**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

----

 

**FORM 10-K**

**ý****  ANNUAL REPORT PURSUANT TOSECTION 13 OR 15(d) OF**

**THE SECURITIES EXCHANGE ACT OF 1934**

**For the fiscal year ended December31, 2001**

**OR**

**o**** TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF**

**THESECURITIES EXCHANGE ACT OF 1934**

**For the transition period from                 to            **

**Commission File No. 0-21130**

----

 

**ENCHIRA BIOTECHNOLOGY CORPORATION**

(Exactname of registrant as specified in its charter)

** **

| **Delaware**                                                   |   | **04-3078857**                    |
|----------------------------------------------------------------|--------|-----------------------------------|
| (State or other jurisdiction of incorporation or organization) |   | (IRS Employer Identification No.) |
|                                                           |   |                              |
| **Enchira Biotechnology Corporation**                          |   | **77381**                         |
| **4200 Research Forest Drive**                                 |   | (zip code)                        |
| **The Woodlands, Texas**                                       |   |                              |
| (Address of principal executive offices)                       |   |                              |
|                                                           |   |                              |
| **(281) 419-7000**                                             |
| (Registrant’s telephone number, including area code)      |

----

Securities registered pursuant to Section 12(b) of the Act: **None**

Securities registered pursuant to Section 12(g) of the Act:

 

Title of Class

Common Stock, parvalue $.01 per share

Preferred StockPurchase Rights

 

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

 

Indicate by check mark if disclosure of delinquentfilers pursuant to Item 405 of Regulation S-K is not contained herein, and willnot be contained, to the best of registrant’s knowledge, in definitive proxy orinformation statements incorporated by reference in Part III of this Form 10-Kor any amendment to this Form 10-K. o

 

The aggregate market value of the voting stock held bynon-affiliates of the registrant was approximately $3,766,343 as of March 8,2002, based on the closing sales price of the registrant’s common stock on theNasdaq National Market on such date of $0.28 per share and assuming fullconversion of the registrant’s Series B Convertible Preferred Stock.  For purposes of the preceding sentence only,all directors, executive officers and beneficial owners of ten percent or moreof the common stock are assumed to be affiliates.  As of March 8, 2002, 10,905,173 shares of common stock wereoutstanding.

 

Certain sections of the registrant’s definitive proxystatement relating to the registrant’s 2002 annual meeting of stockholders,which proxy statement will be filed under the Securities Exchange Act of 1934within 120 days of the end of the registrant’s fiscal year ended December 31,2001, are incorporated by reference into Part III of this Form 10-K.

 

 

*When used in this document, thewords “anticipate,” “believe,” “expect,” “estimate,” “project” and similarexpressions are intended to identify forward-looking statements.  Such statements are subject to certainrisks, uncertainties and assumptions. Should one or more of these risks or uncertainties materialize, orshould underlying assumptions prove incorrect, actual results may varymaterially from those anticipated, believed, expected, estimated orprojected.  For additional discussion ofsuch risks, uncertainties and assumptions, see “Item 1. Business—Risk Factors”included elsewhere in this report. Enchira may be referred to as “we”, “us”, or “our” in this document.*

 

**Part I.**

 

**Item 1. * Business***

 

**Overview**

 

Enchira Biotechnology Corporation (“Enchira”, “EBC” orthe “Company”) is a drug discovery and development company that is engaged indevelopment of therapeutic proteins to inhibit receptor tyrosine kinases(“RTKs”) and their role in certain types of cancer.  RTKs are key elements in cell signaling pathways that have animportant role in normal cell regulatory processes, but aberrant signaling bysome RTKs has been implicated in a number of cancers including breast,colorectal and prostate cancers.  We aredeveloping “Anti-Cancer Ligand” or “ACLÔ”proteins that bind to the external domain of these kinases and block theiractivation and signaling processes.  Ourdevelopment efforts are focused on validated oncology targets within theEpidermal Growth Factor and Insulin-like-Growth Factor families.  In 2000, we entered into a CollaborationAgreement with The University of Texas M. D. Anderson Cancer Center (“M.D.Anderson Cancer Center”) to advance the development of our ACLÔproteins.

 

We made substantial progress in the discovery anddevelopment of our ACLÔ proteins in 2001using our proprietary Drug Candidate Optimization Platform (DCOPÔ)technologies, which are an integrated suite of technologies for proteinengineering, screening, and production. We plan to move a number of candidates to pre-clinical development in2002 under the collaboration agreement with the M.D. Anderson Cancer Center.

 

We believe that our ACLÔproteins will have significant advantages in selectivity, tumor penetration andmanufacturing costs over other approaches for inhibition of RTKs.  We plan to apply our internal scientific andtechnical resources, combined with those of our collaborators andco-development partners, to drive our ACLÔproteins through pre-clinical evaluations and development, clinical trials andultimately to production and marketing. As we develop our therapeutics, we will pursue commercialization optionsincluding additional research collaborations, joint ventures and out-licensingopportunities.  We also intend to enterinto co-development partnerships based on our proprietary discoverytechnologies that will generate up-front payments and research funding, plusmilestone and royalty payments.

 

Enchira’s offices and laboratories are located in TheWoodlands, Texas, near the Texas Medical Center in Houston.  Our facilities include modern laboratoriesfor molecular biology, protein expression and production, mammalian cellculture, and tumor biology research. Our expertise and proprietary drug discovery capabilities span molecularand cellular biology, microbiology, enzymology, high throughput screening,chemistry and bioinformatics.  AScientific Advisory Board of prominent researchers in protein kinases,oncology, cytokine expression and production, pre-clinical testing and clinicalevaluation of new cancer therapeutics rounds out our technical expertise. Until2000, the Company was engaged in the development of biocatalysis technology forthe upgrading of hydrocarbons, primarily biodesulfurization (BDS). The Companyis maintaining its BDS patent portfolio and seeking opportunities to licensethe technology to third parties for the further development andcommercialization of the process.

 

**The Molecular Oncology Opportunity**

 

The recent understanding of the molecular basis ofcancer has led to the development and commercialization of a number of drugsaimed specifically at inhibition of receptor tyrosine kinases, or RTKs.  RTKs are large cell membrane-spanningproteins that are involved in transmission across the cell membrane of signalsfor cell growth and differentiation. Irregularities in expression of certain RTKs have been associated withprogression of tumors from benign to malignant in a variety of cancers.  RTK targets that have already been validatedinclude the

 

2

----

 

Epidermal GrowthFactor Receptor (EGFR) family, the Insulin-like Growth Factor-I Receptor(IGF-IR), Platelet-derived Growth Factor Receptor (PDGFR), Vascular EndothelialGrowth Factor Receptor (VEGFR), and others. Two recently approved drugs that act via molecular inhibition oftyrosine kinase targets are Genentech’s Herceptin®, a monoclonal antibody thattargets the HER-2 growth factor receptor for treatment of breast cancer, andNovartis’ GleevecÔ, a small moleculetherapeutic that targets the Bcr-Abl tyrosine kinase for treatment of chronicmyeloid leukemia and stomach cancer.  Examplesof new therapeutics under development for RTK targets are listed in Table1.1.  Although by no means inclusive,this list reflects the strong interest in development of receptor tyrosinekinase inhibitors as therapeutic agents.

 

**Table1.1:  Examples of Therapeutics UnderDevelopment with Molecular Oncology Targets**

 
| **Product Name**              |   | **Company**     |   | **Product  Type**          |   | **Molecular  Target** |   | **Indication(§)**                                                       |
|-------------------------------|--------|-----------------|--------|----------------------------|--------|-----------------------|--------|------------------------------------------------------------------------------|
| IressaÔ  (ZD1839)   |   | AstraZeneca     |   | Synthetic small  molecule  |   | EGFR                  |   | Non Small Cell  Lung Cancer (NSCLC)                                          |
| TarcevaÔ  (OSI-774) |   | OSI/ Genentech  |   | Synthetic small  molecule  |   | EGFR                  |   | NSCLC,  pancreatic cancer, others                                            |
| ErbituxÔ  (C225)    |   | ImClone         |   | Monoclonal  Antibody (MAb) |   | EGFR                  |   | Colorectal  cancer; head and neck cancer                                     |
| ABX-EGF                       |   | Abgenix         |   | MAb                        |   | EGFR                  |   | Renal cancer,  prostate cancer, colorectal cancer                            |
| AvastinÔ                 |   | Genentech       |   | MAb                        |   | VEGFR                 |   | NSCLC, breast  cancer, renal cancer, others                                  |
| SU101  (Leflunomide)          |   | Sugen/Pharmacia |   | Synthetic small  molecule  |   | PDGFR                 |   | Hormone  refractory prostate cancer, ovarian cancer, glioblastoma multiforme |

 

----

(§) Source: NCI Clinical Trials database, www.nci.nih.gov

 

The cancer therapeutics market is expected to growsignificantly in the next decade as the leading edge of the baby-boomers(approximately 70 million) enters the high-risk years.  We believe that new protein-based therapeuticsthat address molecular oncology targets, particularly RTKs, are attractivebusiness opportunities for Enchira.  Ourcore expertise in molecular biology, protein expression and purification,analytical chemistry, and tumor biology is well matched to drug discoveryprocesses in this field.  We havedeveloped proprietary gene synthesis methods that enable us to create the vastlibraries of candidate protein ligands that are needed for discovery ofspecific inhibitors for RTKs. Additionally, we can take full advantage of a myriad of newly developedindustry tools that accelerate R&D, such as laboratory automation advancesand new phenotype/genotype display technologies that facilitate screening oflarge libraries.  Enchira is locatednear M.D. Anderson Cancer Center, one of the world’s leading cancer centers,and the Texas Medical Center; the close proximity to oncology researchers inthese institutions is an advantage in developing and maintaining collaborativeresearch programs.  Lastly, large pharmaceuticaland biotechnology companies have under-stocked development pipelines and areeager for new, proprietary drugs that they can bring to market.

 

Enchira is focused on well-validated targets.  Current targets are three members of theEpidermal Growth Factor Receptor family (EGFR (HER-1), HER-2/*neu*, and ErbB-3 (HER-3)) and theInsulin-like Growth Factor-I Receptor (IGF-IR).  These targets have been implicated in a number of cancers,including breast, prostate and colorectal cancers.  We plan to pursue indications with clear unmet clinical needs,which may lead to an expedited FDA review process.  In addition, we plan to work with our collaborators and otherscientists to identify and license other ligand/receptor pairs that willbenefit from the Enchira approach.

 

3

----

 

**BusinessStrategy**

 

We made substantial progress in discovery anddevelopment of our ACLÔ proteins in 2001,and we plan to move a number of candidates to pre-clinical development in2002.  We believe that these activitieswill attract the large pharmaceutical and biotechnology partners necessary tocommercialize ACLÔ proteins. Large pharmaceutical companies have often looked to biotech as a sourceof new drug candidates. Historically, forty percent of Phase III drugs fromlarge pharmaceutical companies were brought into their organizations fromoutside. We plan to enter into co-development agreements to commercialize ourfirst ACLÔ products. In addition, we expect to out-license ACLTM products or other technology,particularly in areas outside molecular oncology.  Ultimately, we plan to develop and commercialize ACLTM productsindependently through contract manufacturing of the product.  We also plan to construct an intellectualproperty (IP) portfolio that protects our discovery technologies and the ACLÔproteins that advance to pre-clinical development.

 

Commercialization is a long and costly process.  Our technology and infrastructure haveallowed us to compress the early stages of product development.  Some compression of the standardpre-clinical timeline is also expected because of the experience of ourcollaborators and scientific advisors, the intrinsic differences between biologicsand more traditional chemotherapeutics, and our close relationship withclinical experts whose involvement can minimize mistakes and wasted time.

 

**Description of Enchira’s Technology**

 

*Oncogenic Protein Tyrosine Kinases*

 

Sequencing of the human genome has revealed thepresence of 600 to 1,000 different protein tyrosine kinase (PTK) enzymes. Theseenzymes are key elements of cellular pathways that transmit signals for celldivision, growth or programmed cell death (apoptosis) by catalyzing the transferof phosphate from adensoine triphosphate (ATP) to tyrosine residues inproteins.  An important class of kinasesis the RTKs.  RTKs span the cellmembrane and relay information, transmitted via extracellular cytokines, to theinterior of the cell.  The enzymatickinase domain is located within the cell interior, whereas the receptor bindingdomain extends into the extracellular space. When extracellular proteins, called “ligands”, bind to theircorresponding (or “cognate”) receptors, the internal kinase domain isactivated, triggering the phosphorylation reactions and a subsequent cascade ofmetabolic events within the cell.  Theactivity of RTKs and their cognate ligands are normally well regulated, but,when the activities of RTKs are altered by mutations, control is lost andcancer can result.  Over 30 RTKs havebeen directly linked to cancer.

 

Substantial evidence exists that blocking target RTKscan stop tumor cell growth and proliferation. Investigators have formulated two primary strategies to block theactivation of RTKs.  The first approachis to use antibodies that attach to the extracellular portion of the RTK toblock binding of the cognate ligand and thus block activation of the internalkinase activity.  One example isGenentech’s Herceptin®, a monoclonal antibody (MAb) specifically directed atthe receptor domain of HER-2/*neu*.  Large proteins, such as antibodies, may havelimited tumor penetration due to their large size (150 kDa) and, in general,monoclonal antibodies have the risk of certain toxic immunologicalreactions.  Monoclonal antibodies arealso expensive to manufacture, especially with the current shortage of proteinproduction capacity.  The second approachis to identify small molecule ATP analogs or ATP “mimics” that will bind in theinternal ATP binding pocket and inhibit kinase activity directly.  AstraZeneca’s IressaÔis an example of this strategy. Designing the desired selectivity for a specific RTK is difficult inthis approach, since the ATP binding pocket is a feature that hundreds ofkinases have in common.  In addition, itmay be difficult to administer sufficient amounts of the ATP mimic to competewith ATP for the enzymatic pocket, since ATP is a very common molecule in thecell.

 

4

----

 

*Enchira’s Anti-Cancer Ligands (ACL**Ô) Proteins*

 

Anti-Cancer Ligand (ACLÔ)proteins under development at Enchira represent a third approach.  These proteins are designed to be similar tothe cognate ligand, but will bind to the receptor, block the cognate ligand,and thus block activation of the internal kinase domain.  This approach has several advantages.  First, an ACLÔprotein can display exquisite specificity, at least as specific as a MAb, and100-1,000 fold higher binding affinity than the cognate ligand.  Second, the ACLÔproteins are relatively low molecular weight, (7 kDa), typically 5-10% of thesize of MAbs, so deeper penetration into tumor tissue is expected. The ACLÔprotein approach overcomes the specificity issues that plague small moleculedrug design, and yet should provide enhanced tumor penetration compared withantibodies.  Thirdly, Enchira’s ACLÔproteins can be manufactured more cost effectively than MAbs.

 

Our scientists are not the first to propose creatingligands that bind to RTKs.  Others havetried and failed because they were only able to make small, simple changes inthe cognate ligand.  “Loss of function”mutants could be made readily with this approach, but researchers could notcreate molecules with dramatic new properties, such as stronger binding  (10-1,000 times higher binding constants)yet no activation of the kinase domain.

 

We are developing our ACLÔproteins using our Drug Candidate Optimization Platform (DCOPÔ)technology.  Large libraries offunctional ACLÔ proteins are first synthesized using ourMassively Parallel Gene Synthesis (MPGSÔ)technology.  The objective is tosynthesize in parallel a designed set of proteins, up to trillions ofmolecules, that are analogs of the target protein structure.  Automated screening methods are then used tosort the candidates and identify proteins that inhibit normal ligand-dependentkinase activity, bind to the target receptor, and inhibit ligand-dependenttumor cell proliferation.  Candidatesthat pass all these criteria are considered “hits”.   The next step is pre-clinical evaluation of the effect of theACLÔ protein on tumor growth in mouse xenograftsystems and toxicity testing.  Largeamounts of the ACLÔ proteins are needed for the evaluation of“hits”, and we can meet this need with in-house technologies in proteinexpression, fermentation, recovery and purification.  Successful candidates will enter clinical trials.

 

Among the members of these libraries, “agonists”, orstimulators, of RTKs are also expected to be present.  These agonists may have value as therapeutic agents forindications other than cancer.

 

*Specific Targets*

 

Our development efforts focus on validated molecularoncology targets within the Epidermal Growth Factor and Insulin-like GrowthFactor families.  During 2001, wecreated a pipeline of early-stage ACLÔprotein candidates.  Pre-clinicalevaluation of the most promising ACLÔ proteins isplanned in 2002 under the collaboration agreement with the M.D. Anderson CancerCenter.

 

*Antagoniststo Epidermal Growth Factor Receptor Family*

Research and development activities are directedtoward three RTKs of the Epidermal Growth Factor family.  Each of these targets has been implicated incancers, and structural similarities within the family enable us to achievehigh efficiency in our drug discovery and development activities. EGFR (alsoknown as HER-1 and ErbB-1) is implicated in breast, colorectal and prostatecancer.  HER-2/*neu* (also known as ErbB-2) is implicatedin breast cancer.   HER-3 (ErbB-3) isimplicated in colorectal cancer.  Thecognate ligand for EGFR is termed EGF and that for HER-3 is termedHeregulin.  The properties of EGF havebeen extensively studied, but, in contrast, a cognate ligand for HER-2 has notyet been identified to our knowledge.

 

We have created libraries of EGF-like ACLÔproteins.  Several libraries have beenscreened, and antagonists to EGFR kinase activity have been isolated.  We plan to begin pre-clinical evaluation anddevelopment in 2002.  The libraries arealso being screened against HER-2/*neu*toidentify ACLÔ proteins

 

5

----

 

that could antagonize its activity.  The “orphan” HER-2 receptor plays animportant role in breast cancer, and identification of ligands that antagonizeits activity would be a significant advance.

 

*Antagonistsof Insulin-like Growth Factor-I Receptor (IGF-IR)*

Insulin-like Growth Factor Receptor (IGF-IR) is awell-validated oncology target.  Infact, a high serum level of the ligand, IGF-I, is an indicator of underlyingprostate cancer. The importance of IGF-IR has been demonstrated in a number oflaboratories by using antisense experiments directed against the receptor, MAbblocking experiments, dominant negative mutants and by using broad spectrumkinase inhibitors.  Large pharmaceuticalcompanies have also targeted the IGF-IR system, aiming to develop smallmolecule inhibitors to interfere with kinase activity or to manipulate theseries of extracellular binding proteins that appear to modulate concentrationsof free IGF-I in the blood.  The kinasedomain of IGF-IR and the Insulin Receptor (IR) are very similar, however, so ithas been impossible to achieve the specificity required to inhibit IGF-IRactivity while not affecting IR. Inhibition of the IR system could lead to systemic diabetes-likesymptoms in the patient.

