UNITED
      STATES


SECURITIES
      AND EXCHANGE COMMISSION


WASHINGTON,
      D.C. 20549


**FORM
      10-Q**




(Mark
                  One)x
              QUARTERLY
                  REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT
                  OF 1934
                  FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2006o
              TRANSITION
                  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
                  ACT OF
                  1934 FOR THE TRANSITION PERIOD FROM  TO
 COMMISSION
        FILE NUMBER: 0-23930





**TARGETED
      GENETICS CORPORATION**





(EXACT
      NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)


Washington
            91-1549568(State
                of Incorporation)
            (I.R.S.
                Employer Identification No.)




1100
      Olive Way, Suite 100 Seattle, WA 98101





(Address
      of principal executive offices)(Zip Code)





(206)
      623-7612





(Registrant’s
      telephone number, including area code)





(Former
      name, former address and former fiscal year, if changed since last
      report)





Indicate
      by check mark whether the registrant (1) has filed all reports required to
      be
      filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
      the
      preceding 12 months (or for such shorter period that the registrant was required
      to file such reports), and (2) has been subject to the filing requirements
      for
      at least the past 90 days. Yes x No o





Indicate
      by check mark whether the registrant is a large accelerated filer, an
      accelerated filer, or a non-accelerated filer. See definition of “accelerated
      filer” and “large accelerated filer” in Rule 12b-2 of the Exchange Act.
      (check one):




Large accelerated filer  ̈
            Accelerated
                filer ý
            Non-accelerated
                filer  ̈





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





Shares
      of
      Common Stock, par value $0.01 per share, outstanding as of November 8, 2006:
      10,896,898













**TARGETED
      GENETICS CORPORATION**


Quarterly
      Report on Form 10-Q


For
      the
      quarter ended September 30, 2006




TABLE
      OF
      CONTENTS






Page No**.**PART I
            
            FINANCIAL
                INFORMATIONItem 1.
            
            Financial
                Statementsa)
            
            Condensed
                Consolidated Balance Sheets at September 30, 2006 and December 31,
                2005
            
            1b)
            
            Condensed
                Consolidated Statements of Operations for the three and nine months
                ended
                September 30, 2006 and 2005
            
            2c)
            
            Condensed
                Consolidated Statements of Cash Flows for the nine months ended September
                30, 2006 and 2005
            
            3d)
            
            Notes
                to Condensed Consolidated Financial Statements
            
            4Item
                2.
            
            Management’s
                Discussion and Analysis of Financial Condition and Results of
                Operations
            
            9Item
                3.
            
            Quantitative
                and Qualitative Disclosures About Market Risk
            
            16Item
                4.
            
            Controlsand Procedures
            
            17PART
                II
            
            OTHER
                INFORMATIONItem
                1.
            
            Legal
                Proceedings
            
            17Item
                1A.
            
            Risk
                Factors
            
            17Item
                2.
            
            Unregistered
                Sales of Equity Securities and Use of Proceeds
            
            20Item
                3.
            
            Defaults
                Upon Senior Securities
            
            20Item
                4.
            
            Submission
                of Matters to a Vote of Security Holders
            
            20Item
                5.
            
            Other
                Information
            
            20Item
                6.
            
            Exhibits
            
            20SIGNATURES
            
            21EXHIBIT
                INDEX
            
            22







i






**PART
      I    FINANCIAL INFORMATION**




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




**TARGETED
      GENETICS CORPORATION**




**CONDENSED
      CONSOLIDATED BALANCE SHEETS**


**(Unaudited)**




**September
                30,**
            
            **December
                31,****2006**
            
            **2005****ASSETS**Current
                assets:Cash
                and cash equivalents
            
            $
            9,280,000
            
            $
            14,122,000Accounts
                receivable
            
            
            613,000
            
            
            380,000Prepaid
                expenses and other
            
            
            635,000
            
            
            683,000Total
                current assets
            
            
            10,528,000
            
            
            15,185,000Property
                and equipment, net
            
            
            1,282,000
            
            
            1,747,000Goodwill
            
            
            7,926,000
            
            
            31,649,000Other
                assets
            
            
            209,000
            
            
            217,000Total
                assets
            
            $
            19,945,000
            
            $
            48,798,000**LIABILITIES
                AND SHAREHOLDERS’ EQUITY**Current
                liabilities:Accounts
                payable and accrued expenses
            
            $
            1,895,000
            
            $
            1,770,000Accrued
                employee expenses
            
            
            500,000
            
            
            587,000Accrued
                restructure charges
            
            
            655,000
            
            
            1,838,000Deferred
                revenue
            
            
            323,000
            
            
            278,000Current
                portion of long-term obligations
            
            
            3,195,000
            
            
            155,000Total
                current liabilities
            
            
            6,568,000
            
            
            4,628,000Accrued
                restructure charges and deferred rent
            
            
            6,891,000
            
            
            5,422,000Long-term
                obligations
            
            
            5,002,000
            
            
            8,177,000Commitments
                and ContingenciesShareholders’
              equity:Preferred
                stock, $0.01
                par value, 600,000 shares authorized:Series
                A preferred stock, 180,000 shares designated, none issued and
                outstanding
            
            
            —
            
            
            —Common stock, $0.01 par value, 18,000,000 shares authorized, 9,896,898
                shares issued and outstanding at September 30, 2006 and 8,569,424
                shares
                issued and outstanding at December 31, 2005
            
            
            99,000
            
            
            86,000Additional paid-in capital
            
            
            286,200,000
            
            
            280,543,000Accumulated
                deficit
            
            
            (284,835,000
            )
            
            (250,037,000
            )Accumulated other comprehensive income (loss)
            
            
            20,000
            
            
            (21,000
            )Total
                shareholders’ equity
            
            
            1,484,000
            
            
            30,571,000Total
                liabilities and shareholders’ equity
            
            $
            19,945,000
            
            $
            48,798,000







See
      accompanying notes to condensed consolidated financial statements






1







**TARGETED
      GENETICS CORPORATION**




**CONDENSED
      CONSOLIDATED STATEMENTS OF OPERATIONS**


**(Unaudited)**








**Three
                months ended**
              **September
                30,**
            
            **Nine
                months ended**
              **September
                30,****2006**
            
            **2005**
            
            **2006**
            
            **2005**Revenue
                under collaborative agreements
            
            $
            2,012,000
            
            $
            1,468,000
            
            $
            5,856,000
            
            $
            4,930,000Operating
                expenses:Research
                and development
            
            
            3,123,000
            
            
            4,653,000
            
            
            10,483,000
            
            
            14,000,000General
                and administrative
            
            
            1,687,000
            
            
            1,490,000
            
            
            4,736,000
            
            
            5,035,000Restructure
                charges
            
            
            413,000
            
            
            1,188,000
            
            
            1,818,000
            
            
            1,526,000Goodwill
                impairment charge
            
            
            —
            
            
            —
            
            
            23,723,000
            
            
            —Total
                operating expenses
            
            
            5,223,000
            
            
            7,331,000
            
            
            40,760,000
            
            
            20,561,000Loss
                from operations
            
            
            (3,211,000
            )
            
            (5,863,000
            )
            
            (34,904,000
            )
            
            (15,631,000
            )Investment
                income
            
            
            147,000
            
            
            315,000
            
            
            468,000
            
            
            382,000Interest
                expense
            
            
            (126,000
            )
            
            (135,000
            )
            
            (362,000
            )
            
            (400,000
            )Net
                loss
            
            $
            (3,190,000
            )
            $
            (5,683,000
            )
            $
            (34,798,000
            )
            $
            (15,649,000
            )Net
                loss per common share (basic and diluted)
            
            $
            (0.32
            )
            $
            (0.66
            )
            $
            (3.64
            )
            $
            (1.83
            )Shares
                used in computation of basic and diluted net loss per common
                share
            
            
            9,894,000
            
            
            8,563,000
            
            
            9,548,000
            
            
            8,563,000









See
      accompanying notes to condensed consolidated financial statements






2






**TARGETED
      GENETICS CORPORATION**




**CONDENSED
      CONSOLIDATED STATEMENTS OF CASH FLOWS**


**(Unaudited)**








**Nine
                months ended****September
                30,****2006**
            
            **2005**Operating
                activities:Net
                loss
            
            $
            (34,798,000
            )
            $
            (15,649,000
            )Adjustments
                to reconcile net loss to net cash used in operating
                activities:Depreciation
                and amortization
            
            
            537,000
            
            
            1,009,000Stock-based
                compensation
            
            
            691,000
            
            
            —Stock
                issued to outside vendors
            
            
            141,000
            
            
            —Goodwill
                impairment charge
            
            
            23,723,000
            
            
            —Loss
                (gain) on investments
            
            
            (8,000
            )
            
            136,000Changes
                in assets and liabilities:Increase in accounts receivable
            
            
            (233,000
            )
            
            (207,000
            )Decrease (increase) in prepaid expenses and other
            
            
            48,000
            
            
            (173,000
            )Decrease in other assets
            
            
            8,000
            
            
            459,000Increase in current liabilities
            
            
            38,000
            
            
            4,000Increase in deferred revenue
            
            
            45,000
            
            
            —Increase in accrued restructure expenses and deferred rent
            
            
            286,000
            
            
            986,000Net
                cash used in operating activities
            
            
            (9,522,000
            )
            
            (13,435,000
            )Investing
                activities:Purchases
                of property and equipment
            
            
            (72,000
            )
            
            (618,000
            )Proceeds
                from sale of investments
            
            
            49,000
            
            
            46,000Net
                cash used in investing activities
            
            
            (23,000
            )
            
            (572,000
            )Financing
                activities:Net
                proceeds from sales of common stock
            
            
            4,826,000
            
            
            5,000Proceeds
                from the exercise of stock options
            
            
            12,000
            
            
            2,000Repayment
                of debt
            
            
            —
            
            
            (2,500,000
            )Payments
                under leasehold improvements and equipment financing
                arrangements
            
            
            (135,000
            )
            
            (445,000
            )Net
                cash provided by (used in) financing activities
            
            
            4,703,000
            
            
            (2,938,000
            )Net
                decrease in cash and cash equivalents
            
            
            (4,842,000
            )
            
            (16,945,000
            )Cash
                and cash equivalents, beginning of period
            
            
            14,122,000
            
            
            34,096,000Cash
                and cash equivalents, end of period
            
            $
            9,280,000
            
            $
            17,151,000






See
      accompanying notes to condensed consolidated financial statements






3






**TARGETED
      GENETICS CORPORATION**





**NOTES
      TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**




**(Unaudited)**







**1.   Summary
      of Significant Accounting Policies**





***Basis
      of Presentation***





The
      unaudited condensed consolidated financial statements included in this quarterly
      report have been prepared by Targeted Genetics Corporation, or Targeted
      Genetics, according to the rules and regulations of the Securities and Exchange
      Commission, or SEC, and according to accounting principles generally accepted
      in
      the United States of America, or GAAP, for interim financial statements. The
      accompanying balance sheet information as of December 31, 2005 is derived from
      our audited financial statements. Certain information and footnote disclosures
      normally included in financial statements prepared in accordance with GAAP
      have
      been omitted in accordance with the SEC’s rules and regulations for interim
      financial statements. Our condensed consolidated financial statements include
      the accounts of Targeted Genetics and our inactive, wholly-owned subsidiaries,
      Genovo, Inc. and TGCF Manufacturing Corporation *.* All
      significant intercompany transactions have been eliminated in consolidation.
      The
      financial statements reflect, in the opinion of management, all adjustments
      which consist solely of normal recurring adjustments necessary to present fairly
      our financial position and results of operations as of and for the periods
      indicated. Certain reclassifications have been made to conform prior period
      results to the current period presentation.




