leasing company                                                                               |   | 222                           |    | — |   | — |   |
| Principal  payments on capital lease obligations                                                             |   | (1,471                        | )       | (1,818 | ) | (2,335 | ) |
| Issuance  of common stock, net                                                                               |   | 177                           |    | 1,149 |   | 80,139 |   |
| Payments  to acquire treasury stock                                                                          |   | (181                          | )       | — |   | — |   |
| Note  receivable payments from officers                                                                      |   | —                        |    | 38 |   | 276 |   |
| Net  cash provided by financing activities                                                                   |   | 353                           |    | 5,153 |   | 78,635 |   |
| Effect  of exchange rate changes                                                                             |   | 472                           |    | 96 |   | — |   |
| Net  increase (decrease) in cash and cash equivalents                                                        |   | (1,102                        | )       | (44,875 | ) | 14,309 |   |
| Cash  and cash equivalents at beginning of year                                                              |   | 10,455                        |    | 55,330 |   | 41,021 |   |
| Cash  and cash equivalents at end of year                                                                    |   | $                             | 9,353   |   | $ | 10,455 |   | $ | 55,330 |   |
|                                                                                                         |   |                          |    |   |   |   |   |
| **Supplemental  disclosure of cash flow information:**                                                       |   |                          |    |   |   |   |   |
| Interest  paid                                                                                               |   | $                             | 220     |   | $ | 340 |   | $ | 461 |   |
| **Supplemental  schedule of noncash investing and financing activities:**                                    |   |                          |    |   |   |   |   |
| Equipment  acquired under capital leases                                                                     |   | $                             | 400     |   | $ | 1,062 |   | $ | 944 |   |
| Common  stock issued for litigation settlement                                                               |   | $                             | —  |   | $ | 2,500 |   | $ | — |   |
| Common  stock issued for technology                                                                          |   | $                             | 750     |   | $ | — |   | $ | — |   |
| Warrants  issued for research and technology                                                                 |   | $                             | 122     |   | $ | 1,200 |   | $ | — |   |
| Assets  and liabilities contributed by minority shareholder                                                  |   | $                             | —  |   | $ | 307 |   | $ | — |   |
| Unrealized  gain on short-term investments                                                                   |   | $                             | 2,909   |   | $ | 892 |   | $ | 270 |   |
| Common  stock issued in connection with employee benefit plan, net of forfeitures                            |   | $                             | 138     |   | $ | 284 |   | $ | — |   |
| Cancellation  of notes receivable related to unvested restricted stock, net of payments on  notes receivable |   | $                             | —  |   | $ | 139 |   | $ | (56 | ) |
| Options  issued to non-employees for services                                                                |   | $                             | 42      |   | $ | 105 |   | $ | — |   |
| Cancellation  of  unvested restricted stock                                                             |   | $                             | —  |   | $ | 11 |   | $ | 201 |   |
| Acquisition  of treasury stock in exchange for cancellation  of officer note receivable                 |   | $                             | 529     |   | $ | — |   | $ | — |   |
| Inventory  transferred to fixed assets                                                                       |   | $                             | 1,411   |   | $ | 661 |   | $ | — |   |

 

See accompanyingnotes.

 

F-6

----

 

**NANOGEN, INC.**

 

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS**

 

**December 31, 2002**

 

**1.             Organization**

 

***Organization and Business Activity***

 

Nanogen, Inc. (“Nanogen” or the “Company”) wasincorporated in California on November 6, 1991 and, in November 1997, theCompany reincorporated in Delaware.  TheCompany was established to develop products, which integrate advancedmicroelectronics and molecular biology into a platform technology with broad commercialapplications in the fields of biomedical research, genomics, medicaldiagnostics, genetic testing and drug discovery.

 

## ***Basis ofConsolidation***

 

The accompanying consolidated financial statementsinclude the accounts of the Company and its wholly-owned subsidiary, NanogenEurope B.V. and its majority-owned subsidiary, Nanogen Recognomics. Theconsolidated financial statements include 100 percent of the assets andliabilities of Nanogen Recognomics and the ownership interest of minorityparticipants is recorded as “Minority interest in consolidated subsidiary.” Inaddition, 100 percent of the results of operations of Nanogen Recognomics isreflected as a reduction to the “Minority interest in consolidated subsidiary”account as the minority interest owner provided the first $5.0 million to fundall of the operating costs of the organization up to the amounts advanced. Allsignificant intercompany transactions have been eliminated in consolidation.

 

***Nanogen Europe B.V.***

 

In August 2000, Nanogen Europe B.V. was incorporatedas a company with limited liability in The Netherlands.  In conjunction with the incorporation, theCompany was issued all of the outstanding shares of Nanogen Europe B.V. Thiswholly-owned subsidiary operates as the primary European sales and marketingoffice for the Company. The Company’s consolidated financial statements atDecember 31, 2002 include $2.0 million in net tangible assets, excludingintercompany balances, and an operating loss of $1.9 million for the year endedDecember 31, 2002 related to Nanogen Europe B.V.

 

***Nanogen Recognomics GmbH***

 

In June 2001, the Company entered into agreements withAventis to create a new company, Nanogen Recognomics GmbH (“NanogenRecognomics”).  The company wasestablished to develop new products and applications for the NanoChip® System.  Nanogen Recognomics is sixty percent ownedby the Company and forty percent owned by Aventis and is based in Frankfurt,Germany.  Aventis provided $5.0 millionof funding and other fixed assets for the operations of the new company andalso contributed intellectual property in the form of eighteen patents. Inconjunction with the agreement to form Nanogen Recognomics, the Company issueda warrant to Aventis to purchase 315,863 shares of the Company’s common stockexercisable through July 17, 2006 at an agreed upon price of $9.828 pershare.  The value of this warrant, asdetermined by the Black-Scholes valuation model, is $1.2 million, and isincluded in other assets in the accompanying consolidated financial statementsand is being amortized over a two and a one-half year period.  The Company’s consolidated financialstatements at December 31, 2002 include $3.0 million in net tangible assets,excluding intercompany balances, of which $2.5 million consists of cash andcash equivalents, related to Nanogen Recognomics.  An operating loss of $2.2 million for year ended December 31,2002 related to Nanogen Recognomics is reflected as an offset to “minorityinterest in consolidated subsidiary” as included in the consolidated balancesheets herein.

 

F-7

----

 

**2.             Summaryof Significant Accounting Policies**

 

***Cash and Cash Equivalents***

 

Cash and cash equivalents consist of cash and highlyliquid investments which include debt securities with remaining maturities ofthree months or less when acquired.

 

***Short-termInvestments***

 

Financial Accounting Standards Board (“FASB”)Statement No. 115, “Accounting for Certain Investments in Debt and EquitySecurities,” requires that investments in equity securities that have readilydeterminable fair values and investments in debt securities be classified inthree categories: held-to-maturity, trading and available-for-sale. Based onthe nature of the assets held by the Company and management’s investmentstrategy, the Company’s investments have been classified as available-for-sale.Management determines the appropriate classification of debt securities at thetime of purchase. Securities classified as available-for-sale are carried atestimated fair value, as determined by quoted market prices, with unrealizedgains and losses, net of tax, reported in a separate component of comprehensiveloss.  At December 31, 2002, the Companyhad no investments that were classified as trading or held-to-maturity asdefined by the Statement.  The amortizedcost of debt securities classified as available-for-sale is adjusted foramortization of premiums and accretion of discounts to maturity. Suchamortization is included in interest income. Realized gains and losses are included in other****income.  The cost of securities sold is based on thespecific identification method. Interest on securities classified asavailable-for-sale is included in interest income.

 

***Receivables***

 

Accounts receivable are classified as short-term andreported at the net realizable value. Management estimates losses based on, but not limited to, such factorsas specific identification, past due trends, and payment history.  Estimated losses are recorded within anallowance for doubtful accounts and reported as a deduction from grossreceivables.

 

***Concentration of Risk***

 

The Company invests its excess cash primarily in U.S.government securities and marketable debt securities of financial institutionsand corporations with strong credit ratings. As a result of a settlement agreement in September 2002 as discussed inNote 4, the Company received 4,016,346 shares of CombiMatrix common stock witha value of $14.6 million at December 31, 2002. The Company has established guidelines relative to diversification andmaturities to maintain safety and liquidity. These guidelines are reviewed periodically and modified to takeadvantage of trends in yields and interest rates.  The Company has not experienced any significant realized losseson its investments for the years ended December 31, 2002, 2001, and 2000.  Refer to Note 15 on subsequent eventactivity.

 

***Restricted Cash***

 

Since 1994, the Company has maintained an irrevocablestandby letter of credit to secure its building lease.  The letter of credit is secured by acertificate of deposit, which is reflected as restricted cash in theaccompanying consolidated balance sheet and had a balance of approximately$64,000 at December 31, 2002.

 

***Inventories***

 

Inventories are carried at the lower of cost ormarket, using the first-in, first-out method.

 

***Property and Equipment***

 

Property and equipment is stated at cost anddepreciated over the estimated useful lives of the assets, generally three tofive years, using the straight-line method. Leasehold improvements are statedat cost and amortized over the shorter of the estimated useful lives of theassets or the lease term.

 

***Acquired Technology Rights***

 

Acquired technology rights are recorded at cost andamortized over their estimated useful lives of five years.

 

F-8

----

 

***Impairment of Long-Lived Assets***

 

In accordance with Statement of Financial AccountingStandards (“SFAS”) No. 144, “Accounting for the Impairment or Disposal ofLong-Lived Assets”, if indicators of impairment exist, the Company assesses therecoverability of the affected long-lived assets by determining whether thecarrying value of such assets can be recovered through undiscounted futureoperating cash flows.  If impairment isindicated, the Company will value the asset at fair value.  While the Company’s current and historicaloperating and cash flow losses are indicators of impairment, the Companybelieves the future cash flows to be received from the long-lived assets willexceed the assets’ carrying value. During the year ended December 31, 2002, the Company recognizedimpairment losses totaling $452,000.