 

IGF-I is a highly suitable target for Enchira’s ACLTMapproach.  Many proteins related to thecognate ligand (IGF-I) are described in public sequence databases, and we haveused this information to synthesize ACLÔprotein libraries.  Methods toefficiently produce, recover and purify ACLÔproteins have also been developed. Critical elements of the screening program include identification ofACLTM proteins that bind more strongly than IGF-I to the receptor but which donot interact with the Insulin Receptor. In addition, interactions with the IGF-I binding proteins must also beconsidered.  We are currently developingappropriate screens for these and other criteria.

 

*OtherReceptor/Ligand Pairs*

Over thirty RTKs have been linked to cancer inhumans.  All of these are potentialtargets for development of ACLTM proteins. We are currently evaluating a number of these targets, including membersof the PDGFR, VEGFR, Epithelial Cell Kinase (Eck/EphA2) and the TEK/TIE2endothelial cell RTK families.

 

**Enchira’s Technology Platforms**

 

Enchira’s Drug Candidate Optimization Platform (DCOPÔ)technologies are an integrated suite of technologies for protein engineering,screening and production.  The drugdiscovery process begins with the Massively Parallel Gene Synthesis (MPGSTM)technology.  The MPGSTM technology is arational, synthetic method that uses sequence data for molecules that arerelated (in sequence or function) to the target ligand to design and preparelibraries of analog proteins that differ in amino acid sequence by up to 30%from that of the cognate ligand.  Theselibraries are rich in functional molecules; based on experience to date, morethan 65% of the members display some activity toward the target.  The ability to generate vast libraries is akey advantage in the search for proteins with the desired bindingcharacteristics (100-1,000 fold higher than the cognate ligand) and antagonismof the ligand-induced kinase activity. A fitting analogy is the synthesis of vast libraries of antibodies *in vivo* by the immune system in order toprovide molecules with selective, strong binding to vast numbers ofantigens.  As in the immune system,design and synthesis of very large libraries of analog ACLÔproteins increases the likelihood that a strongly binding antagonist will bepresent.

 

Screening libraries of ACLÔproteins requires a staged series of automated kinase and binding assays,followed by cell proliferation assays and mouse tumor xenograft studies.  Our technical staff and collaborators haveexperience in these areas.  Significantquantities of protein are needed for the latter stages of evaluation.  We have expertise in protein expression,folding and secretion, and we have engineered ACLTM production systems thatproduce large amounts of active protein. We are able to meet our testing needs with in-house fermentation,recovery and purification facilities. These facilities include fermentation capacity up to 300 liters as wellas pilot-plant scale recovery and purification equipment.  We have designed the production of ACLTMproteins to be simple, comparable to the 20-year old production system forrecombinant insulin.  This aspect ofACLTM protein production has

 

6

----

 

importantlong-term implications.  The currentshortage of protein production capacity will impact future manufacturing costs,but our ACLTM proteins should be cost-effective to produce.  We have also established an in-house tissueculture facility to produce RTKs for research. See “Intellectual Property” below for a description of Enchira’sprotections related to the technology described above.

 

**Collaborations**

 

We believe that the fastest and most efficient way todiscover, develop and commercialize our ACLTM proteins is through collaboration,research cooperation, in-licensing of non-core technology and out-sourcing ofspecialized development projects.  InOctober 2000, Enchira entered into a research and development collaborationwith M.D. Anderson Cancer Center and the laboratory of Professor Mien-Chi Hung,Chairman of the Department of Molecular and Cellular Oncology at M.D. AndersonCancer Center.  Dr. Hung is a worldexpert on the molecular biology of the EGFR system and particularly the HER2/*neu* system.  We are working with Dr. Hung’s lab to evaluate the ACLTM proteinsdirected against EGFR and HER2/*neu*.To aid in development of its MPGSÔtechnology, we out-sourced development of a computer algorithm to optimize andautomate key steps in the process.

 

We completed two collaborations in 2001, neither ofwhich involved technologies related to the ACLTM protein technology currentlybeing developed by the Company.  Thefirst project was a two-year effort with Genencor International to improvecertain properties of a commercial enzyme. We used our basic skills in mutagenesis and screening to produce animproved enzyme.  The collaborationended December 31, 2001.  The secondcollaboration was a multiyear program with the U.S. Department of Energy.  This effort was directed at improving theproperties of a biocatalyst involved in the biotransformation of certain sulfurheterocycles. The collaboration was successfully completed and ended inmid-2001.

 

**Competition**

 

Although a large number of new therapeutic agents areunder development for RTK targets, we are unaware of any other company orcommercial research group that is using the same small protein ligand approachas Enchira to interfere with the action of these receptors.  We believe that the ACLTM protein approachcan be superior to the competing small molecule and antibody approaches, andthe ACLTM proteins potentially could be used in combination with othertherapeutic agents or chemotherapies to help patients manage their disease andimprove their quality of life.

 

According to PhRMA (Pharmaceutical Research andManufacturers of America), over 350 drugs were under development for cancertreatment in 2001, representing roughly 1/3 of the total number of drugs underdevelopment.  Many biotechnology and pharmaceutical companies are focusedin inhibition of RTK targets by use of MAb or small molecule drugapproaches.  Companies with activeresearch and development programs in this area include Genentech, ImClone,AstraZeneca, Novartis, Pharmacia, OSI Pharmaceuticals, Celltech, Abgenix, andothers.

 

**Intellectual Property**

 

*General*

 

Enchira’s business and its development rely heavily onpatents and other proprietary rights. Our ability to protect our proprietary technologies from unauthorizeduse by third parties will be effective only to the extent that our proprietaryrights are covered by valid and enforceable patents or are effectivelymaintained as trade secrets.  We intendto seek and maintain patent protection for our drug candidates and proprietarytechnologies.  We are currently pursuingpatent protection on the DCOPÔtechnologies.  We also hold exclusiverights or assignments to 33 U.S. patents and numerous foreign patents inbiocatalysis technologies that are unrelated to ACLÔproteins or DCOPÔ technologies.

 

7

----

 

While we are not aware that any of our products ortechnologies infringe on patents or other proprietary rights of third partiesand are not aware of any claims or other actions at this time, we cannot assurethat a third party would not claim such infringement.  In the event a third party claims such infringement, resultinglitigation to defend our use of our products or technologies would be verycostly and could cause Enchira to no longer be able to operate as a goingconcern.

 

*OtherIntellectual Property Rights*

 

In addition, we depend upon trade secrets, know-howand continuing technological advances to develop and maintain our competitiveposition.  To maintain theconfidentiality of trade secrets and proprietary information, we require ouremployees, scientific advisors, consultants and collaborators, uponcommencement of a relationship with Enchira, to execute confidentialityagreements and, in the case of parties other than research and developmentcollaborators, to agree to assign their inventions to Enchira.  These agreements are designed to protect ourproprietary information and to grant Enchira ownership of technologies that aredeveloped in connection with each of these party’s relationship with Enchira.These agreements may not, however, provide protection for our trade secrets inthe event of unauthorized disclosure of such information.

 

**Employees and Consultants**

 

We believe that our success will be based, among otherthings, on achieving and retaining scientific and technological superiority andon identifying and retaining capable management.  We have assembled a highly qualified team of scientists, aknowledgeable international panel of advisors in oncology drug development, andan executive management team with experience in the biotechnology industry.

 

As of December 31, 2001, Enchira employed 28 people,11 of whom hold Ph.D. degrees.  Thecapabilities of the staff are augmented by that of the Scientific AdvisoryBoard.  The Scientific Advisory Board iscomposed of the following scientists with expertise in cancer research, drugdevelopment and clinical evaluation:

 

Dr. Lee Ellis, M.D.,F.A.C.S., Professor of Surgical Oncology and Professor of Cancer Biology,  University of Texas M.D. Anderson CancerCenter, Houston.  Dr.Ellis’ laboratory is investigating the role of angiogenesis in primary andmetastatic colon cancers.  One of themain targets of his research is the protein tyrosine kinase known as VascularEndothelial Growth Factor (VEGF), which has been found to be the predominantangiogenic factor that leads to colon cancer metastases.

 

Adrian V. Lee, Ph.D.,Assistant Professor , Department of Medicine and Department of Molecular andCellular Biology, Baylor College of Medicine. Dr. Lee’sresearch examines the interaction between steroid hormones and growth factorsin breast cancer growth regulation, with the goal of identifying new targets orpathways that may prove valuable for therapeutic intervention.  Dr. Lee has received numerous awards for hisresearch in breast cancer, including the Specialized Program of ResearchExcellence (SPORE) development award from NCI and the Komen Foundation BasicResearch Award.

 

John F. Smyth, M.D.,Professor of Medical Oncology, University of Edinburgh, Edinburgh, UK.  Dr.Smyth has been the Director of the Medical Oncology Unit of the ImperialCancer Research Fund, one of the world’s leading cancer research organizations,for the past 20 years.  In this capacityhe has secured research funding in excess of £30 million and his personalcontribution includes over 250 papers in the literature.  He is recognized as one of Europe’s leadersin drug development and early clinical evaluation of new anti-cancer agents.  He has served on numerous national and internationalcommittees including being President of the European Society of Oncology andTreasurer of the Federation of European Cancer Societies.  Currently he is a member of the commissionon Safety and Medicines for the United Kingdom Medicines Control Agency and iseditor-in-chief of the *European Journal ofCancer*.

 

8

----

 

James R. Swartz, D. Sci.,Professor, Department of Chemical Engineering, Stanford University.  Dr. Swartz is currently investigating *in vitro* protein synthesis, proteinfolding and the generation and utilization of adenosine triphosphate(ATP).  Prior to joining Stanford in1998, Dr. Swartz spent 17 years with Genentech, Inc.  During his tenure with Genentech, Dr. Swartz focused on the expressionand *invivo* folding of protein tyrosine kinases in *E.coli*, on fermentationprocess development and scale-up, and on the *in vitro* expression andfolding of rDNA proteins.

 

**Government Regulation**

 

Ourresearch and development activities are subject to regulation by governmentalagencies, the most relevant of which is the Food and Drug Administration, orFDA.  None of our technologies have beenapproved for sale in any market.  Beforemarketing in the United States, any drug developed by us or by our collaborativepartners must undergo rigorous pre-clinical testing and clinical trials and anextensive regulatory approval process implemented by the FDA under the FederalFood, Drug and Cosmetic Act. The FDA regulates, among other things, thedevelopment, testing, approval, manufacture, record keeping, labeling, storage,advertising, promotion, sale and distribution of biopharmaceutical products.

 

Theregulatory review and approval process is lengthy, expensive anduncertain.  We and our collaborativepartners will have to submit extensive pre-clinical and clinical data andsupporting information to the FDA for each indication or use to establish adrug candidate’s safety and efficacy before it can secure FDA approval. Theapproval process takes many years, requires the expenditure of substantialresources, involves post-marketing surveillance, and may involve ongoingrequirements for post-marketing studies. Before commencing clinical trials in humans, we or our collaborativepartners must submit to, and receive approval from, the FDA of aninvestigational new drug application, also known as an IND.  We expect to rely on our collaborativepartners to file INDs and generally direct the regulatory approval process forany potential drug candidates.

 

Beforereceiving FDA approval to market a product, we and our collaborative partnersmust demonstrate that the product is safe and effective on the patientpopulation that will be treated.  If theFDA grants approval, this approval will be limited to those disease states andconditions for which the product is effective, as demonstrated through clinicalstudies.  This approval is demonstratedby the FDA’s acceptance of a new drug application, or NDA.  The FDA prohibits marketing or promoting adrug for an unapproved indication or use. Clinical testing must meetrequirements for institutional review board oversight, informed consent andgood clinical practices, and must be conducted under FDA oversight.  Upon approval, a product may be marketedonly in those dosage forms and for those indications approved in the NDA.  However, pursuant to recent US federal courtdecisions, drug marketers may, in some limited circumstances, distributepeer-reviewed materials concerning uses for an approved drug other than thoseuses approved by the FDA.

 

Clinicaltrials are conducted in sequential phases. In Phase I, the drug is administered to a small group of humans, eitherhealthy volunteers or patients, to test for safety, dosage tolerance,absorption, metabolism, excretion, and clinical pharmacology.  In Phase II, a slightly larger number ofpatients are studied to assess the efficacy of the product, to ascertain dosetolerance and the optimal dose range, and to gather additional data relating tosafety and potential adverse events.  InPhase III, studies establish safety and efficacy in an expanded patientpopulation.  The FDA can require PhaseIV post-marketing studies.

 

Thelength of time necessary to complete clinical trials varies significantly andis difficult to predict.  Clinicalresults are frequently susceptible to varying interpretations that may delay,limit or prevent regulatory approvals. Additional factors that can cause delay or termination of clinicaltrials relating to our products, or that may increase the costs of thesetrials, include:

 

•                       slow patientenrollment due to the nature of the clinical trial plan, the proximity ofpatients to clinical sites, the eligibility criteria for participation in thestudy or other factors;

 

9

----

 

•                       inadequatelytrained or insufficient personnel at the study site to assist in overseeing andmonitoring clinical trials; or delays in approvals from a study site’s reviewboard;

 

•                       longertreatment time required to demonstrate effectiveness or determine theappropriate product dose;

 

•                       insufficientsupplies of the drug candidate;

 

•                       adversemedical events or side effects in treated patients; and

 

•                       ineffectivenessof the drug candidate.

 

TheFDA permits expedited development, evaluation, and marketing of new therapiesintended to treat persons with serious or life-threatening conditions for whichthere is an unmet medical need under its Fast Track Drug Development Program. Asponsor can apply for fast track designation at the time of submission of anIND, or at any time prior to receiving marketing approval of the New DrugApplication, or NDA. To receive fast track designation, an applicant mustdemonstrate:

 

•                       that thedrug is intended to treat a serious or life-threatening condition;

 

•                       that thedrug is intended to treat a serious aspect of the condition; and

 

•                       that thedrug has the potential to address unmet medical needs, and this potential isbeing evaluated in the planned drug development program.

 

Overthe course of drug development, a product in a fast track development programmust continue to meet the criteria for fast track designation.

 

Anydrug is likely to produce some toxicity or undesirable side effects in animalsand in humans when administered at sufficiently high doses and/or for asufficiently long time.  Unacceptabletoxicity or side effects may occur at any dose level at any time in the courseof studies in animals designed to identify unacceptable effects of a drugcandidate, known as toxicological studies, or clinical trials of drugcandidates.  The appearance of anyunacceptable toxicity or side effect could cause us or regulatory authoritiesto interrupt, limit, delay or abort the development of any of our drugcandidates and could ultimately prevent approval by the FDA or foreignregulatory authorities for any or all targeted indications.

 

Weor our collaborative partners must submit and receive approval of an NDA andpay user fees prior to commercial marketing of any drug.  As part of the approval process, the FDAmust inspect and approve each manufacturing facility.  Among the conditions of approval is the requirement that amanufacturer’s quality control and manufacturing procedures conform to currentgood manufacturing practices, or cGMP. Manufacturers must expend time, money and effort to ensure compliancewith cGMP, and the FDA conducts periodic inspections to certifycompliance.  Violations may result inrestrictions on the product or manufacturer, including costly recalls or withdrawalof the product from the market.  It maybe difficult for manufacturers of our products to comply with the applicablecGMP and other FDA regulatory requirements. If contract manufacturers fail to comply, then the FDA will not allow usor our collaborative partners to market products that have been affected bysuch failure.

 

Shouldwe or our collaborative partners wish to market products outside the UnitedStates, we must receive marketing authorization from the appropriate regulatoryauthorities. The requirements governing the conduct of clinical trials,marketing authorization, pricing and reimbursement vary widely from country tocountry.  At present, foreign marketingauthorizations are applied for at a national level, although within the EuropeanUnion, or EU, registration procedures are available to companies wishing tomarket a product in more than one EU member state.

 

10

----

 

Ifthe regulatory authority is satisfied that adequate evidence of safety, qualityand efficacy has been presented, a marketing authorization will begranted.  This foreign regulatoryapproval process involves all of the risks associated with FDA approvaldiscussed above.

 

**Forward-Looking Statements**

 

Someof the statements in this Form 10-K and the Exhibits contain forward-lookingstatements within Section 21E of the Securities Exchange Act of 1934, asamended. When used in this Form 10-K and the Exhibits, the words “anticipate,”“believe,” “estimate,” “may,” “expect,” and similar expressions are generallyintended to identify forward-looking statements. These forward-lookingstatements include statements about our :

 

•                       ability tosecure additional funds for future operations;

 

•                       estimate ofthe sufficiency of Enchira’s existing cash and cash equivalents and investmentsto finance operating and capital requirements;

 

•                       expectationsfor increases in operating expenses;

 

•                       expectationsfor increases in research and development and general and administrativeexpenses in order to develop new products and manufacture commercial quantitiesof products;

 

•                       expectationsfor the development, manufacturing, and approval of new products;

 

•                       expectationsfor incurring additional capital expenditures to expand research anddevelopment capabilities;

 

•                       expectationsfor generating revenue or becoming profitable on a sustained basis;

 

•                       ability toaccomplish the technical developments and advances necessary to obtaineconomically sustainable results;  and

 

•                       ability toenter into additional marketing agreements and the ability of existingmarketing partners to commercialize products incorporating Enchira’stechnologies.

 

Ouractual results could differ materially from those results expressed in, orimplied by, these forward-looking statements. Potential risks and uncertainties that could affect actual resultsinclude those discussed below under the heading “Risk Factors.”

 

Althoughwe believe that the expectations reflected in the forward-looking statementsare reasonable, we cannot guarantee future results, events, levels of activity,performance, or achievements.  We do notassume responsibility for the accuracy and completeness of the forward-lookingstatements.

 

Wedo not intend to update any of the forward-looking statements after the date ofthis Form 10-K to conform them to actual results.

