**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

**Form 10-Q**

**(MarkOne)**

**x**                              QUARTERLYREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACTOF 1934

**FORTHE QUARTERLY PERIOD ENDED JUNE 28, 2006**

**OR**

**o**                                 TRANSITIONREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACTOF 1934

**FORTHE TRANSITION PERIOD FROM                    TO                    **

**CommissionFile Number 0-24320**

**TAPESTRY PHARMACEUTICALS, INC.**

(Exact name of Registrantas specified in its charter)

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

 

**4840 Pearl East Circle, Suite 300WBoulder, Colorado 80301**

(Address of principalexecutive office, including zip code)

**(303) 516-8500**

(Registrant’s telephonenumber, including area code)

Indicate by check markwhether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during thepreceding 12 months (or for such shorter period that the registrant wasrequired to file such reports), and (2) has been subject to such filingrequirements for the past 90 days. Yes x  No o

Indicate by check markwhether the registrant is a large accelerated filer, an accelerated filer, or anon-accelerated filer. See definition of “accelerated filer and largeaccelerated filer” in Rule 12b-2 of the Exchange Act. (Checkone):   Large accelerated filer o  Accelerated Filer o   Non-accelerated filer x

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

As of August 2, 2006,the registrant had 16,341,916 shares of common stock, $0.0075 par value,outstanding.

 

----

**TapestryPharmaceuticals, Inc. and Subsidiaries**

**Tableof Contents**
| **Part I**  | ** ** | **Financial  Information** |   | 3                                                                                           |
|------------------|------------|----------------------------|--------|---------------------------------------------------------------------------------------------|
|             |       | Item 1                     |   | Unaudited Financial Statements                                                              |   | 3 |
|             |       | Item 2                     |   | Management’s Discussion and  Analysis of Financial Condition and Results of Operations |   | 16 |
|             |       | Item 3                     |   | Quantitative and Qualitative  Disclosures about Market Risk                                 |   | 23 |
|             |       | Item 4                     |   | Controls and Procedures                                                                     |   | 24 |
| **Part II** | ** ** | **Other Information**      |   | 25                                                                                          |
|             |       | Item 1                     |   | Legal Proceedings                                                                           |   | 25 |
|             |       | Item 1A                    |   | Risk Factors                                                                                |   | 25 |
|             |       | Item 2                     |   | Unregistered Sales of Equity  Securities and Use of Proceeds                                |   | 37 |
|             |       | Item 3                     |   | Defaults upon Senior  Securities                                                            |   | 37 |
|             |       | Item 4                     |   | Submission of Matters to a  Vote of Security Holders                                        |   | 37 |
|             |       | Item 5                     |   | Other Information                                                                           |   | 37 |
|             |       | Item 6                     |   | Exhibits                                                                                    |   | 38 |
| **Signatures**   |       | 39                         |

 

2

----

**Part I**

**FINANCIALINFORMATION**

**Item 1. FinancialStatements**

**TapestryPharmaceuticals, Inc. and SubsidiariesConsolidated Balance Sheets(In thousands, except share data)(Unaudited)**

| ** **                                                                                                                                                                              | ** ** | **June 28,** | ** ** | **December 28,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                              | ** ** | **2006**          | ** ** | **2005**              | ** ** |
| **ASSETS**                                                                                                                                                                              |       |              |       |                  |       |   |   |
| Current assets:                                                                                                                                                                         |       |              |       |                  |       |   |   |
| Cash and cash equivalents                                                                                                                                                               |       | $                 | 140        |                  |       | $ | 534 |   |   |
| Short-term investments                                                                                                                                                                  |       | 31,531            |       |                  | 13,552     |   |   |
| Prepaid expense and other current assets                                                                                                                                                |       | 398               |       |                  | 646        |   |   |
| Total current  assets                                                                                                                                                                   |       | 32,069            |       |                  | 14,732     |   |   |
| Property, plant and equipments, net                                                                                                                                                     |       | 512               |       |                  | 608        |   |   |
| Investment in  ChromaDex, Inc.                                                                                                                                                     |       | 451               |       |                  | 451        |   |   |
| Other assets                                                                                                                                                                            |       | 683               |       |                  | 683        |   |   |
| Total assets                                                                                                                                                                            |       | $                 | 33,715     |                  |       | $ | 16,474 |   |   |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                                           |       |              |       |                  |       |   |   |
| Current liabilities:                                                                                                                                                                    |       |              |       |                  |       |   |   |
| Accounts payable and accrued liabilities                                                                                                                                                |       | $                 | 886        |                  |       | $ | 1,024 |   |   |
| Accrued payroll and payroll taxes                                                                                                                                                       |       | 1,496             |       |                  | 1,241      |   |   |
| Notes payable—current portion, net                                                                                                                                                 |       | 1,152             |       |                  | 840        |   |   |
| Total current  liabilities                                                                                                                                                              |       | 3,534             |       |                  | 3,105      |   |   |
| Notes payable—long term, net                                                                                                                                                       |       | 1,765             |       |                  | 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; 16,341,916 and 3,480,704 shares issued and outstanding at  June 28, 2006 and December 28, 2005, respectively. |       | 123               |       |                  | 26         |   |   |
| Additional paid in capital                                                                                                                                                              |       | 144,117           |       |                  | 118,278    |   |   |
| Deferred compensation                                                                                                                                                                   |       | —            |       |                  | (114       | ) |   |
| Accumulated deficit                                                                                                                                                                     |       | (115,816          | )          |                  | (107,262   | ) |   |
| Accumulated other comprehensive loss                                                                                                                                                    |       | (8                | )          |                  | (42        | ) |   |
| Total  stockholders’ equity                                                                                                                                                        |       | 28,416            |       |                  | 10,886     |   |   |
| Total liabilities and  stockholders’ equity                                                                                                                                        |       | $                 | 33,715     |                  |       | $ | 16,474 |   |   |

 

See accompanying notes to Consolidated Financial Statements.

3

----

**TapestryPharmaceuticals, Inc. and SubsidiariesConsolidated Statements of Operations(In thousands, except share data)(Unaudited)**

| ** **                                                     | ** ** | **Three-Months Ended** | ** ** | **Six-Months Ended** | ** ** |
|----------------------------------------------------------------|------------|-----------------------------|------------|---------------------------|------------|
| ** **                                                     | ** ** | **June 28,**           | ** ** | **June 29,**         | ** ** | **June 28,** | ** ** | **June 29,** | ** ** |
| ** **                                                     | ** ** | **2006**                    | ** ** | **2005**                  | ** ** | **2006** | ** ** | **2005** | ** ** |
| Operating expenses:                                            |       |                        |       |                      |       |   |   |   |   |
| Research and development                                       |       | $                           | 2,391      |                      | $          | 2,785 |   | $ | 5,205 |   | $ | 5,575 |   |
| General and administrative                                     |       | 2,038                       |       | 1,469                     |       | 3,495 |   | 3,066 |   |
| Operating loss                                                 |       | 4,429                       |       | 4,254                     |       | 8,700 |   | 8,641 |   |
| Other income  (expense):                                       |       |                        |       |                      |       |   |   |   |   |
| Interest and other income                                      |       | 394                         |       | 211                       |       | 536 |   | 382 |   |
| Interest and other expense                                     |       | (128                        | )          | (244                      | )          | (302 | ) | (411 | ) |
| Loss from  continuing operations                               |       | (4,163                      | )          | (4,287                    | )          | (8,466 | ) | (8,670 | ) |
| Loss from discontinued operations                              |       | —                      |       | (127                      | )          | (88 | ) | (308 | ) |
| Net loss                                                       |       | $                           | (4,163     | )                         | $          | (4,414 | ) | $ | (8,554 | ) | $ | (8,978 | ) |
| Basic and diluted loss per share from continuing  operations   |       | $                           | (0.28      | )                         | $          | (1.25 | ) | $ | (0.91 | ) | $ | (2.57 | ) |
| Basic and diluted  loss per share from discontinued operations |       | $                           | —     |                      | $          | (0.04 | ) | $ | (0.01 | ) | $ | (0.09 | ) |
| Basic and diluted  loss per share                              |       | $                           | (0.28      | )                         | $          | (1.29 | ) | $ | (0.92 | ) | $ | (2.66 | ) |
| Basic and diluted  weighted average shares outstanding         |       | 15,051,659                  |       | 3,412,361                 |       | 9,268,312 |   | 3,379,024 |   |

 

See accompanying notes to Consolidated Financial Statements.

4

----

**TapestryPharmaceuticals, Inc. and SubsidiariesConsolidated Statements of Cash Flows(In thousands)(Unaudited)**

| ** **                                                                   | ** ** | **Six-Months Ended** | ** ** |
|------------------------------------------------------------------------------|------------|---------------------------|------------|
| ** **                                                                   | ** ** | **June 28,**         | ** ** | **June 29,** | ** ** |
| ** **                                                                   | ** ** | **2006**                  | ** ** | **2005** | ** ** |
| Operating activities:                                                        |       |                      |       |   |   |
| Net loss                                                                     |       | $                         | (8,554     | ) | $ | (8,978 | ) |
| Adjustments to reconcile  net loss to net cash used in operating activities: |       |                      |       |   |   |
| Depreciation and amortization                                                |       | 113                       |       | 132 |   |
| Amortization of debt issue costs                                             |       | —                    |       | 92 |   |
| Amortization of debt discount                                                |       | 262                       |       | 209 |   |
| Amortization of investment premium (discount)                                |       | (106                      | )          | 152 |   |
| Compensation paid with common stock                                          |       | 1,924                     |       | 24 |   |
| Retirement contributions paid with common stock                              |       | 194                       |       | 210 |   |
| Impairment charges                                                           |       | —                    |       | 104 |   |
| (Gain)/loss on sale of investments                                           |       | 38                        |       | (72 | ) |
| Loss on disposal of assets                                                   |       | 1                         |       | 16 |   |
| Changes in  operating assets and liabilities:                                |       |                      |       |   |   |
| Prepaid expense and other assets                                             |       | 442                       |       | 100 |   |
| Accounts payable and accrued liabilities                                     |       | (193                      | )          | (2,269 | ) |
| Accrued payroll and payroll taxes                                            |       | 255                       |       | (916 | ) |
| Net cash used in  operating activities                                       |       | (5,624                    | )          | (11,196 | ) |
| Investing  acitivities:                                                      |       |                      |       |   |   |
| Additions to property and equipment                                          |       | (18                       | )          | (120 | ) |
| Proceeds from assets held for sale                                           |       | —                    |       | 104 |   |
| Purchases of investments                                                     |       | (46,127                   | )          | (19,379 | ) |
| Proceeds from sale of investments                                            |       | 28,250                    |       | 32,831 |   |
| Net cash (used  in) provided by investing activities                         |       | (17,895                   | )          | 13,436 |   |
| Financing  acitivities:                                                      |       |                      |       |   |   |
| Proceeds from the sale of common stock, net of  issuance costs               |       | 23,793                    |       | — |   |
| Payments of notes payable                                                    |       | (668                      | )          | (3,316 | ) |
| Proceeds from the exercise of common stock options                           |       | —                    |       | 31 |   |
| Net cash provided  by (used in) investing activities                         |       | 23,125                    |       | (3,285 | ) |
| Net decrease in  cash and cash equivalents                                   |       | (394                      | )          | (1,045 | ) |
| Cash and cash  equivalents at beginning of period                            |       | 534                       |       | 1,713 |   |
| Cash and cash  equivalents at end of period                                  |       | $                         | 140        |   | $ | 668 |   |
| Supplemental  disclosure of cash flow information;                           |       |                      |       |   |   |
| Interest paid                                                                |       | $                         | —     |   | $ | 136 |   |
| Non-cash  investing and financing activities:                                |       |                      |       |   |   |
| Issuance of  common stock to prepay retirement plan contributions            |       | $                         | 194        |   | $ | 210 |   |

 

See accompanying notes to Consolidated Financial Statements.

5

----

**TapestryPharmaceuticals, Inc.Notes to Consolidated Financial StatementsJune 28, 2006(Unaudited)**

**Note 1.**   Basis of Presentation andSummary of Significant Accounting Policies

In the opinion of management, the accompanyingunaudited consolidated balance sheets, statements of operations and cash flowscontain all adjustments, consisting of only normal, recurring adjustments,necessary to present fairly the financial position of Tapestry Pharmaceuticals, Inc.and its wholly owned subsidiaries (the “Company”) at June 28, 2006 and December 28,2005, the results of its operations for the three and six-months ended June 28,2006 and June 29, 2005, and cash flows for the six-months ended June 28,2006 and June 29, 2005.

The unaudited consolidated financial statementspresented herein have been prepared in accordance with the instructions to Form 10-Qand do not include all the information and note disclosures required byaccounting principles generally accepted in the United States. The consolidatedfinancial statements should be read in conjunction with the auditedconsolidated financial statements and notes thereto contained in the Company’sAnnual Report on Form 10-K for the year ended December 28,2005, filed with the Securities and Exchange Commission on February 23,2006 as well as Form 10-K/A filed on March 31, 2006.

*LIQUIDITY—**The*Company has norevenue and has incurred losses of approximately $4.2 million and $8.6 millionfor the three and six-months ended June 28, 2006, respectively and a lossof approximately $17.5 million for the year ended December 28, 2005 andhas an accumulated deficit of $115.8 million as of June 28, 2006. TheCompany’s capital requirements for research and development, including the costof clinical trials, have been and will continue to be significant. As of June 28,2006, the Company had cash and short-term investments totaling approximately$31.7 million. However, as of December 28, 2005 the Company had cash andshort-term investments totaling approximately $14.1 million. These factors, asof December 28, 2005, raised substantial doubt, which has since been dealtwith, as discussed below, about the Company’s ability to continue as a goingconcern. As a result of these concerns the audit report prepared by the Company’sindependent registered public accounting firm relating to the Company’sconsolidated financial statements for the year ended December 28, 2005included an explanatory paragraph expressing the substantial doubt about theCompany’s ability to continue as a going concern.

