###### FORM 10-Q

** **

**UNITED STATES**

###### SECURITIES ANDEXCHANGE COMMISSION

**Washington, DC  20549**

** **

(MarkOne)

[X]**  QUARTERLYREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE**

**SECURITIES EXCHANGE ACTOF 1934**

or

[  ]  **TRANSITIONREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE**

**SECURITIES EXCHANGE ACTOF 1934**

 

###### For the quarterlyperiod ended September 30, 2006

** **

###### Commission FileNumber 0-23666

 

**TRIPOS, INC.**

(Exact Name ofRegistrant as Specified in its Charter)

** **

| **Utah**                         | ** ** | **43-1454986**      |
|----------------------------------|------------|---------------------|
| (State or Other  Jurisdiction of | ** ** | (I.R.S. Employer    |
| Incorporation or  Organization)  | ** ** | Identification No.) |
| ** **                       | ** ** | ** **          |

**1699 South Hanley Road**

**St. Louis, Missouri 63144**

(Address of PrincipalExecutive Offices and Zip Code)

**(314) 647-1099**

(Registrant's TelephoneNumber, Including Area Code)

** **

Indicate by check mark whether the registrant(1) has filed all reports required to be filed by Section 13 or 15(d) of theSecurities Exchange Act of 1934 during the preceding 12 months (or for suchshorter period that the registrant was required to file such reports), and (2)has been subject to such filing requirement for the past 90 days.

 

Yes    X          No         

 

Indicate by check mark whether the registrant isa large accelerated filer, an accelerated filer, or a non-accelerated filer (asdefined in Rule 12b-2 of the Exchange Act).

|  

Large accelerated  filer  ___ |  

Accelerated filer  ___ |  

Non-accelerated filer   X   |
|--------------------------------------------|-------------------------------------|--------------------------------------------------------------|

 

Indicate by check mark whether the registrant isa shell company (as defined in Rule 12b-2 of the Exchange Act).            Yes              No    X                

 

Number of shares outstanding of the issuer'sCommon Stock, par value $.01 per share, as of November 13, 2006:****10,281,712shares.

 

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**TRIPOS,INC.**

###### TABLE OF CONTENTS

  

|                                                                                                                                                                                                  | **Page**    |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|-------------|
| **PART  I  FINANCIAL INFORMATION**                                                                                                                                                               |        |
| **Item  1.  Financial Statements**                                                                                                                                                               |        |
|   Consolidated  Balance Sheets at September 30, 2006 (Unaudited) and December 31, 2005                                                                                                      | 3           |
|   Consolidated  Statements of Operations for the Three- and Nine-Months Ended 

      September  30, 2006 (Unaudited) and September 30, 2005 (Unaudited) |  

4   |
|   Consolidated  Statements of Cash Flows for the Nine-Months Ended 

      September  30, 2006 (Unaudited) and September 30, 2005 (Unaudited)                 |  

5-6 |
|   Notes  to Consolidated Financial Statements (Unaudited)                                                                                                                                   | 7-26        |
|                                                                                                                                                                                                  |        |
| **Item  2. Management's Discussion and Analysis of Financial Condition**

**      and  Results of Operations**                                                          | 27-38       |
| **Item  3. Quantitative and Qualitative Disclosures about Market Risk**                                                                                                                               | 39          |
| **Item  4. Controls and Procedures**                                                                                                                                                                  | 39-40       |
|                                                                                                                                                                                                  |        |
| **PART  II  OTHER INFORMATION**                                                                                                                                                                  | 40          |
| **SIGNATURES**                                                                                                                                                                                        | 41          |

 

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**PART I**

##### FINANCIALINFORMATION

**Item1.  Financial Statements.**

**TRIPOS, INC.**

**CONSOLIDATED BALANCE SHEETS**

| (In  thousands)                                                                                                                                                      | **09-30-2006**              |  12-31-2005    |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|-----------------------------|---------------------|
| ASSETS                                                                                                                                                                                                                 | **(Unaudited) **       |                |
| Current  assets:                                                                                                                                                                                                       |                        |                |
|      Cash  and cash equivalents                                                                                                                                                               | **$ 2,343 **      | $ 6,241   |
|      Restricted  cash                                                                                                                                                                         | **156 **               | --             |
|      Marketable  securities                                                                                                                                                                   | **127 **               | --             |
|      Accounts  receivable, less allowance for doubtful accounts of $191                                                                                                                       | **3,638 **             | 11,219         |
|      Inventory                                                                                                                                                                                | **7,481 **             | 5,155          |
|      Prepaid  expenses                                                                                                                                                                        | **3,807 **             | 4,386          |
| Total current assets                                                                                                                                                                                                   | **17,552 **            | 27,001         |
|                                                                                                                                                                                                                   | ** **                  |                |
|    Property  and equipment, less accumulated depreciation                                                                                                                                               | **24,278 **            | 26,789         |
|    Capitalized  development costs, less accumulated amortization                                                                                                                                        | **2,328 **             | 2,291          |
|    Goodwill                                                                                                                                                                                             | **5,351 **             | 5,255          |
|    Intangible  assets, less accumulated amortization                                                                                                                                                    | **3,189 **             | 3,554          |
|    Investments  recorded at cost                                                                                                                                                                        | **1,578 **             | 1,695          |
|    Deferred  income taxes                                                                                                                                                                               | **250 **               | 231            |
|    Other  assets                                                                                                                                                                                        | **530 **               | --             |
| Total assets                                                                                                                                                                                                           | **$ 55,056 **     | $ 66,816  |
|                                                                                                                                                                                                                   | ** **                  |                |
| LIABILITIES  AND SHAREHOLDERS' EQUITY                                                                                                                                                                                  |
| Current  liabilities:                                                                                                                                                                                                  | ** **                  |                |
|      Current  portion of long-term debt                                                                                                                                                       | **$ 7,964 **      | $ 5,241   |
|      Current  portion of capital leases                                                                                                                                                       | **2,913 **             | 2,741          |
|      Accounts  payable                                                                                                                                                                        | **1,337 **             | 1,219          |
|      Accrued  expenses                                                                                                                                                                        | **3,566 **             | 4,970          |
|      Deferred  revenue                                                                                                                                                                        | **10,394 **            | 15,898         |
| Total current liabilities                                                                                                                                                                                              | **26,174 **            | 30,069         |
|                                                                                                                                                                                                                   | ** **                  |                |
|    Long-term  portion of capital leases                                                                                                                                                                 | **2,527 **             | 1,343          |
|    Long-term  debt                                                                                                                                                                                      | **1,898 **             | 5,891          |
|    Common  stock warrants                                                                                                                                                                               | **467 **               | --             |
| Total liabilities                                                                                                                                                                                                      | **31,066 **            | 37,303              |
|                                                                                                                                                                                                                   | ** **                  |                |
|    Redeemable convertible preferred stock, $0.01 par value, authorized  1,833  shares, issued 1,833 shares as of    September 30, 2006                                         | ** **

**3,716 ** |  

--     |
| Shareholders'  equity :                                                                                                                                                                                                | ** **                  |                |
|      Common  stock, $0.01 par value; authorized 20,000 shares,

     issued  10,282 shares as of September 30, 2006 and 10,190 shares as of December  31, 2005. | ** **

**103 **   |  

102    |
|      Additional  paid-in capital                                                                                                                                                              | **43,362 **            | 41,846         |
|      Retained  deficit                                                                                                                                                                        | **(22,052)**                | (12,377)            |
|      Accumulated  other comprehensive loss                                                                                                                                                    | **(1,139)**                 | (58)                |
| Total shareholders' equity                                                                                                                                                                                             | **20,274 **            | 29,513         |
|                                                                                                                                                                                                                   | ** **                  |                |
| Total liabilities and shareholders' equity                                                                                                                                                                             | **$ 55,056 **     | $ 66,816  |
|                                                                                                                                                                                                                   |                        |                |

*Seeaccompanying notes.*

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**Item1.  Financial Statements (continued)**

 

**TRIPOS, INC.**

**CONSOLIDATED STATEMENTSOF OPERATIONS**

**(In thousands, exceptper share data)**

**(Unaudited)**

|                                                            | **Three Months Ended**         |                          | **Nine Months Ended** |
|-----------------------------------------------------------------|--------------------------------|--------------------------|-----------------------|
|                                                            | **09-30-2006**                 | 09-30-2005               |                       | **09-30-2006** | 09-30-2005 |
| Net  sales:                                                     | ** **                     | ** **               | ** **            | ** ** |   |
|    Discovery  informatics products & support | **$ 5,670 **         | $ 6,618        | ** **            | **$ 17,763 ** | $ 18,730  |
|    Discovery  informatics services               | **378 **                  | 716                 | ** **            | **2,895 ** | 1,964  |
|    Discovery  research products & services   | **1,605 **                | 5,821               | ** **            | **4,347 ** | 20,842  |
|    Hardware                                      | **3 **                    | 10                  | ** **            | **28 ** | 31  |
| Total net sales                                                 | **7,656 **                | 13,165              | ** **            | **25,033 ** | 41,567  |
|                                                            | ** **                     |                     | ** **            | ** ** |   |
| Cost  of sales                                                  | **4,121 **                | 6,067               | ** **            | **11,082 ** | 20,860  |
| Gross profit                                                    | **3,535 **                | 7,098               | ** **            | **13,951 ** | 20,707  |
|                                                            | ** **                     |                     | ** **            | ** ** |   |
| Operating  expenses:                                            | ** **                     |                     | ** **            | ** ** |   |
|    Sales  and marketing                          | **2,367 **                | 2,556               | ** **            | **8,153 ** | 8,186  |
|    Research  and development                     | **2,834 **                | 2,898               | ** **            | **8,287 ** | 6,810  |
|    General  and administrative                   | **1,760 **                | 1,900               | ** **            | **5,244 ** | 5,787  |
|    Restructuring  charge                              | **338 **                  | --             | ** **            | **1,265 ** | --   |
| Total operating expenses                                        | **7,299 **                | 7,354               | ** **            | **22,949 ** | 20,783  |
|                                                            | ** **                     |                     | ** **            | ** ** |   |
| Loss from operations                                            | **(3,764)**                    | (256)                    | ** **            | **(8,998)** | (76) |
|                                                            | ** **                     |                     | ** **            | ** ** |   |
| Interest  expense                                               | **(569)**                      | (478)                    | ** **            | **(1,597)** | (1,259) |
| Other  income (loss), net                                       | **353 **                  | 311                 | ** **            | **1,525 ** | (346) |
| Loss before income taxes                                        | **(3,980)**                    | (423)                    | ** **            | **(9,070)** | (1,681) |
|                                                            | ** **                     |                     | ** **            | ** ** |   |
| Income  tax expense (benefit)                                   | **62 **                   | (583)                    | ** **            | **46 ** | (2,633) |
| Net income (loss)                                               | **(4,042)**                    | 160                 | ** **            | **(9,116)** | 952  |
|                                                            | ** **                     |                     | ** **            | ** ** |   |
| Preferred dividends                                             | **342 **                  | --                  | ** **            | **559 ** | --  |
|                                                            | ** **                     |                     | ** **            | ** ** |   |
| Net income (loss) available to common shareholder               | ** **

**$ (4,384)** |  

$ 160  | ** **            | ** **

**$ (9,675)** |  

$ 952  |
|                                                            | ** **                     |                     | ** **            | ** ** |   |
| Basic  income (loss) per share                                  | **$ (0.43)**              | $ 0.02         | ** **            | **$ (0.95) ** | $ 0.09  |
| Basic  weighted average number of shares                        | **10,276 **               | 10,114              | ** **            | **10,220 ** | 10,088  |
| Diluted  income (loss) per share                                | **$ (0.43)**              | $ 0.02         | ** **            | **$ (0.95) ** | $ 0.09  |
| Diluted  weighted average number of shares                      | **10,276 **               | 10,143              | ** **            | **10,220 ** |  10,132  |

 

*See accompanying notes.*

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**Item1.  Financial Statements (continued)**

** **

**TRIPOS, INC.**

**CONSOLIDATED STATEMENTSOF CASH FLOWS**

**(In Thousands)**

| **(Unaudited)                            ** | **Nine Months Ended**  |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------------------|
|                                                                                                                                                                                    | **09-30-2006**         | 09-30-2005 |
| **Operating  activities:**                                                                                                                                                              | ** **             |   |
| Net  (loss) income                                                                                                                                                                      | **$ (9,116)**     | $ 952  |
| Adjustments  to reconcile net loss to net cash provided by operating activities:                                                                                                        | ** **             |   |
|    Depreciation  of property and equipment                                                                                                                               | **3,060 **        | 3,121  |
|    Amortization  of capitalized development costs & intangibles                                                                                                      | **974 **          | 513  |
|    Amortization  of debt discount                                                                                                                                        | **187 **          | 42  |
|    Amortization  of deferred issuance costs                                                                                                                              | **98 **           | --  |
|    Gain  on revaluation of common stock warrants                                                                                                                         | **(572)**              | --  |
|    Deferred  tax benefit                                                                                                                                                 | **(6)**                | (1,288) |
|    Gain  from sale of marketable securities                                                                                                                              | **-- **           | (240) |
|    Write-down  of long-term investment                                                                                                                                   | **27 **           | 88  |
|    Loss  on retirement of assets

                                                                                                                                  | **28 **           | --  |
|    Stock-based  compensation expense                                                                                                                                     | **271 **          | --  |
|    Non  employee and director stock compensation expense                                                                                                                 | **29 **           | --  |
| Change  in operating assets and liabilities (excluding acquired business):                                                                                                              | ** **             |   |
|       Restricted  cash                                                                                                                                    | **(156)**              | --  |
|       Accounts  receivable                                                                                                                                | **8,408 **        | 559  |
|       Inventories                                                                                                                                         | **(1,823)**            | 2,993  |
|       Prepaid  expenses and other current assets                                                                                                          | **2,105 **        | (690) |
|       Accounts  payable and accrued expenses                                                                                                              | **(3,224)**            | (3,641) |
|       Deferred  revenue                                                                                                                                   | **(6,519)**            | 318  |
| Net cash (used in) provided by operating activities                                                                                                                                     | **(6,229)**            | 2,727  |
| **Investing  activities:**                                                                                                                                                              | ** **             |   |
| Purchases  of property and equipment                                                                                                                                                    | **(409)**              | (880) |
| Capitalized  development costs                                                                                                                                                          | **(646)**              | (1,470) |
| Acquisition  of business, net of cash received                                                                                                                                          | **-- **           | (4,753) |
| Proceeds  from the sale of marketable securities                                                                                                                                        | **-- **           | 426  |
| Proceeds  from the sale of equipment                                                                                                                                                    | **3,799 **        | 1,995  |
| Proceeds  from distribution from investment in unconsolidated affiliates                                                                                                                | **36 **           | -- |
| Investment  in unconsolidated affiliates                                                                                                                                                | **(88)**               | (133) |
| Net cash provided by (used in) investing activities                                                                                                                                     | **2,692 **        | (4,815) |
| **Financing  activities:**                                                                                                                                                              | ** **             |   |
| Proceeds  from stock issuance pursuant to stock purchase and option plans                                                                                                               | **172 **          | 39  |
| Proceeds  from issuance of common stock                                                                                                                                                 | **-- **           | 500  |
| Proceeds  from issuance of preferred stock                                                                                                                                              | **4,851 **        | --  |
| Payments  of cash dividends on preferred stock                                                                                                                                          | **(237)**              | --  |
| Borrowings  under revolving line of credit                                                                                                                                              | **6,710 **        | 14,380  |
| Proceeds  from issuance of long-term debt and capital leases                                                                                                                            | **-- **           | 3,559  |
| Payments  on long-term debt and capital lease obligations                                                                                                                               | **(11,134)**           | (17,189) |
| Net cash provided by financing activities                                                                                                                                               | **362 **          | 1,289  |
|                                                                                                                                                                                    | ** **             |   |
| Effect of foreign exchange rate changes on cash and cash  equivalents                                                                                                                   | **(723)**              | 194  |
|                                                                                                                                                                                    | ** **             |   |
| Net decrease in cash and cash equivalents                                                                                                                                               | **(3,898)**            | (605) |
| Cash and cash equivalents at beginning of period                                                                                                                                        | **6,241 **        | 4,171  |
| Cash and cash equivalents at end of period                                                                                                                                              | **$ 2,343 ** | $ 3,566  |

*See accompanying notes.*

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**Item1.  Financial Statements (continued)**

** SupplementalDisclosure of Cash Flow Information (amounts in thousands)**

 Information about noncash investing activitiesnot reflected in the Consolidated Statement of Cash Flows follows:

 

|                                                                                                     | Nine Months Ended  |
|----------------------------------------------------------------------------------------------------------|--------------------|
| ** **                                                                                               | 09-30-2006         | 09-30-2005 |
| **Noncash investing activities**                                                                         |               |   |
|   Increase (decrease) in fair value  of marketable securities, 

  net of tax effect |  

$ (9) |  

$ 53 |
|   Purchase of new equipment through  capital lease financing                                   | 3,966         | 1,995 |
|   Issuance of common stock warrants  with PIPE financing                                       | 1,069         | -- |
|   Beneficial conversion feature of  preferred stock and other                                  |               |   |
|     preferred stock  discounts                                                       | (2,055)            | -- |
|   Accretion of preferred stock  discount                                                       | 321           | -- |

 

 In January 2005, the Company acquired OptiveResearch, Inc. for $4,770 in cash, 600 shares of the Company's common stockvalued at $3,200 and direct costs of the acquisition.  The related assets andliabilities at the acquisition date were as follows:

 

|   Cash                              | $ 647    |
|-----------------------------------------------|--------------------|
|   Accounts receivable               | 809           |
|   Prepaids & other              | 30            |
|   Equipment, net                    | 40            |
|   Intangible assets                 | 3,940         |
|   Goodwill                          | 4,308         |
|     Total assets acquired | 9,774         |
|                                          |               |
|   Accounts payable                  | (422)              |
|   Accrued expenses                  | (97)               |
| **  **Deferred revenue              | (655)              |
|   Common stock issued to sellers    | (3,200)            |
|                                          |               |
|   Cash paid                         | $ 5,400  |

 

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**Item 1.  Financial Statements (continued)**

 

**TRIPOS, INC.**

**NOTES TO UNAUDITEDCONSOLIDATED FINANCIAL STATEMENTS**

 **(In thousands,except per share data)**

 

**(1)     Summaryof Significant Accounting Policies**

 

#### Organization

 Our discovery informatics and discovery researchproducts and services enable life science companies to better perform theirdrug discovery.  We combine our resources in computer-aided molecular design,cheminformatics, chemistry research and production, with the expertise of scientistson our staff to address the challenges facing pharmaceutical researchorganizations. We deliver products and services internationally recognized fortheir innovation and quality.  By creating new chemical compounds and providingtools that aid our partners' design of new chemical compounds, we offer ourcustomers advantages in terms of research cycle time, cost, and efficiency ofresearch activities.

