**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

**Form 10-Q**

(Mark One)

**x        QUARTERLY REPORT PURSUANT TOSECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**

**FORTHE QUARTERLY PERIOD ENDED SEPTEMBER 27, 2006**

**OR**

**o        TRANSITION REPORT PURSUANT TOSECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**

**FORTHE TRANSITION PERIODFROM               TO               **

**CommissionFile Number 0-24320**

**TAPESTRY PHARMACEUTICALS, INC.**

(Exact name of Registrantas specified in its charter)

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

**4840Pearl 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. (Check one):   Largeaccelerated filer o   AcceleratedFiler o   Non-accelerated filer x

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

As of October 31,2006, the registrant had 16,344,395 shares of common stock, $0.0075 parvalue, outstanding.

 

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**TapestryPharmaceuticals, Inc. and Subsidiaries**

**Table of 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 | 17 |
|             | Item 3                    | Quantitative  and Qualitative Disclosures about Market Risk                                      | 25 |
|             | Item 4                    | Controls  and Procedures                                                                         | 25 |
| **Part II** | **Other  Information**    | 26                                                                                               |
|             | Item 1                    | Legal  Proceedings                                                                               | 26 |
|             | Item 1A                   | Risk Factors                                                                                     | 26 |
|             | Item 2                    | Unregistered  Sales of Equity Securities and Use of Proceeds                                     | 38 |
|             | Item 3                    | Defaults  upon Senior Securities                                                                 | 38 |
|             | Item 4                    | Submission  of Matters to a Vote of Security Holders                                             | 38 |
|             | Item 5                    | Other  Information                                                                               | 38 |
|             | Item 6                    | Exhibits                                                                                         | 38 |
| **Signatures**   | 39                        |

 

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**Part I**

**FINANCIALINFORMATION**

**Item 1.        Financial Statements**

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

| ** **                                                                                                                                                                                  | ** ** | **September 27,** | ** ** | **December 28,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                                  | ** ** | **2006**               | ** ** | **2005**              | ** ** |
| **ASSETS**                                                                                                                                                                                  |       |                   |       |                  |       |   |   |   |   |
| Current assets:                                                                                                                                                                             |       |                   |       |                  |       |   |   |   |   |
| Cash and cash equivalents                                                                                                                                                                   |       |                   | $          | 839                   |       |   |   | $ | 534 |   |   |
| Short-term investments                                                                                                                                                                      |       |                   | 27,371     |                  |       |   | 13,552 |   |   |
| Prepaid expense and other current assets                                                                                                                                                    |       |                   | 419        |                  |       |   | 646 |   |   |
| Total current  assets                                                                                                                                                                       |       |                   | 28,629     |                  |       |   | 14,732 |   |   |
| Property, plant and equipment, net                                                                                                                                                          |       |                   | 465        |                  |       |   | 608 |   |   |
| Investment in  ChromaDex, Inc.                                                                                                                                                         |       |                   | 451        |                  |       |   | 451 |   |   |
| Other assets                                                                                                                                                                                |       |                   | 664        |                  |       |   | 683 |   |   |
| Total assets                                                                                                                                                                                |       |                   | $          | 30,209                |       |   |   | $ | 16,474 |   |   |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                                               | ** ** |                   |       |                  |       |   |   |   |   |
| Current liabilities:                                                                                                                                                                        |       |                   |       |                  |       |   |   |   |   |
| Accounts payable and accrued liabilities                                                                                                                                                    |       |                   | $          | 908                   |       |   |   | $ | 1,024 |   |   |
| Accrued payroll and payroll taxes                                                                                                                                                           |       |                   | 1,159      |                  |       |   | 1,241 |   |   |
| Notes payable—current portion, net                                                                                                                                                     |       |                   | 1,319      |                  |       |   | 840 |   |   |
| Total current  liabilities                                                                                                                                                                  |       |                   | 3,386      |                  |       |   | 3,105 |   |   |
| Notes payable—long term, net                                                                                                                                                           |       |                   | 1,384      |                  |       |   | 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; 16,341,917 and 3,480,704 shares issued and outstanding at  September 27, 2006 and December 28, 2005, respectively |       |                   | 122        |                  |       |   | 26 |   |   |
| Additional paid in capital                                                                                                                                                                  |       |                   | 144,692    |                  |       |   | 118,278 |   |   |
| Deferred compensation                                                                                                                                                                       |       |                   | —     |                  |       |   | (114 | ) |   |
| Accumulated deficit                                                                                                                                                                         |       |                   | (119,375   | )                     |       |   | (107,262 | ) |   |
| Accumulated other comprehensive loss                                                                                                                                                        |       |                   | —     |                  |       |   | (42 | ) |   |
| Total stockholders’  equity                                                                                                                                                            |       |                   | 25,439     |                  |       |   | 10,886 |   |   |
| Total liabilities and  stockholders’ equity                                                                                                                                            |       |                   | $          | 30,209                |       |   |   | $ | 16,474 |   |   |

 

See accompanying notes to Consolidated Financial Statements.

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

| ** **                                                     | ** ** | **Three-Months Ended** | ** ** | **Nine-Months Ended** | ** ** |
|----------------------------------------------------------------|------------|-----------------------------|------------|----------------------------|------------|
| ** **                                                     | ** ** | **September 27,**      | ** ** | **September 28,**     | ** ** | **September 27,** | ** ** | **September 28,** | ** ** |
| ** **                                                     | ** ** | **2006**                    | ** ** | **2005**                   | ** ** | **2006** | ** ** | **2005** | ** ** |
| Operating expenses:                                            |       |                        |       |                       |       |   |   |   |   |   |   |   |   |   |   |
| Research and development                                       |       | $                           | 2,259      |                       |       | $ | 3,139 |   |   |   | $ | 7,464 |   |   |   | $ | 8,718 |   |   |
| General and administrative                                     |       | 1,575                       |       |                       | 1,530      |   |   |   | 5,070 |   |   |   | 4,596 |   |   |
| Operating loss                                                 |       | 3,834                       |       |                       | 4,669      |   |   |   | 12,534 |   |   |   | 13,314 |   |   |
| Other income  (expense):                                       |       |                        |       |                       |       |   |   |   |   |   |   |   |   |   |   |
| Interest and other income                                      |       | 400                         |       |                       | 274        |   |   |   | 936 |   |   |   | 656 |   |   |
| Interest and other expense                                     |       | (124                        | )          |                       | (140       | ) |   |   | (427 | ) |   |   | (447 | ) |   |
| Impairment charges                                             |       | —                      |       |                       | (963       | ) |   |   | — |   |   |   | (1,067 | ) |   |
| Loss from  continuing operations                               |       | (3,558                      | )          |                       | (5,498     | ) |   |   | (12,025 | ) |   |   | (14,172 | ) |   |
| Loss from discontinued operations                              |       | —                      |       |                       | (43        | ) |   |   | (88 | ) |   |   | (347 | ) |   |
| Net loss                                                       |       | $                           | (3,558     | )                          |       | $ | (5,541 | ) |   |   | $ | (12,113 | ) |   |   | $ | (14,519 | ) |   |
| Basic and diluted loss per share from continuing  operations   |       | $                           | (0.24      | )                          |       | $ | (1.61 | ) |   |   | $ | (1.95 | ) |   |   | $ | (4.18 | ) |   |
| Basic and diluted  loss per share from discontinued operations |       | $                           | —     |                       |       | $ | (0.01 | ) |   |   | $ | (0.01 | ) |   |   | $ | (0.10 | ) |   |
| Basic and diluted  loss per share                              |       | $                           | (0.24      | )                          |       | $ | (1.62 | ) |   |   | $ | (1.96 | ) |   |   | $ | (4.28 | ) |   |
| Basic and diluted  weighted average shares outstanding         |       | 15,051,659                  |       |                       | 3,423,899  |   |   |   | 6,178,875 |   |   |   | 3,393,982 |   |   |

 

See accompanying notes to Consolidated Financial Statements.