In late 2005 and early 2006 the Company took a numberof actions to reduce its monthly cash requirements, including, among otherthings, reductions in workforce and related facilities and payroll costs,reductions in the growth of executive compensation, reductions in facilitycosts, reductions in the number of active programs in development, reductionsin capital expenditures and reductions in charges from outside serviceproviders. At this time the Company also determined that its lead pharmaceuticalprogram warranted expanded clinical development. The Company therefore soughtthe additional capital necessary to fund its ongoing operations related to itslead pharmaceutical program.

On April 6, 2006, the Company sold an aggregateof 12,750,000 shares of its common stock, and related warrants to purchase upto an aggregate of 12,750,000 shares of its common stock for gross proceeds of$25.5 million not including any proceeds from the exercise of the warrants (orapproximately $23.8 million net of transaction fees and expenses). As part ofthe financing, the Company agreed to a covenant that the net proceeds from thetransaction 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 anythree-month period if certain 

6

----

conditions are satisfied,including the trading price of the Company’s common stock exceeding $4.80 for20 consecutive trading days. Up to half of the warrants may be exercisedon a cashless or net exercise basis. There can be no assurance, however, thatthe Company will receive funds from the exercise of warrants. See Note 8 forfurther discussion.

As of June 28, 2006 the Company had cash andshort-term investments of approximately $31.7 million and working capital ofapproximately $28.5 million. The Company believes it has sufficient capital tofund its operations and capital expenditures for more than the next 12 months. However,pharmaceutical development is costly, risky and time intensive activity. Tobring the Company’s various programs to completion will require the Company toraise additional capital as practicable to fund future operations and toprovide additional working capital. There can be no assurance that the Companywill be able to obtain additional capital on terms that will be acceptable tothe Company or on any terms. In addition, the Company may seek to acquire newproduct or technologies through in-licensing, purchase or merger. The cost andrelated capital 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.

*ESTIMATESAND ASSUMPTIONS**—*The preparationof the Company’s consolidated financial statements in conformity withaccounting principles generally accepted in the United States requires theCompany’s management to make estimates and assumptions that affect the reportedamounts of assets and liabilities, and disclosure of contingent assets andliabilities at the date of the financial statements and the reported amounts ofrevenue and expenses during the reporting period. Significant estimates areused when determining useful lives for depreciation and amortization, assessingthe need for impairment charges, accounting for income taxes, estimating thevalue of employee stock options, and various 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. Theresults of these estimates form the basis for making judgments about thecarrying values of assets and liabilities as well as identifying and assessingthe accounting treatment with respect to commitments and contingencies. Actualresults may differ materially from these estimates.

*SHAREBASED COMPENSATION*—As of June 28, 2006, theCompany had five equity incentive plans (the “Plans”), the 1994 Long-TermPerformance Incentive Plan, the 1998 Stock Incentive Plan, the 2004 EquityIncentive Plan, the 2004 Non-Employee Director’s Stock Option Plan, and the2006 Equity Incentive Plan, which was approved by shareholders on April 4,2006.

On December 29, 2005, the Company adoptedStatement of Financial Accounting Standards No. 123 (revised 2004), *Share-Based Payment*, (“SFAS 123(R)”) which requires themeasurement and recognition of compensation expense for all share-based paymentawards made to employees and directors including employee stock based onestimated 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”). Underthe provisions of APB 25 and its related interpretations, no compensationexpense was recognized with respect to the grant of options to purchase theCompany’s common stock when such stock options were granted with exerciseprices equal to or greater than market value of the underlying common stock onthe date of grant.

The Company adopted SFAS 123(R) using themodified prospective transition method, which requires the application of theaccounting standard as of December 29, 2005, the first day of the Company’sfiscal year 2006. The Company’s Consolidated Financial Statements as of and forthe three and six-months ended June 28, 2006 reflect the impact of SFAS123(R). In accordance with the modified prospective transition method, theCompany’s Consolidated Financial Statements for prior periods have not beenrestated to reflect, and do not include, the impact of SFAS 123(R). Stock-basedcompensation expense recognized under SFAS 123(R) for the three-monthsended June 28, 2006 was $1.3 million or 

7

----

$.09 basic anddiluted loss per share from continuing operations. Stock-based compensationexpense recognized under SFAS 123(R) for the six-months ended June 28,2006 was $1.9 million or $.20 basic and diluted loss per share from continuingoperations, and $86,000 or $.01 basic and diluted loss per share fromdiscontinued operations. Included in the stock-based compensation expense forthe three and six-months ended June 29, 2006, is a one time non-cash fixedperiod charge in the amount of $381,000, as a result of the modification ofvested options on April 4, 2006 as discussed in Note 9. The stock-basedcompensation expense is calculated on a straight-line basis over the vestingperiods of the related options. This charge had no impact on the Company’sreported cash flows.

Forthe three and six-months ended June 29, 2005, the Company recordedapproximately $(6,000) and $24,000, respectively of stock compensation expensepursuant to APB 25 associated with the amortization of deferred stockcompensation related to the vesting of stock options that were granted toconsultants for services rendered to the Company. The breakdown of totalstock-based compensation by expense category is as follows (in thousands):

| ** **                 | ** ** | **Three-Months Ended,** | ** ** | **Six-Months Ended,** | ** ** |
|----------------------------|------------|------------------------------|------------|----------------------------|------------|
| ** **                 | ** ** | **June 28,**            | ** ** | **June 29,**          | ** ** | **June 28,** | ** ** | **June 29,** | ** ** |
| ** **                 | ** ** | **2006**                     | ** ** | **2005**                   | ** ** | **2006** | ** ** | **2005** | ** ** |
| Research and  development  |       |                         | $          | 547                        |       |   |   | $ | (5 | ) |   |   | $ | 788 |   |   |   | $ | 22 |   |   |
| General and  adminstrative |       |                         | 747        |                       |       |   | — |   |   |   | 982 |   |   |   | — |   |   |
| Discontinued  operations   |       |                         | —     |                       |       |   | (1 | ) |   |   | 86 |   |   |   | 2 |   |   |
|                       |       |                         | $          | 1,294                      |       |   |   | $ | (6 | ) |   |   | $ | 1,856 |   |   |   | $ | 24 |   |   |

 

Under the modified prospective method of transitionunder SFAS 123(R), the Company is not required to restate its prior periodfinancial statements to reflect expensing of share-based compensation underSFAS 123(R). Therefore, the results for the three and six-months ended June 28,2006 are not directly comparable to the same period in the prior year.

Asrequired by SFAS 123(R), the Company has presented pro forma disclosures of itsnet 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 (in thousands):

| ** **                                                                                                      | ** ** | **Three-Months Ended,** | ** ** | **Six-Months Ended,**  | ** ** |
|-----------------------------------------------------------------------------------------------------------------|------------|------------------------------|------------|-----------------------------|------------|
| ** **                                                                                                      | ** ** | **June 29, 2005**  | ** ** | **June 29, 2005** | ** ** |
| Net loss, as  reported                                                                                          |       |                         | $          | (4,414                      | )          |   |   | $ | (8,978 | ) |   |
| Add: Stock-based  employee compensation expense included in reported net loss                                   |       |                         | (6         | )                           |       |   | 24 |   |   |
| Less: Total stock-based compensation expense  determined under fair value based methods for all options granted |       |                         | (733       | )                           |       |   | (1,490 | ) |   |
| Pro forma net  loss                                                                                             |       |                         | $          | (5,153                      | )          |   |   | $ | (10,444 | ) |   |
| Net loss per share:                                                                                             |       |                         |       |                        |       |   |   |   |   |
| Basic and diluted—as  reported                                                                             |       |                         | $          | (1.29                       | )          |   |   | $ | (2.66 | ) |   |
| Basic and diluted—pro  forma                                                                               |       |                         | $          | (1.51                       | )          |   |   | $ | (3.09 | ) |   |

 

Forpurposes of the disclosure in the foregoing table and for purposes ofdetermining 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. The Company calculated the estimated life of each employeestock option granted in fiscal 2006 based on the average life of the optionestimated by reference to the historical average lives of 

8

----

options issued by the Company since its initial publicoffering in 1994. The risk free rate of return and the historical volatilitywere also based on the average life of the option estimated by reference to thehistorical average lives of options issued by the Company since inception. AsSFAS 123(R) requires that stock-based compensation expense be based onawards that are ultimately expected to vest, stock-based compensation for thethree and six-months ended June 28, 2006 has been reduced for estimatedforfeitures. When estimating forfeitures, the Company takes into considerationboth voluntary and involuntary terminations, as well as trends of actual optionforfeitures. Prior to fiscal 2006, the Company accounted for forfeitures asthey occurred.

| ** **       | ** ** | ** **             | ** ** | ** **   | ** ** | ** **     | ** ** | **Weighted-**         | ** ** |
|------------------|------------|------------------------|------------|--------------|------------|----------------|------------|-----------------------|------------|
| ** **       | ** ** | ** **             | ** ** | ** **   | ** ** | ** **     | ** ** | **Average**           | ** ** |
| ** **       | ** ** | **Risk-Free**          | ** ** | **Dividend** | ** ** | **Volatility** | ** ** | **Option**            | ** ** |
| ** **       | ** ** | **Interest Rate** | ** ** | **Yield**    | ** ** | **Factor**     | ** ** | **Life (Years)** | ** ** |
| Fiscal Year 2006 |       | 4.68%-4.69%            |       |         | 0%         |           |       | 114.83%-121.86%       |       |   | 3.35-5.78 |   |   |
| Fiscal Year 2005 |       | 3.58% - 4.27%          |       |         | 0%         |           |       | 113.17% - 123.33%     |       |   | 5 |   |   |

 

The Black-Scholes option-pricing model requires theinput of highly subjective assumptions. Because the Company’s employee stockoptions have characteristics significantly different from those of tradedoptions, and because changes in the subjective input assumptions can materiallyaffect the fair value estimate, in management’s opinion, the existing modelsmay not provide a reliable single measure of the fair value of stock optionsgranted. Management will continue to assess the assumptions and methodologiesused to calculate estimated fair value of share-based compensation.Circumstances may change and additional data may become available over time,thereby resulting in changes to these assumptions and methodologies. Thesechanges could materially impact the Company’s fair value determination.

A summary of optionactivity under the Plans as of June 28, 2006, and changes during the threeand six-months then ended is presented below:

**Summary Details for Plan Share Options**

| ** **                                | ** ** | **Three-Months Ended,** | ** ** |
|-------------------------------------------|------------|------------------------------|------------|
| ** **                                | ** ** | **June 28, 2006**  | ** ** |
| ** **                                | ** ** | ** **                   | ** ** | ** ** | ** ** | **Weighted-** | ** ** | ** ** | ** ** |
| ** **                                | ** ** | ** **                   | ** ** | **Weighted-** | ** ** | **Average** | ** ** | ** ** | ** ** |
| ** **                                | ** ** | ** **                   | ** ** | **Average** | ** ** | **Remaining** | ** ** | **Aggregate** | ** ** |
| ** **                                | ** ** | **Number of**           | ** ** | **Exercise** | ** ** | **Contractual** | ** ** | **Intrinsic** | ** ** |
| ** **                                | ** ** | **Options**                  | ** ** | **Price** | ** ** | **Life (Years)** | ** ** | **Value** | ** ** |
| Outstanding  Balance, March 29, 2006 |       | 698,004                      |       |   | $ | 37.17 |   |   |   | 5.07 |   |   |   | $ | 2,684 |   |   |
| Granted                                   |       | 4,172,597                    |       |   |     3.99 |   |   |   | — |   |   |   |      460 |   |   |
| Exercised                                 |       | —                       |       |   | — |   |   |   | — |   |   |   | — |   |   |
| Forfeited                                 |       | (628,495                     | )          |   |   37.58 |   |   |   | — |   |   |   | — |   |   |
| Outstanding Balance,  June 28, 2006  |       | 4,242,106                    |       |   | $ | 4.47 |   |   |   | 9.02 |   |   |   | $ | 460 |   |   |

 

| ** **                                   | ** ** | **Six-Months Ended,**  | ** ** |
|----------------------------------------------|------------|------------------------|------------|
| ** **                                   | ** ** | **June 28, 2006** | ** ** |
| ** **                                   | ** ** | ** **             | ** ** | ** ** | ** ** | **Weighted-** | ** ** | ** ** | ** ** |
| ** **                                   | ** ** | ** **             | ** ** | **Weighted-** | ** ** | **Average** | ** ** | ** ** | ** ** |
| ** **                                   | ** ** | ** **             | ** ** | **Average** | ** ** | **Remaining** | ** ** | **Aggregate** | ** ** |
| ** **                                   | ** ** | **Number of**     | ** ** | **Exercise** | ** ** | **Contractual** | ** ** | **Intrinsic** | ** ** |
| ** **                                   | ** ** | **Options**            | ** ** | **Price** | ** ** | **Life (Years)** | ** ** | **Value** | ** ** |
| Outstanding  Balance, December 29, 2005 |       | 724,802                |       |   | $ | 36.70 |   |   |   | — |   |   |   | $ | — |   |   |
| Granted                                      |       | 4,172,597              |       |   |     3.99 |   |   |   | — |   |   |   |        460 |   |   |
| Exercised                                    |       | —                 |       |   | — |   |   |   | — |   |   |   | — |   |   |
| Forfeited                                    |       | (655,293               | )          |   |   37.53 |   |   |   | — |   |   |   | — |   |   |
| Outstanding Balance,  June 28, 2006     |       | 4,242,106              |       |   | $ | 4.47 |   |   |   | 9.02 |   |   |   | $ | 460 |   |   |

 

9

----

A summary of the status ofthe Company unvested shares as of June 28, 2006, and changes during thethree and six-months then ended is presented below:

**Unvested Shares Issued Under the Plan**

| ** **                  | ** ** | **Three-Months Ended,** | ** ** | **Six-Months Ended,**  | ** ** |
|-----------------------------|------------|------------------------------|------------|-----------------------------|------------|
| ** **                  | ** ** | **June 28, 2006**  | ** ** | **June 28, 2006** | ** ** |
| ** **                  | ** ** | ** **                   | ** ** | **Weighted-**               | ** ** | ** ** | ** ** | **Weighted-** | ** ** |
| ** **                  | ** ** | ** **                   | ** ** | **Average**                 | ** ** | ** ** | ** ** | **Average** | ** ** |
| ** **                  | ** ** | **Unvested**                 | ** ** | **Grant-Date**              | ** ** | **Unvested** | ** ** | **Grant-Date** | ** ** |
| ** **                  | ** ** | **Shares**                   | ** ** | **Fair Value**         | ** ** | **Shares** | ** ** | **Fair Value** | ** ** |
| Beginning  unvested balance |       | 272,423                      |       |                        | $          | 33.19 |   |   | 286,268 |   |   | $ | 32.15 |   |   |
| Granted                     |       | 4,172,597                    |       |                        | $          | 2.97 |   |   | 4,172,597 |   |   | $ | 2.97 |   |   |
| Vested                      |       | (498,565                     | )          |                        | $          | 1.13 |   |   | (505,777 | ) |   | $ | 1.23 |   |   |
| Forfeited                   |       | (251,099                     | )          |                        | $          | 33.07 |   |   | (257,732 | ) |   | $ | 40.04 |   |   |
| Ending unvested balance     |       | 3,695,356                    |       |                        | $          | 3.40 |   |   | 3,695,356 |   |   | $ | 3.40 |   |   |

 

As of June 28, 2006, there was $9.3 million oftotal unrecognized compensation expense related to unvested share-basedcompensation arrangements granted under the Plans. This amount includesincremental compensation expense of $178,000 related to unvested modified stockoptions. See Note 9 for further discussion. Total unrecognized compensationexpense will be recognized over a weighted-average period of approximately 5****years.