 We have formed commercial relationships withmost major pharmaceutical companies and with many emerging biotechnologycompanies based on their use of some or all of our products and services. Representative pharmaceutical clients include: Abbott, Bayer, Bristol-MyersSquibb, GlaxoSmithKline, Pfizer, Sanofi-Aventis, Schering AG, Schering-Plough,Servier and Wyeth.  Representative biotechnology clients include: Biovitrum,BioTie, CeNeS, Chronogen and GeminX.  

 Tripos was formed in 1979 to commercializesoftware for molecular visualization, analysis and design.  In building ourdiscovery informatics solutions, we have focused on developing an integratedsuite of offerings at the leading edge of scientific research.  In addition to ourdiscovery informatics product and service offerings, we engage in chemistryresearch enhanced by informatics capabilities to produce high-value productsand services that directly impact our customers' discovery programs.  In certaincases with customers, these capabilities have created opportunities for us toparticipate in research collaborations, in which we have the potential formilestones and/or royalty interests in early-stage new drug candidates.

 Our business model is based primarily onderiving revenues from our discovery informatics and discovery researchbusinesses as follows:

 

•      *Discovery Informatics Products and Services.*  The SYBYL®and UNITY® software suites are the foundation of our discoveryinformatics product (software) offerings.  These suites provide integrated tools for  computer-aided molecular modeling and visualization, virtual screening,  combinatorial library design, data storage and analysis, and  structure-activity relationships to customers in pharmaceutical, biotechnology  and related life science fields of research.  We offer over fifty (50)  software products for these research areas, some of which are in-licensed  from third party scientific partners.  Key  components of these products are being packaged as web services as part of  Tripos' Service-Oriented Informatics strategy, designed to make the company's  valuable discovery tools adaptable to each scientist's workflow in the new  rapidly evolving informatics environment.  In 2005, we launched the Windows®-based  BenchwareTM suite, used by laboratory researchers to support  synthesis and testing decisions; digitally store, search and retrieve  research information; and share experimental results with project team  members, including computational scientists.  These products and  technologies are provided to our customers through a license arrangement,  while certain of the enterprise-wide technologies also involve systems  integration and other services to facilitate a smooth 

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**Item1.  Financial Statements (continued)**

 implementation. Customized software development projects can also be an avenue to assistcustomers to resolve specific research issues that require new scientificmethods, techniques and analytical tools.

•      *DiscoveryResearch Products and Services.*Tripos Discovery Research Centre, based in the United Kingdom, offers compound design and synthesis, molecular analysis, a suite of leaddiscovery and lead optimization capabilities and newly introducedtarget-specific chemical libraries (LeadDiscovery libraries).  Tripos offers off-the-shelf libraries of compounds sold forpharmaceutical screening purposes.  We also participate with our customers instrategic chemistry research projects, primarily on a fee for service basis. In a few cases, the transfer of intellectual property rights for thesetherapeutic collaborations may include royalty or milestone payments associatedwith advancement of the compounds through various stages of drug development. In addition, Tripos' newly introduced target-specific libraries are intended tobe a platform for our further collaborative development with clients.

 We have a geographically diverse customer base,with approximately 51% of our 2006 year-to-date revenues derived from customersoutside of North America.  Our worldwide sales force operates from offices inthe United States, Canada, England, France, and Germany.  We also sell ourproducts through representatives in Brazil and around the Pacific Rim.  Ourheadquarters is in St. Louis, Missouri and our chemistry laboratory is in Bude, England.

**Basisof Presentation**

 The accompanying unaudited consolidatedfinancial statements have been prepared in accordance with generally acceptedaccounting principles for interim financial information and with theinstructions to Form 10-Q and Article 10 of Regulation S-X.  Accordingly, theydo not include all of the information and footnotes required by accountingprinciples generally accepted in the United States for complete financialstatements.  In the opinion of management, all normal recurring adjustmentsnecessary for a fair presentation of such financial statements have beenincluded.  For a further description of accounting policies, please refer tothe "Description of Business and Summary of Significant AccountingPolicies" section in the Company's annual report on Form 10-K for the yearended December 31, 2005.  Operating results for the nine-month period ended September30, 2006 are not necessarily indicative of the results that may be expected forthe year ending December 31, 2006.

**Revenue Recognition **

 

**Discovery Informatics Products and Support**

** **We recognize revenues in accordance with theAmerican Institute of Certified Public Accountants (AICPA) Statement ofPosition (SOP) 97-2, "Software Revenue Recognition," as amended. Revenues from software license agreements are recognized when all of thefollowing criteria are met as set forth in paragraph 8 of SOP 97-2: (1)persuasive evidence of an arrangement exists, (2) delivery has occurred, (3)the fee is fixed or determinable, and (4) collectibility is probable.  

 Our  largest sources of software license revenue are from Term and Bundled  licenses.  These are time-based arrangements for one or multiple software  products that are sold together with maintenance and support for the term of  the license arrangement.  We do not have Vendor Specific Objective Evidence  ("VSOE") to determine fair value of the maintenance and support in term  arrangements and therefore

|  8 |
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**Item 1.  Financial Statements (continued)**

 recognize revenues from these bundled time-basedlicenses ratably over the license term, which typically range from 1 to 3years.

We allocate revenues from perpetual softwarearrangements involving multiple elements to each element based on the relativefair values as determined by the VSOE for each element.  We limit ourassessment of VSOE for each element to the price charged when the same elementis sold separately.  We have analyzed all of the elements included in ourmultiple-element arrangements and determined that we have sufficient VSOE toallocate revenues to maintenance and support services, and training.  We selltraining separately and have established VSOE on this basis.  VSOE formaintenance and support is determined based upon the renewal rates in contractsthemselves, which is based on a fixed percentage of the current perpetuallicense list price.  Accordingly, assuming all other revenue recognitioncriteria are met, revenues from perpetual licenses are recognized upon deliveryof the software using the residual method in accordance with SOP 98-9,"Modification of SOP 97-2, Software Revenue Recognition, with Respect toCertain Transactions." 

 Software maintenance agreements providetechnical support and the right to unspecified enhancements and upgrades on a"when-and-if-available" basis.  Post-contract support revenues onperpetual agreements are recognized ratably over the term of the support period(generally one year), and training and other service revenues are recognized asthe related services are provided.  Any unrecognized portion of amounts paid inadvance for licenses and services is recorded as deferred revenue.

 

**Discovery Informatics Services**

 Discovery Informatics Services (DIS) includes contractsfor the development of packaged Tripos software and/or for the development anddelivery of enterprise-wide customized software (such as laboratory informationsystems or database integration projects).  Technological feasibility exists onthese software arrangements as they normally leverage our existing products ortechniques.  These arrangements typically include installation at thecustomer's site.  We account for these arrangements in accordance with SOP81-1, as required by SOP 97-2 since the contract to deliver software andinstallation requires significant production, modification or customization ofsoftware.

In applying the provisions of SOP 81-1 thepercentage of completion method of accounting for long-term contracts isutilized.  Percentage of completion accounting provides for two methods torecord long-term contract activity:  1) For contracts where customer approvalof contractually required tasks must occur at each distinct milestone, andwhere amounts billable are indicative of progress-to-completion, we recordrevenues when a milestone has been met and accepted by the customer.  2) Forcontracts without distinct milestones, we measure progress using thecost-to-cost method (cumulative costs as a percentage of total expected coststo complete), which approximates progress towards completion.  In addition, whencurrent estimates of total contract revenue and contract cost indicate a loss,a provision for the entire loss on the contract is made in the period that theloss becomes evident.

 DIS also includes software development("SD") projects that are contractual arrangements with customers toleverage our expertise in developing a scientific software tool for use in drugdiscovery.  Billings may be on a time and materials basis; accordingly, werecord the related revenue when the time and costs are incurred at the statedcontractual rates.  Other contracts may be accounted for under milestone orcompleted contract basis depending on the negotiated terms.  For thesearrangements, cost and revenues are deferred until achievement of the milestoneor completion of the contract. 

 

** **

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**Item 1.  Financial Statements (continued)**

** Discovery Research Products and Services**

 Discovery research sales include:  (1) sales ofchemical compounds from inventory, (2) sales of compounds with associatedexclusive intellectual property, (3) long-term contracts to design and producechemical compounds to customer specifications, (4) contracts to performhigh-throughput analytical and/or purification, (5) contracts to performdiscovery research activities, or (6) contracts to provide biological screeningservices. 

 We recognize revenue from the sale of chemicalcompounds upon shipment of the products, FOB shipping point to the customer. This practice is consistent with the four criteria required for revenuerecognition listed in paragraph 1 of Staff Accounting Bulletin ("SAB") 104issued by the U.S. Securities and Exchange Commission ("SEC").  For chemicalcompound transactions, persuasive evidence of an agreement exists upon thereceipt of a contract outlining the purchase and usage terms of the compounds. A purchase order may also be received as confirmation.  As stated above,revenue is not recognized until the compounds have been shipped to thecustomer.  The selling price for compounds is fixed according to the terms of thecontract or customer's purchase order.  Payment terms for chemical compoundtransactions are Net 30 days.  We have experienced very few bad debts arisingfrom these product transactions; as a result, collectibility is reasonablyassured.

 In accordance with SOP 81-1, sales derived fromlong-term contracts to design and produce chemical compounds to customerspecifications are recorded using the percentage of completion method as the finishedgoods are delivered (under the units of delivery method).  The contract costsrelated to delivered compounds are recorded to cost of sales as the compoundsare delivered and revenue is recognized.

 Discovery research activities involve leadcompound optimization projects, custom synthesis, compound design and compound screening.These contracts generally call for non-refundable contractual fees tied to timeand materials.  Accordingly, revenues under contracts of this type are recordedon a time and material basis.  When contracts to perform discovery researchactivities require a specific deliverable, the direct and incremental contractcosts are deferred.  Revenue and the contract costs are then recognized upondelivery and acceptance.

 An access fee for our LeadDiscovery programs mayin some cases be recognized upon completion of a materials transfer agreementand shipment of selected compounds to the customer for screening purposes.  Customersdeciding to retain exclusive rights to promising compounds in the selection arerequired to pay an additional fee.  Certain customers may engage Tripos forfollow-on discovery research services to further refine the lead compound at additionalcost. 

 

**Hardware Sales**

 Hardware sales are recorded upon shipment of theproduct to the customer.

 

**Stock-Based Compensation**

 Prior to January 1, 2006, we accounted forstock-based compensation plans under the intrinsic value method as permittedunder Accounting Principles Board Opinion No. 25 ("APB 25"), "*Accountingfor Stock Issued to Employees*", and related Interpretations.  UnderAPB 25, generally no compensation expense was recognized because the exerciseprice of the options equaled the fair value of the stock at the grant date.

 

| 10 |
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**Item 1.  Financial Statements (continued)**

**Stock-Based Compensation (continued)**

 

EffectiveJanuary 1, 2006, we adopted the fair value recognition provisions of Statementof Financial Accounting Standards ("SFAS") No. 123R ("FAS 123R"),"Share-Based Payment," using the modified-prospective transition method.  Underthis transition method, compensation expense was recognized beginningJanuary 1, 2006 and includes (a) compensation expense for allshare-based employee compensation arrangements granted prior to, but not yetvested as of January 1, 2006, based on the grant date fair value estimatedin accordance with the original provisions of FAS 123, and(b) compensation expense for all share-based employee compensationarrangements granted subsequent to January 1, 2006, based on the grantdate fair value estimated in accordance with the provisions of FAS 123R.  Resultsfor prior periods have not been restated.  See Note 15 of the Notes toConsolidated Financial Statements in this Form 10-Q for further discussion ofstock-based compensation.

 

** IncomeTaxes**

** **We account for income taxes in accordance withSFAS No. 109 ("FAS 109"), *Accounting for Income Taxes,* which prescribesthe use of the asset and liability method whereby deferred tax assets orliabilities are calculated at the balance sheet date using current tax laws andrates in effect.  Valuation allowances are established when necessary to reducedeferred tax assets when it is more likely than not that a portion or all ofthe deferred tax assets will not be realized.  In accordance with FAS 109,income tax expense includes 1) deferred tax expense, which generally representsthe net change in the deferred tax asset or liability balance during the periodplus any change in valuation allowances, and 2) current tax expense, whichrepresents the amount of tax currently payable to or receivable from a taxingauthority.  The primary difference between financial statement income andtaxable income results from the use of different methods of computingdepreciation, capitalized development cost, certain revenue recognitionactivities, other timing differences and the valuation of net operating losscarryforwards.  Deferred taxes do not reflect temporary differences relating toour investment in foreign subsidiaries as these amounts have been deemed to bepermanently invested.  Estimating the deferred tax position on these amounts isnot practical.****

 

The effective tax rate reflectsmanagement's current estimate of the distribution of earnings among thestatutory jurisdictions in which we operate and the valuation of certain taxcredits and net operating losses in the U.S. and U.K. from prior tax years(each ending December 31).  Valuation allowances established for deferred taxassets related to net operating losses does not impair our ability to use thosedeferred tax assets upon achieving profitability in the related jurisdictions. Upon the recognition of income in future periods in the jurisdictions where thedeferred tax assets were created, release of the corresponding valuationallowances may result in a lower effective tax rate.