 

***Revenue Recognition***

 

Product revenue is generated by the sale of commercialproducts and services under various sales programs to the end user or throughdistribution channels. Revenue is recognized in accordance with StaffAccounting Bulletin No. 101, “Revenue Recognition in Financial Statements” andrecorded as follows:

 

The Company sells NanoChip® Molecular BiologyWorkstations under various commercial programs such as; direct sale, reagentrental programs, and cost-per-reportable agreements.  Additionally, the Workstations are sold to customers underdevelopment site programs that may result in one of the above commercialtransactions.  The Company sellsWorkstations direct to the end user and to distributors. Revenue from the saleof consumables is recognized upon shipment (f.o.b. shipping point) as theCompany does not sell consumables with a right of return. 

 

Revenue from the direct sale of NanoChip® Molecular BiologyWorkstations is recognized following receipt of a purchase order, shipment(f.o.b. shipping point) of product, and transfer of title when sold directly tothe end user or to a distributor. In transactions where a right-of-returnexists, revenue is deferred until acceptance has occurred and the period forthe right-of-return has lapsed.  TheNanoChip® Molecular BiologyWorkstation is sold with a one year warranty contract. The fair value of thewarranty is recorded as deferred revenue and recognized ratably over thewarranty period included in the customer contract. The fair value of thewarranty is based on the renewal price paid by the same customer. This renewalprice for the maintenance contract is consistent for all customers. The Companyprovides for the estimated cost of product warranty at the time revenue isrecognized.

 

The Company also recognizes revenue from the sale ofthe NanoChip®System under reagent rental and cost-per-reportable transactions wherebycustomers pay a premium for consumable products (NanoChip® Cartridges orASRs) over a number of years that is intended to cover the sales price of theNanoChip® Workstation,consumables and warranty. Under a reagent rental transaction, the customercommits to purchasing a fixed number of consumable products on a periodic basisfor a specified period of time (i.e. a certain number of cartridges for acertain number of years).  Revenue forthe Workstation, consumables and warranty under reagent rental transactions isrecognized as consumable products are shipped, over a period of generally twoto five years, depending on the specific customer arrangement as they may varyby customer.  The Company reclassifiesthe recorded value of the Workstation from inventory to fixed assets, recognizingthe depreciation expense as cost of sales ratably over the period of thearrangement.  Under acost-per-reportable transaction, the customer agrees to purchase a certainnumber of consumable products on a periodic basis determined by the customer’svolume of reported test results (to third parties) from the use of consumableproducts.  The Company recognizesrevenue under this type of transaction at the time the Company receivesevidence of the customer’s test results reported to third parties. Under thesearrangements, the Company provides product warranty coverage for theWorkstation over the period of the contract. Under both of these sale transactions, the fair value of the warranty isrecognized ratably over the warranty period included in the customercontract.  The cost of sales related tothe consumables is recorded in line with the revenue (i.e. as consumables areshipped or consumed, depending on the terms of the contract).

 

The Company also places NanoChip® Molecular BiologyWorkstations at customer sites under programs, such as development sitearrangements, where title of the NanoChip®Workstation does not transfer to the customer. No revenues are recognized atthe time of placement under these agreements. These arrangements are for aperiod normally between nine and twelve months for the purpose of developingcontent and optimizing assays that may result in the creation or enhancement ofintellectual property that the Company may license in the future. In

 

F-9

----

 

addition, a primary intent of the program is for the customer topurchase the NanoChip®Workstation during the period of the arrangement or at its expiration. TheCompany provides a warranty for these NanoChip®  Workstations as well as insures them duringthe development site period.  Warrantyexpense is recorded ratably over the period of the arrangement within selling,general, and administrative (SG&A) expenses. development site customers arenormally required to purchase any consumables to be used on the instrument fromthe Company during the development site period.  The Company classifies this inventory as consignment inventoryand includes this within finished goods. The Company records a reserve for therefurbishment costs, recorded within SG&A, for each unit included inconsignment inventory for the purpose of resale in the event the unit isreturned under this arrangement. This reserve totaled approximately $489,000and $303,000 at December 31, 2002 and 2001, respectively, and is included inaccrued liabilities.  In addition, theCompany has recorded a reserve related to the older production units that maybe deemed obsolete or sold to the customer at a discount due to the age of theunit during the development site period. Transactions under these types ofprograms do not result in the recognition of revenue, however, if the customeropts to purchase the NanoChip®Workstation at any time, sales revenue is recognized upon receipt of a purchaseorder.  Cost of sales for theWorkstation is provided for at the time revenue is recognized.

 

Workstations sold to distributors are sold outrightwith title transferring at point of shipment (i.e. f.o.b. shipping point)without a right of return.  Workstationsare sold at a discount to the standard sales price (but not below the cost ofmanufacturing the instrument) and without warranty coverage.  

 

Sales revenue is subject to fluctuation due to thetype of acquisition program the Company’s customers may choose.  Sponsored research and contract and grantrevenue are generally recorded as the costs and expenses to perform theresearch are incurred. Under certain arrangements revenue is recorded ratablyover the term of the arrangement as funding is provided for contractually on ascheduled basis.  Payments received inadvance under these arrangements are recorded as deferred revenue until theexpenses are incurred.  Continuation ofcertain sponsored research, contracts and grants are dependent upon the Companyachieving specific contractual milestones.

 

License fees include nonrefundable fees generated fromthe licensing of the Company’s technology. Revenue is recognized immediately when the Company has no furtherobligation to perform and collections are reasonably assured.

 

***Comprehensive Income (Loss)***

 

SFAS No. 130, “Reporting Comprehensive Income” (“SFAS130”) requires reporting and displaying comprehensive income (loss) and itscomponents which, for the Company, includes foreign currency translationadjustments and unrealized gains and losses on short-term investments.  The Company presents other comprehensiveincome (loss) in its consolidated statements of stockholders’ equity.

 

***Net Loss Per Share***

 

The Company computes net income per share inaccordance with SFAS No. 128, “Earnings per Share.”  Under the provisions of SFAS No. 128, basic net income per shareis computed by dividing the net income available to common stockholders for theperiod by the weighted average number of common shares outstanding during theperiod.  Diluted net income per share iscomputed by dividing the net income for the period by the weighted averagenumber of common shares outstanding during the period and dilutive potentialcommon shares outstanding.  Weightedaverage common shares outstanding during the period does not include sharesissued pursuant to the exercise of stock options prior to vesting and sharesissued under the Company’s 401K benefit plan prior to vesting.  Due to the losses incurred by the Companyduring the years ended December 31, 2002, 2001, and 2000, common stockequivalents resulting from the assumed exercise of outstanding stock optionsand warrants have been excluded from the computation of diluted net loss pershare as their effect would be anti-dilutive. The stock options and warrants that have been excluded from thecomputation of diluted net loss per share are as follows:

 
|                  |   | **Years  Ended December 31,** |   |
|-----------------------|--------|-------------------------------|--------|
|                  |   | **2002**                      |   | **2001** |   | **2000** |   |
| Stock options         |   | 4,459,428                     |   | 2,951,564 |   | 2,292,424 |   |
| Warrants  outstanding |   | 365,863                       |   | 315,863 |   | — |   |
|                  |   | 4,825,291                     |   | 3,267,427 |   | 2,292,424 |   |

 

*** ***

***Stock-Based Compensation***

 

As permitted by SFAS No. 123, the Company has electedto follow Accounting Principles Board Opinion No. 25, “Accounting for StockIssued to Employees,” and related Interpretations (“APB 25”), in accounting forits

 

F-10

----

 

employee stock options. Under APB 25, when the exercise price of theCompany’s employee stock options is equal to or exceeds the fair value of theunderlying stock on the date of grant, no compensation expense is recognized.

 

Adjusted pro forma information regarding net loss isrequired by SFAS 123 and has been determined as if the Company had accountedfor its employee stock options under the fair value method of SFAS 123. Thefair value for these options was estimated at the date of grant using theBlack-Scholes valuation model for option pricing with the following assumptionsfor 2002, 2001, and 2000: a risk-free interest rate of 3.0%, 5.0%, and 6.0%,respectively, a dividend yield of zero; volatility factors of the expectedmarket price of the Company’s common stock of 83%, 65%, and 70%, respectively,and a weighted average expected life of the option of five years.

 

The Black-Scholes option valuation model was developedfor use in estimating the fair value of traded options which have no vestingrestrictions and are fully transferable. In addition, option valuation models require the input of highlysubjective assumptions, including the expected stock price volatility.  Because the Company’s employee stock optionshave characteristics significantly different from those of traded options, andbecause changes in the subjective input assumptions can materially affect thefair value estimate, in management’s opinion, the existing models do notnecessarily provide a reliable single measure of the fair value of its employeestock options.

 

For purposes of adjusted pro forma disclosures, theestimated fair value of the options is amortized to expense over the vestingperiod. The Company’s adjusted pro forma information is as follows (in thousands):

 

|                                   |   | **Years  Ended December 31,** |    |
|----------------------------------------|--------|-------------------------------|---------|
|                                   |   | **2002**                      |    | **2001** |   | **2000** |   |
| Adjusted  pro forma net loss           |   | $                             | (28,372 | ) | $ | (38,438 | ) | $ | (26,197 | ) |
| Adjusted  pro forma net loss per share |   | $                             | (1.31   | ) | $ | (1.82 | ) | $ | (1.31 | ) |

 

The weighted average fair value of options grantedduring 2002, 2001 and 2000 was $1.77, $4.05 and $20.83 per share, respectively.

 

The pro forma effect on net loss for 2002, 2001 and2000 is not necessarily indicative of potential pro forma effects on resultsfor future years.

 

Periodically, the Company issues options tonon-employees.  The options are recordedat their fair value (using the Black-Scholes model) as determined in accordancewith SFAS 123 and periodically remeasured in accordance with EITF 96-18“Accounting for Equity Instruments That Are Issued To Other Than Employees forAcquiring, or in Conjunction with Selling, Goods, or Services" and arerecognized over the related service period.

 

***Use of Estimates***

 

The preparation of financial statements in conformitywith accounting principles generally accepted in the United States requiresmanagement to make estimates and assumptions that affect the reported amountsof assets and liabilities and related disclosures at the date of the financialstatements, and the amounts of revenues and expenses reported during theperiod. Actual results could differ from those estimates.