We
      do not
      believe that our results of operations for the three and nine months ended
      September 30, 2006 are necessarily indicative of the results to be expected
      for
      the full year.





The
      unaudited condensed consolidated financial statements included in this quarterly
      report should be read in conjunction with our audited consolidated financial
      statements and related footnotes included in our annual report on Form 10-K
      for
      the year ended December 31, 2005.





On
      May 8,
      2006, the Company’s Board of Directors approved a 1-for-10 reverse stock split,
      which became effective on May 11, 2006. All references to common stock, common
      shares outstanding, average number of common shares outstanding, per share
      amounts and options in these financial statements and notes to financial
      statements have been restated to reflect the 1-for-10 common stock reverse
      split
      on a retroactive basis.





Our
      combined cash and cash equivalents total $9.3 million at September 30, 2006.
      We
      expect that these funds plus the funding we expect from our partners will be
      sufficient to fund our operations into the first quarter of 2007. This estimate
      is based on our ability to perform planned research and development activities
      and the receipt of planned funding from our collaborators. Our near-term
      financing strategy includes leveraging our development capabilities and
      intellectual property assets into additional capital raising opportunities,
      advancing our clinical development programs and accessing the public and private
      capital markets at appropriate times. Additional funding may not be available
      to
      us on reasonable terms, if at all. Depending on our ability to successfully
      access additional funding, we may be forced to take cost reduction measures
      that
      may include scaling back, delaying or terminating one or more research and
      development programs, curtailing capital expenditures or reducing other
      operating activities. We have prepared the accompanying financial statements
      assuming that we will continue as a going concern and our financial statements
      do not reflect adjustments that may impact the amount and classifications of
      assets or liabilities that may result from these liquidity
      uncertainties.





***Stock-Based
      Compensation***





Effective
      January 1, 2006, we adopted Statement of Financial Accounting Standard, or
      SFAS,
      No. 123(R), “*Share-Based
      Payment,”*and
      elected to adopt the modified prospective application method. Accordingly,
      stock-based compensationcost
      is
      measured at the grant date, based on the fair value of the award and is
      recognized as an expense over the requisite service period. For stock awards
      granted in 2006, stock-based compensation expenses are recognized over the
      option vesting period under the straight-line attribution method. For stock
      awards granted prior to 2006, stock-based compensation expenses are recognized
      under the multiple option method prescribed by Financial Accounting Standards
      Board, or FASB, Interpretation No. 28. Previously reported amounts have not
      been
      restated.






4







**2.   Long-Term
      Obligations**




Long-term
      obligations consisted of the following:


**September
                30,******
            
            **December
                31,********2006**
            
            **2005**Loans
                payable to Biogen Idec
            
            $
            8,150,000
            
            $
            8,150,000Equipment
                financing obligations
            
            
            47,000
            
            
            182,000Total
                obligations
            
            
            8,197,000
            
            
            8,332,000Less
                current portion
            
            
            (3,195,000
            )
            
            (155,000
            )Total
                long-term obligations
            
            $
            5,002,000
            
            $
            8,177,000




As
        of
        September 30, 2006 we had $7.5 million of principle remaining on a $10.0
        million
        note payable to Biogen Idec, a beneficial owner of approximately 11.8% of
        our
        outstanding common shares. Outstanding borrowings under this unsecured loan
        agreement bear interest at the one-year London Interbank Offered Rate, or
        LIBOR,
        plus 1%, which is reset quarterly. The loan contains financial covenants
        establishing limits on our ability to declare or pay cash dividends and
        scheduled principal payments of $2.5 million are due August 1 2007, 2008
        and
        2009 with interest due each year on August 31. In addition, we have agreed
        to
        apply one-third of certain up-front payments received from potential future
        corporate collaborations to the outstanding balance on this loan payable,
        first
        to repayment of any accrued and unpaid interest and second to the repayment
        of
        outstanding principal in reverse order of maturity. As of September 30, 2006
        we
        also had a second loan, a promissory note payable to Biogen Idec, which we
        assumed in 2000 as part of our acquisition of Genovo. At September 30, 2006,
        this promissory note had an outstanding principal balance of $650,000, bore
        no
        interest and was scheduled to mature in August 2007.
 
 On
        November 7, 2006, we signed an agreement to restructure $8.15 million of
        debt
        payable to Biogen Idec. Under the agreement, we converted $5.65 million of
        debt
        into one million shares of common stock issued to Biogen Idec. At the time
        of
        signing we made a payment of $500,000 towards the remaining loan balance.
        The
        remaining $2.0 million principal balance continues to bear interest at the
        rate
        of LIBOR plus 1% and is to be paid in two equal installments of $1.0 million
        each on August 1, 2007 and 2008. See Note 7 to the condensed consolidated
        financial statements for the terms of the restructuring.
  **3.   Accrued
      Restructure Charges**





We
      apply
      the provisions of SFAS No. 146, *“Accounting
      for Costs Associated with Exit or Disposal Activities,”* as
      it
      relates to our facility in Bothell, Washington and record restructure charges
      on
      the operating lease for the facility as a result of our 2003 decision to
      discontinue use of the facility. Accrued restructure charges represent our
      best
      estimate of the fair value of the liability as determined under SFAS No. 146
      and
      are computed as the fair value of the difference between the remaining lease
      payments, net of assumed sublease income and expense. We also record accretion
      expense based upon changes in the accrued liability that results from the
      passage of time at an assumed discount rate of 10%. Accretion expense is
      recorded on an ongoing basis through the end of the lease term in September
      2015
      and is reflected as a restructuring charge in the accompanying condensed
      consolidated statements of operations.





The
      table
      below presents a reconciliation of the accrued restructure liability for the
      nine month period ended September 30, 2006:





**Contract
                Termination****Costs**
            
            **Employee
                Termination****Benefits**
            
            **Total**December
                31, 2005 accrued liability
            
            $
            7,149,000
            
            $
            —
            
            $
            7,149,000Charges incurred
            
            
            1,033,000
            
            
            221,000
            
            
            1,254,000Adjustments to the liability (accretion)
            
            
            564,000
            
            
            —
            
            
            564,000Amount paid
            
            
            (1,211,000
            )
            
            (221,000
            )
            
            (1,432,000
            )September
                30, 2006 accrued liability
            
            $
            7,535,000
            
            $
            —
            
            $
            7,535,000





During
      the first quarter of 2006 we recorded additional restructure charges of $639,000
      as a result of updating our estimates of costs and sublease income associated
      with exiting the Bothell facility. Market conditions for subleasing the facility
      continued to be poor, therefore, we extended our estimate for additional time
      that may be required to find a sublease tenant. In addition, we reviewed and
      adjusted downward our assumptions surrounding escalation in sublease rental
      income. In the third quarter of 2006 we recorded additional restructure charges
      of $221,000 as a result of further extending the anticipated lead time for
      subleasing the facility. In addition to these adjustments to the accrued
      restructure liability we have incurred $188,000 of accretion expense for the
      three month period ending September 30, 2006 and $564,000 of accretion expense
      for the nine month period ending September 30, 2006. The total of these charges
      and adjustments to the liability are reflected as restructure charges in the
      accompanying condensed consolidated statement of operations.






5





Restructuring
      charges also includes $221,000 of employee termination benefits recognized
      during the first quarter of 2006 related to the restructuring announced in
      January 2006 in order to reduce expenses and realign resources to advance our
      inflammatory arthritis product through clinical trials. We reduced our workforce
      by 26 employees, primarily in early-stage research and development groups and
      in
      operational and general and administrative functions.





In
      May
      2006, we amended the lease for our Seattle location which reduced our square
      footage three years before the end of the original lease term. We entered into
      this modification to reduce operating costs. Expenses related to the termination
      of the lease totaling $173,000 are included in restructuring charges for the
      three and nine months ending September 30, 2006.





Through
      September 30, 2006, we have recorded contract termination costs totaling $9.8
      million for our Bothell facility. We expect to incur an additional $3.2 million
      in accretion expense and pay $13.6 million in rent through the expiration of
      the
      Bothell lease in September 2015.





We
      periodically evaluate our restructuring estimates and assumptions and record
      additional restructure charges as necessary. Because restructure charges are
      estimates based upon assumptions regarding the timing and amounts of future
      events, significant adjustments to the accrual may be necessary in the future
      based on the actual outcome of events and as we become aware of new facts and
      circumstances.








**4.
      Equity**





***Financing***





On
      March
      10, 2006, we sold 1,279,161 shares of our common stock in a registered offering
      at a price of $3.90 per share and received net proceeds of approximately $4.8
      million.