 

**Risk Factors**

 

*Enchira may be referred to as “we,” “us,” or “our” in the Risk Factors below.*

 

RISKS ASSOCIATED WITH OUR CRITICAL CAPITAL REQUIREMENTS

 

11

----

 

•                                          **Our auditors have expressed substantial doubt over our ability tocontinue as a going concern.**

 

Our accountants have issued a modified opinion on our consolidated financial statements for the year ended December 31, 2001 indicating substantial doubt about our ability to continue as a going concern.  We may have to close operations and/or seek legal protection from our creditors if we are unable to secure additional financing on a timely basis, or at all.  We do not know if additional funding will be available at all or on acceptable terms.

 

•                                          **We have a history of operating losses and we may not be profitable in thefuture.**

 

We have incurred net losses since our inception and expect losses to continue in the foreseeable future as we continue to expend capital for the ongoing development and commercialization of our ACLÔ proteins. At December 31, 2001, we had an accumulated deficit of $91.3 million. We remain uncertain about the amount of time required for us to become profitable. We cannot ensure that we will achieve sustained profitability, if at all.

 

•                                          **We will need additional funds.  Wemay need to enter into financing arrangements with unfavorable terms or whichcould adversely affect your ownership interest and rights as compared to ourother stockholders.  If such financingis not available, we may need to cease operations.**

 

We currently anticipate that our available cash resources will be sufficient to meet our capital requirements through mid-2002.

 

However, our capital requirements depend on several factors, including:

 

1.                                       The level ofresearch and development investment required to develop our technology;

 

2.                                       Our abilityto enter into new agreements with strategic partners or to extend the terms ofour existing collaborative agreements and the terms of any agreement of thistype;

 

3.                                       The successrate of our discovery efforts;

 

4.                                       Our abilityto successfully commercialize products developed independently and the demandfor such products; and

 

5.                                       Costs ofrecruiting and retaining qualified personnel.

 

As additional capital is required to operate our business, we cannot assure that additional financing will be available on terms favorable to us, or at all. If adequate funds are not available or are not available on acceptable terms, our ability to fund our operations, take advantage of opportunities, develop products or technologies or otherwise respond to competitive pressures could be significantly limited. In addition, if financing is not available, we may need to cease operations.

 

If we raise additional funds through the issuance of equity securities, the percentage ownership of our stockholders will be reduced, stockholders may experience additional dilution or such equity securities may provide for rights, preferences or privileges senior to those of the holders of our common stock. If we raise additional funds through the issuance of debt securities, such debt securities would have rights, preferences and privileges senior to holders of common stock and the terms of such debt could impose restrictions on our operations.

 

RISKS ASSOCIATED WITH OUR CAPITALIZATION

 

•                                          **Dividends on our Series B Preferred Stock substantially dilute ownershipin our common stock.**

 

 

12

----

 

In the past, we have from time to time elected to pay dividends on our preferred stock with our common stock, although we may pay dividends in cash or a combination of common stock and cash. Dividends will be payable on the preferred stock only when, as and if declared by our Board of Directors as permitted under Delaware law although we do incur an obligation to pay such dividends in a manner to be determined at our sole discretion until they become payable.  Dividends on the Series B Preferred Stock become payable upon the conversion or redemption of Series B Preferred Stock.  We have incurred net losses since our inception, and we expect our losses to increase in the foreseeable future. While we intend to pay dividends on the preferred stock in common stock, we anticipate that we will continue to incur losses and thus will continue to have a deficiency in fixed charges and preferred stock dividend coverage. Preferred stock dividends may be paid only out of capital surplus (within the meaning of the Delaware General Corporation Law) or out of our net profits for the fiscal year in which the dividend is declared and the preceding fiscal year. We have issued a total of 1,399,369 shares of common stock to date as dividends on the preferred stock.  We have not declared a dividend payment since November 1998, and since that date, have only paid dividends on Series B Preferred Stock upon the conversion or redemption of Series B Preferred Stock.  As of March 8, 2002, there were $771,420 in accrued dividends payable on the outstanding shares of Series B Preferred Stock, which would result in the issuance of 2,660,068 shares of our common stock based on the applicable closing prices of our common stock as of such date, which number of shares is included in the aggregate number of shares issuable upon redemption in the risk factor relating to redemption of our Series B Preferred Stock above.

 

•                                          **One of the holders of our Series B Preferred Stock has required ourredemption of their shares and additional holders may do the same.  This has resulted and may continue to resultin substantial dilution to the holders of common stock.**

 

Under the terms of our Series B Preferred Stock, we are required to redeem all outstanding shares of Series B Preferred Stock at a price of $50 per share on or after February 26, 2002.  Additionally, at the time of redemption, we are also required to pay any accrued but unpaid dividends on the shares of Series B Preferred Stock being redeemed.   We have elected to redeem all shares of Series B Preferred Stock with shares of our common stock.  The number of shares of our common stock issuable upon such redemption is based upon the 10-day average of our closing prices at the time of redemption.  Under the terms of the Series B Preferred Stock, we are required to provide a firm commitment underwriting of the shares of our common stock being issued in connection with the redemption or the holder of Series B Preferred Stock may elect to waive this requirement in the event we are unable to timely provide a firm commitment underwriting.  As a result, during 2002 we have redeemed 41,100 shares of Series B Preferred Stock to date from one holder who waived this requirement, which resulted in the issuance of 3,425,000 shares of our common stock for such redemption and an additional 1,024,075 shares of our common stock in payment of accrued dividends on such shares.  We have an additional 51,600 shares of Series B Preferred Stock outstanding.  If these shares were redeemed at the closing price in effect on March 8, 2002, we would be required to issue an aggregate of 3,209,846 shares of our common stock for the redemption and accrued and unpaid dividends.

 

•                                          **Our common stock will probably be delisted from the Nasdaq NationalMarket and may be delisted from Nasdaq entirely.**

 

Our common stock presently lists on the Nasdaq National Market.  We must maintain certain minimum financial requirements for continued inclusion on Nasdaq. If we cannot satisfy Nasdaq’s maintenance requirements, Nasdaq may delist our common stock. Nasdaq sent us a letter dated February 14, 2002 in which it informed us that we no longer meet certain of Nasdaq’s maintenance requirements.  The letter gave us 90 days within which we can come into compliance with these maintenance requirements or request a hearing.  In the event that we do neither, we can request that we be moved to the Nasdaq SmallCap Market, and we will be granted an additional 90 days to come into compliance with the maintenance requirements for the Nasdaq SmallCap Market.  We intend to request a move to the Nasdaq SmallCap Market if we are unable to come into compliance with the Nasdaq National Market maintenance requirements.  There can be no assurance that we will be able to meet the Nasdaq SmallCap Market maintenance requirements after we move or that we will be able to be successful in a hearing to avoid a delisting.  Should we be unable to satisfy the Nasdaq maintenance requirements and our stock is delisted, we may be required to redeem the remaining outstanding shares of Series B Preferred Stock in cash.

 

13

----

 

from the Nasdaq SmallCap Market.  In the event that our common stock is eventually delisted from the Nasdaq altogether, trading in our common stock would thereafter be conducted in the over-the-counter markets in the so-called “pink sheets” or the NASD’s “Electronic Bulletin Board.” Consequently, the liquidity of our common stock could be impaired, not only in the number of shares which could be bought and sold, but also through delays in the timing of the transactions, reductions in security analysts’ and the news media’s coverage of us, and lower prices for our common stock than it might otherwise attain.

 

•                                          **Stockholders face the risks of holding “penny stocks.”**

 

If Nasdaq delisted our common stock, it could become subject to Rule 15g-9 under the Securities and Exchange Act of 1934, as amended, (the “Exchange Act”), which imposes additional sales practice requirements on broker-dealers which sell such securities to persons other than established customers and “accredited investors” (generally, individuals with net worth in excess of $1,000,000 or annual incomes exceeding $200,000, or $300,000 together with their spouses). For transactions covered by this rule, a broker-dealer must make a special suitability determination for the purchaser and receive the purchaser’s written consent to the transaction prior to sale. Consequently, the rule may adversely affect the ability of the holders of our common stock to sell their shares in the secondary market.

 

Regulations of the Securities and Exchange Commission, or the Commission, define a “penny stock” to be any non-Nasdaq equity security that has a market price (as therein defined) of less than $5.00 per share or with an exercise price of less than $5.00 per share, subject to certain exceptions. For any transaction involving a penny stock, unless exempt, the rules require delivery, prior to any transaction in a penny stock, of a disclosure schedule prepared by the Commission relating to the penny stock market. The Commission also requires disclosure about commissions payable to both the broker-dealer and the registered representative and current quotations for the securities. Finally, the Commission requires monthly statements to be sent disclosing recent price information for the penny stock held in the account and information on the limited market in penny stocks.

 

These penny stock restrictions will not apply to our common stock if Nasdaq continues to list it and has certain price and volume information provided on a current and continuing basis or meets certain minimum net tangible assets or average revenue criteria. We cannot ensure that our common stock will qualify for exemption from these restrictions. Even if our common stock were exempt from such restrictions, we would remain subject to Section 15(b)(6) of the Exchange Act, which gives the Commission the authority to prohibit any person engaged in unlawful conduct while participating in a distribution of a penny stock from associating with a broker-dealer or participating in a distribution of a penny stock, if the Commission finds that such a restriction would be in the public interest. If our common stock were subject to the rules on penny stocks, the market liquidity for our common stock could be severely and adversely affected.

 

RISKS ASSOCIATED WITH OUR BUSINESS AND INDUSTRY

 

•                                          **Because we are developing and deploying new technologies, we may not beable to commercialize our new technologies or products, which could cause us tobe unprofitable or to cease operations.**

 

Any investor must evaluate our business in light of the uncertainties and complexities affecting a development stage biotechnology company. Our existing proprietary technologies are new and in the early stage of development. We may not be successful in the commercial development of these or any further technologies or products. Successful products require significant development and investment to demonstrate their cost-effectiveness prior to regulatory approval and commercialization. To date, we have not deployed any of our drug candidates in the clinic, and have limited animal data as well.  In addition, we have not commercialized any biotechnology products, and we have no strategic partners who have yet incorporated our technologies or inventions into their own commercial products from which we can generate royalties. Because of these uncertainties, our discovery process may not result in the identification of product candidates that our strategic partners or we will commercialize. If we are not able to

 

14

----

 

use our technologies to discover new materials or products with significant commercial potential, we will not be able to achieve our objectives or build a sustainable or profitable business.

 

•                                          **If we are unable to establish and maintain collaborations with otherparties, development of our products and technology may be delayed or stopped.**

 

Because we do not currently possess the financial and other resources necessary to develop potential products that may result from our technologies, or the financial and other resources to complete any approval processes, which may be required for these products, we must enter into collaborative arrangements to develop our products. If we do not enter into new collaborative agreements then our revenues will be reduced, and products utilizing our technologies may not be developed, manufactured or marketed.  We have limited or no control over the resources that any collaborator may devote to our products. Any of our present or future collaborators may not perform their obligations as expected. These collaborators may breach or terminate their agreements with us or otherwise fail to conduct their collaborative activities successfully and in a timely manner. Further, our collaborators may elect not to develop products arising out of our collaborative arrangements or devote sufficient resources to the development, manufacture, marketing or sale of these products.

 

•                                          **Many potential competitors have greater resources and experience than wedo and may develop products and technologies more rapidly than we can or thatmay make our products and technologies obsolete.**

 

The biotechnology industry is characterized by rapid technological change, and cancer treatment is a rapidly evolving field with many competitors. Our future success will depend on our ability to maintain a competitive position with respect to technological advances. Rapid technological development by others may result in our products and technologies becoming obsolete.  We face, and will continue to face, intense competition. There are a number of companies who compete with us in various steps throughout our technology process, including but not limited to Novartis AG, ImClone Systems Incorporated and Keryx Biopharmaceuticals, Inc. Many of these competitors have significantly greater financial and human resources than we do. These organizations may develop technologies that are superior alternatives to our technologies. Further, our competitors may be more effective at implementing their cancer treatment technologies to develop commercial products. Any products that we develop using our ACLTM proteins through our DCOPTM and MPGSTM technologies will compete in multiple, highly competitive markets.  Many of our potential competitors in these markets have substantially greater financial, technical and marketing resources than we do, and we cannot assure any investor that they will not succeed in developing products that would render our products or those of our strategic partners obsolete or noncompetitive. In addition, many of these competitors have significantly greater experience than we do in their respective fields.

 

•                                          **Any inability to adequately protect our proprietary technologies couldharm our competitive position.**

 

Our success will depend in part on our ability to obtain patents and maintain adequate protection of our other intellectual property for our technologies and products in the United States and other countries. If we do not adequately protect our intellectual property, competitors may be able to practice our technologies and erode or negate our competitive advantage. The laws of some foreign countries do not protect our proprietary rights to the same extent as the laws of the United States, and we may encounter significant problems in protecting our proprietary rights in these foreign countries.  We may fail to apply for patents on important technologies or products in a timely fashion or at all, and in any event, the applications we do file may be challenged and may not result in issued patents. At this time, we have not been issued any patents on our new drug discovery platform technologies or our product candidates for treating cancer and any future patents we obtain may not be sufficiently broad to prevent others from practicing our technologies or from developing competing products. Furthermore, others may independently develop similar or alternative technologies or design around our patented technologies. In addition, others may challenge or invalidate our patents, if any, or our patents may fail to provide us with any competitive

 

15

----

 

advantages. If the use or validity of any of our patents is ever challenged, it would result in litigation costs and the diversion of management in defending the patent. In addition, we generally do not control the patent prosecution of technology that we license from others. Accordingly, we are unable to exercise the same degree of control over this intellectual property as we would over technology we own.

 

We rely upon trade secret protection for our confidential and proprietary information. We have taken measures to protect our proprietary information. These measures may not provide adequate protection for our trade secrets or other proprietary information. We seek to protect our proprietary information by entering into confidentiality agreements with employees, collaborators, and consultants. Nevertheless, employees, collaborators, or consultants may still disclose our proprietary information, and we may not be able to meaningfully protect our trade secrets. In addition, others may independently develop substantially equivalent proprietary information or techniques or otherwise gain access to our trade secrets.   Please see “Business — Intellectual Property” for more on our patent position and potential risks associated with it.

 

•                                          **Our ability to market products, either by us or through collaborativepartners, is contingent upon our ability to achieve regulatory approval.**

 

Ourresearch and development activities are subject to regulation by governmentalagencies, the most relevant of which is the Food and Drug Administration, orFDA.  None of our technologies have beenapproved for sale in any market.  Beforemarketing in the United States, any drug developed by us or our collaborativepartners must undergo rigorous pre-clinical testing and clinical trials and anextensive regulatory approval process implemented by the FDA under the FederalFood, Drug, and Cosmetic Act. The FDA regulates, among other things, thedevelopment, testing, approval, manufacture, record keeping, labeling, storage,advertising, promotion, sale and distribution of biopharmaceutical products.

 

Theregulatory review and approval process is lengthy, expensive anduncertain.  We or our collaborativepartners will have to submit extensive pre-clinical and clinical data andsupporting information to the FDA for each indication or use to establish adrug candidate’s safety and efficacy before we can secure FDA approval.  The approval process takes many years,requires the expenditure of substantial resources, involves post-marketingsurveillance, and may involve ongoing requirements for post-marketingstudies.  Before commencing clinicaltrials in humans, we or our collaborative partners must submit to, and receiveapproval from, the FDA of an investigational new drug application, also knownas an IND.  We expect to rely on ourcollaborative partners to file INDs and generally direct the regulatoryapproval process for any potential drug candidates.  We cannot assure that any of our products or technologies will beapproved by the FDA in a timely manner or at all.  If we are unable to obtain approval from the FDA for our productsor technologies, we will likely be required to cease operations.  Please see “Business — GovernmentalRegulation” for a more complete description of the regulatory review process.

 

LEGALRISKS TO OUR BUSINESS

 

•                                          **Litigation or other proceedings of third party claims of intellectualproperty infringement, including the recent arbitration ruling in favor ofMaxygen Inc., could require us to spend time and money and could shut down someor all of our operations.**

 

Our commercial success depends in part on not infringing the patents and proprietary rights of third parties and not breaching any licenses that we have entered into with regard to our technologies and products. The biotechnology industry is characterized by extensive litigation regarding patents and other intellectual property rights. We recently received a final ruling in our arbitration proceeding with Maxygen Inc. relating to Maxygen’s claims of infringement of certain of Maxygen’s technologies by us.  The ruling declared Maxygen as the exclusive owner of RACHITTTM technology between us and Maxygen and enjoined us from using, licensing or selling RACHITTTM technology until 2017.  See “Legal Proceedings” for a complete description of the arbitration and the arbitrator’s ruling.  Other parties may have been issued relevant patents or may have filed relevant patent

 

16

----

 

applications that could affect our ability to obtain patents or to operate as we would like to in our research, development, and commercialization efforts. If we wish to use technologies claimed by third parties in issued and unexpired patents, then we may need to obtain license(s) from the owner(s) of such patent(s), enter into litigation, or incur the risk of litigation. Litigation or failure to obtain necessary licenses may impede our ability to obtain collaborations or to develop our products and could prevent us or our collaborators from developing or commercializing our products.

 

•                                          **We may be sued for product liability.**

 

We may be held liable if any product we develop, or any product, which is made with the use of any of our technologies, causes injury or is found otherwise unsuitable during product testing, manufacturing, marketing or sale. We currently have no product liability insurance**.** When we attempt to obtain product liability insurance, this insurance may be prohibitively expensive, or may not fully cover our potential liabilities. Inability to obtain sufficient insurance coverage at an acceptable cost or otherwise to protect against potential product liability claims could prevent or inhibit the commercialization of products developed by us or our strategic partners.  If we are sued for any injury caused by our products, our liability could exceed our total assets.

 

•                                          **We use hazardous materials in our business.  Any claims relating to improper handling, storage or disposal of thesematerials could be time consuming and costly.**

 

Our research and development processes involve the controlled use of hazardous materials, including chemical, radioactive and biological materials. Our operations also produce hazardous waste products. We cannot eliminate entirely the risk of accidental contamination or discharge and any resultant injury from these materials. Federal, state and local laws and regulations govern the use, manufacture, storage, handling and disposal of these materials. We may be sued for any injury or contamination that results from our use or the use by third parties of these materials, and our liability may exceed our total assets. In addition, compliance with applicable environmental laws and regulations may be expensive, and current or future environmental regulations may impair our research, development or production efforts.

 

GENERAL COMPANY RISKS

 

•                                          **We rely heavily on a few key employees for management and productdevelopment efforts.**

 

We depend on the efforts of our executive officers, scientists and other key employees, the loss of any one of whom could materially and adversely affect us. Shortages of qualified scientists within certain disciplines may occur and competition for the services of qualified scientists may intensify. We may not succeed in recruiting or retaining these personnel in the future.