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

| ** **                                                                   | ** ** | **Nine-Months Ended** | ** ** |
|------------------------------------------------------------------------------|------------|----------------------------|------------|
| ** **                                                                   | ** ** | **September 27,**     | ** ** | **September 28,** | ** ** |
| ** **                                                                   | ** ** | **2006**                   | ** ** | **2005** | ** ** |
| Operating activities:                                                        |       |                       |       |   |   |   |   |   |   |
| Net loss                                                                     |       |                       | $          | (12,113 | ) |   |   | $ | (14,519 | ) |   |
| Adjustments to reconcile  net loss to net cash used in operating activities: |       |                       |       |   |   |   |   |   |   |
| Depreciation and amortization                                                |       |                       | 168        |   |   |   | 197 |   |   |
| Amortization of debt issue costs                                             |       |                       | —     |   |   |   | 92 |   |   |
| Amortization of debt discount                                                |       |                       | 382        |   |   |   | 348 |   |   |
| Amortization of investment (discount)/premium                                |       |                       | (272       | ) |   |   | 198 |   |   |
| Compensation paid with common stock                                          |       |                       | 2,539      |   |   |   | 39 |   |   |
| Retirement contributions paid with common stock                              |       |                       | 291        |   |   |   | 315 |   |   |
| Impairment charges                                                           |       |                       | —     |   |   |   | 1,067 |   |   |
| (Gain)/loss on sale of investments                                           |       |                       | 38         |   |   |   | (72 | ) |   |
| Loss on disposal of assets                                                   |       |                       | —     |   |   |   | 14 |   |   |
| Changes in  operating assets and liabilities:                                |       |                       |       |   |   |   |   |   |   |
| Prepaid expense and other assets                                             |       |                       | 343        |   |   |   | 128 |   |   |
| Accounts payable and accrued liabilities                                     |       |                       | (160       | ) |   |   | (1,418 | ) |   |
| Accrued payroll and payroll taxes                                            |       |                       | (83        | ) |   |   | (852 | ) |   |
| Net cash used in  operating activities                                       |       |                       | (8,867     | ) |   |   | (14,463 | ) |   |
| Investing  acitivities:                                                      |       |                       |       |   |   |   |   |   |   |
| Additions to property, plant and equipment                                   |       |                       | (25        | ) |   |   | (216 | ) |   |
| Proceeds from sale of assets held for sale                                   |       |                       | —     |   |   |   | 104 |   |   |
| Purchases of investments                                                     |       |                       | (59,404    | ) |   |   | (23,379 | ) |   |
| Proceeds from sale of investments                                            |       |                       | 45,861     |   |   |   | 40,731 |   |   |
| Net cash (used  in) provided by investing activities                         |       |                       | (13,568    | ) |   |   | 17,240 |   |   |
| Financing  acitivities:                                                      |       |                       |       |   |   |   |   |   |   |
| Proceeds from the sale of common stock, net of  issuance costs               |       |                       | 23,742     |   |   |   | — |   |   |
| Payments of notes payable                                                    |       |                       | (1,002     | ) |   |   | (3,474 | ) |   |
| Proceeds from the exercise of common stock options                           |       |                       | —     |   |   |   | 31 |   |   |
| Net cash provided  by (used in) financing activities                         |       |                       | 22,740     |   |   |   | (3,443 | ) |   |
| Net  increase/(decrease) in cash and cash equivalents                        |       |                       | 305        |   |   |   | (666 | ) |   |
| Cash and cash  equivalents at beginning of period                            |       |                       | 534        |   |   |   | 1,713 |   |   |
| Cash and cash  equivalents at end of period                                  |       |                       | $          | 839 |   |   |   | $ | 1,047 |   |   |
| Supplemental  disclosure of cash flow information:                           |       |                       |       |   |   |   |   |   |   |
| Interest paid                                                                |       |                       | $          | — |   |   |   | $ | 137 |   |   |
| Non-cash  investing and financing activities:                                |       |                       |       |   |   |   |   |   |   |
| Issuance of  common stock to prepay retirement plan contributions            |       |                       | $          | 97 |   |   |   | $ | 105 |   |   |

 

See accompanying notes to Consolidated Financial Statements.

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**Tapestry Pharmaceuticals, Inc.Notes to Consolidated Financial StatementsSeptember 27, 2006**(Unaudited)

**Note 1.   Basisof Presentation and Summary 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 September 27, 2006and December 28, 2005, the results of its operations for the three andnine-months ended September 27, 2006 and September 28, 2005, and cashflows for the nine-months ended September 27, 2006 and September 28,2005.

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 $3.6 million and $12.1 millionfor the three and nine-months ended September 27, 2006, respectively and aloss of approximately $17.5 million for the year ended December 28, 2005and has an accumulated deficit of $119.4 million as of September 27, 2006.The Company’s capital requirements for research and development, including thecost of clinical trials, have been and will continue to be significant. As of September 27,2006, the Company had cash and short-term investments totaling approximately$28.2 million. However, as of December 28, 2005 the Company had cashand short-term investments totaling approximately $14.1 million. The amount ofthe Company’s cash and short-term investments, as of December 28, 2005,raised substantial doubt, which has since been addressed as discussed below,about the Company’s ability to continue as a going concern. As a result ofthese concerns the audit report prepared by the Company’s independentregistered public accounting firm relating to the Company’s consolidatedfinancial statements for the year ended December 28, 2005 included anexplanatory paragraph expressing the substantial doubt about the Company’sability 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 that time the Company also determined that its leadpharmaceutical program warranted expanded clinical development. The Companytherefore sought the additional capital necessary to fund its ongoingoperations related to its lead 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 

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Company may call up to 20%of the outstanding warrants during any three-month period if certain conditionsare satisfied, including the trading price of the Company’s common stockexceeding $4.80 for 20 consecutive trading days. Up to half of thewarrants may be exercised on a cashless or net exercise basis. There can be noassurance, however, that the Company will receive funds from the exercise ofwarrants. See Note 8 for further discussion.

As of September 27, 2006 the Company had cash andshort-term investments of approximately $28.2 million and working capitalof approximately $25.2 million. The Company believes it has sufficient capitalto fund its operations and capital expenditures for at least the next 12 months.However, pharmaceutical development is costly, risky and time intensiveactivity. To bring the Company’s various programs to completion will requirethe Company to raise additional capital as practicable to fund futureoperations and to provide additional working capital. There can be no assurancethat the Company will be able to obtain additional capital on terms that willbe acceptable to the Company or on any terms. In addition, the Company may seekto acquire new products or technologies through in-licensing, purchase ormerger. The cost and related capital expenditures of acquiring and developingsuch resources may be significant, and the Company may not be able to obtaincapital for the development of these products or technologies.

*ESTIMATESAND ASSUMPTIONS—*The preparation of the Company’sconsolidated financial statements in conformity with accounting principlesgenerally accepted in the United States requires the Company’s management tomake estimates and assumptions that affect the reported amounts of assets andliabilities, and disclosure of contingent assets and liabilities at the date ofthe financial statements and the reported amounts of revenue and expensesduring the reporting period. Significant estimates are used when determininguseful lives for depreciation and amortization, assessing the need forimpairment charges, accounting for income taxes, estimating the value ofemployee stock options, and various others items. The Company evaluates theseestimates and assumptions on an ongoing basis and bases its estimates onhistorical experience, current conditions and various other assumptions thatare believed to be reasonable under the circumstances. The results of theseestimates form the basis for making judgments about the carrying values ofassets and liabilities as well as identifying and assessing the accountingtreatment with respect to commitments and contingencies. Actual results maydiffer materially from these estimates.

*SHARE BASED COMPENSATION***—**Asof September 27, 2006, the Company had five equity incentive plans (the “Plans”),the 1994 Long-Term Performance Incentive Plan, the 1998 Stock Incentive Plan,the 2004 Equity Incentive Plan, the 2004 Non-Employee Director’s Stock OptionPlan, and the 2006 Equity Incentive Plan (the “2006 Incentive Plan”), which wasapproved 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 to employees of options topurchase the Company’s common stock when such stock options were granted withexercise prices equal to or greater than market value of the underlying commonstock on the 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’s2006 fiscal year. The Company’s Consolidated Financial Statements as of and forthe three and nine-months ended September 27, 2006 reflect the impact ofSFAS 123(R). In accordance with the modified prospective transition method, theCompany’s Consolidated Financial Statements for prior 

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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 September 27, 2006 was $593,000 or $.04 basic and diluted loss pershare from continuing operations. Stock-based compensation expense recognizedunder SFAS 123(R) for the nine-months ended September 27, 2006 was$2.4 million or $.38 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 nine-months ended September 27, 2006, is a one time non-cashfixed period charge in the amount of $381,000, as a result of the modificationof vested 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 nine-months ended September 28, 2005, the Company recordedapproximately $15,000 and $39,000, 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,** | ** ** | **Nine-Months Ended,**  | ** ** |
|----------------------------|------------|------------------------------|------------|------------------------------|------------|
| ** **                 | ** ** | **September 27,  2006** | ** ** | **September 28,  2005** | ** ** | **September 27,  2006** | ** ** | **September 28,  2005** | ** ** |
| Research and  development  |       |                         | $          | 247                          |       |   |   | $ | 15 |   |   |   | $ | 1,035 |   |   |   | $ | 29 |   |   |
| General and  adminstrative |       |                         | 346        |                         |       |   | — |   |   |   | 1,328 |   |   |   | 7 |   |   |
| Discontinued  operations   |       |                         | —     |                         |       |   | — |   |   |   | 86 |   |   |   | 3 |   |   |
|                       |       |                         | $          | 593                          |       |   |   | $ | 15 |   |   |   | $ | 2,449 |   |   |   | $ | 39 |   |   |