 

***Reclassifications***

 

Certain prior period amounts have been reclassified toconform to current period presentation. For the year ended December 31, 2001, research and development andminority interest in loss of consolidated subsidiary include $1,034,000 and$907,000, respectively, have been reclassified and presented on a gross basis.For the year ended December 31, 2001, litigation costs totaling $578,000 havebeen reclassified from selling, general and administrative to litigation andsettlement of patent matters.

 

***Foreign Currency***

 

The functional currency for our Netherlands and Germansubsidiaries is the U.S. dollar and euro, respectively. The German subsidiary’saccounts are translated from the euro to the U.S. dollar using the currentexchange rate in effect at the balance sheet date for balance sheet accounts,and using the average exchange rate during the period for revenues and expenseaccounts. The effects of translation are recorded in accumulated othercomprehensive income in the consolidated financial statements included herein.In certain instances, our subsidiaries conduct business with customers andvendors in euros or in other local European currencies. Exchange gains and lossesarising from these transactions are recorded using the actual exchange ratedifferences on the date of the transaction. We have not taken any action toreduce our exposure to changes in foreign currency exchange rates, such asoptions or futures

 

F-11

----

 

contracts, with respect to transactions with our European customers andvendors. During fiscal years 2002 and 2001, foreign currency transaction losseswere not material.

 

***Segment Information***

 

SFAS No. 131, “Segment Information,” amends therequirements for public enterprises to report financial and descriptiveinformation about its reportable operating segments.  Operating segments, as defined in SFAS No. 131, are components ofan enterprise for which separate financial information is available and isevaluated regularly by the Company in deciding how to allocate resources and inassessing performance.  The financialinformation is required to be reported on the basis that is used internally forevaluating this segment performance. The Company operates in one business and operating segment only.

 

***Recent Accounting Pronouncements***

 

In July 2001, the Financial Accounting StandardsBoard (FASB) issued FASB Statements Nos. 141 and 142 (FAS 141 andFAS 142), “Business Combinations” and “Goodwill and Other IntangibleAssets.”  FAS 141 replacesAPB 16 and eliminates pooling-of-interests accounting prospectively. Italso provides guidance on purchase accounting related to the recognition ofintangible assets and accounting for negative goodwill.  FAS 142 changes the accounting forgoodwill from an amortization method to an impairment-only approach. UnderFAS 142, goodwill will be tested annually and whenever events or circumstancesoccur indicating that goodwill might be impaired. FAS 141 and FAS 142are effective for all business combinations completed after June 30, 2001.Upon adoption of FAS 142, amortization of goodwill recorded for businesscombinations consummated prior to July 1, 2001 will cease, and intangibleassets acquired prior to July 1, 2001 that do not meet the criteria forrecognition under FAS 141 will be reclassified to goodwill.  Theadoption of these standards did not have a material impact on the Company’sresults of operations and financial position.

 

In June 2002, the FASB issuedStatement No. 146, or SFAS No. 146, “Accounting for Costs Associated with Exitor Disposal.”  SFAS No. 146 addressesfinancial accounting and reporting for costs associated with exit or disposalactivities and nullifies EITF Issue No. 94-3, “Liability Recognition forCertain Employee Termination Benefits and Other Costs to Exit an Activity(including Certain Costs Incurred in a Restructuring).”  The principal difference between Statement146 and Issue 94-3 relates to Statement 146’s requirements for recognition of aliability for a cost associated with an exit or disposal activity. Statement146 requires that a liability for a cost associated with an exit or disposalactivity be recognized when the liability is incurred.  Under Issue 94-3, a liability for an exitcost as generally defined in Issue 94-3 was recognized at the date of anentity’s commitment to an exit plan. The provisions of this Statement 146 are effective for exit or disposalactivities that are initiated after December 31, 2002, with early applicationencouraged. We do not expect the adoption of SFAS No. 146 will have a materialimpact on the consolidated financial statements.

 

In December 2002, the FASB issued Statement No. 148,“Accounting for Stock-Based Compensation—Transition and Disclosure” to providealternative methods of transition for a voluntary change to the fair valuebased method of accounting for stock-based employee compensation. In addition,this Statement amends the disclosure requirements of Statement 123 to requireprominent disclosures in both annual and interim financial statements about themethod of accounting for stock-based employee compensation and the effect ofthe method on reported results.  The adoption of these standards did not have amaterial impact on the Company’s results of operations and financial position.

 
| **3.** |   | **Financial Statement Details**                                                           |
|--------|--------|-------------------------------------------------------------------------------------------|
|   |   |                                                                                      |
|   |   | ***Short-term  Investments***                                                             |
|   |   |                                                                                      |
|   |   | Short-term investments  consisted of the following (in thousands) at December 31:

  |

 

|                                     |   | **Amortized  Cost** |         | **Market  Value** |   | **Unrealized  Gain (loss)** |   |
|------------------------------------------|--------|---------------------|--------------|-------------------|--------|-----------------------------|--------|
| **2002**                                 |   |                |         |              |   |                        |   |
| Obligations  of U.S. government agencies |   | $                   | 14,362       |              | $      | 14,483                      |   | $ | 121 |   |
| Corporate  debt securities               |   | 5,212               |         | 5,271             |   | 59                          |   |
| Asset  backed securities                 |   | 8,887               |         | 9,003             |   | 116                         |   |
| Marketable  equity securities            |   | 10,844              |         | 14,619            |   | 3,775                       |   |
|                                     |   | $                   |  39,305 |              | $      |  43,376                |   | $ |  4,071 |   |
|                                     |   |                |         |              |   |                        |   |
| **2001**                                 |   |                |         |              |   |                        |   |
|                                     |   |                |         |              |   |                        |   |
| Obligations  of U.S. government agencies |   | $                   | 21,592       |              | $      | 21,991                      |   | $ | 399 |   |
| Corporate  debt securities               |   | 27,315              |         | 27,931            |   | 616                         |   |
| Asset  backed securities                 |   | 7,000               |         | 7,147             |   | 147                         |   |
|                                     |   | $                   | 55,907       |              | $      | 57,069                      |   | $ | 1,162 |   |

 

F-12

----

 

The estimated fair value of available for salesecurities, excluding equity securities valued at $14.6 million, by contractualmaturity at December 31, 2002 is as follows (in thousands):

 

|                              |   | **Amortized  Cost** |   | **Market  Value** |   |
|-----------------------------------|--------|---------------------|--------|-------------------|--------|
| Due  in one year or less          |   | $                   | 13,195 |              | $      | 13,307 |   |
| Due  between one and two years    |   | 12,194              |   | 12,357            |   |
| Due  between three and five years |   | 3,072               |   | 3,093             |   |
|                              |   | $                   | 28,461 |              | $      | 28,757 |   |

 

Realized gains from sale of securities totaled$197,000, for the year ended December 31, 2002 and $116,000 for the year endedDecember 31, 2001. There were no gains or losses realized from the sale ofsecurities for the year ended December 31, 2000. Refer to Note 15 forsubsequent event activity.

 

***Receivables***

 

Receivables are comprised of the following (in thousands) as of:

 

|                             |   | **December  31,** |   |
|----------------------------------|--------|-------------------|--------|
|                             |   | **2002**          |   | **2001** |   |
| Product                          |   | $                 | 1,549  |   | $ | 1,569 |   |
| Sponsored  research              |   | —            |   | 2,714 |   |
| Contract  and grant              |   | 246               |   | 296 |   |
|                             |   | 1,795             |   | 4,579 |   |
| Allowance  for doubtful accounts |   | (41               | )      | (199 | ) |
|                             |   | $                 | 1,754  |   | $ | 4,380 |   |

*** ***

***Inventories***

 

Inventories consist ofthe following (in thousands) as of:

 

|                      |   | **December  31,** |   |
|---------------------------|--------|-------------------|--------|
|                      |   | **2002**          |   | **2001** |   |
| Raw  materials            |   | $                 | 1,062  |   | $ | 796 |   |
| Work  in process          |   | 1,485             |   | 1,436 |   |
| Finished  goods           |   | 4,428             |   | 3,956 |   |
|                      |   | 6,975             |   | 6,188 |   |
| Reserve  for obsolescence |   | (2,258            | )      | (1,500 | ) |
|                      |   | $                 | 4,717  |   | $ | 4,688 |   |

 

Finished goods includes $3.2 million and $2.0 millionof NanoChip®Systems at December 31, 2002 and 2001, respectively, that are installed atcustomer sites where title has not transferred to the customer.

 

***Property and Equipment***

 

Property and equipment consist of the following (inthousands) as of:

 

|                                            |   | **December  31,** |   |
|-------------------------------------------------|--------|-------------------|--------|
|                                            |   | **2002**          |   | **2001** |   |
| Scientific  equipment                           |   | $                 | 7,165  |   | $ | 5,356 |   |
| Office  furniture and equipment                 |   | 3,323             |   | 3,155 |   |
| Manufacturing  equipment                        |   | 387               |   | 334 |   |
| Leasehold  improvements                         |   | 4,336             |   | 4,336 |   |
|                                            |   | 15,211            |   | 13,181 |   |
| Less  accumulated depreciation and amortization |   | (10,229           | )      | (7,795 | ) |
|                                            |   | $                 | 4,982  |   | $ | 5,386 |   |

 

F-13

----

 

For the years ended December 31, 2002, 2001, and 2000,depreciation expense totaled $2.4 million, $2.0 million, and $1.8 million,respectively.

 

***Acquired Technology Rights***

 

As of December 31, 2002 and 2001, acquired technologyrights is presented net of accumulated amortization of $2.6 million and $2.0million respectively.  For the yearsended December 31, 2002, 2001 and 2000, amortization totaled $1.2 million, $1.2million, and $826,000, respectively. Amortization expense for the years endedDecember 31, 2003, 2004, 2005, 2006, and 2007 is estimated at $1.5 million,$1.0 million, $395,000, $20,000, and $20,000, respectively.