 

•                                          **Some of our existing stockholders can exert control over us and may notmake decisions that are in the best interests of all stockholders.**

 

Our officers, directors and principal stockholders (greater than 5% stockholders) together control approximately 75 % of our outstanding common stock. As a result, these stockholders, if they act together, will be able to exert a significant degree of influence over our management and affairs and over matters requiring stockholder approval, including the election of directors and approval of significant corporate transactions. In addition, this concentration of ownership may influence, delay or prevent a change in control of us and might affect the market price of our common stock, even when a change may be in the best interests of all stockholders. In addition, the interests of this concentration of ownership may not always coincide with our interests or the interests of other stockholders and accordingly, they could cause us to enter into transactions or agreements which we would not otherwise consider.

 

17

----

 

•                                          **Certain charter and bylaw provisions and our stockholder rights plan maynegatively affect the stockholders.**

 

Certain provisions of our charter, bylaws and rights plan may discourage proposals by third parties to acquire a controlling interest in us, which could deprive stockholders of the opportunity to consider an offer that would be beneficial to them.

 

**Item2. *Properties***

 

**Facilities**

 

Our corporateoffices and laboratories are situated in a 25,000 square-foot leased buildinglocated at 4200 Research Forest Drive in The Woodlands, Texas, a suburb ofHouston, Texas.  Pursuant to the lease,monthly payments of $33,678 are required for base rent.  The lease for this facility expires in2003.  Approximately 20,500 square feetof this space is devoted to research and development.  The facility includes laboratories designed for molecular biologyand microbiology, tissue culture, biochemistry, a high throughput screeningwith robotics, media preparation, analytical chemistry (DNA sequencing, geldocumentation, GC/MS and LC/MS), protein purification and fermentation.  The facility also houses numerousfermentation units with scale from 1 to 300 liters and peripheral equipment.

 

**Item 3. *Legal Proceedings***

 

On November 3, 2001, the arbitrator issued his final ruling in the arbitration between Maxygen Inc. and Enchira. The ruling stated that we are enjoined until May 19, 2017 from using, licensing or selling RACHITTTM technology.  This injunction does not prohibit us from independently developing and commercializing other technologies that are not described and claimed in any RACHITTTM applications.  Additionally, we are enjoined for a period of three years from using, licensing or selling Maxygen High Throughput Screening (as defined in the arbitration award) technology, but this injunction does not prohibit us from independently developing and commercializing different HTS technology.  The arbitrator’s ruling further declared Maxygen the exclusive owner of RACHITTTM between Maxygen and us.  We were required to pay Maxygen’s attorneys’ fees in the amount of $556,826 and arbitration costs in the amount of $100,000 as well as any unbilled fees of the arbitrator. As a result of the ruling, we returned $550,000 to Genencor for license fees previously received under the license agreement with Genencor, which was terminated****on November 12, 2001.  Genencor also terminated its research and development collaboration agreement with us on December 31, 2001.

 

Immediately following the execution of the award, wefiled an application to set aside or modify the arbitration award in the 151stDistrict Court of Harris County, Texas. The petition requests that the Court enter judgment setting aside thearbitration award in its entirety or modify the arbitration award in certainrespects due to its vague and ambiguous nature.  No action has been taken by us to pursue this application as ofyet.

 

18

----

 

**Part II.**

 

**Item 5. *Market for the Registrant’s CommonEquity and Related Stockholder Matters.***

 

Enchira’s common stock (symbol: ENBC) is traded on theNasdaq National Market.  The followingtable sets forth the range of high and low sales prices for each calendarquarter in the two years ended December 31, 2001 as reported on the NasdaqNational Market:

 
| **Year Ended December 31, 2001** |   | **High** |       | **Low** |       |
|----------------------------------|--------|----------|------------|---------|------------|
| First Quarter                    |   | $        | 6.88       |    | $          | 1.00 |   |
| Second Quarter                   |   | 1.83     |       | 0.60    |       |
| Third Quarter                    |   | 0.98     |       | 0.33    |       |
| Fourth Quarter                   |   | 1.10     |       | 0.25    |       |
|                             |   |     |       |    |       |
| **Year Ended December 31, 2000** |   | **High** | ** ** | **Low** | ** ** |
| First Quarter                    |   | $        | 30.63      |    | $          | 3.75 |   |
| Second Quarter                   |   | 15.50    |       | 5.00    |       |
| Third Quarter                    |   | 10.81    |       | 5.31    |       |
| Fourth Quarter                   |   | 8.94     |       | 3.06    |       |

 

As of March 8, 2002, 10,905,173 shares of common stockwere outstanding and we had approximately 150 shareholders of record.

 

**Dividends**

 

Enchira has paid dividends on its Series B PreferredStock in shares of common stock and in certain circumstances in cash.  We currently intend to retain any earningsto finance the growth and development of our business and do not anticipatepaying cash dividends on our common stock in the foreseeable future.  For a discussion of dividends paid or payableon the Series B Preferred Stock, see “Item 1. Business — Risk Factors —Dividends on Preferred Stock Dilute Ownership in our Common Stock and Create aDeficiency in Both Fixed Charges and Preferred Stock Dividend Coverage.”

 

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

 

The selected financial data set forth below withrespect to our statements of operations for each of the five years in theperiod ended December 31, 2001 and with respect to our balance sheets as ofDecember 31, 1997, 1998, 1999, 2000 and 2001 are derived from the auditedfinancial statements of Enchira.  Our accountants have issued a modifiedopinion on our consolidated financial statements for the year ended December31, 2001 indicating substantial doubt about our ability to continue as a goingconcern.  The financialdata should be read in conjunction with the “Management’s Discussion andAnalysis of Financial Condition and Results of Operations” and the Company’sFinancial Statements and Notes thereto included elsewhere in this report.

 

19

----

 

 
|                                                                    |   | **Year Ended  December 31,**                        |       |
|-------------------------------------------------------------------------|--------|-----------------------------------------------------|------------|
|                                                                    |   | **1997**                                            |       | **1998** |   | **1999** |   | **2000** |   | **2001** |   |
|                                                                    |   | **(in thousands, except share and per share data)** | ** ** |
| **Statements of Operations Data:**                                      |   |                                                |       |   |   |   |   |   |   |   |   |
| Revenues:                                                               |   |                                                |       |   |   |   |   |   |   |   |   |
| Sponsored research revenues                                             |   | $                                                   | 1,652      |   | $ | 689 |   | $ | 1,415 |   | $ | 841 |   | $ | 739 |   |
| Costs and expenses:                                                     |   |                                                |       |   |   |   |   |   |   |   |   |
| Research and development                                                |   | 9,087                                               |       | 7,706 |   | 4,848 |   | 4,195 |   | 4,057 |   |
| General and administrative                                              |   | 2,754                                               |       | 2,188 |   | 1,906 |   | 2,934 |   | 4,200 |   |
| Total costs and expenses                                                |   | 11,841                                              |       | 9,894 |   | 6,754 |   | 7,129 |   | 8,257 |   |
| Interest and investment income                                          |   | 650                                                 |       | 394 |   | 214 |   | 308 |   | 149 |   |
| Loss on disposal of fixed assets                                        |   | —                                              |       | (34 | ) | (140 | ) | (43 | ) | (19 | ) |
| Net loss                                                                |   | $                                                   | (9,539     | ) | $ | (8,845 | ) | $ | (5,265 | ) | $ | (6,023 | ) | $ | (7,388 | ) |
| Net loss per common share - basic and diluted                           |   | $                                                   | (7.64      | ) | $ | (5.20 | ) | $ | (1.78 | ) | $ | (1.10 | ) | $ | (0.94 | ) |
| Shares used in computing net loss per common share - basic and  diluted |   | 1,681,351                                           |       | 1,875,414 |   | 4,635,930 |   | 7,576,121 |   | 9,557,383 |   |

 

Net loss per common share has been computed bydividing the net loss, which has been increased for periodic accretion anddividends on the Series A Preferred Stock issued in October 1994 and the SeriesB Preferred Stock issued in February and March 1997, by the weighted averagenumber of shares of common stock outstanding during the period. 

 
|                            |   | **December  31,**   |   |
|---------------------------------|--------|---------------------|--------|
|                            |   | **1997**            |   | **1998** |   | **1999** |   | **2000** |   | **2001** |   |
|                            |   | **(in  thousands)** |   |
| **Balance  Sheet Data:**        |   |                |   |   |   |   |   |   |   |   |   |
| Cash and cash equivalents       |   | $                   | 9,661  |   | $ | 2,795 |   | $ | 2,510 |   | $ | 7,524 |   | $ | 3,032 |   |
| Working capital                 |   | 10,102              |   | 2,488 |   | 5,591 |   | 11,357 |   | 3,247 |   |
| Total assets                    |   | 14,965              |   | 6,127 |   | 8,064 |   | 15,858 |   | 5,218 |   |
| Accumulated deficit             |   | (55,204             | )      | (67,200 | ) | (75,079 | ) | (82,973 | ) | (91,286 | ) |
| Total stockholders’ equity |   | 13,698              |   | 5,306 |   | 7,557 |   | 14,257 |   | 4,391 |   |
|                                 |        |                     |        |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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

 

*Overview*

 

Enchira has devoted substantially all of its effortsto research and development.  There havebeen no revenues from operations other than sponsored research revenues and onesite license fee in 1998 and there is no assurance of future revenues.  We have an accumulated deficit sinceinception of approximately $91.3 million and believe that we can conserve ourexisting financial resources to fund operations through mid-2002.  As of February 27, 2002, Enchira hadapproximately $2.7 million in cash, cash equivalents and investments andapproximately $0.6 million in liabilities.

 

Our independent public accountants have included amodified paragraph in their report on our financial statements as of and forthe year ended December 31, 2001, that describes the substantial doubtregarding our ability to continue as a going concern. We are currently seekingadditional financing through various alternatives that include debt and equityfinancings, government funding and alliances with corporate partners.  However, there can be no assurance that wewill be able to obtain the necessary financing on acceptable terms or atall.  In the event we are unable toobtain such financings, we will consider other alternatives, including:

 

•                                          a license,sale or other disposition of our technologies, or certain rights relatingthereto;

•                                          a sale orother reorganization of Enchira;

 

20

----

 

•                                          thecombination of Enchira with another entity;

•                                          legalprotection from creditors; or

•                                          ceaseoperations.

 

*Significant Accounting Policies*

 

*Cash,Cash Equivalents and Short-Term Investments*

 

Enchira considersshort-term investments with original maturities of 90 days or less to be cashequivalents.  Investments consisting ofcommercial paper and corporate bonds are classified as held to maturity and arereported at amortized cost, which approximates fair value.  Enchira does not have any available for saleor trading securities.

 

*Intangibleand Other Assets*

 

Intangible and other assets mainly consist of patentcosts, which are primarily legal fees. These costs are being amortized over the life of the patent, whichranges from 15 to 20 years.  Accumulatedamortization at December 31, 2000 and 2001 amounted to $973,135 and $1,035,553,respectively.

 

*RevenueRecognition*

 

The Company recognizes revenue in accordance withStaff Accounting Bulletin No. 101, Revenue Recognition in Financial Statements(“SAB 101”).  Revenue fromnon-refundable sponsored research and development payments is recognized asservices are performed, provided a contractual arrangement exists, the contractprice is fixed or determinable, and the collection of the resulting receivableis probable.  Sponsored research anddevelopment and licensing payments received that are refundable or for whichservice obligations remain are reflected as deferred revenue.

 

*Researchand Development*

 

All research and development costs, both generatedinternally and externally from research and development contracts, are expensedas incurred.  Enchira allocates certainindirect costs to research and development expenses, which consist primarily ofoverhead related to the administration of research and development activities.

 

21

----

 

*Useof Estimates*

 

The preparation of financial statements in conformitywith generally accepted accounting principles requires management to makeestimates and assumptions that affect the reported amounts of assets and liabilitiesat the date of the financial statements and the reported amounts of revenue andexpenses and the disclosure of contingent assets and liabilities during thereporting period.  Actual results coulddiffer from those estimates.

 

*RecentAccounting Pronouncements*

 

SFAS No. 144, “Accounting for the Impairment orDisposal of Long-Lived Assets,” supersedes SFAS No. 121 and a portion of APBOpinion No. 30.  This statementestablishes a single accounting model for the disposal of long-lived assets andresolves significant implementation issues related to SFAS No. 121.  This standard, which becomes effectiveJanuary 1, 2002, will have no impact on Enchira’s financial statements uponadoption.

 

*Results of Operations*

 

We had sponsored research revenues for the years endedDecember 31, 1999, 2000 and 2001 of $1,415,177, $840,552 and $738,934,respectively.  From 1999 to 2000sponsored research revenues decreased by $574,625 reflecting a decrease infunding from the U. S. Department of Energy (“DOE”) grant.  The decrease of $101,618 in sponsoredresearch revenues from 2000 to 2001 is also due to a decrease in the DOEfunding upon completion of the related grant in the second quarter of 2001offset in part by a research collaboration agreement with Genencor.

 

We had research and development expenses for the yearsended December 31, 1999, 2000 and 2001 of $4,847,641, $4,195,043 and$4,057,167, respectively.  The decreasesof $652,598 from 1999 to 2000 and of $137,876 from 2000 to 2001 are primarily aresult of a reduction in research and development personnel.  Research and development costs include thefollowing categories: personnel costs, laboratory costs, research costs,building costs, utilities, insurance and an allocation of corporate costs.

 

We had general and administrative expenses for theyears ended December 31, 1999, 2000 and 2001 of  $1,905,815, $2,934,150 and $4,199,724, respectively.  The increases of $1,028,335 from 1999 to 2000and of $1,265,574 from 2000 to 2001 resulted primarily from increased legal costsassociated with the arbitration with Maxygen and legal expenses paid to Maxygenresulting from the settlement of the arbitration and the addition of a VicePresident for Business Development at the end of the third quarter of 2000.

 

Interest and investment income increased from 1999 to2000 by $94,954 as a result of an increase in cash, cash equivalents andrelated investments resulting from cash proceeds from issuance of commonstock.  Interest and investment incomedecreased by $158,990 from 2000 to 2001 as a result of a decrease in availablecash.

 

*Liquidity and Capital Resources*

 

Since its inception in December 1989, Enchira hasdevoted substantially all of its resources to research and development.  To date, all of our revenues have resultedfrom interest and investment income and sponsored research payments fromcollaborative agreements and government grants.  We****have incurredcumulative losses since inception and expect to incur continued losses for atleast the next several years, due primarily to continued research anddevelopment activities and the development of our new Drug CandidateOptimization Platform (DCOPTM) technologies to create new therapeuticproteins.  We expect that losses willfluctuate from quarter to quarter and that such fluctuations may besubstantial.  As of December 31, 2001,our accumulated deficit was approximately $91.3 million.

 

For the year ended December 31, 2001, Enchira used$6,523,291 of funds in operating activities. At December 31, 2001, Enchira had cash, cash equivalents and short-terminvestments totaling $3,807,747 and working capital of $3,246,564.  We believe that we can conserve its existingfinancial resources to fund operations through mid-2002.

 

22

----

 

 

From inception of the Company through mid-1999,Enchira’s research and development efforts were devoted to its BDS technology,a proprietary process involving the use of enzymes in bacteria to remove sulfurfrom petroleum.  From mid-1999 throughthe end of 2000, Enchira focused its research on the development of itsRACHITTTM technology, a proprietary gene shuffling method.  The arbitration with Maxygen and theeventual ruling of the arbitrator, which declared Maxygen as the exclusiveowner of the RACHITTTM technology resulted in our abandoning that research anddevelopment effort.  The Company’sprimary research in 2001 was focused on the development of our Anti-CancerLigand ("ACLÔ") proteins.

 

Our existing proprietary technologies are new and inthe early stage of development and successful development of our products arehighly uncertain.  We made substantialprogress in the discovery and development of our ACLTM proteins in 2001 usingour proprietary Drug Candidate Optimization Platform ("DCOPÔ")technologies, which are an integrated suite of technologies for proteinengineering, screening, and production. We plan to move a number of candidates to pre-clinical development in2002 under the collaboration agreement with The University of Texas M. D.Anderson Cancer Center (“M. D. Anderson”) .

 

We believe that our ACLÔproteins will have significant advantages in selectivity, tumor penetration andmanufacturing costs over other approaches for inhibition of RTKs.  We plan to apply our internal scientific andtechnical resources, combined with those of our collaborators andco-development partners, to drive our ACLÔproteins through pre-clinical evaluations and development, clinical trials andultimately to production and marketing. As we develop our therapeutics, we will pursue commercialization optionsincluding additional research collaborations, joint ventures and out-licensingopportunities.  We also intend to enterinto co-development partnerships based on our proprietary discoverytechnologies that will generate up-front payments and research funding, plusmilestone and royalty payments.

 

An estimation of completion dates and completion costscan vary significantly for each product and are difficult to predict. Clinicaltrials are conducted in sequential phases. In Phase I the drug is administeredto a small group of humans either healthy volunteers or patients, to test forsafety, dosage tolerance, absorption, metabolism, excretion, and clinicalpharmacology. In Phase II, a slightly larger number of patients are studied toassess the efficacy of the product, to ascertain dose tolerance and the optimaldose range, and to gather additional data relating to safety and potentialadverse events. In Phase III, studies establish safety and efficacy in anexpanded patient population. The FDA can require Phase IV post-marketingstudies. The length of time to completion can vary substantially according tothe type, complexity, novelty and intended use of a product candidate.  The cost relating to pre-clinical andclinical trials vary significantly over the life of a project.  Our primary mechanism for budgeting andtracking these costs is by type of cost incurred.  The types of costs include the following categories:  personnel costs, laboratory costs, researchcosts, building costs, utilities, insurance and an allocation of corporatecosts.

 

We expect to incur substantial additional research anddevelopment expenses, including expenses associated with development oftherapeutic proteins using our Drug Candidate Optimization Platform (“DCOPTM”)technologies.  We are subject to a costsharing arrangement under the collaborative agreement with the M. D. AndersonCancer Center as discussed in Note 7 to the Financial Statements attached tothis Form 10-K.  We also expect ourgeneral and administrative expenses to increase as we increase our businessdevelopment.

 

We have a non-cancelable operating lease for ourcorporate office space, which expires in October 2003 and includes futureminimum lease payments of approximately $437,000 and $364,000 in 2002 and 2003,respectively.