 

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 nine-months ended September 27,2006 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 (inthousands):

| ** **                                                                                                      | ** ** | **Three-Months Ended,  September 28, 2005** | ** ** | **Nine-Months Ended,  September 28, 2005** | ** ** |
|-----------------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------------|------------|-----------------------------------------------------------|------------|
| Net loss, as  reported                                                                                          |       |                                                       | $          | (5,541                                                    | )          |   |   | $ | (14,519 | ) |   |
| Add: Stock-based  employee compensation expense included in reported net loss                                   |       |                                                       | 15         |                                                      |       |   | 39 |   |   |
| Less: Total stock-based compensation expense  determined under fair value based methods for all options granted |       |                                                       | (643       | )                                                         |       |   | (2,156 | ) |   |
| Pro forma net  loss                                                                                             |       |                                                       | $          | (6,169                                                    | )          |   |   | $ | (16,636 | ) |   |
| Net loss per  share:                                                                                            |       |                                                       |       |                                                      |       |   |   |   |   |
| Basic and diluted—as  reported                                                                             |       |                                                       | $          | (1.62                                                     | )          |   |   | $ | (4.28 | ) |   |
| Basic and diluted—pro  forma                                                                               |       |                                                       | $          | (1.80                                                     | )          |   |   | $ | (4.90 | ) |   |

 

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 in

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the following table. The Company calculated theestimated life of each employee stock option granted in fiscal 2006 based onthe average life of the option estimated by reference to the historical averagelives of options issued by the Company since its initial public offering in1994. The risk free rate of return and the historical volatility were alsobased 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 on awardsthat are ultimately expected to vest, stock-based compensation for the threeand nine-months ended September 27, 2006 have 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 |       | 4.67%  - 5.18%    |       | 0%           |       | 110.00%  - 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. Circumstancesmay change and additional data may become available over time, therebyresulting in changes to these assumptions and methodologies. These changescould materially impact the Company’s fair value determination.

A summary of optionactivity under the Plans as of September 27, 2006, and changes during thethree and nine-months then ended is presented below:

**Summary Details for Plan Share Options**

| ** **                                    | ** ** | **Three-Months Ended,  September 27, 2006** | ** ** |
|-----------------------------------------------|------------|------------------------------------------------------------|------------|
| ** **                                    | ** ** | **Number of  Options**                                | ** ** | **Weighted-  Average  Exercise  Price** | ** ** | **Weighted-  Average  Remaining  Contractual  Life (Years)** | ** ** | **Aggregate  Intrinsic  Value** | ** ** |
| Outstanding  Balance, June 28, 2006      |       | 4,242,106                                                  |       |   | $ | 4.47 |   |   |   | 9.02 |   |   |   | $ | 460 |   |   |
| Granted                                       |       | 1,000                                                      |       |   | $ | 2.89 |   |   |   | — |   |   |   | — |   |   |
| Exercised                                     |       | —                                                     |       |   | — |   |   |   | — |   |   |   | — |   |   |
| Forfeited                                     |       | (5,588                                                     | )          |   | $ | 4.04 |   |   |   | — |   |   |   | — |   |   |
| Outstanding Balance, September 27,  2006 |       | 4,237,518                                                  |       |   | $ | 4.47 |   |   |   | 8.77 |   |   |   | — |   |   |

 

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| ** **                                    | ** ** | **Nine-Months Ended,  September 27, 2006** | ** ** |
|-----------------------------------------------|------------|-----------------------------------------------------------|------------|
| ** **                                    | ** ** | **Number of  Options**                               | ** ** | **Weighted-  Average  Exercise  Price** | ** ** | **Weighted-  Average  Remaining  Contractual  Life (Years)** | ** ** | **Aggregate  Intrinsic  Value** | ** ** |
| Outstanding  Balance, December 29, 2005  |       | 724,802                                                   |       |   | $ | 36.70 |   |   |   | — |   |   |   | $ | — |   |   |
| Granted                                       |       | 4,173,597                                                 |       |   | $ | 3.99 |   |   |   | — |   |   |   | — |   |   |
| Exercised                                     |       | —                                                    |       |   | — |   |   |   | — |   |   |   | — |   |   |
| Forfeited                                     |       | (660,881                                                  | )          |   | $ | 37.25 |   |   |   | — |   |   |   | — |   |   |
| Outstanding Balance,  September 27, 2006 |       | 4,237,518                                                 |       |   | $ | 4.47 |   |   |   | 8.77 |   |   |   | — |   |   |

 

Included in the number of stock options granted andforfeited in the table above during the nine-months ended September 27,2006, are 626,568 stock options that were cancelled and reissued as a result ofthe repricing of outstanding stock options as described in Note 9.

A summary of the status ofthe Company unvested shares as of September 27, 2006, and changes duringthe three and nine-months then ended is presented below:

**Unvested Shares Issued Under the Plan**

| ** **                  | ** ** | **Three-Months Ended,  September 27, 2006** | ** ** | **Nine-Months Ended,  September 27, 2006** | ** ** |
|-----------------------------|------------|------------------------------------------------------------|------------|-----------------------------------------------------------|------------|
| ** **                  | ** ** | **Unvested  Shares**                                       | ** ** | **Weighted-  Average  Grant-Date  Fair Value**       | ** ** | **Unvested  Shares** | ** ** | **Weighted-  Average  Grant-Date  Fair Value** | ** ** |
| Beginning  unvested balance |       | 3,695,356                                                  |       |                                                      | $          | 3.40 |   |   | 286,268 |   |   | $ | 32.15 |   |   |
| Granted                     |       | 1,000                                                      |       |                                                      | $          | 2.06 |   |   | 4,173,597 |   |   | $ | 4.71 |   |   |
| Vested                      |       | (36,558                                                    | )          |                                                      | $          | 12.83 |   |   | (542,335 | ) |   | $ | 5.91 |   |   |
| Forfeited                   |       | (5,400                                                     | )          |                                                      | $          | 2.93 |   |   | (263,132 | ) |   | $ | 39.28 |   |   |
| Ending unvested balance     |       | 3,654,398                                                  |       |                                                      | $          | 3.39 |   |   | 3,654,398 |   |   | $ | 3.39 |   |   |

 

Included in the number of stock options granted andforfeited in the table above during the nine-months ended September 27,2006, are 248,856 stock options that were cancelled and reissued as a result ofthe repricing of outstanding stock options as described in Note 9.

On October 5, 2006, the Compensation Committee ofthe Board of Directors approved the grant of 1,550,000 stock options from the2006 Incentive Plan to executive employees of the Company, including itsexecutive officers.

As of September 27, 2006, there was $9.1 millionof total unrecognized compensation expense related to unvested share-basedcompensation arrangements granted under the Plans. Total unrecognized compensationexpense will be recognized over a weighted-average period of approximately 4.5****years.

***DERIVATIVE INSTRUMENTS******—***Companiesare required to recognize all of their derivative instruments as either assetsor liabilities on the balance sheet at fair value. The accounting for changesin the 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 incurrent earnings during the period of change. The Company currently has onederivative instrument (Note 8) that is assessed on a quarterly basis, and anychanges in fair value will be recognized in current earnings in the period ofchange.

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*RECENT ACCOUNTINGPRONOUNCEMENTS*—On June 9, 2005, the FASB issuedSFAS 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. The adoption of SFAS No. 154 didnot have a material impact on the Company’s financial results.

**Note 2.  **Reverse Stock Split and Nasdaq Listing

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, the Company 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 its common stockincreased and on February 24, 2006 the Company received notice from theNasdaq that the Company regained compliance with the minimum bid pricerequirement.

**Note 3.   DiscontinuedOperations**

In November 2004 the Company discontinuedresearch on its remaining genomics programs, other than the Huntington’sDisease program, and sought a buyer for these programs. After attempting tosell the intellectual property assets related to the genomics programs over thecourse of 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 from the sale of certain fixed assets of thegenomics business that were previously reserved for in the fourth quarter of2004 and classified as Assets Held for Sale.