 

***Accrued Liabilities***

 

Accrued liabilities are comprised of the following (inthousands) as of:

 

|                               |   | **December  31,** |   |
|------------------------------------|--------|-------------------|--------|
|                               |   | **2002**          |   | **2001** |   |
| Accrued  compensation and benefits |   | $                 | 2,683  |   | $ | 2,640 |   |
| Accrued  legal fees                |   | 639               |   | 628 |   |
| Other                              |   | 2,579             |   | 1,648 |   |
|                               |   | $                 | 5,901  |   | $ | 4,916 |   |

 

**4.             Commitmentsand Contingencies**

 

***Licensing and Research Agreements***

 

In July 2000, the Company executed a ten-year agreementwith Hitachi, Ltd., Nissei Sangyo Co. Ltd. and Hitachi Instruments Service Co.Ltd. of Japan (collectively, “Hitachi”) to develop, manufacture and distributeproducts based on the parties’ proprietary technologies, potentially including,among other things, reduced-size instruments for genetic testing, integratedamplification and point of care detection. The agreement provides that the parties will jointly determine whichprojects to prioritize over the term of the agreement. The agreement may beterminated before its expiration by either party, subject to certainrestrictions. Hitachi has the right to be the exclusive distributor ofcollaboration products in Japan and, based upon the attainment of minimum salestargets to be mutually agreed upon, in other Asian countries.  The Company retains the exclusive right todistribute collaboration products outside of these countries.  Pursuant to the terms of the agreement, Hitachiand the Company each may contribute up to $28.5 million in cash over the ten-yearperiod. At a minimum the Company is required to contribute on an annual basisfunding for its own general technology development in an amount equal to orgreater than payments made by Hitachi. The Company received $2.8 million, $2.3million and $1.0 million from Hitachi pursuant to this agreement during theyears ended December 31, 2002, 2001 and 2000, respectively.

 

In June 2001, the Company entered into agreements withAventis to create a new company, Nanogen Recognomics GmbH (“Nanogen Recognomics”).  Nanogen Recognomics was established todevelop new products and applications for the NanoChip® System. TheCompany is required to spend an aggregate of $5.5 million, at the rate of $1.1million per year beginning April 1, 2001, for its own general technologydevelopment which benefits the commercialization and development of potentialNanogen Recognomics products.

 

The Company is a party to development site agreementswith various entities whereby the Company may be obligated to pay license feesor royalties for any customer owned or licensed intellectual property is usedto develop any Nanogen commercial products. None of these agreementsindividually are considered material.

 

***Other Long-Term Debt and Purchase Commitments***

 

  The Company’smanufacturing agreement with Hitachi, Ltd. (“Hitachi”) requires that theCompany provide annual purchase commitments to Hitachi for NanoChip®Workstations.  As of December 31, 2002,the Company had commitments to purchase approximately $2.4 million in NanoChip® Workstationsthrough June 30, 2003.  At December 31,2002, the inventory under our purchase commitment with Hitachi is within ourexpected usage levels based upon current and estimated future demands.

 

F-14

----

 

In connection with the agreement entered into withHitachi in July 2000, the Company is required to repay fifty percent of thetotal contributions made by Hitachi. Payment amounts are determined as apercentage to the Company’s gross NanoChip® Cartridge sales untilthe liability is paid in full.  Thisliability is non-interest bearing and will survive any termination of theagreement among the parties until it is paid. Amounts are reflected as “Otherlong-term liabilities” in the accompanying balance sheets and totaledapproximately $3.0 million and $1.6 million at December 31, 2002 and 2001,respectively.

 

In October 2000, the Company entered into an agreementwith Hitachi for the service by Hitachi of the NanoChip® Molecular BiologyWorkstations after their sale or placement by the Company with the Company’scustomers. In December 2001, this agreement was amended to include, among otherthings, a commitment by the Company to provide Hitachi with a minimum of$200,000 in payments for maintenance service provided in fiscal 2002. Thisexpense was recorded during fiscal 2002 over the relative service periods.

 

***Leases***

 

The Company leases its facilities and certainequipment under operating lease agreements that expire at various dates through2010.  Rent expense was $927,000,$783,000, and $631,000 in 2002, 2001 and 2000, respectively.

 

The Company leases certain equipment under capitallease obligations. Cost and accumulated amortization of equipment under capitallease were $14.1 million and $9.7 million at December 31, 2002 and $11.9million and $7.6 million at December 31, 2001, respectively.  Amortization of equipment under capitallease obligations is included in depreciation expense.

 

Annual future minimum obligations for operating andcapital leases as of December 31, 2002 are as follows (in thousands):

 

|                                                       |   | **Operating  Leases** |   | **Capital  Lease  Obligations** |   |
|------------------------------------------------------------|--------|-----------------------|--------|---------------------------------|--------|
| 2003                                                       |   | 1,028                 |   | 997                             |   |
| 2004                                                       |   | 1,016                 |   | 756                             |   |
| 2005                                                       |   | 1,252                 |   | 396                             |   |
| 2006                                                       |   | 1,171                 |   | 40                              |   |
| 2007                                                       |   | 1,179                 |   | —                          |   |
| Thereafter                                                 |   | 2,802                 |   | —                          |   |
| Total  minimum lease payments                              |   | $                     | 8,448  |                            | $      | 2,189 |   |
| Less  amount representing interest                         |   |                  |   | 250                             |   |
| Present  value of future minimum capital lease obligations |   |                  |   | 1,939                           |   |
| Less  amounts due in one year                              |   |                  |   | 805                             |   |
| Long  term portion of capital lease obligations            |   |                  |   | $                               | 1,134  |   |
|                                                            |        |                       |        |                                 |        |  |  |

 

As of December 31, 2002, the Company has approximately$1.0 million of available funding under equipment lease lines.

 

F-15

----

 

***Litigation***

 

In July 2001, the Company entered into a settlementagreement with Motorola, Genometrix, and MIT concluding the declaratoryjudgment action by the Company against Motorola, Genometrix and MIT andMotorola’s counterclaim against the Company. In connection with the settlement,the Company has secured a license from Motorola to certain claims of the ‘939Patent. In exchange, the Company made a one-time payment of $2.5 million incash and issued 416,666 shares of the Company’s common stock (valued atapproximately $2.5 million based upon a per share price of $6.00, the fairmarket value on the date of settlement, as determined using the Black-Scholesvaluation model) to the parties involved. The settlement did not include anycross-licensing provisions of the Company’s technology to Motorola, Genometrixor MIT. The lawsuit and the counterclaim have now been dismissed.

 

For the years ended December 31, 2001 and 2000 costsassociated with the litigation and settlement of the Motorola patent mattertotaled $6.3 million and $0, respectively. Costs incurred during the year ended December 31, 2001, primarily consistof the settlement fee of $5.0 million in addition to legal fees incurredrelated to the litigation process.

 

In September 2002, the Companyentered into a settlement agreement with CombiMatrix Corp. (“CombiMatrix”) andDr. Donald Montgomery concluding pending litigation in the U.S. District Courtfor the Southern District of California. Pursuant to the settlement agreement, Nanogen agreed to drop its claimsagainst CombiMatrix and Dr. Montgomery that include certain causes of actionrelating to U.S. patent Nos. 6,093,302 and 6,280,595 (the “patentedtechnology”) that were assigned by Dr. Montgomery, an ex-Nanogen employee, toCombiMatrix in 1995 and assertions relating to other matters. In exchange,CombiMatrix agreed to pay $1.0 million as a reimbursement of legal costs; issue4,016,346 shares of CombiMatrix tracking common stock that as of December 18,2002 became publicly tradable on the Nasdaq National Market and were initiallyvalued upon receipt at $10.8 million, which represents seventeen and one-halfpercent (17.5%) of its outstanding common stock; and make royalty payments oftwelve and one-half percent (12.5%) on sales of products by either CombiMatrixor its affiliates that incorporate the patented technology. The $1.0 million isdue in two installments of $500,000, one in 2002 and the second by September2003. Also, as part of the settlement agreement, CombiMatrix and Dr. Montgomeryagreed to drop their counterclaims against Nanogen and CombiMatrix retainedsole ownership of the patented technology.

 

The net benefit and costs associated with thelitigation and settlement of the CombiMatrix and Dr. Montgomery litigationpatent matter totaled approximately $165,000 and $578,000 for the years endedDecember 31, 2002 and 2001, respectively. The benefit of $165,000 for the year ended December 31, 2002 is net ofthe settlement receivable of $1.0 million from CombiMatrix.  A receivable totaling $500,000 has beenrecorded in the Company’s financial statements which represents the unpaidbalance of the $1.0 million settlement as of December 31, 2002.

 

In December, 2002, Oxford Gene Technologies (“OGT”)filed a complaint against the Company in the United States District Court forthe District of Delaware claiming that Nanogen infringes U.S. Patent No.  6,054,270 (the “‘270 Patent”) entitled“Analyzing Polynucleotide Sequences”. Nanogen denies that it infringes the ‘270 Patent.  Nevertheless, if the litigation continues,significant attorneys’ costs and fees could result.  Although it is Nanogen’s position that OGT’s assertions ofinfringement have no merit, neither the outcome of the litigation nor theamount and range of potential fees can yet be assessed.  No assurances can be given that the Companywill prevail in the lawsuit or that it can successfully defend itself againstthe claim and the Company may not prevail in the action, which could have amaterial adverse effect on the Company.

 

**5.             RelatedParty Transactions**

 

The Company has advanced funds aggregating $240,000 tocertain officers in connection with various employment agreements.  These agreements provide for forgiveness ofthe advance over a four-year period.  Ifthe individual terminates his relationship with the Company, the unforgivenportion of the advances and any accrued interest are due and payable upontermination.  As of December 31, 2002,$140,000 of these advances has been forgiven and $100,000 was repaid to theCompany in 2000 in conjunction with the termination of the individuals’relationship with the Company. Additionally, there was a full-recourse note receivable from RandyWhite, former Chief Executive Officer, totaling approximately $150,000 accruinginterest at a rate of 7%, compounded quarterly, and due in 2005 which isincluded in other assets as of December 31, 2002.  These advances and the note receivable are secured by secondtrust deeds on the personal residences of the respective officers.  In addition, there are full-

 

F-16

----

 

recourse notes receivable from certain officers collateralized by thecommon stock of the Company.  In lieu ofcancellation of a note totaling approximately $529,000 due the Company and acash payment totaling approximately $133,000, the Company acquired 339,857shares of its own common stock from Mr. Birndorf, Chairman of the Board and anofficer of the Company, during 2002. There were full-recourse notes receivable from certain officers totalingapproximately $513,000 related to stock purchase agreements as of December 31,2002.

