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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549



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Form 10-Q



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(Mark One)

|x | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
|- | ---------------------------------------------------------------------------------------



For the quarterly period ended September 30, 2005.



OR



| ̈ | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
|- | ----------------------------------------------------------------------------------------



For the transition period from
 to



Commission file number 000-29173



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DIVERSA CORPORATION

(Exact name of registrant as specified in its charter)



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|                                                               |  |                                     
|-------------------------------------------------------------- |  | ------------------------------------
|Delaware                                                       |  | 22-3297375                          
|(State or other jurisdiction of incorporation or organization) |  | (I.R.S. Employer Identification No.)
|                                                               | 
|4955 Directors Place, San Diego, California                    |  | 92121                               
|(Address of principal executive offices)                       |  | (Zip Code)                          



(Registrants
telephone number, including area code (858) 526-5000)



---



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



Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).

x Yes ̈No



Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of
the Exchange Act).

 ̈Yes x No



The number of shares of the
registrants Common Stock outstanding as of October 21, 2005 was 44,798,866.



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##### Table of Contents



DIVERSA CORPORATION

INDEX



|                               |  |                                                                                                                             |  |         
|------------------------------ |  | --------------------------------------------------------------------------------------------------------------------------- |  | --------
|                               |  |                                                                                                                             |  | Page No.
|PART I - FINANCIAL INFORMATION |  |                                                                                                                            
|                               |  |                                                                                                                            
|Item 1.                        |  | Condensed Consolidated Financial Statements                                                                                 |  |         
|                               |  |                                                                                                                            
|                               |  | Condensed Consolidated Balance Sheets as of September 30, 2005 (unaudited) and December 31, 2004                            |  | 3       
|                               |  |                                                                                                                            
|                               |  | Condensed Consolidated Statements of Operations for the three and nine months ended September 30, 2005 and 2004 (unaudited) |  | 4       
|                               |  |                                                                                                                            
|                               |  | Condensed Consolidated Statements of Cash Flows for the nine months ended September 30, 2005 and 2004 (unaudited)           |  | 5       
|                               |  |                                                                                                                            
|                               |  | Notes to Condensed Consolidated Financial Statements (unaudited)                                                            |  | 6       
|                               |  |                                                                                                                            
|Item 2.                        |  | Managements Discussion and Analysis of Financial Condition and Results of Operations                                       |  | 11      
|                               |  |                                                                                                                            
|Item 3.                        |  | Quantitative and Qualitative Disclosures about Market Risk                                                                  |  | 28      
|                               |  |                                                                                                                            
|Item 4.                        |  | Controls and Procedures                                                                                                     |  | 28      
|                               | 
|PART II - OTHER INFORMATION    |  |                                                                                                                            
|                               |  |                                                                                                                            
|Item 1.                        |  | Legal Proceedings                                                                                                           |  | 29      
|                               |  |                                                                                                                            
|Item 2.                        |  | Unregistered Sales of Equity Securities and Use of Proceeds                                                                 |  | 29      
|                               |  |                                                                                                                            
|Item 3.                        |  | Defaults Upon Senior Securities                                                                                             |  | 29      
|                               |  |                                                                                                                            
|Item 4.                        |  | Submission of Matters to a Vote of Security Holders                                                                         |  | 30      
|                               |  |                                                                                                                            
|Item 5.                        |  | Other Information                                                                                                           |  | 30      
|                               |  |                                                                                                                            
|Item 6.                        |  | Exhibits                                                                                                                    |  | 30      
|                               | 
|SIGNATURES                     |  | 31                                                                                                                         



2



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DIVERSA CORPORATION



PART I - FINANCIAL INFORMATION



|Item 1. | Condensed Consolidated Financial Statements
|------- | -------------------------------------------