 

In October 2000, Enchira established a jointcollaboration with M. D. Anderson to apply our DCOPTM technologies to thedevelopment of more effective cancer therapies targeted toward epidermal growthfactor receptors.  In thiscollaboration, Enchira will provide its recombination technologies and roboticscreening research and has retained certain ownership and licensing rights todevelopments made by Enchira that come out of the relationship.  As of December 31, 2001, we have incurredexpenses of $187,500 to M. D. Anderson and have a commitment of an additional$112,500 under the collaboration.

 

In August 2000, we entered into a collaborationagreement with Genencor for research and development work on improvedindustrial proteins.  Under theagreement Genencor will provide $1 million of funding to us over a two-yearperiod.  Through December 31, 2001, wehave received $625,000 for research and development under the Genencorcollaboration agreement.  Genencorterminated the collaboration agreement effective December 31, 2001.

 

In May 2000, we entered into a licensing agreementwith Genencor involving Enchira’s proprietary gene shuffling technology fordirected evolution.  Under theagreement, Genencor would use our proprietary technologies, which includes theRACHITTTM technology, to develop gene-based products for the cleaning, textiles,grain processing, animal-feed and food ingredients industries.  Genencor paid an initial licensing fee andan additional fee for an option to expand the licensing field in June 2000.  Revenues of $550,000 received during thesecond quarter of 2000 have been refunded in 2001 as a result of the November3, 2001 arbitrator’s ruling that Maxygen is the exclusive owner of the RACHITTTMtechnology between Maxygen and Enchira and that Enchira is enjoined fromlicensing the RACHITTTM technology.  TheGenencor licensing agreement was terminated in November 2001.

 

In August 1997, Enchira was awarded funding by the DOEfor a $2.9 million program. The program was amended and extended to May 2001,and was dedicated to the development of a biodesulfurization application forgasoline.  Through December 31, 2001 wehave recognized all the sponsored research revenue from the grant.

 

In September 2001, Enchira made an offer to holders ofthe Series B Preferred Stock to convert their shares to common stock.  We believed this offer would removepotential impediments to future financings and was in the best

 

23

----

 

interest of our shareholders. Of the 307,700 shares of Series B Preferred Stock outstanding atSeptember 30, 2001, owners of 215,000 shares of Series B Preferred Stock agreedto convert their Series B Preferred Stock into 641,394 shares of common stockin October 2001. In connection with the conversion, we paid $2,510,733 incash for accrued dividends on shares of Series B Preferred Stock in October2001.  The remaining 92,700 shares ofSeries B Preferred Stock are convertible into 276,551 shares of common stock.

 

On October 19, 2001 we purchased, at a significantdiscount from the publicly traded market price, 1,080,000 shares of theCompany’s issued and outstanding common stock from several stockholders whoseshares were under common management.  Inconnection with this repurchase, we acquired and cancelled for no additionalconsideration warrants to purchase an aggregate of 376,500 shares of our commonstock that were held by the sellers. The repurchased common stock was recorded at its aggregate cost of $21,600as treasury stock in our stockholders’ equity. As a result of this transaction, the number of outstanding shares ofcommon stock is approximately 10.5 million.

 

Nasdaq sent us a letter dated February 14, 2002 inwhich it informed us that we no longer meet certain of Nasdaq’s maintenancerequirements.  The letter gave us 90days within which we can come into compliance with these maintenancerequirements or request a hearing.  Inthe event that we do neither, we can request that we be moved to the NasdaqSmallCap Market, and we will be granted an additional 90 days to come intocompliance with the maintenance requirements for the Nasdaq SmallCapMarket.  We intend to request a move tothe Nasdaq SmallCap Market if we are unable to comply with the Nasdaq NationalMarket maintenance requirements.  Therecan be no assurance that we will be able to meet the Nasdaq SmallCap Marketmaintenance requirements or that we will be able to be successful in a hearingto avoid a delisting from the Nasdaq SmallCap Market.  In the event that our common stock is eventually delisted fromthe Nasdaq altogether, trading in our common stock would thereafter beconducted in the over-the-counter markets in the so-called “pink sheets” or theNASD’s “Electronic Bulletin Board.” Consequently, the liquidity of our common stockcould be impaired, not only in the number of shares which could be bought andsold, but also through delays in the timing of the transactions, reductions insecurity analysts’ and the news media’s coverage of us, and lower prices forour common stock than it might otherwise attain.  Should we be unable to satisfy the Nasdaq maintenancerequirements and our common stock is delisted, we may be required to redeem theremaining outstanding shares of Series B Preferred Stock in cash.

 

Under the terms of our Series B Preferred Stock, weare required to redeem all outstanding shares of Series B Preferred Stock at aprice of $50 per share on or after February 26, 2002.  Additionally, at the time of redemption, we are also required topay any accrued but unpaid dividends on the shares of Series B Preferred Stockbeing redeemed.   We have elected toredeem all shares of Series B Preferred Stock with shares of our commonstock.  The number of shares of ourcommon stock issuable upon such redemption is based upon the 10-day average ofour closing prices at the time of redemption. Under the terms of the Series B Preferred Stock, we are required toprovide a firm commitment underwriting of the shares of our common stock beingissued in connection with the redemption, otherwise the holders of Series BPreferred Stock may elect to waive this requirement in the event we are unableto provide a firm commitment underwriting in a timely manner.  As a result, we have redeemed 41,100 sharesof Series B Preferred Stock to date from one holder who waived thisrequirement, which resulted in the issuance of 3,425,000 shares of our commonstock for such redemption and an additional 1,024,075 shares of our commonstock in payment of accrued dividends on such shares.  We have an additional 51,600 shares of Series B Preferred Stockoutstanding.  If these shares wereredeemed at the closing price in effect on March 8, 2002, we would be requiredto issue an aggregate of 3,209,846 shares of our common stock for theredemption and accrued and unpaid dividends.

 

We have experienced negative cash flow from operationssince our inception and have funded our activities to date primarily fromequity financings and sponsored research revenues.  We will continue to require substantial funds to continue ourresearch and development activities and to market, sell and commercialize ourtechnology. We will need to raise substantial additional capital to fund ourfuture operations.  Our capitalrequirements will depend on many factors, including the problems, delays,expenses and complications frequently encountered by companies developing andcommercializing new technologies; the progress of our research and developmentactivities; the rate of technological advances; determinations as to thecommercial potential of our technology under development; the status ofcompetitive technology; the establishment of collaborative relationships; thesuccess of our sales and marketing programs; the cost of filing, prosecutingand defending and enforcing patents and intellectual property

 

24

----

 

rights; and other changes in economic, regulatory or competitiveconditions in our planned business. Estimates about adequacy of funding for our activities are based uponcertain assumptions, including assumptions that the research and developmentprograms relating to our technology can be conducted at projected costs andthat progress towards the commercialization of our technology will be timelyand successful.  There can be no assurancethat changes in our research and development plans, acquisitions or otherevents will not result in accelerated or unexpected expenditures.

 

To satisfy our capital requirements, we will seekadditional financing through debt and equity financings, government funding andthrough alliances with pharmaceutical companies and corporate partners.  There can be no assurance that any suchfundings will be available to us on favorable terms or at all.  If adequate funds are not available whenneeded, we may be required to delay, scale back or eliminate some or all of ourresearch and product development programs. If we are successful in obtaining additional financings, the terms ofsuch financings may have the effect of diluting or adversely affecting the holdingsor the rights of the holders of our common and preferred stock.

 

**Item 7A.*Quantitative and QualitativeDisclosures About Market Risk.***

 

None

 

**Item 8. *Financial Statements.***

 

The financial statements required by this Item areincorporated under Item 14 in Part IV of this report.

 

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

 

None.

 

25

----

 

**Part III.**

 

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

 

The information required by this Item as to thedirectors and executive officers of Enchira is hereby incorporated by referencefrom the information appearing under the captions “Election of Directors” and“Executive Officers” in Enchira’s definitive proxy statement which involves theelection of directors and is to be filed with the Securities and ExchangeCommission (“Commission”) pursuant to the Securities Exchange Act of 1934within 120 days of the end of Enchira’s fiscal year on December 31, 2001.

 

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

 

The information required by this Item as to themanagement of Enchira is hereby incorporated by reference from the informationappearing under the captions “Executive Compensation” and “Election ofDirectors - Director Compensation” in Enchira’s definitive proxy statementwhich involves the election of directors and is to be filed with the Commissionpursuant to the Securities Exchange Act of 1934 within 120 days of the end ofthe Company’s fiscal year on December 31, 2001.  Notwithstanding the foregoing, in accordance with theinstructions to Item 402 of Regulation S-K, the information contained inEnchira’s proxy statement under the sub-heading “Report of the CompensationCommittee of the Board of Directors” and “Performance Graph” shall not bedeemed to be filed as part of or incorporated by reference into this Form 10-K.

 

**Item 12. *Security Ownership of CertainBeneficial Owners and Management.***

 

The information required by this Item as to theownership by management and others of securities of Enchira is herebyincorporated by reference from the information appearing under the caption“Security Ownership of Certain Beneficial Owners and Management” to Enchira’sdefinitive proxy statement which involves the election of directors and is tobe filed with the Commission pursuant to the Securities Exchange Act of 1934within 120 days of the end of Enchira’s fiscal year on December 31, 2001.

 

**Item 13. *Certain Relationships and Related Transactions.***

 

The information required by this Item as to certainbusiness relationships and transactions with management and other relatedparties of Enchira is hereby incorporated by reference to such informationappearing under the captions “Certain Transactions” and “Compensation CommitteeInterlocks and Insider Participation” in Enchira’s definitive proxy statementwhich involves the election of directors and is to be filed with the Commissionpursuant to the Securities Exchange Act of 1934 within 120 days of the end ofEnchira’s fiscal year on December 31, 2001.

 

26

----

 

**Part IV.**

 

**Item 14. *Exhibits, Financial StatementSchedules, and Reports on Form 8-K.***

 

(a) Documents Filed as a Part of this Report

 

**1.  Financial Statements:**

 
| Report of  Independent Public Accountants                                                     |
|-----------------------------------------------------------------------------------------------|
| Balance Sheets as of December 31, 2000  and 2001                                              |
| Statements  of Operations for the Years Ended December 31, 1999, 2000 and 2001                |
| Statements of Stockholders’  Equity for the Years Ended December 31, 1999, 2000 and 2001 |
| Statements  of Cash Flows for the Years Ended December 31, 1999, 2000 and 2001                |
| Notes to Financial  Statements                                                                |

 

All other schedules are omitted because they are notapplicable, not required, or because the required information is included inthe financial statements or notes thereto.

 

**2.  Exhibits:**

 

Exhibits to the Form 10-K have been included only withthe copies of the Form 10-K filed with the Commission and the Nasdaq StockMarket.  Upon request to Enchira andpayment of a reasonable fee, copies of the individual exhibits will befurnished.

 
| **Exhibit No.** |   | **Description**                                                                                                                                                                                                                                                                                                                                                                                                                                 |
|-----------------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.1(a)          |   | EBC’s Amended and Restated Certificate of  Incorporation (incorporated by reference to Exhibit 2 to Post Effective  Amendment No. 1 to EBC’s Registration Statement on Form 8-A as filed with the  Commission on March 15, 1993).                                                                                                                                                                                                     |
|            |   |                                                                                                                                                                                                                                                                                                                                                                                                                                            |
| 3.1(b)          |   | Certificate of Amendment to EBC’s Amended and  Restated Certificate of Incorporation (incorporated by reference to Exhibit  3.1 to EBC’s Current Report on Form 8-K dated June 8, 2000).                                                                                                                                                                                                                                              |
|            |   |                                                                                                                                                                                                                                                                                                                                                                                                                                            |
| 3.1(c)          |   | EBC’s Certificate of Designation of Series One  Junior Participating Preferred Stock (incorporated by reference to Exhibit  3.1(c) to EBC’s Annual Report on Form 10-K for the year ended December 31,  2000 (the “2000 Form 10-K”)).                                                                                                                                                                                       |
|            |   |                                                                                                                                                                                                                                                                                                                                                                                                                                            |
| 3.1(d)          |   | EBC’s Certificate of the Powers, Designation,  Preferences and Rights of the Series B Convertible Preferred Stock  (incorporated by reference to Exhibit 3.1(d) to EBC’s Annual Report on Form  10-K for the year ended December 31, 1997).                                                                                                                                                                                           |
|            |   |                                                                                                                                                                                                                                                                                                                                                                                                                                            |
| 3.2             |   | EBC’s Bylaws (incorporated by reference to Exhibit 3  filed with Post-Effective Amendment No. 1 to EBC’s Registration Statement on  Form 8-A as filed with the Commission on March 15, 1993).                                                                                                                                                                                                                                         |
|            |   |                                                                                                                                                                                                                                                                                                                                                                                                                                            |
| 4.1             |   | Form of Stock Purchase Agreement, dated as of  February 21, 1997, by and between EBC and the Purchasers of the Series B  Convertible Preferred Stock (incorporated by reference to Exhibit 4.2 to  EBC’s Annual Report on Form 10-K for the year ended December 31, 1996 (the  “1996 Form 10-K”)).                                                                                                                               |
|            |   |                                                                                                                                                                                                                                                                                                                                                                                                                                            |
| 4.2             |   | Form of Stock Exchange Agreement, dated as of  February 21, 1997, by and between EBC and the Exchanging Holders of Series A  Convertible Preferred Stock (incorporated by reference to Exhibit 4.3 to the  1996 Form 10-K).                                                                                                                                                                                                                     |
|            |   |                                                                                                                                                                                                                                                                                                                                                                                                                                            |
| 4.3             |   | Stockholder Rights Agreement dated as of March 8,  1995 between EBC and Computershare Investor Services LLC (as successor in  interest to Society National Bank and Harris Trust & Savings Bank)  (incorporated by reference to Exhibit 4.3 to the 2000 Form 10-K).                                                                                                                                                                         |
|            |   |                                                                                                                                                                                                                                                                                                                                                                                                                                            |
| 4.4             |   | First Amendment to Stockholder Rights Agreement  dated as of April 30, 1997 between EBC and Computershare Investor Services  LLC (as successor in interest to Society National Bank and Harris Trust &  Savings Bank) (incorporated by reference to Exhibit 4.3 to Post Effective  Amendment No. 2 to EBC’s Registration Statement on Form 8-A/A as filed with  the Commission on June 23, 2000 (the “2000 8-A Amendment”)). |
|            |   |                                                                                                                                                                                                                                                                                                                                                                                                                                            |
| 4.5             |   | Second Amendment to Stockholder Rights Agreement  dated as of June 23, 2000 between EBC and Computershare Investor Services LLC  (as successor in interest to Society National Bank and Harris Trust &  Savings Bank) (incorporated by reference to Exhibit 4.4 to the 2000 8-A  Amendment).                                                                                                                                                |
|            |   |                                                                                                                                                                                                                                                                                                                                                                                                                                            |
| 4.6             |   | Third Amendment to Stockholder Rights Agreement  dated as of February 25, 2002 between EBC, Computershare Investor Services  LLC and Harris Trust and Savings Bank (incorporated by reference to Exhibit  4.5 to Amendment No. 3 to EBC’s Registration Statement on Form 8-A/A as filed  with the Commission on February 25, 2002).                                                                                                        |
|            |   |                                                                                                                                                                                                                                                                                                                                                                                                                                            |
| 10.1†      |   | Sponsored Laboratory Study Agreement dated October  4, 2000 between EBC and The University of Texas M.D. Anderson Cancer Center  (incorporated by reference to Exhibit 10.3 to the 2000 Form 10-K).                                                                                                                                                                                                                                             |
|            |   |                                                                                                                                                                                                                                                                                                                                                                                                                                            |
| 10.2            |   | Site License Agreement dated March 6, 1998 between  EBC and Petro Star Inc.****(incorporated  by reference to Exhibit 10.4 to the 2000 Form 10-K)                                                                                                                                                                                                                                                                                               |
|            |   |                                                                                                                                                                                                                                                                                                                                                                                                                                            |
| 10.3            |   | Lease Agreement dated May 24, 1993 between EBC and  Woodlands Office Equities — ‘95 Limited (as successor in interest to The  Woodlands Corporation) (incorporated by reference to Exhibit 10.7 to the 2000  Form 10-K).                                                                                                                                                                                                              |
|            |   |                                                                                                                                                                                                                                                                                                                                                                                                                                            |
| 10.4            |   | Extension, Modification and Ratification of Lease  dated January 27, 1994 between EBC and Woodlands Office Equities – ‘95  Limited (as successor in interest to The Woodlands Corporation) (incorporated  by reference to Exhibit 10.8 to the 2000 Form 10-K).                                                                                                                                                                        |
|            |   |                                                                                                                                                                                                                                                                                                                                                                                                                                            |
| 10.5            |   | Extension, Modification and Ratification of Lease  dated March 23, 1998 between EBC and Woodlands Office Equities – ‘95 Limited  (as successor in interest to The Woodlands Corporation) (incorporated by  reference to Exhibit 10.36 to EBC’s Annual Report on Form 10-K for the fiscal  year ended December 31, 1998 (the “1998 Form 10-K”)).                                                                        |
|            |   |                                                                                                                                                                                                                                                                                                                                                                                                                                            |
|            |   | **Management Contracts and  Compensatory Plans**                                                                                                                                                                                                                                                                                                                                                                                                |
|            |   |                                                                                                                                                                                                                                                                                                                                                                                                                                            |
| 10.6            |   | EBC 1997 Stock Option Plan, as amended (incorporated  by reference to Exhibit A to EBC’s Definitive Proxy Statement as filed with  the Commission on April 27, 1999 (the “1999 Proxy Statement”)).                                                                                                                                                                                                                               |
|            |   |                                                                                                                                                                                                                                                                                                                                                                                                                                            |
| 10.7            |   | EBC 1992 Stock Compensation Plan (incorporated by  reference to Exhibit 10.10 to EBC’s Registration Statement on Form S-1 (No.  33-56718)).                                                                                                                                                                                                                                                                                                |
|            |   |                                                                                                                                                                                                                                                                                                                                                                                                                                            |
| 10.8            |   | EBC Non-Employee Director Option Plan, as amended  (incorporated by reference to Exhibit B to the 1999 Proxy Statement).                                                                                                                                                                                                                                                                                                                        |
|            |   |                                                                                                                                                                                                                                                                                                                                                                                                                                            |
| 10.9            |   | Simplified Employee Pension Plan Retirement Plan  Adoption Agreement (incorporated by reference to Exhibit 10.15 to EBC’s  Registration Statement on Form S-1 (No. 33-56718)).                                                                                                                                                                                                                                                             |
|            |   |                                                                                                                                                                                                                                                                                                                                                                                                                                            |
| 10.10           |   | Employment Agreement dated December 4, 1998 between  EBC and Peter P. Policastro (incorporated by reference to Exhibit 10.35 to  the 1998 Form 10-K).                                                                                                                                                                                                                                                                                           |
|            |   |                                                                                                                                                                                                                                                                                                                                                                                                                                            |
| 10.11           |   | Employment Agreement dated January 31, 1996 between  EBC and Daniel J. Monticello (incorporated by reference to Exhibit 10.10 to  the 1996 Form 10-K).                                                                                                                                                                                                                                                                                          |
|            |   |                                                                                                                                                                                                                                                                                                                                                                                                                                            |
| 10.12           |   | Employment Agreement dated July 18, 1995 between EBC  and Paul G. Brown, III (incorporated by reference to Exhibit 10.10 to EBC’s  Registration Statement on Form S-1 (No. 33-96096)).                                                                                                                                                                                                                                                     |
|            |   |                                                                                                                                                                                                                                                                                                                                                                                                                                            |
| 10.13           |   | Employment Letter dated August 30, 2000 between EBC  and David Carpi (incorporated by reference to Exhibit 10.2 to the Third  Quarter 2000 Form 10-Q).                                                                                                                                                                                                                                                                                          |
|            |   |                                                                                                                                                                                                                                                                                                                                                                                                                                            |
| *11.1           |   | Computation of earnings per share.                                                                                                                                                                                                                                                                                                                                                                                                              |
|            |   |                                                                                                                                                                                                                                                                                                                                                                                                                                            |
| *23.1           |   | Consent of Arthur Andersen LLP.                                                                                                                                                                                                                                                                                                                                                                                                                 |
|            |   |                                                                                                                                                                                                                                                                                                                                                                                                                                            |
| *99.1           |   | Letter from Enchira Biotechnology Corporation to the  Securities and Exchange Commission dated April 1, 2002 regarding  representations from Arthur Andersen LLP.                                                                                                                                                                                                                                                                               |

 

----

*                                         Filedherewith

†                                          Portionsof this exhibit have been omitted based on a request for confidential treatmentpursuant to Rule 24b-2 of the Exchange Act. Such omitted portions have been filed separately with the Commission.