 

In November 1998, the Company entered into aStandstill Agreement and Right of First Negotiation (the “Agreement”) withGraviton, Inc. (“Graviton”), granting the Company an exclusive period of timeto negotiate a license to certain technologies licensed to and/or developed byGraviton.  In exchange for theAgreement, the Company advanced to Graviton through a secured loan the sum of$500,000.  In May 1999, the Companyadvanced to Graviton through a secured loan an additional $500,000, theproceeds of which were to be used by Graviton in part to secure additionalintellectual property rights which the Company could license.  In December 1999, the Company entered into aCollaboration and License Agreement with Graviton.  Pursuant to this agreement, the total loans of $1.0 million, plusaccrued interest, were exchanged for license fees which are reflected as“acquired technology rights, net”, in the amount of approximately $603,000 inthe accompanying consolidated balance sheets as of December 31, 2001.

 

In July 2002, the Company entered into an agreementwith Graviton, Inc. to terminate and release (the “July 2002 Release”) Nanogenand Graviton of their obligations under the Collaboration and License Agreementdated December 15, 1999.  The Companyreceived compensation from Graviton for termination of this arrangement in theform of 50,000 shares of Graviton Series D-Prime Preferred Stock and a waiverof the exercise price of $1.00 per share for a warrant to purchase 23,076shares of Graviton Series B Preferred Stock, which was exercised in July2002.  As Graviton is privately-held andcurrently does not maintain a market for its stock, the fair value of thesesecurities was determined to be immaterial.

 

In September 2002, Graviton commenced arecapitalization and a new round of financing. In exchange for Nanogen’s consent for the recapitalization and new roundof financing, Graviton issued to Nanogen a ten-year warrant to purchase 440,000shares of Series 1 Preferred Stock at a price of $2.00 per share, the price atwhich the September 2002 financing was completed.  As a result of the termination of the collaboration agreement,the Company recorded a loss of approximately $452,000 (the remaining carryingvalue of the acquired technology rights obtained in 1999) during 2002.

 

Mr. Birndorf, Chairman of the Board and an officer ofthe Company, is also a director of and investor in Graviton.  Following Graviton’s recapitalization andadditional financing, Mr. Birndorf held an approximate 3.5% ownership interestin Graviton and Mr. Buonaiuto, a director of the Company, held less than 1%ownership interest in Graviton as of December 31, 2002.  Given the interrelationship among theparties, the Company’s Board appointed a committee of disinterested Boardmembers to evaluate these transactions with Graviton.  After full disclosure of the above-referenced interrelationships,the Committee determined that it was in the best interest of the Company toenter into the license agreement which was executed on December 15, 1999, andthe subsequent July 2002 Release and September 2002 Settlement Agreement.  As of March 2003, the Company was notifiedthat Graviton is in the process of dissolution.

 

Mr. Birndorf owned an aircraft which was leased by alocal charter aircraft company. For the years ended December 31, 2002, 2001 and2000, the Company paid approximately $175,000, $420,000 and $137,000,respectively, to the local charter aircraft company for the Company’s use ofMr. Birndorf’s aircraft for business related travel.  Mr. Birndorf receives $1,500 per hour of usage when his aircraftis leased to outside parties. Mr. Birndorf received approximately $82,000,$207,000 and $59,000 for the years ended December 31, 2002, 2001 and 2000,respectively, as a result of the Company’s use of Mr. Birndorf’s aircraft.  The Company believes that the terms of thecharter arrangements are no less favorable to the Company than those that couldbe obtained from unrelated third parties, based on review of lease feespublished by other charter aircraft companies.

 

In December 2002, the Company entered into aseparation agreement with Randy White, its then Chief Executive Officer. Under the terms of the agreement, the Company made a one time net severancepayment of $58,000 in January 2003 to settle all outstanding obligationsbetween the two parties, including indebtedness to the Company amounting to$167,000.  The cost of this separationagreement has been accrued in the Company’s financial statements as of December31, 2002.

 

F-17

----

 

Also in December 2002, Kieran Gallahue, Nanogen’s thenPresident, resigned effective in January 2003. In connection with Mr.Gallahue’s resignation, the Company made a one time net paymentof approximately $384,000 in January 2003 to settle all outstandingobligations between the two parties, including indebtedness to the Companyamounting to approximately $300,000. The cost of this separation has been accrued in the Company’s financialstatements as of December 31, 2002.

 

**6.             EmployeeBenefit Plans**

 

***401(k) Plan***

 

The Company has a 401(k) defined contribution savingsand retirement plan (the “Plan”).  ThePlan is for the benefit of all qualifying employees and permits employees tomake voluntary contributions up to a maximum of 20% of base salary (asdefined), subject to annual limits.  TheBoard of Directors may, at its sole discretion, approve Companycontributions.  The CompensationCommittee of the Board of Directors approved a Company match in the form ofCompany stock equal to 25% or approximately $188,000 and 50% or approximately$335,000 of total employees’ contributions for the years ended December 31,2001 and 2000, respectively.  No matchwas approved for the year ended December 31, 2002.

 

***Retirement Plans***

 

The Company’s foreign subsidiary maintains separatedefined contribution retirement savings plans for each country in which itsemployees reside.  Participants maycontribute a portion of their annual salaries subject to statutory annuallimitations in each country.  TheCompany contributes to these plans as required by local statute and may makeadditional contributions at its discretion.

 

***Stock Option Plans***

 

Under the Company’s 1993 Stock Option Plan, as amendedin April 1995, 654,671 shares of common stock were reserved for issuance uponexercise of stock options granted by the Company.  In April 1995, the Board of Directors adopted the 1995 StockOption/Stock Issuance Plan under which 333,333 shares of common stock werereserved for issuance.  In April 1996,an additional 650,000 shares of common stock were reserved for issuance underthe 1995 Plan.  The plans provide forthe grant of stock options to officers, directors, employees and consultants tothe Company.

 

In August 1997, the Board of Directors adopted the1997 Stock Incentive Plan, under which 1,641,341 shares of common stock werereserved for issuance upon exercise of stock options granted by theCompany.  In November 1997, June 1999,June 2000, June 2001 and June 2002, an additional 600,000 shares, 925,000shares, 1,000,000 shares, 1,500,000 shares and 750,000 shares, respectively,were reserved for issuance under the 1997 Plan.

 

The exercise price of incentive stock options to begranted under the stock option plans shall not be less than 100% of the fairvalue of such shares on the date of grant. The exercise price of nonqualified stock options to be granted under theplans shall not be less than 85% of the fair value of such shares on the dateof grant.  Options granted prior toApril 13, 1998 (the date of the Company’s initial public offering) aregenerally exercisable immediately; however, options granted subsequent to theinitial public offering are generally exercisable only as they vest.  Shares granted under the Stock Option Plansgenerally vest at the rate of one fourth after one year and the remainderratably over the remaining three years. Options granted have a term of up toten years.

 

As of December 31, 2002, 629,249 shares are availablefor future grant under the stock option plans. The following table summarizesstock option activity through December 31, 2002:

 

|                              |   | **Number of  Shares** |   | **Price Per  Share** |      | **Weighted  Average  Exercise  Price Per  Share** |   |
|-----------------------------------|--------|-----------------------|--------|----------------------|-----------|---------------------------------------------------|--------|
| Outstanding  at December 31, 1999 |   | 1,259,268             |   | $                    | .02  | to                                                | $      | 21.88 |   | $ | 4.86 |   |
| Granted                           |   | 1,518,150             |   | $                    | 8.50      | to                                                | $      | 45.81 |   | $ | 33.17 |   |
| Exercised                         |   | (247,734              | )      | $                    | .15       | to                                                | $      | 9.63 |   | $ | 2.88 |   |
| Cancelled                         |   | (237,260              | )      | $                    | .15       | to                                                | $      | 45.81 |   | $ | 27.23 |   |
| Outstanding  at December 31, 2000 |   | 2,292,424             |   | $                    | .02       | to                                                | $      | 45.81 |   | $ | 21.50 |   |
| Granted                           |   | 2,000,641             |   | $                    | 3.70      | to                                                | $      | 12.09 |   | $ | 7.55 |   |
| Exercised                         |   | (259,258              | )      | $                    | .02       | to                                                | $      | 8.00 |   | $ | 3.34 |   |
| Cancelled                         |   | (1,082,243            | )      | $                    | .15       | to                                                | $      | 45.81 |   | $ | 24.36 |   |
| Outstanding  at December 31, 2001 |   | 2,951,564             |   | $                    | .90       | to                                                | $      | 45.81 |   | $ | 12.61 |   |
| Granted                           |   | 2,857,325             |   | $                    | 1.68      | to                                                | $      | 6.06 |   | $ | 3.01 |   |
| Exercised                         |   | (6,725                | )      | $                    | 3.78      | to                                                | $      | 5.41 |   | $ | 3.45 |   |
| Cancelled                         |   | (1,342,736            | )      | $                    | .90       | to                                                | $      | 45.81 |   | $ | 8.12 |   |
| Outstanding  at December 31, 2002 |   | 4,459,428             |   | $                    | .90       | to                                                | $      | 45.81 |   | $ | 7.82 |   |

 

F-18

----

 

The Company has the option to repurchase, at theoriginal issue price, unvested shares issued pursuant to early exercise ofoptions in the event of termination of employment or engagement.  There were 9,483 and 18,063 shares issuedunder the stock option plans subject to repurchase by the Company at December31, 2002 and 2001, respectively.

 

On January 26, 2001, the Compensation Committee of theBoard of Directors authorized a plan for certain option holders whereby eachholder could cancel certain of his or her vested and unvested options onFebruary 28, 2001 and receive a written promise from the Company to issue, on aone-for-one basis, new options which would be granted and priced at the fairmarket value on August 29, 2001.  Thisplan applied only to options granted to employees of the Company (excludingexecutive officers and directors) between January 1, 2000 and February 27,2001.  These options were exercisable onAugust 29, 2001 or when they vest, whichever is later.  The new options granted contain similarvesting schedules as the cancelled options. A total of 389,900 option shares were cancelled on February 28, 2001 and281,600 option shares were subsequently granted on August 29, 2001 related tothis plan.