Net losses related to theGenomics Division that are included in discontinued operations totaled $0 and$43,000 for the three-months ended September 27, 2006 and September 28,2005, respectively and $88,000 and $347,000 for the nine-months ended September 27,2006 and September 28, 2005, respectively. No material revenue has beenrecognized in this division. There were no assets held for sale at September 27,2006 and December 28, 2005, which relate to the discontinued operations ofthe 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 and 

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therefore has classified these investments asshort-term. All investments are classified as available-for-sale and arerecorded at market value. Unrealized gains and losses are treated as a separatecomponent of stockholders’ equity until the security is sold or until a declinein fair value market value is determined to be other than temporary. As of September 27,2006 and December 28, 2005, the amortized cost basis, aggregate fair valueand gross unrealized holding gains and losses by major security type ofinvestment classified as available-for-sale are as follows (in thousands):

| ** **                  | ** ** | **Amortized** | ** ** | **Unrealized** | ** ** | **Fair**   | ** ** |
|-----------------------------|------------|---------------|------------|----------------|------------|------------|------------|
| **Security Type**      | ** ** | ** **    | ** ** | **Cost**       | ** ** | **Losses** | ** ** | **Value** | ** ** |
| **September 27, 2006** | ** ** |          | ** ** | ** **     |       |       | ** ** | ** ** |   | ** ** | ** ** |
| Auction rate  securities    |       |          | $          | 9,800          | ** ** |       |       | $ | — |   |   | $ | 9,800 |   |
| Commercial paper            |       |          | 10,946     | ** **     |       |       | —     |   |   | 10,946 |   |
| Corporate debt  securities  |       |          | 4,000      | ** **     |       |       | —     |   |   | 4,000 |   |
| Government  agencies        |       |          | 2,625      | ** **     |       |       | —     |   |   | 2,625 |   |
| Total investments           |       |          | $          | 27,371         | ** ** |       |       | $ | — |   |   | $ | 27,371 |   |
| **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 |   |
|                             |            |               |            |                |            |            |            |  |  |  |  |  |  |  |  |  |

 

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,** | ** ** | **Nine-Months Ended,** | ** ** |
|----------------------------------------------------------|------------|------------------------------|------------|-----------------------------|------------|
| ** **                                               | ** ** | **September 27,**       | ** ** | **September 28,**      | ** ** | **September 27,** | ** ** | **September 28,** | ** ** |
| ** **                                               | ** ** | **2006**                     | ** ** | **2005**                    | ** ** | **2006** | ** ** | **2005** | ** ** |
| Net loss, as  reported                                   |       |                         | $          | (3,558                      | )          |   |   | $ | (5,541 | ) |   |   | $ | (12,113 | ) |   |   | $ | (14,519 | ) |   |
| Unrealized gain  (loss) on available-for-sale securities |       |                         | 8          |                        |       |   | 16 |   |   |   | 42 |   |   |   | (9 | ) |   |
| Comprehensive net loss                                   |       |                         | $          | (3,550                      | )          |   |   | $ | (5,525 | ) |   |   | $ | (12,071 | ) |   |   | $ | (14,528 | ) |   |

 

**Note 5.   Investmentin 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 (“SFAS144”), *Accounting for the Impairment of Long-Lived Assets*,the Company recognized an impairment charge of $963,000 on the carrying valueof its investment in ChromaDex to revalue it to an estimated fair value of$451,000 as a result of then available financial information.

**Note 6.   OtherLong-Term Assets—Land**

As part of the Company’spreparation of its interim financial statements for the second quarter ending June 29,2005, and in accordance with Statement of Financial Accounting Standards No. 144(“SFAS 144”), *Accounting for theImpairment of Long-Lived Assets*, the Company recognized animpairment charge on the carrying value of its land of $104,000 to revalue itto an estimated fair market value of $614,000.

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**Note 7.   NotesPayable, Current and Long-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 its 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 43,814 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. To date, under thisprogram, 5,256 shares have been surrendered due to employees leaving employmentwith the Company. The stock component of the program includes 18,463 sharesthat vested on September 6, 2006 and 20,095 additional shares to vest on September 6,2007, contingent upon participants being employed by the Company on those dates.The total value of the common stock component of the program is $139,000 (netof terminations) based on the fair value of the underlying common stock at thedate of grant. The cash component related to the tax effects of the programamounted to $93,000 and was expensed in the third quarter of 2005. For thethree and nine-months ended September 27, 2006, $20,000 and $69,000,respectively, of expense related to the program was recognized. As a result ofthe adoption of SFAS 123(R), the deferred compensation balance has beeneliminated against additional paid in capital. The remaining unamortizedexpense associated with the program of $33,000 will be recognized over thevesting 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.

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 maintaineffectiveness. If sales cannot be made under the registration statement (otherthan for certain periods 

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when the Company ispermitted under the agreement to suspend use of the registration statement whenit has delayed disclosure of material nonpublic information) then the Companyis obligated to pay each investor liquidated damages, in cash, equal to 1.5%per 30 day period (or pro rata for a portion thereof) of the aggregate purchaseprice paid by such investor. The SEC declared the Company’s Form S-3effective 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 registrationrights agreement has nominal value. Under this approach, the registrationrights agreement is accounted for separately from the financial instrument inaccordance with SFAS 133 *“Accounting for DerivativeInstruments and Hedging Activities”*. Accordingly, the classificationof the warrants has been determined under EITF 00-19, *“Accounting for Derivative Financial InstrumentsIndexed to, and Potentially Settled in, a Company’s Own Stock,”*andthe warrants have been accounted for as permanent equity.

The Company has valued theliquidated damages provision of the registration rights agreement at nominal value.In determining this as the fair value, the Company considered the followingfactors. The agreement provides that there is a 90-day period to have theregistration statement declared effective before liquidated damages apply. TheCompany believed at the closing of the Private Placement it 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 future if sales may not be madethereunder for periods other than as permitted thereunder. The Company believesthe events that would lead to sales being unable to be made under theregistration statement for periods other than as permitted are unlikely tooccur. In future periods, should the Company conclude that it is probable, asdefined in SFAS No. 5, “Accounting for Contingencies,” that a liabilityfor liquidated damages will occur, the Company will record the estimated cashvalue of the liquidated damages liability at that time.

**Note 9.   EquityIncentive Plans**

As of September 27,2006, the Company had five equity incentive 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 andthe 2006 Equity Incentive Plan, which was approved by shareholders on April 4,2006.

*2006 EquityIncentive Plan and New Stock Option Grants*

In January 2006, the Board of Directors adopted,subject to stockholder approval, the Company’s 2006 Equity Incentive Plan. TheBoard adopted the 2006 Incentive Plan at the same time it approved the PrivatePlacement. In conjunction with the adoption of the 2006 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 the2006 Incentive Plan and grant of the stock options thereunder was received on April 4,2006.

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The number of shares initially reserved for issuanceunder the 2006 Incentive Plan totals 6,577,106. Subject to limited exceptions,the grant 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. The resulting exercise price of $4.02was above the closing sales price of the Company’s common stock on April 4,2006. Each option vests as follows: 1¤6 when the 20trading day average of the closing sale prices of the common stock equals orexceeds 130% (or $5.23) of the exercise price of the stock option; 1¤6when such average equals or exceed 160% (or $6.43) of the exercise price; 1¤6when such average equals or exceeds 190% (or $7.64) of the exercise price; 1¤6when 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¤6when such average equals or exceeds 300% (or $12.06) of the exercise price. Allstock options vest at the latest on the fifth anniversary of the date of grant.The awards otherwise were made in accordance with the terms and conditions ofthe 2006 Incentive Plan and the Form of Stock Option Agreement for grantsthereunder.

On October 5, 2006,the Compensation Committee of the Board of Directors approved the grant of1,550,000 stock options from the 2006 Incentive Plan to executive employees ofthe Company, including its executive officers.

*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 October 5, 2006 the total number of commonshares authorized for issuance related to grants under all of the equityincentive plans was 6,577,106, of which 5,787,468 options (excluding 50 optionsissued outside of the above plans) remain outstanding and 789,588 sharesremain reserved for future grants.

**Note 10.   Reductionin 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.   IncomeTaxes**

At December 29, 2005,the Company had available net operating loss and research and developmentcredit carryforwards of $100.8 million and $3.9 million, respectively, forincome tax purposes. The Tax Reform Act of 1986 contains provisions that limitthe utilization 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 tax purposes,the Company believes that there are substantial limitations on the utilizationof its net operating loss and tax credit carryforwards.

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**Note 12.   NetIncome (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 12,917,900 shares at September 27,2006 and 568 shares at September 28, 2005). Net loss per common share iscomputed using the weighted average number of shares of common stockoutstanding.

**Note 13.   SettlementAgreement**

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 that waspaid in the third quarter of fiscal 2006.