***Stock
      Compensation***





We
      have
      various stock option plans, or Option Plans, that provide for the issuance
      of
      nonqualified and incentive stock options to acquire up to 1,297,944 shares
      of
      our common stock. These stock options may be granted by our Board of Directors
      to our employees, directors and officers and to consultants, agents, advisors
      and independent contractors who provide services to us. The exercise price
      for
      incentive stock options shall not be less than the fair market value of the
      shares on the date of grant. Options granted under our Option Plans expire
      no
      later than ten years from the date of grant and generally vest and become
      exercisable over a four-year period following the date of grant. In May and
      June
      of 2006, as part of an employee retention plan, we granted options to purchase
      an aggregate of 306,500 shares of common stock with an accelerated twelve month
      vesting period. We granted a total of 198,000 of these options to purchase
      shares of common stock with exercise prices of $3.80, exceeding the $2.46 fair
      value of the common stock on the grant date. Every non-employee member of our
      Board of Directors receives an annual nonqualified stock option grant and these
      options vest over a twelve month period provided they continue service to us.
      Stock option exercises are fulfilled through the issuance of new shares of
      common stock.





Effective
      January 1, 2006, we adopted SFAS No. 123R, *“Share-Based
      Payment.”* SFAS No.
      123R requires us to expense the fair value of stock options granted over the
      vesting period. We have adopted SFAS No. 123R using the modified prospective
      application method and recognized $227,000 of stock-based compensation expense
      in the third quarter of 2006 and $691,000 for the nine months ending September
      30, 2006. This compensation expense includes: (a) compensation cost for all
      share-based stock options granted prior to, but not yet vested as of January
      1,
      2006, based on the grant-date fair value used for prior pro forma disclosures
      adjusted for forfeitures and (b) compensation cost for all share-based payments
      granted subsequent to January 1, 2006, based on the grant-date fair value
      estimate in accordance with the provisions of SFAS No. 123R. For the three
      months ended September 30, 2006, we classified $117,000 of the stock-based
      compensation expense as research and development expense and $110,000 as general
      and administrative expense. For the nine months ended September 30, 2006 we
      classified $379,000 as research and development expense and $312,000 as general
      and administrative expense. As of September 30, 2006, total unrecognized
      compensation cost related to unvested options was approximately $835,000, net
      of
      estimated forfeitures, which we expect to recognize over a weighted average
      period of approximately 9.5 months.





Prior
      to
      January 1, 2006, we presented pro forma disclosure of stock-based compensation
      expense under SFAS No. 123, “ *Accounting
      for Stock-Based Compensation,* ”
and
      accounted for stock options under Accounting Principles Board No. 25, *“Accounting
      for Stock Issued to Employees,”* which
      uses the intrinsic value method and generally recognizes no compensation cost
      for employee stock option grants. The following table illustrates the effect
      on
      net loss and loss per share amounts if we had applied the fair value recognition
      provisions of SFAS No. 123 to stock-based employee compensation for the three
      months and nine months ended September 30, 2005:






6








**Three
                months
                ended**
            
            **Nine
                months
                ended****September
                30, 2005**
            
            **September
                30, 2005**Net
                loss:As
                reported
            
            $
            (5,683,000
            )
            $
            (15,649,000
            )Pro
                forma stock-based compensation expense
            
            
            (374,000
            )
            
            (1,242,000
            )Pro
                forma
            
            $
            (6,057,000
            )
            $
            (16,891,000
            )Basic
                and diluted net loss per share:As
                reported
            
            $
            (0.66
            )
            $
            (1.83
            )Pro
                forma
            
            
            (0.71
            )
            
            (1.97
            )






The
      following is a summary of our stock option activity and related prices for
      the
      first nine months of 2006:





**Shares**
            
            **Weighted****Average**
              **Exercise****Price**Balance,
                December 31, 2005
            
            
            704,071
            
            $
            20.84Granted
            
            
            336,100
            
            
            3.33Exercised
            
            
            (3,350
            )
            
            3.44Forfeited
            
            
            (129,265
            )
            
            15.17Balance,
                September 30, 2006
            
            
            907,556
            
            
            15.23





The
      weighted average fair value of stock options granted during the nine months
      ending September 30, 2006 was $1.84 per share and was $6.80 per share for the
      nine months ending September 30, 2005. The weighted average remaining
      contractual term of options currently exercisable as of September 30, 2006
      is
      6.15 years and was 5.93 years for options exercisable at September 30,
      2005.  We
      received $12,000 from the exercise of stock options for the nine months ending
      September 30, 2006.








Stock
      options outstanding and exercisable as of September 30, 2006 are summarized
      below:





**Outstanding**
            
            **Exercisable****Range
                of Exercise Prices**
            
            **Number
                of**
              **Option****Shares**
            
            **Weighted**
              **Average**
              **Exercise**
              **Price**
            
            **Weighted
                Average**
              **Remaining**
              **Contractual
                Life**
              **(Years)**
            
            **Number
                of**
              **Option
                Shares**
            
            **Weighted**
              **Average**
              **Exercise**
              **Price**$
                1.80 - $2.90
            
            
            128,420
            
            $
            2.53
            
            
            9.16
            
            
            54,064
            
            $
            2.653.80
            
            
            212,000
            
            
            3.80
            
            
            9.70
            
            
            49,499
            
            
            3.804.30
                - 12.20
            
            
            188,834
            
            
            7.91
            
            
            7.47
            
            
            116,876
            
            
            7.6312.60
                - 15.60
            
            
            187,613
            
            
            13.33
            
            
            7.28
            
            
            120,395
            
            
            13.4515.90 - 148.80
            
            
            190,689
            
            
            45.60
            
            
            3.65
            
            
            187,409
            
            
            45.98Balance,
                September 30, 2006
            
            
            907,556
            
            
            15.23
            
            
            7.39
            
            
            528,243
            
            
            21.69





The
      total
      intrinsic value of stock options is summarized as follows:





******Number
                of****Option
                Shares**
            
            **Aggregate****Intrinsic
                Value**Options
                outstanding at September 30, 2006
            
            
            907,556
            
            $
            —Options
                exercisable at September 30, 2006
            
            
            528,243
            
            
            —Options
                exercised during the nine months ended September 30, 2006
            
            
            3,350
            
            
            3,199










7






The
      aggregate intrinsic value is determined using the closing price of our common
      stock on September 30, 2006 of $1.81 per share. The fair value of each stock
      option award is estimated on the date of the grant using the
      Black-Scholes-Merton option pricing model. The following are the weighted
      average assumptions for the periods noted:





**Nine
                Months ended September 30,****2006**
            
            **2005**Expected
                dividend rate
            
            
            Nil
            
            
            NilExpected
                stock price volatility range
            
            
            1.067-1.107
            
            
            1.116-1.122Risk-free
                interest rate range
            
            
            4.25-4.85
            %
            
            3.25-4.13
            %Expected
                life of options range
            
            
            4-5
                years
            
            
            4
                years





The
      risk-free interest rate is based on the U.S. treasury security rate. We estimate
      the expected life of options and the expected volatility ranges based on our
      historical data.


**5.  
        **Goodwill****


The table
      below reflects changes in the balance related to goodwill for the nine months
      ended September 30, 2006:





December
                31, 2005 goodwill balance
            
            $
            31,649,000Impairment charge
            
            
            (23,723,000
            )September
                30, 2006 goodwill balance
            
            $
            7,926,000





We
      perform goodwill impairment tests in accordance with SFAS No. 142, *“Goodwill
      and Other Intangible Assets”* on an
      annual basis or more frequently if events and changes in business conditions
      indicate that the carrying amount of our goodwill may not be recoverable.
      Normally, we perform our annual impairment test as of October 1.
      However , as a
      result of a decline in our traded share price of our common stock during June
      2006, to a level which reduced our market capitalization to an amount less
      than
      the fair value of the Company’s net assets, we concluded that this was an
      indicator of impairment of our goodwill and therefore, we were required to
      perform an interim goodwill impairment test. In the first step of this testing,
      since the Company is comprised of only one reporting unit, we compared the
      fair
      value of the Company, as measured by market capitalization and discounted cash
      flow analysis, to the net carrying value of our assets. Since the indicated
      fair
      value of the Company was less than the net carrying value of our assets, we
      were
      then required to perform the second step of the evaluation and measure the
      amount of the impairment loss. This analysis requires us to determine the
      implied value of goodwill by allocating the estimated fair value of the Company
      to its assets and liabilities including intangible assets such as in-process
      research and development, completed technology, and trademarks and trade names
      using a hypothetical purchase price allocation as if the Company had been
      acquired in a business combination as of the date of the impairment test. This
      evaluation resulted in an implied goodwill balance of $7.9 million and a second
      quarter 2006 non-cash goodwill impairment charge of $23.7 million.





**6.  
      Other Comprehensive Loss**





Comprehensive
      loss is the total of net loss and all other non-owner changes in equity.
      Comprehensive loss includes unrealized gains and losses from investments and
      foreign currency translations, as presented in the following table:








**Three
                months ended**
              **September
                30,**
            
            **Nine
                months ended**
              **September
                30,****2006**
            
            **2005**
            
            **2006**
            
            **2005**Net
                loss as reported
            
            $
            (3,190,000
            )
            $
            (5,683,000
            )
            $
            (34,798,000
            )
            $
            (15,649,000
            )Other
                comprehensive loss:Unrealized
                gain (loss) on available-for-sale securities
            
            
            (22,000
            )
            
            48,000
            
            
            26,000
            
            
            48,000Foreign
                currency translation adjustment
            
            
            2,000
            
            
            7,000
            
            
            15,000
            
            
            7,000Other
                comprehensive loss
            
            $
            (3,210,000
            )
            $
            (5,628,000
            )
            $
            (34,757,000
            )
            $
            (15,594,000
            )






8






**7.  
      Subsequent Events**





On
      November 7, 2006, we signed an agreement to restructure $8.15 million of debt
      payable to Biogen Idec. Under the agreement, we converted $5.65 million of
      debt
      into one million shares of common stock issued to Biogen Idec. At the time
      of
      signing we made a payment of $500,000 towards the remaining loan balance. The
      remaining $2.0 million principal balance continues to bear interest at the
      rate
      of LIBOR plus 1% and is to be paid in two equal installments of $1.0 million
      each on August 1, 2007 and 2008. In addition, the agreement provides for early
      repayment of the 2007 installment within thirty days of a change in control
      of
      the Company. Several of the provisions of the modified loan agreement entered
      into in September 2005 continue including the requirement to apply one-third
      of
      certain up-front payments received from potential future corporate
      collaborations to the outstanding balance on this loan payable.