 

In July 2002, the Compensation Committee of the Boardof Directors (“the Compensation Committee”) approved the issuance of employeeretention options for 969,500 shares of the Company’s common stock.  The options were issued to the Company’semployees and the employees of the Company’s subsidiary, Nanogen Europe B.V.pursuant to the Company’s 1997 Stock Incentive Plan, as amended.  Each incentive stock option grant will be50% vested on January 1, 2003 and 50% will vest ratably over the period January1, 2003 through July 26, 2004.

 

Following is a further breakdown of the optionsoutstanding as of December 31, 2002:

 
| **Range of  Exercise  Prices** |   | **Options  Outstanding** |   | **Weighted  Average  Remaining  Life in  Years** |   | **Weighted  Average  Exercise  Price** |   | **Options  Exercisable** |      | **Weighted  Average  Exercise  Price of  Options  Exercisable** |   |
|--------------------------------|--------|--------------------------|--------|--------------------------------------------------|--------|----------------------------------------|--------|--------------------------|-----------|-----------------------------------------------------------------|--------|
| $ .90 - $ 1.71                 |   | 109,611                  |   | 9.02                                             |   | $                                      | 1.55   |                     | 14,170    |                                                            | $      | .90 |   |
| $ 1.72 - $ 1.90                |   | 879,025                  |   | 9.59                                             |   | $                                      | 1.89   |                     | 6,748     |                                                            | $      | 1.87 |   |
| $ 1.92 - $ 2.14                |   | 500,867                  |   | 10.14                                            |   | $                                      | 2.00   |                     | 884       |                                                            | $      | 2.01 |   |
| $ 2.16 - $ 3.81                |   | 547,129                  |   | 8.66                                             |   | $                                      | 3.14   |                     | 125,381   |                                                            | $      | 3.60 |   |
| $ 3.83 - $ 5.11                |   | 501,921                  |   | 8.79                                             |   | $                                      | 4.73   |                     | 146,114   |                                                            | $      | 4.77 |   |
| $ 5.14 - $ 6.15                |   | 488,580                  |   | 8.72                                             |   | $                                      | 5.83   |                     | 205,719   |                                                            | $      | 6.01 |   |
| $ 6.22 - $ 7.00                |   | 494,638                  |   | 8.02                                             |   | $                                      | 6.70   |                     | 340,389   |                                                            | $      | 6.72 |   |
| $ 7.12 - $ 11.93               |   | 465,513                  |   | 8.06                                             |   | $                                      | 9.52   |                     | 329,302   |                                                            | $      | 9.21 |   |
| $ 12.09 - $ 41.75              |   | 168,604                  |   | 7.64                                             |   | $                                      | 20.39  |                     | 109,038   |                                                            | $      | 21.44 |   |
| $ 45.81 - $ 45.81              |   | 303,540                  |   | 7.10                                             |   | $                                      | 45.81  |                     | 222,290   |                                                            | $      | 45.81 |   |
| $ .90 - $ 45.81                |   | 4,459,428                |   | 8.76                                             |   | $                                      | 7.82   |                     | 1,500,035 |                                                            | $      | 13.51 |   |

 

***Restricted Stock Awards***

 

On July 27, 1999, the Board of Directors authorizedthe issuance of an aggregate of 251,000 shares of the Company’s common stock tocertain officers and key employees at a price per share of par value($0.001).  All of these shares werepurchased by the respective officers and key employees and were subject torepurchase if the officer or key employee terminated employment with theCompany prior to July 26, 2001. Deferred compensation aggregating $1.8 million has been recorded for theexcess of the fair market value of the stock on the date of the award over thepurchase price per share and has been fully amortized as of December 31, 2001.

 

Compensation expense related to options granted priorto the effective date of the Company’s initial public offering, as mentionedabove, and restricted stock awards, was $327,000 and $947,000 for the yearsended December 31, 2001, and 2000, respectively.

 

F-19

----

 

These restricted shares have been included in thesummary of stock option activity under the caption ***Stock Option Plans***above.

*** ***

***Stock Bonus Plan***

 

In April 2002, the Board of Directors adopted a StockBonus Plan.  This plan was approved bythe Company’s stockholders in June 2002 under which 250,000 shares of commonstock were authorized for issuance under the plan.  The purpose of this plan is to promote the long-term success ofthe Company and the creation of stockholder value by (a) encouraging keyemployees to focus on critical long-range objectives, (b) encouraging theattraction and retention of key employees with exceptional qualifications and(c) linking key employees directly to stockholder interest through increasedstock ownership.  This plan seeks toachieve this purpose by providing for payment of some or a portion of annualbonuses in the form of restricted shares. Amount of payout is based on Board approval.  As of December 31, 2002, there were no shares issued oroutstanding under this plan.

 

***Employee Stock Purchase Plan***

 

In November 1997, the Board of Directors approved theEmployee Stock Purchase Plan (the “Purchase Plan”), under which 300,000 sharesof common stock were authorized for issuance under the Purchase Plan.  In June 2001, an additional 150,000 shareswere reserved for issuance under the Purchase Plan. The Purchase Plan permitseligible employees of the Company to purchase shares of common stock, atsemi-annual intervals, through periodic payroll deductions.  Payroll deductions may not exceed 15% of theparticipant’s base salary subject to certain limitations, and the purchaseprice will not be less than 85% of the lower of the fair market value of thestock at either the beginning of the applicable “offering period” or the lastday of the accumulation period.  Eachoffering period is 24 months long, with new offering periods commencing everysix months, and an accumulation period is six months in duration.  During the years ended December 31, 2002,2001, and 2000, there were 75,009, 70,329, and 75,773 shares, respectively,issued under the Purchase Plan.

### * *

***Shares Reserved for Future Issuance***

 

The following shares of common stock are reserved forfuture issuance at December 31, 2002:

 

| Stock  options                |   | 5,088,677 |   |
|-------------------------------|--------|-----------|--------|
| Employee  stock purchase plan |   | 166,890   |   |
| Warrants  outstanding         |   | 365,863   |   |
|                          |   | 5,621,430 |   |

 

**7.             StockholderRights Plan**

 

In November 1998, the Company’s Board of Directorsadopted a Stockholder Rights Plan which provides for a dividend of onePreferred Stock Purchase Right for each share of common stock to stockholdersof record on November 30, 1998.  EachRight will entitle stockholders to buy one one-thousandth of a share of SeriesA Participating Preferred Stock of the Company at an exercise price of $50.00,subject to antidilution adjustments. The Rights will become exercisable only if a person or group becomes thebeneficial owner of 15% or more of the common stock, or commences a tender orexchange offer which would result in the offeror beneficially owning 15% ormore of common stock, which is not approved by the Company’s Board ofDirectors.  The Board of Directors isentitled to redeem the Rights at $0.01 per Right at any time prior to thepublic announcement of the existence of a 15% holder. If not earlier terminatedor redeemed, the Rights will expire on November 17, 2008.

 

On December 12, 2000, the Company’s Board of Directorsamended the Rights Plan to allow Citigroup Inc. and its affiliates andassociates to acquire the beneficial ownership of up to 25% of the outstandingcommon stock of the Company without triggering the ability of the Company’sstockholders to exercise the rights governed by the Rights Plan.  The Board of Directors required Citigroup tomaintain its status as a filer on Schedule 13G with respect to its beneficialownership of the Company’s common stock to take advantage of this exception.

 

F-20

----

 

**8.             StockRepurchase Plan**

 

In November 2002, the Board of Directors authorized alimited stock repurchase program under which the Company may purchase up to anaggregate of ten percent (10%) of its outstanding Common Stock from time totime.  Any purchases under the Nanogenstock repurchase program may be made by the Company during certain periods inthe open market or in privately negotiated transactions and may be initiatedand discontinued at any time.  For theyear ended December 31, 2002, Nanogen had acquired 366,857 shares of theCompany’s outstanding common stock for treasury at a cost of $710,000.

 

**9.             IncomeTaxes**

 

Significant components of the Company’s deferred taxassets and liabilities as of December 31, 2002 and 2001 are shown below. Avaluation allowance of $60.6 million has been established to offset thedeferred tax assets as realization of such assets is uncertain.

 
|                                         |   | **2002** |   | **2001** |   |
|----------------------------------------------|--------|----------|--------|----------|--------|
| Deferred  tax assets:                        |   |     |   |     |   |
| Net  operating loss carryforwards            |   | $        | 49,181 |     | $      | 39,462 |   |
| Research  and development credits            |   | 7,603    |   | 6,208    |   |
| Capitalized  research expenses               |   | 1,772    |   | 4,191    |   |
| Accrued  expenses                            |   | 788      |   | 835      |   |
| Amortization                                 |   | 440      |   | 551      |   |
| Other,  net                                  |   | 1,106    |   | 665      |   |
| Total  deferred tax assets                   |   | 60,890   |   | 51,912   |   |
| Valuation  allowance for deferred tax assets |   | (60,603  | )      | (51,662  | )      |
| Net  deferred tax assets                     |   | 287      |   | 250      |   |
| Deferred  tax liabilities:                   |   |     |   |     |   |
| Depreciation                                 |   | (287     | )      | (250     | )      |
| Net  deferred tax assets                     |   | $        | — |     | $      | — |   |

 

At December 31, 2002, the Company has federal andstate net operating loss carryforwards of approximately $127.0 million and$24.1 million, respectively.  Thedifference between the federal and State tax loss carryforwards is primarilyattributable to the capitalization of research and development expenses forstate tax purposes and the 60% percent limitation on state loss carryforwards.  The federal tax loss carryforwards willbegin expiring in 2006 unless previously utilized.  The state tax loss carryforwards will begin to expire in 2004,unless previously utilized. The Company also has federal and state research anddevelopment tax credit carryforwards of approximately $4.8 million and $3.4million, respectively, which will begin expiring in 2007 unless previouslyutilized.