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**Item 2.        Management’s Discussion and Analysis ofFinancial 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 readthis discussion in conjunction with the Financial Statements and Notes includedelsewhere in this report and with Management’s Discussion and Analysisof Financial 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 Section 21Eof the Securities Exchange Act of 1934, as amended. See “Special Note RegardingForward-Looking Statements” and “Risk Factors” appearing elsewhere in thisReport.

**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 thetreatment of cancer. We filed an Investigational New Drug (“IND”) applicationon December 21, 2004 covering TPI 287, and commenced human clinical trialswith TPI 287 in the second quarter of 2005. We are also actively engaged inevaluating new therapeutic agents and/or related technologies. Our evaluationof new products and technologies may involve the examination of individualmolecules, classes of compounds or platform technologies. Acquisitions of newproducts or technologies may involve the purchase or license of such productsor technologies, or the acquisition of, or merger 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 exercise priceequal to $2.40 per share. We may call up to 20% of the outstandingwarrants during any three month period if certain conditions are satisfied,including the trading price of our common stock exceeding $4.80 for 20consecutive trading days. Up to half 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 ofquassinoid analogs.

During the third quarter of 2005, we 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).

During the first quarter of 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, we recorded an obligationof $646,000 for termination benefits at March 29, 2006 that was paid inthe third quarter of fiscal 2006.

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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 $12.0 million for the nine-months ended September 27, 2006. Ouraccumulated deficit was $119.4 million as of September 27, 2006. As aresult of our implementation of SFAS 123(R), for the nine-months ended September 27,2006, operating expenses were increased by non-cash compensation chargestotaling $2.5 million, including one-time non-cash fixed period charge in theamount of $381,000 relating to the modifications of vested stock options. Weanticipate that losses will continue until such time, if ever, as we are ableto commercialize our product candidates and generate sufficient sales tosupport our development operations, including the research and developmentactivity 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 ofcancer. The table below shows our research and development expense by majorcategory, with the expense related to our Genomics Division included indiscontinued operations(in thousands):

| ** **                 | ** ** | **Three-Months Ended,** | ** ** | **Nine-Months Ended,** | ** ** |
|----------------------------|------------|------------------------------|------------|-----------------------------|------------|
| ** **                 | ** ** | **September 27,**       | ** ** | **September 28,**      | ** ** | **September 27,** | ** ** | **September 28,** | ** ** |
| ** **                 | ** ** | **2006**                     | ** ** | **2005**                    | ** ** | **2006** | ** ** | **2005** | ** ** |
| Oncology                   |       |                         | $          | 2,259                       |       |   |   | $ | 2,918 |   |   |   | $ | 7,554 |   |   |   | $ | 8,150 |   |   |   |
| Huntington’s  Disease |       |                         | —     |                        |       |   | 221 |   |   |   | (90 | ) |   |   | 568 |   |   |   |
| Discontinued  operations   |       |                         | —     |                        |       |   | 43 |   |   |   | 88 |   |   |   | 392 |   |   |   |
|                       |       |                         | $          | 2,259                       |       |   |   | $ | 3,182 |   |   |   | $ | 7,552 |   |   |   | $ | 9,110 |   |   |   |

 

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 proprietary thirdgeneration taxane. On December 21, 2004, we filed an Investigational NewDrug (“IND”) application, and on January 21, 2005, we were cleared toproceed into clinical trials by the U.S. Food and Drug Administration (“FDA”). InMay 2005, we treated our first patient in a once every 7 day Phase Iclinical trial 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 modelswhen tested against standard comparative agents. The *in vitro*activity was seen across multiple cell lines including cell lines known to besensitive to taxanes and cell lines known to be resistant to 

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taxanes. Taxane sensitivecell lines in which TPI 287 shows activity include cell lines derived frombreast cancer, uterine cancer and non-small cell lung cancer. Taxane resistantcell lines in which TPI 287 has shown activity include cell 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.

·  InOctober 2006, we reached the maximum tolerated dose (MTD”) in our onceevery 21 day Phase I trial. We continue to add patients in this Phase I trialat the MTD to provide us with additional clinical experience with TPI 287 atthis dosing schedule. In addition, we are continuing to recruit patients in ouronce every 7 day Phase I trial and hope to reach MTD in this study by the endof 2006. We expect to begin treating patients in our first Phase II trials ofTPI 287 in both prostate and non-small cell lung cancer in the first quarter offiscal 2007. Additional Phase II studies in other indications will followthereafter. Our Phase II trials are designed to determine in what tumor typeour compound might be advanced for Phase III studies, if any. As we recruit patientsfor these first Phase II studies, and others to follow, we will see an increasein our clinical spending.

*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-MonthsEnded September 27, 2006 Compared to the Three-Months Ended September 28,2005

*Research and Development Expense.**  *Research and developmentexpense from continuing operations for the three-months ended September 27,2006 was $2.3 million, a decrease of $880,000 from the prior year period. Oncologyresearch and development expenditures decreased by $659,000 to $2.3 million inthe three-months ended September 27, 2006, and Huntington’s Diseaserelated spending decreased by $221,000 to $0.

Thedecrease in oncology expense was primarily due to decreased compensation costs($250,000), decreased manufacturing costs of ($660,000) and decreasedtoxicology costs of ($100,000), offset by increased supplies costs ($359,000). Thedecrease in expense related to the Huntington’s Disease program was a result ofthe termination of the program in January 2006. Included in research and developmentexpense is a non-cash compensation expense in the amount of $259,000 and$14,000 for the quarter ended September 27, 2006 and September 28,2005, 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 September 27, 2006 was $1.6 million, anincrease of $45,000 from the prior year period.

Thisincrease was due primarily due to increased compensation costs ($236,000), aswell as increased Board of Directors costs ($44,000), partially offset bydecreases in other consulting expense ($31,000), accounting and auditingexpense ($40,000), outside legal expense ($29,000), other outside services($89,000) as well as insurance ($45,000). The increase in compensation relatedexpenses, which includes Board of Directors costs, was primarily the result ofnon-cash compensation expense in the amount of $356,000 and $0 for the quarterended September 27, 2006 and September 28, 2005, respectively, as aresult of the implementation of SFAS 123(R) and the modification of vestedstock options which was partially offset by lower salary expense due to thestaffing reductions in July 2005.

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*Interest and Other Income.**  *Interest and other incomefor the three-months ended September 27, 2006 of $400,000 represented anincrease of $126,000 compared to the prior year period. The increase wasattributable to higher interest income due to higher investment balances aswell as higher effective interest rates earned in the three-months ended September 27,2006 compared to the prior year period.

*Interest and Other Expense.**  *Interest and other expensefor the three-months ended September 27, 2006 of $124,000 was $16,000 lessthan the prior year period due to the reduction in principal of the notepayable to TL Ventures.

*Impairment Charges.**  *Impairment charges for thethree-months ended September 28, 2005 of $963,000 were the result of arevaluation of our investment in ChromaDex (see Note 5). There were noimpairment charges in the current year quarter.

*Discontinued Operations.**  *Loss from discontinuedoperations was $0 for the three-months ended September 27, 2006 comparedto a loss of $43,000 in the prior year period. This decrease is the result ofthere being no activity in the Genomics Division in the current quarter.

**Results of Operations**—Nine-MonthsEnded September 27, 2006 Compared to the Nine-Months Ended September 28,2005

*Research and Development Expense.**  *Research and developmentexpense from continuing operations for the nine-months ended September 27,2006 was $7.5 million, a decrease of $1.3 million from the prior year period. Oncologyresearch and development expenditures decreased by $596,000 to $7.6 million forthe nine-months ended September 27, 2006, and Huntington’s Disease relatedspending decreased by $658,000 to ($90,000).

Thedecrease in oncology expense was due to an increase in compensation costs($676,000), increased clinical trial cost ($232,000) as well as increasedsupplies costs of ($377,000), offset by reductions in outside manufacturingcosts ($1.4 million) associated with preparing active pharmaceutical ingredientand drug product material for the clinical trials of TPI 287, a decrease inconsulting and other outside service costs ($419,000) and a decrease inoccupancy costs ($68,000).