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




**Forward-Looking
      Statements**




This
      quarterly report on Form 10-Q contains forward-looking statements that involve
      risks and uncertainties. Forward-looking statements include statements about
      our
      product development and commercialization goals and expectations, potential
      market opportunities, our plans for and anticipated results of our clinical
      development activities and the potential advantage of our product candidates,
      our future cash requirements and the sufficiency of our cash and cash
      equivalents to meet these requirements, our ability to raise capital when needed
      and other statements that are not historical facts. Words such as “may,” “will,”
“believes,” “estimates,” “expects,” “anticipates,” “plans” and “intends,” or
      statements concerning “potential” or “opportunity” and other words of similar
      meaning or the negative thereof, may identify forward-looking statements, but
      the absence of these words does not mean that the statement is not
      forward-looking. In making these statements, we rely on a number of assumptions
      and make predictions about the future. Our actual results could differ
      materially from those stated in, or implied by; forward-looking statements
      for a
      number of reasons, including the risks described in the section entitled “Risk
      Factors” in Part II, Item 1A of this quarterly report.





You
      should not unduly rely on these forward-looking statements, which speak only
      to
      our expectations as of the date of this quarterly report. We undertake no
      obligation to publicly revise any forward-looking statement after the date
      of
      this quarterly report to reflect circumstances or events occurring after the
      date of this quarterly report or to conform the statement to actual results
      or
      changes in our expectations. You should, however, review the factors, risks
      and
      other information we provide in the reports we file from time to time with
      the
      Securities and Exchange Commission, or SEC.




**BUSINESS
      OVERVIEW**





Targeted
      Genetics Corporation is a clinical-stage biotechnology company. We are at the
      forefront of developing a new class of gene-based products. We believe that
      a
      wide range of diseases may be treated or prevented with gene-based products.
      In
      addition to treating diseases which have not had treatments in the past, we
      believe that there is also a significant opportunity to use gene-based products
      to more effectively treat diseases that are currently treated using other
      therapeutic classes of drugs including proteins, monoclonal antibodies, or
      small
      molecule drugs. We have multiple product candidates, two of which are currently
      in clinical trials. Our clinical-stage candidates are aimed at inflammatory
      arthritis and HIV/AIDS. Our preclinical product candidates are in development
      with a variety of collaboration partners and are aimed at congestive heart
      failure, HIV/AIDS and Huntington’s disease.





Our
      product candidates consist of a delivery vehicle, called a vector, and genetic
      material. The role of the vector is to carry the genetic material into a target
      cell. Once delivered into the cell, the gene can express or direct production
      of
      the specific proteins encoded by the gene. Gene delivery may be used to treat
      disease by replacing the missing or defective gene to facilitate the normal
      protein production or gene regulation capabilities of cells. In addition, gene
      delivery may be used to enable cells to perform additional roles in the body.
      Gene delivery may also be used to shut down cellular functions.





We
      are a
      leader in the preclinical and clinical development of adeno-associated viral
      vector, or AAV-based gene products and in the manufacture of AAV-vectors.
      Through our research and development activities, we have developed expertise
      and
      intellectual property related to gene delivery technologies. We have developed
      and applied processes to manufacture our potential products at a scale amenable
      to late-stage clinical development and expandable to large-scale commercial
      production. We have established broad capabilities in applying our AAV-based
      gene delivery technologies to several indications, and we have developed an
      infrastructure that allows us to expand these capabilities into multiple product
      opportunities. We have treated over 250 subjects using AAV-based products with
      no major safety concerns.






9






We
      are
      primarily focused on the following product development programs:





**Description**
            **Indication**
            **Funding
                Partner**
            **Development
                Status**AAV
                delivery of TNF-alpha antagonist (tgAAC94)
            Inflammatory
                Arthritis
            
            Phase
                I/IIAAV
                delivery of HIV antigens (tgAAC09)
            HIV/AIDS
            IAVI
            Phase
                IIAAV
                delivery of HIV antigens
            HIV/AIDS
            NIAID
            PreclinicalAAV
                delivery of SERCA2a
            Congestive
                Heart Failure
            Celladon
            PreclinicalAAV
                expression of htt siRNA
            Huntington’s
                disease
            Sirna
            Preclinical








In
      June
      2006, we reported preliminary data from our ongoing Phase I/II trial of tgAAC94
      in patients with inflammatory arthritis. In the study, approximately 120 adults
      are being randomized into three dose groups to receive a single intra-articular
      injection of either tgAAC94 or a placebo, followed by an open-label injection
      of
      tgAAC94 after 12 to 30 weeks, depending on when the target joint meets criteria
      for re-injection. To date, approximately 40 subjects have received an injection
      of blinded study drug or placebo. Preliminary data indicate tgAAC94 is safe
      and
      well-tolerated at doses of up to 5x10(12) particles, or DRP, /mL in subjects
      with and without systemic TNF-alpha antagonists. Data from the first cohort
      of
      subjects treated with doses of 1x10(11) DRP/mL of joint volume demonstrate
      a
      trend toward sustained improvement in tenderness and swelling in treated joints,
      compared to placebo. Additionally, fewer patients receiving tgAAC94 had symptoms
      requiring re-injection at the 12-week time point, compared with patients in
      the
      placebo arm. Although the numbers are small, the data also suggest a trend
      toward greater responses to tgAAC94 in patients taking systemic TNF-alpha
      antagonist therapy compared with patients not on these therapies. We are
      continuing to follow the subjects and plan on reporting additional results
      in
      the fourth quarter of 2006.





In
      August
      2006, we reported interim data from a Phase I clinical trial of tgAAC09, an
      investigational HIV/AIDS vaccine candidate based upon recombinant
      adeno-associated virus vector serotype 2, or AAV2. Our collaborative partner,
      the International AIDS Vaccine Initiative (IAVI), is conducting this trial.
      IAVI
      enrolled healthy volunteers from Belgium, Germany and India who were not
      infected with HIV. The Phase I trial is primarily designed to evaluate safety
      and tolerability of the vaccine at escalating dose levels and is also designed
      to evaluate immune responses following vaccination. No safety concerns were
      identified and the vaccine was well tolerated. In a subset of the volunteers
      receiving a single administration of the highest dose of the vaccine, modest
      immune responses to the HIV antigens were observed. A second clinical trial
      of
      tgAAC09 is ongoing in South Africa, Uganda and Zambia to evaluate a higher
      dose
      and to systematically evaluate the utility and optimal timing of boost
      vaccination.





Our
      recorded goodwill originated with our acquisition of Genovo, Inc. in September,
      2000. As a result of a decline in our share price during June 2006, to a level
      which reduced our market capitalization to an amount less than the fair value
      of
      the Company’s net assets, we were required to perform an interim goodwill
      impairment test. This impairment test resulted in the second quarter 2006
      recognition of a loss on impairment of goodwill in the amount of $23.7 million.
      This non-cash charge resulted both from the decline in the Company’s fair value
      (as indicated by the decline in our share price) as well as the calculation
      of
      implied goodwill resulting from a hypothetical allocation of the Company’s fair
      value to the fair value of its assets and liabilities including intangible
      assets as if the Company had been acquired in a hypothetical business
      combination on the date of the impairment test.





We
      have
      financed our operations primarily through proceeds from public and private
      sales
      of our equity securities, through cash payments received from our collaborative
      partners for product development and manufacturing activities, through proceeds
      from the issuance of debt and loan funding under equipment financing
      arrangements.





Our
      expenses are primarily incurred in conducting our research and development
      programs, the conduct of preclinical studies and clinical trials and general
      and
      administrative support for these activities and accordingly, to an extent,
      we
      are able to reduce expenses and conserve our resources by reducing these
      activities. For example, in January 2006 we restructured our operations to
      concentrate our resources on generating data from the clinical trials of our
      inflammatory arthritis product candidate, maintaining our manufacturing
      capabilities and advancing our partner funded product development efforts.
      As
      part of this restructuring we eliminated 26 positions, which reduced our
      workforce by approximately 27%, including scientific, operations and
      administrative functions that were not required to support our programs.





As
      of
      September 30, 2006, our accumulated deficit totaled $284.8 million and our
      shareholders’ equity totaled $1.5 million. We expect to generate substantial
      additional losses for the foreseeable future, primarily due to the costs
      associated with the development of our research and development programs, the
      conduct of preclinical studies and clinical trials and general and
      administrative support for these activities.






10






Notwithstanding
      our January 2006 cost-cutting measures, we will require access to significant
      amounts of capital in order to successfully develop our lead inflammatory
      arthritis product candidate and our partnered product candidates. We may be
      unable to obtain required funding when needed or on acceptable terms, obtain
      or
      maintain corporate partnerships or complete acquisition transactions necessary
      or desirable to complete the development of our product candidates.





Over
      the
      longer term, our business strategy is to leverage our technology assets,
      manufacturing capabilities and gene therapy product development expertise into
      multiple development programs and collaborations to maximize our opportunities
      to commercialize a product candidate. We believe that, if successful, our
      product candidates will have significant market potential. We intend to pursue
      product development programs that enable us to demonstrate the potential of
      our
      technology and eventually to commercialize gene-based therapeutics that address
      currently unmet medical needs.





The
      development of pharmaceutical products, including our potential inflammatory
      arthritis, prophylactic HIV/AIDS vaccine, congestive heart failure, and
      Huntington’s disease product candidates discussed above, involves extensive
      preclinical development followed by human clinical trials that take several
      years or more to complete. The length of time required to completely develop
      any
      product candidate varies substantially according to the type, complexity and
      novelty of the product candidate, the degree of involvement by a development
      partner and the intended use of the product candidate. Our commencement and
      rate
      of completion of clinical trials may vary or be delayed for many reasons,
      including those discussed in the section entitled “Risk Factors” presented
      below.





**CRITICAL
      ACCOUNTING POLICIES, ESTIMATES AND ASSUMPTIONS**





Other
      than with respect to those items described below, there have been no material
      changes from the critical accounting policies, estimates and assumptions as
      disclosed in Item 7 Management’s Discussion and Analysis of Financial Condition
      and Results of Operations of the Company’s Annual Report on Form 10-K for the
      year ended December 31, 2005. The critical accounting policies, estimates and
      assumptions below have been updated to provide more recent financial and factual
      information as of September 30, 2006.