 

Under Sections 382 and 383 of the Internal RevenueCode, the annual use of the Company’s net operating loss and creditcarryforwards may be limited because of cumulative changes in ownership of morethan 50% which occurred during 1995, 1997 and 1998.

 

**10.          CollaborativeAlliances**

 

***Hitachi, Ltd.***

 

Manufacturing Agreement

 

In January 2000, the Company executed an agreementwith Hitachi, Ltd., effective as of December 15, 1999, for the full-scalecommercial manufacturing and distribution of the NanoChip® Molecular BiologyWorkstation in specified research markets. Hitachi, Ltd.’s Instrument Groupprovides technology and technical support to aid in the manufacturing of theNanoChip® Molecular BiologyWorkstation’s components.

 

Hitachi, Ltd. has the right to be the sole distributorof NanoChip®Molecular Biology Workstations in Japan. Hitachi, Ltd. also has the non-exclusiveright to distribute NanoChip®Cartridges in Japan. Under this arrangement, the Company receives a royalty forNanoChip® Molecular BiologyWorkstations sold by Hitachi, Ltd. in Japan. The Company retains the right todistribute, directly or through others, NanoChip® Molecular BiologyWorkstations outside of Japan.  Inaddition, the Company manufactures NanoChip® Cartridges at itsSan Diego, California

 

F-21

----

 

facility for distribution worldwide. The Company also retains the rightto form other manufacturing and distribution agreements.

 

Pursuant to our manufacturing agreement with Hitachi,the Company is required to provide annual purchase commitments to Hitachi forNanoChip®Workstations.  As of December 31, 2002,the Company had a commitment to purchase approximately $2.4 million in NanoChip® Workstations fromHitachi through June 30, 2003.

 

Research CollaborationAgreement

 

In July 2000, the Company executed a ten-yearagreement with Hitachi, Ltd., Nissei Sangyo Co. Ltd. and Hitachi InstrumentsService Co. Ltd. of Japan (collectively, “Hitachi”) to develop, manufacture anddistribute additional potential products based on the parties’ proprietarytechnologies, potentially including, among other things, reduced-sizeinstruments for genetic testing, integrated amplification and point-of-caredetection.  The agreement provides thatthe parties will jointly determine which projects to prioritize over the termof the agreement. The agreement may be terminated before its expiration byeither party, subject to certain restrictions. Pursuant to the terms of theagreement, Hitachi and the Company each may contribute, toward the research anddevelopment efforts of the Company, up to $28.5 million in cash over theten-year period.  At a minimum theCompany is required to contribute on an annual basis funding for its owngeneral technology development in an amount equal to or greater than paymentsmade by Hitachi.  In addition, theCompany is liable to repay to Hitachi fifty percent of all funding provided byHitachi over an indefinite period of time. Repayment amounts are determined as a percentage of the Company’s grossNanoChip®Cartridge sales until the liability is paid in full.  Furthermore, Hitachi made an equity investment in the Company bypurchasing 74,590 shares of the Company’s common stock worth approximately $2.0million pursuant to a private sale by the Company based on a per share price of$26.813 (the fair market value as of the signing date of the Hitachiagreement).  Hitachi has the right to bethe exclusive distributor of collaboration products in Japan and, based uponthe attainment of minimum sales targets to be mutually agreed upon, in otherAsian countries.  The Company retainsthe exclusive right to distribute collaboration products outside of thesecountries.

 

Sponsored research revenue recognized under thisagreement totaled $1.4 million, $1.1 million, and $417,000 for the years endedDecember 31, 2002, 2001, and 2000, respectively.  In accordance with SFAS No. 68, the Company records sponsoredresearch revenue under this arrangement as expenses are incurred not exceedingscheduled payments under the agreement. The Company records a long-term liability for fifty percent of the fundsreceived from Hitachi upon the receipt of such funds. The amount owed toHitachi for proceeds received under this agreement was $3.0 million and $1.6million at December 31, 2002 and 2001, respectively.  The current portion of the long-term liability remains immaterialas payment amounts due under this obligation are determined as a percentage ofthe Company’s gross NanoChip®Cartridge sales which have not been significant to date.  As such, the Company has classified theentire balance of this liability as long-term.

 

Service Agreement

 

In October 2000, the Company entered into an agreementwith Hitachi for the service by Hitachi of the NanoChip® Molecular BiologyWorkstations in the United States after their sale or placement by the Companywith the Company’s customers.  TheCompany pays an agreed-upon amount (as specified in the agreement) to Hitachifor annual service for each Workstation covered under the agreement.  Nanogen amortizes the cost of the warrantyagreement over the service period.  Asthe Company provides the first year of warranty at no charge to the customer,the Company defers the portion of the Workstation sale revenue that relates tothe warranty agreement.  This deferredrevenue is then amortized into revenue ratably over the annual service period.  In subsequent years, the customer can pay anannual service fee to the Company and the Company will in turn pay Hitachi theannual service amount as specified in the agreement.  The amount charged to the customer by the Company is based uponthe cost of the service (i.e. the payment to Hitachi) plus an industry acceptedprofit margin for comparable service on similar types of products.  Both the service revenue and the serviceexpense are amortized ratably over the service period, generally one year.

 

In December 2001, this agreement was amended toinclude, among other things, a commitment by the Company to provide Hitachiwith a minimum of $200,000 in payments for warranty service in fiscal 2002 andthe expense was recorded over the relative service periods during fiscal 2002.

 

F-22

----

 

***Aventis Research and Technologies***

 

In December 1997, the Company entered into anagreement with Aventis Research and Technologies, an affiliate of Hoechst AG(“Aventis”) for, among other things, an exclusive research and developmentcollaboration relating to the development of molecular recognition arrays.  In December 1998, the Company and Aventisentered into a Collaborative Research and Development Agreement which, amongother things, extended the guaranteed term of the research program from two tothree years.  In conjunction with thisagreement, the Company issued to Aventis a warrant to purchase 120,238 sharesof common stock exercisable through December 2003, which was exercised byAventis in October 2000 at an agreed-upon exercise price of $6.17 per share.

 

In September 1999, the Company entered into twotechnology development programs with Aventis Research and Technologies, anaffiliate of Hoechst AG (“Aventis”), which focused on the development of geneexpression tools utilizing electronic bioarrays and the development of highthroughput screening tools for kinase analyses.  In total, the two programs provided $11.9 million in funding tothe Company through December 31, 2001. Under these programs, the Companydemonstrated quantitative, multiplexed and reliable gene expression monitoringon a Nanogen electronic microarray system. Additionally, the Company deliveredan electronic hybridization-based gene expression prototype detection system aswell as a prototype system for analyzing protein kinases. This prototype systemwas sold during the fourth quarter of 2001 to an affiliate of Aventis. Allproject milestones established under these arrangements were completed as ofDecember 31, 2001 at which time the agreements expired. The Company does notexpect to receive additional funding for these projects.

 

Revenue is primarily recognized under these agreementsas expenses are incurred, and totaled $6.4 million and $7.7 million for theyears ended December 31, 2001 and 2000, respectively.  Funding received in advance of incurred expenses is recorded asdeferred revenue until the expenses are incurred, and totaled none and $123,000at December 31, 2001 and 2000, respectively. No revenue was recorded in 2002 asthese projects were completed as of December 31, 2001.

 

In June 2001, the Company entered into agreements withAventis to create a new company, Nanogen Recognomics GmbH (“NanogenRecognomics”).  Nanogen Recognomics wasestablished to develop new products and applications for the NanoChip® System.  Nanogen Recognomics is sixty percent ownedby the Company and forty percent owned by Aventis and is based in Frankfurt,Germany.  Aventis provided the first $5million of funding for the operations of Nanogen Recognomics and alsocontributed intellectual property in the form of eighteen patents.  The Company is also required to spend anaggregate of $5.5 million, at the rate of $1.1 million per year beginning April1, 2001, for its own general technology development which benefits thecommercialization and development of potential Nanogen Recognomics products.This funding is recorded as research and development expense in the Company’sstatement of operations as incurred. The amounts contributed by Aventis are spent by the joint venture andreported in the operating results of the joint venture.  Aventis has no further commitments toprovide funding beyond the first five years of operation.  In addition, Nanogen Recognomics will ownseveral patent applications filed jointly by the Company and Aventis.  The Company has licensed certain aspects ofits NanoChip®technology to Nanogen Recognomics and will seek to commercialize new productsand applications developed by Nanogen Recognomics.  Aventis retains the right to utilize the former Aventis patentportfolio in fields outside of Nanogen Recognomics.  In conjunction with the agreement to form Nanogen Recognomics,the Company issued a warrant to Aventis to purchase 315,863 shares of commonstock exercisable through July 17, 2006 at an agreed upon price of $9.828 pershare.   The value of this warrant, asdetermined by the Black-Scholes valuation model, was $1.2 million, is includedin other assets in the accompanying consolidated financial statements and isbeing amortized over a two and a half year period, the estimated period forwhich the $5 million in funding will provide for operating expenses.Assumptions used in determining the value of the warrant were as follows:dividend yield of 0%, expected volatility of 70%, risk-free interest rate of6.5%, expected life of 5 years, stock price of $6.79 per share, and an exerciseprice of $9.828 per share.  In the eventNanogen Recognomics should run out of funds, the Company will take over wind-downcosts and Nanogen Recognomics will be restructured to hold the original patentscontributed by Aventis and any jointly owned patents. The restructured companywill collect royalties, if any, and pay the equity owners accordingly. TheCompany’s exclusive commercialization license will continue for 10 years afterrestructuring.

 

F-23

----

 

The results of operations for Recognomics are fullyconsolidated in the Company’s financial statements.  The total operating loss of Recognomics is reflected as areduction of the “minority interest in consolidated subsidiary” liabilityaccount and totaled $2.2 million and $907,000 for the years ended December 31,2002 and 2001, respectively.