Theincrease in compensation expense in the nine-months ended September 27,2006 was primarily related to the non-cash compensation expense in the amountof $1.0 million for the nine-months ended September 27, 2006 compared to$32,000 for the nine-months ended September 28, 2005, respectively, as aresult of the implementation of SFAS 123(R) and the modifications ofvested stock options. In addition, in the first quarter of 2006, we recorded a$646,000 charge 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 nine-months ended September 27, 2006 was $5.1 million, anincrease of $474,000 from the same period in 2005. This increase was due tohigher compensation related costs ($849,000) and Board of Directors costs($164,000) offset by lower insurance costs ($119,000), lower outside legalcosts ($122,000), lower outside accounting and auditing costs $(81,000), lowertravel costs ($31,000), and lower outside service costs related to investorrelations ($157,000). The increase in compensation related expenses, includingBoard of Director costs, was primarily the result of non-cash compensationexpense in the amount of $1.3 million and $7,000 for the nine-months ended September 27,2006 and September 28, 2005, respectively, as a result of theimplementation of SFAS 123(R) and the modification of vested stockoptions, offset by lower salary expense due to the staffing reductions in July 2005.

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*Interest and Other Income.**  *Interest and other incomefor the nine-months ended September 27, 2006 of $936,000 represented anincrease of $280,000 compared to the prior year period. The increase wasattributable to higher interest income due to higher investment balances andhigher effective interest rates earned in the nine-months ended September 27,2006 compared to the prior year period.

*Interest and Other Expense.**  *Interest and other expensefor the nine-months ended September 27, 2006 of $427,000 was $20,000 lessthan the prior year period due to the reduction in principal of the notepayable to TL Ventures.

*Impairment Charges.**  *Impairment charges for thenine-months ended September 28, 2005 of $1.1 million were primarilythe result of a revaluation of our investment in ChromaDex (see Note 5) in theamount of $963,000 and a reduction in value of our land (see Note 6) in theamount of $104,000. There were no impairment charges in the current yearperiod.

*Discontinued Operations.**  *Loss from discontinuedoperations was $88,000 for the nine-months ended September 27, 2006compared to a loss of $347,000 in the prior year period. This decrease isprimarily a result of there being no activity in the Genomics Division in thenine-months ended September 27, 2006, except for non-cash compensationexpense in the amount of $86,000 as a result of the implementation of SFAS123(R), as compared to salary, occupancy and patent related charges in theprior year period.

*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. Weare 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 nine-months ended September 27, 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 September 27, 2006, there was approximately $593,000,or $.04 basic and diluted loss per share from continuing operations of optionrelated compensation expense which was allocated among research and development($247,000) and general and administrative ($346,000) based on the function ofthe employee option holder. For the nine-months ended September 27, 2006,there was approximately $2.4 million, or $.38 basic and diluted loss per sharefrom continuing operations of option related compensation expense which wasallocated among research and development ($1.1 million) and general andadministrative ($1.3 million). Included in stock-based compensation expense forthe nine-months ended September 27, 2006, is a one-time non-cash fixedperiod charge in the amount of $381,000, respectively, as a result of themodification of vested shares on April 4, 2006, as discussed in Note 9 toour unaudited financial statements included elsewhere in the report. As of September 27,2006, unrecognized compensation expense related to unvested share-basedcompensation arrangements granted under the various equity incentive planstotaled approximately $9.1 million.

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**Liquidity and Capital Resources**

Our workingcapital requirements for research and development have been, and will continueto be, significant. As of September 27, 2006 we had working capital of$25.2 million compared to working capital of $11.6 million at December 28,2005. Through September 27, 2006, we have funded our capital requirementsprimarily with the net proceeds of public offerings of common stock, withprivate placements of equity securities, with the exercise of warrants andoptions and with debt. We also have funded our capital requirements from thegross proceeds of the sale of our paclitaxel business (approximately $71.7 million)to Mayne Pharma (USA) Inc. (f/k/a Faulding Pharmaceutical, Inc.) (“MaynePharma”), a subsidiary of Mayne Group Limited, on December 12, 2003 andits operations prior to that date.

Cash and cash equivalents increased $305,000 to $839,000 atSeptember 27, 2006 from $534,000 at December 28, 2005. As of September 27,2006, cash, cash equivalents and short-term investments increased $14.1 millionto $28.2 million from $14.1 million at December 28, 2005. The increase wasprimarily due to $22.7 million of net cash provided by financing activitiesoffset by $8.9 million of net cash used by operating activities and $13.6million of net cash used by investing activities.

*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 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. 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 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 PurchaseAgreement.

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 our 

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paclitaxel business to MaynePharma, we paid approximately $3,184,000 in cash and issued promissory notes inthe amount of $4,670,000 in exchange for the delivery of the debentures by TLVentures to the Company for cancellation. The notes do not bear interest andare payable in monthly installments of $110,000 in 2006 and $150,000 in 2007with a $1,000,000 payment due on January 31, 2008. Accrued interest ofapproximately $134,000 was included in the cash payment made as part of thesettlement. We recorded the obligation resulting from the settlement on ourbalance sheet as of December 29, 2004. We imputed an interest rate of 18%on the notes. No gain or loss was recognized in connection with the settlement.

*Going Concern*

We have no revenue and we incurred a loss ofapproximately $3.6 million and $12.1 million for the three and nine-monthsended September 27, 2006, respectively and a loss of approximately $17.5million for the year ended December 28, 2005 and we have an accumulateddeficit of $119.4 million as of September 27, 2006. Our capitalrequirements for research and development, including the cost of clinicaltrials, have been and will continue to be significant.

As of September 27, 2006, we had cash andshort-term investments totaling approximately $28.2 million. However, asof December 28, 2005 we had cash and short-term investments totalingapproximately 14.1 million. The amount of the Company’s cash and short-terminvestments, as of December 28, 2005, raised substantial doubt, which hassince been addressed, as discussed below, about our ability to continue as agoing concern. The audit report prepared by our independent registered publicaccounting firm relating to our consolidated financial statements for the yearended December 28, 2005 included 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, reductionsin capital expenditures and reductions in charges from outside serviceproviders. After implementing these and other cost savings measures and furtherdetermining that our lead pharmaceutical program warranted expanded clinicaldevelopment, we determined to seek the additional capital necessary to fund ourongoing operations related to our lead pharmaceutical program.

On April 6, 2006, weclosed the Private Placement, as described above. As of September 27, 2006we have cash and short-term investments of approximately $28.2 million andworking capital of approximately $25.2 million. We believe we have sufficientcapital to fund our operations and capital expenditures for at least the next12 months. However, pharmaceutical development is costly, risky and time intensiveactivity. To bring our various programs to completion will require us to raiseadditional capital as practicable to fund future operations and to provideadditional working capital. There can be no assurance that we will be able toobtain additional capital on terms that will be acceptable to us or on anyterms. In addition, we may seek to in-license or purchase new products ortechnologies. The cost and related capital expenditures of acquiring anddeveloping such resources may be significant, and we may not be able to obtaincapital for the development of these 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 

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below$1.00 per share for 30 consecutive business days and that our 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 February 24, 2006, we received notice from the NasdaqStock Market, Inc. that we regained compliance with the minimum bid pricerequirement.

**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 beginningafter the date SFAS No. 154 is issued. The adoption of SFAS No. 154did not have 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.

Such forward-lookingstatements involve known and unknown risks, uncertainties and other factors,which may cause our actual results, performance or achievements, or industryresults, to be materially different from any future results, performance orachievements expressed or implied by such forward-looking statements. Factors that could cause or contribute tosuch differences include, but are not limited to, those described below under “Risk Factors”identified in Item 1A of Part II of this Report. As a result, you shouldnot place undue reliance on these forward-looking statements, which apply onlyas of the date 

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of this report. Should one or more of theserisks materialize (or the consequences of such a development worsen), or shouldthe underlying assumptions prove incorrect, actual results could differmaterially from those forecasted or expected. We undertake no obligation toupdate any of the forward-looking statements after the date of this Report toconform such statements to actual results.

**Item 3.        Quantitative and Qualitative Disclosuresabout 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, an immediate 1% change ininterest rates would not have a material impact on our financial position,results of operations or cash flows.

**Item 4.        Controls and 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 informationrequired to be disclosed by the Company in the reports that it files or submitsto the SEC under the Act is accumulated and communicated to the Company’smanagement, including its Principal Executive Officer and its PrincipalFinancial Officer, as appropriate to allow timely decisions to be maderegarding required disclosure. The Company carried out an evaluation, under thesupervision and with the participation of the Company’s management, includingthe Company’s Chief Executive Officer and Chief Financial Officer, of theeffectiveness of the design and operation of the Company’s disclosure controlsand procedures as of September 27, 2006. Based upon that evaluation, the Company’sChief Executive Officer and Chief Financial Officer concluded that theCompany’s disclosure controls and procedures are effective in timely alertingthem to material information relating to the Company required to be included inthe Company’s periodic 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 certain assumptionsabout the likelihood of future events. Because of these and other inherentlimitations of control systems, there can be no assurance that any design willsucceed in achieving its stated goals under all potential future conditions,regardless of how remote.