***DERIVATIVE INSTRUMENTS****—*Companies arerequired to recognize all of their derivative instruments as either assets orliabilities in the balance sheet at fair value. The accounting for changes inthe fair value (i.e. gains or losses) of a derivative instrument depends onwhether it has been designated and qualifies as part of a hedging relationshipand further, on the type of hedging relationship. For derivative instrumentsnot designated as hedging instruments, the gain or loss is recognized in currentearnings during the period of change. The Company currently has one derivativeinstrument (Note 8) that is assessed on a quarterly basis, and any changes infair value will be recognized in current earnings in the period of change.

*RECENT ACCOUNTING PRONOUNCEMENTS*—OnJune 9, 2005, the FASB issued SFAS No. 154, Accounting Changes andError Corrections. SFAS No. 154 replaces APB Opinion No. 20,Accounting Changes, and SFAS No. 3, Reporting Accounting Changes inInterim Financial Statements, and changes the requirements for the accountingfor and reporting of a change in accounting principle. SFAS No. 154applies to all voluntary changes in accounting principle. It also applies tochanges required by an accounting pronouncement in the unusual instance thatthe pronouncement does not include specific transition provisions. SFAS No. 154must be adopted for accounting changes and corrections of errors made in fiscalyears beginning after December 15, 2005. The adoption of SFAS No. 154did not have a material impact on the Company’s financial results.

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

The Company implemented aone-for-ten reverse split of its common stock effective for trading on February 6,2006, and all share and per share amounts for all periods presented have beenrestated to reflect this reverse stock split. The Company’s common stock islisted on the Nasdaq Capital Market. In order to maintain that listing, theCompany must satisfy minimum financial and other 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 ofthe one-for-ten reverse split, the minimum bid price of our common stockincreased and on 

10

----

February 24,2006 the Company received notice from the Nasdaq that the Company regainedcompliance with the minimum bid price requirement.

**Note 3.**   Discontinued Operations

In November 2004 the Company discontinuedresearch on its genomics programs, other than the Huntington’s Disease program,and sought a buyer for these programs. After attempting to sell theintellectual property assets related to the genomics programs over the courseof the fourth quarter of 2004, the Company determined that there were noactively interested buyers. In the fourth quarter of 2004, the Company recordeda charge of $1.7 million primarily relating to an impairment of intangibleassets acquired in connection with the December 2002 acquisition of thegenomics business of Pangene Corporation ($1.1 million), a charge for fixedassets likely to be disposed of at less than their book value ($150,000),severance costs ($250,000) and lease termination costs ($200,000). Additionalexpenses related to the closure were charged to discontinued operations asincurred. Most costs relating to the closure were incurred by the end of January 2005,although certain lease costs continued through May 2005. In April 2005,the Company received $104,000 for certain fixed assets of the genomics businessthat were previously reserved for in the fourth quarter of 2004 and classifiedas Assets Held for Sale.

Net losses related to theGenomics Division that are included in discontinued operations totaled $0 and$127,000 for the three-months ended June 28, 2006 and June 29, 2005,respectively and $88,000 and $308,000 for the six-months ended June 28,2006 and June 29, 2005, respectively. No material revenue has been recognizedin this division. There were no assets held for sale at June 28, 2006 and December 28,2005, which relate to the discontinued operations of the genomics business.

**Note 4.**   Investments

Short-terminvestments consist of investment grade government agency, auction rate, andcorporate debt securities due within one year. The Company’s investments inauction rate securities are recorded at cost, which approximates fair marketvalue. In accordance with ARB 43, *Restatement and Revisionof Accounting Research Bulletins*, despite the long-term nature oftheir stated contractual maturities, the Company has the ability and intent toliquidate investments in auction rate securities within six months andtherefore has classified these investments as short-term. All investments areclassified as available-for-sale and are recorded at market value. Unrealizedgains and losses are treated as a separate component of stockholders’ equityuntil the security is sold or until a decline in fair value market value isdetermined to be other than temporary. As of June 28, 2006 and December 28,2005, the amortized cost basis, aggregate fair value and gross unrealizedholding gains and losses by major security type of investment classified asavailable-for-sale are as follows (in thousands):

| ** **                  | ** ** | **Amortized** | ** ** | **Unrealized** | ** ** | **Fair**   | ** ** |
|-----------------------------|------------|---------------|------------|----------------|------------|------------|------------|
| **Security Type**      | ** ** | ** **    | ** ** | **Cost**       | ** ** | **Losses** | ** ** | **Value** | ** ** |
| **June 28, 2006**      | ** ** | ** **    | ** ** |           | ** ** | ** ** |       | ** ** | ** ** |
| Auction rate  securities    |       | $             | 11,100     | ** **     |       | $          | —     |   |   | $ | 11,100 |   |
| Commercial paper            |       | 11,939        | ** ** |           | (8         | )          |       | 11,931 |   |
| Corporate debt  securities  |       | 4,500         | ** ** |           | —     |       |       | 4,500 |   |
| Government  agencies        |       | 4,000         | ** ** |           | —     |       |       | 4,000 |   |
| Total investments           |       | $             | 31,539     | ** **     |       | $          | (8         | ) |   | $ | 31,531 |   |
| **December 28,  2005** | ** ** | ** **    | ** ** |           | ** ** | ** ** |       | ** ** | ** ** |
| Auction rate  securities    |       | $             | 8,750      | ** **     |       | $          | —     |   |   | $ | 8,750 |   |
| Corporate debt  securities  |       | 4,844         | ** ** |           |   (42 | )          |       | 4,802 |   |
| Total investments           |       | $             | 13,594     | ** **     |       | $          | (42        | ) |   | $ | 13,552 |   |
|                             |            |               |            |                |            |            |            |  |  |  |  |  |  |  |

 

11

----

Comprehensiveloss for the Company consists of net loss and unrealized holding gains andlosses on available-for-sale investments as presented below (in thousands):

| ** **                                        | ** ** | **Three-Months Ended,** | ** ** | **Six-Months Ended,** | ** ** |
|---------------------------------------------------|------------|------------------------------|------------|----------------------------|------------|
| ** **                                        | ** ** | **June 28,**            | ** ** | **June 29,**          | ** ** | **June 28,** | ** ** | **June 29,** | ** ** |
| ** **                                        | ** ** | **2006**                     | ** ** | **2005**                   | ** ** | **2006** | ** ** | **2005** | ** ** |
| Net loss, as  reported                            |       | $                            | (4,163     | )                          | $          | (4,414 | ) | $ | (8,554 | ) | $ | (8,978 | ) |
| Unrealized loss  on available-for-sale securities |       | (8                           | )          | (11                        | )          | (34 | ) | (25 | ) |
| Comprehensive net loss                            |       | $                            | (4,171     | )                          | $          | (4,425 | ) | $ | (8,588 | ) | $ | (9,003 | ) |

 

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

In April 2003, theCompany sold its technical and analytical services group to privately heldChromaDex, Inc. in exchange for approximately 15%, on a fully dilutedbasis, of the then outstanding common stock 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 of Financial Accounting Standards No. 144, *Accounting for the Impairment of Long-Lived Assets*(“SFAS144”), the Company recognized an impairment charge of $963,000 on the carryingvalue of its investment in ChromaDex to revalue it to an estimated fair valueof $451,000 as a result of then available financial information.

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

As part of the Company’spreparation of its interim financial statements for the quarter ending June 29,2005, and in accordance with SFAS 144, 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 andLong-Term

On February 18, 2005, the Company entered into anagreement with TL Ventures providing for a complete settlement of its ongoinglitigation with them over whether certain debentures issued to TL Ventureswere subject to redemption upon completion of the sale of our paclitaxelbusiness to Mayne Pharma, a mutual release of claims, the payment ofapproximately $3,184,000 in cash and the issuance by the Company of promissorynotes in an aggregate amount of $4,670,000 in exchange for delivery forcancellation of debentures in the principal amount of $8,000,000 that had beenissued by the Company. The notes are payable in monthly installments of$110,000 in 2006 and $150,000 in 2007, with a final payment of $1,000,000 dueon January 31, 2008. The notes do not bear interest; however, an imputedinterest rate of 18% was used to determine a fair carrying value of the notes. Accruedinterest of approximately $134,000 was included in the cash payment made aspart of the settlement. The Company recorded the obligation resulting from thesettlement on its balance sheet as of December 29, 2004.

**Note 8.**   Stockholders’ Equity

In September 2005, the Company initiated aretention incentive program for non-executive employees that consisted of agrant of approximately 42,075 shares of restricted stock under the Company’sequity incentive plans to vest at future dates, as well as a cash componentrelated to the individual tax effects of 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 commonstock component of the program is $151,000 based on the value of the underlyingcommon stock at the date of grant. The cash component related to the taxeffects of the program amounted to $93,000 and was expensed in the thirdquarter of 2005. For the three and six-months ended June 28, 2006, $24,000and $48,000, respectively, of expense related to the 

12

----

program was recognized. Asa result of the adoption of SFAS 123(R), the deferred compensation balance hasbeen eliminated against additional paid in capital. The remaining unamortizedexpense associated with the program will be recognized over the vesting period,through September 2007.

On April 6, 2006, the Company sold an aggregateof 12,750,000 shares of common stock and warrants to purchase up to 12,750,000shares of common stock (the “Private Placement”), for a total of$25.5 million (excluding any proceeds that might be received upon exerciseof the warrants) or approximately $23.8 million, net of the placementagent fees and other expenses, pursuant to a Purchase Agreement dated February 2,2006 (the “Purchase Agreement). 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. The Company may call up to 20% of the outstandingwarrants during any three month period if certain conditions are satisfied,including the trading price of the Company’s common stock exceeding $4.80 for20 consecutive trading days. Up to half of the warrants may be exercisedon a cashless or net exercise basis. There can be no assurance, however, thatthe Company will receive funds from the exercise of warrants.

In addition, the Company issued warrants to purchase50,000 shares of common stock to a financial advisor and issued warrants topurchase 100,000 shares of common stock to an outside consultant as a finders’fee on substantially similar terms as the warrants issued under the PurchaseAgreement. The Company agreed to include the shares underlying the warrants inany registration statement filed by the Company on behalf of the Purchasers.

Pursuant to the terms of the registration rightsagreement entered into by the Company at the closing of the Private Placement,the Company filed with the SEC a registration statement on Form S-3covering the resale of the common stock sold to investors in the PrivatePlacement. The registration rights agreement provides, among other things, thatthe Company will use commercially reasonable efforts to effect the registrationof the securities within 90 days of closing, and to continuously remaineffectiveness. If sales cannot be made under the registration statement (otherthan for certain periods when the Company is permitted under the agreement tosuspend use of the registration statement when it has delayed disclosure ofmaterial nonpublic information) then the Company is obligated to pay eachinvestor liquidated damages, in cash, equal to 1.5% per 30 day period (or pro ratafor a portion thereof) of the aggregate purchase price paid by such investor. TheSEC declared the Company’s Form S-3 effective on May 18, 2006,which was within 90 days of closing.

The Company views the registration rights agreementcontaining the liquidated damages provision as a separate freestanding contractas discussed in Emerging Issues Task Force (“EITF”) Issue No. 05-4,*The Effect of a Liquidated Damages Clause on aFreestanding Financial Instrument Subject to EITF Issue No. 00-19, ‘Accountingfor Derivative Financial Instruments Indexed to, and Potentially Settled in, aCompany’s Own Stock*(“EITF 05-4”)*’*, and that the registration rights agreement has nominalvalue. Under this approach, the registration rights agreement is accounted forseparately from the financial instrument in accordance with SFAS 133 *“Accounting for Derivative Instruments and Hedging Activities”*.Accordingly, the classification of the warrants has been determined under EITF00-19, *“Accounting for DerivativeFinancial Instruments Indexed to, and Potentially Settled in, a Company’s OwnStock,”*and the warrants have been accounted for as permanentequity.

The Company has valued the liquidated damagesprovision of the registration rights agreement at nominal value. In determiningthis as the fair value, the Company considered the following factors. Theagreement provides that there is a 90-day period to have the registrationstatement declared effective before liquidated damages apply. The Companybelieved at the closing of the Private Placement that is was probable theregistration statement would be declared effective within the 90-dayperiod. The registration statement was declared effective in less than 90 daysand in the same fiscal quarter as the closing of the private placement, andtherefore the Company was aware that there was no value to the liquidatedamages provision for the initial 90 day period. The liquidated damagesprovision would only have value in the 

13

----

futureif sales may not be made thereunder for periods other than as permittedthereunder. The Company believes the events that would lead to sales beingunable to be made under the registration statement for periods other than aspermitted are unlikely to occur. In future periods, should the Company concludethat it is probable, as defined in SFAS No. 5, *Accountingfor Contingencies*, that a liability for liquidated damages willoccur, the Company will record the estimated cash value of the liquidateddamages liability at that time.

