**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

**Form 10-Q**

 
| **(Mark One)**                                                                                                                  |
|---------------------------------------------------------------------------------------------------------------------------------|
| **ý**                                                                                                                      | **QUARTERLY  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES  EXCHANGE ACT OF 1934** |
| ** **                                                                                                                      | ** ** |
| **FOR THE QUARTERLY PERIOD ENDED MARCH 29,  2006**                                                                              |
| ** **                                                                                                                      |
| **OR**                                                                                                                          |
| ** **                                                                                                                      |
| **o**                                                                                                                           | **TRANSITION  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES  EXCHANGE ACT OF 1934** |
| ** **                                                                                                                      | ** ** |
| **FOR THE TRANSITION PERIOD  FROM               TO** |

 

**Commission File Number 0-24320**

 

**TAPESTRYPHARMACEUTICALS, INC.**

(Exact name of Registrant as specified in itscharter)

 
| **Delaware**                                                    | ** ** | **84-1187753**                        |
|-----------------------------------------------------------------|------------|---------------------------------------|
| (State or other jurisdiction of  incorporation or organization) |       | (I.R.S. Employer  Identification No.) |

 

**4840 Pearl East Circle, Suite 300WBoulder, Colorado 80301**(Address of principal executive office, including zipcode)

 

**(303) 516-8500**

(Registrant’s telephone number, includingarea code)

 

Indicate by check mark whether the registrant (1) has filed allreports required to be filed by Section 13 or 15(d) ofthe Securities Exchange Act of 1934 during the preceding 12 months (or forsuch shorter period that the registrant was required to file such reports), and(2) has been subject to such filing requirements for the past90 days. Yes ý  No o

 

Indicate by check mark whether the registrant is a large acceleratedfiler, an accelerated filer, or a non-accelerated filer.  See definition of “accelerated filer andlarge accelerated filer” in Rule 12b-2 of the Exchange Act. (Checkone):   Large accelerated filer o Accelerated Filer o   Non-accelerated filer ý

 

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

 

As of May 5, 2006, the registrant had 16,231,918 shares of commonstock, $0.0075 par value, outstanding.

 

 

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**Tapestry Pharmaceuticals, Inc. andSubsidiaries**

**Table of Contents**

 
| **Part I**  | **Financial  Information** |                                                                                        |
|------------------|----------------------------|---------------------------------------------------------------------------------------------|
| ** **       | ** **                 |                                                                                        |
|             | Item 1                     | Unaudited Financial Statements                                                              |   |
|             |                       |                                                                                        |   |
|             | Item 2                     | Management’s  Discussion and Analysis of Financial Condition and Results of Operations |   |
|             |                       |                                                                                        |   |
|             | Item 3                     | Quantitative and Qualitative Disclosures  about Market Risk                                 |   |
|             |                       |                                                                                        |   |
|             | Item 4                     | Controls and Procedures                                                                     |   |
|             |                       |                                                                                        |   |
| **Part II** | **Other  Information**     |                                                                                        |
| ** **       | ** **                 |                                                                                        |
|             | Item 1                     | Legal Proceedings                                                                           |   |
|             |                       |                                                                                        |   |
|             | Item 1A                    | Risk Factors                                                                                |   |
|             |                       |                                                                                        |   |
|             | Item 2                     | Unregistered Sales of Equity Securities and  Use of Proceeds                                |   |
|             |                       |                                                                                        |   |
|             | Item 3                     | Defaults upon Senior Securities                                                             |   |
|             |                       |                                                                                        |   |
|             | Item 4                     | Submission of Matters to a Vote of Security Holders                                         |   |
|             |                       |                                                                                        |   |
|             | Item 5                     | Other Information                                                                           |   |
|             |                       |                                                                                        |   |
|             | Item  6                    | Exhibits                                                                                    |   |
|             |                       |                                                                                        |   |
| **Signatures**   |                       |

 

2

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**Part I**

**FINANCIAL INFORMATION**

 

**Item1.  Financial Statements**

 

**Tapestry Pharmaceuticals, Inc. andSubsidiaries**

**Consolidated Balance Sheets**

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

(Unaudited)

 
| ** **                                                                                                                                                                                      | ** ** | **March 29,  2006** | ** ** | **December 28,  2005** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------|------------|-----------------------------|------------|
| ** **                                                                                                                                                                                      | ** ** | ** **          | ** ** | ** **                  | ** ** |
| **ASSETS**                                                                                                                                                                                      | ** ** | ** **          | ** ** | ** **                  | ** ** |
| Current  assets:                                                                                                                                                                                |       |                |       |                        |       |
| Cash and cash equivalents                                                                                                                                                                       |       | $                   | 395        |                        | $          | 534 |   |
| Short-term investments                                                                                                                                                                          |       | 10,250              |       | 13,552                      |       |
| Prepaid expense and other current assets                                                                                                                                                        |       | 927                 |       | 646                         |       |
| Total  current assets                                                                                                                                                                           |       | 11,572              |       | 14,732                      |       |
|                                                                                                                                                                                            |       |                |       |                        |       |
| Property,  plant and equipment, net                                                                                                                                                             |       | 550                 |       | 608                         |       |
| Investment  in ChromaDex, Inc.                                                                                                                                                             |       | 451                 |       | 451                         |       |
| Other assets                                                                                                                                                                                    |       | 682                 |       | 683                         |       |
| Total assets                                                                                                                                                                                    |       | $                   | 13,255     |                        | $          | 16,474 |   |
|                                                                                                                                                                                            |       |                |       |                        |       |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                                                   | ** ** | ** **          | ** ** | ** **                  | ** ** |
| Current  liabilities:                                                                                                                                                                           |       |                |       |                        |       |
| Accounts payable and accrued liabilities                                                                                                                                                        |       | $                   | 1,284      |                        | $          | 1,024 |   |
| Accrued payroll and payroll taxes                                                                                                                                                               |       | 1,781               |       | 1,241                       |       |
| Notes payable — current portion, net                                                                                                                                                       |       | 989                 |       | 840                         |       |
| Total  current liabilities                                                                                                                                                                      |       | 4,054               |       | 3,105                       |       |
|                                                                                                                                                                                            |       |                |       |                        |       |
| Notes  payable — long term, net                                                                                                                                                            |       | 2,131               |       | 2,483                       |       |
|                                                                                                                                                                                            |       |                |       |                        |       |
| Commitments  and contingencies                                                                                                                                                                  |       |                |       |                        |       |
|                                                                                                                                                                                            |       |                |       |                        |       |
| Stockholders’  equity:                                                                                                                                                                     |       |                |       |                        |       |
| Preferred stock, $.001 par value; 2,000,000  shares authorized; none issued                                                                                                                     |       | —              |       | —                      |       |
| Common stock, $.0075 par value; 100,000,000  shares authorized; 3,485,433 and 3,840,704 shares issued and outstanding at  March 29, 2006 and December 28, 2005, respectively (See Note 13) |       | 26                  |       | 26                          |       |
| Additional paid-in capital                                                                                                                                                                      |       | 118,787             |       | 118,278                     |       |
| Deferred compensation                                                                                                                                                                           |       | (81                 | )          | (114                        | )          |
| Accumulated deficit                                                                                                                                                                             |       | (111,653            | )          | (107,262                    | )          |
| Accumulated other comprehensive loss                                                                                                                                                            |       | —              |       | (42                         | )          |
| Treasury stock, 2,440 shares at cost at  March 29, 2006                                                                                                                                         |       | (9                  | )          | —                      |       |
| Total  stockholders’ equity                                                                                                                                                                |       | 7,070               |       | 10,886                      |       |
| Total  liabilities and stockholders’ equity                                                                                                                                                |       | $                   | 13,255     |                        | $          | 16,474 |   |

 

See accompanying notes to ConsolidatedFinancial Statements.

 

3

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**Tapestry Pharmaceuticals, Inc. andSubsidiaries**

**Consolidated Statements of Operations**

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

**(Unaudited)**

 
| ** **                                                     | ** ** | **Quarter  Ended**       | ** ** |
|----------------------------------------------------------------|------------|--------------------------|------------|
| ** **                                                     | ** ** | **March 29,  2006** | ** ** | **March 30,  2005** | ** ** |
|                                                           |       |                     |       |   |   |
| Operating expenses:                                            |       |                     |       |   |   |
| Research and development                                       |       | $                        | 2,814      |   | $ | 2,789 |   |
| General and administrative                                     |       | 1,457                    |       | 1,597 |   |
| Operating loss                                                 |       | 4,271                    |       | 4,386 |   |
|                                                           |       |                     |       |   |   |
| Other income (expense):                                        |       |                     |       |   |   |
| Interest and other income                                      |       | 141                      |       | 170 |   |
| Interest and other expense                                     |       | (173                     | )          | (167 | ) |
| Net loss from continuing operations                            |       | (4,303                   | )          | (4,383 | ) |
|                                                           |       |                     |       |   |   |
| Discontinued operations:                                       |       |                     |       |   |   |
| Loss from discontinued operations                              |       | (88)                     |       | (181 | ) |
|                                                           |       |                     |       |   |   |
| Net loss                                                       |       | $                        | (4,391     | ) | $ | (4,564 | ) |
|                                                           |       |                     |       |   |   |
| Basic and diluted loss per share from  continuing operations   |       | $                        | (1.23      | ) | $ | (1.31 | ) |
| Basic and diluted loss per share from  discontinued operations |       | $                        | (0.03      | ) | $ | (0.05 | ) |
| Basic and diluted loss per share                               |       | $                        | (1.26      | ) | $ | (1.36 | ) |
|                                                           |       |                     |       |   |   |
| Basic and diluted weighted average shares  outstanding         |       | 3,485                    |       | 3,346 |   |

 

Operating expenses include stock based compensation expense of $477,000and $26,000 for the three months ended March 29, 2006 and March 30, 2005,respectively.  Included in loss fromdiscontinued operations is $86,000 and $4 of stock based compensation for thethree months ended March 29, 2006 and March 30, 2005, respectively.  There was no stock based compensation expenserelated to employee stock options under SFAS 123(R) in the first quarter of2005 because the Company had not adopted the recognition provisions of SFAS 123(R)at that time.  See Note 13 to theConsolidated Financial Statements for additional information.

 

See accompanying notes to ConsolidatedFinancial Statements.

 

4

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**Tapestry Pharmaceuticals, Inc. andSubsidiaries**

**Consolidated Statements of Cash Flows**

**(In thousands)**

**(Unaudited)**

 
| ** **                                                                   | ** ** | **Quarter  Ended**       | ** ** |
|------------------------------------------------------------------------------|------------|--------------------------|------------|
| ** **                                                                   | ** ** | **March 29,  2006** | ** ** | **March 30,  2005** | ** ** |
| Operating activities:                                                        |       |                     |       |   |   |
| Net loss                                                                     |       | $                        | (4,391     | ) | $ | (4,564 | ) |
| Adjustments to reconcile net loss to net  cash used in operating activities: |       |                     |       |   |   |
| Depreciation and amortization                                                |       | 57                       |       | 69 |   |
| Amortization of debt issue cost                                              |       | —                   |       | 92 |   |
| Amortization of debt discount                                                |       | 136                      |       | 70 |   |
| Amortization of investment premium                                           |       | 6                        |       | 88 |   |
| Compensation paid with common stock and  options                             |       | 605                      |       | 30 |   |
| (Gain)/loss on sale of investments                                           |       | 38                       |       | — |   |
| Changes in operating assets and  liabilities:                                |       |                     |       |   |   |
| Prepaid expense and other assets                                             |       | (281                     | )          | (47 | ) |
| Accounts payable and accrued liabilities                                     |       | 188                      |       | (1,176 | ) |
| Accrued payroll and payroll taxes                                            |       | 540                      |       | (1,035 | ) |
| Net cash used in operating activities                                        |       | (3,102                   | )          | (6,473 | ) |
|                                                                         |       |                     |       |   |   |
| Investing activities:                                                        |       |                     |       |   |   |
| Additions to property and equipment                                          |       | —                   |       | (63 | ) |
| Purchases of investment                                                      |       | (5,450                   | )          | (6,400 | ) |
| Proceeds from sale of investments                                            |       | 8,750                    |       | 14,975 |   |
| Net cash provided by investing activities                                    |       | 3,300                    |       | 8,512 |   |
|                                                                         |       |                     |       |   |   |
| Financing activities:                                                        |       |                     |       |   |   |
| Payments of notes payable                                                    |       | (337                     | )          | (3,158 | ) |
| Proceeds from the exercise of common stock  options                          |       | —                   |       | 31 |   |
| Net cash used in financing activities                                        |       | (337                     | )          | (3,127 | ) |
| Net decrease in cash and cash equivalents                                    |       | (139                     | )          | (1,088 | ) |
| Cash and cash equivalents at beginning of  period                            |       | 534                      |       | 1,713 |   |
| Cash and cash equivalents at end of period                                   |       | $                        | 395        |   | $ | 625 |   |
|                                                                         |       |                     |       |   |   |
| Supplemental disclosure of cash flow  information:                           |       |                     |       |   |   |   |
|                                                                         |       |                     |       |   |   |
| Interest paid                                                                |       | $                        | —     |   | $ | 135 |   |
|                                                                              |            |                          |            |  |  |  |  |  |

 

See accompanying notes to ConsolidatedFinancial Statements.

 

5

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**Tapestry Pharmaceuticals, Inc.**

**Notes to Consolidated Financial Statements**

**March29, 2006**

**(Unaudited)**

 

**Note 1.  Basisof Presentation and Summary of Significant Accounting Policies**

 

In the opinion of management, the accompanying unaudited consolidatedbalance sheets, statements of operations and cash flows contain alladjustments, consisting of only normal, recurring adjustments necessary topresent fairly the financial position of Tapestry Pharmaceuticals, Inc. and itswholly owned subsidiaries (the “Company”) at March 29, 2006 and December 28,2005, the results of its operations for the three month periods ended March 29,2006 and March 30, 2005, and cash flows for the three month periods ended March29, 2006 and March 30, 2005.

 

The unauditedconsolidated financial statements presented herein have been prepared inaccordance with the instructions to Form 10-Q and do not include all theinformation and note disclosures required by accounting principles generallyaccepted in the United States.  Theconsolidated financial statements should be read in conjunction with theaudited consolidated financial statements and notes thereto contained in theCompany’s Annual Report on Form 10-K for the year ended December 28, 2005, filedwith the Securities and Exchange Commission on February 23, 2006 as well asForm 10-K/A filed on March 31, 2006.

 

*LIQUIDITY* – The Company has no revenue and hasincurred a loss of approximately $4.4 million for the three month period endedMarch 29, 2006 and a loss of approximately $17.5 million for the year endedDecember 28, 2005 and has an accumulated deficit of $111.7 million as of March29, 2006.  The Company’s capitalrequirements for research and development, including the cost of clinicaltrials, have been and will continue to be significant.  

 

Asof December 28, 2005, the Company had cash and short-term investments totaling approximately$14.1 million.  These factors, as ofDecember 28, 2005, raised substantial doubt, which has since been dealt with,as discussed below, about the Company’s ability to continue as a goingconcern.  As a result of these concernsthe audit report prepared by the Company’s independent registered publicaccounting firm relating to the Company’s consolidated financial statements forthe year ended December 28, 2005 includes an explanatory paragraphexpressing the substantial doubt about the Company’s ability to continue as agoing concern.