 

**Inventory**

 We account for abnormal amounts of idle facilityexpense, freight, handling costs, and wasted material (spoilage) ascurrent-period charges and not included in overhead as required by SFAS No. 151"Inventory Costs-an amendment of ARB No. 43, Chapter 4" ("FAS151").  In addition, FAS 151 requires that allocation of fixed productionoverheads to the costs of conversion be based on the normal capacity of theproduction facilities.  We have adopted FAS 151 effective January 1, 2006.  Theadoption of FAS 151 coincided with the completion of our four-year $90 millionfile enrichment project with Pfizer.  As a result, there are more currentperiod charges of approximately $247 and $719 in the third quarter and first ninemonths of 2006, respectively, and we are estimating a total of approximately $933for fiscal year 2006, unless excess property is sold, based upon decreasedproduction.

| 11 |
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**Item 1.  Financial Statements (continued)**

 **(2)     ComprehensiveIncome (Loss)**

 

The components of comprehensive income, net ofrelated tax, for the three- and nine-month periods ended September 30, 2006 and2005 were as follows:

|                                                                              | **Three-month Period**         |                          | **Nine-month Period** |
|-----------------------------------------------------------------------------------|--------------------------------|--------------------------|-----------------------|
|                                                                              | **09-30-2006**                 | 09-30-2005               |                       | **09-30-2006** | 09-30-2005 |
| Net income (loss) available to common	

   shareholder             | ** **

**$ (4,384)** |  

$ 160  |                  | ** **

**$ (9,675)** |  

$ 952  |
| Unrealized gain (loss)on marketable securities                                    | **(9)**                        | --                  |                  | **(9)** | 53  |
| Less: reclassification for (gain) loss  included in     net income | **-- **                   | --                  |                  | **-- ** | (149) |
| Foreign currency translation adjustments                                          | **(163)**                      | 207                 |                  | **(1,072)** | 1,522  |
| Comprehensive income (loss)                                                       | **$ (4,556)**             | $ 367          |                  | **$ (10,756)** | $ 2,378  |

 

The components ofaccumulated other comprehensive income, net of related tax, at September 30,2006 and December 31, 2005 were as follows:

|                                     | **09-30-2006**     | 12-31-2005  |
|------------------------------------------|--------------------|-------------|
| Foreign currency translation adjustments | **$ (1,130)** | $ (58) |
| Unrealized loss on marketable securities | **(9)**            | --     |
| Accumulated other comprehensive  loss    | **$ (1,139)** | $ (58) |

 

 **(3)     ContingentLiabilities**

 

*Securities Class Action Litigation*

On or about July 24, 2003, the Company and twoof its executive officers, Dr. John P. McAlister and Mr. B. James Rubin, weresued in federal district court in St. Louis, Missouri on behalf of purchasersof the Company's common stock during the first half of 2002.  The consolidatedclass action complaint alleged that statements made by the Company in pressreleases and other public disclosures contained materially false and misleadinginformation in violation of the federal securities laws.  On or about May 5,2004, plaintiffs filed a second amended complaint on behalf of a purportedclass of purchasers of the Company's common stock between February 9, 2000 andJuly 1, 2002 (the "Class Period").  The second amended complaintgenerally alleges that, during the Class Period, defendants made false ormisleading statements of material fact about the Company's prospects and failedto follow generally accepted accounting principles in violation of the federalsecurities laws.  The second amended complaint also named Ernst & YoungLLP, the Company's former independent registered public accounting firm, as aco-defendant.  In August 2004, the Company and the individual defendants andErnst & Young filed motions to dismiss the second amended complaint.  OnSeptember 30, 2005, the Company was informed that its motion to dismiss wasdenied; however, the motion to dismiss filed by Ernst & Young was granted.

 

On March 21, 2006, the parties reached a tentativeagreement to settle the class action litigation.  The total amount of thesettlement is $3,150 which is to be paid by our insurers.  The settlement wassubject to court approval after notice and an opportunity to object wasprovided to the putative shareholder class.  On August 4, 2006, the Courtentered an order approving the settlement and dismissing with prejudice allclaims against the defendants.  

| 12 |
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**Item 1.  Financial Statements (continued)**

* *

**(3)     ContingentLiabilities (continued)**

* *

*Shareholder Derivative Litigation*

On or about February 10, 2006, a shareholderderivative action was filed in the Circuit Court of the County of St. Louis.  The complaint named certain of the Company's officers and directors as defendantsand names the Company as a nominal defendant.  The complaint alleged thatcertain of the Company's officers and directors breached their fiduciary dutiesto the Company by engaging in alleged wrongful conduct including conductcomplained of in the securities class action litigation described above.  

 

On March 21, 2006, theparties reached a tentative agreement to settle this litigation, subject tofinal documentation and court approval, involving the implementation of certainpolicies and procedures by the Company and the payment of attorneys' fees of$200 to plaintiffs' counsel.  All fees are to be paid by our insurers.  OnSeptember 8, 2006, the Court granted preliminary approval to the parties'settlement and scheduled a final approval hearing for November 17, 2006.  Therecan be no assurance that the settlement will be approved, in which case we willcontinue to vigorously defend ourselves against these claims.  

* *

 *Grant Programs*

In 2002, Tripos, Inc.and its U.K. subsidiary, Tripos Discovery Research Ltd. ("TDR") was awarded aGBP2400 grant by the U.K Department of Trade and Industry ("DTI") based on thecreation of jobs in the region and capital investment.  In 2002 and 2004 we metall criteria for the first and second installments and received GBP550 andGBP990, respectively.  We may be obligated to repay portions or all of thegrant money received for a period of up to five years after our first draw,which was January 2003, under the DTI grant programs if we eliminate jobs orexit the property.  On January 24, 2006 we reduced headcount as described inNote 10 by seventy-six positions.  We reduced headcount further on August 11,2006 and the fourth quarter, 2006 by fourteen positions and twenty-sevenpositions, respectively.  Calculation of any amounts repayable to the U.K. government will be based on employee staffing levels at December 31, 2006.  Actualstaffing levels at that date will be compared to staffing levels previouslyfunded by the grant.  Any shortfall in actual staffing could require repaymentto the DTI calculated at a rate of GBP17 per employee up to a maximum amount ofGBP1,540 (approximately $2,800).  The Company has initiated discussions withthe DTI with the goal of negotiating a reduced repayment obligation.  TheCompany has yet to receive an indication from the DTI as to the amount to berepaid nor as to the timing of the repayments, if any, and is unable toestimate the potential liability at this time.

  

**(4)     SignificantCustomer **

** **During the third quarter and nine months endedSeptember 2006, we had no customer representing over 10% of net sales.  Duringthe third quarter and nine months ended September 2005, Pfizer, Inc.represented 43% and 46%, respectively, of total net sales.  We providedproducts and services to Pfizer under three separate contracts: multi-yearworldwide licenses to our discovery software products, multi-year collaborativesoftware development project and a $90 million four-year discovery researchproject to design and synthesize exclusive compound libraries which wascompleted in the fourth quarter 2005.  We continue to provide worldwidelicenses to our discovery software products to Pfizer during 2006; however revenuesfrom Pfizer have dropped below 10% of third quarter and nine months endedSeptember 2006 total revenues.  

| 13 |
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**Item 1.  FinancialStatements (continued)**

** (5)     Earnings(Loss) Per Share** 

 

The following table setsforth the computation of basic and diluted earnings per share for the three-and nine-month periods ended September 30, 2006 and 2005.

|                                                                                                                                       | **Three-months Ended**   |              | **Nine-months Ended** |
|--------------------------------------------------------------------------------------------------------------------------------------------|--------------------------|--------------|-----------------------|
|                                                                                                                                       | **09-30-2006**           | 09-30-2005   |                       | **09-30-2006** | 09-30-2005 |
| **Numerator:**                                                                                                                             | ** **               |         |                  | ** ** |   |
| Numerator for basic earnings per share--

     net income  (loss) allocable to common shareholders      | **$ (4,384)**       | $160         |                  | **$ (9,675)** | $ 952 |
| **     **dividends accruing to  preferred shareholders

        (Note  C) | ** **

**-- ** |  

--   |                  | ** **

**-- ** |  

-- |
| Numerator for diluted earnings per  share                                                                                                  | **$ (4,384)**       | $160         |                  | **$ (9,675)** | $ 952 |
| **Denominator:**                                                                                                                           | ** **               |         |                  | ** ** |   |
| Denominator for basic earnings per share--     Weighted average shares                                                      | **10,276 **         | 10,114       |                  | **10,220 ** | 10,088 |
| Effect of dilutive securities:                                                                                                             | ** **               | ** **   | ** **            | ** ** | ** ** |
|    Warrants  (Note A)                                                                                                  | **-- **             | --           |                  | **-- ** | -- |
|    Employee stock options (Note  B)                                                                                    | **-- **             | 29           |                  | **-- ** | 44 |
|    Assumed conversion of  Series C preferred 

      Shares  (Note C)                         | ** **

**-- ** |  

--   |                  | ** **

**-- ** |  

-- |
| Denominator for diluted earnings  per share--     Adjusted weighted average shares                                          | **10,276 **         |  10,143 |                  | **10,220 ** | 10,132 |
| ** **                                                                                                                                 | ** **               |         |                  | ** ** |   |
| **Basic** and diluted earnings (loss) per share                                                                                            | **$ (0.43)**        | $ 0.02  |                  | **$ (0.95)** | $ 0.09 |

 

Note A: For the threeand nine-months periods in 2006 and 2005, the dilutive effect of the 156outstanding warrants to purchase shares of common stock issued to Horizon hasbeen excluded as the average market price of Tripos common stock was below theprice of the warrants and therefore the warrants could not be deemed to havebeen converted into common stock.  The 550 warrants and 16 warrants issued toMidwood Capital and Seven Hills, respectively, have also been excluded for thethree and nine-months periods in 2006 as the average market price of Triposcommon stock was below the price of the warrants and therefore the warrantscould not be deemed to have been converted into common stock.

 Note B:  For the threeand nine-months periods in 2006, weighted average shares outstanding did notinclude shares related to the effect of employee stock options as none wereexercisable due to the market price of the Company's common stock during theperiods. 

 Note C:   For the threeand nine-months periods ending September 30, 2006, weighted average sharesoutstanding were not adjusted for the conversion of the Series C PreferredStock as their inclusion would have been anti-dilutive.  Accordingly, therelated preferred dividends were not added back to the numerator for dilutedearnings per share.

 For additionaldisclosures regarding earnings per share, see the notes to the Company's 2005consolidated financial statements in its Form 10-K.

 

| 14 |
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**Item1.  Financial Statements (continued)**

** (6)     Inventory**

 We maintain a physical inventory of chemicalcompound libraries in various states of completion for LeadQuest, LeadDiscoveryand customer-specific chemistry research projects.  Costs associated with themanufacture of compounds are calculated using the standard cost method and arecarried at the lower of cost (standard cost method approximating FIFO) ormarket.  In calculating the reserve for obsolescence, collections of compoundsare reviewed for their age, possible chemical degradation and cumulative salestrends, and if necessary, a reserve provision is made so that the carryingvalue is at or below the respective net realizable values.  If there is, in ouropinion, a significant adverse deviation in sales trends for a specificcompound collection or library, an additional reserve provision is taken.  Aportion of the LeadQuest inventory is used in discovery research projects.  Amortizationof this inventory is recorded in the reserve for obsolescence over its 10-yearexpected useful life.  Similarly, LeadDiscovery libraries containing patentedcompound series are amortized over the anticipated patent life.  The remainingLeadDiscovery libraries are amortized over a 10-year period.  Amortizationrelated to these inventory components was $135 during the third quarter and $255for the nine-month period of 2006.  In all cases, customers may purchase any orall remaining quantities of LeadQuest or LeadDiscovery libraries.  Work inprocess and finished goods inventory includes the accumulated cost of compoundsin production or awaiting shipment to customers under discovery research orcustom synthesis contracts.  The increase in finished goods inventory atSeptember 30, 2006 is due to the movement of LeadQuest libraries from work inprocess at December 31, 2005 to finished goods in 2006 and the production ofapproximately $2,500 of new LeadDiscovery compounds in 2006.  

 

Inventory balances at September 30, 2006 andDecember 31, 2005 were:

|                                                                                                                               | **09-30-2006**         | 12-31-2005         |
|------------------------------------------------------------------------------------------------------------------------------------|------------------------|--------------------|
|      Raw materials                                                                                        | **$ 1,953 ** | $ 1,763  |
|      Work in process                                                                                      | **1,847 **        | 3,339         |
|      Finished goods                                                                                       | **7,376 **        | 3,217         |
|      Reserve for  obsolescence                                                                            | **(3,695)**            | (3,164)            |
|          Total  inventory                                                             | **$ 7,481 ** | $ 5,155  |
| Costs of discovery research customer projects  included in       Work in Process and Finished Goods above | **$ 986 **   | $ 534    |

 

**(7)     Time-basedSoftware License Arrangements**

 Certain time-basedsoftware license arrangements are covered by non-cancelable agreements whoseterms generally range from one to five years.  The typical term of thecontracts is three years.  Revenue from these time-based software licensearrangements is recognized ratably over the agreed term.  The following tableshows the amount of revenues to be recognized from these non-cancelablearrangements after September 30, 2006:

 

|   | Revenues to be  recognized in:                  | Amount        |
|--------|-------------------------------------------------|---------------|
|   |    2006  (remaining 4th quarter) | $ 4,891  |
|   |    2007                          | 8,052         |
|   |    2008                          | 1,669         |
|   |    2009  and later               | 247           |
|   | Total                                           | $ 14,859 |

 

| 15 |
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**Item 1.  Financial Statements (continued)**

** (7)     Time-basedSoftware License Arrangements (continued)**

 Tripos is typically paid annually under thesecontracts.  Shown below are the amounts to be billed under these contractssubsequent to September 30, 2006 (amounts not included in the accompanyingbalance sheets at September 30, 2006).

|   | Amounts to be billed  in: | Amount       |
|--------|---------------------------|--------------|
|   |    2006    | $ 2,067 |
|   |    2007    | 3,249        |
|   |    2008    | 472          |
|   | Total                     | $ 5,788 |

** **

**(8)     Debt Facilities**

** **As of September 30, 2006 we have existing creditfacilities provided by LaSalle Bank in the form of a revolving line of creditand a mortgage loan for our corporate headquarters building, due to expire onJanuary 1, 2007 and April 18, 2008, respectively.  The credit facilities arecollateralized by substantially all of our U.S. assets and stock pledges foreach of the U.S. and U.K. subsidiaries.  

 The revolving line of credit borrowing capacity is$6,000 and has a borrowing base of 80% of domestic and insured foreign accountsreceivable plus an allowance of $1,800 against excess equity in U.S. realestate.  Covenants under the credit facility include a minimum shareholders'equity covenant tested quarterly and a minimum consolidated cash balancecovenant tested monthly.  There is no annual clean-down requirement.  Borrowingsunder the revolving line of credit bear interest at variable rates tied toLIBOR or the bank's prime rate.  The line of credit carries a commitment fee of3/8% of the unused portion of the line.  Due to the short term commitment ofthe amended credit facility, draws on the line of credit are classified asshort-term debt. Borrowingbase availability was $3,310 and we had borrowings outstanding of $3,310 at September30, 2006.  The mortgage note calls for even quarterly principal payments basedon a twenty-year amortization schedule.  Interest on the mortgage loan is basedon LIBOR plus 3.0%.  Interest rates paid by the Company on the mortgageaveraged 8.5% and 7.5% during the third quarter of 2006 and first nine monthsof 2006, respectively.  As of September 30, 2006, $3,534 was remaining on themortgage.  We were in violation of the Minimum Net Worth covenant on September30, 2006 and therefore have reflected all amounts outstanding on the revolvingline of credit and mortgage loan as current on the balance sheet.  Wehave requested a waiver of this covenant violation for the period endedSeptember 30, 2006; however, there are no assurances that the bank will grant awaiver or that the bank will not impose additional terms as a condition togranting a waiver.  In addition, the  LaSalle Bank facility matures January 1,2007, and LaSalle Bank has advised Tripos that is does not intend to renew orextend revolving credit to Tripos beyond January 1, 2007.  Nonetheless,Tripos plans to request an extension from LaSalle Bank to enable it to completecertain strategic transactions that are currently under negotiation. Tripos' ability to fund the anticipated capital and operating needs of itsbusiness following maturity of the LaSalle Bank facility and absent completionof certain strategic transactions is dependent, among other things, on the replacement of thisfacility or the ability to secure alternative bank or other debt financingand/or equity funding.  See"Management's Discussion and Analysis-Liquidity" for further informationconcerning our liquidity and financial position.  