**Note 9.**   Equity Incentive Plans

As of June 28, 2006,the Company had five equity incentive plans, the 1994 Long-Term PerformanceIncentive Plan, the 1998 Stock Incentive Plan, the 2004 Equity Incentive Plan,the 2004 Non-Employee Director’s Stock Option Plan and the 2006 EquityIncentive Plan, which was approved by shareholders on April 4, 2006.

*2006 Equity IncentivePlan and New Stock Option Grants*

In January 2006, the board of directors adopted,subject to stockholder approval, the Company’s 2006 Equity Incentive Plan (the “IncentivePlan”). The Board adopted the Incentive Plan at the same time it approved thePrivate Placement. 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 of Directors (“Compensation Committee”) granted optionsto purchase shares of common stock to employees of the Company, including itsexecutive officers, totaling 3,079,480 shares. Stockholder approval for theIncentive Plan and grant of the stock options thereunder was received on April 4,2006.

The number of shares initially reserved for issuanceunder the Incentive Plan totals 6,577,106. Subject to limited exceptions, thegrant date for the each of the options, as discussed above, is April 4,2006. The exercise price of such options is $4.02 and was established as theaverage of the closing sale prices of the Company’s common stock on the NasdaqCapital Market on the fourth through eighth trading days following the Company’sannouncement of the Private Placement. Each option vests as follows: 1/6 whenthe 20 trading day average of the closing sale prices of the common stockequals or exceeds 130% (or $5.23) of the exercise price of the stock option;1/6 when such average equals or exceed 160% (or $6.43) of the exercise price;1/6 when such average equals or exceeds 190% (or $7.64) of the exercise price;1/6 when such average equals or exceeds 220% (or $8.84) of the exercise price; 1/6when such average equals or exceeds 250% (or $10.05) of the exercise price; and1/6 when such average equals or exceeds 300% (or $12.06) of the exercise price.All stock options vest at the latest on the fifth anniversary of the date ofgrant. The awards otherwise were made in accordance with the terms andconditions of the Incentive Plan and the Form of Stock Option Agreementfor grants thereunder.

On May 4, 2006 the Compensation Committeeapproved the grant of 56,650 stock options and 10,000 restricted shares ofcommon stock to newly hired non-executive employees of the Company. Inaddition, the Compensation Committee approved a total of up to 250,000 stockoptions to be awarded immediately to non-executive employees in recognition ofpast service, of which 212,000 where issued. The Compensation Committee alsoapproved the establishment of a discretionary pool of 150,000 shares forgranting stock options to future new hires and future grants to non-executiveemployees.

On June 23, 2006 inaccordance with the 2006 Equity Incentive Plan, non-employee directors wereissued stock options at the annual meeting of the Company’s shareholders. Thetotal number of stock options granted to non-employee directors totaled 15,900shares.

14

----

*Repricing of StockOptions*

On February 8, 2006, the board of directors ofthe Company approved, subject to stockholder approval, the modification ofcertain outstanding options to purchase shares of common stock under theCompany’s existing equity incentive plans, including certain stock optionsgranted to the Company’s directors and executive officers. Stockholder approvalof such modifications was received on April 4, 2006 and the exercise priceof each such modified option was reduced to $4.02 per share as of such date. Asof February 8, 2006, stock options for approximately 696,253 shares wereoutstanding under all of the Company’s equity compensation plans, of whichoptions to purchase approximately 626,568 shares of common stock, havingexercise prices ranging from $4.20 to $112.50, were modified. As a result ofthe modification of vested stock options, in accordance with SFAS 123(R), theCompany recorded a $381,000 one-time non-cash fixed period charge in the secondquarter of 2006.

After giving effect to theabove transactions, as of June 28, 2006 the total number of common sharesauthorized for issuance related to grants under all of the equity incentiveplans was 6,577,106, of which 4,242,056 options (excluding 50 options issuedoutside of the above plans) remain outstanding and 2,335,000 shares remainreserved for future grants.

**Note 10.**   Reduction in Operations

During the third quarterof 2005, the Company incurred severance costs of $299,000 associated with theelimination of two executive positions, five general and administrativepositions and 15 research and development positions (including one consultant).

**Note 11.**   Income Taxes

At December 29, 2005,the Company had available net operating loss and research and development creditcarryforwards of $100.8 million and $3.9 million, respectively, for income taxpurposes. The Tax Reform Act of 1986 contains provisions that limit theutilization of net operating loss and tax credit carryforwards if there hasbeen a change of ownership, as described in Section 382 of the InternalRevenue Code. As a result of the private placement of equity securities inApril, 2006, which the Company considers a change of ownership for taxpurposes, the Company believes that there are substantial limitations on theutilization of its net operating loss and tax credit carryforwards.

**Note 12.**   Net Income (Loss) Per Share

Basic earnings (loss) pershare is measured as net income or loss divided by the weighted averageoutstanding common shares for the period. Diluted earnings per share is similarto basic earnings per share but presents the dilutive effect on a per sharebasis of potential common shares (e.g. stock options, warrants and convertiblesecurities) as if they had been converted at the beginning of the periodspresented. Potential common shares that have an antidilutive effect areexcluded from diluted earnings per share (e.g. vested stock options andwarrants that could be converted representing 11,778,752 shares at June 28,2006 and 300 shares at June 29, 2005). Net loss per common share iscomputed using the weighted average number of shares of common stockoutstanding.

**Note 13.**   Settlement Agreement

On March 22, 2006 the Company and Dr. PatriciaPilia entered into a Settlement Agreement (the “Settlement Agreement”) inconnection with Dr. Pilia’s termination of employment by the Companywithout cause on February 23, 2006. Dr. Pilia is a member of theBoard of Directors and previously served as Executive Vice President andSecretary of the Company and was party to an employment agreement with theCompany. In connection with the Settlement Agreement, the Company recorded anobligation of $646,000 for termination benefits at March 29, 2006 thatwill be paid in the third quarter of fiscal 2006.

15

----

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

The following discussion and analysis provides informationthat management believes is relevant to an assessment and understanding of theresults of operations of Tapestry Pharmaceuticals, Inc. You should read thisdiscussion in conjunction with the Financial Statements and Notes includedelsewhere in this report and with Management’s Discussion and Analysis ofFinancial Condition and Results of Operations for the year ended December 28,2005 contained in our 2005 Annual Report on Form 10 K and Form 10 K/A. Certainstatements set forth below constitute “forward-looking statements” within themeaning of Section 27A of the Securities Act of 1933, as amended, and Section21E of the Securities Exchange Act of 1934, as amended. See “Special NoteRegarding Forward-Looking Statements” and “Risk Factors” Appearing elsewhere inthis Report.

**General**

Tapestry Pharmaceuticals, Inc. (“we,” “Tapestry”or “the Company”) is a pharmaceutical company focused on the development ofproprietary therapies for the treatment of cancer. Our primary developmenteffort is focused on TPI 287, a novel taxane under development for the treatmentof cancer. We filed an Investigational New Drug (“IND”) application on December 21,2004 covering TPI 287, and commenced human clinical trials with TPI 287 in thesecond quarter of 2005. Other programs in development include oral formulationof TPI 287 and linked cytotoxics. Currently, we cannot predict when or if anyof these other programs will be advanced into clinical development. We are alsoactively engaged in evaluating new therapeutic agents and/or relatedtechnologies. Our evaluation of new products and technologies may involve theexamination of individual molecules, classes of compounds, or platformtechnologies. Acquisitions of new products or technologies may involve thepurchase or license of such products or technologies, or the acquisition of, ormerger with, 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 $23.8 million, net of theplacement agent fees and other expenses. The purchase price was $2.00 per shareof common stock, and each warrant to purchase common stock has an exerciseprice equal 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 of the warrants may be exercised on acashless or net exercise basis. There can be no assurance, however, that wewill receive funds from the exercise of warrants.

In November 2004 we discontinued research on ourgenomics programs, other than the Huntington’s Disease program, and sought a buyer ofthese programs. After attempting to sell the intellectual property assetsrelated to the genomics programs over the course of the fourth quarter of 2004,we determined that there were no actively interested buyers and we proceeded toeffect an orderly closure of such operations, which was substantially completedby January 2005. In January 2006, we terminated the Oligo Therapyprogram related to Huntington’s Disease and the development of TPI 284, alinked cytotoxic compound. In June 2006, we discontinued the study of quassinoidanalogs.

During the third quarter of 2005, the Company incurredseverance costs of $299,000 associated with the elimination of two executivepositions, five other general and administrative positions and 15 research anddevelopment positions (including one consultant).

We willincur substantial research and development expense, including expense forclinical trials related to the development of our proprietary anti-canceragents. We have incurred significant losses, including losses from continuingoperations of $8.6 million for the six-months ended June 28, 2006. Ouraccumulated deficit was $115.8 million as of June 28, 2006. As a result ofour implementation of SFAS 123(R), for the six-months ended June 28,2006, operating expenses were increased by non-cash 

16

----

compensation charges totaling $1.9 million, including a one-timenon-cash fixed period charge in the amount of $381,000 relating to themodifications of vested stock options. We anticipate that losses will continueuntil such time, if ever, as we are able to commercialize our productcandidates and generate sufficient sales to support our development operations,including the research and development activity mentioned above.

Our ability to generate sufficient sales to support ouroperations currently depends upon the successful development andcommercialization of products based on our proprietary oncology technologies.

**Research and Development**

Our current business is focusedprimarily on the clinical development of TPI 287, along with limited researchand development of other proprietary therapies for the treatment of cancer. Thetable below shows our research and development expense by major category, withthe expense related to our Genomics Division included in discontinuedoperations (in thousands):

| ** **                 | ** ** | **Three-Months Ended,** | ** ** | **Six-Months Ended,** | ** ** |
|----------------------------|------------|------------------------------|------------|----------------------------|------------|
| ** **                 | ** ** | **June 28,**            | ** ** | **June 29,**          | ** ** | **June 28,** | ** ** | **June 29,** | ** ** |
| ** **                 | ** ** | **2006**                     | ** ** | **2005**                   | ** ** | **2006** | ** ** | **2005** | ** ** |
| Oncology                   |       |                         | $          | 2,396                      |       |   |   | $ | 2,615 |   |   |   | $ | 5,295 |   |   |   | $ | 5,232 |   |   |
| Huntington’s  Disease |       |                         | (5         | )                          |       |   | 170 |   |   |   | (90 | ) |   |   | 343 |   |   |
| Discontinued operations    |       |                         | —     |                       |       |   | 123 |   |   |   | 88 |   |   |   | 353 |   |   |
|                       |       |                         | $          | 2,391                      |       |   |   | $ | 2,908 |   |   |   | $ | 5,293 |   |   |   | $ | 5,928 |   |   |

 

Thefollowing chart identifies our three therapeutic candidate programs that are inthe most advanced 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      |       | Various Solid Tumors                               |       | Preclinical Development     |
| Linked Cytotoxics |       | Cancers                                            |       | Research                    |

 

We terminated theOligo Therapy program related to Huntington’s Disease in January 2006. Wealso terminated the development of TPI 284, a linked cytotoxic compound, in January 2006and we discontinued the study of quassinoid analogs in June 2006. We arecontinuing limited research relating to linked cytotoxic agents.

•     TPI 287 is a proprietarythird generation taxane. On December 21, 2004, we filed an InvestigationalNew Drug (“IND”) application, and on January 21, 2005, we were cleared toproceed into clinical trials by the U.S. Food and Drug Administration (“FDA”).In May 2005, we treated our first patient in this Q7D Phase I clinicaltrial of the intravenous (“IV”) formulation of TPI 287. In January 2006,we began a second Phase I clinical trial of TPI 287 IV to evaluate analternative dosing schedule. In preclinical testing, TPI 287 demonstrated theability to inhibit tumor cell growth in a number of *in vitro*cell lines and showed inhibition of tumors in certain animal xenograft models whentested 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. Taxaneresistant 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 and prostate cancer. In *in vivo*animal testing, TPI 287 demonstrated tumor growth inhibition activity in tumorcell lines with mutant tubulin and multiple drug resistance, or MDR1. Inaddition to the IV formulation of 

17

----

TPI 287, we haveinitiated development of an oral formulation of the compound which is currentlyin preclinical development.

•     Linked cytotoxics arecytotoxic agents linked to agents designed to improve therapeutic index. Currently,we cannot predict when or if any of these linked cytotoxics will be advancedinto clinical development.

*CertainRisks and Limitations.**  *Theclinical development of these drugs has many risks of failure. We have included adiscussion of a number of the risks and uncertainties associated withcompleting our product development plans under “Risk Factors”.

Wecontinuously reassess all of our research and development efforts, includingthose for the therapeutic products described above. At any time, we may expand,delay, terminate or dispose of all or any portion of our research anddevelopment programs and therapeutic products or we may develop or acquirerights to new product candidates.

**Results **of Operations******—Three-Months**Ended June 28, 2006 Compared to the Three-Months EndedJune 29, 2005

*Research and Development Expense.**  *Research and developmentexpense from continuing operations for the three-months ended June 28,2006 was $2.4 million, a decrease of $394,000 from the prior year period. Oncologyresearch and development expenditures decreased by $219,000 to $2.4 million inthe three-months ended June 28, 2006, and Huntington’s Disease relatedspending decreased by $175,000 to $(5,000). The decrease in oncology expensewas primarily due to decreased manufacturing costs of ($478,000) and consultingcosts ($152,000), offset by increased salary costs ($269,000) and increasedoutside preformulation costs ($102,000). The decrease in expense related to theHuntington’s Disease program was a result of the termination of the program in January 2006. Included in research and developmentexpense is a non-cash compensation expense in the amount of $547,000 and$(6,000) for the quarter ended June 28, 2006 and June 29, 2005,respectively, as a result of the implementation of SFAS 123(R) andthe modification of vested stock options that was partially offset by lowersalary expense due to the staffing reductions in July 2005.