 

TheCompany has taken a number of actions to reduce its monthly cash requirements,including, among other things, reductions in workforce and related facilitiesand payroll costs, reductions in the growth of executive compensation,reductions in facility costs, reductions in the number of active programs indevelopment, reductions in capital expenditures and reductions in charges fromoutside service providers. After implementing these and other cost savingsmeasures and further determining that the Company’s lead pharmaceutical programwarranted expanded clinical development, the Company determined that it shouldseek the additional capital necessary to fund its ongoing operations related toits lead pharmaceutical program.

 

OnApril 6, 2006, the Company sold an aggregate of 12,750,000 shares of its commonstock, and related warrants to purchase up to an aggregate of 12,750,000 sharesof its common stock for gross proceeds of $25.5 million not including anyproceeds from the exercise of the warrants (or approximately $24 million net oftransaction fees and expenses).  As partof the financing, the Company agreed to a covenant that the net proceeds fromthe transaction be used solely to fund the development of its leading productcandidate, TPI 287, in accordance with an approved budget for fiscal years 2006and 2007.  The Company may call up to 20%of the outstanding warrants during any three month period if certain conditionsare satisfied, including the trading price of the Company’s common stockexceeding $4.80 for 20 consecutive trading days.  Up to half of the warrants may be exercisedon a cashless or net exercise basis.  Therecan be no assurance, however, that the Company will receive funds from theexercise of warrants.  See Note 13 forfurther discussion.

 

Followingclosing the above transaction, as of April 6, 2006 the Company had cash andshort-term investments of approximately $34.6 million and working capital ofapproximately $31.5 million.  The Companybelieves it has sufficient capital to fund its operations and capitalexpenditures for more than the next 12 months. However, pharmaceutical development is costly, risky and time intensiveactivity.  To bring the Company’s variousprograms to completion will require the Company to raise additional capital aspracticable to fund future operations and to provide additional workingcapital.  There can be no assurance thatthe Company will be able to obtain additional capital on terms that will beacceptable to the Company or on any terms. In addition, the Company may seek to acquire new product or technologiesthrough in-

 

6

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licensing,purchase or merger.  The cost and relatedcapital expenditures of acquiring and developing such resources may besignificant, and the Company may not be able to obtain capital for thedevelopment of these products or technologies.

 

*ESTIMATES AND ASSUMPTIONS -*The preparation ofthe Company’s consolidated financial statements in conformity with accountingprinciples generally accepted in the United States requires the Company’smanagement to make estimates and assumptions that affect the reported amountsof assets and liabilities, and disclosure of contingent assets and liabilitiesat the date of the financial statements and the reported amounts of revenue andexpenses during the reporting period. Significant estimates are used when determining useful lives fordepreciation and amortization, assessing the need for impairment charges,accounting for income taxes, estimating the value of employee stock options, andvarious others items.  The Companyevaluates these estimates and judgments on an ongoing basis and bases itsestimates on historical experience, current conditions and various otherassumptions that are believed to be reasonable under the circumstances.  The results of these estimates form the basisfor making judgments about the carrying values of assets and liabilities aswell as identifying and assessing the accounting treatment with respect tocommitments and contingencies.  Actualresults may differ from these estimates under different assumptions orconditions.

 

*SHARE BASED COMPENSATION***-**Asof March 29, 2006, the Company had four equity incentive plans (the “Plans”),the 1994 Long-Term Performance Incentive Plan, the 1998 Stock Incentive Plan,the 2004 Equity Incentive Plan and the 2004 Non-Employee Director’s StockOption Plan.  As further discussed inNote 13, on April 4, 2006 the shareholders approved the 2006 Equity IncentivePlan.

 

On December 29, 2005, the Company adopted Statement of FinancialAccounting Standards No. 123 (revised 2004), *Share-BasedPayment*, (“SFAS 123(R)”) which requires the measurement andrecognition of compensation expense for all share-based payment awards made toemployees and directors including employee stock based on estimated fair values.  SFAS 123(R) supersedes the Company’s previousaccounting under Accounting Principles Board Opinion No. 25, *Accounting for Stock Issued to Employees* (“APB 25”) forperiods beginning in fiscal 2006.  Underthe provisions of APB 25 and its related interpretations, no compensation expensewas recognized with respect to purchases of the Company’s common stock whenstock options were granted with exercise prices equal to or greater than marketvalue on the date of grant.

 

The Company adopted SFAS 123(R) using the modified prospective transitionmethod, which requires the application of the accounting standard as ofDecember 29, 2005, the first day of the Company’s fiscal year 2006.  The Company’s Consolidated FinancialStatements as of and for the three months ended March 29, 2006 reflect theimpact of SFAS 123(R).  In accordancewith the modified prospective transition method, the Company’s ConsolidatedFinancial Statements for prior periods have not been restated to reflect, anddo not include, the impact of SFAS 123(R). Stock-based compensation expense recognized under SFAS 123(R) for thethree months ended March 29, 2006 was $477,000 or $.14 basic and diluted loss pershare from continuing operations, and $86,000 or $.02 basic and diluted lossper share from discontinued operations.  Thestock-based compensation expense is calculated on a straight-line basis overthe vesting periods of the related options. This charge had no impact on theCompany’s reported cash flows.  

 

For the three-month period ended March 30, 2005, the Company recordedapproximately $30,000 of stock compensation expense pursuant to APB 25associated with the amortization of deferred stock compensation related to thevesting of stock options that were granted to consultants for services renderedto the Company.  The breakdown of totalstock-based compensation by expense category is as follows (in thousands).

 
| ** **                 | ** ** | **Three  Months Ended,** | ** ** |
|----------------------------|------------|--------------------------|------------|
| ** **                 | ** ** | **March  29,  2006**     |       | **March  30,  2005** | ** ** |
|                       |       |                     |       |   |   |
| Research and development   |       | $                        | 242        |   | $ | 26 |   |
| General and administrative |       | 235                      | ** ** | — | ** ** |
| Discontinued operations    |       | 86                       |       | 4 |   |
| Total                      |       | $                        | 563        |   | $ | 30 |   |

 

7

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Under the modified prospective method of transition under SFAS 123(R),the Company is not required to restate its prior period financial statements toreflect expensing of share-based compensation under SFAS 123(R).  Therefore, the results as of March 29, 2006are not directly comparable to the same period in the prior year.  

 

As required by SFAS 123(R), the Company has presented pro forma disclosuresof its net loss and net loss per share for the prior year period assuming theestimated fair value of the options granted prior to December 29, 2005 isamortized to expense over the option-vesting period as illustrated below (inthousands).

 
| ** **                                                                                                               | ** ** | **Three  Months  Ended  March 30, 2005** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------|------------|
|                                                                                                                     |       |                                          |       |
| Net loss, as reported                                                                                                    |       | $                                             | (4,564     | ) |
| Add: Stock-based employee compensation expense included in reported  net loss                                            |       | 30                                            |       |
|                                                                                                                     |       |                                          |       |
| Less: Total stock-based employee compensation expense determined  under fair value based methods for all options granted |       | (759                                          | )          |
| Pro forma net loss                                                                                                       |       | $                                             | (5,293     | ) |
|                                                                                                                     |       |                                          |       |
| Net loss per share:                                                                                                      |       |                                          |       |
| Basic and diluted - as reported                                                                                          |       | $                                             | (1.36      | ) |
| Basic and diluted – pro forma                                                                                       |       | $                                             | (1.58      | ) |

 

For purposes of the disclosure in the foregoing table and for purposesof determining estimated fair value under SFAS 123(R), the Company has computedthe estimated fair values of all share-based compensation using theBlack-Scholes option pricing model and has applied the assumptions set forth inthe following table.  There were nooption grants during the first quarter of fiscal 2006.  The Company calculated the estimated life ofstock options granted prior to fiscal 2006 based on the average life of theoption estimated by reference to the historical average lives of options issuedby the Company since its initial public offering in 1994.  The risk free rate of return and thehistorical volatility were also based on the average life of the optionestimated by reference to the historical average lives of options issued by theCompany since inception.  As SFAS 123(R)requires that stock-based compensation expense be based on awards that areultimately expected to vest, stock-based compensation for the three monthperiod ended March 29, 2006 has been reduced for estimated forfeitures.  When estimating forfeitures, the Companytakes into consideration both voluntary and involuntary terminations, as wellas trends of actual option forfeitures.  Priorto fiscal 2006, the Company accounted for forfeitures as they occurred.

 
| ** **       | ** ** | **Risk-Free    Interest Rate** | ** ** | **Dividend    Yield** | ** ** | **Volatility    Factor** | ** ** | **Weighted-  Average  Option  Life (Years)** | ** ** |
|------------------|------------|--------------------------------|------------|-----------------------|------------|--------------------------|------------|----------------------------------------------|------------|
| Fiscal Year 2005 |       | 3.58% - 4.27%                  |       | 0%                    |       | 113.17% - 123.33%        |       | 5                                            |       |

 

The Black-Scholes option-pricing model requires the input of highly subjectiveassumptions.  Because the Company’semployee stock options have characteristics significantly different from thoseof traded options, and because changes in the subjective input assumptions canmaterially affect the fair value estimate, in management’s opinion, theexisting models may not provide a reliable single measure of the fair value ofstock options granted.  Management willcontinue to assess the assumptions and methodologies used to calculateestimated fair value of share-based compensation. Circumstances may change andadditional data may become available over time, which result in changes tothese assumptions and methodologies, which could materially impact the Company’sfair value determination.

 

A summary of option activity under the Plans as of March 29, 2006, andchanges during the three-month period then ended is presented below.

 

8

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**Summary Details for Plan Share Options**

 
| ** **                              | ** ** | **Number  of  Options** | ** ** | **Weighted-  Average  Exercise  Price** | ** ** | **Weighted-  Average  Remaining  Contractual  Life (Years)** | ** ** | **Aggregate  Intrinsic  Value** | ** ** |
|-----------------------------------------|------------|-------------------------|------------|-----------------------------------------|------------|--------------------------------------------------------------|------------|---------------------------------|------------|
| ** **                              | ** ** | ** **              | ** ** | ** **                              | ** ** | ** **                                                   | ** ** | **(in  thousands)**             | ** ** |
| Outstanding Balance, December 29, 2005  |       | 724,802                 |       | $                                       | 36.70      | ** **                                                   | **—** | ** **                      | **—** | ** ** |
| Granted                                 |       | —                  |       | —                                  | ** ** | **—**                                                   | ** ** | **—**                      | ** ** |
| Exercised                               |       | —                  |       | —                                  | ** ** | **—**                                                   | ** ** | **—**                      | ** ** |
| Forfeited                               |       | (26,798                 | )          | $                                       | 20.10      | ** **                                                   | **—** | ** **                      | **—** | ** ** |
| Outstanding Balance, March 29, 2006     |       | 698,004                 |       | $                                       | 37.17      |                                                         | 5.07       |                            | $          | 2,684 |   |
|                                    |       |                    |       |                                    |       |                                                         |       |                            |       |
| Exercisable shares as of March 29, 2006 |       | 425,581                 |       | $                                       | 34.76      |                                                         | 3.92       |                            | $          | 1,150 |   |
|                                         |            |                         |            |                                         |            |                                                              |            |                                 |            |  |  |  |

 

A summary of the status of the Company unvested shares as of March 29,2006, and changes during the three-month period then ended is presented below.

 

**Unvested Shares Issued Under the Plan**

 
| ** **                          | ** ** | **Unvested  Shares** | ** ** | **Weighted-  Average  Grant-Date  Fair Value** | ** ** |
|-------------------------------------|------------|----------------------|------------|------------------------------------------------|------------|
| Unvested Balance, December 29, 2005 |       | 286,268              |       | $                                              | 32.15      |   |
| Granted                             |       | —               |       | —                                         |       |
| Vested                              |       | (7,219               | )          | 8.34                                           |       |
| Forfeited                           |       | (6,626               | )          | 12.09                                          |       |
| Unvested Balance, March 29, 2006    |       | 272,423              |       | 33.19                                          |       |
|                                     |            |                      |            |                                                |            |  |

 

As of March 29, 2006, there was $1.2 million of total unrecognizedcompensation expense related to unvested share-based compensation arrangementsgranted under the Plans.  Prior to thegrant modifications outlined in Note 13, this expense would have been expectedto be recognized over a weighted-average period of 4****years.  

 

As described in Note 13, modifications have been made to the optionsoutstanding at March 29, 2006 and options on a substantial number of additionalshares have been granted.  As a result ofthese modifications and new options granted, the amount of future expenserecognized and the period over which it will be recognized will make thestock-based compensation expense in future quarters not directly comparable tothat recorded in the first quarter of 2006. In addition, in the second quarter of fiscal 2006, the Company willrecord a non-cash fixed period charge related to the modified vested options. 

 

9

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*RECENT ACCOUNTING PRONOUNCEMENTS* - OnJune 9, 2005, the FASB issued SFAS No. 154, *AccountingChanges and Error Corrections*. SFAS No. 154 replaces APB Opinion No. 20, *AccountingChanges*, and SFAS No. 3, *Reporting AccountingChanges in Interim Financial Statements*, and changes therequirements for the accounting for and reporting of a change in accountingprinciple.  SFAS No. 154 applies to allvoluntary changes in accounting principle. It also applies to changes required by an accounting pronouncement inthe unusual instance that the pronouncement does not include specifictransition provisions.  SFAS No. 154 mustbe adopted for accounting changes and corrections of errors made in fiscalyears beginning after December 15, 2005. Early adoption is permitted for accounting changes and corrections oferrors made in fiscal years beginning after the date SFAS No. 154 is issued.  The adoption of SFAS No. 154 did not have amaterial impact on the Company’s financial results.

 

# **Note 2**.  Reverse Stock Split and NasdaqListing

 

The Company implemented a one-for-ten reverse split of its common stockeffective for trading on February 6, 2006, and all share and per shareamounts for all periods presented have been restated to reflect this reversestock split.   The Company’s common stockis listed on the Nasdaq Capital Market.  Inorder to maintain that listing, the Company must satisfy minimum financial andother requirements.  On February 25,2005, we received notice from the Nasdaq Stock Market, Inc. (the “Nasdaq”)that the minimum bid price of the Company’s common stock had fallen below $1.00per share for 30 consecutive business days and such common stock was,therefore, subject to delisting from the Nasdaq Capital Market.  As a result of the one-for-ten reverse split,the minimum bid price of our common stock increased and on February 24, 2006the Company received notice from the Nasdaq that the Company regainedcompliance with the minimum bid price requirement. 

 

# **Note 3.  Discontinued Operations**

 

In December 2003, the Company made a decision to sell its geneisolation and service business, which was acquired in December 2002.  As a result of this decision, the Company shutdown a majority of the operations as well as sold a majority of the assetsrelated to this business.   

 

In November 2004 the Company discontinued research on itsremaining genomics programs, other than the Huntington’s Disease program, andsought a buyer for these programs.  Afterefforts to sell the intellectual property assets related to the genomicsprograms over the course of the fourth quarter of 2004, the Company determinedthat there were no actively interested buyers. In the fourth quarter of 2004, the Company recorded a charge of $1.7million primarily relating to an impairment of intangible assets acquired inconnection with the December 2002 acquisition of the genomics business ofPangene Corporation ($1.1 million), a charge for fixed assets likely to be disposedof at less than their book value ($150,000), severance costs ($250,000) andlease termination costs ($200,000). Additional expenses related to the closure were charged to discontinuedoperations as incurred.  Most costsrelating to the closure were incurred by the end of January 2005, althoughcertain lease costs continued through May 2005.  In April 2005, the Company received $104,000for certain fixed assets of the genomics business that were previously reservedfor in the fourth quarter of 2004 and classified as Assets Held for Sale.