 Inconnection with the Optive acquisition, the Company issued a subordinatedpromissory note to Horizon Technology Finance with a face value of $3,500 and astated interest rate of 11.42%.  The repayment terms of the promissory noterequire monthly interest only payments of $33 for the first 18 months, followedby 30 monthly principal and interest payments of $135 beginning on August 1,2006.  Each payment of principal will be accompanied by payment of accruedbut unpaid interest to the date of the payment.  The subordinatedpromissory note contains prepayment penalties.  The balance outstanding atSeptember 30, 2006 was $3,296.  In addition, as part of the financingtransaction, 112 shares of common stock were issued to Horizon and Sand HillCapital at a discounted price of $4.48 per share.  Warrants to purchase 156common shares were issued to Horizon at a negotiated price of $4.48.  Thesetransactions resulted in original issuance debt discount of $89 related to thecommon stock issued at a discount and $432 related to the warrants, calculatedbased upon relative fair values.  The debt discounts are being amortized tointerest expense over the life of the loan using the effective interest ratemethod. As a result of the default under the LaSalle Bank credit facilitydescribed above, we are required to notify Horizon of the existence of thedefault and of the ability to toaccelerate this indebtedness if the default is not cured within 30 days.

| 16 |
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**Item 1.  Financial Statements (continued)**

** ****(9)     Goodwilland Other Intangible Assets**

** **At September 30, 2006and December 31, 2005, the Company had the following intangible asset balances:

|                   |   | September 30, 2006 |   | December 31, 2005 |
|------------------------|--------|--------------------|--------|-------------------|
|                   |   | Gross              |   |              |   | Gross |   |   |
|                   |   | Carrying           |   | Accumulated       |   | Carrying |   | Accumulated |
|                   |   | Amount             |   | Amortization      |   | Amount |   | Amortization |
| Acquired software      |   | $ 3,590       |   | $ 668        |   | $ 3,590 |   | $ 382 |
| Noncompete agreements  |   | 350                |   | 162               |   | 350 |   | 92 |
| Patents and trademarks |   | 192                |   | 113               |   | 192 |   | 104 |
| Total                  |   | $ 4,132       |   | $ 943        |   | $ 4,132 |   | $ 578 |

 Amortized intangible assets have the followingweighted average useful lives as of September 30, 2006:  acquired software --14.4 years; non-compete agreements -- 3.9 years; patents and trademarks -- 16.7years; and intangible assets in total -- 13.6 years.

 Amortization expense was approximately $122 and$121 for the three-month periods ended September 30, 2006 and 2005, and $365and $364 for the nine-month periods respectively.  Estimated annualamortization expense for the next 5 years is: 2006 - $486; 2007 - $476; 2008 -$475; 2009 - $391 and 2010 - $9.

 The changes in the carrying amount of goodwill forthe nine months ended September 30, 2006 are as follows:

|                                      |   | Discovery    |   | Discovery    |   |         |
|-------------------------------------------|--------|--------------|--------|--------------|--------|--------------|
|                                      |   | Informatics  |   | Research     |   | Total        |
| Balance at December  31, 2005             |   | $ 4,308 |   | $ 947   |   | $ 5,255 |
| Foreign currency  translation adjustments |   | --      |   | 96           |   | 96           |
| Balance at September 30,  2006            |   | $ 4,308 |   | $ 1,043 |   | $ 5,351 |

The goodwill related toDiscovery Informatics is not tax deductible.

 

**(10)**    **Restructuring Charge**

OnJanuary 24, 2006 we completed a reduction in force for our Discovery Researchbusiness based in Bude, England which was previously announced on December 19,2005.  This action coincided with the conclusion of the 30-day consultationperiod with employees mandated by U.K. law.  We reduced the number of employeesby 76 positions to streamline and refine our Discovery Research business andassociated cost structure as a result of our fourth quarter 2005 completion of thefour-year $90 million file enrichment project with Pfizer Inc.  More than halfof the employees affected left the Company under a voluntary separation plan. In addition, a restructuring of our US based employees resulted in a staffreduction of 9 employees.  As a result of these actions, the Company recorded apre-tax restructuring charge in the first quarter 2006 of approximately $807and $120 related to our Discovery Research and Discovery Informatics divisions,respectively, for one-time termination benefits and outplacement costs.  Thesecosts are recorded in the consolidated statement of operations in therestructuring charge line item.  All costs associated with these restructuringswere paid by the end of the second quarter.

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**Item 1.  Financial Statements (continued)**

**(10)**    **Restructuring Charge(continued)**

 Thefollowing table summarizes the activity related to the January 24, 2006restructuring:

 

|                                     |   | Discovery Informatics |   | Discovery Research |   |  

Total   |
|------------------------------------------|--------|-----------------------|--------|--------------------|--------|-----------------|
| Restructuring  charge first quarter 2006 |   | $ 120       |   | $ 807    |   | $927       |
| Cash  payments first quarter 2006        |   | (114)                 |   | (803)              |   | (917)           |
| Accrual  balance at March 31, 2006       |   | $ 6         |   | $ 4      |   | $10        |
| Cash  payments second quarter 2006       |   | (6)                   |   | (4)                |   | (10)            |
| Remaining  accrual balance               |   | $ --        |   | $ --     |   | $ --  |

 

On August 11, 2006 wecompleted an additional 14-position reduction in force for our DiscoveryResearch business, resulting in a pre-tax restructuring charge of $338. Wesolicited and obtained voluntary terminations for all positions affected inexchange for one-time termination benefits and outplacement costs. All costs associatedwith this restructuring not paid during the third quarter are expected to bepaid in the fourth quarter of this year. 

 Thefollowing table summarizes the activity related to the August 11, 2006restructuring:

 

|                                     |   | Discovery Informatics |   | Discovery Research |   |  

Total |
|------------------------------------------|--------|-----------------------|--------|--------------------|--------|---------------|
| Restructuring  charge third quarter 2006 |   | $ --        |   | $ 338    |   | $338     |
| Cash  payments third quarter 2006        |   | --               |   | (295)              |   | (295)         |
| Accrual  balance at September 30, 2006   |   | $ --        |   | $ 43     |   | $43      |

 In the fourth quarter of2006 we performed a third reduction in force for an additional 27 positions,reducing our headcount in this business segment to 43 positions.  These actionswere necessary in order to further streamline the Discovery Research unit.  See Note 16 "SubsequentEvent" for further discussion. 

 

**(11)     Long-termInvestments**

 Since2001, we have invested in the Life Science Ventures II fund administered byA.M. Pappas.  This fund invests in new and developing companies in the lifescience sector.  Our investment commitment of $2,500 represents approximately2.0% of the total capital of the fund.  During the third quarter of 2006, weinvested an additional $88, increasing the total amount invested to $2,163 or 87%of our total commitment.  The fund's managers record investment impairmentswhen identified, for which we recognize our pro-rata share of such impairments. We received a distribution from the fund in August 2006, reducing ourinvestment by $29 and recognizing a $6 gain.  Our net investment balance in theA.M. Pappas Life Science Ventures II Fund at September 30, 2006 totals $1,578,and is reflected in investments recorded at cost on the balance sheet. 

 Duringthe third quarter 2005, we received shares of common stock of InfinityPharmaceuticals, a private cancer drug discovery and development company,valued at $191 as part of an early termination agreement for a software licensecontract.  Compensation for the early termination agreement consisted of cash plusshares and represented the full value of our software license agreement.  InApril 2006, Infinity Pharmaceuticals announced its intent to merge withDiscovery Partners International, Inc. to become a public company.   This mergerwas completed on September 12, 2006.  The value of our shares on the date ofmerger was $141, resulting in a loss on our investment of $50.  At the date ofmerger, our $141 investment in the combined company was moved from investmentsrecorded at cost to marketable securities and marked to market at September 30,2006.

| 18 |
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**Item 1.  Financial Statements (continued)**

** (12)     SeriesC Preferred Stock**

** **On May 4, 2006, Tripos completed the sale of1,833 shares of Redeemable Convertible Preferred Stock ("Preferred Stock") at aprice of $3.00 per share and issued 550 five-year common stock warrantsexercisable at $3.50 per share to Midwood Capital, a private equity firm, forgross proceeds of $5,500.  Net proceeds from this transaction, after theplacement agent's fee and estimated legal and other costs incurred by theCompany, were approximately $4,851.  Proceeds were utilized to reduce theborrowings under the revolving line of credit and to fund working capitalrequirements.  The warrants to purchase common stock were exercisable uponissuance.  The shares of Preferred Stock represent approximately 18 percent ofTripos' outstanding common stock on an as-converted basis (1 preferred share isconvertible into 1 share of common stock).  Each outstanding share of PreferredStock is entitled to voting rights equal to the number of full shares of CommonStock into which such shares are convertible on the date of issuance.  ThePreferred Stock also has preferential distribution rights in the event of aliquidation, dissolution or winding-up of the Company or a deemed liquidation. The Preferred Stock bears a dividend at an annual rate of 10.5% and isredeemable in two years at the option of the holders.  If certain events occurprior to January 26, 2007, which events relate primarily to a sale oracquisition of Tripos, the dividends will be accelerated such that the holdersof the Preferred Stock will receive dividends in the aggregate amount of $958(or dividends in the aggregate amount of $1,155 if the event occurs on or afterJanuary 26, 2007) inclusive of any dividends received to date.  This financingstrengthened the Company's balance sheet, enhancing its ability to explorestrategic alternatives and support current and potential business initiatives.

 Upon issuance, the fair value of the warrantswas determined based on the Black-Scholes option-pricing model and recorded onthe balance sheet as a liability in the amount of $1,040.  The warrants were determinedto be a liability, as under Emerging Issues Task Force ("EITF) 00-19,"Accounting for Derivative Financial Instruments Indexed to, and PotentiallySettled in, a Company's Own Stock", they could not be recorded in equity due toregistration rights obligations and cash penalty requirements that were notcapped in the event of an unsuccessful registration.  The maximum penalty forfailure to register or maintain effectiveness of a registration was determinedto exceed the spread between the fair value of a registered and unregisteredshare and, as such, cash settlement was assumed for this determination.  Theweighted-average assumptions utilized in determining the Black-Scholes valueswere as follows:  stock price-$2.96; strike price-$3.50; dividend yield-0%;risk-free interest rate-5.0%; volatility factor-0.79 and expected life-5years.  The Company will reassess the fair value of the warrants on a quarterlybasis until exercise or expiration and record any resulting gain or lossthrough "other income" in the statement of operations.  The Company evaluatedthe conversion feature of the preferred stock under FAS No. 133, "Accountingfor Derivative Instruments and Hedging Activities" and determined that it wasclearly and closely related to the host contract (preferred stock) and was moreakin to equity.  The conversion feature therefore was not separated from thehost contract.  The equity features of the preferred stock are voting rightssimilar to common stock, participation in distributions to common shareholders,the holder has a residual interest in the Company, and the preferred shares arenot mandatorily redeemable.  The Company therefore determined that theconversion feature should be evaluated under EITF No. 98-5, " Accounting forConvertible Securities with Beneficial Conversion Features or ContingentlyAdjustable Conversion Rations" and EITF No. 00-27, "Application of Issue No.98-5 to Certain Convertible Instruments."  After taking into account theallocation of the proceeds to the warrants, the Company determined that thePreferred Stock contained a beneficial conversion feature valued at $1,015based upon the intrinsic value of the shares at the closing stock price versusthe value assigned to the preferred stock.  Together, the value assigned to thewarrants and the beneficial conversion feature created a preferred stockdiscount in the amount of $2,055, which is being accreted through preferreddividend expense over a two-year period using the effective interest ratemethodology.  

| 19 |
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**Item 1.  Financial Statements (continued)**

** (12)     SeriesC Preferred Stock (continued)**

 In addition the transaction costs of $629 wererecorded as a deferred issuance cost on the balance sheet and are beingamortized to interest expense over a two-year period also using the effectiveinterest rate methodology.  Included in the transaction costs are 16 warrantsvalued at $29 to purchase common stock issued to the placement agent.  Thesewarrants were issued with the same terms as the warrants issued to the holdersof Preferred Stock.  Accretion of the preferred stock discount and amortizationof the deferred issuance cost during the third quarter 2006 totaled $197 and$62, respectively, while year-to-date accretion and amortization amounts are $321and $98, respectively.  The Company adjusted the warrant valuation at September30, 2006 to the fair value at that date of $467 indicated by Black-Scholes,reducing the liability for the quarter by $215 and recording a gain through"other income" in the statement of operations.  For the year, the cumulativeadjustment to the warrant value as indicated by Black-Scholes is a reduction of$572.  The Black-Scholes assumptions utilized at September 30 were the same asthe assumption utilized upon issuance with the exception of the stock pricereduced to $1.71, the risk-free interest rate adjusted to 4.59% and theexpected life reduced to 4.58 years.

Upon issuance, cash in the amount of $388 wasdeposited into a separate account at LaSalle Bank to cover dividends payable upto December 31, 2006.  On June 30, 2006 and September 30, 2006, dividends of$93 and $144, respectively, were paid from this account to Midwood Capital. The remaining balance and accrued interest of $156 are shown as "Restrictedcash" on the Consolidated Balance Sheets.

** **

** (13)     NewAccounting Pronouncements**

 In June 2006, the FinancialAccounting Standards Board ("FASB") issued FASB Interpretation No. 48,"Accounting for Uncertainty in Income Taxes-an interpretation of FASB StatementNo. 109."  This Interpretation prescribes a recognition threshold andmeasurement attribute for the financial statement recognition and measurementof a tax position taken or expected to be taken in a tax return.  ThisInterpretation also provides guidance on derecognition, classification,interest and penalties, accounting in interim periods, disclosure, andtransition.  The Interpretation is effective for fiscal years beginning afterDecember 15, 2006.  We are currently evaluating the requirements of thisInterpretation, but do not expect that the adoption will have a material effecton our financial statements or tax returns.  

In September 2006, the FASBissued SFAS No. 157 "FairValue Measurements" ("FAS 157").  FAS 157 defines fair value, establishes aframework for measuring fair value in generally accepted accounting principles,and expands disclosures about fair value measurements.  The provisions of FAS157 are effective for financial statements issued for fiscal years beginningafter November 15, 2007.  We are currently evaluating the provisions of FAS157.  

** **In September 2006, the SEC staff issued StaffAccounting Bulletin 108 "Considering the Effects of Prior Year Misstatementswhen Quantifying Misstatements in Current Year Financial Statements" ("SAB108"). SAB 108 requires that public companies utilize a "dual-approach" toassessing the quantitative effects of financial misstatements. This dualapproach includes both an income statement focused assessment and a balancesheet focused assessment. The guidance in SAB 108 must be applied to annualfinancial statements for fiscal years ending after November 15, 2006.  We arecurrently assessing the impact of adopting SAB 108 but do not expect that itwill have a material effect on our consolidated financial position or resultsof operations. 

** **

 

| 20 |
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**Item 1.  FinancialStatements (continued)**

** (14)     Segments**

The Company operates intwo reporting segments, Discovery Informatics and Discovery Research.  TheCompany's Discovery Informatics segment designs and produces, or in-licenses,and sells licenses to software suites that provide computer-aided molecularmodeling and visualization, virtual screening, combinatorial library design,data storage and analysis, and structure-activity relationships to customers inpharmaceutical, biotechnology and related life science fields ofresearch.  The Company's Discovery Research segment provides drugdiscovery services to pharmaceutical and biotechnology companies.  High-endservices offered are based on application by Tripos of its proprietaryhigh-throughput combinatorial chemistry, high-throughput analytical andpurification methods, medicinal chemistry, and our ChemSpace database searchingand selection technologies, including the Lead Hopping method for quickidentification of alternative chemistries for customer's needs.