There havebeen no changes in our internal controls over financial reporting during thefiscal quarter ended September 27, 2006 that have materially affected, or arereasonably likely to materially affect, our internal control over financial reporting.

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**Part II—OtherInformation**

**Item 1.        Legal Proceedings**

There have been no material developments in legalproceedings affecting the Company during the quarter.

**Item 1A      Risk Factors**

*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 adversely impair us. If anyof the events or circumstances described in the following risk factors actuallyoccurs, our business may suffer, the trading price of common stock coulddecline, and you may lose all or part of your investment.*

**Risks Related toOur Business**

**We currently arefocusing our development efforts on only one product candidate, TPI 287, and wewill have limitedprospects for successful operations if TPI 287 does not prove successful inclinical trials or is never commercialized because of the costs of continuingdevelopment or for other reasons.**

In 2005, we closed ourGenomics division, and in 2006, we terminated our program relating toHuntington’s Disease and terminated development of TPI 284 as well as wediscontinued the study of quassinoid analogs. These actions have permitted usto focus our development efforts primarily on the development of TPI 287, whichis still in Phase I clinical trials. Our other product candidates are inpreclinical development and we have no products that are approved forcommercial sale. TPI 287 will require extensive additional clinical evaluation,regulatory review, marketing efforts and significant investment before wereceive any revenues from it, if ever. We currently do not have the capitalresources necessary to bring any of our product candidates through tocommercial approval, and we do not expect TPI 287 or any of our other productcandidates or technologies to be commercially available for several years. Webelieve that our recently consummated financing will only be sufficient topermit us to generate preliminary Phase II data on TPI 287 in a number of tumortypes. Our efforts may not lead to commercially successful products for anumber of reasons, including the inability to be proven safe and effective inclinical trials, the lack of regulatory approvals or obtaining regulatoryapprovals that are narrower than we seek, inadequate financial resources tocomplete the development and commercialization of our product candidates or thelack of acceptance in the marketplace. Given the limited focus on one productcandidate, if TPI 287 does not prove successful in clinical trials or is notcommercialized because we have insufficient resources for continued developmentfor any other reason, we may be required to suspend or discontinue ouroperations and you could lose your entire investment in the Company.

**If we fail toobtain the capital necessary to fund our operations when needed, we could beforced to discontinueour 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 numberof active 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 

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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 $25.5million 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 product candidates.Further, we will not have sufficient resources to develop fully any newproducts 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 productcandidates and technologies are in an early state of development and there is ahigh risk that they maynever be commercialized because of the costs of continuing development or forother 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 

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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 the subjectsparticipating in trials are being exposed to unacceptable health risks or if itfinds 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 potentialproducts and technologies must undergo rigorous clinical testing and regulatoryapprovals andcompliance, which could substantially delay or prevent us from marketing anyproducts.**

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 has 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. Evenif regulatory approval is granted for a product, this approval will be limitedto those disease states and conditions for which the product is useful, asdemonstrated through clinical trials. In addition, regulatory agencies may notapprove the labeling claims that are necessary or desirable for the successfulcommercialization of our product candidates. Even if we receive regulatoryapprovals, our product candidates may later exhibit adverse effects that limitor prevent their widespread use or that force us to withdraw those productcandidates from the market. In addition, a marketed product continues to besubject to strict regulation after approval. Any unforeseen problems with anapproved product or any violation of regulations could result in restrictionson 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.

**Manufacturingissues may delay or hinder development or marketing of our product 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. 

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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 tomanufacture the product, would be revoked. Unless we build our ownmanufacturing facilities, we will have to rely on third parties to manufactureour products. Although we may be able find third-party manufacturers withexperience and the proper licensing requirements from the FDA, we may not beable to negotiate favorable terms regarding costs or a long-term commitment tomanufacture our products. Our dependence on third parties may reduce futureprofit margins and delay or limit our ability to develop and commercialize ourproducts on a timely and competitive basis.

**We rely onthird-parties to perform certain services for us and any interruption ortermination of thesearrangements may adversely affect our business.**

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:

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

·  acontractor may not commit sufficient resources to our projects;

·  acontractor may file for bankruptcy protection or otherwise lack sufficientresources to perform all of its obligations under our agreement;

·  theterms of our contracts with contractors may not be favorable to us; and

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

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.

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**We may be requiredto rely on strategic partners for the development, marketing and manufacturingof future products andtechnologies that may delay or impair our ability to generate significantrevenue and may otherwise adversely 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:

·  itmay be difficult to successfully negotiate arrangements with potentialstrategic partners on acceptable terms;

·  ifan arrangement with a strategic partner expires or is terminated, we may not beable to replace it or the terms on which we replace it may be unacceptable;

·  apartner involved in the development of new products or technologies may notcommit enough capital or other resources to develop or commercialize theseproducts or technologies successfully;

·  astrategic partner may not commit enough resources to the marketing anddistribution of our products;

·  wemay have disputes with strategic partners that could delay or terminate thedevelopment or commercialization of our products or result in significantlitigation or arbitration proceedings;

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

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

·  ourstrategic partners could develop drugs which compete with our products;

·  ourstrategic partners could turn their focus away from oncology;

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

·  third-partymanufacturers may be unable to manufacture products in a cost-effective or timelymanner.

**We may not besuccessful in obtaining required foreign regulatory approvals, which wouldprevent us frommarketing our products internationally.**

Outside the U.S., ourability to market a product is contingent upon receiving a marketing authorizationfrom the appropriate regulatory authority. This foreign regulatory approvalprocess includes many of the same steps and uncertainties associated with FDAapproval described above. We cannot be certain that we will obtain anyregulatory approvals for our product candidates and technologies in othercountries. In order to market our products outside of the U.S., we also mustcomply with numerous and varying foreign regulatory requirements implemented byforeign regulatory authorities governing the conduct of clinical trials,product licensing, pricing and reimbursement. The approval procedure variesamong countries and can involve additional testing. The time required to obtainapproval may differ from that required to obtain FDA approval and approval by theFDA does not ensure approval by the health authorities of any other country. Theprocess of obtaining foreign regulatory approvals can be lengthy and requirethe expenditure 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.

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**We may be unable toattract and retain the qualified employees we need to be 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 with thenecessary skills to develop our product candidates. Recruiting and retainingqualified technical and managerial personnel will also be critical to oursuccess. 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 ofhazardous materials exposes us to the risk of material environmentalliabilities, and we mayincur substantial additional costs to comply with environmental laws inconnection with the operation of our research and 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, ourfacilities. Decontamination costs associated with radioactivity releases, otherclean-up costs, and related damages or liabilities could be significant andcould harm our 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 productliability lawsuits are successfully brought against us, we may incursubstantial liabilities andmay be required to limit commercialization of our 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 complete clinicaltesting for our product candidates and receive regulatory approval to marketour products, we will include warnings on our products that identify the knownpotential adverse effects and the patients who should not receive our product. Therecan be no assurance that these warnings will be deemed adequate, or thatphysicians 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 

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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:

·  research and development;

·  preclinical studies and clinical trials;

·  obtaining regulatory approvals;

·  manufacturing; and

·  marketing and 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 andregulatory proposals to reduce the cost of health care could adversely affectour 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, includingproposals to reform health care or reduce government insurance programs. Ourbusiness is affected by these efforts and these efforts could adversely affectprices of our products. In addition, government pricing controls exist invarying forms in other countries. The emphasis on managed care in the U.S. hasalso increased and will likely continue to increase the pressure to reduce theprices of pharmaceutical products. We cannot predict whether any of theseproposals will be adopted or the effect these proposals or managed care effortsmay have on our business. In addition, the current discussion of drugreciprocation into the U.S. could also affect our future business operations. Someproposals would permit the reimportation of approved drugs that were originallymanufactured in the U.S. from other countries where the drugs were sold at alower price. These and other initiatives could decrease the price we or anypotential marketing partners receive for our products, adversely affecting ourprofitability. The pendency or approval of such proposals could result in adecrease in our stock price or limit our ability to raise capital, enter intostrategic partnerships or obtain licenses.