 

**11.          LicensedTechnology**

 

The Company has acquired various licenses totechnologies which are incorporated into certain of the Company’s currentproducts or products under development. The Company capitalizes the cost (which includes cash and equityconsideration) in conjunction with the acquisition of these licenses andamortizes the cost over the expected life of the product.  In June 2002, the Company issued 254,151shares of the Company’s common stock in a private stock transaction valued at$750,000, based on the closing price of the Company’s stock at the effectivedate, to a licensor in exchange for license rights. Pursuant to the licenseagreement, Nanogen must either (a) register the common stock one year from thedate of the agreement and provide the licensor with additional shares toincrease the value of the registered shares to $750,000 or (b) buy back theshares at a price of $750,000.  In April2002, the Company issued a warrant to a licensor which is exercisable throughApril 12, 2007 to purchase 50,000 shares of the Company’s common stock at a pershare price of $4.10, the fair market value on the effective date of theagreement.  The value of the warrant wasdetermined to be $122,000 using the Black-Scholes valuation model.  Assumptions used in determining the value ofthe warrant were as follows: dividend yield of 0%, expected volatility of 65%,risk-free interest rate of 5.5%, expected life of 5 years, stock price of $4.10per share, and an exercise price of $4.10 per share.  The warrant has a term of five years, and was issued in returnfor license rights.

 

In July 2002, the Company and Graviton, Inc. enteredinto an agreement to terminate and release Nanogen and Graviton of theirobligations under the Collaboration and License Agreement dated December 15,1999 (see footnote 9 for further discussion of this transaction) whichoriginally resulted in acquired technology rights of $1 million by the Companyin fiscal 1999.  In September 2002, theCompany and Graviton, Inc. entered into a subsequent agreement to terminate andrelease Nanogen and Graviton of their obligations under the Collaboration andLicense Agreement dated December 15, 1999 and the termination and releaseagreement entered into in July 2002. As a result of the termination of thiscollaboration arrangement, the Company recorded a loss of approximately$452,000 included in research and development expenses (the remaining value ofthe acquired

 

F-24

----

 

technology rights obtained in 1999) during 2002.  As of March 2003, the Company was notifiedthat Graviton is in the process of dissolution.

 

**12.          Contractand Grant Revenue**

 

In September 1998, the Company was awarded a contractby the Space and Naval Warfare Systems Center San Diego (“SSC San Diego”) forthe Defense Advanced Research Projects Agency (“DARPA”) in an amount totalingapproximately $2.4 million over a two-year period.  The goal of the contract is to develop and refine electronicallydriven sample preparation protocols on specifically designed microelectronicchips.  In August 2000, a second DARPAcontract was granted to Nanogen in an amount totaling approximately $1.6million over a two-year period which was subsequently reduced to $1.4 million.  The contract is focused on developing anelectronic sample preparation chip for the detection of biowarfare agents fromblood samples.  Revenue is recognizedunder these agreements as expenses are incurred and totaled $601,000, $737,000,and $1.1 million for the years ended December 31, 2002, 2001, and 2000, respectively.

 

In October 2000, the Company entered into acooperative agreement with the U.S. Army Medical Research Acquisition Activity(“USAMRAA”) in an amount totaling approximately $1.1 million over a three-yearperiod.  The objective of the USAMRAAagreement is to develop an arrayable electronic system for the identificationof biological warfare or infectious disease agents.  In October 2001,****the Company entered into an additionalcooperative agreement with USAMRAA in the amount totaling $1.5 million over athree-year period. The second cooperative agreement is to develop miniaturizedelectronic devices for isolation and detection of biological warfare andinfectious disease agents.  Inconjunction with the agreements, funding provided by the agency is matcheddollar-for-dollar with Nanogen funds. Revenue is recognized under theseagreements as expenses are incurred and totaled $688,000, $340,000, and $6,000for the years ended December 31, 2002, 2001, and 2000, respectively.

 

The National Institute of Justice, U.S. Department ofJustice, provides funding for the development of a chip based genetic detectorfor rapid DNA-based identification of individuals.  Revenue is recognized under these agreements as expenses are incurredand totaled $232,000, $383,000, and $599,000 for the years ended December 31,2002, 2001, and 2000, respectively.

 

The National Institute of Health, U.S. Department ofHealth and Human Services, provides funding for the development of a compactcentrifugal microfluidics based BWA analyzer. Revenue is recognized under this agreement as expenses are incurred andtotaled $25,000 for the year ended December 31, 2002.

 

**13.          GeographicSales and Significant Customers**

 

The Company has determined that, in accordance withSFAS No. 131, it operates in one segment as it only reports operatingresults on an aggregate basis to chief operating decision makers of theCompany. The Company had product sales and license fees revenues by region asfollows for the years ended December 31, 2002, 2001, and 2000 (inthousands):

 

|                |   | **2002** |   | **2001** |   | **2000** |   |
|---------------------|--------|----------|--------|----------|--------|----------|--------|
| Customer  Location: |   |     |   |     |   |     |   |
| United  States      |   | $        | 12,554 |     | $      | 1,097    |   | $ | 571 |   |
| Europe              |   | 1,664    |   | 943      |   | 348      |   |
| Mexico/Canada       |   | 10       |   | 205      |   | —   |   |
| Total               |   | $        | 14,228 |     | $      | 2,245    |   | $ | 919 |   |

 

Revenue from customersrepresenting 10% or more of total revenue during 2002, 2001 and 2000 is asfollows:

 

|                 |   | **2002** |   | **2001** |   | **2000** |   |
|----------------------|--------|----------|--------|----------|--------|----------|--------|
| Sponsored  research: |   |     |   |     |   |     |   |
| Customer  A          |   | —   | %      | 57       | %      | 69       | %      |
| Customer  B          |   | —   | %      | 10       | %      | 4        | %      |
| License  fees:       |   |     |   |     |   |     |   |
| Customer  C          |   | 63       | %      | —   | %      | —   |   |

 

F-25

----

 

**14.          QuarterlyFinancial Data (unaudited)**

 

Summarized quarterly financial data for fiscal 2002and 2001 are as follows (in thousands, except per share data):

 

|                                                      |   | **1st Quarter** |   | **2nd  Quarter** |   | **3rd  Quarter** |   | **4th  Quarter** |   |
|-----------------------------------------------------------|--------|-----------------|--------|------------------|--------|------------------|--------|------------------|--------|
| Fiscal  2002                                              |   |            |   |             |   |             |   |             |   |
| Revenues                                                  |   | $               | 1,533  |             | $      | 1,951            |   | $                | 1,551  |   | $ | 12,144 |   |
| Operating  expenses (2)                                   |   | 10,392          |   | 11,609           |   | 10,932           |   | 10,928           |   |
| Income  (loss) from operations                            |   | (8,859          | )      | (9,658           | )      | (9,381           | )      | 1,216            |   |
| Net  income (loss)                                        |   | (7,532          | )      | (8,521           | )      | (8,224           | )      | 2,031            |   |
| Net  income (loss) per share – basic and diluted (1) |   | $               | (0.35  | )                | $      | (0.39            | )      | $                | (0.38  | ) | $ | 0.09 |   |
|                                                      |   |            |   |             |   |             |   |             |   |
| Fiscal  2001                                              |   |            |   |             |   |             |   |             |   |
| Revenues                                                  |   | $               | 2,939  |             | $      | 2,715            |   | $                | 3,219  |   | $ | 2,296 |   |
| Operating  expenses (2)(3)                                |   | 10,538          |   | 15,561           |   | 11,930           |   | 11,106           |   |
| Loss  from operations (3)                                 |   | 7,599           |   | 12,846           |   | 8,711            |   | 8,810            |   |
| Net  loss                                                 |   | 6,279           |   | 11,750           |   | 7,020            |   | 7,452            |   |
| Net  loss per share – basic and diluted (1)          |   | $               | (0.30  | )                | $      | (0.56            | )      | $                | (0.33  | ) | $ | (0.35 | ) |

 

----

(1)   Net loss per share is computed independentlyfor each of the quarters presented. Therefore, the sum of the quarterly net loss per share will notnecessarily equal the total for the year.

(2)   Since a significant portion of the Company’srevenues are derived from sponsored research and contracts and grants and therelated costs are reported as research and development expense, the Companychose to disclose operating expenses rather than cost of sales as required.

(3)   To conform to current year presentation,operating expenses for the three months ended September 30, 2001 and December31, 2001 as reflected in the Form 10-K include operating losses of theCompany’s joint venture totaling $547,000 and $487,000, respectively.  These amounts were previously reported inthe Form 10-K for the period ended December 31, 2001 as an offset to researchand development expenses at year end.

 

**15.          SubsequentEvent**

 

In February 2003, the Company sold 3,000,000 shares ofCombiMatrix common stock for net proceeds totaling $4.5 million and recognizeda realized loss of approximately $3.6 million in the first quarter of 2003.

 

F-26

----

 

**NANOGEN, INC.**

**EXHIBIT INDEX**

 

 
| **Exhibit No.** |   | **Description**                                                                                   |
|-----------------|--------|---------------------------------------------------------------------------------------------------|
|            |   |                                                                                              |
| 10.21           |   | Separation Agreement  between Registrant and Kieran T. Gallahue, dated as of January 2, 2003      |
| 10.22           |   | Separation Agreement between  Registrant and Dr. Vance R. White, dated as of December 11, 2002    |
| 10.23           |   | Employment Agreement  between Registrant and Ira Marks, dated January 24, 2003                    |
| 10.24           |   | Employment Agreement  between Registrant and Bruce A. Huebner, dated December 1, 2002             |
| 10.25           |   | Employment Agreement  between Registrant and William Franzblau, dated January24, 2003             |
| 10.26           |   | Employment Agreement  between Registrant and David Macdonald, dated January 24, 2003              |
| 10.27           |   | Employment Agreement  between Registrant and Graham Lidgard, dated January 24, 2003               |
| 10.30           |   | Indemnification  Agreement between Registrant and Bruce A. Huebner, dated as of December 1,  2002 |
| 10.31           |   | Indemnification  Agreement between Registrant and Graham Lidgard, dated as of January 24, 2003    |
| 23.1            |   | Consent of Ernst &  Young LLP, independent auditors.                                          |
| 99.1            |   | Chief Executive Officer  and Chief Financial Officer Certification Letters, dated March 28, 2003  |
| 99.2            |   | Nanogen, Inc. Ethics  Policy                                                                      |

 

----