 Summarized financialinformation concerning the industry segments follows:

 DI = Discovery Informatics

DR = Discovery Research

 

|                                                        | ** ** | **Three-Months End September 30,** |
|-------------------------------------------------------------|------------|------------------------------------|
|                                                        |       | **2006**                           |   | 2005 |
|                                                        |       | **DI**                             | **DR** | **Total** |   | DI | DR | Total |
| Revenues:                                                   |       |                               |   |   |   |   |   |   |
| DI products (including  hardware)

                    |       | **$ 5,673**                   | **$ -- ** | **$ 5,673 ** |   | $ 6,628 | $ --  | $ 6,628  |
| DI services                                                 |       | **378**                            | **-- ** | **378 ** |   | 716 | --  | 716  |
| DR products &  services                                 |       | **--**                             | **1,605 ** | **1,605 ** |   | -- | 5,821  | 5,821  |
| Total  revenues                                             |       | **$ 6,051**                   | **$ 1,605 ** | **$ 7,656 ** |   | $ 7,344 | $ 5,821  | $ 13,165  |
|                                                        |       | ** **                         | ** ** | ** ** |   |   |   |   |
| Depreciation & amortization                             |       | **$ 586**                     | **$ 741 ** | **$ 1,327 ** |   | $ 372 | $ 884  | $ 1,256  |
| Corporate non-allocated                                     |       | ** **                         | ** ** | ** 37 ** |   |   |   |  71  |
| Depreciation & amortization  on statement of operations |       | ** **                         | ** ** | **$ 1,364 ** |   |   |   | $ 1,327  |
|                                                        |       | ** **                         | ** ** | ** ** |   |   |   |   |
| Operating income (loss)                                     |       | **$ (477)**                   | **$ (2,046)** | **$ (2,523)** |   | $ 1,523 | $ (143) | $ 1,380  |
| Non-allocated corporate  department expense                 |       | ** **                         | ** ** | **(1,241)** |   |   |   | (1,636) |
| Operating loss on  statement of operations                  |       | ** **                         | ** ** | **$ (3,764)** |   |   |   | $ (256) |
|                                                        |       | ** **                         | ** ** | ** ** |   |   |   |   |
| Long-lived assets                                           |       | **$ 15,274**                  | **$ 19,872** | **$ 35,146 ** |   | $ 17,633 | $ 23,210  | $ 40,843  |
|                                                        |       | ** **                         | ** ** | ** ** |   |   |   |   |
| Total assets (1)                                            |       | **$ 23,245**                  | **$ 29,185** | **$ 52,430 ** |   | $ 30,025 | $ 35,092  | $ 65,117  |
| Consolidated cash and  marketable securities           |       | ** **                         | ** ** | **2,626 ** |   |   |   | 3,566  |
| Total assets  on balance sheet                              |       | ** **                         | ** ** | **$ 55,056 ** |   |   |   | $ 68,683  |

(1)           Excludes cash and cash equivalents, restricted cash and marketablesecurities of $2,626 and $3,566 in 2006 and 2005, respectively as cash and cashequivalents are monitored on a consolidated basis.

| 21 |
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**Item 1.  FinancialStatements (continued)**

** (14)     Segments(continued)**

 

|                                                        | ** ** | ** **                        |
|-------------------------------------------------------------|------------|-----------------------------------|
|                                                        | ** ** | **Nine-Months End September 30,** |
|                                                        |       | **2006**                          |   | 2005 |
|                                                        |       | **DI**                            | **DR** | **Total** |   | DI | DR | Total |
| Revenues:                                                   |       |                              |   |   |   |   |   |   |
| DI products (including  hardware)                           |       | **$ 17,791**                 | **$ -- ** | **$ 17,791 ** |   | $ 18,761 | $ -- | $ 18,761  |
| DI services                                                 |       | **2,895**                         | **-- ** | **2,895 ** |   | 1,964 | -- | 1,964  |
| DR products &  services                                 |       | **--**                            | **4,347 ** | ** 4,347 ** |   | -- | 20,842 |  20,842  |
| Total  revenues                                             |       | **$ 20,686**                 | **$ 4,347 ** | **$ 25,033 ** |   | $ 20,725 | $ 20,842 | $ 41,567  |
|                                                        |       | ** **                        | ** ** | ** ** |   |   |   |   |
| Depreciation & amortization                             |       | **$ 1,710**                  | **$ 2,199 ** | **$ 3,909 ** |   | $ 1,065 | $ 2,317 | $ 3,382  |
| Corporate non-allocated                                     |       | ** **                        | ** ** | **125 ** |   |   |   | 252  |
| Depreciation & amortization  on statement of operations |       | ** **                        | ** ** | **$ 4,034 ** |   |   |   | $ 3,634  |
|                                                        |       | ** **                        | ** ** | ** ** |   |   |   |   |
| Operating income (loss)                                     |       | **$ 449**                    | **$ (5,486)** | **$  (5,037)** |   | $ 3,551 | $ 1,037 | $  4,588  |
| Non-allocated corporate  department expense                 |       | ** **                        | ** ** | **(3,961)** |   |   |   | (4,664) |
| Operating income (loss) on  statement of operations         |       | ** **                        | ** ** | **$  (8,998)** |   |   |   | $  (76) |
|                                                        |       | ** **                        | ** ** | ** ** |   |   |   |   |
| Long-lived assets                                           |       | **$ 15,274**                 | **$ 19,872** | **$ 35,146 ** |   | $ 17,633 | $ 23,210 | $ 40,843  |
|                                                        |       | ** **                        | ** ** | ** ** |   |   |   |   |
| Total assets (2)                                            |       | **$ 23,245**                 | **$ 29,185** | **$ 52,430 ** |   | $ 30,025 | $ 35,092 | $ 65,117  |
| Consolidated cash and marketable securities                 |       | ** **                        | ** ** | **2,626 ** |   |   |   | 3,566  |
| Total assets  on balance sheet                              |       | ** **                        | ** ** | **$ 55,056 ** |   |   |   | $ 68,683  |

 

(2)           Excludes cash and cash equivalents, restricted cash and marketablesecurities of $2,626 and $3,566 in 2006 and 2005, respectively as cash and cashequivalents are monitored on a consolidated basis.

** **

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**Item 1.  FinancialStatements (continued)**

  

**(15)      Stock-basedCompensation**

 Prior to January 1, 2006, we accounted forstock-based compensation plans under the intrinsic value method as permittedunder Accounting Principles Board Opinion No. 25 ("APB 25"), "*Accountingfor Stock Issued to Employees*", and related Interpretations.  UnderAPB 25, generally no compensation expense was recognized because the exerciseprice of the options equaled the fair value of the stock on the grant date.

 Effective January 1, 2006, we adopted thefair value recognition provisions of SFAS No. 123R ("FAS 123R"),"Share-Based Payment," using the modified-prospective transition method.  Underthis transition method, compensation expense was recognized beginningJanuary 1, 2006 and includes (a) compensation expense for allshare-based employee compensation arrangements granted prior to, but not yetvested as of January 1, 2006, based on the grant date fair value estimatedin accordance with the original provisions of FAS 123, and(b) compensation expense for all share-based employee compensationarrangements granted subsequent to January 1, 2006, based on the grantdate fair value estimated in accordance with the provisions of FAS 123R.  Underthe modified-prospective transition method of FAS 123R, results for priorperiods are not restated. 

 As a result of adoptingFAS 123R on January 1, 2006, earnings before income taxes and net incomefor the three- and nine-months ended September 30, 2006 were both $53 and$271 lower, respectively, than if we had continued to account for share-basedcompensation under APB No. 25.  Basic earnings per share for the three-and nine-months ended September 30, 2006 was reduced by $0.01 and $0.03 pershare, respectively, as a result of the adoption of this statement.  Themajority of options granted by the Company qualify as Incentive Stock Options(ISO) for which no tax benefit is available to be recognized until the optionsare exercised and sold by the grantee within one year of exercise.  Typically, Non-Qualifying(NQ) options provide a deferred tax benefit to the Company at the time of grantand normally a tax benefit in the year of exercise.  However, due to theCompany's present net deferred tax asset position, a valuation allowance wasrecorded to offset the projected tax benefit from the compensation expenserecorded in the third quarter and year to date.  The Company will only realizethe tax benefits when and if they result in an actual reduction in taxespayable.

 Prior to the adoption of FAS 123R, we presentedtax benefits for which we received deductions resulting from the exercise ofstock options as operating cash flows in the Consolidated Condensed Statementsof Cash Flows.  FAS 123R requires the cash flows from the tax benefitsresulting from tax deductions in excess of the compensation expense recognizedfor those options (excess tax benefits) to be classified as financing cashflows.  There were no exercises of stock options in the first nine months of2006, therefore no tax benefits were recorded as financing proceeds in the cashflow statement.  The effect of FAS 123R on our year-to-date consolidatedstatement of cash flows was to add back the $271 of non-cash compensationexpense to the cash flows from operating activities.   

The following tableillustrates the effect on the third quarter and nine-months of 2005 netearnings and earnings per basic and diluted common share if we had applied thefair value recognition provisions of FAS 123 to options granted under ourstock-based employee compensation plans.  For purposes of this pro formadisclosure, the value of the options was estimated using a Black-Scholesoption-pricing valuation model and amortized to expense over the options'vesting periods. 

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**Item1.  Financial Statements (continued)**

** (15)      Stock-basedCompensation (continued)**

 

 

|                                                                                                                                                                                                        |            | Three-month Period |            | Nine-month Period |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------|------------|-------------------|
|                                                                                                                                                                                                        |            | 09-30-2005         |            | 09-30-2005        |
| Net  income as reported                                                                                                                                                                                     | ** ** | $ 160    | ** ** | $ 952   |
| Deduct:  Total stock-based employee     compensation expense determined      under fair value based method for all     awards, net of related tax effects | ** ** | 242           | ** ** | 302          |
| Pro  forma net income (loss)                                                                                                                                                                                | ** ** | $ (82)        | ** ** | $ 407   |
|                                                                                                                                                                                                        | ** ** |               | ** ** |              |
| Pro  forma income (loss) per share:                                                                                                                                                                         | ** ** |               | ** ** |              |
|       Basic  and diluted- as reported                                                                                                                                         | ** ** | $ 0.02   | ** ** | $ 0.09  |
|       Basic  and diluted- pro forma                                                                                                                                           | ** ** | $ (0.01)      | ** ** | $ 0.04  |
|                                                                                                                                                                                                        | ** ** | ** **         | ** ** |              |

** ** 

**Equity Incentive Plans.**  In 2005, we adoptedthe 2005 Equity Incentive Plan ("2005 Plan") that provides for incentive and/ornon-statutory stock options, stock appreciation rights, restricted stock,restricted stock units, performance shares and units, deferred stock units anddividend equivalents to be granted to our employees, consultants anddirectors.  A total of 800,000 shares are available for issuance under the 2005Plan plus any outstanding options under the Company's 1994 Employee StockOption Plan that subsequently expire unexercised, up to a maximum of 300,000shares.  As of September 30, 2006, only stock options have been granted.  Stockoptions may be granted under the 2005 Plan at an exercise price not less than100% of the fair market value on the date of grant.  Options become exercisableand expire at the times and terms established by the administrator, butgenerally vest over four years and expire five to ten years after the grantdate.  The Company satisfies the exercise of stock options by issuing newshares.  Options for 25 shares were granted during the nine months ended September30, 2006.  No options have been exercised in 2006. 

 The fair value of each option award is estimatedon the date of grant using the Black-Scholes valuation model based onassumptions for volatility, interest rates, dividend rates, expected timeoutstanding until exercised (expected term) and expected forfeitures made atthe time of the grant.  The requisite service life equals the vesting term,primarily four years.  Expected volatilities are based on daily observations ofthe historical volatility of our common stock over comparable length periodsand other factors.  No adjustment was made in contemplation of the affect offuture events.  We estimate option exercises and employee terminations based onhistorical data for groups of employees that have similar exercise andtermination behavior (the groups identified are: a. employees, b. officers, andc. directors).  The expected term of options granted is derived by consideringactual historical exercise data and represents the period of time that optionsgranted are expected to be outstanding.  The risk-free interest rate is basedon the U.S Treasury yield curve in effect at the time of the grant.

| 24 |
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**Item1.  Financial Statements (continued)**

** (15)     Stock-based Compensation (continued)**

 Asummary of option activity under the plans for the nine months ended September30, 2006 is as follows:

 

| **Directors**                    |  

 

Shares |  

Weighted Average  Exercise Price | Weighted Average  Remaining Contractual Term |  

Aggregate Intrinsic  Value |
|----------------------------------|------------------------|------------------------------------------|----------------------------------------------|------------------------------------|
| Outstanding,  January 1, 2006    | 417               | $8.64                                    |                                         |                               |
| Granted                          | --                | --                                       |                                         |                               |
| Exercised                        | --                | --                                       |                                         |                               |
| Forfeited                        | --                | --                                       |                                         |                               |
| Expired                          | (15)                   | $4.25                                    |                                         |                               |
| Outstanding,  September 30, 2006 | 402               | $8.80                                    | 4.4 years                                    | $0                                 |
| Options  Exercisable             | 345               | $9.22                                    | 4.0 years                                    | $0                                 |

 

| **Officers**                     |  

 

Shares |  

Weighted Average  Exercise Price | Weighted Average Remaining  Contractual Term |  

Aggregate Intrinsic  Value |
|----------------------------------|------------------------|------------------------------------------|----------------------------------------------|------------------------------------|
| Outstanding,  January 1, 2006    | 867               | $7.62                                    |                                         |                               |
| Granted                          | --                | --                                       |                                         |                               |
| Exercised                        | --                | --                                       |                                         |                               |
| Forfeited                        | --                | --                                       |                                         |                               |
| Expired                          | (64)                   | $3.62                                    |                                         |                               |
| Outstanding,  September 30, 2006 | 803               | $7.95                                    | 4.1 years                                    | $0                                 |
| Options  Exercisable             | 676               | $8.71                                    | 3.9 years                                    | $0                                 |

 

| **Employees**                    |  

 

Shares |  

Weighted Average  Exercise Price | Weighted Average  Remaining Contractual Term |  

Aggregate Intrinsic  Value |
|----------------------------------|------------------------|------------------------------------------|----------------------------------------------|------------------------------------|
| Outstanding,  January 1, 2006    | 671               | $5.83                                    |                                         |                               |
| Granted                          | 25                | $2.99                                    |                                         |                               |
| Exercised                        | --                | --                                       |                                         |                               |
| Forfeited                        | (20)                   | $3.76                                    |                                         |                               |
| Expired                          | (32)                   | $5.07                                    |                                         |                               |
| Outstanding,  September 30, 2006 | 644               | $5.82                                    | 4.1 years                                    | $0                                 |
| Options  Exercisable             | 452               | $6.71                                    | 3.7 years                                    | $0                                 |

 A summary of the statusof the Company's Nonvested shares as of September 30, 2006 and changes duringthe nine months then ended is as follows:

|  

 

Nonvested Shares |   |  

 

Shares |   |   |
|----------------------------------|--------|------------------------|--------|--------|
| Nonvested  at January 1, 2006    |   | 492               |   |   |
| Granted                          |   | 25                |   |   |
| Vested                           |   | (110)                  |   |   |
| Forfeited                        |   | (31)                   |   |   |
| Nonvested  at September 30, 2006 |   | 376               |   |   |

 

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**Item1.  Financial Statements (continued)**

** (15)     Stock-based Compensation (continued)**

 As of September 30, 2006, there was approximately$400 of total unrecognized compensation expense related to nonvested stockoptions.  This expense is expected to be recognized in the remainder of 2006, 2007,2008 and 2009 in the amounts of $176, $155, $51, and $18, respectively.  Thetotal fair value of shares vested during the three and nine-month periods endedSeptember 30, 2006 was $39 and $228, respectively plus the value of the ESPPshares vesting in the same periods of $14 and $43, respectively.  

**Employee Stock Purchase Plan. **In 2002, we adopted the2002 Employee Stock Purchase Plan that allows eligible employees to purchasedstock at the lower of 85% of the fair market value of the stock on theenrollment date or exercise date as defined by the plan.  Issuances of sharesunder the Employee Stock Purchase Plan occur each six months on June 30 and December31.  Pursuant to the plan, employee purchases are limited to 10% of annualcompensation.  The plan originally had 250 shares reserved for issuance.  In2004 the shareholders approved an increase in the reserve of 450 shares.  Theplan is in effect for ten years unless terminated or amended sooner by theBoard of Directors.  At September 30, 2006, 418 shares have been purchasedunder this plan leaving 282 shares available for future issuance.  79 shareswere issued on June 30, 2006.  The value of the 15% discount and a pro-ratashare of the fair value of the implied six-month options is included in thecost of stock-based compensation expense for the three and nine-months ending September30, 2006.

 **1996 Director Stock Plan.**  The Director StockPlan provides for automatic and discretionary issuances of the Company's commonstock to non-employee directors.  The principle purpose of the Plan is tocompensate the non-employee Directors for their service on the Board. Compensation is paid quarterly in the form of 50% cash and 50% in common stockissued from the Plan's reserve based on the closing market value on the lasttrading day of each fiscal quarter.  Compensation expense for the Board ofDirectors is reflected in General and Administrative expense for all periodspresented.  The total expense is the combination of the cash portion and marketvalue of the stock component on the date of issue.

 An initial reserve of 160 shares was approved bythe shareholders in 1996 with an expiration date of May 2006.  Shareholdersapproved a five-year extension of the Plan at the Annual Meeting ofShareholders held on May 17, 2006.  As of September 30, 2006, approximately 93 sharesremain available for issuance.  Further details on the 1996 Director Stock Plancan be found in the Company's Proxy Statement for its 2006 Annual Meeting ofShareholders.  

 ** **

**(16)      SubsequentEvent**

In the fourth quarter of 2006, the Companyconducted a further reduction of staff levels at its laboratory facility in Bude, England, eliminating 27 positions in our continued effort to streamline this business. Of the 27 positions, 21 were voluntary, 5 involuntary and another wasreassigned to our Discovery Informatics division.  Costs associated with thiseffort are estimated at $500 and, when finalized, will be reflected in theCompany's fourth quarter 2006 financial results.