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**We may be unable toeffectively price our products or obtain adequate reimbursement for sales ofour products, whichwould prevent our products from becoming profitable.**

Our product candidates, if developed andcommercialized, may not be considered cost-effective, and coverage and adequatepayments may not be available or may not be sufficient to allow us to sellthese products on a competitive basis. In both the United States and elsewhere,sales of medical products and treatments are dependent, in part, on theavailability of reimbursement from health maintenance organizations, otherprivate insurance plans, governmental programs such as Medicare, and otherthird-party payors. Third-party payers are increasingly challenging the pricescharged for pharmaceutical products and services. Government and otherthird-party payors increasingly are attempting to contain health care costs bylimiting both coverage and the level of reimbursement for new drugs and byrefusing, in some cases, to provide coverage for uses of approved products fordiseases or conditions for which the FDA has not granted labeling approval.Significant uncertainty exists as to whether and how much third-party payorswill reimburse patients for their use of newly-approved drugs, which in turnwill put pressure on the pricing of drugs. Third-party insurance coverage maynot be available to patients for our products. If government and otherthird-party payors do not provide adequate coverage and reimbursement levelsfor our products, their market acceptance may be reduced or we may not be ableto commercialize our products.

**Risks Related toOur Intellectual Property**

**Our success isdependent on obtaining and defending patents and proprietary technology.**

Our success in commercializing, producing andmarketing products and technologies in the future depends, in part, on ourability to obtain and maintain adequate protection of the intellectual propertyrelated to our technologies and products, both in the U.S. and other countries,and to operate without infringing the proprietary rights of third parties. Wewill be able to protect our proprietary rights from unauthorized use by thirdparties only to the extent that our proprietary technologies are covered byvalid and enforceable patents. The patent positions of biotechnology companies,including our patent positions, are generally uncertain and involve complexlegal and factual 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. Tothe 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 from marketingproducts that are currently protected by those patents could be reduced oreliminated. We could then face increased competition resulting in reducedmarket 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 affordus protection against competitors, especially since there is a lengthy timebetween when a patent application is filed and when it is issued. We may alsoincur substantial costs in asserting claims against, and defending claimsasserted against us by third parties to prevent the 

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infringementof our patents and proprietary rights by others. Participation in suchinfringement proceedings may adversely affect our business and financialcondition, even if the eventual outcome is favorable.

**Litigation or thirdparty claims of intellectual property infringement could require us to spendsubstantial time andmoney and adversely affect our ability to develop and commercialize ourproducts.**

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:

·  the diversion of management and technicalpersonnel in defending us against any such claims or enforcing our patents. Inthis regard, we may be required to defend a lawsuit or defend a proceeding inthe United States Patent and Trademark Office, either of which could beexpensive and time consuming;

·  paying a large sum for damages if we are foundto infringe;

·  being prohibited from selling or licensing ourproducts or product candidates unless and until we obtain a license from thepatent holder, who may refuse to grant us a license or who may only agree to doso on unfavorable terms. Even if we are granted a license, we may have to paysubstantial royalties or grant cross-licenses to our patents;

·  redesigning our products or product candidatesso they do not infringe on the patent holder’s technology if we are unable toobtain a license. This may not be possible and, even if possible, it couldrequire substantial additional capital and could significantly delaycommercialization while we attempt to design around the patents or rightsinfringed;

·  incurring substantial cost in defendingourselves and indemnifying our strategic partners in patent infringement orproprietary rights violation actions brought against them relating to theirdevelopment and commercialization of our products; and

·  incurringsubstantial cost in 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.

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**We may be requiredto obtain rights to proprietary technologies that are required to furtherdevelop our business andthat may not be available or may be 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 terms acceptable to us. Our inability to obtain anyone or more of these licenses, on commercially reasonable terms, if at all, orto circumvent the need for any such license, could cause significant delays andcost increases and materially affect our ability to develop and commercializeour product candidates. In connection with our efforts to obtain rights tothese proprietary technologies, we may find it necessary to convey rights toour technology to others. Some of our products may require the use of multipleproprietary technologies. Consequently, we may be required to make cumulativeroyalty payments to several third parties. These cumulative royalties couldbecome commercially prohibitive. We may not be able to successfully negotiatethe amounts of these royalties on terms acceptable to us.

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 toOur Stock**

**The investors inour recently consummated financing have acquired shares of common stock and warrants representingsubstantially more than a majority of shares of our outstanding common stockand have the ability to exert control over 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 thefinancing. As a result, those investors hold a sufficient portion of ouroutstanding shares so as to permit them, if they chose to act in concert, toapprove all actions requiring stockholder approval, including the election ofdirectors and the approval of mergers or other business combinationtransactions, without obtaining the approval of any other stockholder.

**Future sales andissuances of our common stock or rights to purchase common stock, includingpursuant to our equityincentive plans, could result in additional dilution of the percentageownership of our stockholders and could cause 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 5,787,468 optionsare outstanding and 789,588 shares remain reserved for future grants as of October 18,2006. The shares available for issuance under this equity incentive plan may beincreased by up to 1,600,000 shares of common stock based upon the number ofshares of common stock we issue during the three year period after April 5,2006. Our stockholders also recently approved an amendment to our bylaws andour existing stock option plans to permit the repricing of approximately630,038 of our currently outstanding stock options, which was effected on April 4,2006 and the exercise price of each such repriced option was reduced to $4.02per share.

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

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 that salesmay have on the then prevailing market price of our common stock. Pursuant to aRegistration Rights Agreement entered into between us and the purchasers of ourcommon stock and warrants in the financing recently closed on April 6,2006, such purchasers are entitled to certain registration rights with respectto the shares of common stock that were issued to them at closing and that maybe issued upon exercise of the warrants issued to them at closing, pursuant towhich we must, among other things, file with the Securities and ExchangeCommission a registration statement for the resale of such shares of commonstock and the shares of common stock underlying such warrants.

**If we fail tocontinue to meet all applicable Nasdaq Capital Market requirements and Nasdaqdetermines to delist ourcommon stock, the delisting could adversely affect the market liquidity of ourcommon stock and the market price 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 compensationexpense will negatively impact our earnings, and as we report the fair value of employee stock options asan expense in conjunction with a new accounting standard, our reportedfinancial performance will be adversely affected, which may cause our stockprice 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 have recognized stock-based compensation expense of $593,000or $.04 basic and diluted per share from continuing operations for thethree-months ended September 27, 2006. In addition, we have recognized 

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stock-basedcompensation expense of $2.4 million or $.38 basic and diluted per share from continuingoperations for the nine-months ended September 27, 2006. Included in thestock-based compensation expense for the nine-months ended September 27,2006 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 September 27, 2006, there was $9.1 million of totalunrecognized compensation expense related to unvested share-based compensationarrangements granted under our stock option plans. This amount will berecognized over a weighted-average period of approximately 4.5 years.

**We have implementedanti-takeover provisions that may reduce the market price 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 dividendtook the form of a right, which entitles the holders to purchase oneone-hundredth of a share of a new series of junior participating preferredstock, 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. The adoptionof the rights plan makes it more difficult for a third party to acquire controlof us without the approval of our Board of Directors. We are also subject toprovisions of Delaware law that prohibit us from engaging in any businesscombination with any “interested stockholder,” meaning generally that astockholder who beneficially owns more than 15% of our stock cannot acquire usfor a period of three years from the date this person became an interestedstockholder, unless various conditions are met, such as approval of thetransaction by our Board of Directors.

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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 issued and outstanding common stock, not including theshares of common stock issued to the investors in the financing or shares ofcommon stock issued upon exercise of the warrants issued to the investors inthe financing.

**Item 2.        Unregistered Sales of Equity Securitiesand Use of Proceeds**

Not applicable

**Item 3.        Defaults upon Senior Securities**

Not applicable.

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

Not applicable

**Item 5.        Other Information**

**Notapplicable.**

**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))* |

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*       Filedherewith

#      Thiscertification “accompanies” this Form 10-Q, is not deemed filed with theSEC and is not to be incorporated by reference into any filing of the Companyunder the Securities Act of 1933, as amended, or the Securities Exchange Act of1934, as amended (whether made before or after the date of the Form 10-Q),irrespective of any general incorporation language contained in such filing.

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**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.                  |
|-----------------------|--------------------------------------------------|
| November 6, 2006 | By:                                              | /s/ LEONARD P. SHAYKIN |   |
| ** **            | **Leonard P. Shaykin**                           |
| ** **            | ***Chairman of the Board of  Directors,***       |
| ** **            | ***Chief Executive Officer***                    |
| November 6, 2006 | By:                                              | /s/ GORDON LINK |   |
| ** **            | **Gordon Link**                                  |
| ** **            | ***Senior Vice President,***                     |
| ** **            | ***Chief Financial Officer***                    |
| ** **            | ***(Principal  Financial Officer)***             |
| November 6, 2006 | By:                                              | /s/ MATTHEW J. MAJOROS |   |
| ** **            | **Matthew J. Majoros**                           |
| ** **            | ***Controller (Principal  Accounting Officer)*** |
|                       |                                                  |  |  |  |  |

 

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**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))* |

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*       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

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