G ***oodwill***





When
      we
      purchased Genovo, Inc. in 2000 we recorded intangible assets of $39.5 million
      on
      our financial statements, which represented know-how, an assembled workforce
      and
      goodwill. Between 2000 and 2002 we recognized $8.1 million of amortization
      of
      the goodwill and intangible assets and in 2002 we implemented SFAS No. 142, *“Goodwill
      and Other Intangible Assets”* .
      SFAS
      No. 142 discontinued amortization of goodwill and requires us to perform
      goodwill impairment tests annually or more frequently if events and changes
      in
      business conditions indicate that the carrying amount of our goodwill may not
      be
      recoverable. We assess any potential impairment using a two-step process. Since
      we have only one reporting unit for purposes of applying SFAS No. 142, the
      first
      step requires us to compare the fair value of the total Company, as measured
      by
      market capitalization to the company’s net book value. If the fair value of the
      company is greater, then no impairment is indicated. If the fair value of the
      Company is less then the net carrying value of its assets, then we are required
      to perform the second step to determine the amount, if any, of goodwill
      impairment. In step two, the implied fair value of goodwill is calculated and
      compared to its carrying amount. If the goodwill carrying amount exceeds the
      implied fair value, an impairment loss must be recognized equal to that excess.
      The implied goodwill amount is determined by allocating the fair value of the
      Company to all of its assets and liabilities including intangible assets such
      as
      in process research and development and developed technology as if the company
      had been acquired in a hypothetical business combination as of the date of
      the
      impairment test. The Company engaged an independent valuation firm to assist
      with the evaluation, including the assessment of the estimated fair value of
      the
      Company and the hypothetical purchase price allocations.





As
      a
      result of an interim goodwill impairment test performed in the second quarter
      of
      2006, we recognized a non-cash loss on impairment of goodwill of $23.7 million
      based on an assessment that the implied value of goodwill was $7.9
      million.





The
      process of evaluating the potential impairment of goodwill is subjective and
      requires significant judgment. In estimating the fair value of the Company,
      we
      make estimates and judgments about its future revenues and cash flows,
      application of a discount rate, and the potential control premium relative
      to
      the market price of the Company’s stock at the valuation date. In estimating the
      fair value of the Company’s net assets, including intangible assets we make
      estimates and judgments relating to the fair value of specific assets and
      liabilities. These estimates generally involve projections of the cash flows
      which may be provided by specific assets such as in process research and
      development, completed technology and trademarks and trade names, including
      assumptions as to the probability of bringing drug candidates to market, the
      timing of product development, the market size addressed by our potential
      products, and the application of discount rates. Changes in these estimates
      could impact the Company’s conclusion as to whether an impairment has occurred
      and could also significantly impact the amount of impairment recorded.






11





***Stock-Based
      Compensation***





** Prior
      to
      January 1, 2006, we had applied the intrinsic value method of accounting for
      stock options granted to our employees and directors under the provisions of
      Accounting Principles Board Opinion No. 25, “ *Accounting
      for Stock Issued to Employees”* ,
      and
      related interpretations, as permitted by SFAS No. 123 “ *Accounting
      for Stock-Based Compensation.”* Accordingly, we did not recognize any compensation expense for options granted
      to employees or directors because we grant all options at fair market value
      on
      the date of grant.





On
      January 1, 2006, we adopted SFAS No. 123R, “ *Share-Based
      Payment.”* We have
      adopted the SFAS No. 123R fair value recognition provisions using the modified
      prospective transition method. Under the modified prospective method ,
      compensation expense includes: (a) compensation cost for all share-based stock
      options granted prior to, but not yet vested as of January 1, 2006, based on
      the
      grant-date fair value used for prior pro forma disclosures adjusted for
      forfeitures and (b) compensation cost for all share-based payments granted
      subsequent to January 1, 2006, based on the grant-date fair value estimate
      in
      accordance with the provisions of SFAS No. 123R. Results for periods prior
      to
      January 1, 2006 have not been restated. As a result of adopting SFAS No. 123R,
      we recorded $227,000 of expense for stock-based compensation for the three
      months ending September 30, 2006 and $691,000 for the nine months ending
      September 30, 2006. This expense is classified as follows:








**Three
                months ended September 30, 2006**
            
            **Nine
                months ended September 30, 2006**Research
                and development
            
            $
            117,000
            
            $
            379,000General
                and administrative
            
            
            110,000
            
            
            312,000Total
                stock-based compensation
            
            $
            227,000
            
            $
            691,000








The
      proforma cost of stock option compensation for the three months ended September
      30, 2005 was $374,000 and the proforma cost of stock option compensation for
      the
      nine months ending September 30, 2005 was $1,242,000 for which no expense was
      recorded as allowed under the provisions of APB Opinion No. 25. As of September
      30, 2006, total unrecognized compensation cost related to unvested options
      was
      approximately $835,000, net of estimated forfeitures, which we expect to
      recognize over a weighted average period of approximately 9.5 months.





Determining
      the appropriate fair value model and calculating the fair value of share-based
      payment awards require the input of highly subjective assumptions, including
      the
      expected life of the share-based payment awards and stock price volatility.
      We
      based our volatility and expected life estimates based on our historical data.
      The assumptions used in calculating the fair value of share-based payment awards
      represent our best estimates, but these estimates involve inherent uncertainties
      and the application of judgment. As a result, if factors change and we use
      different assumptions, our stock-based compensation expense could be materially
      different in the future. In addition, we are required to estimate the expected
      forfeiture rate and only recognize expense for those shares expected to vest.
      If
      our actual forfeiture rate is materially different from our estimate, the
      stock-based compensation expense could be significantly different from what
      we
      have recorded in the current period. See Note 4 to the condensed consolidated
      financial statements for a further discussion on stock-based
      compensation.








**RESULTS
      OF OPERATIONS**





***Revenue***





Revenue
      for the three months ending September 30, 2006 increased to $2.0 million
      compared to $1.5 million for the same period in 2005. Revenue increased to
      $5.9
      million for the nine months ended September 30, 2006 compared to $4.9 million
      for the same period in 2005. The increase in revenue reflects higher research
      and development activities under our collaboration with Celladon and research
      and development activities under the National Institute of Allergy and
      Infectious Disease, or NIAID, contract initiated in Q4-2005. These increases
      were partially offset by decreased research and development activities from
      our
      collaboration with IAVI. We expect that our revenue for the remainder of 2006
      will consist primarily of research and development revenue earned under our
      collaborations with Celladon, the NAID and IAVI. For the next several years,
      our
      revenue will depend on the continuation of the current collaborations and our
      success with entering into and performing under new collaborations.






12





***Operating
      Expenses***





*Research
      and Development Expenses* .    Research
      and development expenses decreased to $3.1 million for the three months ended
      September 30, 2006 compared to $4.7 million for the same period in 2005. This
      decrease reflects lower preclinical costs incurred as a result of the January
      2006 restructuring and lower costs related to our cystic fibrosis project
      partially offset by higher expenses in support of our inflammatory arthritis
      program. Research and development expense decreased to $10.5 million for the
      nine months ended September 30, 2006 compared to $14.0 million for the same
      period in 2005. This decrease reflects lower costs related to our HIV/AIDS
      vaccine collaboration with IAVI and reduced costs related to our cystic fibrosis
      project offset by increases in development efforts related to our inflammatory
      arthritis project and lower costs as a result of the restructuring efforts
      implemented in January 2006.





The
      following is an allocation of our total research and development costs between
      our programs in clinical development and those that are in research or
      preclinical stages of development:





**Three
                months ended**
              **September
                30,**
            
            **Nine
                months ended**
              **September
                30,****2006**
            
            **2005**
            
            **2006**
            
            **2005**Programs
                in clinical development:HIV/AIDS
                vaccine
            
            $
            383,000
            
            $
            337,000
            
            $
            1,494,000
            
            $
            2,325,000Inflammatory
                arthritis
            
            
            771,000
            
            
            615,000
            
            
            2,204,000
            
            
            1,782,000Cystic
                fibrosis(1)
            
            
            2,000
            
            
            191,000
            
            
            37,000
            
            
            465,000Indirect
                costs
            
            
            554,000
            
            
            889,000
            
            
            2,150,000
            
            
            3,499,000Total
                clinical development program expense
            
            
            1,710,000
            
            
            2,032,000
            
            
            5,885,000
            
            
            8,071,000Research
                and preclinical development program expense
            
            
            1,413,000
            
            
            2,621,000
            
            
            4,598,000
            
            
            5,929,000Total
                research and development expense
            
            $
            3,123,000
            
            $
            4,653,000
            
            $
            10,483,000
            
            $
            14,000,000




(1)  No
      longer in development.





Research
      and development costs attributable to programs in clinical development include
      the costs of salaries and benefits, clinical trial costs, outside services,
      materials and supplies incurred to support the clinical programs. Indirect
      costs
      allocated to clinical programs include facility and building occupancy costs,
      research and development administrative costs, and license and royalty payments.
      These costs are further allocated between clinical and preclinical programs
      based on relative levels of program activity. IAVI separately manages and funds
      the clinical trial costs of our AIDS vaccine program. As a result, we do not
      include those costs in our research and development expenses.





Costs
      attributed to research and preclinical programs represent our earlier-stage
      development activities and include costs incurred for the HIV/AIDS vaccine
      development activities under the NIAID contract and the congestive heart failure
      programs as well as other programs prior to their transition into clinical
      trials. Research and preclinical program expense also includes costs that are
      not allocable to a clinical development program, such as unallocated
      manufacturing infrastructure costs. Because we conduct multiple research
      projects and utilize resources across several programs, our research and
      preclinical development costs are not directly assigned to individual programs.





For
      purposes of reimbursement from our collaboration partners, we capture the level
      of effort expended on a program through our project management system, which
      is
      based primarily on human resource time allocated to each program, supplemented
      by an allocation of indirect costs and other specifically identifiable costs,
      if
      any. As a result, the costs allocated to programs identified in the table above
      do not necessarily reflect the actual costs of the program.





*General
      and Administrative Expenses* .    General
      and administrative expenses increased to $1.7 million for the three months
      ended
      September 30, 2006 compared to $1.5 million for the same period in 2005. This
      increase reflects increased consulting costs and stock based compensation
      expense partially offset by lower payroll costs as a result of the January
      2006
      restructuring. General and administrative expenses decreased to $4.7 million
      for
      the nine months ended September 30, 2006 from $5.0 million for the same period
      in 2005. The decrease reflects lower payroll expenses as a result of the January
      2006 restructuring and lower patent costs, offset partially by stock-based
      compensation expense for general and administrative employees.