 Tripos Discovery Research Ltd.	is in negotiations to sell certain excess real properties at its Bude,England location.

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**Item 2.  Management'sDiscussion and Analysis of Financial Condition and Results of Operations**

**Forward-lookingStatements**

 The remainder of this report may contain certainstatements that are forward-looking and involve risks and uncertainties.  Wordssuch as "expects", "anticipates", "projects","estimates", "intends", "plans", "believes",variations of such words and similar expressions are intended to identify suchforward looking statements.  These statements are based on current expectationsand projections made by management and are not guarantees of futureperformance.  Therefore, actual events, outcomes and results may differmaterially from what is expressed or forecast in such forward-lookingstatements.  Among the factors that could cause actual results to differmaterially from the forward-looking statements are set forth under the caption "RiskFactors" in Part 1A of Tripos' Form 10*-*K for 2005.  Tripos undertakes noobligation to update any forward-looking statements in this Form 10-Q.

 The following discussion should be read inconjunction with the audited consolidated financial statements and notesthereto.

 

** ****Update on Strategic Alternatives**

	Tripos has been engaged in exploring strategic options for most of 2006. 	Tripos has determined to exit the discovery research business.  Tripos	will proceed as a stand-alone public Discovery Informatics business unless	it is able to negotiate and conclude a transaction to sell the Discovery	Informatics business.

   	With respect to Tripos' Discovery Research business, Tripos:

      	

       -Has	completed further staffing reductions at Tripos Discovery Research. 	The business now has 43 research and sales professionals dedicated to this	business;

**       -**Is	currently engaged in advanced discussions for the sale of the UK-based	Discovery Research business.  The buyer would assume substantially all	the assets and liabilities of that business;

        -Is	in negotiations to sell certain surplus real estate in the U.K.

   	With respect to Tripos' Discovery Informatics business, Tripos:

         -Is working to restructure the Discovery Informatics business as a public	company to continue to provide software and enterprise solutions to the	pharmaceutical and biotechnology industry;

         -As part of the restructuring, the Company is seeking funding for the	near-term capital needs of the Discovery Informatics business, either	through replacement of its bank credit facility (which matures January 1,	2007) or through the proceeds of other debt or equity financings, any of	which may be dilutive to the interests of current stockholders;

         -Continues to evaluate possible sale transactions, and is currently in	advanced discussions with a potential buyer for the Discovery Informatics	business.

	We cannot provide any assurance that we will be able to complete the	transactions described in the preceding paragraphs or whether the proposed	terms of such transactions would be acceptable to our Board of Directors or	our stockholders.

**Overview**

We provide products andservices to the pharmaceutical, biotechnology, and life science industries tosupport early stage research activities.  Our products are used by researchchemists to make decisions about the most productive new compounds to make andtest as potential therapeutics.  Through our own chemistry laboratories, wealso manufacture those compounds for our clients.  Through strategicpartnerships, we can also participate more directly with our clients in thedevelopment and testing of new therapeutic compounds for our clients.

The industries that weserve are highly research driven.  Mature pharmaceutical companies typicallyspend up to 20% of their annual revenues on research to find new blockbusterdrugs.  This research process consists of several phases from early discoveryof compounds of interest, through testing of the promising ones for activityand safety in animals, to final testing of these compounds in humans.  Theinvestment in research activity increases dramatically in the second and thirdphases.  Tripos' offerings are most relevant to the initial phase of thisactivity, namely discovery of compounds.  Our products and services aredesigned and intended to provide our pharmaceutical and biotechnology customerswith improved ways to identify and select the most promising drug candidates totake forward into the more expensive and time consuming stages of the drugdevelopment process.   Depending on the number of compounds that a particularcompany has in different stages of their new therapeutic pipeline, they mayreduce or increase investment in the other phases of research.  Further,decisions by the pharmaceutical industry concerning their research investmentsare strongly influenced by decisions by the various governments of the worldregarding drug pricing and regulation.

 Tripos' software products are primarily sold on a renewable license basis,typically with terms of one to three years.  This business has been generally predictable, as we have experienced high renewal rates inthe past for licenses.  Tripos management closely monitors license expirationsand deploys sales staff to ensure the highest probability of renewals.  Tripos'service businesses, both informatics and chemistry, are much less predictable. The sales cycles for these offerings are typically long -- from six to eighteenmonths -- and are highly influenced by factors in the macro-economicenvironment, including the general state of the pharmaceutical industry and theextent to which governments regulate local pharmaceutical pricing.  To forecastpotential business in these areas, Tripos management strives to closelyinteract with the management of our customers and is closely involved inbusiness development activities for material service project opportunities.

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**Item 2.  Management'sDiscussion and Analysis of Financial Condition and Results of Operations(continued)**

 Large service contracts for pharmaceuticalresearch, both informatics and chemistry, are complex and, because they aredeployed in research applications where outcomes are uncertain, have a largerisk component.  Risk management in these projects begins with the definitionof project requirements and continues through performance metrics and customeracceptance milestones.  Due to the complexity of the projects and changingpriorities within client organizations, it is typical that many decision pointswill arise that require management attention both at Tripos and at the client. To mitigate the project difficulties, Tripos has developed a focused process inwhich management monitors milestones in the project plan according to theprocess workflow.  Despite best efforts, however, some projects are ofsufficient complexity that they present challenges that require revisions tothe project plan and scope. 

 Having been a publiccompany spinout in 1994 with limited capital, we have focused on profitabilityand cashflow.  That said, we have not always been profitable, but have achievedprofitability in certain years.  Major investments, such as the recentexpansion of our chemistry research laboratories in England, have been fundedby other successful investments (e.g. Arena Pharmaceuticals), cash fromoperations, temporary use of debt capacity, and grant funding.

 We license our DiscoveryInformatics products and post-contract support ("PCS") as eitherperpetual licenses or time-based licenses, typically one to three-yearrenewable contracts.  The magnitude of these license fees is dependent on eachcustomer's required usage levels, that is, the number of locations andindividual users.  Variations in licensing levels range from tens of thousandsup to several million dollars.  The following are descriptions of our currentsales models for discovery software:

 **    Perpetual licenses:**

Software pricing istaken from our price list based on the quantity of individual modules andnumber of users.  Customers are billed upon delivery.  Revenue for software isrecognized upon delivery of product and issuance of perpetual keys.  PCS isoptional for each customer and is priced as a fixed percentage of the totalcurrent list price of the software purchased. Where applicable, PCS istypically billed annually.

 The Company has analyzedthe other elements included in its multiple element arrangements involvingperpetual licenses, and has determined it has sufficient Vendor SpecificObjective Evidence ("VSOE") to allocate revenues to PCS and/ortraining.  VSOE for PCS and training is established based on the price chargedwhen those elements are sold separately.  For PCS, this allocation amount isestablished based on the renewal rate specified in the arrangement, which isconsistently priced at a percentage of the list price of the purchasedlicenses.  Training is charged consistently from the Company's price list. 

 **    Bundled licenses:**

Time-based bundledlicenses are an alternative to perpetual licenses.  This type of license allowsour customers to obtain multiple software products bundled with PCS that iscoterminus with the period of the arrangement.  A bundled license includesspecific software modules and specified numbers of users of each module withall product and access keys delivered on or before the effective date of thecontract.  Tripos software is sold to professional users on an "off theshelf" basis in which the customer is responsible for installation.  Thesenon-cancelable, non-refundable contracts are normally three years in durationalthough certain customers request shorter or longer contract periods.  At theend of the contract term, the customer must renew the license, or the softwarewill cease to operate.  PCS, which includes unspecified updates, upgrades, and"help desk" services, is 

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**Item 2. Management's Discussion and Analysis ofFinancial Condition and Results of Operations (continued)**

 included in the totalprice of the contract.  The PCS provided under bundled arrangements is the sameas that provided to customers under perpetual agreements.  Bundled contractpricing is taken from our established price list (includes package pricing anda-la-cart pricing) that is based on the number of users and length of term. All contracted products are delivered at inception.  If the customer shouldwant additional modules, users, or license to any new software products, the customermust enter a new contract (or addendum) and pay the incremental fees topurchase these items.  Software revenue and PCS revenues under bundled licenseagreements are recognized ratably over the contract period.

 **   Term licenses:**

Term Licenses representone-year arrangements for a software product and one-year of PCS.  The price istaken from the Company's price list by product.  The support renewal fee is afixed percentage of the software price (similar to perpetual model).  The PCSprovided for under term arrangements is the same as that provided to customersunder perpetual agreements.  Software and support pricing are separately statedand billed upon delivery of product.  To continue to operate the software, thecustomer must pay their annual renewal fee.  Software revenue and PCS revenuesunder term license agreements are recognized ratably over the contract period.

 Our integration ofchemistry and biological data in the life sciences industries creates a revenueopportunity for discovery informatics services (software consulting).  To servethis market, we maintain a staff of specialists who use our proprietary dataintegration framework, such as FormsBuilder, Discovery-360 (formerly "SMART-IDEA"),Benchware Notebook, ChemCoreRIO and AUSPYXTM to configure customizedsolutions for data management.  Revenue may be generated on a billable rate perday, or upon achievement of milestones or deliverables and is recognized asproduction activities are performed.  These contracts may also generate licensefee revenue for our proprietary software technologies.  Similarly to ourdiscovery informatics products, licensing levels are dependent on the number ofusers and sites and may range from the low hundred-thousands up to milliondollar levels.

 We develop andmanufacture general screening compound libraries for sale to the life sciencesindustry for a fee per compound delivered.  In addition we offer ourLeadDiscovery libraries which include higher value intellectual property rights(such as patent applications).  These compounds and libraries have created theopportunity to offer follow-up discovery research methods to customers fordesign and synthesis of focused libraries for lead optimization.  We alsomarket a comprehensive research process to our life sciences customers forrapid and cost effective discovery.  This process combines advancedinformatics, chemistry, and biology products and services, with proprietarydiscovery technologies for efficient lead development, refinement, andoptimization resulting in a tightly integrated process to facilitate synergiesin drug discovery. 

In the past we haveacted as a reseller of computer hardware.  Hardware sales are generally made tofacilitate our software customers' access to hardware components and not a primaryfocus of our sales activities.  We act as an authorized reseller and only orderhardware products on an "as needed" basis, and thus do not maintainany inventory.

We license discoveryinformatics tools to customers, provide ongoing support (including upgradesselected by customers) and provide informatics services to customers thatenable integration of our existing and newly developed discovery tools into ourcustomers' discovery operations.  We generally expense research and developmentcosts associated with software enhancements and new functionality.  Thus, asignificant portion of the costs associated with development and enhancement ofsoftware is accounted for as research and development and not as a cost ofsoftware sales.  Certain software 

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**Item 2. Management'sDiscussion and Analysis of Financial Condition and Results of Operations(continued)**

 development projectsrequire substantial commitments of time and resources.  Costs of these projectsare capitalized upon achievement of technological feasibility and/or a workingmodel according to the Financial Accounting Standards Board ("FASB")Statement of Financial Accounting Standards ("SFAS") No. 86.  

Quarterly expensesinclude the fixed costs of research and development for software developmentand new chemistry research.  We believe that core selling and administrativecosts will remain generally consistent on an annual basis.  Variability inquarterly expenses primarily occurs in relation to the level of revenues.  Thisis due to sales compensation, bonuses, staffing for selling, general andadministrative functions and for periodic marketing activities such asappearances at trade exhibitions.  The relationship between the quarterlyamounts presented for cost of sales or research and development expense mayfluctuate based on the utilization of our employees on either billablecontracts or research projects.

Ourrevenues and expenses vary from quarter to quarter depending upon, among otherthings, the timing of customers' budget processes, the success of our salesefforts, the lengthy sales cycle and our ability to influence customers andprospective customers to make decisions to outsource portions of theirdiscovery process, the size of the customers' capital expenditure budgets, theability to produce compound libraries and achieve product release schedules(including by Tripos' third party software providers and collaborators) in atimely manner, the rate of market acceptance of new products and enhancedversions of existing products, the timing of new product introductions by usand other vendors, changes in licensing and pricing policies (ours, ourpartners and that of other vendors), consolidation in the customer base, clientinvolvement in decision points in contracts related to project plans, ourability to accurately match contract costs to milestone or contract performancerequirements on our larger collaborative arrangements, and changes in generaleconomic, regulatory, and competitive conditions.  See Note 1 of the Notes toConsolidated Financial Statements for a discussion of revenue recognitionpolicies.  Because much of our software license and PCS revenue along with ourcontracted discovery research revenue is recognized ratably over multipleperiods, fluctuations in our quarterly revenues and earnings are causedprincipally by sales of compounds or by achievement of milestones on specific projects. Our management team monitors quarterly business activity with the aid of salespipeline reports and monthly financial reports.

** Resultsof Operations**(Amountsin thousands, except per share amounts)

 **Net sales** for the third quarter of 2006 were $7,656 comparedto $13,165 in 2005, a decrease of 42%.  Discovery informaticsproducts and support sales decreased 14% to $5,670 in the third quarter 2006from $6,618 for the same period in 2005.  This decrease is attributable toseveral factors.  One is lower product sales in the Pacific Rim while wereplace distributors in India and China.  A second impact is lower currentsales during a promotional period offering a free evaluation of a replacement product. Discovery informatics revenues in 2005 included approximately $373 related toan early termination agreement with a customer.  The prior year quarter alsoincluded the recording of revenues that were delayed due to a patentinfringement case in Japan relating to a software product that we in-licensedfrom a third party.  The third party introduced what we believed to be anon-infringing version of the software in the second quarter 2005 and ourdistributor in Japan was able to close approximately $200 of previously delayedtransactions.  Discovery informatics services revenues for the third quarter of2006 decreased 47% to $378 from $716 in the third quarter of 2005.  Much of therevenue recorded in the third quarter of 2005 was related to the Scheringproject that was completed later in that year.  In the third quarter of 2006 wewere unable to recognize revenue on the project with Wyeth Pharmaceuticals thatthe Company announced on January 11, 2006. Late in the third quarter we determinedthat changes to the plan would 

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**Item 2.  Management'sDiscussion and Analysis of Financial Condition and Results of Operations(continued)**

 be required on this "Next-Generation DiscoveryIT" project resulting in incremental costs to complete the assignment.  As aresult of the addition of incremental costs, the cumulative percentage ofrevenue to be recognized was held at the same level as that at the end of thesecond quarter of 2006 based upon the percentage of completion methodology,thus not recognizing approximately $1,450 of revenues in the third quarter thatotherwise would have been recognized had the estimated costs to complete theproject not changed.  The timing of revenue recognition from discoveryinformatics services may fluctuate during any period based on achievement ofcontractual milestones or changes in overall costs estimates for "percentagecompletion" contracts.  A collection of smaller projects was comparable for thetwo quarterly periods in 2006 and 2005.  Discovery research sales accounted for$1,605 in the third quarter of 2006 and $5,821 in the same period in 2005, adecrease of $4,216 or 72%.  This decrease in discovery research business wasattributable to the completion of our four-year $90 million strategic compoundfile enrichment and hit follow-up contract with Pfizer, Inc. in the fourthquarter of 2005.  Revenues from Pfizer in the third quarter 2005 wereapproximately $5,100. This decrease was partially offset by an increase in thenumber of smaller projects in the current year. Hardware sales for the third quarter2006 were $3 compared to $10 in 2005.  We do not actively market hardwareproducts, but rather facilitate customer demand as necessary.

 For the nine-month period in 2006, total netsales decreased 40% to $25,033 from $41,567 for the same period in 2005.  Discoverysoftware and support sales decreased by $967 or 5% from $18,730 in thenine-month period ending September 30, 2005 to $17,763 in the nine-month periodending September 30, 2006.  This decrease was primarily due to lower supportrevenues in the Pacific Rim and decreased new product sales in 2006, partiallyattributable to the promotional period offering a free evaluation of areplacement product and the non-renewal by several customers due to mergerswith other Companies.  The 2005 revenues also included approximately $373 fromthe early termination agreement with a customer.  Revenues from discovery informaticsservices increased by 47% to $2,895 for the nine-month period in 2006 from $1,964in 2005.  The increase in discovery informatics service revenues is principallyattributable to progress of work being performed on the project for WyethPharmacueticals for the implementation of our Benchware Discovery 360 technologies. Discovery research revenues decreased by 79% for the first nine months in 2006to $4,347 from $20,842.  The decrease in discovery research revenues was fromthe completion of the Pfizer compound file enrichment project in 2005. Revenues from discovery research projects for other customers are higher than 2005by 52%.   