 

Net losses related to the Genomics Division that are included indiscontinued operations totaled $88,000 and $181,000 for the quarters endedMarch 29, 2006 and March 30, 2005, respectively.  No material revenue has been recognized inthis division.  There were no assets heldfor sale, at March 29, 2006 and December 28, 2005, which relate to thediscontinued operations of the genomics business. 

 

# **Note 4.  Investments**

 

Short-term investments consisted of investment grade commercial paperdue within one year.  The Company’sinvestments in auction rate securities are recorded at cost, which approximatesfair market value.  In accordance withARB 43, *Restatement and Revision of Accounting ResearchBulletins*, despite the long-term nature of their stated contractualmaturities, the Company has the ability and intent to liquidate investments inauction rate securities within six months and therefore has classified theseinvestments as short-term.  Allinvestments are classified as available-for-sale and are recorded at marketvalue.  Unrealized gains and losses arereflected in other comprehensive net loss.

 

Comprehensive loss for the Company consists of net loss and unrealizedholding gains and losses on available-for-sale investments as presented below(in thousands):

 

10

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| ** **                                               | ** ** | **Quarter  Ended**       | ** ** |
|----------------------------------------------------------|------------|--------------------------|------------|
| ** **                                               | ** ** | **March 29,  2006** | ** ** | **March 30,  2005** | ** ** |
| Net loss, as reported                                    |       | $                        | (4,391     | ) | $ | (4,564 | ) |
| Unrealized gain (loss) on  available-for-sale securities |       | 42                       |       | (14 | ) |
| Comprehensive net loss                                   |       | $                        | (4,349     | ) | $ | (4,578 | ) |

 

**Note 5. Investment in ChromaDex, Inc.**

 

In April 2003, the Company sold its technical and analyticalservices group to privately held ChromaDex, Inc. in exchange forapproximately 15%, on a fully diluted basis, of the then outstanding commonstock of ChromaDex.  ChromaDex is asupplier of phytochemical reference standards for the nutraceutical, dietarysupplement and functional food industries. In the third quarter of fiscal 2005, in accordance with Statement ofFinancial Accounting Standards No. 144 (“SFAS 144”), *Accountingfor the Impairment of Long-Lived Assets*, the Company recognized animpairment charge of $963,000 on the carrying value of its investment inChromaDex to revalue it to an estimated fair value of $451,000 as a result of newlyavailable financial information. 

 

**Note 6. Other Long-Term Assets - Land**

 

As part of the Company’s preparation of its interim financialstatements for the quarter ending June 29, 2005, and in accordance with Statementof Financial Accounting Standards No. 144 (“SFAS 144”), *Accountingfor the Impairment of Long-Lived Assets*, the Company recognized animpairment charge on the carrying value of its land of $104,000 in the secondquarter of fiscal 2005 to revalue it to an estimated fair market value of$614,000.  

 

# **Note 7.  Notes Payable, Current and Long-Term**

 

OnFebruary 18, 2005, the Company entered into an agreement with TL Venturesproviding for a complete settlement of its ongoing litigation with them, amutual release of claims, the payment of approximately $3,184,000 in cash andthe issuance by the Company of promissory notes in an aggregate amount of$4,670,000 in exchange for delivery for cancellation of debentures in theprincipal amount of $8,000,000 that had been issued by the Company.  The notes are payable in monthly installmentsof $110,000 in 2006 and $150,000 in 2007, with a final payment of $1,000,000due on January 31, 2008.  The notesdo not bear interest; however, an imputed interest rate of 18% was used todetermine a fair carrying value of the notes. Accrued interest of approximately $134,000 was included in the cashpayment made as part of the settlement. The Company recorded the obligation resulting from the settlement on itsbalance sheet as of December 29, 2004.

 

# **Note 8.  Stockholders’ Equity**

 

In September 2005, the Company initiated a retention incentive programfor non-executive employees that consisted of a grant of approximately 42,075 sharesof restricted stock under the Company’s equity incentive plans to vest atfuture dates, as well as a cash component related to the individual tax effectsof the program.  The stock component ofthe program includes 19,842 shares to vest on September 6, 2006 and 22,233additional shares to vest on September 6, 2007, contingent upon participantsbeing employed by the Company on those dates. The total value of the common stock component of the program is $151,000based on the value of the underlying common stock at the date of grant.  The cash component related to the tax effectsof the program amounted to $93,000 and was expensed in the third quarter.  During the first quarter of 2006, $24,000 ofexpense related to the program was recognized. The remaining expense associated with the program will be recognizedover the vesting period, through September 2007.

 

As further explained at Note 13 on April 6, 2006, the Company sold,pursuant to a Purchase Agreement dated February 2, 2006, an aggregate of12,750,000 shares of common stock and warrants to purchase up to 12,750,000shares of common stock, for a total of $25.5 million (excluding anyproceeds that might be received upon exercise of the warrants) or approximately$24 million, net of the placement agent fees and other expenses.

 

11

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# **Note 9.  Equity Incentive Plans**

 

As of March 29, 2006, the Company had four equity incentive plans, the1994 Long-Term Performance Incentive Plan, the 1998 Stock Incentive Plan, the2004 Equity Incentive Plan and the 2004 Non-Employee Director’s Stock OptionPlan.  Also as of that date, the totalnumber of common shares authorized for issuance related to grants under theseplans was 1,077,834, of which 697,954 options (excluding 50 options issuedoutside of the above plans) remain outstanding and 246,465 shares remainreserved for future grants.  

 

As of April 4, 2006, options to purchase 626,568 shares of commonstock, having exercise prices ranging from $4.20 to $112.50, were modified to,among other things, reduce their exercise price to $4.02 and amend the vestingprovisions of certain stock options.  Nofurther grants will be awarded under these plans.  In accordance with SFAS 123(R), in the secondquarter of 2006, the Company will record a non-cash fixed period charge relatedto the modified vested options.   SeeNote 13 for further discussion.

 

As further discussed in Note 13, on April 4, 2006 the shareholdersapproved the 2006 Equity Incentive Plan. 

 

# **Note 10.  Reduction in Operations**

# ** **

During the third quarter of 2005, the Company incurred severance costsof $299,000 associated with the elimination of 2 general and administrativeexecutives, 5 other general and administrative employees and 15 research anddevelopment positions (including one consultant). 

 

# **Note 11.  Net Income (Loss) Per Share**

# ** **

Basic earnings (loss) per share is measured as net income or lossdivided by the weighted average outstanding common shares for the period.  Diluted earnings per share is similar tobasic earnings per share but presents the dilutive effect on a per share basisof potential common shares (e.g. stock options, warrants and convertiblesecurities) as if they had been converted at the beginning of the periodspresented.    Potential common sharesthat have an antidilutive effect are excluded from diluted earnings per share(e.g. vested stock options that could be converted representing 400 shares atMarch 29, 2006 and 1,737 shares at March 30, 2005).  Net loss per common share is computed usingthe weighted average number of shares of common stock outstanding.  Going forward, the net loss per share will includethe 12,750,000 shares of common stock sold on April 6, 2006 in the transaction describedin Note 13 and will take into consideration the dilutive effects, if any, ofthe warrants to purchase up to 12,750,000 shares of common stock included inthe same transaction.

 

**Note 12.****      Settlement Agreement**

** **

On March 22, 2006 the Company and Dr. Patricia Pilia entered into aSettlement Agreement (the “Settlement Agreement”) in connection with Dr. Pilia’stermination of employment by the Company without cause on February 23,2006.  Dr. Pilia is a member of the Boardof Directors and previously served as Executive Vice President and Secretary ofthe Company and was previously covered under an employment agreement.  In connection with the Settlement Agreement,the Company recorded an obligation of $646,000 for termination benefits atMarch 29, 2006. 

 

**Note 13.  Subsequent Events**

 

*Private Placement*

* *

On April 6, 2006, the Company sold an aggregate of 12,750,000 shares ofcommon stock and warrants to purchase up to 12,750,000 shares of common stock(the “Private Placement”), for a total of $25.5 million (excluding anyproceeds that might be received upon exercise of the warrants) or approximately$24 million, net of the placement agent fees and other expenses, pursuantto a Purchase Agreement dated February 2, 2006 (the “Purchase Agreement”), byand among the Company and Special Situations Cayman Fund, L.P., SpecialSituations Fund III, L.P., Special Situations Fund III QP, L.P., SpecialSituations Life Sciences Fund, L.P., Special Situations Private Equity Fund,L.P., Tang Capital Partners, LP, Baker Biotech Fund II (Z), L.P., Baker BiotechFund III, L.P., Baker Biotech Fund III (Z), L.P., Baker Bros. Investments II,L.P., 14159, L.P., Biotechnology Value Fund, L.P., Biotechnology Value Fund II,L.P., BVF Investments, L.L.C., Investment 10, L.L.C., Fort Mason Master, L.P.,Fort Mason Partners, L.P., Capital Ventures International, Merlin BioMed LongTerm Appreciation, LP, Merlin BioMed Offshore Master Fund, Versant CapitalManagement LLC, Xmark JV Investment Partners, LLC, Xmark Opportunity Fund,L.P., Xmark Opportunity Fund, Ltd. and the other parties signatory thereto.  The purchase price was $2.00 per share ofcommon stock, and each warrant to purchase common stock has an exercise priceequal to $2.40 per share.  TheCompany may call up to 20% of the outstanding warrants during any three monthperiod if certain conditions

 

12

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aresatisfied, including the trading price of the Company’s common stock exceeding$4.80 for 20 consecutive trading days. Up to half of the warrants may be exercised on a cashless or netexercise basis.  There can be noassurance, however, that the Company will receive funds from the exercise ofwarrants.

 

Under a letter agreement, dated October 2005, with FerghanaSecurities, Inc. (“Ferghana”), the Company retained Ferghana to provideadvisory services in connection with a financing transaction and to render afairness opinion in connection with the Private Placement.  The Companypaid to Ferghana an advisory fee of $400,000 in addition to monthly retainerpayments and, at closing, issued a warrant to Ferghana to acquire 50,000 sharesof the Company’s common stock on substantially similar terms as the warrantsissued under the Purchase Agreement.  As of March 29, 2006 and December28, 2005 the Company paid Ferghana approximately $210,000 and $200,000,respectively, which is included in prepaid expense and other current assets.  These amounts will be reclassified toadditional paid in capital in the second quarter of fiscal 2006.

 

In addition, in connection with the Private Placement, the Companyentered into a Finder’s Fee Agreement with Reedland Capital Partners (“Reedland”)under which the Company at closing of the Private Placement paid to Reedlandcash compensation of 2.75% of the $25.5 million gross proceeds and issuedto Reedland a warrant to acquire 100,000 shares of the Company’s common stockon substantially similar terms as the warrants issued under the PurchaseAgreement.  The Company has agreed to include the shares underlying thewarrants issued to Ferghana and Reedland in any registration statement filed bythe Company on behalf of the Purchasers.

 

On May 4, 2006, the Company filed a registration statement that, when declaredeffective by the Securities and Exchange Commission, will register the resaleof the shares sold in the Private Placement as well as the shares underlyingthe warrants issued in the Private Placement and the warrants issued tofinancial advisors and consultants in conjunction with the PrivatePlacement.  Shares and warrants issued inconjunction with the Private Placement were not considered in calculating netloss per share as of March 29, 2006 because the closing of the PrivatePlacement and related stock issuance did not occur until April 6, 2006. 

 

*Repricing*of*Stock Options*

 

On February 8, 2006, the board of directors of the Company approved,subject to stockholder approval, the amendment of certain outstanding optionsto purchase shares of common stock under the Company’s existing equityincentive plans, including certain stock options granted to the Company’sdirectors and executive officers.  Stockholder approval of such amendmentwas received on April 4, 2006 and the exercise price of each such modified optionwas reduced to $4.02 per share as of such date.  As of February 8,2006, stock options for approximately 696,253 shares were outstanding under allof the Company’s equity compensation plans, of which options to purchaseapproximately 626,568 shares of common stock, having exercise prices rangingfrom $4.20 to $112.50, were modified.

 

*2006 Equity Incentive Plan and New StockOption Grants*

 

In January 2006, the board of directors adopted, subject to stockholderapproval, the Company’s 2006 Equity Incentive Plan (the “Incentive Plan”). The Board adopted the Incentive Plan at the same time it approved the PrivatePlacement.  In conjunction with the adoption of the Incentive Plan, andsubject to stockholder approval, the Board granted options to purchase 30,000shares of common stock to each non-employee director of the Board totaling180,000 shares.  In addition, subject to stockholder approval, the CompensationCommittee of the Board granted options to purchase shares of common stock toemployees of the Company, including its executive officers, totaling 3,079,480shares.  Stockholder approval for the Incentive Plan and grant of the stockoptions thereunder was received on April 4, 2006.

 

The number of shares initially reserved for issuance under theIncentive Plan totals 6,577,106 and as of April 4th, 2006outstanding options granted under the Incentive Plan is 3,259,480.  Subject to limited exceptions, the grant datefor the each of these options is April 4, 2006.  The exercise price ofsuch options is $4.02 and was established as the average of the closing saleprices of the Company’s common stock on the Nasdaq Capital Market on the fourththrough eighth trading days following the Company’s announcement of the PrivatePlacement.  Each option vests as follows: 1/6 when the 20 trading dayaverage of the closing sale prices of the common stock equals or exceeds 130% ofthe exercise price of the stock option; 1/6 when such average equals or exceed160% of the exercise price; 1/6 when such average equals or exceeds 190% of theexercise price; 1/6 when such average equals or exceeds 220% of the exerciseprice; 1/6 when such average equals or exceeds 250% of the exercise price; and1/6 when such average equals or exceeds 300% of the exercise price.  All stockoptions vest at the latest on the fifth anniversary of the date of grant. The awards otherwise were made in accordance with the terms andconditions of the Incentive Plan and the Form of Stock Option Agreement forgrants thereunder.  After giving effectto the foregoing stock options granted by the Board and the CompensationCommittee, a total of 3,317,626 shares remain available for grant under theIncentive Plan under its terms as specified above.

 

13

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Below is a summary of the outstanding stock options of the Companyadjusted for modifications and newly issued stock options as described above:

 
| ** **                          | ** ** | **Number  of   Options** | ** ** | **Weighted-  Average  Exercise  Price** | ** ** | **Weighted-  Average  Remaining  Contractual   Life (Years)** | ** ** | **Aggregate  Intrinsic  Value** | ** ** |
|-------------------------------------|------------|--------------------------|------------|-----------------------------------------|------------|---------------------------------------------------------------|------------|---------------------------------|------------|
| ** **                          | ** ** | ** **               | ** ** | ** **                              | ** ** | ** **                                                    | ** ** | **(in  thousands)**             | ** ** |
| Outstanding Balance, March 29, 2006 |       | 698,004                  |       | $                                       | 37.17      | ** **                                                    | 5.07       |                            | $          | 2,684 | ** ** |
| Granted from 2006 Equity Plan       |       | 3,259,480                |       | 4.02                                    | ** ** | —                                                        |       | —                          | ** ** |
| Reissued for modified options       |       | 626,568                  |       | 4.02                                    | ** ** | —                                                        |       | —                          | ** ** |
| Cancelled for modified options      |       | (626,568                 | )          | 37.62                                   | ** ** | —                                                        |       | —                          | ** ** |
| Outstanding Balance, April 4, 2006  |       | 3,957,484                |       | $                                       | 4.55       |                                                          | 9.90       |                            |       | — |   |

 

As a result of the modifications and new options granted as discussedabove, the amount of future expense recognized and the period over which itwill be recognized will make the stock-based compensation expense in futurequarters not directly comparable to that recorded in the first quarter.  In addition, in the second quarter of fiscal2006, the Company will record a non-cash fixed charge related to the modifiedvested options.  