*Restructure
      Charges.* Restructure
      charges decreased to $413,000 for the three months ended September 30, 2006,
      compared to $1.2 million for the same period in 2005. We recorded $221,000
      in
      additional charges during the three months ending September 30, 2006 due to
      a
      change in estimates regarding the lead time to find a sublessor at the Bothell
      facility. In addition, there was $188,000 in accretion expense for the period.
      This is lower than the prior year due to a $1.0 million charge resulting from
      a
      change in assumptions related to the terms of the Bothell lease in the third
      quarter of 2005. Restructure charges increased to $1.8 million for the nine
      months ended September 30, 2006, compared to $1.5 million for the same period
      in
      2005. Restructuring charges in the nine month periods include charges of
      $860,000 in 2006 related to changes in our expectations regarding market
      conditions for the Bothell facility subleasing market and $1.1 million in 2005
      primarily related to a change in the assumptions related to the terms of the
      Bothell sublease. Restructuring charges also include accretion expense of
      $564,000 in the nine month period ended September 30, 2006 and $394,000 in
      the
      nine month period ended September 30, 2005. In January 2006, we recorded a
      $221,000 charge related to the employee termination benefits of our
      restructuring efforts to realign our resources to advance our lead inflammatory
      arthritis product through clinical trials. In the second quarter of 2006, as
      a
      result of first quarter 2006 staff count reductions, we recorded additional
      restructure charges of $173,000 to reflect a lease buyout for a portion of
      our
      Seattle facility lease.






13





*Goodwill
      impairment charge.* As
      discussed in Note 5 to the condensed consolidated financial statements, we
      recognized a non-cash loss on impairment of goodwill during the nine month
      period ended September 30, 2006. As a result of a decline in our share price
      during June 2006, to a level which reduced market capitalization to an amount
      less than the fair value of the Company’s net assets, we were required to
      perform an interim goodwill impairment test. As a result of this evaluation
      we
      recognized a non-cash impairment charge of $23.7 million, which is equal to
      the
      recorded value of goodwill in excess of its implied value.





***Other
      Income and Expense***





*Investment
      Income* .    Investment
      income decreased to $147,000 for the three month period ended September 30,
      2006
      compared to $315,000 for the same period in 2005 due primarily to a realized
      gain on investments of $142,000 from the receipt of shares of Chromos stock
      in
      the third quarter of 2005. These shares were consideration received for a
      debenture that had been previously written down to zero. Investment income
      increased to $468,000 for the nine month period ended September 30, 2006
      compared to $382,000 for the same period in 2005 due to a non-cash charge of
      $244,000 to record an other than temporary impairment in the carrying value
      of
      the Chromos securities in the second quarter of 2005. This loss is partially
      offset by the $142,000 gain on investments discussed previously. Investment
      income primarily reflects interest income earned on our short term
      investments.





*Interest
      Expense* .    Interest
      expense relates to interest on outstanding loans from our collaborative
      partners, notes and obligations under equipment financing arrangements that
      we
      use to finance purchases of laboratory and computer equipment, furniture and
      leasehold improvements. Interest expense decreased to $126,000 for the three
      months ended September 30, 2006, compared to $135,000 for the same period in
      2005. Interest expense decreased to $362,000 for the nine months ending
      September 30, 2006 compared to $400,000 for the same period in 2005. The
      decrease primarily reflects lower interest charges on decreased principal
      amounts outstanding under our equipment financing arrangements and the Biogen
      note.







**Liquidity
      and Capital Resources**




We
      had
      cash and cash equivalents balances of $9.3 million as of September 30, 2006
      compared to $14.1 million as of December 31, 2005. Our cash and cash equivalents
      decreased in the nine months ending September 30, 2006 reflecting our cash
      used
      in operations of $9.5 million partially offset by the net proceeds of $4.8
      million from our March 2006 sale of our common stock. Our shareholders’ equity
      decreased to $1.5 million at September 30, 2006, compared to $30.6 million
      at
      December 31, 2005 primarily due to losses of $34.8 million for the nine months
      ended September 30, 2006 including a goodwill impairment charge of $23.7 million
      described above. As discussed in Note 7 to the condensed consolidated financial
      statements, we expect to record a fourth quarter 2006 decrease in our
      liabilities and increase to our shareholders’ equity balance as a result of
      Biogen’s November 7, 2006 conversion of $5.65 million of debt to
      equity.




In
      March
      2006, we sold 1,279,161 shares of our common stock in a registered offering
      at a
      price of $3.90 per share and received net proceeds of approximately $4.8
      million. We intend to continue to seek appropriate opportunities to access
      the
      public and private capital markets, however, our ability to issue equity
      securities at the current market price will likely be adversely affected by
      the
      fact that we are presently ineligible under SEC rules to utilize Form S-3 for
      primary offerings of our securities because the aggregate market value of our
      outstanding common stock held by non-affiliates is less than $75 million. This
      ineligibility results in a longer length of time necessary to raise
      capital.





Our
      primary expenses are related to the development of our research and development
      programs, the conduct of preclinical studies and clinical trials and general
      and
      administrative support for these activities. Our HIV/AIDS vaccine candidate
      and
      our inflammatory arthritis product candidate are both in clinical trials. We
      expect to continue incurring significant expense in advancing our inflammatory
      arthritis product candidate toward commercialization. As a result, we do not
      expect to generate sustained positive cash flow from our operations for at
      least
      the next several years and only then if we can successfully develop and
      commercialize our product candidates. We will require substantial additional
      financial resources to fund the development and commercialization of our lead
      product candidate in inflammatory arthritis.






14





Since
      implementing a reduction in force in January 2006, we have focused our
      development funding on our inflammatory arthritis product candidate, which
      is in
      clinical trials. During 2005, we spent approximately $2.4 million on this
      program in outside costs and allocated staff costs to support research and
      development activities and clinical trial costs, and we expect to spend
      approximately $3 million in 2006 on this program, largely for clinical trial
      expenses. We currently fund all costs of this program from our working capital
      and expect to do so for the foreseeable future, although our strategy is to
      ultimately seek a partner to fund later-stage development of this
      program.





In
      addition to the funding necessary to advance our product development and fund
      our ongoing operating costs, we also have significant outstanding debt, lease
      commitments and long-term obligations which draw on our cash resources. Our
      most
      significant obligation is approximately $13.6 million of remaining Bothell
      facility lease payments which we are obligated to pay at $1.4 million to $1.6
      million per year until the year 2015. On November 7, 2006, we signed an
      agreement to restructure our $8.15 million loan payable to Biogen Idec. Under
      the agreement, we converted $5.65 million of debt into one million shares of
      common stock issued to Biogen Idec. At the time of signing we made a payment
      of
      $500,000 towards the remaining loan balance. The remaining $2.0 million
      principal balance continues to bear interest at the rate of LIBOR plus 1% and
      is
      to be paid in two equal installments of $1.0 million each on August 1, 2007
      and
      2008. In addition, the agreement provides for early repayment of the 2007
      installment within thirty days of a change in control of the Company. Several
      of
      the provisions of the modified loan agreement entered into in September 2005
      continue including the requirement to apply one-third of certain up-front
      payments received from potential future corporate collaborations to the
      outstanding balance on this loan payable. We will need to raise additional
      capital to perform planned research and development activities and make the
      scheduled lease payments and to repay these notes.





We
      expect
      the level of our future operating expenses to be driven by the needs of our
      product development programs, our debt obligations and our lease obligations
      offset by the availability of funds through equity offerings, partner-funded
      collaborations or other financing or business development activities. The size,
      scope and pace of our product development activities depend on the availability
      of these resources. Our future cash requirements will depend on many factors,
      including:





•  the
      rate
      and extent of scientific progress in our research and development programs;





•  the
      timing, costs and scope of, and our success in, conducting clinical trials,
      obtaining regulatory approvals and pursuing patent prosecutions;





•  competing
      technological and market developments;





•  the
      timing and costs of, and our success in, any product commercialization
      activities and facility expansions, if and as required; and





•  the
      existence and outcome of any litigation or administrative proceedings involving
      intellectual property.





We
      have
      financed our product development activities and general corporate functions
      primarily through proceeds from public and private sales of our equity
      securities, through cash payments received from our collaborative partners
      and
      proceeds from the issuance of debt. To a lesser degree, we have also financed
      our operations through interest earned on cash and cash equivalents, loan
      funding under equipment financing agreements and research grants. These
      financing sources have historically allowed us to maintain adequate levels
      of
      cash and cash equivalents.





Our
      development collaborations have typically provided us with funding in several
      forms, including purchases of our equity securities, loans, payments for
      reimbursement of research and development costs and milestone fees and payments.
      We and our partners typically agree on a target disease and create a development
      plan for the product candidate, which subject to termination by the
      collaborative partner, often extends for multiple years. For example, in the
      second half of 2005 we extended the scope of our HIV/AIDS vaccine program via
      a
      collaboration between CHOP, CCRI and us under a contract awarded by the NIAID.
      During the first nine months of 2006 we received $589,000 under this
      collaboration and our portion of the funding could be up to an additional $17.6
      million over the next four years.





The
      funding from each of our collaborative partners fully offsets our incremental
      program costs from each collaboration and also partially funds development
      of
      our inflammatory arthritis product candidate, overhead and fixed costs. Our
      revenue from collaborative agreements totaled $6.9 million in 2005 and $9.7
      million in 2004 and assuming that we complete all of the planned development
      activities for each of these funded projects, we expect to earn revenue of
      approximately $8 million in 2006.






15





Our
      partners have the right to terminate our collaborations and their obligation
      to
      provide research funding at any time for any reason. For example, IAVI can
      terminate our HIV/AIDS vaccine collaboration with 180 days notice. If we were
      to
      lose the collaborative funding expected from our IAVI collaboration or our
      NIAID
      collaboration with CHOP and CCRI and were unable to obtain alternative sources
      of funding for the product candidate under development in that collaboration,
      we
      may be unable to continue our research and development program for that product
      candidate.





Our
      near-term financing strategy includes leveraging our development capabilities
      and intellectual property assets into additional capital raising opportunities,
      advancing our clinical development programs and accessing the public and private
      capital markets at appropriate times.  In addition, we intend to manage our
      cash by focusing on advancing our inflammatory product candidate through
      clinical testing. Our financing strategy is focused around the advancement
      of
      our two programs in clinical development, advancement of our newer development
      collaborations and generating value out of our other intellectual assets and
      capabilities. In the biotechnology industry there is a low level of success
      in
      clinical trials and our ability to raise capital depends in part on clinical
      trial success.