Net sales for the Company's activities outsideof North America represented approximately 58% and 73% for the three-monthperiods and 51% and 76% for the nine-month periods ending September 30, 2006and 2005, respectively.  North American net sales accounted for 42% of 2006 and27% of 2005 total third quarter sales.  For the respective nine-month periods,North American sales were 49% in 2006 and 24% in 2005.  Net sales in Europe decreased $4,821 or 55% to $3,947 for the third quarter of 2006 compared to 2005,and accounted for 52% and 67%, respectively, of total sales.  Year-to-date netsales in Europe declined to $10,932 in 2006 from $29,647 in 2005, a decline of63%.  The decrease in Europe is principally related to revenues included in2005 related to progress on the Pfizer strategic compound design and synthesisproject that was contracted through our U.K. office and completed in the fourthquarter 2005.  Net sales in the Pacific Rim decreased by 35% and 14% for the thirdquarter of 2006 and the nine months ended, respectively, compared to the sameperiods in 2005.  The decrease in Pacific Rim revenues was from discoveryinformatics support, and lower discovery research compound sales.  The Pacific Rim accounted for 6% of net sales for the three-month periods in 2006 and 2005, and7% and 5% for the nine-month periods.

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**Item 2.  Management'sDiscussion and Analysis of Financial Condition and Results of Operations(continued)**

 **Cost of sales** for the three-month period ending September30, 2006 decreased by $1,946 or 32% to $4,121 compared to $6,067 for the sameperiod in 2005, primarily related to lower costs in discovery research due tothe completion of the four-year discovery research contract with Pfizer at theend of 2005, partially offset by increased costs on discovery informaticsservices projects.  Cost of sales as a percent of net sales was 54% and 46% forthe three-month periods in 2006 and 2005, respectively.  Included in the 2005cost of sales was approximately $3,600 related to the Pfizer discovery researchcontract.  The increased costs in discovery informatics services for thequarter was $679, primarily attributable to work being performed on the projectfor Wyeth Pharmaceuticals for the development and implementation of ourBenchware Discovery 360 product.  The third quarter 2006 cost of sales for discoveryinformatics products and support included approximately $107 of incrementalamortization expense related to capitalized software development costs forproducts that were released to the market in the third quarter of 2005 and $60of new amortization related to new Benchware products launched in June 2006. Nine-month year-to-date cost of sales declined 47% to $11,082 in 2006 from $20,860in 2005.  Cost of sales was 44% and 50% of total net sales for 2006 and 2005,respectively.  The 2005 year-to-date cost of sales included approximately $12,800incurred in discovery research activities for the Pfizer compound fileenrichment project.  The increased incremental amortization expense for theyear related to capitalized software development products released to themarket is $522.  In addition, cost of sales year to date for discovery informaticsservices increased by $1,460, primarily related to the Wyeth Next-GenerationDiscovery IT project.

 **Gross profit** margin for the third quarter 2006 decreasedto 46% of total net sales versus 54% in the third quarter of 2005 primarily dueto lower margins in discovery informatics products and support, discoveryinformatics services and discovery research services, offset by an overallincrease in gross profit margin due to shift in business mix.  Relativelyhigher margin discovery informatics now represents a larger percentage of businesscompared to the third quarter of 2005.  This shift is a result of ourcompletion of the four-year$90 million discoveryresearch contractwith Pfizer, Inc. in the fourth quarter of 2005.  Gross profit margin in the third quarter relatedto discovery informatics products and support declined to 72% in 2006 versus 77%in 2005 due to increased amortization expense related to capitalized softwarecosts for new products released in latter-2005 and June 2006.  Gross profitmargin in the third quarter of 2006 was (178%) in discovery informatics servicescompared to 48% the prior year due to a cumulative adjustment on the Wyethinformatics project to reflect the anticipated incremental costs to completethe project and their impact on the calculation of percentage of completion asof September 30, 2006. Based on current estimates, we still anticipated positive gross margins for theproject as a whole.  Discovery Research gross profit margin decreased from 24%to (6%) for the third quarter and were negatively impacted by cost overruns onone contract and initial stages on another that included pass-through costsfrom a third-party vendor at no margin.  The gross profit margin on compoundsalso decreased due to promotional pricing on new compound libraries.

 Nine-month year-to-date gross profit marginimproved to 56% in 2006 from 50% in the 2005 nine-month year-to-date period.  Theincrease in year-to-date gross margin was primarily due to a shift in businessmix with Discovery Informatics representing a larger portion of business atrelatively higher gross margins than Discovery Research.  This shift is aresult of our completion of the four-year $90 million Discovery Research contract with Pfizer,Inc. in the fourth quarter of 2005.  This increase was partially offset by a decreasein gross margin related to discovery informatics products and services as wellas decreases in gross margin for discovery research products and services.  Grossprofit margin decreased in discovery informatics products and support due tothe additional amortization expense associated with new products released tothe market.

** **

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**Item 2.  Management'sDiscussion and Analysis of Financial Condition and Results of Operations(continued)**

 Gross profit margin in discovery informaticsservices declined to 5% for the first nine months of 2006 versus 34% in thefirst nine months of 2005 due to a cumulative adjustment on the Wyeth project toreflect the impact of the anticipated incremental costs and the revisedpercentage of completion as discussed above.  Gross profit margin in discovery researchdecreased from 23% to 4% for year-to-date periods due to the previouslymentioned cost overruns on one contract and initial stages on another thatincluded pass-through costs from a third party vendor at no margin.  Theseevents plus inventory provisions combined with lower revenues in the businessunit resulted in the lower margins for the first nine months of the year.

 **Sales and marketing** expenses decreased 7%to $2,367 for the third quarter of 2006 from $2,556 in the same period in 2005. Sales and marketing expenses as a percentage of net sales were 31% and 19% for thethree-month periods in 2006 and 2005, respectively.  For the nine-month periodin 2006, sales and marketing expenses were flat at $8,153 compared to $8,186. Sales and marketing was 33% of total net sales for the first nine months of2006 and 20% in 2005.  The decreases in sales and marketing spending in thethird quarter 2006 compared to the third quarter 2005 were attributable to loweradvertising and promotional expenditures and reduced travel and commissionexpenses. These decreases were partially offset by an increase in salary andconsulting costs as a result of additional employees in the current year,including the addition of a VP Marketing position in the fourth quarter 2005.  Theincrease as a percentage of total revenues is primarily due to overall lowersales after completion of the Pfizer discovery research contract at the end of2005. 

 **Research and development**expenses for the quarterdecreased by $64 or 2% to $2,834 from $2,898 and represented 37% and 22% of netsales in 2006 and 2005, respectively.  Nine-month year-to-date R&D expensewas $8,287 in 2006 compared to $6,810 in 2005, an increase of 22%. Year-to-date R&D expense as a percent to total sales was 33% and 16% in2006 and 2005, respectively.  The increase in R&D expense year-over-yearwas partially attributable to reduced levels of capitalization of new developmentcosts related to discovery informatics products.  In 2006 we capitalized $191and $646 for the three and nine-month periods, respectively, while in 2005 wecapitalized $313 and $1,470 for the quarter and year-to-date periods.  We havebeen developing one enterprise-wide product in 2006 compared to six computationalchemistry software products in 2005.  R&D expense also increased in thethird quarter of 2006 at our laboratory facility in England to $1,079 from $649in the third quarter of 2005 due to higher utility costs and less efficientoperations arising from managing multiple smaller contracts.  With theconclusion of the large Pfizer discovery research contract in 2005, ourchemistry operations have changed from servicing primarily one large contractto servicing several smaller contracts.  This change, coupled with asubstantial increase in utility costs, has resulted in more costs expensed asR&D rather than being charged to cost of sales or absorbed into inventoryfor the third quarter of 2006.  

 The nine-month year-to-date results in 2006 wereadversely affected by inefficiencies and redundant staff at our discoveryresearch facility during a statutory consultation period in the first quarter leadingup to a reduction in force as well as lower amounts capitalized related todiscovery informatics products mentioned above.  In December 2005 we announced that we hadinitiated a 30 day consultation period as mandated by UK law to complete a reduction in force for our Discovery Research business based in Bude, England.  We initiated this action to streamline our Discovery Research business andassociated cost structure as a result of our successful completion of thefour-year $90 million file enrichment project with Pfizer in the fourth quarterof 2005.  We completed this process in January 2006, reducing our workforce by76 positions.  Reorganization and reassignment of chemistry staff werefinalized during February.  Afurther reduction of 15 positions was made in August 2006 and subsequentlyanother 27 

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**Item 2.  Management'sDiscussion and Analysis of Financial Condition and Results of Operations(continued)**

 positions in the fourth quarter.  In addition, due to thelower staffing levels and increased facility costs, we estimate that we willpass approximately $933 of charges through our income statement in fiscal 2006 as a result of theadoption of Statement of Financial Accounting Standards No. 151 "InventoryCosts-an amendment of ARB No. 43, Chapter 4" ("FAS 151").   FAS151 clarifies the accounting for abnormal amounts of idle facility expense,freight, handling costs, and wasted material (spoilage) to require that theseitems be included as current-period charges and not included in inventory.  

 **General and administrative**expenses decreased $140 or7% to $1,760 in 2006 from $1,900 for the third quarter of 2005, and represented21% and 14% of net sales for the corresponding periods.  G&A expense forthe nine-month period in 2006 was $5,244, a 9% decrease from $5,787 in 2005.  Thereduced G&A expense for 2006 is a result of reduced staff, lower publiccompany costs and lower legal defense costs as a result of meeting ourinsurance deductible in the first quarter 2006 related to the class actionlawsuit.  See Note 3 for further details on the class action lawsuit.

 **Stock-Based Compensation** expense is included in eacharea of expense (Selling and Marketing, Research and Development, and Generaland Administrative) in the third quarter and year-to-date periods of 2006.  Thetotals of $53 and $271 for the quarter and year-to-date periods, respectively,are now required under FAS 123R.  Prior year amounts were reflected on apro-forma basis in the footnotes to the financial statements.  See Note 15 fora further discussion of the prior year amounts and stock-based compensationaccounting treatment. 

 **Restructuring charge**represents a reductionin force primarily related to our Discovery Research division.  On January 24,2006 we completed a reduction in force for our Discovery Research business based in Bude, England that wasinitiated in December 2005 following completion of the four-year****$90 million fileenrichment project for Pfizer.  This action coincidedwith the conclusion of the 30-day consultation period with employees mandatedby U.K. law.  We reduced the number of employees at the laboratory by 76positions.  More than half of the employees affected left the Company under avoluntary separation plan.  In addition, a restructuring of our US based employees resulted in a reduction of 9 positions.  As a result of these actions,the Company recorded pre-tax restructuring charges of approximately $807 and $120in the first quarter 2006 related to our Discovery Research and DiscoveryInformatics divisions, respectively, for one-time termination benefits andoutplacement costs.  The annualized effect of the downsizing is estimated toresult in a cash savings from payroll and related benefits of $2,400.  Thisamount would have been distributed as follows:  $250 in Selling and Marketing;$1,790 in Research and Development; and $360 in General and Administrative. Certain departments within R&D would have qualified for absorption intoinventory and ultimately been reflected through reduced cost of sales.  Othervariable costs related to production are not estimable at this time.  

 The Company furtherreduced staffing levels on August 11, 2006 by 14 positions, resulting in apre-tax restructuring charge of $338 and projected annualized savings frompayroll and related benefits of $1,076.  The distribution of the projectedannualized savings would have been $858 in Research and Development and $218 inGeneral and Administrative.  We solicited and obtained voluntary terminations for allpositions affected in exchange for one-time termination benefits andoutplacement costs.  All costs were incurred and paid in the third quarter andare reflected in the restructuring line item on the consolidated statement ofoperations.   This action was necessary in order to further streamline thisbusiness with the goal of obtaining positive cash flows from this business forthe remaining months of the year.  

 In the fourth quarter of 2006 we had a furtherreduction in force of 27 positions with an estimated cost of $500.  See Note 16"Subsequent Event" for further discussion.  Costs of this additionalrestructuring, when finalized, will be reflected in the fourth quarter 2006financial statements.

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**Item 2.  Management's Discussion and Analysis ofFinancial Condition and Results of Operations (continued)**

** Interest expense**increased to $569 in thethird quarter of 2006 from $478 in the same period in 2005.  For the nine-monthperiods, interest expense increased to $1,597 in 2006 from $1,259 in 2005.  Theincreases were primarily due to higher interest rates on our revolving line ofcredit and mortgage note, along with additional amortization of the debtdiscount that arose from the funding of the Optive Research acquisition in early2005 and the amortization of the deferred issuance costs related to theConvertible Preferred Stock transaction beginning in the second quarter of 2006. The interest expense related to the deferred issuance costs was $62 and $98 forthe third quarter and nine months of 2006, respectively.  Incremental interestexpense related to the debt discount represents $46 in the third quarter and$144 year-to-date.  Capital lease interest expense decreased in the thirdquarter of 2006 by $47 compared to the third quarter of 2005 but was comparablefor the nine month periods.

 **Other income**was $353 for the thirdquarter of 2006 versus $311 in 2005.  Included in 2006 is $153 related tocurrency gains, $215 non-cash gain on the revaluation of common stock warrantsand $58 of interest income and miscellaneous income, offset by a writedown ofinvestments of $50 and $23 loss on disposal of equipment.  The 2005 thirdquarter gain resulted from a distribution from A.M. Pappas of $305 and interestincome of $22, offset by a currency loss of $16.  In the nine-monthyear-to-date period for 2006, other income totaled $1,525 that includedcurrency gains of $876, the non-cash gain on the revaluation of common stockwarrants of $572, interest income and miscellaneous income of $131 and gains onA.M. Pappas of $22 , offset by a writedown of investments of $50 and a $26 losson disposal of equipment.  For the same year-to-date period in 2005, we had a lossfrom other items netting to $346.  This total included currency losses of $890that were partially offset by interest income of $85 and net gains fromunconsolidated investments of $457.  The net gains from investments arose fromsales of NuVasive and losses on our holdings in the A.M. Pappas Life Science IIfund.****

** **

**Income tax** expense was $46 for the first nine-monthsof 2006 compared to a benefit of $2,633 for the same period in 2005, which representeffective tax rates of 0% and (157%), respectively.  The 0% effective tax ratefor 2006 reflects management's current estimate of the distribution of earningsamong the statutory jurisdictions in which we operate, realization of R&Dtax credits in the U.K. and the valuation of certain net operating loss carry forwards.The rate for 2005 included recording of R&D tax credits in the U.K. for a prior period when it became more likely than not that they would be realized.

** Liquidity,Capital Resources and Capital Commitments**

 Net cash used in operations in 2006 was $6,229. The primary uses of cash were from a net loss of $9,116, increases ininventories of $1,823, reductions in accounts payable and accrued expenses of $3,224along with lower deferred revenues of $6,519 and the noncash gain onrevaluation of commons stock warrants of $572.  These uses of cash werepartially offset by collections of accounts receivable of $8,408, reduction ofprepaid expenses and other current assets of $2,105, plus the add-back ofnon-cash depreciation and amortization, including the amortization of debtdiscount, totaling $4,221, along with the add-back of non-cash stock-basedcompensation expense of $300 and accretion of the deferred issuance costs of $98. The increase in inventory is primarily related to on-going customer contractsand development of our next generation of compounds for our LeadQuest andLeadDiscovery libraries.  The drop in accounts receivable reflects the normalseasonal collection of balances.  Reductions in deferred revenue reflect theratable recognition of revenue in the year and the cyclicality of softwarecontract renewals.  Payments on accounts payable and accrued expenses alsoreflect the seasonality of the balances.  The reduction in prepaid expenses andother current assets reflects the ratable recognition of prepaid royalties and distributorcommissions consistent with the recognition of deferred revenues.  Net 

 

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**Item 2.  Management's Discussion and Analysis ofFinancial Condition and Results of Operations (continued)**

 cash provided by operations in the firstnine-months of 2005 was $2,727.  The primary sources of cash were from netincome of $952, reductions in accounts receivable of $559, reductions ininventory of $2,993, increases in deferred revenue of $318 plus the add-back ofnon-cash depreciation and amortization, including the amortization of debtdiscount of $3,676 combined and the write-down on long-term investment of $88. These increases of cash were partially offset by payments of accounts payableand accrued expenses of $3,641, additions to prepaid expenses of $690 and achange in deferred tax benefit of $1,288 less the pre-tax gain of $240 from thesale of shares of NuVasive common stock.  The change in deferred tax benefit isa result of recording the R&D tax credits in the U.K.  The timing ofcollections of accounts receivable and reductions of deferred revenues bothcontinue regular annual cyclical patterns.  Reductions in inventory levelsprincipally reflect the status of the deliveries of finished goods to Pfizer.