 

14

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

 

The followingdiscussion and analysis provides information that management believes isrelevant to an assessment and understanding of the results of operations ofTapestry Pharmaceuticals, Inc.  Youshould read this discussion in conjunction with the Financial Statements andNotes included elsewhere in this report and with Management’sDiscussion and Analysis of Financial Condition and Results of Operations forthe year ended December 28, 2005 contained in our 2005 Annual Report onForm 10-K and Form 10-K/A.  Certain statementsset forth below constitute “forward-lookingstatements” within the meaning of Section 27A of the Securities Act of1933, as amended, and Section 21E of the Securities Exchange Act of 1934,as amended.  See “Special NoteRegarding Forward-Looking Statements” and “Risk Factors.”

 

**General**

 

Tapestry Pharmaceuticals, Inc. (“we”, “Tapestry” or “the Company”) is a pharmaceutical companyfocused on thedevelopment of proprietary therapies for the treatment of cancer.  The Company’s primary development effort isfocused on TPI 287, a novel taxane under development for the treatment ofcancer.  We filed an Investigational NewDrug (“IND”) application on December 21, 2004 covering TPI 287, and commencedhuman clinical trials with TPI 287 in the second quarter of 2005.  Other programs in development include ourquassinoids, linked cytotoxics and oral formulation of TPI 287.  Currently, we cannot predict when or if anyof these other programs will be advanced into clinical development.  We are also actively engaged in evaluatingnew therapeutic agents and/or related technologies.  Our evaluation of new products andtechnologies may involve the examination of individual molecules, classes ofcompounds, or platform technologies. Acquisitions of new products or technologies may involve the purchase orlicense of such products or technologies, or the acquisition of, or mergerwith, other companies.

 

On April 6, 2006,we sold an aggregate of 12,750,000 shares of common stock and warrants topurchase up to 12,750,000 shares of common stock (the “Private Placement”), fora total of $25.5 million (excluding any proceeds that might be receivedupon exercise of the warrants) or approximately $24 million, net of the placementagent fees and other expenses.  The purchase price was $2.00 per share ofcommon stock, and each warrant to purchase common stock has an exercise priceequal to $2.40 per share.  We may call up to 20% of the outstandingwarrants during any three month period if certain conditions are satisfied,including the trading price of our common stock exceeding $4.80 for 20consecutive trading days.  Up to half ofthe warrants may be exercised on a cashless or net exercise basis.  There can be no assurance, however,that we will receive funds from the exercise of warrants.

 

In November 2004 we discontinued research on our genomicsprograms, other than the Huntington’s Disease program, and sought a buyer ofthese programs.  After completingreasonable efforts to sell the intellectual property assets related to thegenomics programs over the course of the fourth quarter of 2004, we determinedthat there were no actively interested buyers and we proceeded to affect anorderly closure of such operations, which was substantially completed byJanuary 2005.

 

During the third quarter of 2005, the Company incurred severance costsof $299,000 associated with the elimination of 2 general and administrativeexecutives, 5 other general and administrative employees and 15 research anddevelopment positions (including one consultant). 

 

We will incursubstantial research and development expense, including expense relating toclinical trials, related to the development of our proprietary anti-canceragents.  We have incurred significantlosses, including losses from continuing operations of $4.4 million for the threemonths ended March 29, 2006.  Ouraccumulated deficit was $111.7 million as of March 29, 2006.  As a result of our implementation of SFAS123(R), our first quarter 2006 operating expenses were increased by non-cashcompensation charge totaling $477,000. These non-cash compensation charges are expected to increase significantlyin the second quarter both as a result of modification of certain outstandingunvested employee stock options as well as the grant of new options under our2006 Equity Incentive Plan approved by shareholders on April 4, 2006 (see Note 13to the Consolidated Financial Statements for further discussion).  We anticipate that losses will continue untilsuch time, if ever, as we are able to commercialize our product candidates andgenerate sufficient sales to support our development operations, including theresearch and development activity mentioned above.

 

Our ability togenerate sufficient sales to support our operations currently depends upon thesuccessful development and commercialization of products based on ourproprietary oncology technologies.

 

15

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**Researchand Development**

 

Our current business is focused primarily on the clinical development ofTPI 287, along with research and development of other proprietary therapies forthe treatment of cancer.  The table belowshows our research and development expense by major category, with the expenserelated to our Genomics Division included in discontinued operations (in thousands):

 
| ** **                | ** ** | **Three  months ended**    | ** ** |
|---------------------------|------------|----------------------------|------------|
| ** **                | ** ** | **March 29,    2006** | ** ** | **March 30,    2005** | ** ** |
|                      |       |                       |       |   |   |
| Oncology                  |       | $                          | 2,898      |   | $ | 2,617 |   |
| Huntington’s Disease |       | (84                        | )     | 172 |   |
| Discontinued operations   |       | 88                         |       | 230 |   |
|                      |       | $                          | 2,902      |   | $ | 3,019 |   |
|                           |            |                            |            |  |  |  |  |  |  |

 

The following chartidentifies our four therapeutic candidate programs that are in the mostadvanced stages of development.

 
| **Program**               | ** ** | **Potential  Indication(s)**                                                   | ** ** | **Development Status**   |
|---------------------------|------------|--------------------------------------------------------------------------------|------------|--------------------------|
| TPI  287 IV               |       | Prostate,  Non-Small Cell Lung, and Breast Cancers                             |       | Phase  I                 |
| TPI  287 oral formulation |       | Prostate,  Non-Small Cell Lung, Pancreatic,  Ovarian, Breast and Colon Cancers |       | Preclinical  Development |
| Quassinoids               |       | Cancers                                                                        |       | Preclinical  Development |
| Linked  Cytotoxics        |       | Cancers                                                                        |       | Preclinical  Development |

 

We terminated the OligoTherapy program related to Huntington’s Disease in January 2006.  We also terminated the development of TPI284, a linked cytotoxic compound, in January 2006. We are continuinglimited preclinical research relating to quassinoid analogs and linkedcytotoxic agents with additional potential lead compounds being tested.

 

•  TPI 287 is a proprietary third generationtaxane. On December 21, 2004, we filed an Investigational New Drug (“IND”)application, and on January 21, 2005, we were cleared to proceed intoclinical trials by the U.S. Food and Drug Administration (“FDA”). InMay 2005, we treated our first patient in this Q7D Phase I clinical trialof the intravenous (“IV”) formulation of TPI 287. In January 2006, webegan a second Phase I clinical trial of TPI 287 IV to evaluate an alternativedosing schedule. In preclinical testing, TPI 287 demonstrated the ability toinhibit tumor cell growth in a number of *in vitro* celllines and has shown inhibition of tumors in certain animal xenograft modelswhen tested against standard comparative agents. The *in vitro*activity was seen across multiple cell lines including cell lines known to besensitive to taxanes and cell lines known to be resistant to taxanes. Taxanesensitive cell lines in which TPI 287 shows activity include cell lines derivedfrom breast cancer, uterine cancer and non-small cell lung cancer. Taxaneresistant cell lines in which TPI 287 shows activity include lines derived frombreast cancer, colon cancer, prostate cancer and pancreatic cancer. In *in vivo* animal testing, TPI 287 demonstrated tumor growthinhibition activity in four tumor cell lines with multiple drug resistance, orMDR1. In addition to the IV formulation of TPI 287, we have initiateddevelopment of an oral formulation of the compound.

 

•  Quassinoids are complex polyfunctional,polycyclic natural products of the plant family *Simaroubaceae*, which exhibit antitumor activity. We havein-licensed several quassinoid compositions as well as processes for theirisolation and synthesis. We have completed several *in vitro* and *in vivo*preclinical studies on our proprietary quassinoid analogs, and additionalpreclinical studies are in progress to better delineate the potential antitumoractivity of these compounds. Currently, we cannot predict if or when any ofthese quassinoids will be advanced into clinical development.

 

•  Linked cytotoxics are cytotoxic agentslinked to agents designed to improve therapeutic index. Currently, we cannotpredict when or if any of these linked cytotoxics will be advanced intoclinical development.

 

*Certain Risks andLimitations.**  *The clinicaldevelopment of these drugs has many risks of failure. We have included a discussion of a number of the risks anduncertainties associated with completing our product development plans under “RiskFactors”.

16

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We continuously reassess all of our research anddevelopment efforts, including those for the therapeutic products describedabove. At any time, we may expand, delay, terminate or dispose of all or anyportion of our research and development programs and therapeutic products or wemay develop or acquire rights to new product candidates.

 

**Results of Operations** - Quarter Ended March 29,2006 Compared to Quarter Ended March 30, 2005

 

*Researchand Development Expense.*  Research anddevelopment expense from continuing operations for the first quarter of 2006was $2.8 million, anincrease of $25,000 from the first quarter of 2005.  Oncology research and developmentexpenditures increased by $281,000 to $2.9 million in the first quarter of 2006,and Huntington’s Disease related spending decreased by $256,000 to ($84,000).  The increase in oncology expense wasprimarily due to an increase in salaries costs ($657,000) as well as increasedclinical trial cost ($144,000), offset by a reduction in outside manufacturing costsassociated with preparing active pharmaceutical ingredient and drug productmaterial for the clinical trials of TPI 287 ($267,000) and a decrease inconsulting and other outside service costs ($201,000).  The increase in compensation expense in the currentquarter was mostly related to the employment agreement payout due to thetermination of the Company’s Executive Vice President and Secretary, in theamount of $646,000 offset by the associated reduction in salary expense.  The decrease in expense related to theHuntington’s Disease program was a result of a reversal of laboratory fees owedto the University of Delaware as well as the reduction in work force.  Included in research and development expenseis a non-cash compensation expense in the amount of $242,000 and $0 for thethree months ended March 29, 2006 and March 30, 2005, respectively, as a resultof the implementation of SFAS 123(R).

 

*Generaland Administrative Expense.*  General andadministrative expense for the current year quarter was $1.5 million, adecrease of $140,000 from the prior year quarter.  This decrease was due to lower insurancecosts ($49,000), lower outside legal costs ($40,000), lower travel costs($28,000), as well as lower outside service costs related to investor relations($59,000), partially offset by an increase in other consulting expense ($33,000)as well as an increase in compensation costs. The increase in compensation related expenses was the result of lowersalaries due to the staffing reductions in July 2005 which was offset by a non-cashcompensation expense in the amount of $235,000 and $0 for the three monthsended March 29, 2006 and March 30, 2005, respectively, as a result of theimplementation of SFAS 123(R).

 

*Interestand Other Income.*  Interest and otherincome for the first quarter of 2006 of $141,000 represented a decrease of $29,000compared to the prior year quarter.  The decreasewas attributable to lower interest income due to lower cash balances partiallyoffset by higher effective interest rates earned in the first quarter of 2006compared to the first quarter of 2005.

 

*Interestand Other Expense.*  Interest and otherexpense for the first quarter of 2006 of $173,000 was $6,000 more than theprior year quarter due to a loss on the sale of an investment in the firstquarter of 2006 ($38,000) partially offset by a partial repayment of ourobligations to TL Ventures in February 2005 ($29,000) in connection with therestructuring of our notes owed to them. 

 

*DiscontinuedOperations. *Loss from discontinuedoperations was $88,000 for the current year quarter compared to a loss of $181,000in the prior year quarter.  This decreaseis primarily a result of there being no activity in the Genomics Division inthe current quarter, except for a non-cash compensation expense in the amountof $86,000 as a result of the implementation of SFAS 123(R), as compared tosalaries, occupancy and patent related charges in the prior year quarter.

 

*ShareBased Compensation.* Effective December 29, 2005, we adopted the fair valuemethod of accounting for share-based compensation arrangements in accordancewith Financial Accounting Standards Board (“FASB”) Statement No. 123(R),*Share-Based Payment*(“SFAS 123(R)”),using the modified prospective method of transition.  Under the provisions of SFAS 123(R), theestimated fair value of options granted under the Company’s various equityincentive plans is recognized as compensation expense over the option-vestingperiod.  Using the modified prospectivemethod, compensation expense is recognized beginning with the effective date ofadoption of SFAS 123(R) for all share-based payments (i) granted after theeffective date of adoption and (ii) granted prior to the effective date ofadoption and that remain unvested on the date of adoption and we are notrequired to restate our prior period financial statements to reflect expensingof share based compensation under SFAS 123(R). Therefore, the results of March 29, 2006 are not directly comparable tothe same period in 2005.

 

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Prior to December29, 2005, we accounted for stock-based employee compensation plans using theintrinsic value method of accounting in accordance with Accounting PrinciplesBoard Opinion No. 25, *Accounting forStock Issued to Employees* (“APB 25”), and its relatedinterpretations.  Under the provisions ofAPB 25, no compensation expense was recognized when stock options were grantedwith exercise prices equal to or greater than market value on the date ofgrant.

 

In accordance withthe provisions of SFAS 123(R), for the quarter ended March 29, 2006, there was approximately$477,000, or $.14 basic and diluted loss per share from continuing operationsof option related compensation expense which was allocated among research anddevelopment ($242,000) and general and administrative ($235,000) based on thefunction of the employee option holder.  Asof March 29, 2006, there was approximately $1.2 million of total unrecognizedcompensation expense related to unvested share-based compensation arrangementsgranted under the various equity incentive plans.

 

As a result of the modifications and new options granted as discussed below,the amount of future expense recognized and the period over which it will berecognized will make the stock-based compensation expense in future quartersnot directly comparable to that recorded in the first quarter.  In addition, in the second quarter of fiscal2006, we will record a non-cash fixed charge related to the modified vestedoptions.  

 

See Note 1. Basis of Presentation and Summary of Significant Accounting Policies;Share Based Compensation of the Unaudited Notes to Consolidated FinancialStatements dated March 29, 2006 for additional information about the adoptionof SFAS 123 (R).

 

**Liquidityand Capital Resources**

 

Our working capitalrequirements for research and development have been, and will continue to be,significant.  As of March 29, 2006 we hadworking capital of $7.5 million compared to working capital of $11.6 million atDecember 28, 2005.  As a result of theApril 6, 2006 financing discussed below, as of April 6, 2006 we had workingcapital of approximately $31.5 million.  ThroughMarch 29, 2006, we have funded our capital requirements primarily with the netproceeds of public offerings of common stock of approximately $21.1 million,with private placements of equity securities of approximately $67.5 million,with the exercise of warrants and options of approximately $8.0 million andwith net indebtedness of approximately $3.1 million.  We also have funded our capital requirementsfrom the gross proceeds of the sale of our paclitaxel business (approximately$71.7 million) to Mayne Pharma (USA) Inc. (f/k/a FauldingPharmaceutical, Inc.) (“Mayne Pharma”), a subsidiary of Mayne Group Limited,on December 12, 2003 and its operations prior to that date.