*General and Administrative Expense.**  *General and administrativeexpense for the three-months ended June 28, 2006 was $2.0 million, anincrease of $569,000 from the prior year period. This increase was dueprimarily due to increase compensation costs ($628,000), as well as increasedBoard of Directors costs ($94,000), partially offset by decreases in otherconsulting expense ($30,000), accounting and auditing expense ($38,000),outside legal expense ($53,000) as well as insurance ($25,000). The increase incompensation related expenses, which includes Board of Directors costs, wasprimarily the result of non-cash compensation expense in the amount of $747,000and $0 for the quarter ended June 28, 2006 and June 29, 2005,respectively, as a result of the implementation of SFAS 123(R) and themodification of vested stock options which was partially offset by lower salaryexpense due to the staffing reductions in July 2005.

*Interest and Other Income.**  *Interest and other incomefor the three-months ended June 28, 2006 of $394,000 represented an increaseof $183,000 compared to the prior year period. The increase was attributable tohigher interest income due to higher investment balances as well as highereffective interest rates earned in the three-months ended June 28, 2006compared to the prior year period.

*Interest and Other Expense.**  *Interest and other expensefor the three-months ended June 28, 2006 of $128,000 was $116,000 lessthan the prior year period primarily due to the impairment of land in thesecond quarter of 2005 ($104,000).

18

----

*Discontinued Operations.**  *Loss from discontinued operationswas $0 for the three-months ended June 28, 2006 compared to a loss of$127,000 in the prior year period. This decrease is the result of there beingno activity in the Genomics Division in the current quarter.

**Results **of Operations******—Six-Months******EndedJune 28, 2006 Compared to the Six-Months Ended June 29, 2005

*Research and Development Expense.**  *Research and developmentexpense from continuing operations for the six-months ended June 28, 2006was $5.2 million, a decrease of $370,000 from the prior year period. Oncologyresearch and development expenditures increased by $63,000 to $5.3 million forthe six-months ended June 28, 2006, and Huntington’s Disease relatedspending decreased by $433,000 to ($90,000).

Theincrease in oncology expense was due to an increase in salaries and relatedcosts ($866,000), increased clinical trial cost ($224,000) as well as increasedinsurance charges ($101,000), offset by reductions in outside manufacturingcosts ($744,000) associated with preparing active pharmaceutical ingredient anddrug product material for the clinical trials of TPI 287, a decrease in consultingand other outside service costs ($332,000) and a decrease in occupancy costs($61,000).

Theincrease in compensation expense in the six-months ended June 28, 2006 wasprimarily related to the non-cash compensation expense in the amount of$788,000 for the six-months ended June 28, 2006 compared to $24,000 forthe six-months ended June 29, 2005, respectively, as a result of theimplementation of SFAS 123(R) and the modifications of vested stockoptions. In addition, in the first quarter of 2006, we recorded a $646,000charge as a result of the employment agreement settlement due to thetermination of the employment of the Company’s Executive Vice President andSecretary. These increases were offset by lower salary expense due to thestaffing reductions in July 2005.

Thedecrease in expense related to the Huntington’s Disease program was a result ofa reversal of laboratory fees owed to the University of Delaware as well as thereduction in work force.

*General and Administrative Expense.**  *General and administrativeexpense for the six-months ended June 28, 2006 was $3.5 million, anincrease of $429,000 from the same period in 2005. This increase was due tohigher compensation related costs ($629,000) and Board of Directors costs($120,000) offset by lower insurance costs ($74,000), lower outside legal costs($93,000), and lower travel costs ($37,000), and lower outside service costsrelated to investor relations ($69,000). The increase in compensation relatedexpenses, which included Board of Director costs, was primarily the result ofnon-cash compensation expense in the amount of $982,000 and $0 for thesix-months ended June 28, 2006 and June 29, 2005, respectively, as aresult of the implementation of SFAS 123(R) and the modification of vestedstock options, offset by lower salary expense due to the staffing reductions inJuly 2005.

*Interest and Other Income.**  *Interest and other incomefor the six-months ended June 28, 2006 of $536,000 represented an increaseof $154,000 compared to the prior year period. The increase was attributable tohigher interest income due to higher investment balances and higher effectiveinterest rates earned in the six-months ended June 28, 2006 compared tothe prior year period.

*Interest and Other Expense.**  *Interest and other expensefor the six-months ended June 28, 2006 of $302,000 was $109,000 less thanthe prior year period primarily due to the impairment of land in the secondquarter of 2005 ($104,000).

*Discontinued Operations.**  *Loss from discontinuedoperations was $88,000 for the six-months ended June 28, 2006 compared toa loss of $308,000 in the prior year period. This decrease is primarily aresult of there being no activity in the Genomics Division in the six-monthsended June 28, 2006, except for non-cash compensation expense in theamount of $86,000 as a result of the implementation of SFAS 123(R), as comparedto salary, occupancy and patent related charges in the prior year period.

19

----

*Share Based Compensation.*   Effective December 29,2005, we adopted the fair value method of accounting for share-basedcompensation arrangements in accordance with Financial Accounting StandardsBoard (“FASB”) Statement No. 123(R),*Share-Based Payment*(“SFAS 123(R)”), using the modified prospectivemethod of transition. Under the provisions of SFAS 123(R), the estimated fairvalue of options granted under our various equity incentive plans is recognizedas compensation expense over the option-vesting period. Using the modifiedprospective method, compensation expense is recognized beginning with theeffective date of adoption of SFAS 123(R) for all share-based payments (i) grantedafter the effective date of adoption and (ii) granted prior to theeffective date of adoption and that remain unvested on the date of adoption andwe are not required to restate our prior period financial statements to reflectexpensing of share based compensation under SFAS 123(R). Therefore, the resultsfor the three and six-months ended June 28, 2006 are not directlycomparable to the same period in 2005.

Prior to December 29,2005, 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 of APB 25, no compensation expense wasrecognized when stock options were granted with exercise prices equal to orgreater than market value on the date of grant.

In accordance with the provisions of SFAS 123(R), for thethree-months ended June 28, 2006, there was approximately $1.3 million, or$.09 basic and diluted loss per share from continuing operations of optionrelated compensation expense which was allocated among research and development($547,000) and general and administrative ($747,000) based on the function ofthe employee option holder. For the six-months ended June 28, 2006, therewas approximately $1.9 million, or $.20 basic and diluted loss per share fromcontinuing operations of option related compensation expense which wasallocated among research and development ($875,000) and general andadministrative ($982,000). Included in stock-based compensation expense for thethree and six-months ended June 28, 2006, is a one-time non-cash fixedperiod charge in the amount of $381,000, as a result of the modification ofvested shares on April 4, 2006, as discussed in Note 9. As of June 28,2006, unrecognized compensation expense related to unvested share-basedcompensation arrangements granted under the various equity incentive planstotaled approximately $9.3 million.

**Liquidity and Capital Resources**

Our workingcapital requirements for research and development have been, and will continue tobe, significant. As of June 28, 2006 we had working capital of $28.5million compared to working capital of $11.6 million at December 28, 2005.Through June 28, 2006, we have funded our capital requirements primarilywith the net proceeds of public offerings of common stock, with privateplacements of equity securities, with the exercise of warrants and options andwith debt.  We also have funded ourcapital requirements from the gross proceeds of the sale of our paclitaxelbusiness (approximately $71.7 million) to Mayne Pharma (USA) Inc. (f/k/aFaulding Pharmaceutical, Inc.) (“Mayne Pharma”), a subsidiary of MayneGroup Limited, on December 12, 2003 and its operations prior to that date.

Cash and cash equivalents decreased $394,000 to $140,000 atJune 28, 2006 from $534,000 at December 28, 2005. As of June 28,2006, cash, cash equivalents and short-term investments increased $17.6 millionto $31.7 million from $14.1 million at December 28, 2005. The increase wasprimarily due to $23.1 million of net cash provided by financing activitiesoffset by $5.6 million of net cash used by operating activities. In the thirdquarter of fiscal 2006, we will pay approximately $646,000 for accruedtermination benefits to our former Executive Vice President and Secretary. Werecorded this obligation on our balance sheet as of March 29, 2006.

20

----

*Private Placement.*

On April 5,2006 we sold an aggregate of 12,750,000 shares of common stock and warrants topurchase up to 12,750,000 shares of common stock for a total of $25.5 million(excluding any proceeds that might be received upon exercise of the warrants)or approximately $23.8 million, net of the placement agent fees and otherexpenses, pursuant to a Purchase Agreement dated February 2, 2006 (the “PurchaseAgreement”). The purchase price was $2.00 per share of common stock, and eachwarrant to purchase common stock has an exercise price equal to $2.40 per share.We may call up to 20% of the outstanding warrants during any three month periodif certain conditions are satisfied, including the trading price of our commonstock exceeding $4.80 for 20 consecutive trading days. Up to half of thewarrants may be exercised on a cashless or net exercise basis. There can be noassurance, however, that we will receive funds from the exercise of warrants.

In addition, we issued warrants to purchase 50,000shares of common stock to a financial advisor and issued warrants to purchase100,000 shares of common stock to an outside consultant as a finders’ fee onsubstantially similar terms as the warrants issued under the Purchase Agreement.We agreed to include the shares underlying the warrants in any registrationstatement filed by us on behalf of the Purchasers.

In connection with thePrivate Placement, we entered into a registration rights agreement wherein weagreed to make the requisite SEC filings to achieve and substantially maintainthe effectiveness of a registration statement covering shares sold in thePrivate Placement. If the Company failed to file a required registrationstatement or to achieve or substantially maintain the effectiveness of arequired registration statement during the related period (subject to theCompany’s right to suspend use of the registration statement in certaincircumstances), we will be obligated to pay liquidated damages in an amount upto 1.5% of the $25.5 million purchase price paid by investors for each 30 dayperiod or pro rata for any portion thereof in excess of our allotted time. On May 4,2006, we filed a registration statement on Form S-3 to register theresale of the shares sold in the Private Placement as well as the sharesunderlying the warrants issued in the Private Placement and the warrants issuedto financial advisors and consultants in conjunction with the Private Placement.This registration statement was declared effective by the Securities andExchange Commission on May 18, 2006. We are now required to maintain theeffectiveness of the registration statement, subject to certain exceptions,through the period the warrants are outstanding and up to an additional twoyears for a maximum period of seven years through April 6, 2013.

*Note Payable.*

In connection with the February 18, 2005 settlement oflitigation with TL Ventures over whether certain debentures issued to TLVentures were subject to redemption upon completion of the sale of ourpaclitaxel business to Mayne Pharma, we paid approximately $3,184,000 in cashand issued promissory notes in the amount of $4,670,000 in exchange for thedelivery of the debentures by TL Ventures to the Company for cancellation. Thenotes do not bear interest and are payable in monthly installments of $110,000in 2006 and $150,000 in 2007 with a $1,000,000 payment due on January 31,2008. Accrued interest of approximately $134,000 was included in the cashpayment made as part of the settlement. We recorded the obligation resultingfrom the settlement on our balance sheet as of December 29, 2004. Weimputed an interest rate of 18% on the notes. No gain or loss was recognized inconnection with the settlement.

*Going Concern.*

We have no revenue and we incurred a loss ofapproximately $4.2 million and $8.6 million for the three and six-months ended June 28,2006, respectively and a loss of approximately $17.5 million for the year endedDecember 28, 2005 and we have an accumulated deficit of $115.8 million asof June 28, 2006. 

21

----

Our capital requirementsfor research and development, including the cost of clinical trials, have beenand will continue to be significant.

As of June 28, 2006, we had cash and short-terminvestments totaling approximately $31.7 million. However, as of December 28,2006 we had cash and short-term investments totaling approximately 14.1 million.These factors, as of December 28, 2005, raised substantial doubt, whichhas since been addressed, as discussed below, about our ability to continue asa going concern. The audit report prepared by our independent registered publicaccounting firm relating to our consolidated financial statements for the yearended December 28, 2005 includes an explanatory paragraph expressing thesubstantial doubt about our ability to continue as a going concern.

In late 2005 and early 2006 we undertook a number ofactions to reduce our monthly cash requirements, including, among other things,reductions in workforce and related payroll costs, reductions in facilitycosts, reductions in the number of active programs in development, reductions incapital expenditures and reductions in charges from outside service providers. Afterimplementing these and other cost savings measures and further determining thatour lead pharmaceutical program warranted expanded clinical development, wedetermined to seek the additional capital necessary to fund our ongoingoperations related to our lead pharmaceutical program.

On April 6, 2006, weclosed the Private Placement, as described above. As of June 28, 2006 we hadcash and short-term investments of approximately $31.7 million and workingcapital of approximately $28.5 million.  We believe we have sufficient capital to fundour operations and capital expenditures for at least the next 12 months. However,pharmaceutical development is costly, risky and time intensive activity. Tobring our various programs to completion will require us to raise additionalcapital as practicable to fund future operations and to provide additionalworking capital. There can be no assurance that we will be able to obtain additionalcapital on terms that will be acceptable to us or on any terms. In addition, wemay seek to in-license or purchase new product or technologies. The cost andrelated capital 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 Splitand Nasdaq Listing.*

We implemented aone-for-ten reverse split of our common stock effective for trading on February 6,2006, and all share and per share amounts for all periods presented have beenrestated to reflect this reverse stock split. Our common stock is listed on theNasdaq Capital Market. In order to maintain that listing, we must satisfyminimum financial and other requirements. On February 25, 2005, wereceived notice from the Nasdaq Stock Market, Inc. that the minimum bidprice of our common stock had fallen below $1.00 per share for 30 consecutivebusiness days and that our common stock was, therefore, subject to delistingfrom 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 24,2006, we received notice from the Nasdaq Stock Market, Inc. that weregained compliance with the minimum bid price requirement.

**Recent AccountingPronouncements**

On June 9, 2005, theFASB issued SFAS No. 154, *Accounting Changes andError Corrections*. SFAS No. 154 replaces APB Opinion No. 20,*Accounting Changes*, and SFAS No. 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 allvoluntary changes in accounting principle. It also applies to changes requiredby an accounting pronouncement in the unusual instance that the pronouncementdoes not include specific transition provisions. SFAS No. 154 must beadopted for accounting changes and corrections of errors made in fiscal yearsbeginning after December 15, 2005. Early adoption is permitted foraccounting changes and corrections of errors made in fiscal years beginning 

22

----

afterthe date SFAS No. 154 is issued. The adoption of SFAS No. 154 did nothave a material impact on our financial results.