 Cash provided by investing activities during 2006totaled $2,692, consisting of proceeds from the sale of equipment of $3,799 anddistribution from A.M. Pappas Life Science Fund of $36, partially offset by propertyand equipment acquisitions of $409, capitalized development costs for ourdiscovery informatics software products of $646 and additional investments inthe A.M. Pappas Life Science Fund of $88.  Cash used in investing activitiesduring the first nine months of 2005 totaled $4,815 and were for property andequipment acquisitions of $880, capitalized development costs for our discoveryinformatics software products of $1,470, cash used in the acquisition of OptiveResearch, Inc. of $4,753 and additional investments in the A. M. Pappas LifeScience Fund totaling $133.  These were partially offset by $1,995 of proceedsfrom the sale of equipment and $426 of gross proceeds from the sale of NuVasiveshares.  Over the next 12 to 18 months of 2006-2007, we may be asked to fundthe remainder of our investment commitment ($338) to the A.M. Pappas LifeScience II Fund.  

 For the first nine months of 2006, cash providedby financing activities was $362, consisting of borrowings under our revolvingline of credit of $6,710, net proceeds from the issuance of convertible preferredstock of $4,851 and proceeds from stock issuance pursuant to stock purchase andoption plans of $172.  This was partially offset by cash payments on long-termdebt and capital lease obligations totaling $11,134 along with dividendpayments on the preferred stock amounting to $237.  For the first nine monthsof 2005, $1,289 of cash was generated through financing activities from theissuance of common stock of $500, the issuance of subordinated debt in theamount of $3,500 to fund part of the acquisition of Optive Research, theissuance of new capital leases of $59 and the issuance of shares under ouremployee stock plans of $39.  We had borrowings on our line of credit withLaSalle Bank of $14,380, while payments on our line of credit, mortgage and capitalleases during the period totaled $17,189.  

** **OnApril 18, 2006, the Company and LaSalle Bank completed an amendment to theexisting credit facility and mortgage loan.  The term of the revolving line ofcredit was extended to January 1, 2007 and the line of credit was amended to$6,000.  The amended line of credit has a borrowing base equal to 80% ofdomestic and insured foreign accounts receivable plus $1,800 allowance for theexcess equity in U.S. real estate, a revised minimum shareholders' equity covenanttested quarterly and a minimum consolidated cash balance covenant testedmonthly.  The annual clean-down requirement was eliminated.  Interest on the mortgageloan was modified to LIBOR plus 3.0%.  All other terms of the revolving line ofcredit remain the same.

 On May 4, 2006, the Company completed the saleof 1.8 million shares of ConvertiblePreferred Stock at a price of $3.00 per share and issued 550 thousand five-yearcommon stock warrants exercisable at $3.50 per share to Midwood Capital, a Boston-basedinvestment partnership, for gross proceeds of $5,500.  The 

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**Item 2.  Management's Discussion and Analysis ofFinancial Condition and Results of Operations (continued)**

 shares of Convertible Preferred Stock representedapproximately 18% of Tripos' outstanding common stock on an as-converted basisat the time of the transaction.  The Convertible Preferred Stock bears adividend at an annual rate of 10.5% and is redeemable in two years. If certainevents occur prior to January 26, 2007, which events related primarily to asale or acquisition of Tripos, the dividends will be accelerated such that theholders of the Convertible Preferred Stock will receive dividends in theaggregate amount of $958 (or dividends in the aggregate amount of $1,155 if theevent occurs on or after January 26, 2007) inclusive of any dividends receivedto date.  Net proceeds from this transaction, after the placement agent's feeand estimated legal and other costs, were $4,851.  This financing strengthenedthe Company's balance sheet, enhancing its ability to explore strategicalternatives and support current and potential business initiatives. 

 Due to the financialperformance in the third quarter of 2006,  we were not in compliance with the minimum shareholders' equity covenant of our revolving credit facilitywith LaSalle Bank N.A.  We have requested a waiver of this covenant violationfor the period ended September 30, 2006; however, there are no assurances thatthe bank will grant the waiver or regarding the additional terms that might be imposed inconnection with a waiver.  Due to the covenant violation at September 30,all outstanding amounts under the revolving line of credit and mortgage loanhave been shown as current liabilities on the balance sheet.

In addition, the  LaSalle Bank facilitymatures January 1, 2007, and LaSalle Bank has advised Tripos that is does notintend to renew or extend revolving credit to Tripos beyond January 1, 2007.  Nevertheless, Tripos	has requested an extension from LaSalle Bank to enable itto complete certain strategic transactions that are currently under negotiation. Tripos' ability to fund the anticipated capital and operating needs of itsbusiness following maturity of the LaSalle Bank facility and absent completionof certain strategic transactions is dependent on the replacement of thisfacility or the ability to secure alternative bank or other debt financingand/or equity funding.   In the event that the Company is unable to obtain the waiver or to extend and amend its credit facility on acceptable terms or arrange alternate financing, the Company's capital resources and liquidity would be materially adversely affected.  

 We are exploring the sale of our headquartersbuilding and the lease-back of a portion of the facility.  If completed, thetransaction would eliminate the existing mortgage balance on the property andgenerate additional cash.  We anticipate that this transaction could provideprospective savings to the Company by reducing the ongoing cost of occupancy.  In addition,we are seeking to sell certain excess real properties at the Bude, England location.We are also pursuing  the sale of our investment in the A.M.Pappas Life Sciences Ventures II Fund.

 Ourcontinuing financial viability is dependent upon our ability to take furthersteps to control costs and/or increase revenues and our ability to obtain financingto replace the LaSalle Bank facility and meet our working capital needs. We will seek to obtain this funding from our current bank, from an alternativelending source, or from other providers of debt or equity funding.  Wecannot predict whether such financing will be available or what the terms offinancing might be.  Any financing may have an equity feature that could bedilutive to common stockholders.

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**Critical Accounting Policies**

 For further discussionof the Company's critical accounting policies, please see the section entitled"Critical Accounting Policies" in Management's Discussion andAnalysis of Financial Condition and Results of Operations in Form 10-K for theyear ending December 31, 2005.   With the adoption of FAS 123R at thebeginning of fiscal 2006, we have determined that "Stock-Based Compensation" should be included asone of the Company's identified critical accounting policies. We account forstock-based compensation in accordance with the provisions of FAS 123R. We use the Black-Scholes option-pricing model, which requires the input ofhighly subjective assumptions.  These assumptions include estimating thelength of time employees will retain their stock options before exercising them("expected term"), the estimated volatility of the Company's common stock priceover the expected term and the number of options that will ultimately notcomplete their vesting requirements ("forfeitures").  Changes in the subjectiveassumptions can materially affect the estimated fair value of stock-basedcompensation and consequently, the related amount recognized on theconsolidated statements of operations.  See Note 15 of the Notes toConsolidated Financial Statements in this Form 10-Q for further discussion of stock-basedcompensation.  There have been no material changes to the other criticalaccounting policies previously reported in our Annual Report on Form 10-K forthe fiscal year ended December31, 2005.

** **

**New Accounting Pronouncements**

 In June 2006, the FASB issuedFASB Interpretation No. 48, "Accounting for Uncertainty in Income Taxes-aninterpretation of FASB Statement No. 109."  This Interpretation prescribes arecognition threshold and measurement attribute for the financial statementrecognition and measurement of a tax position taken or expected to be taken ina tax return.  This Interpretation also provides guidance on derecognition,classification, interest and penalties, accounting in interim periods,disclosure, and transition.  The Interpretation is effective for fiscal yearsbeginning after December 15, 2006.  We are currently evaluating therequirements of this Interpretation, but do not expect that the adoption willhave a material effect on our financial statements or tax returns.  

In September 2006, the FASBissued SFAS No. 157 "FairValue Measurements" ("FAS 157").  FAS 157 defines fair value, establishes aframework for measuring fair value in generally accepted accounting principles,and expands disclosures about fair value measurements.  The provisions of FAS157 are effective for financial statements issued for fiscal years beginningafter November 15, 2007.  We are currently evaluating the provisions of FAS157.  

In September 2006, the Securities and ExchangeCommission ("SEC") staff issued Staff Accounting Bulletin 108 "Considering theEffects of Prior Year Misstatements when Quantifying Misstatements in CurrentYear Financial Statements" ("SAB 108"). SAB 108 requires that public companiesutilize a "dual-approach" to assessing the quantitative effects of financialmisstatements. This dual approach includes both an income statement focusedassessment and a balance sheet focused assessment. The guidance in SAB 108 mustbe applied to annual financial statements for fiscal years ending afterNovember 15, 2006.  We are currently assessing the impact of adopting SAB 108but do not expect that it will have a material effect on our consolidatedfinancial position or results of operations. 

** **Periodic reports on Form 10-Q, Form 10-K andother filings with the Securities and Exchange Commission on Form 8-K and S-8,can be found on the Tripos web site at www.tripos.com under the headingInvestor Relations - SEC Filings.

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**Item 3. Quantitative and Qualitative Disclosuresabout Market Risk**

 Our exposure to marketrisks is limited to foreign exchange variances and fluctuations in interestrates.  To date, interest rate exposure has not resulted in a materialimpact.   During 2003, 2004 and 2005, the Company did experience a significantimpact from foreign exchange.  The costs to perform the custom design andsynthesis contract with Pfizer were incurred in British pounds sterling whilewe were compensated in U.S. dollars for much of the work.  As a result, ourgross profit was adversely affected by the decline in the U.S. dollar againstthe pound.  Part of this effect was offset through foreign currency forwardcontracts whose gains were recorded in "Other Income".

 Our foreign exchangerisk is presently limited to currencies that historically have exhibited onlyminor fluctuations although from 2003 through 2005, these currencies have shownmore significant variation.  Assets outside the United States subject tocurrency fluctuation are located in England, Germany and France.  Our investments in foreign subsidiaries with a functional currency other than the U.S.dollar are not hedged.  The assets in foreign subsidiaries most susceptible toexchange rate variances were as follows:  US dollar/UK pound balances 2005$13.0 million, and US dollar/Euro balances 2005 $3.0 million.  The potentialreduction in fair value resulting from a hypothetical 10% adverse change in USdollar/UK pound currency exchange rates would be approximately $1.3 million atDecember 31, 2005, while the same 10% adverse movement in the US dollar/Eurorates would be approximately, $300,000 for 2005.  Any loss in fair value ofpermanently invested funds would be reflected in Other Comprehensive Income andwould not impact our net income. 

 Our interest rate riskis attributable to borrowings under the line-of-credit and mortgage loan.  Wemonitor our exposure to floating interest rate risk on line-of-creditborrowings along with the outstanding balance on the mortgage loan and may, attimes, endeavor to mitigate this risk through the use of appropriate hedginginstruments.

 

**Item 4.  Controls and Procedures**

 We have established andmaintain disclosure controls and procedures that are designed to ensure thatmaterial information relating to the Company and our subsidiaries required tobe disclosed by us in the reports that we file or submit under the SecuritiesExchange Act of 1934 is recorded, processed, summarized, and reported withinthe time periods specified in the SEC's rules and forms, and that suchinformation is accumulated and communicated to our management, including ourChief Executive Officer and Chief Financial Officer, as appropriate to allowtimely decisions regarding required disclosure.  In designing andevaluating the disclosure controls and procedures, management recognized thatany controls and procedures, no matter how well designed and operated, canprovide only a reasonable assurance of achieving the desired controlobjectives, and management was necessarily required to apply its judgment inevaluating the cost-benefit relationship of possible controls andprocedures.  

 The Company's ChiefExecutive Officer and Chief Financial Officer have evaluated the effectivenessof the design and operation of the Company's disclosure controls and procedures(as defined under Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Actof 1934, as amended) as of the end of the period covered by this report. Basedupon that evaluation, the Company's Chief Executive Officer and Chief FinancialOfficer have concluded that the Company's disclosure controls and procedures wereeffective at the reasonable assurance level as of the date of such evaluation. 

 On October 12, 2006, B. JamesRubin resigned as the Company's Chief Financial Officer and John D. Yinglingwas appointed to this position.  Mr. Rubin remains with the Company as a SeniorVice 

** **

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**Item 4.  Controls and Procedures (continued)**

 President and willcontinue to work with other members of the Company's senior management team onkey corporate initiatives.

During the quarterlyperiod covered by this report, there were no other changes in the Company'sinternal control over financial reporting that have materially affected, or arereasonably likely to materially affect, the Company's internal control overfinancial reporting.

** **

** **

**PART II**

**OTHER INFORMATION**

 

Item 1.     LegalProceedings

          OnAugust 4, 2006, the federal district court in St. Louis, Missouri approved the tentativeagreement reached on March 21, 2006 to settle a class action litigation suitagainst the Company.  Thetotal amount of the settlement is $3,150 which is to be paid by our insurers.  Acourt date has been set for November 17, 2006 to review the terms of the March21, 2006 tentative settlement in the shareholder derivative suit.  See "ContingentLiabilities" in the Notes to Unaudited Financial Statements above for a generaldescription of legal proceedings.  Reference is made to the "Legal Proceedings"section of our Form 10-K for the year ending December 31, 2005 for a detaileddescription of legal proceedings.

** **Item 1A.   Risk Factors

          Adescription of the risk factors associated with our business is contained inItem 1A, "Risk Factors," of our 2005 Annual Report on Form 10-K filed with theSecurities and Exchange Commission on April 11, 2006 and incorporated herein byreference.  These cautionary statements are to be used as a reference inconnection with any forward-looking statements.  The factors, risks anduncertainties identified in these cautionary statements are in addition tothose contained in any other cautionary statements, written or oral, which maybe made or otherwise addressed in connection with a forward-looking statementor contained in any of our subsequent filings with the Securities and ExchangeCommission.

 Item2.     Unregistered Sales of Equity Securities and Useof Proceeds

          None

 Item3.     Defaults upon Senior Securities

          None

 Item4.     Submission of Matters to a Vote of SecurityHolders

          None

 Item5.     Other Information

                Pursuant	to the terms of the Company's revolving loan facility with LaSalle Bank	N.A., the Company is obligated to maintain a minimum net	worth calculated pursuant to the terms of the agreement.  On November 13,	2006, LaSalle Bank notified the Company that it was in default under the	minimum net worth covenant under its revolving loan facility.  This facility	provides for borrowing capacity of $6 million, based on a borrowing base and	matures January 1, 2007.  See Note 8 to the Financial Statements contained	herein.  LaSalle Bank also notified the Company that it does not intend to	extend or renew the revolving loan facility.  LaSalle Bank also holds a	security interest in certain property of the Company including a mortgage on	the Company's principal offices which matures April 18, 2008.  The total	amount currently outstanding under the revolving loan maturing January 1,	2007  is approximately $5.1 million.  

           	Under the revolving loan agreement, while the	event of default exists, LaSalle Bank is entitled to cancel all its	commitments under the facility and declare all loan obligations immediately	due and payable.  Furthermore, if the default is not cured within 30	days, Horizon will have the right to accelerate all loan obligations under	its credit agreement with the Company.  If LaSalle Bank and Horizon elect to exercise these rights,	approximately $6.6 million of additional	indebtedness of the Company would be	accelerated.

 Item6.     Exhibits 

           31.1    Section302 Certification of the Chief Executive Officer

           31.2    Section302 Certification of the Chief Financial Officer

           32.1    WrittenStatement of Chief Executive Officer and Chief Financial Officer Pursuant toSection 906 of the Sarbanes-Oxley Act of 2002

 

 

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**TRIPOS, INC.**

**SIGNATURES**

** **

Pursuant to the requirements of the SecuritiesExchange Act of 1934, the Registrant has duly caused this report to be signedon its behalf by the undersigned hereunto duly authorized.

 

TRIPOS, INC.

 

| Date:  | November 14, 2006 | /s/  John P. McAlister      |
|--------|-------------------|-----------------------------|
|   |              | President and               |
|   |              | Chief Executive Officer     |
|   |              |                        |
| Date:  | November 14, 2006 | /s/ John D. Yingling        |
|   |              | Vice President,             |
|   |              | Chief Financial Officer and |
|   |              | Assistant Secretary         |

 

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