 

Cash and cash equivalents decreased $139,000 to $395,000 atMarch 29, 2006 from $534,000 at December 28, 2005.  At March 29, 2006, cash, cash equivalents,short-term and long-term investments decreased $3.5 million to $10.6 millionfrom $14.1 million at December 28, 2005. The decrease was primarily due to $3.1 million net cash used byoperating activities.  As a result of theApril 6, 2005 financing discussed below, as of April 6, 2006 we have cash andcash equivalents of approximately $34.6 million.  In the third quarter of fiscal 2006, weexpect to pay approximately $646,000 for accrued termination benefits to ourformer Executive Vice President and Secretary. We recorded this obligation on our balance sheet as of March 29, 2006.

 

*Private Placement.*

* *

On April 5, 2006 wesold an aggregate of 12,750,000 shares of common stock and warrants to purchaseup to 12,750,000 shares of common stock for a total of $25.5 million(excluding any proceeds that might be received upon exercise of the warrants)or approximately $24 million, net of the placement agent fees and otherexpenses, pursuant to a Purchase Agreement dated February 2, 2006 (the “PurchaseAgreement”), by and among the Company and Special Situations Cayman Fund, L.P.,Special Situations Fund III, L.P., Special Situations Fund III QP, L.P.,Special Situations Life Sciences Fund, L.P., Special Situations Private EquityFund, L.P., Tang Capital Partners, LP, Baker Biotech Fund II (Z), L.P., BakerBiotech Fund III, L.P., Baker Biotech Fund III (Z), L.P., Baker Bros.Investments II, L.P., 14159, L.P., Biotechnology Value Fund, L.P.,Biotechnology Value Fund II, L.P., BVF Investments, L.L.C., Investment 10,L.L.C., Fort Mason Master, L.P., Fort Mason Partners, L.P., Capital VenturesInternational, Merlin BioMed Long Term Appreciation, LP, Merlin BioMed OffshoreMaster Fund, Versant Capital Management LLC, Xmark JV Investment Partners, LLC,Xmark Opportunity Fund, L.P., Xmark Opportunity Fund, Ltd. and the otherparties signatory thereto.  The purchase price was $2.00 per share ofcommon stock, and each warrant to purchase common stock has an exercise priceequal to $2.40 per share.  We may call up to 20% of the outstandingwarrants during any three month period if certain conditions are satisfied,including the trading price of our common stock exceeding $4.80 for 20consecutive trading days.  Up to half ofthe warrants may be exercised on a cashless or net exercise basis.  There can be no assurance, however,that we will receive funds from the exercise of warrants.

 

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Under a letteragreement, dated October 2005, with Ferghana Securities, Inc. (“Ferghana”),we retained Ferghana to provide advisory services in connection with afinancing transaction and to render a fairness opinion in connection with thePrivate Placement.  We paid Ferghana an advisory fee of $400,000 inaddition to monthly retainer payments and, at closing, issued a warrant toFerghana to acquire 50,000 shares of the Company’s common stock onsubstantially similar terms as the warrants issued under the Purchase Agreement. In addition, in connection with the Private Placement, we entered into a Finder’sFee Agreement with Reedland Capital Partners (“Reedland”) under which we at closingof the Private Placement paid to Reedland cash compensation of 2.75% of the$25.5 million gross proceeds and issued to Reedland a warrant to acquire100,000 shares of our common stock on substantially similar terms as the warrantsissued under the Purchase Agreement.  We have agreed to include the sharesunderlying the warrants issued to Ferghana and Reedland in any registrationstatement filed by us on behalf of the Purchasers.

 

On May 4 2006, we fileda registration statement that, when declared effective by the Securities andExchange Commission, will register the resale of the shares sold in the PrivatePlacement as well as the shares underlying the warrants issued in the PrivatePlacement and the warrants issued to financial advisors and consultants in conjunctionwith the Private Placement.  

 

*Note Payable.*

* *

In connection withthe February 18, 2005 settlement of litigation with TL Ventures overwhether the debentures were subject to redemption upon completion of the saleof our paclitaxel business to Mayne Pharma, we paid approximately $3,184,000 incash and issued promissory notes in the amount of $4,670,000 in exchange forthe delivery of the debentures by TL Ventures to the Company for cancellation.  The notes do not bear interest and arepayable in monthly installments of $110,000 in 2006 and $150,000 in 2007 with a$1,000,000 payment due on January 31, 2008.  Accrued interest of approximately $134,000was included in the cash payment made as part of the settlement.  We recorded the obligation resulting from thesettlement on our balance sheet as of December 29, 2004.  We imputed an interest rate of 18% on thenotes.  No gain or loss was recognized inconnection with the settlement.

 

*GoingConcern.*

* *

Wehave no revenue and we incurred a loss of approximately $4.4 million for thethree month period ended March 29, 2006 and a loss of approximately $17.5million for the year ended December 28, 2005 and we have an accumulated deficitof $111.7 million as of March 29, 2006. Our capital requirements for research and development, including thecost of clinical trials, have been and will continue to be significant.  

 

Asof December 28, 2005, we had cash and short-term investments totalingapproximately $14.1 million.  Thesefactors, as of December 28, 2005, raised substantial doubt, which has sincebeen dealt with, as discussed below, about our ability to continue as a goingconcern.  As a result of these concernsthe audit report prepared by our independent registered public accounting firmrelating to our consolidated financial statements for the year endedDecember 28, 2005 includes an explanatory paragraph expressing thesubstantial doubt about the Company’s ability to continue as a going concern.

 

Wehave undertaken a number of actions to reduce our monthly cash requirements,including, among other things, reductions in workforce and related payrollcosts, reductions in facility costs, reductions in the number of activeprograms in development, reductions in capital expenditures and reductions incharges from outside service providers. After implementing these and other costsavings measures and further determining that our lead pharmaceutical programwarranted expanded clinical development, we determined to seek the additionalcapital necessary to fund our ongoing operations related to our leadpharmaceutical program.

 

OnApril 6, 2006, we sold an aggregate of 12,750,000 shares of our commonstock, and related warrants to purchase up to an aggregate of 12,750,000 sharesof our common stock for gross proceeds of $25.5 million, not including anyproceeds from the exercise of the warrants (or approximately $24 million net oftransaction fees and expenses).  As partof the financing, we agreed to a covenant that the net proceeds from thetransaction be used solely to fund the development of its lead productcandidate, TPI 287, in accordance with an approved budget for fiscal years 2006and 2007.  We may call up to 20% of the outstandingwarrants during any three month period if certain conditions are satisfied,including the trading price of our common stock exceeding $4.80 for 20consecutive trading days.  Up to half ofthe warrants may be exercised on a cashless or net exercise basis.  There can be no assurance, however,that we will receive funds from the exercise of warrants. See above for further discussion.

 

Followingclosing of the above described transaction, as of April 6, 2006 we had cash andshort-term investments of approximately $34.6 million and working capital ofapproximately $31.5 million.   We believewe have sufficient capital to fund our operations and capital expenditures forat least the next 12 months.  However,pharmaceutical development is costly, risky and time intensive activity.  To bring our various programs to completionwill require us to raise additional

 

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capitalas practicable to fund future operations and to provide additional workingcapital.  There can be no assurance thatwe we will be able to obtain additional capital on terms that will beacceptable to us or on any terms.  Inaddition, we may seek to in-license or purchase new product ortechnologies.  The cost and relatedcapital expenditures of acquiring and developing such resources may besignificant, and we may not be able to obtain capital for the development ofthese products or technologies.

 

*Reverse Stock Split and Nasdaq Listing.*

* *

We implemented a one-for-ten reverse split of our common stockeffective for trading on February 6, 2006, and all share and per shareamounts for all periods presented have been restated to reflect this reversestock split. Our common stock is listed on the Nasdaq Capital Market.  In order to maintain that listing, we mustsatisfy minimum financial and other requirements.  On February 25, 2005, we received noticefrom the Nasdaq Stock Market, Inc. that the minimum bid price of ourcommon stock had fallen below $1.00 per share for 30 consecutive business daysand that our common stock was, therefore, subject to delisting from the NasdaqCapital Market.  As a result of theone-for-ten reverse split, the minimum bid price of our common stock increasedand on February 24, 2006, we received notice from the Nasdaq Stock Market, Inc.that we regained compliance with the minimum bid price requirement. 

 

# **Recent AccountingPronouncements**

# ** **

On June 9, 2005, the FASB issued SFAS No. 154, *Accounting Changes and Error Corrections*.  SFAS No. 154 replaces APB OpinionNo. 20, *Accounting Changes*, and SFASNo. 3, *Reporting Accounting Changes in Interim FinancialStatements*, and changes the requirements for the accounting for andreporting of a change in accounting principle. SFAS No. 154 applies to all voluntary changes in accountingprinciple.  It also applies to changesrequired by an accounting pronouncement in the unusual instance that thepronouncement does not include specific transition provisions.  SFAS No. 154 must be adopted for accountingchanges and corrections of errors made in fiscal years beginning afterDecember 15, 2005.  Early adoptionis permitted for accounting changes and corrections of errors made in fiscalyears beginning after the date SFAS No. 154 is issued.  The adoption of SFAS No. 154 did not have amaterial impact on our financial results.

 

**Special Note Regarding Forward-Looking Statements**

 

The statements in this report that are not historical facts areforward-looking statements that represent management’s beliefs and assumptionsas of the date of this report, based on currently available information.  Forward-looking statements can be identifiedby the use of words such as “believe,” “intend,” “estimate,” “may,” “will,” “should,”“anticipated,” “expected,” “trusts” or comparable terminology or by discussionsof strategy.  Such forward-lookingstatements may include, among others:

 

•      statementsconcerning the success of TPI 287 in clinical trials and our ability to pursueadditional clinical trials relating to TPI 287, and the timing of any suchfurther clinical development;

 

•      statementsconcerning our plans, objectives and future economic prospects, such as mattersrelative to developing new products;

 

•      theavailability of patent and other protection for our intellectual property;

 

•      thecompletion of preclinical studies, clinical trials and regulatory filings;

 

•      theprospects for, and timing of, regulatory and institutional review boardapprovals;

 

•      theneed and plans for, and availability of, additional capital;

 

•      theamount and timing of capital expenditures;

 

•      theability to outsource activities;

 

•      thefuture acquisition of technology, products or business entities;

 

•      prospectsfor future operations; and

 

•      otherstatements of expectations, beliefs, future plans and strategies, anticipatedevents or trends and similar expressions concerning matters that are nothistorical facts.

 

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Although we believe that the expectations reflected in suchforward-looking statements are reasonable, we cannot assure you that theseexpectations will prove to be correct. Such forward-looking statements involve known and unknown risks,uncertainties and other factors, which may cause our actual results,performance or achievements, or industry results, to be materially differentfrom any future results, performance or achievements expressed or implied bysuch forward-looking statements.   Factors that could cause or contribute to suchdifferences include, but are not limited to, those described below under “Risk Factors”. As a result, you should not place unduereliance on these forward-looking statements, which apply only as of the dateof this report.   Should one or more of these risks materialize(or the consequences of such a development worsen), or should the underlyingassumptions prove incorrect, actual results could differ materially from thoseforecasted or expected.  We undertake noobligation to update any of the forward-looking statements after the date ofthis Quarterly Report on Form 10-Q to conform such statements to actualresults.

 

**Item 3. Quantitative andQualitative Disclosures about Market Risk**

 

We currently invest our excess cash balances in money market accounts,and short-term and long-term investments that are subject to interest raterisk.  The amount of interest income we earn on these funds will change asinterest rates in general change.  Our investments are subject to a lossof principal if market interest rates increase and they are sold prior tomaturity.  However, due to the short-termnature of the majority of our investments, the high credit quality of ourportfolio and our ability to hold our investments until maturity, an immediate 1%change in interest rates would not have a material impact on our financialposition, results of operations or cash flows.

 

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

 

The Company maintains a system of disclosure controls andprocedures.  The term “disclosure controls and procedures,” as defined by regulations of the SEC, means controls andother procedures that are designed to ensure that information required to bedisclosed in the reports that the Company files or submits to the SEC under theSecurities Exchange Act of 1934, as amended (“the Act”), is recorded,processed, summarized andreported, within the time periods specified in the SEC’s rules and forms. Disclosure controls and procedures include, without limitation, controlsand procedures designed to ensure that information required to be disclosed bythe Company in the reports that it files or submits to the SEC under the Act isaccumulated and communicated to the Company’smanagement, including its Principal Executive Officer and its PrincipalFinancial Officer, as appropriate to allow timely decisions to be maderegarding required disclosure.  TheCompany carried out an evaluation, under the supervision and with theparticipation of the Company’smanagement, including the Company’sChief Executive Officer and Chief Financial Officer, of the effectiveness ofthe design and operation of the Company’sdisclosure controls and procedures as of March 29, 2006.  Based upon that evaluation, the Company’sChief Executive Officer and Chief Financial Officer concluded that the Company’sdisclosure controls and procedures are effective in timely alerting them tomaterial information relating to the Company required to be included in theCompany’s periodic SEC filings.

 

Any system of controls, however well designedand operated, can provide only reasonable, and not absolute, assurance that theobjectives of the system are met.  Inaddition, the design of any control system is based in part upon certainassumptions about the likelihood of future events.  Because of these and other inherentlimitations of control systems, there can be no assurance that any design willsucceed in achieving its stated goals under all potential future conditions,regardless of how remote.

 

There have been no changes in our internal controls over financialreporting during the fiscal quarter ended March 29, 2006 that have materiallyaffected, or are reasonably likely to materially affect, our internal controlover financial reporting.

 

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**Part II- Other Information**

 

**Item 1. Legal Proceedings**

 

The Company is currently in arbitration through theAmerican Arbitration Association with the licensor of certain patents andpatent applications relating to pharmaceutical formulations containing VitaminE TPGS. The arbitration was instituted in November, 2005 in Boulder, Colorado.The Company licensed these patent applications in 1998. The inventor/licensorclaims that the Company has failed in its obligation to develop the licensedtechnology and is demanding return of the patents. The Company denies thisclaim, and in addition alleges that the inventor/licensor committed fraud ininducing the Company to enter into the license agreement. The Company isseeking as yet unspecified damages against the inventor/licensor.  

 

**Item 1A Risk Factors**

 

*You shouldcarefully consider the following risk factors related to our current businessoperations before making a decision to invest in our common stock. Additionalrisks of which we are not yet aware or that we currently believe are immaterialmay also impair our business operations. If any of the events or circumstancesdescribed in the following risk factors actually occurs, our business maysuffer, the trading price of common stock could decline, and you may lose allor part of your investment.*

* *

**Risks Related to Our Business**

 

**We currently are focusing our development efforts on only oneproduct candidate, TPI 287, and we will have limited prospects for successfuloperations if TPI 287 does not prove successful in clinical trials or is nevercommercialized because of the costs of continuing development or for otherreasons.**

 

In2005, we closed our Genomics division, and in 2006, we terminated our programrelating to Huntington’s Disease and terminated development of TPI 284. Theseactions have permitted us to focus our development efforts primarily on thedevelopment of TPI 287, which is still in Phase I clinical trials. Our otherproduct candidates are in preclinical development and we have no products thatare approved for commercial sale. TPI 287 will require extensive additionalclinical evaluation, regulatory review, marketing efforts and significant investmentbefore we receive any revenues from it, if ever. We currently do not have thecapital resources necessary to bring any of our product candidates through tocommercial approval, and we do not expect TPI 287 or any of our other productcandidates or technologies to be commercially available for several years. Webelieve that our recently consummated financing will only be sufficient topermit us to generate preliminary Phase II efficacy data on TPI 287 in a numberof major tumor types, as well as begin development of, upon continuedconfirmatory data, a preliminary oral form of this drug candidate.