 

----

(b) Reports on Form 8-K

 

Enchira filed Current Reports on Form 8-K on October 10 and November 6,2001 which both reported events under Item 5.

 

27

----

 

**SIGNATURES**

 

**Pursuantto the requirements of Section 13 or 15(d) of the Securities Exchange Act of1934, EBC has duly caused thisReport to be signed on its behalf by the undersigned, thereunto dulyauthorized.**

 

 
|                               | ENCHIRA  BIOTECHNOLOGY CORPORATION    |
|------------------------------------|---------------------------------------|
|                               |                                  |
|                               | By:                                   | /s/ Peter P. Policastro |
|                               | Peter P. Policastro                   |
|                               | Chief Executive Officer and President |
|                               |                                  |
| DATED the 26th day of  March 2002. |                                  |

 

**Pursuantto the requirements of the Securities Exchange Act of 1934, this Report hasbeen signed below by the following persons on behalf of EBC and in thecapacities and on the dates indicated:**

 

 
| **Name**                    |                                                                                   | **Title**                              |           | **Date** |
|-----------------------------|----------------------------------------------------------------------------------------|----------------------------------------|----------------|----------|
| /s/ Peter P.  Policastro    |                                                                                   | Chief Executive Officer  and President | March 26, 2002 |
| Peter P. Policastro, Ph.D.  | (Principal executive  officer)                                                         |                                   |
|                        |                                                                                   |                                   |
| /s/ Paul G.  Brown III      |                                                                                   | Chief Financial Officer  and Vice      | March 26, 2002 |
| Paul G. Brown,  III         | President—Finance and Administration (Principal financialand  accounting officer) |                                   |
|                        |                                                                                   |                                   |
| /s/ William E.  Nasser      |                                                                                   | Chairman of the Board                  | March 26, 2002 |
| William E.  Nasser          |                                                                                   |                                   |
|                        |                                                                                   |                                   |
| /s/ Daniel J.  Monticello   |                                                                                   | Vice President—Science  and       | March 26, 2002 |
| Daniel J. Monticello, Ph.D. | Technology and Director                                                                |                                   |
|                        |                                                                                   |                                   |
| /s/ R. James  Comeaux       |                                                                                   | Director                               | March 26, 2002 |
| R. James Comeaux            |                                                                                   |                                   |
|                        |                                                                                   |                                   |
| /s/ Thomas E.  Messmore     |                                                                                   | Director                               | March 26, 2002 |
| Thomas E. Messmore          |                                                                                   |                                   |
|                        |                                                                                   |                                   |
| /s/ William D.  Young       |                                                                                   |                                   |           |
| William D. Young            | Director                                                                               | March 26, 2002                         |
|                             |                                                                                        |                                        |                |          |  |  |  |

 

28

----

 

**REPORTOF INDEPENDENT PUBLIC ACCOUNTANTS**

 

To EnchiraBiotechnology Corporation:

 

We have auditedthe accompanying balance sheets of Enchira Biotechnology Corporation (“theCompany”) (a Delaware corporation), as of December 31, 2000 and 2001, and therelated statements of operations, stockholders’ equity and cash flows for eachof the three years in the period ended December 31, 2001.  These financial statements are theresponsibility of the Company’s management. Our responsibility is to express an opinion on these financialstatements based on our audits.

 

We conducted ouraudits in 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,the financial statements referred to above present fairly, in all materialrespects, the financial position of Enchira Biotechnology Corporation as ofDecember 31, 2000 and 2001, and the results of its operations and its cashflows for each of the three years in the period ended December 31, 2001 inconformity with accounting principles generally accepted in the United States.

 

The accompanyingfinancial statements have been prepared assuming that the Company will continueas a going concern.  As discussed inNote 1 to the financial statements, the Company has devoted substantially allof its efforts to performing research and development.  The Company has experienced negative cashflows from operations and has not realized revenues other than sponsoredresearch revenues and has an accumulated deficit of $91.3 million since itsinception.  In order to complete theresearch and development and other activities necessary to commercialize itsproducts, additional financing will be required.  The Company has not secured any commitments for any suchadditional funding.   These factorsraise substantial doubt about the Company’s ability to continue as a goingconcern.  Management’s plans in regardto these matters are also described in Note 1. The financial statements do not include any adjustments relating to therecoverability and classification of asset carrying amounts, includingintangible and other assets, or the amount and classification of liabilitiesthat might result should the Company be unable to continue as a going concern.

 

ARTHUR ANDERSENLLP

 

Houston, Texas

March 8, 2002

 

F-1

----

 

**ENCHIRABIOTECHNOLOGY CORPORATION**

** **

**BALANCESHEETS**
|                                                                                                                                                                                   |   | **December  31,** |       |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|-------------------|------------|
|                                                                                                                                                                                   |   | **2000**          | ** ** | **2001** | ** ** |
| **ASSETS**                                                                                                                                                                             |   |              |       |   |   |
| Current assets:                                                                                                                                                                        |   |              |       |   |   |
| Cash and cash equivalents                                                                                                                                                              |   | $                 | 7,524,191  |   | $ | 3,031,806 |   |
| Short term investments                                                                                                                                                                 |   | 4,475,679         |       | 775,941 |   |
| Prepaid expenses and other current assets                                                                                                                                              |   | 900,266           |       | 221,833 |   |
| Total current assets                                                                                                                                                                   |   | 12,900,136        |       | 4,029,580 |   |
|                                                                                                                                                                                   |   |              |       |   |   |
| Long term investments                                                                                                                                                                  |   | 1,280,937         |       | — |   |
| Furniture, equipment and leasehold improvements, net                                                                                                                                   |   | 638,865           |       | 373,279 |   |
| Intangible and other assets, net                                                                                                                                                       |   | 1,038,175         |       | 814,716 |   |
| Total assets                                                                                                                                                                           |   | $                 | 15,858,113 |   | $ | 5,217,575 |   |
|                                                                                                                                                                                   |   |              |       |   |   |
| **LIABILITIES & STOCKHOLDERS’ EQUITY**                                                                                                                                        |   |              |       |   |   |
|                                                                                                                                                                                   |   |              |       |   |   |
| Current liabilities:                                                                                                                                                                   |   |              |       |   |   |
| Accounts payable and accrued liabilities                                                                                                                                               |   | $                 | 544,836    |   | $ | 589,372 |   |
| Capital lease, short term                                                                                                                                                              |   | 12,304            |       | 13,644 |   |
| Deferred revenue                                                                                                                                                                       |   | 730,000           |       | 180,000 |   |
| Note payable                                                                                                                                                                           |   | 255,867           |       | — |   |
| Total current liabilities                                                                                                                                                              |   | 1,543,007         |       | 783,016 |   |
|                                                                                                                                                                                   |   |              |       |   |   |
| Capital lease, long term                                                                                                                                                               |   | 57,991            |       | 43,170 |   |
|                                                                                                                                                                                   |   |              |       |   |   |
| Commitments and contingencies                                                                                                                                                          |   |              |       |   |   |
|                                                                                                                                                                                   |   |              |       |   |   |
| Stockholders’ equity:                                                                                                                                                             |   |              |       |   |   |
| Series B convertible preferred stock $0.01 par value (liquidation  value $6,497,538; 760,000 shares authorized; 387,700  and 94,700 shares issued and outstanding,  respectively) |   | 23,512,474        |       | 6,398,799 |   |
| Common stock, $0.01 par value (30,000,000 shares authorized,  9,067,700 and 9,763,320 shares issued and outstanding, respectively)                                                     |   | 90,677            |       | 108,433 |   |
| Treasury stock, zero and 1,080,000 shares, respectively, at cost                                                                                                                       |   | —            |       | (21,600 | ) |
| Additional paid-in capital                                                                                                                                                             |   | 73,626,674        |       | 89,191,974 |   |
| Accumulated deficit                                                                                                                                                                    |   | (82,972,710       | )          | (91,286,217 | ) |
| Total stockholders’ equity                                                                                                                                                        |   | 14,257,115        |       | 4,391,389 |   |
| Total liabilities and stockholders’ equity                                                                                                                                        |   | $                 | 15,858,113 |   | $ | 5,217,575 |   |

 

The accompanyingnotes are an integral part of these financial statements.

 

F-2

----

 

**ENCHIRABIOTECHNOLOGY CORPORATION**

 

**STATEMENTS OF OPERATIONS**

 
|                                                                         |   | **Year Ended  December 31,** |       |
|------------------------------------------------------------------------------|--------|------------------------------|------------|
|                                                                         |   | **1999**                     |       | **2000** |   | **2001** |   |
| Sponsored research revenues                                                  |   | $                            | 1,415,177  |   | $ | 840,552 |   | $ | 738,934 |   |
|                                                                         |   |                         |       |   |   |   |   |
| Costs and expenses:                                                          |   |                         |       |   |   |   |   |
| Research and development                                                     |   | 4,847,641                    |       | 4,195,043 |   | 4,057,167 |   |
| General and administrative                                                   |   | 1,905,815                    |       | 2,934,150 |   | 4,199,724 |   |
|                                                                         |   |                         |       |   |   |   |   |
| Total costs and expenses                                                     |   | 6,753,456                    |       | 7,129,193 |   | 8,256,891 |   |
|                                                                         |   |                         |       |   |   |   |   |
| Interest and investment income                                               |   | 213,458                      |       | 308,412 |   | 149,422 |   |
| Loss on disposal of fixed assets                                             |   | (139,641                     | )          | (43,311 | ) | (18,931 | ) |
| Net loss                                                                     |   | $                            | (5,264,462 | ) | $ | (6,023,540 | ) | $ | (7,387,466 | ) |
|                                                                         |   |                         |       |   |   |   |   |
| Net loss per common share  basic and diluted                                 |   | $                            | (1.78      | ) | $ | (1.10 | ) | $ | (0.94 | ) |
|                                                                         |   |                         |       |   |   |   |   |
| Shares used in computing net loss per common share — basic and  diluted |   | 4,635,930                    |       | 7,576,121 |   | 9,557,383 |   |

 

The accompanying notes are an integral part of thesefinancial statements.

 

F-3

----

 

**ENCHIRABIOTECHNOLOGY CORPORATION**

** **

**STATEMENTSOF STOCKHOLDERS’ EQUITY**

** **

 
|                                                        |   | **Preferred  Stock** |   | **Common  Stock** |       | **Treasury** |       | **Additional  Paid-in** |   | **Accumulated** |   |        |    |
|-------------------------------------------------------------|--------|----------------------|--------|-------------------|------------|--------------|------------|-------------------------|--------|-----------------|--------|-------------|---------|
|                                                        |   | **Amount**           |   | **Shares**        |       | **Shares**   |       | **Amount**              |   | **Stock**       |   | **Capital** |    | **Deficit** |   | **Total** |   |
| Balance at December 31, 1998                                |   | 696,400              |   | $                 | 33,955,166 |         | 2,179,142  |                    | $      | 21,791          |   | $           | —  |   | $ | 38,529,097 |   | $ | (67,199,595 | ) | $ | 5,306,459 |   |
| Accretion and dividends on series B  preferred stock        |   | —               |   | 2,995,084         |       | —       |       | —                  |   | —          |   | (379,866    | )       | (2,615,218 | ) | — |   |
| Conversion of series B preferred stock to  common stock     |   | (177,000             | )      | (8,850,000        | )          | 174,379      |       | 1,744                   |   | —          |   | 8,848,256   |    | — |   | — |   |
| Common stock issued toconsultant                            |   | —               |   | —            |       | 1,549        |       | 16                      |   | —          |   | 5,984       |    | — |   | 6,000 |   |
| Issuance of common stock and warrants                       |   | —               |   | —            |       | 4,214,820    |       | 42,148                  |   | —          |   | 7,461,415   |    | — |   | 7,503,563 |   |
| Exercise of common stock warrants                           |   | —               |   | —            |       | 2,245        |       | 22                      |   | —          |   | 5,366       |    | — |   | 5,388 |   |
| Net loss                                                    |   | —               |   | —            |       | —       |       | —                  |   | —          |   | —      |    | (5,264,462 | ) | (5,264,462 | ) |
| **Balance at December 31, 1999**                            |   | 519,400              |   | 28,100,250        |       | 6,572,135    |       | 65,721                  |   | —          |   | 54,470,252  |    | (75,079,275 | ) | 7,556,948 |   |
| Accretion and dividends on series B  preferred stock        |   | —               |   | 2,312,556         |       | —       |       | —                  |   | —          |   | (442,661    | )       | (1,869,895 | ) | — |   |
| Conversion of series B preferred stock to  common stock     |   | (131,700             | )      | (6,585,000        | )          | 328,261      |       | 3,283                   |   | —          |   | 6,581,697   |    | — |   | (20 | ) |
| Dividends on series B preferred stock paid  in common stock |   | —               |   | (199,810          | )          | 39,025       |       | 390                     |   | —          |   | 199,420     |    | — |   | — |   |
| Dividends on series B preferred stock paid  in cash         |   | —               |   | (115,522          | )          | —       |       | —                  |   | —          |   | —      |    | — |   | (115,522 | ) |
| Common stock issued to consultant                           |   | —               |   | —            |       | 12,820       |       | 128                     |   | —          |   | 84,872      |    | — |   | 85,000 |   |
| Issuance of common stock and warrants, net                  |   | —               |   | —            |       | 2,000,000    |       | 20,000                  |   | —          |   | 12,425,853  |    | — |   | 12,445,853 |   |
| Exercise of common stock warrants and  options              |   | —               |   | —            |       | 115,459      |       | 1,155                   |   | —          |   | 307,241     |    | — |   | 308,396 |   |
| Net loss                                                    |   | —               |   | —            |       | —       |       | —                  |   | —          |   |        |    | (6,023,540 | ) | (6,023,540 | ) |
| **Balance at December 31, 2000**                            |   | 387,700              |   | 23,512,474        |       | 9,067,700    |       | 90,677                  |   | —          |   | 73,626,674  |    | (82,972,710 | ) | 14,257,115 |   |
| Accretion and dividends on series B  preferred stock        |   | —               |   | 1,720,178         |       | —       |       | —                  |   | —          |   | (480,595    | )       | (1,239,583 | ) | — |   |
| Conversion of series B preferred stock to  common stock     |   | (293,000             | )      | (14,650,000       | )          | 874,089      |       | 8,741                   |   | —          |   | 14,641,248  |    | — |   | (11 | ) |
| Dividends on series B preferred stock paid  in common stock |   | —               |   | (1,359,589        | )          | 889,918      |       | 8,899                   |   | —          |   | 1,350,690   |    | — |   | — |   |
| Dividends on series B preferred stock paid  in cash         |   | —               |   | (2,824,264        | )          | —       |       | —                  |   | —          |   | —      |    | 313,542 |   | (2,510,722 | ) |
| Common Stock issued to consultant                           |   | —               |   | —            |       | 9,638        |       | 96                      |   | —          |   | 49,904      |    | — |   | 50,000 |   |
| Exercise of common stock warrants and  options              |   | —               |   | —            |       | 1,975        |       | 20                      |   | —          |   | 4,053       |    | — |   | 4,073 |   |
| Purchase of 1,080,000 shares of treasury  stock             |   | —               |   | —            |       | —       |       | —                  |   | (21,600         | )      | —      |    | — |   | (21,600 | ) |
| Net loss                                                    |   | —               |   | —            |       | —       |       | —                  |   | —          |   | —      |    | (7,387,466 | ) | (7,387,466 | ) |
| **Balance at December 31, 2001**                            |   | 94,700               |   | $                 | 6,398,799  |         | 10,843,320 |                    | $      | 108,433         |   | $           | (21,600 | ) | $ | 89,191,974 |   | $ | (91,286,217 | ) | $ | 4,391,389 |   |

 

 The accompanyingnotes are an integral part of these financial statements.