We
      are
      currently evaluating additional sources of financing which could involve one
      or
      more of the following:





·
            entering
                into additional product development
                collaborations;





·
            mergers
                and acquisitions;





·
            issuing
                equity in the public or private markets;





·
            extending
                or expanding our current
                collaborations;





·
            selling
                or licensing our technology or product candidates;





·
            borrowing
                under loan or equipment financing arrangements;
                or





·
            issuing
                debt.




We
        expect
        that our total cash requirements, which consists of cash used in operations
        plus
        capital expenditures and payments of obligations, for 2006 will range from **$** 13
        million to $15 million and that our cash and cash equivalents at September
        30,
        2006, plus the funding from our product development collaborations and contracts
        will be sufficient to fund our operations into the first quarter of 2007.
        This
        estimate is based on our ability to perform planned research and development
        activities and the receipt of planned funding from our collaborators.
        Accordingly, we will need to raise additional funds in the near
        term.
 
 Additional
        funding may not be available to us on reasonable terms, if at all. Our ability
        to issue equity, and our ability to issue it at the current market price,
        may be
        adversely affected by the fact that we are presently ineligible under SEC
        rules
        to utilize Form S-3 for primary offerings of our securities because the
        aggregate market value of our outstanding common stock held by non-affiliates
        is
        less than $75 million. In addition, our shareholders’ equity of $1.5 million as
        of September 30, 2006 is lower than the minimum listing requirements of the
        Nasdaq Capital Market. As a result of our November 7, 2006 debt restructuring
        agreement with Biogen Idec, discussed in Note 7 to the condensed consolidated
        financial statements, we expect to record a fourth quarter 2006 decrease
        in our
        liabilities and increase to our shareholders’ equity balance as a result of
        Biogen’s conversion of $5.65 million of debt to equity. Notwithstanding this
        restructuring of our debt to Biogen Idec, we may receive a letter from Nasdaq
        notifying us that we were not in compliance with Nasdaq Marketplace Rule
        4320(e)(2) at September 30, 2006 and Nasdaq may institute delisting proceedings.
        A delisting would negatively impact our ability to raise additional funding.
        Depending on our ability to successfully access additional funding, we may
        be
        forced to implement significant cost reduction measures. These adjustments
        may
        include scaling back, delaying or terminating one or more research and
        development programs, curtailing capital expenditures or reducing other
        operating activities. We may also be required to relinquish some rights to
        our
        technology or product candidates or grant licenses on unfavorable terms,
        either
        of which would reduce the ultimate value to us of the technology or product
        candidates.
  **Item
        3.** ***Quantitative
        and Qualitative Disclosures About Market Risk*** ****





*Items
      with interest rate risk:*





·  *Short
      term investments* :
      Because
      of the short-term nature of our investments, we believe that our exposure to
      market rate fluctuations on our investments is minimal. Currently, we do not
      use
      any derivative or other financial instruments or derivative commodity
      instruments to hedge any market risks and do not plan to employ these
      instruments in the future. At September 30, 2006, we held $9.3 million in cash
      and cash equivalents, which are primarily invested in money market funds and
      denominated in U.S. dollars. An analysis of the impact on these securities
      of a
      hypothetical 10% change in short-term interest rates from those in effect at
      September 30, 2006, indicates that such a change in interest rates would not
      have a significant impact on our financial position or on our expected results
      of operations in 2006.






16


·  *Notes
        payable* :
        Our
        results of operations are affected by changes in short-term interest rates
        as a
        result of a loan from Biogen which contains a variable interest rate. Interest
        payments on this loan are established quarterly based upon the one-year London
        Interbank Offered Rate, or LIBOR, plus 1%. As of September 30, 2006, we were
        accruing interest on the note at a rate of 6.59%. The carrying amount of
        the
        note payable approximates fair value because the interest rate on this
        instrument changes with, or approximates, market rates.
 
 On
        November 7, 2006, we signed an agreement to restructure $8.15 million of
        debt
        payable to Biogen Idec. Under the agreement, we settled $5.65 million of
        debt
        through the issuance of one million shares of common stock to Biogen Idec.
        At
        the time of signing we also made a payment of $500,000 towards the remaining
        loan balance. The remaining $2.0 million principal balance continues to bear
        interest at the rate of LIBOR plus 1% and is to be paid in two equal
        installments of $1.0 million each on August 1, 2007 and 2008. The following
        table provides information about our remaining debt obligations that are
        sensitive to changes in interest rate fluctuations as adjusted to reflect
        this
        agreement which is described in Note 7 to the condensed consolidated financial
        statements:
 
 Expected
                  Maturity Date2006
              
              2007
              
              2008
              
              2009
              
              2010
              
              TotalVariable
                  rate note
              
              $
              —
              
              $
              1,000,000
              
              $
              1,000,000
              
              $
              —
              
              $
              —
              
              $
              2,000,000


*Items
      with market and foreign currency exchange risk:*





·  *Investment
      in Chromos Molecular Systems, Inc.:* At
      September 30, 2006, we held 2.5 million shares of Chromos Molecular Systems,
      or
      Chromos, common shares with a market value of $0.17 per common share denominated
      in Canadian dollars. As of September 30, 2006 the Canadian to US exchange rate
      was US $0.8979 per CA $1.00. As of September 30, 2006, our investment is
      recorded at $375,000 with a $20,000 unrealized gain and is classified on our
      Condensed Consolidated Balance Sheet within prepaid expenses and other. We
      hold
      these shares of common stock as available-for-sale securities as we periodically
      sell them on the Toronto Stock Exchange. During the first 2 quarters of 2006
      we
      sold 280,000 shares of Chromos stock in 2006 and recorded $8,000 of net realized
      gains and received $49,000 in cash. The amount of potential realizable value
      in
      this investment will be determined by the market, the exchange rate between
      the
      Canadian and US dollar and our ability to sell the shares.








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




*Evaluation
      of disclosure controls and procedures.* Based
      on
      our management’s evaluation, with the participation of our Chief Executive
      Officer and Chief Financial Officer, of the effectiveness of our disclosure
      controls and procedures as of the end of the period covered by this quarterly
      report, our Chief Executive Officer and Chief Financial Officer have concluded
      that our disclosure controls and procedures are effective in ensuring that
      information we are required to disclose in reports that we file or submit under
      the Securities Exchange Act of 1934, as amended, is recorded, processed,
      summarized and reported within the time periods specified in the Securities
      and
      Exchange Commission rules and forms.





*Changes
      in internal control over financial reporting.* There
      was
      no change in our internal control over financial reporting, that occurred during
      the period covered by this quarterly report that materially affected, or is
      reasonably likely to materially affect, our internal control over financial
      reporting.







**PART
      II    OTHER INFORMATION**




**Item
      1.    Legal Proceedings**




None.




**Item
      1A.    Risk Factors**





Other
      than with respect to the risk factors below, there have been no material changes
      from the risk factors disclosed in “Section 1A. Risk Factors” of the Company’s
      Annual Report on Form 10-K for the year ended December 31, 2005 as updated
      in Section 1A of our Quarterly Reports on Form 10-Q for the quarters ended
      March
      31, 2006 and June 30, 2006. The risk factors below were disclosed those prior
      filings and have been updated to provide more recent financial and factual
      information as of September 30, 2006.





***If
      we are unable to raise additional capital when needed, we will be unable to
      conduct our operations and develop our potential
      products.***





Because
      internally generated cash flow will not fund development and commercialization
      of our product candidates, we will require substantial additional financial
      resources. Our future capital requirements will depend on many factors,
      including:






17







·
            the
                rate and extent of scientific progress in our research and development
                programs;





·
            the
                timing, costs and scope of, and our success in, conducting clinical
                trials, obtaining regulatory approvals and pursuing patent
                prosecutions;





·
            competing
                technological and market developments;





·
            the
                timing and costs of, and our success in, any product commercialization
                activities and facility expansions, if and as required;
                and





·
            the
                existence and outcome of any litigation or administrative proceedings
                involving intellectual property.








We
      expect that our cash and cash equivalents at September 30, 2006, plus the
      funding from our partners will be sufficient to fund our operations into the
      first quarter of 2007. This estimate is based on our ability to perform planned
      research and development activities and the receipt of planned funding from
      our
      collaborators. Accordingly, we will need to raise additional funding in the
      near
      term. In addition, as of November 7, 2006 we owe to Biogen Idec approximately
      $2.0 million in aggregate principal amount. The terms of the note requires
      us to
      make annual interest payments and scheduled principal payments of $1.0 million
      in each of August 2007 and 2008. We will need to raise additional capital to
      perform planned research and development activities and make these scheduled
      payments. Additional sources of financing could involve one or more of the
      following:





·
            entering
                into additional product development
                collaborations;





·
            mergers
                and acquisitions;





·
            issuing
                equity in the public or private markets;





·
            extending
                or expanding our current
                collaborations;





·
            selling
                or licensing our technology or product candidates;





·
            borrowing
                under loan or equipment financing arrangements; or





·
            issuing
                debt.





Additional
      funding may not be available to us on reasonable terms, if at all. Our ability
      to issue equity, and our ability to issue it at the current market price, may
      be
      adversely affected by the fact that we are presently ineligible under SEC rules
      to utilize Form S-3 for primary offerings of our securities because the
      aggregate market value our outstanding common stock held by non-affiliates
      is
      less than $75 million.





The
      perceived risk associated with the possible sale of a large number of shares
      could cause some of our stockholders to sell their stock, thus causing the
      price
      of our stock to decline. In addition, actual or anticipated downward pressure
      on
      our stock price due to actual or anticipated sales of stock could cause some
      institutions or individuals to engage in short sales of our common stock, which
      may itself cause the price of our stock to decline.





If
      our
      stock price declines, we may be unable to raise additional capital. A sustained
      inability to raise capital could force us to go out of business. Significant
      declines in the price of our common stock could also impair our ability to
      attract and retain qualified employees, reduce the liquidity of our common
      stock
      and result in the delisting of our common stock from the NASDAQ Capital
      Market.