 

Ourefforts may not lead to commercially successful products for a number areasons, including the inability to be proven safe and effective in clinical trials,the lack of regulatory approvals or obtaining regulatory approvals that arenarrower than we seek, inadequate financial resources to complete thedevelopment and commercialization of our product candidates or the lack ofacceptance in the marketplace. Given the limited focus on one productcandidate, if TPI 287 does not prove successful in clinical trials or is notcommercialized because we have insufficient resources for continued developmentfor any other reason, we may be required to suspend or discontinue ouroperations and you could lose your entire investment in the Company.

 

**If we fail to obtain the capital necessary to fund ouroperations when needed, we could be forced to discontinue our operations.**

 

Theaudit report prepared by our independent registered public accounting firmrelating to our consolidated financial statements for the year endedDecember 28, 2005 includes an explanatory paragraph expressing thesubstantial doubt about our ability to continue as a going concern. We have undertakena number of actions to reduce our monthly cash requirements, including, amongother things, reductions in workforce and related payroll costs, reductions infacility costs, reductions in the number of active programs in development,reductions in capital expenditures and reductions in charges from outsideservice providers. After implementing these and other cost savings measures andfurther determining that our lead pharmaceutical program warranted expandedclinical development, we determined that we should seek the additional capitalnecessary to fund our ongoing operations related to our lead pharmaceuticalprogram.

 

OnApril 6, 2006, we sold an aggregate of 12,750,000 shares of our commonstock, and related warrants to purchase up to an aggregate of 12,750,000 sharesof our common stock for gross proceeds of $25.5 million not including anyproceeds

 

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from the exercise of the warrants (orapproximately $24 million net of transaction fees and expenses).  As part of the financing, we agreed to acovenant that the net proceeds from the transaction be used solely to fund thedevelopment of TPI 287 in accordance with an approved budget for fiscal years2006 and 2007.

 

Despitethis recent financing, our business will require substantial additionalinvestment that we have not yet secured. We cannot be sure how much we willneed to spend in order to develop, market and manufacture new products andtechnologies in the future. We expect to continue to spend substantial amountson research and development, including amounts spent on conducting clinicaltrials for our product candidates. Further, we will not have sufficientresources to develop fully any new products or technologies unless we are ableto raise substantial additional financing on acceptable terms. We could also berequired to seek strategic partners at an earlier stage than might bepreferable and on less favorable terms than might be otherwise available. Tothe extent we raise additional capital by issuing equity securities, ourstockholders may experience substantial dilution. In addition, any newsecurities issued might have rights, preferences or privileges senior to thoseof the securities held by stockholders. If we raise additional funds through theissuance of debt, we might become subject to restrictive covenants or we maysubject our assets to security interests. To the extent that we raise additional funds through collaboration andlicensing arrangements, we may be required to relinquish some rights to ourtechnologies or product candidates, or grant licenses on terms that are notfavorable to us.  Our failure to raisecapital when needed would adversely affect our business, financial conditionand results of operations, and could force us to reduce or discontinue ouroperations at some time in the future.

 

**Our product candidates and technologies are in an early stateof development and there is a high risk that they may never be commercializedbecause of the costs of continuing development or for other reasons.**

** **

Wedo not currently have any products that have received regulatory approval forcommercial sale, and we face the risk that none of our product candidates willever receive regulatory approval. All of our product candidates are in early stagesof development. Our existing product candidates will require extensiveadditional clinical evaluation, regulatory review, marketing efforts andsignificant investment before they result in any revenues. We currently do nothave the funds to bring any of our product candidates through to commercialapproval. Therefore, advancing the development of our product candidates willrequire substantial additional investment. Continued development of theseprograms is therefore dependent upon raising additional capital. We cannot becertain that we will be able to obtain capital on acceptable terms, or at all.We do not expect any of our prospective products or technologies to becommercially available for at least several years and our efforts may not leadto commercially successful products for a number a reasons including theinability to be proven safe and effective in clinical trials, the lack ofregulatory approvals or obtaining regulatory approvals that are narrower thanwe seek, inadequate financial resources to complete the development andcommercialization of our product candidates or the lack of acceptance in themarketplace. We continuously reassess all of our research and developmentefforts, including those for the therapeutic products described in the “Business”section of our most recent annual report on Form 10-K.  As new information about each technologybecomes available, it may change perceptions of previously accepted data, whichcould require additional periods of time to review and interpret these data. Asa result, we may find deficiencies in the design or application stages whiledeveloping our clinical trial studies, or in the subsequent implementationstages of such studies, which could cause us or the FDA to delay, suspend orterminate our trials at any time. Potential problems we may encounter in theimplementation stages of our studies include the chance that we may not be ableto conduct clinical trials at preferred sites, obtain sufficient test subjectsor begin or successfully complete clinical trials in a timely fashion, if atall. Furthermore, the FDA may suspend clinical trials at any time if itbelieves the subjects participating in trials are being exposed to unacceptablehealth risks or if it finds deficiencies in the clinical trial process orconduct of the investigation. At any time, we may expand, delay, terminate ordispose of all or any portion of our research and development programs andtherapeutic products or we may develop or acquire rights to new productcandidates.

 

**Our potential products and technologies must undergo rigorousclinical testing and regulatory approvals and compliance, which couldsubstantially delay or prevent us from marketing any products.**

** **

Theclinical development of our product candidates has many risks of failure. Drugsmust be proven safe and effective before they can be approved for human use.The advancement of drug candidates into human clinical trials is dependent onthe positive outcome of pending preclinical studies, decisions by the FDA, institutionalreview boards, and other regulatory factors. Patient recruitment for clinicaltrials can be difficult, and clinical trials may be delayed or prolonged due toinability to recruit a sufficient number of patients. We may encountersignificant delays or excessive costs in our efforts to secure regulatoryapprovals. Our product candidates rely on new and unproven technologies, andnone of our proposed products or technologies have yet completed clinical testsdesigned to measure their safety or effectiveness in humans. The data obtainedfrom preclinical and clinical activities are susceptible to varyinginterpretations which could delay, limit or prevent regulatory approvals.Failure to comply with applicable FDA or other regulatory requirements may resultin criminal prosecution, civil penalties and other actions that would seriouslyimpair our ability to conduct our business. Even if regulatory approval isgranted for a product, this approval will be limited to those disease statesand conditions for which the product is useful, as

 

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demonstrated through clinical trials. Inaddition, regulatory agencies may not approve the labeling claims that arenecessary or desirable for the successful commercialization of our productcandidates. Even if we receive regulatory approvals, our product candidates maylater exhibit adverse effects that limit or prevent their widespread use orthat force us to withdraw those product candidates from the market. In addition,a marketed product continues to be subject to strict regulation after approval.Any unforeseen problems with an approved product or any violation ofregulations could result in restrictions on the product, including itswithdrawal from the market.

 

Anydelay in, or failure to receive or maintain regulatory approval for, any of ourproducts could prevent us from ever generating meaningful revenues or achievingprofitability. Given the uncertainty of drug development, it is impossible tosay how long the clinical development of any of these compounds will take. Wecannot be sure that our clinical testing for these programs will progress atthe times estimated in this document. We also cannot be sure of the cost of theeffort necessary to complete these programs or when, if ever, we will receivematerial revenues from these programs. Successfully completing these programsand obtaining an approved product for sale in the U.S. and offshore will bedependent upon our raising additional capital. We cannot be certain that wewill be able to obtain capital on acceptable terms or at all.

 

**Manufacturing issues may delay or hinder development ormarketing of our product candidates.**

** **

Themanufacture of our drug candidates is a complex process. Manufacturing thesedrugs for use in clinical trials, according to FDA guidelines, presents anumber of significant risks and challenges. The manufacture of TPI 287, inparticular, is a very complex and difficult process. If we are unable tomanufacture adequate supplies of any of our compounds for our clinical trials,our timelines for development could be delayed significantly. If we are able togain regulatory approval of our products after successful clinical trials andthen commercialize and sell those products, we may be unable to manufactureenough products to maintain our business, which could have a negative impact onour financial condition. We have no experience in manufacturing any of ourproposed product candidates on a commercial basis. We also have no laboratoriesor manufacturing facilities for such commercial manufacturing activity. If weare unable to manufacture our products in a cost-effective manner, we are notlikely to become profitable. We have not received a license from the FDA forany necessary manufacturing facilities, and cannot apply for one until wesubmit a new potential product for commercial approval. Even if we do receive amanufacturing license, we may fail to maintain adequate compliance with the FDA’sregulations concerning current good manufacturing practices, in which case thelicense, and our authorization to manufacture the product, would be revoked.Unless we build our own manufacturing facilities, we will have to rely on thirdparties to manufacture our products. Although we may be able find third-partymanufacturers with experience and the proper licensing requirements from theFDA, we may not be able to negotiate favorable terms regarding costs or along-term commitment to manufacture our products. Our dependence on thirdparties may reduce future profit margins and delay or limit our ability todevelop and commercialize our products on a timely and competitive basis.

 

**We rely on third-parties to perform certain services for usand any interruption or termination of these arrangements may adversely affectour business.**

** **

Werely on third-party contractors to provide certain services related to ourresearch and development activities. Contractors handle our U.S. andinternational regulatory affairs, provide certain manufacturing, technical andanalytical services and manage certain aspects of our clinical development. Ouroutsourcing of certain functions to independent, third parties poses thefollowing risks:

 

•**     **ourcontracts with independent contractors may expire or be terminated, and we maynot be able to replace them;

 

•**     **a contractormay not commit sufficient resources to our projects;

 

•**     **a contractormay file for bankruptcy protection or otherwise lack sufficient resources toperform all of its obligations under our agreement;

 

•**     **the terms ofour contracts with contractors may not be favorable to us; and

 

•**     **disputeswith our contractors may arise, leading to delays in or termination of thedevelopment or commercialization of our products or resulting in significantlitigation or arbitration proceedings.

 

Thefailure of our third-party contractors to provide services to us in a timelymanner could materially harm our business and financial condition. In addition,our use of outside parties could potentially lead to difficulties incoordinating activities. Outside parties may have staffing difficulties, mayundergo changes in priorities or may have inadequate financial or otherresources, adversely affecting their willingness or ability to provide certainservices to us. We may experience unexpected cost increases that are beyond ourcontrol. Problems with the timeliness or quality of the work of a third partycontractor may lead us to seek to terminate the relationship and use analternative service provider. Making this change might be costly and

 

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may delay our clinical trials. Further,contractual restrictions may make such a change difficult or impossible.Additionally, it may be impossible to find a replacement organization that canassist us in an acceptable manner and at an acceptable cost.

 

**We may be required to rely on strategic partners for thedevelopment, marketing and manufacturing of future products and technologiesthat may delay or impair our ability to generate significant revenue and mayotherwise adversely affect our profitability.**

** **

Wemay, in the future rely on strategic partners for the development, marketingand manufacturing of future products and technologies because we lack theresources or capabilities to develop our product candidates. Our reliance onstrategic partners poses a number of risks, including the following:

 

•**     **it may bedifficult to successfully negotiate arrangements with potential strategicpartners on acceptable terms;

 

•**     **if anarrangement with a strategic partner expires or is terminated, we may not beable to replace it or the terms on which we replace it may be unacceptable;

 

•**     **a partnerinvolved in the development of new products or technologies may not commitenough capital or other resources to develop or commercialize these products ortechnologies successfully;

 

•**     **a strategicpartner may not commit enough resources to the marketing and distribution ofour products;

 

•**     **we may havedisputes with strategic partners that could delay or terminate the developmentor commercialization of our products or result in significant litigation orarbitration proceedings;

 

•**     **contractswith our strategic partners may not provide significant protection or may bedifficult to enforce if a strategic partner fails to perform;

 

•**     **ourstrategic partners may decide not to further develop or commercialize ourproducts;

 

•**     **ourstrategic partners could develop drugs which compete with our products;

 

•**     **ourstrategic partners could turn their focus away from oncology;

 

•**     **ourstrategic partners who may manufacture future products could fail to operatetheir facilities in accordance with federal good manufacturing practicesregulations; and

 

•**     **third-partymanufacturers may be unable to manufacture products in a cost-effective ortimely manner.

 

**We may not be successful in obtaining required foreignregulatory approvals, which would prevent us from marketing our productsinternationally.**

** **

Outsidethe U.S., our ability to market a product is contingent upon receiving amarketing authorization from the appropriate regulatory authority. This foreignregulatory approval process includes many of the same steps and uncertaintiesassociated with FDA approval described above. We cannot be certain that we willobtain any regulatory approvals for our product candidates and technologies inother countries. In order to market our products outside of the U.S., we alsomust comply with numerous and varying foreign regulatory requirementsimplemented by foreign regulatory authorities governing the conduct of clinicaltrials, product licensing, pricing and reimbursement. The approval procedurevaries among countries and can involve additional testing. The time required toobtain approval may differ from that required to obtain FDA approval andapproval by the FDA does not ensure approval by the health authorities of anyother country. The process of obtaining foreign regulatory approvals can belengthy and require the expenditure of substantial capital and other resources.We may not be successful in obtaining the necessary approvals. Any delay orfailure to demonstrate the safety and effectiveness of a pharmaceutical productcandidate under development and obtain foreign regulatory approval could have amaterial adverse effect on our business.

 

**We may be unable to attract and retain the qualifiedemployees we need to be successful.**

** **

Weare highly dependent on members of our staff that lead or play critical rolesin our research and development efforts. We require highly qualified andtrained scientists with the necessary skills to develop our product candidates.Recruiting and retaining qualified technical and managerial personnel will alsobe critical to our success. We face intense competition for these professionalsfrom other companies in our industry and the turnover rate for theseprofessionals can be high. The loss of any of these persons, or our inabilityto recruit additional personnel necessary to our business, could substantiallyimpair our research and development efforts and impede our ability to developand commercialize any of our products. In addition, we rely on otherconsultants and advisors to assist us in formulating our research anddevelopment strategy. Some have consulting or other advisory arrangements withother entities that may conflict or compete with their obligations to us.

 

25

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**Our use of hazardous materials exposes us to the risk ofmaterial environmental liabilities, and we may incur substantial additionalcosts to comply with environmental laws in connection with the operation of ourresearch and manufacturing facilities.**

** **

Wemay use radioactive materials and other hazardous or biohazardous substances inour research and development. As a result, we are potentially subject tomaterial liabilities related to personal injuries or property damages that maybe caused by the spread of radioactive contamination or by other hazardoussubstance releases or exposures at, or from, our facilities. Decontaminationcosts associated with radioactivity releases, other clean-up costs, and relateddamages or liabilities could be significant and could harm our business. Thecost of this liability could exceed our resources.

 

Weare required to comply with increasingly stringent laws and regulationsgoverning environmental protection and workplace safety, including requirementsgoverning the handling, storage and disposal of radioactive and other hazardoussubstances and wastes, and laboratory operating and safety procedures. Theselaws and regulations can impose substantial fines and criminal sanctions forviolations. Maintaining compliance with these laws and regulations with regardto our operations could require substantial additional resources. These costscould decrease our ability to conduct operations in a cost-effective manner.