**SpecialNote Regarding Forward-Looking Statements**

The statements inthis report that are not historical facts are forward-looking statements thatrepresent management’s beliefs and assumptions as of the date of this report,based on currently available information. Forward-looking statements can beidentified by the use of words such as “believe,” “intend,” “estimate,” “may,” “will,”“should,” “anticipated,” “expected,” “trusts” or comparable terminology or bydiscussions of strategy. Such forward-looking statements may include, amongothers:

·       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.

Although we believe thatthe expectations reflected in such forward-looking statements are reasonable,we cannot assure you that these expectations will prove to be correct. Suchforward-looking statements involve known and unknown risks, uncertainties andother factors, which may cause our actual results, performance or achievements,or industry results, to be materially different from any future results,performance or achievements expressed or implied by such forward-lookingstatements.  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 undue reliance on these forward-lookingstatements, which apply only as of the date of 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 no obligation to update any of theforward-looking statements after the date of this  Report to conform such statements to actualresults.

**Item 3.   Quantitativeand Qualitative Disclosures about Market Risk**

We currently invest ourexcess cash balances in money market accounts and short-term investments thatare subject to interest rate risk. The amount of interest income we earn onthese funds will change as interest rates in general change. Our investmentsare subject to a loss of principal if market interest rates increase and theyare sold prior to maturity. However, due to the short-term nature of themajority of our investments, the high credit quality of our portfolio and ourability to hold our investments until maturity, 

23

----

animmediate 1% change in interest rates would not have a material impact on ourfinancial position, results of operations or cash flows.

**Item 4.   Controlsand Procedures**

The Companymaintains a system of disclosure controls and procedures. The term “disclosurecontrols and procedures,” as defined by regulations of the SEC, means controlsand other procedures that are designed to ensure that information required tobe disclosed in the reports that the Company files or submits to the SEC underthe Securities Exchange Act of 1934, as amended (“the Act”), is recorded,processed, summarized and reported, within the time periods specified in theSEC’s rules and forms. Disclosure controls and procedures include, withoutlimitation, controls and procedures designed to ensure that information requiredto be disclosed by the Company in the reports that it files or submits to theSEC under the Act is accumulated and communicated to the Company’s management,including its Principal Executive Officer and its Principal Financial Officer,as appropriate to allow timely decisions to be made regarding requireddisclosure. The Company carried out an evaluation, under the supervision andwith the participation of the Company’s management, including the Company’sChief Executive Officer and Chief Financial Officer, of the effectiveness ofthe design and operation of the Company’s disclosure controls and procedures asof June 28, 2006. Based upon that evaluation, the Company’s Chief ExecutiveOfficer and Chief Financial Officer concluded that the Company’s disclosurecontrols and procedures are effective in timely alerting them to materialinformation relating to the Company required to be included in the Company’speriodic SEC filings.

Any systemof controls, however well designed and operated, can provide only reasonable,and not absolute, assurance that the objectives 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 otherinherent limitations of control systems, there can be no assurance that anydesign will succeed in achieving its stated goals under all potential futureconditions, regardless of how remote.

There have been no changes in our internal controlsover financial reporting during the fiscal quarter ended June 28, 2006that have materially affected, or are reasonably likely to materially affect,our internal control over financial reporting.

24

----

**Part II—OtherInformation**

**Item 1.**                        LegalProceedings

There have been no developments in legal proceedingsaffecting the Company.

**Item 1A**                   RiskFactors

*You should carefully consider the following riskfactors related to our current business operations before making a decision toinvest in our common stock. Additional risks of which we are not yet aware orthat we currently believe are immaterial may also impair our businessoperations. If any of the events or circumstances described in the followingrisk factors actually occurs, our business may suffer, the trading price ofcommon stock could decline, and you may lose all or part of your investment.*

**Risks Related toOur Business**

**We currently are focusing our development efforts ononly one product candidate, TPI 287, and we will have limited prospects forsuccessful operations if TPI 287 does not prove successful in clinical trialsor is never commercialized because of the costs of continuing development orfor other reasons.**

In 2005, we closed our Genomics division, and in 2006,we terminated our program relating to Huntington’s Disease and terminateddevelopment of TPI 284 as well as we discontinued the study of quassinoidanalogs. These actions have permitted us to focus our development effortsprimarily on the development of TPI 287, which is still in Phase I clinicaltrials. Our other product candidates are in preclinical development and we haveno products that are approved for commercial sale. TPI 287 will requireextensive additional clinical evaluation, regulatory review, marketing effortsand significant investment before we receive any revenues from it, if ever. Wecurrently do not have the capital resources necessary to bring any of ourproduct candidates through to commercial approval, and we do not expect TPI 287or any of our other product candidates or technologies to be commerciallyavailable for several years. We believe that our recently consummated financingwill only be sufficient to permit us to generate preliminary Phase II efficacydata on TPI 287 in a number of major tumor types, as well as begin developmentof, upon continued confirmatory data, a preliminary oral form of this drugcandidate.

Our efforts may not leadto commercially successful products for a number a reasons, including the inabilityto be proven safe and effective in clinical trials, the lack of regulatoryapprovals or obtaining regulatory approvals that are narrower than we seek,inadequate financial resources to complete the development andcommercialization of our product candidates or the lack of acceptance in themarketplace. Given the limited focus on one product candidate, if TPI 287 doesnot prove successful in clinical trials or is not commercialized because wehave insufficient resources for continued development for any other reason, wemay be required to suspend or discontinue our operations and you could loseyour entire investment in the Company.

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

The audit report prepared by our independentregistered public accounting firm relating to our consolidated financialstatements for the year ended December 28, 2005 includes an explanatoryparagraph expressing the substantial doubt about our ability to continue as agoing concern. We have undertaken a number of actions to reduce our monthlycash requirements, including, among other things, reductions in workforce andrelated payroll costs, reductions in facility costs, reductions in the number ofactive programs in development, reductions in capital expenditures andreductions in charges from outside service providers. After implementing theseand other cost savings measures and further determining that our leadpharmaceutical program warranted expanded clinical development, we determinedthat we should 

25

----

seek the additionalcapital necessary to fund our ongoing operations related to our leadpharmaceutical program.

On April 6, 2006, we sold an aggregate of12,750,000 shares of our common stock, and related warrants to purchase up toan aggregate of 12,750,000 shares of our common stock for gross proceeds of$25.5 million not including any proceeds from the exercise of the warrants (orapproximately $23.8 million net of transaction fees and expenses). As part ofthe financing, we agreed to a covenant that the net proceeds from thetransaction be used solely to fund the development of TPI 287 in accordancewith an approved budget for fiscal years 2006 and 2007.

Despite this recentfinancing, our business will require substantial additional investment that wehave not yet secured. We cannot be sure how much we will need to spend in orderto develop, market and manufacture new products and technologies in the future.We expect to continue to spend substantial amounts on research and development,including amounts spent on conducting clinical trials for our productcandidates. Further, we will not have sufficient resources to develop fully anynew products or technologies unless we are able to raise substantial additionalfinancing on acceptable terms. We could also be required to seek strategicpartners at an earlier stage than might be preferable and on less favorableterms than might be otherwise available. To the extent we raise additionalcapital by issuing equity securities, our stockholders may experiencesubstantial dilution. In addition, any new securities issued might have rights,preferences or privileges senior to those of the securities held bystockholders. If we raise additional funds through the issuance of debt, wemight become subject to restrictive covenants or we may subject our assets tosecurity interests. To the extent that we raise additional funds throughcollaboration and licensing arrangements, we may be required to relinquish somerights to our technologies or product candidates, or grant licenses on termsthat are not favorable to us. Our failure to raise capital when needed wouldadversely affect our business, financial condition and results of operations,and could force us to reduce or discontinue our operations at some time in thefuture.

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

We do not currently haveany products that have received regulatory approval for commercial sale, and weface the risk that none of our product candidates will ever receive regulatoryapproval. All of our product candidates are in early stages of development. Ourexisting product candidates will require extensive additional clinicalevaluation, regulatory review, marketing efforts and significant investmentbefore they result in any revenues. We currently do not have the funds to bringany of our product candidates through to commercial approval. Therefore,advancing the development of our product candidates will require substantialadditional investment. Continued development of these programs is thereforedependent upon raising additional capital. We cannot be certain that we will beable to obtain capital on acceptable terms, or at all. We do not expect any ofour prospective products or technologies to be commercially available for atleast several years and our efforts may not lead to commercially successfulproducts for a number a reasons including the inability to be proven safe andeffective in clinical trials, the lack of regulatory approvals or obtainingregulatory approvals that are narrower than we seek, inadequate financialresources to complete the development and commercialization of our productcandidates or the lack of acceptance in the marketplace. We continuouslyreassess all of our research and development efforts, including those for thetherapeutic products described in the “Business” section of our most recentannual 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 

26

----

conductclinical trials at preferred sites, obtain sufficient test subjects or begin orsuccessfully complete clinical trials in a timely fashion, if at all.Furthermore, the FDA may suspend clinical trials at any time if it believes thesubjects participating in trials are being exposed to unacceptable health risksor if it finds deficiencies in the clinical trial process or conduct of theinvestigation. At any time, we may expand, delay, terminate or dispose of allor any portion of our research and development programs and therapeuticproducts or we may develop or acquire rights to new product candidates.

**Our potential products and technologies must undergo rigorous clinicaltesting and regulatory approvals and compliance, which could substantiallydelay or prevent us from marketing any products.**

The clinical development of our product candidates hasmany risks of failure. Drugs must be proven safe and effective before they canbe approved for human use. The advancement of drug candidates into humanclinical trials is dependent on the positive outcome of pending preclinicalstudies, decisions by the FDA, institutional review boards, and otherregulatory factors. Patient recruitment for clinical trials can be difficult,and clinical trials may be delayed or prolonged due to inability to recruit asufficient number of patients. We may encounter significant delays or excessivecosts in our efforts to secure regulatory approvals. Our product candidatesrely on new and unproven technologies, and none of our proposed products ortechnologies have yet completed clinical tests designed to measure their safetyor effectiveness in humans. The data obtained from preclinical and clinicalactivities are susceptible to varying interpretations which could delay, limitor prevent regulatory approvals. Failure to comply with applicable FDA or otherregulatory requirements may result in criminal prosecution, civil penalties andother actions that would seriously impair our ability to conduct our business.Even if regulatory approval is granted for a product, this approval will belimited to those disease states and conditions for which the product is useful,as demonstrated through clinical trials. In addition, regulatory agencies maynot approve the labeling claims that are necessary or desirable for thesuccessful commercialization of our product candidates. Even if we receiveregulatory approvals, our product candidates may later exhibit adverse effectsthat limit or prevent their widespread use or that force us to withdraw thoseproduct candidates from the market. In addition, a marketed product continuesto be subject to strict regulation after approval. Any unforeseen problems withan approved product or any violation of regulations could result inrestrictions on the product, including its withdrawal from the market.

Any delay in, or failureto receive or maintain regulatory approval for, any of our products couldprevent us from ever generating meaningful revenues or achieving profitability.Given the uncertainty of drug development, it is impossible to say how long theclinical development of any of these compounds will take. We cannot be surethat our clinical testing for these programs will progress at the timesestimated in this document. We also cannot be sure of the cost of the effortnecessary to complete these programs or when, if ever, we will receive materialrevenues from these programs. Successfully completing these programs andobtaining 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 or marketing of ourproduct candidates.**

The manufacture of ourdrug candidates is a complex process. Manufacturing these drugs for use inclinical trials, according to FDA guidelines, presents a number of significantrisks and challenges. The manufacture of TPI 287, in particular, is a verycomplex and difficult process. If we are unable to manufacture adequatesupplies of any of our compounds for our clinical trials, our timelines fordevelopment could be delayed significantly. If we are able to gain regulatoryapproval of our products after successful clinical trials and thencommercialize and sell those products, we may be unable to manufacture enoughproducts to maintain our business, which could have a negative impact on ourfinancial condition. We have no experience in manufacturing any of our proposedproduct candidates on a commercial basis. 

27

----

We alsohave no laboratories or manufacturing facilities for such commercialmanufacturing activity. If we are unable to manufacture our products in acost-effective manner, we are not likely to become profitable. We have notreceived a license from the FDA for any necessary manufacturing facilities, andcannot apply for one until we submit a new potential product for commercialapproval. Even if we do receive a manufacturing license, we may fail tomaintain adequate compliance with the FDA’s regulations concerning current goodmanufacturing practices, in which case the license, and our authorization to manufacturethe product, would be revoked. Unless we build our own manufacturingfacilities, we will have to rely on third parties to manufacture our products.Although we may be able find third-party manufacturers with experience and theproper licensing requirements from the FDA, we may not be able to negotiatefavorable terms regarding costs or a long-term commitment to manufacture ourproducts. Our dependence on third parties may reduce future profit margins anddelay or limit our ability to develop and commercialize our products on atimely and competitive basis.

**We rely on third-parties to perform certain services for us and anyinterruption or termination of these arrangements may adversely affect ourbusiness.**

We rely onthird-party contractors to provide certain services related to our research anddevelopment activities. Contractors handle our U.S. and internationalregulatory affairs, provide certain manufacturing, technical and analyticalservices and manage certain aspects of our clinical development. Ouroutsourcing of certain functions to independent, third parties poses thefollowing risks:

·       our contracts withindependent contractors may expire or be terminated, and we may not be able toreplace them;

·       a contractor may not commitsufficient resources to our projects;

·       a contractor may file forbankruptcy protection or otherwise lack sufficient resources to perform all ofits obligations under our agreement;

·       the terms of our contractswith contractors may not be favorable to us; and

·       disputes with ourcontractors may arise, leading to delays in or termination of the developmentor commercialization of our products or resulting in significant litigation orarbitration proceedings.