The funding that we expect to receive from our collaborations depends on
      continued scientific progress under the collaboration and our collaborators’
ability and willingness to continue or extend the collaboration. If we are
      unable to successfully access additional capital, we may need to scale back,
      delay or terminate one or more of our development programs, curtail capital
      expenditures or reduce other operating activities. We may also be required
      to
      relinquish some rights to our technology or product candidates or grant or
      take
      licenses on unfavorable terms, either of which would reduce the ultimate value
      to us of our technology or product candidates.







18





***We
      expect to continue to operate at a loss and may never become
      profitable.***





Substantially all of our revenue has been derived under collaborative research
      and development agreements relating to the development of our potential product
      candidates. We have incurred, and will continue to incur for the foreseeable
      future, significant expense to develop our research and development programs,
      conduct preclinical studies and clinical trials, seek regulatory approval for
      our product candidates and provide general and administrative support for these
      activities. As a result, we have incurred significant net losses since
      inception, and we expect to continue to incur substantial additional losses
      in
      the future.  As
      of
      September 30, 2006, we had an accumulated deficit of $284.8 million. We may
      never generate profits and, if we do become profitable, we may be unable to
      sustain or increase profitability.





***All
      of our product candidates are in early-stage clinical trials or preclinical
      development, and if we are unable to successfully develop and commercialize
      our
      product candidates we will be unable to generate sufficient capital to maintain
      our business.***





In
      November 2005, IAVI initiated a Phase II trial for our HIV/AIDS vaccine
      product candidate in South Africa. In March 2006, we initiated a Phase I/II
      trial for our inflammatory arthritis product candidate in the United States
      and
      Canada. We will not generate any product revenue for at least several years
      and
      then only if we can successfully develop and commercialize our product
      candidates. Commercializing our potential products depends on successful
      completion of additional research and development and testing, in both
      preclinical development and clinical trials. Clinical trials may take several
      years or more to complete. The commencement, cost and rate of completion of
      our
      clinical trials may vary or be delayed for many reasons, including the risks
      discussed elsewhere in this section. If we are unable to successfully complete
      preclinical and clinical development of some or all of our product candidates
      in
      a timely manner, we may be unable to generate sufficient product revenue to
      maintain our business.





Even if our potential products succeed in clinical trials and are approved
      for
      marketing, these products may never achieve market acceptance. If we are
      unsuccessful in commercializing our product candidates for any reason, including
      greater effectiveness or economic feasibility of competing products or
      treatments, the failure of the medical community or the public to accept or
      use
      any products based on gene delivery, inadequate marketing and distribution
      capabilities or other reasons discussed elsewhere in this section, we will
      be
      unable to generate sufficient product revenue to maintain our business.





***If
      we lose our collaborative partners, we may be unable to develop our potential
      products.***




A portion of our operating expenses are funded through our collaborative
      agreements with third parties. We currently have strategic partnerships with
      two
      biotechnology companies, Sirna Therapeutics and Celladon, one public health
      organization, IAVI, and through a contract with a U.S. government agency, NIAID,
      that provide for funding, collaborative development, intellectual property
      rights or expertise to develop certain of our product candidates. With limited
      exceptions, each collaborator has the right to terminate its obligation to
      provide research funding at any time for scientific or business reasons. In
      addition, to the extent that funding is provided by a collaborator for
      non-program-specific uses, the loss of significant amounts of collaborative
      funding  could
      result in the delay, reduction or termination of additional research and
      development programs, a reduction in capital expenditures or business
      development and other operating activities, or any combination of these
      measures. For example, we have a collaboration and license agreement with
      Celladon which may be terminated at will by Celladon subject to a notice
      provision in the agreement. We expect Celladon to provide us with funding to
      reimburse research and development and manufacturing expenses that we incur
      in
      connection with the collaboration.





***A
      decline in our stock price or decline in our shareholders’ equity could cause
      our common stock to be delisted from the NASDAQ Capital Market and the liquidity
      and the market price of our common stock to
      decline.***





Our
      stock is listed on the NASDAQ Capital Market. In order to continue to be listed
      on the NASDAQ Capital Market, we must meet specific quantitative standards,
      including maintaining a minimum bid price of $1.00 for our common stock. On
      May
      31, 2005, we received a notice from the NASDAQ Stock Market informing us that
      for 30 consecutive business days the bid price of our common stock had closed
      below the minimum $1.00 per share requirement for continued inclusion under
      Marketplace Rule 4310(c)(4). The letter stated that under Marketplace Rule
      4310(c)(8)(d), we were provided with 180 calendar days, or until November 28,
      2005, to regain compliance with Marketplace Rule 4310(c)(4). As of November
      28,
      2005, we had not regained compliance with Market place Rule 4310(c). However,
      since we met all of the NASDAQ Stock Market’s criteria set forth in Marketplace
      Rule 4310(c), except for the bid price requirement, the NASDAQ provided us
      with
      an additional 180 calendar day compliance period, or until May 26, 2006, to
      demonstrate full compliance and maintain our listing on the NASDAQ Capital
      Market.






19





On May 8, 2006, our board of directors approved an amendment to our
      articles of incorporation to reduce our number of authorized shares of common
      stock from 180,000,000 to 18,000,000 and also approved a one-for-ten reverse
      stock split of our common stock. The reverse stock split was effective with
      respect to shareholders of record at the close of trading on May 10, 2006,
      and
      our common stock began trading on a split-adjusted basis on May 11, 2006.
      On May 25, 2006, we received notification from the Nasdaq Listing Qualifications
      Staff that we had regained compliance with Marketplace Rule 4310(c)(4) and
      that the Staff would give this matter no further consideration. There can be
      no
      assurance that we will continue to meet the $1.00 minimum bid requirement.




As
        of
        September 30, 2006, our shareholders’ equity was $1.5 million. The
        minimum continued listing requirement for the Nasdaq Capital Market is
        $2.5 million. We have incurred significant net losses since our inception
        and may incur additional losses in the future. When a company’s shareholders’
equity decreases below $2.5 million, they will be notified by the Nasdaq
        Listing Qualifications Department that they are not in compliance with the
        minimum $2.5 million shareholders’ equity requirement of Nasdaq Marketplace
        Rule 4320(e)(2). On November 7, 2006, we and Biogen Idec entered into an
        agreement to settle a portion of our remaining outstanding debt to Biogen
        Idec.
        As a result of this transaction we expect our shareholders’ equity will increase
        by approximately $5.5 million. Notwithstanding
        the restructuring of our debt to Biogen Idec, we may receive a letter from
        Nasdaq notifying us that we were not in compliance with Nasdaq Marketplace
        Rule
        4320(e)(2) at September 30, 2006 and Nasdaq may institute delisting
        proceedings.


If
      we
      were delisted from the NASDAQ Capital Market, trading, if any, in our shares
      may
      continue to be conducted on the OTC Bulletin Board or in a non-NASDAQ
      over-the-counter market, such as the “pink sheets.” Delisting of our shares
      would result in limited release of the market price of those shares and limited
      analyst coverage and could restrict investors’ interest in our securities. Also,
      a delisting could have a material adverse effect on the trading market and
      prices for our shares and our ability to issue additional securities or to
      secure additional financing. In addition, if our shares were not listed and
      the
      trading price of our shares was less than $5 per share, our shares could be
      subject to Rule 15g-9 under the Securities Exchange Act of 1934 which, among
      other things, requires that broker/dealers satisfy special sales practice
      requirements, including making individualized written suitability determinations
      and receiving a purchaser’s written consent prior to any transaction. In such
      case, our securities could also be deemed to be a “penny stock” under the
      Securities Enforcement and Penny Stock Reform Act of 1990, which would require
      additional disclosure in connection with trades in those shares, including
      the
      delivery of a disclosure schedule explaining the nature and risks of the penny
      stock market. Such requirements could severely limit the liquidity of our
      securities.





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




Certain
      of our loan agreements contain financial covenants establishing limits on our
      ability to declare or pay cash dividends.




**Item
      3.    Defaults Upon Senior Securities**




None.




**Item
      4.    Submission of Matters to a Vote of Security Holders**




None.




**Item
      5.    Other Information**




None.




**Item
      6.    Exhibits**




See the Index to Exhibits included in this quarterly report.







20







**SIGNATURES**




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




TARGETEDGENETICSCORPORATIONDate: 
              November 9, 2006
            By:
            /s/                                        
              H. STEWART PARKER**H. Stewart Parker,**
              **President, Chief Executive Officer and Director**
              **(Principal
                Executive Officer)**




Date: 
                November 9, 2006
              By:
              /s/                                          
                DAVID J. POSTON**David J. Poston,**
                **Vice President and Chief Financial
                  Officer**
                ****(Principal
                  Financial and Accounting
                  Officer)****
   21







**INDEX
      TO EXHIBITS**










**Incorporated
                by Reference****Exhibit No.**
            
            **Exhibit
                Description**
            
            **Form**
            
            **Date**
            
            **Number**
            
            **Filed
                Herewith**3.1
            
            Amended
              and Restated Articles of Incorporation
            
            
            8-K
            
            
            05/26/2005
            
            
            3.13.2
            
            Amended
              and Restated Bylaws
            10-K
            
            
            12/31/1996
            
            
            3.210.1
            
            Change
              of Control Agreement dated September 14, 2006 between Targeted Genetics
              Corporation and David J. Poston
            
            
            8-K
            
            
            9/14/2006
            
            
            10.110.2
            
            Amendment
              No. 3 to Funding Agreement dated November 7, 2006 between Targeted
              Genetics Corporation and Biogen Idec MA Inc.
            
            
            8-K
            
            
            11/7/2006
            
            
            10.110.3
            
            Amended
              and Restated Promissory Note issued by Targeted Genetics Corporation
              to
              Biogen Idec MA Inc. dated November 7, 2006
            
            
            8-K
            
            
            11/7/2006
            
            
            10.231.1
            
            Certification
              of Chief Executive Officer pursuant to Rules 13a-15(e) and 15d-15(e)
              under
              the Securities Exchange Act of 1934, as amended
            
            
            
            
            
            
            
            
            
            
            
            X31.2
            
            Certification
              of Chief Financial Officer pursuant to Rules 13a-15(e) and 15d-15(e)
              under
              the Securities Exchange Act of 1934, as amended
            
            
            
            
            
            
            
            
            
            
            
            X32.1
            
            Certification
              of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted
              pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
            
            
            
            
            
            
            
            
            
            
            
            X32.2
            
            Certification
              of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted
              pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
            
            
            
            
            
            
            
            
            
            
            
            X








22