 

**If product liability lawsuits are successfully broughtagainst us, we may incur substantial liabilities and may be required to limitcommercialization of our product candidates.**

** **

Ourbusiness may expose us in the future to product liability risks, which areinherent in the testing, manufacture, marketing and sale of pharmaceuticalproducts. Product liability claims might be brought against us by clinicaltrial patients, consumers or health care providers or by pharmaceuticalcompanies or others selling our products. If we complete clinical testing forour product candidates and receive regulatory approval to market our products,we will include warnings on our products that identify the known potentialadverse effects and the patients who should not receive our product. There canbe no assurance that these warnings will be deemed adequate, or that physiciansand patients will comply with these warnings.

 

Ifwe cannot successfully defend ourselves against such claims, we may incursubstantial liabilities or be required to limit commercialization of our futureproducts. We cannot predict all of the possible harms or side effects that mayresult and, as a result, the amount of insurance coverage we currently hold, orthat we may obtain, may not be adequate to protect us from any liabilities. Wemay require increased liability coverage as our product candidates advance inclinical trials and later develop and commercialize these products. Further,insurance coverage is increasingly expensive, and we do not know whether wewill be able to maintain insurance coverage at a reasonable cost or insufficient amounts to protect us against losses due to liability. A successfulproduct liability claim brought against us in excess of our insurance coverageor a product recall could adversely affect our business, results of operationsand financial condition.

 

**Risks Related to Our Industry**

** **

**Competition from third parties may hinder our success.**

** **

Ifwe develop and commercialize our product candidates in the future, we expectcompetition from fully integrated pharmaceutical companies and more establishedbiotechnology companies as well as government, universities and public andprivate research institutions. These companies and institutions conductresearch, seek patent protection and establish collaborative arrangements forproduct development and marketing. Most of these companies and institutionshave significantly greater financial resources and expertise than we do in thefollowing:

 

•      research and development;

 

•      preclinical studies and clinical trials;

 

•      obtaining regulatory approvals;

 

•      manufacturing; and

 

•      marketing and distribution.

 

Smallercompanies may also prove to be significant competitors, particularly throughcollaborative arrangements with large pharmaceutical companies or otherorganizations. In addition, other companies and institutions compete with us inrecruiting and retaining highly qualified scientific and management personnel.If we develop and commercialize our product candidates in the future, ourcompetitors may develop more effective, safer or more affordable products andtechnologies, or commercialize products earlier than we do. If our competitorsare successful in this respect, it could limit the prices that we are able tocharge for the products that we market, and prevent us from becomingprofitable. In some cases, competing products could render obsolete anyproducts we eventually develop.

 

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**Legislative and regulatory proposals to reduce the cost ofhealth care could adversely affect our business.**

 

Therehave been a number of federal and state proposals in the U.S. to implementgovernment controls on pricing and other efforts to reduce the cost of healthcare, including proposals to reform health care or reduce government insuranceprograms. Our business is affected by these efforts and these efforts could adverselyaffect prices of our products. In addition, government pricing controls existin varying forms in other countries. The emphasis on managed care in the U.S.has also increased and will likely continue to increase the pressure to reducethe prices of pharmaceutical products. We cannot predict whether any of theseproposals will be adopted or the effect these proposals or managed care effortsmay have on our business. In addition, the current discussion of drugreciprocation into the U.S. could also affect our future business operations.Some proposals would permit the reimportation of approved drugs that wereoriginally manufactured in the U.S. from other countries where the drugs weresold at a lower price. These and other initiatives could decrease the price weor any potential marketing partners receive for our products, adverselyaffecting our profitability. The pendency or approval of such proposals couldresult in a decrease in our stock price or limit our ability to raise capital,enter into strategic partnerships or obtain licenses.

 

**We may be unable to effectively price our products or obtainadequate reimbursement for sales of our products, which would prevent ourproducts from becoming profitable.**

** **

Ourproduct candidates, if developed and commercialized, may not be consideredcost-effective, and coverage and adequate payments may not be available or maynot be sufficient to allow us to sell these products on a competitive basis. Inboth the United States and elsewhere, sales of medical products and treatmentsare dependent, in part, on the availability of reimbursement from healthmaintenance organizations, other private insurance plans, governmental programssuch as Medicare, and other third-party payors. Third-party payers areincreasingly challenging the prices charged for pharmaceutical products andservices.  Government and otherthird-party payors increasingly are attempting to contain health care costs bylimiting both coverage and the level of reimbursement for new drugs and byrefusing, in some cases, to provide coverage for uses of approved products fordiseases or conditions for which the FDA has not granted labelingapproval.  Significant uncertainty existsas to whether and how much third-party payors will reimburse patients for theiruse of newly-approved drugs, which in turn will put pressure on the pricing ofdrugs. Third-party insurance coverage may not be available to patients for ourproducts. If government and other third-party payors do not provide adequatecoverage and reimbursement levels for our products, their market acceptance maybe reduced or we may not be able to commercialize our products.  

 

**Risks Related to Our Intellectual Property**

** **

**Our success is dependent on obtaining and defending patentsand proprietary technology.**

** **

Oursuccess in commercializing, producing and marketing products and technologiesin the future depends, in part, on our ability to obtain and maintain adequateprotection of the intellectual property related to our technologies andproducts, both in the U.S. and other countries, and to operate withoutinfringing the proprietary rights of third parties. We will be able to protectour proprietary rights from unauthorized use by third parties only to theextent that our proprietary technologies are covered by valid and enforceablepatents. The patent positions of biotechnology companies, including our patentpositions, are generally uncertain and involve complex legal and factualquestions.

 

Wecannot predict the breadth of claims that will be allowed and issued to us forpatents related to biotechnology or pharmaceutical applications. Before apatent is issued, its coverage can be significantly narrowed, either in theU.S. or abroad. We also do not know whether any of our pending or future patentapplications will result in the issuance of patents. To the extent patents havebeen issued or will be issued, some of these patents are subject to furtherproceedings that may limit their scope and once patents have been issued, wecannot predict how the claims will be construed or enforced. It is not possibleto determine which patents may provide significant proprietary protection orcompetitive advantage, or which patents may be circumvented or invalidated.Furthermore, patents already issued to us, or patents that may be issued on ourpending applications, may become subject to dispute, including interferenceproceedings in the U.S. to determine priority of invention. If our currentlyissued patents are invalidated or if the claims of those patents are narrowed, ourability to prevent competitors from marketing products that are currentlyprotected by those patents could be reduced or eliminated. We could then faceincreased competition resulting in reduced market share, prices and profit.

 

Inaddition, the laws of some foreign countries do not protect proprietary rightsto the same extent as the laws of the U.S., and many companies have encounteredsignificant problems in protecting and defending their proprietary rights inforeign jurisdictions. For example, methods of treating humans are notpatentable in many countries outside of the U.S.

 

Ourpatents may not afford us protection against competitors, especially sincethere is a lengthy time between when a patent application is filed and when itis issued. We may also incur substantial costs in asserting claims against, anddefending claims asserted against us by third parties to prevent theinfringement of our patents and proprietary rights by others. Participation insuch infringement proceedings may adversely affect our business and financialcondition, even if the eventual outcome is favorable.

 

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**Litigation or third party claims of intellectual propertyinfringement could require us to spend substantial time and money and adverselyaffect our ability to develop and commercialize our products.**

** **

Ourcommercial success also depends in part on our ability to avoid infringingpatents and proprietary rights of third parties and not breaching any licensesthat we have entered into with regard to any future products. There are manypharmaceutical and chemical patents and applications being filed, published,and issued frequently throughout the world. Some of these patents andapplications contain disclosures and claims that are similar to technologiesand products that we are using and developing. Some of these patents anddisclosures contain claims and disclosures that are difficult to interpret. Itis possible that a third party may own or control issued patents, or patentapplications or in the future may file, patent applications coveringtechnologies or products we are developing.

 

Ifour technology, products or activities are deemed to infringe the othercompanies’ rights, we could be subject to damages or be prevented from usingthe technology or selling the product that is infringing other companies’rights, or we could be required to obtain licenses to use that technology orsell the product. If patents covering technologies required by our operationsare issued to others, we may have to rely on licenses from third parties, whichmay not be available on commercially reasonable terms, if at all. Third partiesmay accuse us of employing their proprietary technology without authorization.In addition, third parties may obtain patents that relate to our technologiesand claim that our use of such technologies infringes their patents, even if wehave received patent protection for our technology. Such claims could requireus to incur substantial costs and could have a material adverse effect on us,regardless of the merit of the claims, including the following:

 

•      the diversion of management and technical personnel in defending us against anysuch claims or enforcing our patents. In this regard, we may be required todefend a lawsuit or defend a proceeding in the United States Patent andTrademark Office, either of which could be expensive and time consuming;

 

•      paying a large sum for damages if we are found to infringe;

 

•      being prohibited from selling or licensing our products or product candidatesunless and until we obtain a license from the patent holder, who may refuse togrant us a license or who may only agree to do so on unfavorable terms. Even ifwe are granted a license, we may have to pay substantial royalties or grantcross-licenses to our patents;

 

•      redesigning our products or product candidates so they do not infringe on thepatent holder’s technology if we are unable to obtain a license. This may notbe possible and, even if possible, it could require substantial additionalcapital and could significantly delay commercialization while we attempt todesign around the patents or rights infringed;

 

•      incurring substantial cost in defending ourselves and indemnifying ourstrategic partners in patent infringement or proprietary rights violationactions brought against them relating to their development andcommercialization of our products; and

 

•      incurring substantial cost in indemnifying the investors in the financing thatclosed on April 5, 2006 in the event that any intellectual propertyinfringement is deemed to be a breach of the purchase agreement for thefinancing.

 

**We may be required to obtain rights to proprietarytechnologies that are required to further develop our business and that may notbe available or may be costly.**

** **

Ouroncology programs may require the use of multiple products or technologiesproprietary to other parties. Third party suppliers may not be able to furnishus with a supply of these products sufficient to satisfy our requirements. Wemay not be able to obtain additional licenses we may need in the future onterms acceptable to us. Our inability to obtain any one or more of theselicenses, on commercially reasonable terms, if at all, or to circumvent theneed for any such license, could cause significant delays and cost increasesand materially affect our ability to develop and commercialize our productcandidates. In connection with our efforts to obtain rights to theseproprietary technologies, we may find it necessary to convey rights to ourtechnology to others. Some of our products may require the use of multipleproprietary technologies. Consequently, we may be required to make cumulativeroyalty payments to several third parties. These cumulative royalties couldbecome commercially prohibitive. We may not be able to successfully negotiatethe amounts of these royalties on terms acceptable to us.

 

Wemay rely in part on third party licenses for access to intellectual propertyrelating to our oncology programs. Such licenses may obligate us to exercisediligence in pursuing the development of product candidates, to make specifiedmilestone payments and/or to pay royalties. Our inability or failure to meetany such diligence requirements or make any required payments would likelyresult in a reversion to the licensor of the rights granted, which couldmaterially and adversely affect our ability to develop and market productsbased on our licensed technologies.

 

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**Risks Related to Our Stock**

** **

**The investors in our recently consummated financing haveacquired shares of common stock and warrants representing substantially morethan a majority of shares of our outstanding common stock and have the abilityto exert control over our activities.**

** **

Theinvestors in the recently consummated financing have acquired shares of ourcommon stock and warrants to acquire such shares representing up toapproximately 88% of our common stock, assuming the exercise in full of thewarrants issued in the financing.  As aresult, those investors hold a sufficient portion of our outstanding shares soas to permit them, if they chose to act in concert, to approve all actionsrequiring stockholder approval, including the election of directors and theapproval of mergers or other business combination transactions, withoutobtaining the approval of any other stockholder.

 

**Future sales and issuances of our common stock or rights topurchase common stock, including pursuant to our equity incentive plans, couldresult in additional dilution of the percentage ownership of our stockholdersand could cause our stock price to fall.**

** **

Weexpect that significant additional capital will be required in the future tocontinue our research and development efforts. To the extent we raise additional capital by issuing equity securities,our stockholders may experience substantial dilution.  We may sell common stock in one or moretransactions at prices and in a manner we determine from time to time. If we sellcommon stock in more than one transaction, stockholders who purchase stock maybe materially diluted by subsequent sales. Such sales may also result inmaterial dilution to our existing stockholders. In addition, our Board ofDirectors and stockholders recently adopted a new equity incentive plan thatwill provide for an initial reservation of 6,577,106 shares of common stock,for which options on 3,259,480 shares were immediately granted thereunder. Theshares available for issuance under this equity incentive plan may be increasedby up to 1,600,000 shares of common stock based upon the number of shares ofcommon stock we issue during the three year period after April 5, 2006. Ourstockholders also recently approved an amendment to our bylaws and our existingstock option plans to permit the repricing of approximately 630,038 of ourcurrently outstanding stock options, which was effected on April 4, 2006 andthe exercise price of each such repriced option was reduced to $4.02 per share.

 

**Substantialsales of shares may impact the market price of our common stock.**

 

Salesof a substantial number of shares of our common stock in the public market, orthe perception that these sales might occur, could depress the market price ofour common stock and could impair our ability to raise capital through the saleof additional equity securities. We are unable to predict the effect that salesmay have on the then prevailing market price of our common stock. Pursuant to aRegistration Rights Agreement entered into between us and the purchasers of ourcommon stock and warrants in the financing recently closed on April 6, 2006,such purchasers are entitled to certain registration rights with respect to theshares of common stock that were issued to them at closing and that may beissued upon exercise of the warrants issued to them at closing, pursuant towhich we must, among other things, file with the Securities and ExchangeCommission a registration statement for the resale of such shares of commonstock and the shares of common stock underlying such warrants.

 

**If we fail to continue to meet all applicable Nasdaq CapitalMarket requirements and Nasdaq determines to delist our common stock, thedelisting could adversely affect the market liquidity of our common stock andthe market price of our common stock could decrease.**

** **

Ourcommon stock is listed on the Nasdaq Capital Market. In order to maintain thatlisting, we must satisfy minimum financial and other requirements. OnFebruary 25, 2005, we received notice from the Nasdaq StockMarket, Inc. that our common stock had not met the $1 per share minimumbid price requirement for 30 consecutive business days and that, if we wereunable to demonstrate compliance with this requirement during the applicablegrace periods, our common stock would be delisted after that time.  On February 6, 2006, we effectuated a one forten reverse stock split to regain compliance with this listingrequirement.  Since the reverse stockspilt was effectuated, the closing bid price of our common stock has remainedabove $1.00 in compliance with the minimum bid price requirement.

 

Notwithstandingthat the trading price of our common stock currently exceeds the minimum bidprice required to maintain compliance with the Nasdaq Capital Market listingrequirements, it is possible that the minimum bid price of our common stockcould fall below the required level or that we would otherwise fail to satisfyanother Nasdaq requirement for continued listing of our common stock. Forexample, we could fail to maintain compliance with the Nasdaq Capital Marketlisting requirements if we did not maintain minimum stockholder equity of atleast $2.5 million as a result of continuing losses.

 

Ifwe fail to continue to meet all applicable Nasdaq Capital Market requirementsin the future and Nasdaq determines to delist our common stock, the delistingcould adversely affect the market liquidity of our common stock and the marketprice

 

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of our common stock could decrease. Suchdelisting could also adversely affect our ability to obtain financing for thecontinuation of our operations and could result in the loss of confidence byinvestors, suppliers and employees.