The failure of ourthird-party contractors to provide services to us in a timely manner couldmaterially harm our business and financial condition. In addition, our use ofoutside parties could potentially lead to difficulties in coordinatingactivities. Outside parties may have staffing difficulties, may undergo changesin priorities or may have inadequate financial or other resources, adverselyaffecting their willingness or ability to provide certain services to us. Wemay experience unexpected cost increases that are beyond our control. Problemswith the timeliness or quality of the work of a third party contractor may leadus to seek to terminate the relationship and use an alternative serviceprovider. Making this change might be costly and may delay our clinical trials.Further, contractual restrictions may make such a change difficult orimpossible. Additionally, it may be impossible to find a replacementorganization that can assist us in an acceptable manner and at an acceptablecost.

28

----

**We may be required to rely on strategic partners for the development,marketing and manufacturing of future products and technologies that may delayor impair our ability to generate significant revenue and may otherwiseadversely affect our profitability.**

We may, in thefuture rely on strategic partners for the development, marketing andmanufacturing of future products and technologies because we lack the resourcesor capabilities to develop our product candidates. Our reliance on strategicpartners poses a number of risks, including the following:

·       it may be difficult tosuccessfully negotiate arrangements with potential strategic partners onacceptable terms;

·       if an arrangement with astrategic partner expires or is terminated, we may not be able to replace it orthe terms on which we replace it may be unacceptable;

·       a partner involved in thedevelopment of new products or technologies may not commit enough capital orother resources to develop or commercialize these products or technologiessuccessfully;

·       a strategic partner may notcommit enough resources to the marketing and distribution of our products;

·       we may have disputes withstrategic partners that could delay or terminate the development orcommercialization of our products or result in significant litigation orarbitration proceedings;

·       contracts with our strategicpartners may not provide significant protection or may be difficult to enforceif a strategic partner fails to perform;

·       our strategic partners maydecide not to further develop or commercialize our products;

·       our strategic partnerscould develop drugs which compete with our products;

·       our strategic partnerscould turn their focus away from oncology;

·       our strategic partners whomay manufacture future products could fail to operate their facilities inaccordance with federal good manufacturing practices regulations; and

·       third-party manufacturersmay be unable to manufacture products in a cost-effective or timely manner.

**We may not be successful in obtaining required foreign regulatoryapprovals, which would prevent us from marketing our products internationally.**

Outside the U.S., our ability to market a product iscontingent upon receiving a marketing authorization from the appropriateregulatory authority. This foreign regulatory approval process includes many ofthe same steps and uncertainties associated with FDA approval described above.We cannot be certain that we will obtain any regulatory approvals for ourproduct candidates and technologies in other countries. In order to market ourproducts outside of the U.S., we also must comply with numerous and varyingforeign regulatory requirements implemented by foreign regulatory authoritiesgoverning the conduct of clinical trials, product licensing, pricing andreimbursement. The approval procedure varies among countries and can involveadditional testing. The time required to obtain approval may differ from thatrequired to obtain FDA approval and approval by the FDA does not ensureapproval by the health authorities of any other country. The process ofobtaining foreign regulatory approvals can be lengthy and require theexpenditure of substantial capital and other resources. We may not besuccessful in obtaining the necessary approvals. Any delay or failure todemonstrate the safety and effectiveness of a pharmaceutical product candidateunder development and obtain foreign regulatory approval could have a materialadverse effect on our business.

29

----

**We may be unable to attract and retain the qualified employees we need tobe successful.**

We are highly dependent onmembers of our staff that lead or play critical roles in our research anddevelopment efforts. We require highly qualified and trained scientists withthe necessary skills to develop our product candidates. Recruiting andretaining qualified technical and managerial personnel will also be critical toour success. We face intense competition for these professionals from othercompanies in our industry and the turnover rate for these professionals can behigh. The loss of any of these persons, or our inability to recruit additionalpersonnel necessary to our business, could substantially impair our researchand development efforts and impede our ability to develop and commercialize anyof our products. In addition, we rely on other consultants and advisors toassist us in formulating our research and development strategy. Some haveconsulting or other advisory arrangements with other entities that may conflictor compete with their obligations to us.

**Our use of hazardous materials exposes us to the risk of materialenvironmental liabilities, and we may incur substantial additional costs tocomply with environmental laws in connection with the operation of our researchand manufacturing facilities.**

We may use radioactive materials and other hazardousor biohazardous substances in our research and development. As a result, we arepotentially subject to material liabilities related to personal injuries orproperty damages that may be caused by the spread of radioactive contaminationor by other hazardous substance releases or exposures at, or from, our facilities.Decontamination costs associated with radioactivity releases, other clean-upcosts, and related damages or liabilities could be significant and could harmour business. The cost of this liability could exceed our resources.

We are required to complywith increasingly stringent laws and regulations governing environmentalprotection and workplace safety, including requirements governing the handling,storage and disposal of radioactive and other hazardous substances and wastes,and laboratory operating and safety procedures. These laws and regulations canimpose substantial fines and criminal sanctions for violations. Maintainingcompliance with these laws and regulations with regard to our operations couldrequire substantial additional resources. These costs could decrease ourability to conduct operations in a cost-effective manner.

**If product liability lawsuits are successfully brought against us, we mayincur substantial liabilities and may be required to limit commercialization ofour product candidates.**

Our business may expose us in the future to productliability risks, which are inherent in the testing, manufacture, marketing andsale of pharmaceutical products. Product liability claims might be broughtagainst us by clinical trial patients, consumers or health care providers or bypharmaceutical companies or others selling our products. If we completeclinical testing for our product candidates and receive regulatory approval tomarket our products, we will include warnings on our products that identify theknown potential adverse effects and the patients who should not receive ourproduct. There can be no assurance that these warnings will be deemed adequate,or that physicians and patients will comply with these warnings.

If we cannot successfullydefend ourselves against such claims, we may incur substantial liabilities orbe required to limit commercialization of our future products. We cannotpredict all of the possible harms or side effects that may result and, as aresult, the amount of insurance coverage we currently hold, or that we mayobtain, may not be adequate to protect us from any liabilities. We may requireincreased liability coverage as our product candidates advance in clinicaltrials and later develop and commercialize these products. Further, insurancecoverage is increasingly expensive, and we do not know whether we will be ableto maintain insurance coverage at a reasonable cost or in sufficient amounts toprotect us against losses due to liability. A successful product liabilityclaim brought against us in excess of our insurance 

30

----

coverageor a product recall could adversely affect our business, results of operationsand financial condition.

**Risks Related toOur Industry**

**Competition fromthird parties may hinder our success.**

If we develop andcommercialize our product candidates in the future, we expect competition fromfully integrated pharmaceutical companies and more established biotechnologycompanies as well as government, universities and public and private researchinstitutions. These companies and institutions conduct research, seek patentprotection and establish collaborative arrangements for product development andmarketing. Most of these companies and institutions have significantly greaterfinancial resources and expertise than we do in the following:

·       researchand development;

·       preclinicalstudies and clinical trials;

·       obtainingregulatory approvals;

·       manufacturing;and

·       marketingand distribution.

Smaller companies may alsoprove to be significant competitors, particularly through collaborativearrangements with large pharmaceutical companies or other organizations. Inaddition, other companies and institutions compete with us in recruiting andretaining highly qualified scientific and management personnel. If we developand commercialize our product candidates in the future, our competitors maydevelop more effective, safer or more affordable products and technologies, orcommercialize products earlier than we do. If our competitors are successful inthis respect, it could limit the prices that we are able to charge for theproducts that we market, and prevent us from becoming profitable. In somecases, competing products could render obsolete any products we eventuallydevelop.

**Legislative and regulatory proposals to reduce the cost of health carecould adversely affect our business.**

There have been a numberof federal and state proposals in the U.S. to implement government controls onpricing and other efforts to reduce the cost of health care, including proposalsto reform health care or reduce government insurance programs. Our business isaffected by these efforts and these efforts could adversely affect prices ofour products. In addition, government pricing controls exist in varying formsin other countries. The emphasis on managed care in the U.S. has also increasedand will likely continue to increase the pressure to reduce the prices ofpharmaceutical products. We cannot predict whether any of these proposals willbe adopted or the effect these proposals or managed care efforts may have onour business. In addition, the current discussion of drug reciprocation intothe U.S. could also affect our future business operations. Some proposals wouldpermit the reimportation of approved drugs that were originally manufactured inthe U.S. from other countries where the drugs were sold at a lower price. Theseand other initiatives could decrease the price we or any potential marketingpartners receive for our products, adversely affecting our profitability. The pendencyor approval of such proposals could result in a decrease in our stock price orlimit our ability to raise capital, enter into strategic partnerships or obtainlicenses.

**We may be unable to effectively price our products or obtain adequatereimbursement for sales of our products, which would prevent our products frombecoming profitable.**

Our product candidates, ifdeveloped and commercialized, may not be considered cost-effective, andcoverage and adequate payments may not be available or may not be sufficient toallow us to sell these 

31

----

productson a competitive basis. In both the United States and elsewhere, sales ofmedical products and treatments are dependent, in part, on the availability ofreimbursement from health maintenance organizations, other private insuranceplans, governmental programs such as Medicare, and other third-party payors.Third-party payers are increasingly challenging the prices charged forpharmaceutical products and services. Government and other third-party payorsincreasingly are attempting to contain health care costs by limiting bothcoverage and the level of reimbursement for new drugs and by refusing, in somecases, to provide coverage for uses of approved products for diseases orconditions for which the FDA has not granted labeling approval. Significantuncertainty exists as to whether and how much third-party payors will reimbursepatients for their use of newly-approved drugs, which in turn will put pressureon the pricing of drugs. Third-party insurance coverage may not be available topatients for our products. If government and other third-party payors do notprovide adequate coverage and reimbursement levels for our products, theirmarket acceptance may be reduced or we may not be able to commercialize ourproducts.

**Risks Related toOur Intellectual Property**

**Our success is dependent on obtaining and defending patents andproprietary technology.**

Our success in commercializing, producing andmarketing products and technologies in the future depends, in part, on our abilityto obtain and maintain adequate protection of the intellectual property relatedto our technologies and products, both in the U.S. and other countries, and tooperate without infringing the proprietary rights of third parties. We will beable to protect our proprietary rights from unauthorized use by third partiesonly to the extent that our proprietary technologies are covered by valid andenforceable patents. The patent positions of biotechnology companies, includingour patent positions, are generally uncertain and involve complex legal andfactual questions.

We cannot predict the breadth of claims that will beallowed and issued to us for patents related to biotechnology or pharmaceuticalapplications. Before a patent is issued, its coverage can be significantlynarrowed, either in the U.S. or abroad. We also do not know whether any of ourpending or future patent applications will result in the issuance of patents.To the extent patents have been issued or will be issued, some of these patentsare subject to further proceedings that may limit their scope and once patentshave been issued, we cannot predict how the claims will be construed orenforced. It is not possible to determine which patents may provide significantproprietary protection or competitive advantage, or which patents may becircumvented or invalidated. Furthermore, patents already issued to us, orpatents that may be issued on our pending applications, may become subject todispute, including interference proceedings in the U.S. to determine priorityof invention. If our currently issued patents are invalidated or if the claimsof those patents are narrowed, our ability to prevent competitors frommarketing products that are currently protected by those patents could bereduced or eliminated. We could then face increased competition resulting inreduced market share, prices and profit.

In addition, the laws of some foreign countries do notprotect proprietary rights to the same extent as the laws of the U.S., and manycompanies have encountered significant problems in protecting and defendingtheir proprietary rights in foreign jurisdictions. For example, methods oftreating humans are not patentable in many countries outside of the U.S.

Our patents may not afford us protection against competitors,especially since there is a lengthy time between when a patent application isfiled and when it is issued. We may also incur substantial costs in assertingclaims against, and defending claims asserted against us by third parties toprevent the infringement of our patents and proprietary rights by others.Participation in such infringement proceedings may adversely affect ourbusiness and financial condition, even if the eventual outcome is favorable.

32

----

**Litigation or third party claims of intellectual property infringementcould require us to spend substantial time and money and adversely affect ourability to develop and commercialize our products.**

Our commercial success also depends in part on ourability to avoid infringing patents and proprietary rights of third parties andnot breaching any licenses that we have entered into with regard to any futureproducts. There are many pharmaceutical and chemical patents and applicationsbeing filed, published, and issued frequently throughout the world. Some ofthese patents and applications contain disclosures and claims that are similarto technologies and products that we are using and developing. Some of thesepatents and disclosures contain claims and disclosures that are difficult tointerpret. It is possible that a third party may own or control issued patents,or patent applications or in the future may file, patent applications coveringtechnologies or products we are developing.

If our technology,products or activities are deemed to infringe the other companies’ rights, wecould be subject to damages or be prevented from using the technology orselling the product that is infringing other companies’ rights, or we could berequired to obtain licenses to use that technology or sell the product. Ifpatents covering technologies required by our operations are issued to others,we may have to rely on licenses from third parties, which may not be availableon commercially reasonable terms, if at all. Third parties may accuse us ofemploying their proprietary technology without authorization. In addition,third parties may obtain patents that relate to our technologies and claim thatour use of such technologies infringes their patents, even if we have receivedpatent protection for our technology. Such claims could require us to incursubstantial costs and could have a material adverse effect on us, regardless ofthe merit of the claims, including the following:

·       thediversion 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;

·       payinga large sum for damages if we are found to infringe;

·       beingprohibited from selling or licensing our products or product candidates unlessand until we obtain a license from the patent holder, who may refuse to grantus a license or who may only agree to do so on unfavorable terms. Even if weare granted a license, we may have to pay substantial royalties or grantcross-licenses to our patents;

·       redesigningour products or product candidates so they do not infringe on the patent holder’stechnology if we are unable to obtain a license. This may not be possible and,even if possible, it could require substantial additional capital and couldsignificantly delay commercialization while we attempt to design around thepatents or rights infringed;

·       incurringsubstantial cost in defending ourselves and indemnifying our strategic partnersin patent infringement or proprietary rights violation actions brought againstthem relating to their development and commercialization of our products; and

·       incurring substantial costin indemnifying the investors in the financing that closed on April 5,2006 in the event that any intellectual property infringement is deemed to be abreach of the purchase agreement for the financing.