 

F-4

----

 

**ENCHIRABIOTECHNOLOGY CORPORATION**

** **

**STATEMENTS OF CASH FLOWS**

 
|                                                                         |   | **Year Ended  December 31,** |       |
|------------------------------------------------------------------------------|--------|------------------------------|------------|
|                                                                         |   | **1999**                     |       | **2000** |   | **2001** |   |
| **CASH  FLOWS FROM OPERATING ACTIVITIES:**                                   |   |                         |       |   |   |   |   |
| Net loss                                                                     |   | $                            | (5,264,462 | ) | $ | (6,023,540 | ) | $ | (7,387,466 | ) |
| Adjustments to reconcile net loss to net cash used in operating  activities: |   |                         |       |   |   |   |   |
| Depreciation and amortization                                                |   | 1,015,754                    |       | 750,351 |   | 454,354 |   |
| Issuance of common stock for services                                        |   | 6,000                        |       | 85,000 |   | 50,000 |   |
| Net loss on disposal of fixed assets                                         |   | 139,641                      |       | 43,311 |   | 18,931 |   |
| Write-off of RACHITT patent costs                                            |   | —                       |       | — |   | 167,921 |   |
| Changes in assets and liabilities:                                           |   |                         |       |   |   |   |   |
| (Increase) decrease in prepaid expenses and otherassets                      |   | 369,472                      |       | (384,977 | ) | 678,433 |   |
| Increase (decrease) in accounts payable and accruedliabilities               |   | (186,523                     | )          | 217,686 |   | 44,536 |   |
| Increase (decrease) in deferred revenue                                      |   | —                       |       | 550,000 |   | (550,000 | ) |
| Net cash used in operating activities                                        |   | (3,920,118                   | )          | (4,762,169 | ) | (6,523,291 | ) |
|                                                                         |   |                         |       |   |   |   |   |
| **CASH  FLOWS FROM INVESTING ACTIVITIES:**                                   |   |                         |       |   |   |   |   |
| Capital expenditures                                                         |   | (152,157                     | )          | (134,595 | ) | (58,472 | ) |
| Patent expenditures                                                          |   | (164,282                     | )          | (285,407 | ) | (114,189 | ) |
| Sale of fixed assets                                                         |   | 14,263                       |       | — |   | 20,500 |   |
| Sale (purchase) of investments held to maturity                              |   | (3,445,199                   | )          | (2,311,417 | ) | 4,980,675 |   |
| Net cash provided by (used in) investing activities                          |   | (3,747,375                   | )          | (2,731,419 | ) | 4,828,514 |   |
|                                                                         |   |                         |       |   |   |   |   |
| **CASH  FLOWS FROM FINANCING ACTIVITIES:**                                   |   |                         |       |   |   |   |   |
| Payments on note payable                                                     |   | (126,613                     | )          | (118,087 | ) | (255,867 | ) |
| Payments on capital lease obligations                                        |   | —                       |       | (13,135 | ) | (13,481 | ) |
| Proceeds from exercise of stock options and warrants                         |   | 5,388                        |       | 308,396 |   | 4,073 |   |
| Dividends paid                                                               |   | —                       |       | (115,522 | ) | (2,510,733 | ) |
| Issuance of common stock                                                     |   | 7,503,563                    |       | 12,445,853 |   | — |   |
| Purchase of treasury stock                                                   |   | —                       |       | — |   | (21,600 | ) |
| Net cash provided by (used in) financing activities                          |   | 7,382,338                    |       | 12,507,505 |   | (2,797,608 | ) |
|                                                                         |   |                         |       |   |   |   |   |
| **NET  INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS**                    |   | (285,155                     | )          | 5,013,917 |   | (4,492,385 | ) |
|                                                                         |   |                         |       |   |   |   |   |
| **CASH  AND CASH EQUIVALENTS AT BEGINNING OF YEAR**                          |   | 2,795,429                    |       | 2,510,274 |   | 7,524,191 |   |
| **CASH  AND CASH EQUIVALENTS AT END OF YEAR**                                |   | $                            | 2,510,274  |   | $ | 7,524,191 |   | $ | 3,031,806 |   |
|                                                                         |   |                         |       |   |   |   |   |
| **Supplemental  information of noncash financingactivities:**                |   |                         |       |   |   |   |   |
| Note payable issued for prepaid insurance                                    |   | $                            | —     |   | $ | 255,867 |   | $ | — |   |
| Dividends on Series B preferred stock paid in commonstock                    |   | —                       |       | 199,810 |   | 1,359,589 |   |

 

The accompanying notes are an integral part of thesefinancial statements.

 

F-5

----

 

**ENCHIRABIOTECHNOLOGY CORPORATION**

** **

**NOTES TO FINANCIAL STATEMENTS**

**December31, 2001**

 

**1.  Description of theCompany**

 

Enchira Biotechnology Corporation (“Enchira” or the“Company”), formerly Energy BioSystems Corporation, was incorporated in theState of Delaware on December 20, 1989, and commenced operations in January1990. Enchira is a drug discovery and development company that is engaged inthe development of therapeutic proteins to inhibit certain cancers.  It is applying its new proprietary DrugCandidate Optimization Platformäto create new therapeutic proteins.  TheCompany is focusing its efforts on protein kinases, which are involved invarious cellular processes. Irregularities of these proteins have been implicated in many humandiseases, including cancer and other proliferative disorders.  Of particular interest are certain proteintyrosine kinases (PTKs) and related receptor tyrosine kinases (RTKs) thatregulate cell growth and proliferation and that have been implicated in themost malignant forms of cancer.

 

On November 3, 2001, the arbitrator issued a ruling inthe arbitration between Maxygen Inc. (“Maxygen”) and the Company.  The ruling states that we are enjoined untilMay 19, 2017 from using, licensing or selling the RACHITTTM technology.  This injunction does not prohibit us fromindependently developing and commercializing other technologies that are notdescribed and claimed in any RACHITTTM applications.  Additionally, we are enjoined for a period of three years fromusing, licensing or selling Maxygen High Throughput Screening (as defined inthe arbitration award) technology, but this injunction does not prohibit usfrom independently developing and commercializing different High ThroughputScreening technology.  The arbitrator’sruling further declared Maxygen the exclusive owner of RACHITTTM between Maxygenand us.  We were required to payMaxygen’s attorneys’ fees in the amount of $556,826 and arbitration costs inthe amount of $100,000 as well as any unbilled fees of the arbitrator.  These costs were paid in December 2001 andexpensed as general and administrative costs. We wrote-off $167,921 in RACHITTTM-related patent costs to expense duringthe third quarter of 2001.  As a resultof the ruling, we returned $550,000 to Genencor International Inc. (“Genencor”)for license fees previously received under the license agreement with Genencor,which was terminated on November 12, 2001. Such amounts refunded to Genencor were previously recorded as deferredrevenue in the accompanying balance sheet. Enchira also had a research and development collaboration agreement withGenencor, which was terminated on December 31, 2001.

 

Immediately following the execution of the award, theCompany filed an application to set aside or modify the arbitration award inthe 151st District Court of Harris County, Texas.  The petition requests that the Court enterjudgment setting aside the arbitration award in its entirety or modify thearbitration award in certain respects due to its vague and ambiguousnature.  No action has been taken by theCompany to pursue this application as of yet.

 

Enchira's common stock presently lists on the NasdaqNational Market.  We must maintaincertain minimum financial requirements for continued inclusion on Nasdaq. If wecannot satisfy Nasdaq’s maintenance requirements, Nasdaq may delist our commonstock.  Nasdaq sent us a letter datedFebruary 14, 2002 in which it informed us that we no longer meet certain ofNasdaq’s maintenance requirements.  Theletter gave us 90 days within which we can comply with the maintenance requirementsor request a hearing.  Should we beunable to satisfy the Nasdaq maintenance requirements and our common stock isdelisted, we may be required to redeem the remaining outstanding shares ofSeries B Preferred Stock in cash.

 

Enchira has devoted substantially all of its effortsto research and development.  There havebeen no revenues from operations other than sponsored research revenues and onesite license fee of its biodesulfurization ("BDS") technology in 1998(excluding the Genencor license fees which were refunded) and there is no assuranceof future revenues.  During 2001,Enchira used $6,523,291 in cash for operating activities.  As of December 31, 2001, Enchira had$3,807,747 in cash, cash equivalents and short-term investments and $826,186 inliabilities.  Enchira has an accumulateddeficit since inception of approximately $91.3 million and expects that itsexisting financial resources will fund operations through mid-2002.  However, Enchira may be required to redeemits 51,600 shares of Series B Preferred Stock, which remain outstanding atMarch 8, 2002, for approximately $2.6 million in cash should Enchira becomedelisted from Nasdaq.  All of thesefactors raise substantial doubt about Enchira’s ability to continue as a goingconcern.  Enchira is currently seekingadditional financings through various alternatives that include debt and equityfinancings, government funding and alliances with pharmaceutical companies andcorporate partners. Adequate funds for these purposes, whether obtained throughfinancial markets or collaborative or other arrangements with corporatepartners or from other resources, may not be available when needed or on termsacceptable to Enchira.  In the event weare unable to obtain such financing, we will consider other alternatives,including:  a license, sale or otherdisposition of our technologies, or certain rights relating thereto; a sale orother reorganization of Enchira; the combination of Enchira with anotherentity; legal protection from creditors; or cease operations.

 

F-6

----

 

The Company’s property and equipment and intangibleand other assets are unique to the proprietary technology and processes thatEnchira has and continues to develop. Realization of the Company’s investments in these assets is dependentupon the success of future operations or the sale or licensing of intellectualproperties.  The Company is maintainingits BDS patent portfolio and seeking opportunities to license the technology tothird parties for the further development and commercialization of theprocess.  If Enchira is unable tocontinue as a going concern, the recorded asset carrying amounts may be greaterthan the amounts that will be realized in the event of liquidation.

 

**2.  AccountingPolicies**

 

*Cash,Cash Equivalents and Short-Term Investments*

 

Enchira considers short-term investments with originalmaturities of 90 days or less to be cash equivalents.  Investments consisting of commercial paper and corporate bondsare classified as held to maturity and are reported at amortized cost, whichapproximates fair value.  Enchira doesnot have any available for sale or trading securities.

 

*Furniture,Equipment and Leasehold Improvements*

 

Furniture and equipment consists of office furnitureand equipment, computers and laboratory equipment and are recorded atcost.  Depreciation is calculated on thestraight-line method using a five-year estimated useful life. Leaseholdimprovements are amortized on the straight-line method over the term of thelease or over the useful life of the assets whichever is shorter.

 

Maintenance and repairs that do not improve or extendthe life of assets and expenditures for research and development equipment forwhich there is no future alternative use are expensed as incurred.  Expenditures that improve or extend the lifeof assets are capitalized.

 

*Intangibleand Other Assets*

 

Intangible and other assets mainly consist of patentcosts, which are primarily legal fees. These costs are being amortized over the life of the patent, whichranges from 15 to 20 years.  Accumulatedamortization at December 31, 2000 and 2001 amounted to $973,135 and $1,035,553,respectively.

 

*RevenueRecognition*

 

The Company recognizes revenue in accordance withStaff Accounting Bulletin No. 101, Revenue Recognition in Financial Statements(“SAB 101”).  Revenue fromnon-refundable sponsored research and development payments is recognized asservices are performed, provided a contractual arrangement exists, the contractprice is fixed or determinable, and the collection of the resulting receivableis probable.  Sponsored research anddevelopment and licensing payments received that are refundable or for whichservice obligations remain are reflected as deferred revenue.

 

*Researchand Development*

 

All research and development costs, both generatedinternally and externally from research and development contracts, are expensedas incurred.  Enchira allocates certainindirect costs to research and development expenses, which consist primarily ofoverhead related to the administration of research and development activities.

 

*NetLoss Per Common Share*

 

Net loss per common share has been computed bydividing the net loss, which has been increased for periodic accretion anddividends accumulated for the period on the Series B Convertible PreferredStock by the weighted average number of shares of common stock outstandingduring the periods. In all applicable years, common stock equivalents wereanti-dilutive and, accordingly, were not included in the computation.

 

F-7

----

 

*Use ofEstimates*

 

The preparation of financial statements in conformitywith generally accepted accounting principles requires management to makeestimates and assumptions that affect the reported amounts of assets andliabilities at the date of the financial statements and the reported amounts ofrevenue and expenses and the disclosure of contingent assets and liabilitiesduring the reporting period.  Actualresults could differ from those estimates.

 

*RecentAccounting Pronouncements*

 

SFAS No. 144, “Accounting for the Impairment orDisposal of Long-Lived Assets,” supersedes SFAS No. 121 and a portion of APBOpinion No. 30.  This statementestablishes a single accounting model for the disposal of long-lived assets andresolves significant implementation issues related to SFAS No. 121.  This standard, which becomes effectiveJanuary 1, 2002, will have no impact on Enchira’s financial statements uponadoption.

 

**3. Furniture, Equipment and Leasehold Improvements**

 

A summary of furniture, equipment and leaseholdimprovements is as follows:

 
|                                                 |   | **December  31,** |    |
|------------------------------------------------------|--------|-------------------|---------|
|                                                 |   | **2000**          |    | **2001** | ** ** |
| Office furniture and equipment                       |   | $                 | 344,537 |   | $ | 344,537 |   |
| Laboratory  equipment                                |   | 3,929,569         |    | 3,735,318 |   |
| Computer  equipment                                  |   | 238,445           |    | 252,388 |   |
| Leasehold improvements                               |   | 1,734,011         |    | 1,734,011 |   |
| Equipment under capital lease                        |   | 83,410            |    | 83,410 |   |
| Automobiles                                          |   | 23,670            |    | 23,670 |   |
|                                                 |   | 6,353,642         |    | 6,173,334 |   |
| Less—Accumulated  depreciation and amortization |   | (5,714,777        | )       | (5,800,055 | ) |
|                                                 |   | $                 | 638,865 |   | $ | 373,279 |   |

 

**4. Stockholders’ Equity**

 

*SeriesB Convertible Preferred Stock*

 

Shares of Series B Preferred Stock are convertibleinto shares of common stock at an adjusted conversion price currently equal to$16.76 per share, subject to certain adjustments.  The Series B Preferred Stock may be redeemed by the Company undercertain circumstances after February 26, 1999 and, is required to be redeemed,subject to certain limitations, on February 26, 2002 at a redemption price of$50.00 per share, plus accrued and unpaid dividends. The redemption price ispayable in cash or common stock at the option of the Company.  It is the Company’s present intent to redeemthe Series B Preferred Stock for common stock, subject to certain requirements.  Accordingly, the Series B Preferred Stock isincluded in stockholders’ equity.  Underthe terms of the Series B Preferred Stock, we are required to provide a firmcommitment underwriting of the shares of our common stock being issued inconnection with the redemption, otherwise the holders of Series B PreferredStock may elect to waive this requirement in the event we are unable to providea firm commitment underwriting in a timely manner.  During the year ended December 31, 2001, 293,000 shares of SeriesB Preferred Stock were converted to 874,089 shares of common stock. As ofDecember 31, 2001, 607,400 aggregate shares of Series B Preferred Stock havebeen converted to 1,382,344 shares of common stock.   See Note 10.  Subsequent Events.for a discussion of the Series B Preferred Stock that has been redeemed or isredeemable by the Company.

 

Dividends on the Series B Preferred Stock arecumulative from February 27, 1997, and are payable, at the Company’s election,in cash or common stock of the Company, or a combination thereof, at an annualrate equal to (i) $4.00 per share to the extent the dividend is paid in cashand (ii) $4.50 per share to the extent the dividend is paid 

 

F-8

----

 

in common stock. The Company has not declared a dividend payment since November 1998, andsince that date, has not paid dividends on Series B Preferred Stock except onconversion of Series B Preferred Stock to common stock or upon redemptionthereof.  As of December 31, 2001,Enchira has paid common stock dividends of 1,399,369 shares of common stock andcash dividends of $2,626,244 on Series B Preferred Stock.  See Note 10.  Subsequent Events.

 

*Common Stock*

 

On October 19, 2001 we purchased, at a significantdiscount from the publicly traded market price, 1,080,000 shares of its issuedand outstanding common stock from several stockholders whose shares were undercommon management.  In connection withthis repurchase, we acquired and cancelled for no additional considerationwarrants to purchase an aggregate of 376,500 shares of our common stock thatwere held by the sellers.  Therepurchased common stock was recorded at its aggregate cost of $21,600 astreasury stock in our stockholders’ equity. As a result of this transaction, the number of outstanding shares ofcommon stock is approximately 10.5 million.

 

The Company completed a private placement of itscommon stock during September 2000.  TheCompany offered and sold 2,000,000 shares of its common stock at $6.4325 pershare.  Net proceeds from the offeringwere approximately $12.5 million.  Inconnection with the closing, warrants to purchase 600,000 shares of theCompany’s common stock were issued at an exercise price of $7.44.  In addition, warrants to purchase 31,375shares of the Company’s common stock at an exercise price of $7.44 per sharewere issued to The Trout Group, LLC, one of the Company’s placement agents, inpartial payment of their placement fees. The warrants expire in September 2002 and have been recorded at anaggregate estimated fair value of $2,522,094, which was computed using theBlack-Scholes option pricing model and the following assumptions:  risk free rate of 6.19 percent; expecteddividend yield of zero; expected life of two years; and a weighted-averageexpected volatility of 125 percent.

 

During March 1998, Enchira issued a warrant inconnection with a license agreement (see Note 7).  The warrant entitles the purchaser to purchase 28,571 shares ofcommon stock at an exercise price of $21.77 per share over a four-year term.

 

Enchira maintains a Stockholder Rights Plan (the“Rights Plan”), as amended, in which Preferred Stock Purchase Rights (the“Rights”) were distributed for each share of common stock held as of the closeof business on March 27, 1995 and are distributed to each share of common stockissued thereafter until the earlier of (i) the Distribution Date (as defined inthe Rights Plan), (ii) the date Rights are redeemed or (iii) March 8,2005.  The Rights Plan is designed todeter coercive takeover tactics and to prevent an acquirer from gaining controlof Enchira without offering a fair price to all of Enchira’s stockholders.  The Rights will expire on March 8, 2005.

 

Each Right entitles stockholders to buy one-hundredthof a share of a new series of Junior Preferred Stock of Enchira at an exerciseprice of $50.00 per one-hundredth of a share. The Rights are exercisable only if a person acquires beneficialownership of 20% or more of Enchira’s outstanding common stock.  The Rights Plan grandfathers any holder ofSeries B Preferred Stock, who would otherwise have triggered the exercisabilityof the Rights solely as a result of the redemption or conversion of Series BPreferred Stock, from triggering the exercisability of the Rights and alsoexcludes persons who are registered investment companies or advisers fromtriggering the exercisability of the Rights.