 

**Our stock compensation expense will negatively impact ourearnings, and as we report the fair value of employee stock options as anexpense in conjunction with a new accounting standard, our reported financialperformance will be adversely affected, which may cause our stock price todecline.**

** **

InDecember 2004, the Financial Accounting Standards Board issued SFAS123(R), “Accounting for Stock-Based Compensation”. SFAS 123(R) establishesstandards for the accounting for transactions in which an entity exchanges itsequity instruments for goods or services. This statement focuses primarily onaccounting for transactions in which an entity obtains employee services inshare-based payment transactions. SFAS 123(R) requires that the fair valueof such equity instruments be recognized as an expense in the historical financialstatements as services are performed. Prior to SFAS 123(R), only certainpro forma disclosures of fair value were required. As a result of the adoptionof SFAS 123(R) in the first quarter 2006, we recorded stock-based compensationexpense of $477,000 or $.14 basic and diluted per share from continuingoperations and $86,000 or $.02 basic and diluted loss per share fromdiscontinued operations.  As a result ofthe amendment of certain outstanding options under the our existing equityincentive plans as well as the grant of additional stock options, the amount ofexpense recognized and the period over which it will be recognized will resultin a substantial increase in stock-based compensation expense in futurequarters.  In addition, in the second quarterof fiscal 2006, the Company will record a non-cash fixed period charge relatedto the amended vested options.

 

**We have implemented anti-takeover provisions that may reducethe market price of our common stock.**

** **

Ourcertificate of incorporation and bylaws provide that the Board of Directorswill be divided into three classes, each consisting, as nearly as possible, ofone-third of the total number of directors, with each class having a three-yearterm. Stockholders may take action only at a stockholders’ meeting and not bywritten consent. Certain provisions of our certificate of incorporation andbylaws, including the provisions providing for a classified Board of Directors,may not be amended without the vote of at least 80% of the voting power of all ofour capital stock entitled to vote generally in the election of directors,voting together as a single class. Our bylaws provide that stockholders wishingto nominate a director at an annual meeting or at a special meeting called forthe purpose of electing directors or to bring business before any meeting ofstockholders must comply with strict advance written notice provisions. Ourbylaws also provide that special meetings of stockholders may be called only bythe chairman of our Board of Directors, or certain of our officers, or byresolution of our directors.

 

Theseprovisions of our certificate of incorporation and our bylaws could discouragepotential acquisition proposals and could delay or prevent a change in control.These provisions are intended to enhance the likelihood of continuity andstability in the composition of our Board of Directors and in the policiesformulated by our Board of Directors. We also intended these provisions todiscourage certain types of transactions that may involve an actual orthreatened change of control. We designed these provisions to reduce ourvulnerability to unsolicited acquisition proposals and to discourage certaintactics that may be used in proxy contests. These provisions, however, couldalso have the effect of discouraging others from making tender offers for ourshares. As a consequence, they also may inhibit fluctuations in the marketprice of our shares that could result from actual or rumored takeover attempts.Such provisions also may have the effect of preventing changes in ourmanagement. We are permitted to issue shares of our preferred stock withoutstockholder approval upon such terms as our Board of Directors determines.Therefore, the rights of the holders of our common stock are subject to, and maybe adversely affected by, the rights of the holders of our preferred stock thatmay be issued in the future. In addition, the issuance of preferred stock couldhave a dilutive effect on the holdings of our current stockholders.

 

InNovember 1996, we adopted a stockholder rights plan and distributed adividend for each share of common stock. This dividend took the form of aright, which entitles the holders to purchase one one-hundredth of a share of anew series of junior participating preferred stock, Series B. Thestockholder rights plan was amended and restated in September 2001, and weintend to replace this plan with a similar rights plan in 2006. In certainevents after the rights become exercisable they will entitle each holder, otherthan the acquirer, to purchase, at the rights’ then current exercise price, anumber of shares of common stock having market value of twice the right’sexercise price or a number of the acquiring company’s common shares having amarket value at the time of twice the rights’ exercise price. The adoption ofthe rights plan makes it more difficult for a third party to acquire control ofus without the approval of our Board of Directors. We are also subject toprovisions of Delaware law that prohibit us from engaging in any businesscombination with any “interested stockholder,” meaning generally that astockholder who beneficially owns more than 15% of our stock cannot acquire usfor a period of three years from the date this person became an interestedstockholder, unless various conditions are met, such as approval of thetransaction by our Board of Directors.

 

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Becausethe investors in our financing that closed on April 5, 2006 own a substantialpercentage of our outstanding common stock, we amended the stockholder rightsplan in connection with the closing of such financing to provide that suchinvestors and their respective affiliates will be exempt from the stockholderrights plan, unless an investor and its affiliates acquire, after April 4,2006, more than 1% of our then issued and outstanding common stock, notincluding the shares of common stock issued to the investors in the financingor shares of common stock issued upon exercise of the warrants issued to the investorsin the financing.

 

**Item 2. UnregisteredSales of Equity Securities and Use of Proceeds**

 

Not applicable.

 

##### **Item 3.  Defaultsupon Senior Securities**

##### ** **

Not applicable.

 

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

 

At a special meeting of shareholders held on April 4, 2006, thefollowing four proposals were presented to stockholders and were approved.

 

Proposal1.  To approve the sale and issuance, ina private placement to certain investors, of 12,750,000 shares of our commonstock at a price of $2.00 per share, and warrants to purchase up to anadditional 12,750,000 shares of our common stock at an exercise price of $2.40per share, in exchange for aggregate gross proceeds payable to the Company of$25.5 million not including any proceeds from exercise of the warrants.  1,340,411 shares were voted for thisproposal; 493,758 shares were voted against the proposal; and holders of 4,327shares abstained from voting.  

 

Proposal2.  To approve the Company’s 2006 EquityIncentive Plan and the grant of certain stock options thereunder.  1,082,010 shares were voted for thisproposal; 712,548 shares were voted against the proposal; and holders of 43,938shares abstained from voting.  

 

Proposal 3. Toapprove an amendment to the Company’s bylaws to delete a limitation on theCompany’s ability to reduce the exercise price of any stock option grantedunder any existing or future stock option plan. 1,085,115 shares were voted for this proposal; 708,747 shares were votedagainst the proposal; and holders of 44,634 shares abstained from voting.

 

Proposal 4. Toapprove the repricing of options to purchase up to 630,038 shares of commonstock previously granted under the Company’s equity incentive plans, wherebythe exercise price of such options would be reduced to $4.02 per share.  1,067,105 shares were voted for thisproposal; 726,913 shares were voted against the proposal; and holders of 44,478shares abstained from voting.  

 

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**Item 5. Other Information**

 

Not applicable.

 

**Item 6. Exhibits**

 
| **Exhibit  Number** | ** ** | **Description  of Exhibit**                                                                                                                                                                                                                      |
|---------------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.1                | ** ** | Purchase  Agreement, dated February 2, 2006 (together with schedule prepared in  accordance with Instruction 2 to Item 601 of Regulation S-K) (1)                                                                                                |
| 10.2                | ** ** | Registration  Rights Agreement, dated April 5, 2006 entered into by and among Tapestry  Pharmaceuticals, Inc. and the Purchasers (2)                                                                                                        |
| 10.3                | ** ** | Form  of Warrant, dated April 5, 2006 between the Company and the Purchasers  (together with schedule prepared in accordance with Instruction 2 to Item 601  of Regulation S-K) (2)                                                              |
| 10.4                | ** ** | Lock-Up  Agreement by and among Tapestry Pharmaceuticals, Inc. and certain  officers and directors thereof(1)                                                                                                                               |
| 10.5                | ** ** | Amendment  No. 1 to the Rights Agreement, dated April 4, 2006 (2)                                                                                                                                                                                |
| 10.6                | ** ** | 2006  Equity Incentive Plan (2)                                                                                                                                                                                                                  |
| 10.7                | ** ** | Form of Stock Option Agreement for certain option grant under  the Company’s 2006 Equity Incentive Plan*                                                                                                                               |
| 10.8                | ** ** | Settlement Agreement dated March 22, 2006 between Tapestry  Pharmaceuticals, Inc. and Patricia A. Pilia(3)                                                                                                                                       |
| 10.9                | ** ** | Amendment to Employment Agreement executed by the Company and  Patricia Pilia dated March 22, 2006 (3)                                                                                                                                           |
| 10.10               | ** ** | Form of Amendment to Employment Agreement executed by the Company and  Leonard Shaykin, Gordon Link and Kai Larson dated February 27, 2006 (together  with Schedule required by Instruction 2 to Item 601 of Regulation S-K) (4)                 |
| 10.11               | ** ** | Form of waiver letter signed by Leonard Shaykin, Gordon Link and  Kai P. Larson on February 24, 2005 (together with Schedule required by  Instruction 2 to Item 601 of Regulation S-K) (4)                                             |
| 31.1                |       | Certification of Chief Executive Officer (pursuant to  Rule 13a-14(a)/15d-14(a) under the Securities Exchange Act of 1934,  as amended) *                                                                                              |
| 31.2                |       | Certification of Chief Financial Officer (pursuant to  Rule 13a-14(a)/15d-14(a) under the Securities Exchange Act of 1934,  as amended) *                                                                                              |
| 32.1#               |       | Certification of Chief Executive Officer (pursuant to  Rule 13a-14(b) of the Securities Exchange Act of 1934, as amended,  and Section 1350 of Chapter 63 of Title 18 of the United States Code (18  U.S.C. Section 1350)) * |
| 32.2#               |       | Certification of Chief Financial Officer (pursuant to  Rule 13a-14(b) of the Securities Exchange Act of 1934, as amended,  and Section 1350 of Chapter 63 of Title 18 of the United States Code (18  U.S.C. Section 1350)) * |

 

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*              Filedherewith

#              This certification “accompanies” thisForm 10-Q, is not deemed filed with the SEC and is not to be incorporatedby reference into any filing of the Company under the Securities Act of 1933,as amended, or the Securities Exchange Act of 1934, as amended (whether made beforeor after the date of the Form 10-Q), irrespective of any generalincorporation language contained in such filing.

(1)           Incorporatedherein by reference to the Company’s Current Report on Form 8-K datedFebruary 2, 2006 (File No. 0-24320) filed February 6, 2006

(2)           Incorporatedherein by reference to the Company’s Current Report on Form 8-K datedApril 4, 2006 (File No. 0-24320) filed April 10, 2006

(3)           Incorporatedherein by reference to the Company’s Current Report on Form 8-K datedMarch 22, 2006 (File No. 0-24320) filed March 27, 2006

(4)           Incorporatedherein by reference to the Company’s Current Report on Form 8-K datedFebruary 23, 2006 (File No. 0-24320) filed March 1, 2006

 

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# **Signatures**

 

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

 

 
|         | TAPESTRY PHARMACEUTICALS, INC.                        |
|--------------|-------------------------------------------------------|
|         |                                                  |
| May 10, 2006 | By:                                                   | /s/ Leonard P. Shaykin |   |
| ** **   | **Leonard P. Shaykin**                                |
| ** **   | **Chairman of the Board of Directors,**               |
| ** **   | **Chief Executive Officer**                           |
| ** **   | ** **                                            |
|         |                                                  |
| May 10, 2006 | By:                                                   | /s/ Gordon Link |   |
| ** **   | **Gordon Link**                                       |
| ** **   | **Senior Vice President,**                            |
| ** **   | **Chief Financial Officer**                           |
| ** **   | **(Principal Financial Officer and**                  |
| ** **   | **     Principal Accounting Officer)** |

 

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**Index of Exhibits**

 
| **Exhibit  Number** | ** ** | **Description  of Exhibit**                                                                                                                                                                                                                      |
|---------------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.1                | ** ** | Purchase  Agreement, dated February 2, 2006 (together with schedule prepared in  accordance with Instruction 2 to Item 601 of Regulation S-K) (1)                                                                                                |
| 10.2                | ** ** | Registration  Rights Agreement, dated April 5, 2006 entered into by and among Tapestry  Pharmaceuticals, Inc. and the Purchasers (2)                                                                                                        |
| 10.3                | ** ** | Form  of Warrant, dated April 5, 2006 between the Company and the Purchasers  (together with schedule prepared in accordance with Instruction 2 to Item 601  of Regulation S-K) (2)                                                              |
| 10.4                | ** ** | Lock-Up  Agreement by and among Tapestry Pharmaceuticals, Inc. and certain  officers and directors thereof(1)                                                                                                                               |
| 10.5                | ** ** | Amendment  No. 1 to the Rights Agreement, dated April 4, 2006 (2)                                                                                                                                                                                |
| 10.6                | ** ** | 2006  Equity Incentive Plan (2)                                                                                                                                                                                                                  |
| 10.7                | ** ** | Form of  Stock Option Agreement for certain option grant under the Company’s 2006  Equity Incentive Plan*                                                                                                                              |
| 10.8                | ** ** | Settlement  Agreement dated March 22, 2006 between Tapestry Pharmaceuticals, Inc. and  Patricia A. Pilia(3)                                                                                                                                      |
| 10.9                | ** ** | Amendment  to Employment Agreement executed by the Company and Patricia Pilia dated  March 22, 2006 (3)                                                                                                                                          |
| 10.10               | ** ** | Form  of Amendment to Employment Agreement executed by the Company and Leonard  Shaykin, Gordon Link and Kai Larson dated February 27, 2006 (together with  Schedule required by Instruction 2 to Item 601 of Regulation S-K) (4)                |
| 10.11               | ** ** | Form of  waiver letter signed by Leonard Shaykin, Gordon Link and Kai P. Larson on  February 24, 2005 (together with Schedule required by Instruction 2 to  Item 601 of Regulation S-K) (4)                                            |
| 31.1                |       | Certification of Chief Executive Officer (pursuant to  Rule 13a-14(a)/15d-14(a) under the Securities Exchange Act of 1934,  as amended) *                                                                                              |
| 31.2                |       | Certification of Chief Financial Officer (pursuant to  Rule 13a-14(a)/15d-14(a) under the Securities Exchange Act of 1934,  as amended) *                                                                                              |
| 32.1#               |       | Certification of Chief Executive Officer (pursuant to  Rule 13a-14(b) of the Securities Exchange Act of 1934, as amended,  and Section 1350 of Chapter 63 of Title 18 of the United States Code (18  U.S.C. Section 1350)) * |
| 32.2#               |       | Certification of Chief Financial Officer (pursuant to  Rule 13a-14(b) of the Securities Exchange Act of 1934, as amended,  and Section 1350 of Chapter 63 of Title 18 of the United States Code (18  U.S.C. Section 1350)) * |

 

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*              Filedherewith

#              This certification “accompanies” thisForm 10-Q, is not deemed filed with the SEC and is not to be incorporatedby reference into any filing of the Company under the Securities Act of 1933,as amended, or the Securities Exchange Act of 1934, as amended (whether madebefore or after the date of the Form 10-Q), irrespective of any generalincorporation language contained in such filing.

(1)           Incorporatedherein by reference to the Company’s Current Report on Form 8-K datedFebruary 2, 2006 (File No. 0-24320) filed February 6, 2006

(2)           Incorporatedherein by reference to the Company’s Current Report on Form 8-K datedApril 4, 2006 (File No. 0-24320) filed April 10, 2006

(3)           Incorporatedherein by reference to the Company’s Current Report on Form 8-K datedMarch 22, 2006 (File No. 0-24320) filed March 27, 2006

(4)           Incorporatedherein by reference to the Company’s Current Report on Form 8-K datedFebruary 23, 2006 (File No. 0-24320) filed March 1, 2006

 

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