**We may be required to obtain rights to proprietary technologies that arerequired to further develop our business and that may not be available or maybe costly.**

Our oncology programs may require the use of multipleproducts or technologies proprietary to other parties. Third party suppliersmay not be able to furnish us with a supply of these products sufficient tosatisfy our requirements. We may not be able to obtain additional licenses wemay need in the future on 

33

----

terms acceptable to us.Our inability to obtain any one or more of these licenses, on commerciallyreasonable terms, if at all, or to circumvent the need for any such license,could cause significant delays and cost increases and materially affect ourability to develop and commercialize our product candidates. In connection withour efforts to obtain rights to these proprietary technologies, we may find itnecessary to convey rights to our technology to others. Some of our productsmay require the use of multiple proprietary technologies. Consequently, we maybe required to make cumulative royalty payments to several third parties. Thesecumulative royalties could become commercially prohibitive. We may not be ableto successfully negotiate the amounts of these royalties on terms acceptable tous.

We may rely in part onthird party licenses for access to intellectual property relating to ouroncology programs. Such licenses may obligate us to exercise diligence inpursuing the development of product candidates, to make specified milestonepayments and/or to pay royalties. Our inability or failure to meet any suchdiligence requirements or make any required payments would likely result in areversion to the licensor of the rights granted, which could materially andadversely affect our ability to develop and market products based on ourlicensed technologies.

**Risks Related to OurStock**

**The investors in our recently consummated financing have acquired sharesof common stock and warrants representing substantially more than a majority ofshares of our outstanding common stock and have the ability to exert controlover our activities.**

The investors in therecently consummated financing have acquired shares of our common stock andwarrants to acquire such shares representing up to approximately 88% of ourcommon stock, assuming the exercise in full of the warrants issued in the financing.As a result, those investors hold a sufficient portion of our outstandingshares so as to permit them, if they chose to act in concert, to approve allactions requiring stockholder approval, including the election of directors andthe approval of mergers or other business combination transactions, withoutobtaining the approval of any other stockholder.

**Future sales and issuances of our common stock or rights to purchasecommon stock, including pursuant to our equity incentive plans, could result inadditional dilution of the percentage ownership of our stockholders and couldcause our stock price to fall.**

We expect that significantadditional capital will be required in the future to continue our research anddevelopment efforts. To the extent we raise additional capital by issuingequity securities, our stockholders may experience substantial dilution. We maysell common stock in one or more transactions at prices and in a manner wedetermine from time to time. If we sell common stock in more than onetransaction, stockholders who purchase stock may be materially diluted bysubsequent sales. Such sales may also result in material dilution to ourexisting stockholders. In addition, our Board of Directors and stockholdersrecently adopted a new equity incentive plan that will provide for an initialreservation of 6,577,106 shares of common stock, for which options on 3,259,480shares were immediately granted thereunder. The shares available for issuanceunder this equity incentive plan may be increased by up to 1,600,000 shares ofcommon stock based upon the number of shares of common stock we issue duringthe three year period after April 5, 2006. Our stockholders also recentlyapproved an amendment to our bylaws and our existing stock option plans to permitthe repricing of approximately 630,038 of our currently outstanding stockoptions, which was effected on April 4, 2006 and the exercise price ofeach such repriced option was reduced to $4.02 per share.

**Substantial sales of shares may impact the market price of our commonstock.**

Sales of a substantialnumber of shares of our common stock in the public market, or the perceptionthat these sales might occur, could depress the market price of our commonstock and could impair our ability to raise capital through the sale ofadditional equity securities. We are unable to predict the effect 

34

----

thatsales may have on the then prevailing market price of our common stock.Pursuant to a Registration Rights Agreement entered into between us and thepurchasers of our common stock and warrants in the financing recently closed onApril 6, 2006, such purchasers are entitled to certain registration rightswith respect to the shares of common stock that were issued to them at closingand that may be issued upon exercise of the warrants issued to them at closing,pursuant to which we must, among other things, file with the Securities andExchange Commission a registration statement for the resale of such shares ofcommon stock and the shares of common stock underlying such warrants.

**If we fail to continue to meet all applicable Nasdaq Capital Marketrequirements and Nasdaq determines to delist our common stock, the delistingcould adversely affect the market liquidity of our common stock and the marketprice of our common stock could decrease.**

Our common stock is listed on the Nasdaq CapitalMarket. In order to maintain that listing, we must satisfy minimum financialand other requirements. On February 25, 2005, we received notice from theNasdaq Stock Market, Inc. that our common stock had not met the $1 pershare minimum bid price requirement for 30 consecutive business days and that,if we were unable to demonstrate compliance with this requirement during theapplicable grace periods, our common stock would be delisted after that time. OnFebruary 6, 2006, we effectuated a one for ten reverse stock split toregain compliance with this listing requirement. Since the reverse stock spiltwas effectuated, the closing bid price of our common stock has remained above$1.00 in compliance with the minimum bid price requirement.

Notwithstanding that the trading price of our commonstock currently exceeds the minimum bid price required to maintain compliancewith the Nasdaq Capital Market listing requirements, it is possible that theminimum bid price of our common stock could fall below the required level orthat we would otherwise fail to satisfy another Nasdaq requirement forcontinued listing of our common stock. For example, we could fail to maintaincompliance with the Nasdaq Capital Market listing requirements if we did notmaintain minimum stockholder equity of at least $2.5 million as a result ofcontinuing losses.

If we fail to continue tomeet all applicable Nasdaq Capital Market requirements in the future and Nasdaqdetermines to delist our common stock, the delisting could adversely affect themarket liquidity of our common stock and the market price of our common stockcould decrease. Such delisting could also adversely affect our ability toobtain financing for the continuation of our operations and could result in theloss of confidence by investors, suppliers and employees.

**Our stock compensation expense will negatively impact our earnings, andas we report the fair value of employee stock options as an expense inconjunction with a new accounting standard, our reported financial performancewill be adversely affected, which may cause our stock price to decline.**

In December 2004, theFinancial Accounting Standards Board issued SFAS 123(R), “Accounting forStock-Based Compensation”. SFAS 123(R) establishes standards for theaccounting for transactions in which an entity exchanges its equity instrumentsfor goods or services. This statement focuses primarily on accounting fortransactions in which an entity obtains employee services in share-basedpayment transactions. SFAS 123(R) requires that the fair value of suchequity 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), we recognized stock-based compensation expense of $1.3 or $.09basic and diluted per share from continuing operations for the three-monthsended June 28, 2008. In addition, we recognized stock-based compensationexpense of $1.9 million or $.20 basic and diluted per share from continuingoperations and $86,000 or $.01 basic and diluted loss per share fromdiscontinued operations for the six-month months ended June 28, 2006. Includedin the stock-based compensation expense for the three and six-months ended June 28,2006 is a one-time non-cash fixed charge in the amount of $381,000 as a resultof the amendment of certain vested options under the our existing equityincentive plans. As of June 28, 2006, 

35

----

therewas $9.3 million of total unrecognized compensation expense related to unvestedshare-based compensation arrangements granted under our stock option plans. Thisamount will be recognized over a weighted-average period of approximately 5years.

**We have implemented anti-takeover provisions that may reduce the marketprice of our common stock.**

Our certificate of incorporation and bylaws providethat the Board of Directors will be divided into three classes, eachconsisting, as nearly as possible, of one-third of the total number ofdirectors, with each class having a three-year term. Stockholders may takeaction only at a stockholders’ meeting and not by written consent. Certainprovisions of our certificate of incorporation and bylaws, including theprovisions providing for a classified Board of Directors, may not be amendedwithout the vote of at least 80% of the voting power of all of our capitalstock entitled to vote generally in the election of directors, voting togetheras a single class. Our bylaws provide that stockholders wishing to nominate adirector at an annual meeting or at a special meeting called for the purpose ofelecting directors or to bring business before any meeting of stockholders mustcomply with strict advance written notice provisions. Our bylaws also providethat special meetings of stockholders may be called only by the chairman of ourBoard of Directors, or certain of our officers, or by resolution of ourdirectors.

These provisions of our certificate of incorporationand our bylaws could discourage potential acquisition proposals and could delayor prevent a change in control. These provisions are intended to enhance thelikelihood of continuity and stability in the composition of our Board ofDirectors and in the policies formulated by our Board of Directors. We alsointended these provisions to discourage certain types of transactions that mayinvolve an actual or threatened change of control. We designed these provisionsto reduce our vulnerability to unsolicited acquisition proposals and todiscourage certain tactics that may be used in proxy contests. Theseprovisions, however, could also have the effect of discouraging others frommaking tender offers for our shares. As a consequence, they also may inhibitfluctuations in the market price of our shares that could result from actual orrumored takeover attempts. Such provisions also may have the effect ofpreventing changes in our management. We are permitted to issue shares of ourpreferred stock without stockholder approval upon such terms as our Board ofDirectors determines. Therefore, the rights of the holders of our common stockare subject to, and may be adversely affected by, the rights of the holders ofour preferred stock that may be issued in the future. In addition, the issuanceof preferred stock could have a dilutive effect on the holdings of our currentstockholders.

In November 1996, we adopted a stockholder rightsplan and distributed a dividend for each share of common stock. This dividend tookthe form of a right, which entitles the holders to purchase one one-hundredthof a share of a new series of junior participating preferred stock, Series B.The stockholder rights plan was amended and restated in September 2001,and we intend to replace this plan with a similar rights plan in 2006. Incertain events after the rights become exercisable they will entitle eachholder, other than the acquirer, to purchase, at the rights’ then currentexercise price, a number of shares of common stock having market value of twicethe right’s exercise price or a number of the acquiring company’s common shareshaving a market value at the time of twice the rights’ exercise price. Theadoption of the rights plan makes it more difficult for a third party to acquirecontrol of us without the approval of our Board of Directors. We are alsosubject to provisions of Delaware law that prohibit us from engaging in anybusiness combination with any “interested stockholder,” meaning generally thata stockholder who beneficially owns more than 15% of our stock cannot acquireus for 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.

Because the investors inour financing that closed on April 5, 2006 own a substantial percentage ofour outstanding common stock, we amended the stockholder rights plan inconnection with the closing of such financing to provide that such investorsand their respective affiliates will be exempt from the stockholder rightsplan, unless an investor and its affiliates acquire, after April 4, 2006,more than 1% of our then 

36

----

issuedand outstanding common stock, not including the shares of common stock issuedto the investors in the financing or shares of common stock issued uponexercise of the warrants issued to the investors in the financing.

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

On April 6, 2006, theCompany sold an aggregate of 12,750,000 shares of common stock and warrants topurchase up to 12,750,000 shares of common stock, for a total of$25.5 million (excluding any proceeds that might be received upon exerciseof the warrants) or approximately $23.8 million, net of the placementagent fees and other expenses, pursuant to a Purchase Agreement dated February 2,2006, 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 of commonstock, and each warrant to purchase common stock has an exercise price equal to$2.40 per share. The Company may call up to 20% of the outstanding warrantsduring any three month period if certain conditions are satisfied, includingthe trading price of the Company’s common stock exceeding $4.80 for 20 consecutivetrading days. Up to half of the warrants may be exercised on a cashless or netexercise basis.

**Item 3.**                        Defaultsupon Senior Securities

Not applicable.

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

Information concerning proposals submitted tostockholders at a special meeting held on April 4, 2006 was disclosed inour Quarterly Report on Form 10-Q for the quarter ended March 29,2006.

In addition, on June 21, 2006, the Company heldits annual meeting of shareholders. There were 11, 926,909 shares present atthe meeting, either in person or by proxy, representing over 73% of the Company’soutstanding shares.

The following shareholder actions were taken:

Three directors were re-elected to serve until the2009 Annual Meeting of Shareholders:

Leonard P. Shaykin (10,692,879 votes cast forre-election; 1,234,030 votes withheld)

Arthur H. Hayes, Jr., M.D. (11,672,237 votes castfor re-election; 254,672 votes withheld)

Robert E. Pollack, Ph.D. (11,712,609 votes cast forre-election; 214,300 votes withheld)

Additionally, theselection by the Audit Committee of the Board of Directors of Grant ThorntonLLP as independent auditors of the Company for the fiscal year ending December 27,2006 was ratified with 11,876,632 votes for ratification, and 12,222 votesagainst ratification.

**Item 5.**                        OtherInformation

Not applicable.

37

----

**Item6.**                        Exhibits

| Exhibit  Number | ** ** | ** **                                                                                                                                                                                                                                      | ** ** | **Description of Exhibit** |
|-----------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------|
| 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))* |

----

*                    Filedherewith

#                 Thiscertification “accompanies” this Form 10-Q, is not deemed filed withthe SEC and is not to be incorporated by reference into any filing of theCompany under the Securities Act of 1933, as amended, or the SecuritiesExchange Act of 1934, as amended (whether made before or after the date of the Form 10-Q),irrespective of any general incorporation language contained in such filing.

38

----

**Signatures**

Pursuantto the requirements of the Securities Exchange Act of 1934, the registrant hasduly caused this report to be signed on its behalf by the undersigned thereuntoduly authorized.
|                      | TAPESTRY PHARMACEUTICALS,  INC.            |
|----------------------|--------------------------------------------|
| August 7,  2006 | By:                                        | /s/ LEONARD P. SHAYKIN |   |
| ** **           | **Leonard P. Shaykin**                     |
| ** **           | ***Chairman of the Board of  Directors,*** |
| ** **           | ***Chief Executive Officer***              |
| August 7,  2006 | By:                                        | /s/ GORDON LINK |   |
| ** **           | **Gordon Link**                            |
| ** **           | ***Senior Vice President,***               |
| ** **           | ***Chief Financial Officer***              |
| ** **           | ***(Principal Financial Officer  and***    |
| ** **           | ***Principal  Accounting Officer)***       |

 

39

----

**Indexof Exhibits**
| Exhibit  Number | ** ** | **Description of Exhibit**                                                                                                                                                                                                                      |
|-----------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 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))* |

----

*                    Filedherewith

#                 Thiscertification “accompanies” this Form 10-Q, is not deemed filed withthe SEC and is not to be incorporated by reference into any filing of theCompany under the Securities Act of 1933, as amended, or the SecuritiesExchange Act of 1934, as amended (whether made before or after the date of the Form 10-Q),irrespective of any general incorporation language contained in such filing.

40

----