 

In 2000 and 2001, the Company issued to consultants12,820 and 9,638 shares of common stock, respectively, valued and recorded asexpense at $5.56 and $12.32 per share in 2000 and $5.19 per share in 2001.

 

**5.  Stock Options**

 

In January 1997, Enchira’s Board of Directors adoptedthe 1997 Stock Option Plan (the “1997 Plan”). Under the 1997 Plan, Enchira may issue options for and sell up to 14,285shares of Common Stock to employees and consultants of Enchira.  The options granted under this plan may nothave an exercise price per share less than the fair market value on the date ofgrant and are limited to a term not to exceed ten years.  In May 1999, the 1997 Plan was amended toincrease the number of shares available for grant to 1,200,000.

 

F-9

----

 

Enchira maintains a Stock Compensation Plan (the “1992Plan”), which is composed of non-qualified stock options, incentive stockoptions, year-end stock bonuses and restricted and non-restricted stockgrants.  Under the 1992 Plan, 290,147shares of common stock are reserved for issuance upon the exercise of stockoptions.

 

Under a 1994 Non-Employee Director Option Plan,composed of non-qualified stock options, 200,000 shares of common stock arereserved for issuance upon the exercise of stock options.

 

At December 31, 2001, options to purchase 852,041shares of common stock were outstanding pursuant to the 1992 and 1997 Plans.Additionally, as of December 31, 2001 consultants and directors had outstandingoptions to purchase 228,702 shares of common stock that were not issued underthe 1992 or 1997 Plans (15,598 options were not issued under any plan),including 213,104 shares underlying options granted under the 1994 Non-EmployeeDirector Option Plan. Options generally vest over a three-year period and uponthe earlier of the completion of the specified performance milestones, over afour-year period, or nine years and ten months from the date of grant.  The options expire ten years from the dateof grant. The following table summarizes information regarding optionsoutstanding at December 31, 2001:

 
| **Options  Outstanding**      |   | **Options  Exercisable** |   |
|-------------------------------|--------|--------------------------|--------|
| **Range of  Exercise Prices** |   | **Outstanding  Shares**  |   | **Weighted  Average  Remaining  Contractual Life  (In Years)** |   | **Weighted  Average  Exercise Price** |   | **Exercisable  Shares** |   | **Weighted  AverageExercise  Price** |   |
| $0.44 - $10.00                |   | 1,006,969                |   | 8.0 |   | $ | 3.91 |   | 484,827 |   | $ | 3.23 |   |
| $17.50 - $35.88               |   | 48,000                   |   | 5.3 |   | $ | 23.90 |   | 37,114 |   | $ | 23.05 |   |
| $43.75 - $84.00               |   | 25,774                   |   | 3.5 |   | $ | 59.17 |   | 16,707 |   | $ | 61.71 |   |

 

A summary of the status of Enchira’s stock options atDecember 31, 1999, 2000 and 2001, and changes during the years then ended ispresented in the table and narrative below:

 
|                             |   | **1992 and  1997 Plans** |   | **Options  not issued under Plan**    |   |
|----------------------------------|--------|--------------------------|--------|---------------------------------------|--------|
|                             |   | **Number  of Options**   |   | **Weighted  Average  Exercise Price** |   | **Number of  Options** |   | **Weighted  Average  Exercise Price** |   |
| Balance at December 31, 1998     |   | 166,581                  |   | $                                     | 31.21  |   | 35,617 |   | $ | 26.11 |   |
| Granted                          |   | 453,200                  |   | 2.11                                  |   | 3⁄4 |   | 3⁄4 |   |
| Exercised                        |   | —                   |   | —                                |   | 3⁄4 |   | 3⁄4 |   |
| Forfeited                        |   | (51,384                  | )      | 36.05                                 |   | — |   | 3⁄4 |   |
| Balance at December 31, 1999     |   | 568,397                  |   | 7.80                                  |   | 35,617 |   | 26.11 |   |
| Granted                          |   | 176,200                  |   | 6.01                                  |   | 3⁄4 |   | 3⁄4 |   |
| Exercised                        |   | (13,813                  | )      | 4.67                                  |   | 3⁄4 |   | 3⁄4 |   |
| Forfeited                        |   | (25,401                  | )      | 9.22                                  |   | — |   | — |   |
| Balance at December 31, 2000     |   | 705,383                  |   | 7.20                                  |   | 35,617 |   | 26.11 |   |
| Granted                          |   | 223,800                  |   | 5.33                                  |   | 3⁄4 |   | 3⁄4 |   |
| Exercised                        |   | (1,975                   | )      | 2.06                                  |   | 3⁄4 |   | 3⁄4 |   |
| Forfeited                        |   | (75,167                  | )      | 8.01                                  |   | (20,019 | ) | 5.21 |   |
| Balance at December 31, 2001     |   | 852,041                  |   | 6.65                                  |   | 15,598 |   | 52.95 |   |
|                             |   |                     |   |                                  |   |   |   |   |   |
| Exercisable at December 31, 2001 |   | 309,946                  |   | $                                     | 8.07   |   | 15,598 |   | $ | 52.95 |   |

 

The weighted average fair value of the options issuedunder the 1992 and 1997 Plans for the years ended December 31, 1999, 2000 and2001 was $1.92, $5.72 and $5.08, respectively.

 

F-10

----

 

During the years ended December 31, 1999, 2000 and2001, Enchira granted 83,100, 88,000 and 30,500 options respectively, under theNon-Employee Director Option Plan. These options are fully vested upon issuance. The weighted average exerciseprice per share on these grants was $2.29, $6.66 and $0.89, respectively.  As of December 31, 2001, Enchira had198,820 options exercisable, under this plan with a weighted-average exerciseprice of $6.19.  The weighted averagefair market value of the options issued under this plan during the years endedDecember 31, 1999, 2000 and 2001 was $1.89, $6.38 and $0.90, respectively.

 

Enchira accounts for its stock options under APBOpinion No. 25. Enchira records deferred compensation for the difference betweenthe exercise price and the fair market value on the measurement date.  During 1999, 2000 and 2001, Enchira issuedall options at fair market value and therefore, no compensation cost wasrecognized.  Had compensation cost forthese options been determined consistent with SFAS. 123, Enchira’s net loss andloss per share would have been increased to the following pro forma amounts:

 
|                       |   |        |   | **1999**   |       | **2000**   |   | **2001**   |   |
|----------------------------|--------|-------------|--------|------------|------------|------------|--------|------------|--------|
| Net Loss:                  |   | As Reported |   | $          | (5,264,462 | )          | $      | (6,023,540 | )      | $ | (7,387,466 | ) |
|                       |   | Pro Forma   |   | (8,562,311 | )          | (9,106,624 | )      | (9,785,771 | )      |
|                       |   |        |   |       |       |       |   |       |   |
| Net Loss Per Common Share: |   | As Reported |   | $          | (1.78      | )          | $      | (1.10      | )      | $ | (0.94 | ) |
|                       |   | Pro Forma   |   | (1.85      | )          | (1.20      | )      | (1.02      | )      |

 

Because the SFAS 123 method of accounting has not beenapplied to options granted prior to January 1, 1995, the resulting pro formacompensation cost may not be representative of that expected in future years.

 

The fair market value of each option grant isestimated on the date of grant using the Black-Scholes option pricing modelwith the following weighted-average assumptions used for grants in 1999, 2000and 2001, respectively:  risk-freeinterest rates of 6.4, 6.1 and 5.1 percent; expected dividend yields of zero;expected lives of nine years and ten months; and expected volatility of 100.8,112.7 and 119.6 percent.

 

**6.  Federal IncomeTaxes**

 

Enchira has had losses since inception and, therefore,has not been subject to federal income taxes. As of December 31, 2001, Enchira had accumulated net operating losses(“NOL”) and research and development tax credit carryforwards for income taxpurposes of approximately $76.2 million and $1.9 million, respectively.  These carryforwards begin to expire in2005.  The Tax Reform Act of 1986provided for an annual limitation on the use of NOL and tax credit carryforwardsfollowing certain ownership changes that limit Enchira’s ability to utilizethese carryforwards.  In April 1991,October 1994 and July 2000, Enchira underwent a “more than 50 percent change inownership” as defined by Internal Revenue Code Section 382.  Additionally, because U.S. tax laws limit thetime during which NOL and tax credit carryforwards may be applied againstfuture taxable income and tax liabilities, Enchira may not be able to take fulladvantage of its NOL and tax credits for federal income tax purposes.

 

F-11

----

 

Significant components of Enchira’s net deferred taxasset at December 31, 2000 and 2001 are as follows:

 
|                                                                                       |   | **2000**    |       | **2001**    |   |
|--------------------------------------------------------------------------------------------|--------|-------------|------------|-------------|--------|
| Deferred tax assets and  liabilities relating to:                                          |   |        |       |        |   |   |
| Federal NOL  carryforwards                                                                 |   | $           | 23,512,630 |        | $      | 26,667,137 |   |
| Research and  development credit carryforwards                                             |   | 1,815,159   |       | 1,954,129   |   |
| Capital and Texas  business loss carryforwards                                             |   | 1,107,717   |       | 1,107,717   |   |
| Book/tax differences on  depreciable, amortizable and other assets and accrued liabilities |   | (3,296      | )          | 133,915     |   |
| Deferred revenue and  unrealized gains                                                     |   | 248,200     |       | 63,000      |   |
|                                                                                       |   |        |       |        |   |
| Deferred tax valuation  allowance                                                          |   | (26,680,410 | )          | (29,925,898 | )      |
| Net deferred tax asset                                                                     |   | $           | —     |        | $      | — |   |
|                                                                                            |        |             |            |             |        |  |  |  |

 

Enchira accounts for its taxes using SFAS 109, whichrequires recognition of deferred tax liabilities and assets for the expectedfuture tax consequences of events that have been recognized in the financialstatements or tax returns.  SinceEnchira has incurred losses since inception and there is no assurance of futuretaxable income, a valuation allowance has been established to fully offset thedeferred tax assets.  Enchira’seffective income tax rate differs from the statutory federal income tax ratebecause of the increase in the deferred tax valuation allowance.

 

**7. License and Research Agreements**

 

To finance its research and development budgets,Enchira intends to seek additional collaborative research and developmentagreements with corporate partners.

 

In October 2000, the Company established a jointcollaboration with The University of Texas M. D. Anderson Cancer Center toapply its directed evolution technologies to the development of more effectivecancer therapies targeted toward epidermal growth factor receptors.  In this collaboration, Enchira will providedirected evolution and robotic screening research and has retained certainrights to developments that come out of the relationship.  The agreement may be terminated by eitherparty with 30 days advanced written notice. As of December 31, 2001, $187,500 has been expensed under thiscollaboration and Enchira has committed to an additional $112,500 to be paid in2002 under the collaboration agreement.

 

In August 2000, the Company entered into acollaboration agreement with Genencor International, Inc. (“Genencor”) forresearch and development work on improved industrial proteins.  Under the agreement, Genencor was to provide$1 million of funding over two years. As a result of the ruling in the arbitration with Maxygen, this agreementwas terminated on December 31, 2001. Monies received to date on the research and development collaborationagreement are nonrefundable and have been included in revenue.

 

In May 2000, the Company entered into a licensingagreement with Genencor involving Enchira’s proprietary gene shufflingtechnology for directed evolution. Under the agreement, Genencor was to use the Company’s proprietaryRACHITTTM technology to develop gene-based products for the cleaning, textiles,grain processing, animal feed and food ingredients industries. Genencor paid aninitial licensing fee and an additional fee for an option to expand thelicensing field in June 2000.  As aresult of the arbitration with Maxygen, Genencor’s rights to the RACHITTTMtechnology were materially and adversely affected and the payments of $550,000received from Genencor under the licensing agreement were refunded in November2001 upon termination of the licensing agreement.

 

In March 1998, Enchira entered into a site licenseagreement with Petro Star Inc. (“Petro Star”) regarding the design andinstallation of a BDS unit at Petro Star’s Valdez, Alaska refinery.  The agreement involves several stages ofwork, the first of which, involving the completion of scoping economics, iscompleted.  In addition, the agreementprovides Enchira with certain rights to conduct development work anddemonstrations of its BDS technology at Petro Star’s refinery.  The agreement calls for the payment ofstaged license fees and royalties to 

 

F-12

----

 

Enchira, including a $200,000 initial site license fee upon executionof the agreement.  As is customary insuch arrangements in the petroleum refining industry, the agreement providescertain approval and termination rights to Petro Star at the completion of eachstage prior to commercialization.  Inconnection with the execution of the agreement, Enchira issued a four-yearwarrant entitling Petro Star to purchase 28,571 shares of Enchira common stockat an exercise price of $21.77 per share. The warrant was recorded as research and development expense at anestimated fair value of $404,500, which was computed using the Black-Scholesoption-pricing model. The successful implementation of a commercial BDS unitwill be dependent upon Enchira’s ability to achieve additional improvements inthe productivity of the biocatalyst (e.g., reaction rates, specificity andstability) and process technology (e.g., bioreactor and separationstechnology).  In September 2000, Enchiranotified Petro Star that it will not continue to pursue development of BDStechnology at the Petro Star refinery. 

 

In August 1997, Enchira was awarded funding by theU.S. Department of Energy (“DOE”) for a $2.9 million program, as amended andextended to May 2001, dedicated to the development of a BDS application forgasoline.  Through December 31, 2001,Enchira had recognized $2.9 million in sponsored research revenue from thegrant.

 

**8. Commitments and Contingencies**

 

Enchira maintains a Simplified Employee Pension Plan(the “Plan”) for all employees.  Underthe terms of the Plan, employees are eligible to participate after completionof six months of service.  Enchiracontributes an amount equal to 8 percent of employees’ annual compensation tothe Plan.  Employees are vestedimmediately and there is presently no employee contribution.  Total expenses under the Plan wereapproximately $195,000, $159,000 and $165,000 for the years ended December 31,1999, 2000 and 2001, respectively.

 

Enchira has recorded a capital lease in theaccompanying balance sheet for laboratory equipment financed pursuant to apromissory note as of January 1, 2000. The note has an outstanding balance of $56,814 at December 31, 2001,matures in January 2004 and is subject to interest at 10.38 percent.

 

The Company has a non-cancelable operating lease forits corporate office space, which expires in October 2003.  Future minimum payments under thenon-cancelable operating lease consist of the following at December 31, 2001:

 
| **Fiscal Year**               |   |    |    |   |
|-------------------------------|--------|---------|---------|--------|
| 2002                          |   | $       | 436,998 |   |
| 2003                          |   | 364,165 |    |
|                          |   |    |    |   |
| Total minimum lease  payments |   | $       | 801,163 |   |

 

Enchira incurred rent expense of $382,829, $308,056and $344,451 during 1999, 2000 and 2001, respectively.  Rent expense in 2000 and 2001 is net ofsublease income of approximately $84,000 and $96,000, respectively.

 

F-13

----

 

**9.  Quarterly Information (Unaudited)**

** **
|                                           |   | **Fiscal  Year Quarters** |       |
|------------------------------------------------|--------|---------------------------|------------|
|                                           |   | **First**                 |       | **Second** |   | **Third** |   | **Fourth** |   | **Total** |   |
| Year ended December 31, 2001                   |   |                      |       |   |   |   |   |   |   |   |   |
| Revenues                                       |   | $                         | 256,636    |   | $ | 273,965 |   | $ | 125,000 |   | $ | 83,333 |   | $ | 738,934 |   |
| Costs and expenses                             |   | 2,026,041                 |       | 1,873,805 |   | 2,577,951 |   | 1,779,094 |   | 8,256,891 |   |
|                                           |   |                      |       |   |   |   |   |   |   |   |   |
| Net loss                                       |   | $                         | (1,719,871 | ) | $ | (1,473,439 | ) | $ | (2,466,133 | ) | $ | (1,728,023 | ) | $ | (7,387,466 | ) |
|                                           |   |                      |       |   |   |   |   |   |   |   |   |
| Loss per common share — basic and diluted |   | $                         | (0.25      | ) | $ | (0.21 | ) | $ | (0.31 | ) | $ | (0.19 | ) | $ | (0.94 | ) |
|                                           |   |                      |       |   |   |   |   |   |   |   |   |
| Year ended December 31, 2000                   |   |                      |       |   |   |   |   |   |   |   |   |
| Revenues                                       |   | $                         | 287,697    |   | $ | 70,468 |   | $ | 135,157 |   | $ | 347,230 |   | $ | 840,552 |   |
| Costs and expenses                             |   | 1,478,051                 |       | 1,522,741 |   | 1,780,661 |   | 2,347,740 |   | 7,129,193 |   |
|                                           |   |                      |       |   |   |   |   |   |   |   |   |
| Net loss                                       |   | $                         | (1,119,378 | ) | $ | (1,397,810 | ) | $ | (1,577,064 | ) | $ | (1,929,288 | ) | $ | (6,023,540 | ) |
|                                           |   |                      |       |   |   |   |   |   |   |   |   |
| Loss per common share — basic and diluted |   | $                         | (0.27      | ) | $ | (0.28 | ) | $ | (0.28 | ) | $ | (0.27 | ) | $ | (1.10 | ) |

 

**10.   Subsequent Events**

 

Under the terms of the Company’s Series B PreferredStock, the Company is required to redeem all outstanding shares of Series BPreferred Stock at a price of $50 per share on or after February 26, 2002.  Additionally, at the time of redemption, theCompany is also required to pay any accrued but unpaid dividends on the sharesof Series B Preferred Stock being redeemed.  The Company has elected to redeem all shares of Series B Preferred Stockwith shares of its common stock.  Underthe terms of the Series B Preferred Stock, the Company is required to provide afirm commitment underwriting of the shares of its common stock being issued inconnection with the redemption or the holder of Series B Preferred Stock mayelect to waive this requirement in the event the Company is unable to timelyprovide a firm commitment underwriting. As a result, the Company will complete the redemption of 41,100 sharesof Series B Preferred Stock from one holder who waived this requirement, whichwill result in the issuance of 3,425,000 shares of the Company’s common stockfor the redemption and an additional 1,024,075 shares of the Company’s commonstock in payment of accrued dividends on the shares.  The Company has an additional 51,600 shares of Series B PreferredStock outstanding.  If these shares wereredeemed at the closing price in effect on March 8, 2002, the Company would berequired to issue 549,778 shares of its common stock for the redemption and anadditional 2,660,068 shares of its common stock in payment of accrued butunpaid dividends.

 

 

F-14

----