DIVERSA CORPORATION

CONDENSED CONSOLIDATED BALANCE SHEETS

(In thousands, except share and per share data)



|                                                                                                                                                                   |  |                    |          |   |                   |   |          |  
|------------------------------------------------------------------------------------------------------------------------------------------------------------------ |  | ------------------ | -------- | - | ----------------- | - | -------- | -
|                                                                                                                                                                   |  | September 30, 2005 |          |   | December 31, 2004 |  
|                                                                                                                                                                   |  | (Unaudited)        |          |   | (Note)            |  
|ASSETS                                                                                                                                                             |  |                    |          |   |                   |   |          |  
|Current assets:                                                                                                                                                    |  |                    |          |   |                   |   |          |  
|Cash and cash equivalents                                                                                                                                          |  | $                  | 38,956   |   |                   | $ | 33,796   |  
|Short-term investments                                                                                                                                             |  |                    | 31,003   |   |                   |   | 64,397   |  
|Accounts receivable (including $1,675 and $1,453 from a related party at September 30,
2005 and December 31, 2004)                                                 |  |                    | 7,912    |   |                   |   | 5,771    |  
|Other current assets                                                                                                                                               |  |                    | 4,515    |   |                   |   | 3,252    |  
|                                                                                                                                                                   |  |                    |          |   |                   |   |          |  
|Total current assets                                                                                                                                               |  |                    | 82,386   |   |                   |   | 107,216  |  
|Property and equipment, net                                                                                                                                        |  |                    | 23,197   |   |                   |   | 27,019   |  
|Acquired intangible assets, net                                                                                                                                    |  |                    | 43,296   |   |                   |   | 47,201   |  
|Other assets                                                                                                                                                       |  |                    | 2,207    |   |                   |   | 2,620    |  
|                                                                                                                                                                   |  |                    |          |   |                   |   |          |  
|Total assets                                                                                                                                                       |  | $                  | 151,086  |   |                   | $ | 184,056  |  
|                                                                                                                                                                   |  |                    |          |   |                   |   |          |  
|LIABILITIES AND STOCKHOLDERS EQUITY                                                                                                                               |  |                    |          |   |                   |   |          |  
|Current liabilities:                                                                                                                                               |  |                    |          |   |                   |   |          |  
|Accounts payable                                                                                                                                                   |  | $                  | 4,274    |   |                   | $ | 2,195    |  
|Accrued liabilities                                                                                                                                                |  |                    | 7,560    |   |                   |   | 7,216    |  
|Deferred revenue (including $5,516 and $5,325 from a related party at September 30, 2005 and December 31, 2004)                                                    |  |                    | 6,158    |   |                   |   | 5,892    |  
|Current portion of notes payable and capital lease obligations                                                                                                     |  |                    | 7,024    |   |                   |   | 8,982    |  
|                                                                                                                                                                   |  |                    |          |   |                   |   |          |  
|Total current liabilities                                                                                                                                          |  |                    | 25,016   |   |                   |   | 24,285   |  
|Notes payable, less current portion                                                                                                                                |  |                    | 7,170    |   |                   |   | 8,825    |  
|Commitments and contingencies                                                                                                                                      |  |                    |          |   |                   |   |          |  
|Stockholders equity:                                                                                                                                              |  |                    |          |   |                   |   |          |  
|Preferred stock - $0.001 par value; 5,000,000 shares authorized, no shares issued and outstanding at September 30, 2005 and
December 31, 2004                      |  |                    |         |   |                   |   |         |  
|Common stock - $0.001 par value; 90,000,000 shares authorized, 44,799,000 and 43,730,000 shares issued and outstanding at September 30,
2005 and December 31, 2004 |  |                    | 45       |   |                   |   | 44       |  
|Additional paid-in capital                                                                                                                                         |  |                    | 358,156  |   |                   |   | 351,736  |  
|Deferred compensation                                                                                                                                              |  |                    | (3,498   | ) |                   |   |         |  
|Accumulated deficit                                                                                                                                                |  |                    | (235,527 | ) |                   |   | (200,497 | )
|Accumulated other comprehensive loss                                                                                                                               |  |                    | (276     | ) |                   |   | (337     | )
|                                                                                                                                                                   |  |                    |          |   |                   |   |          |  
|Total stockholders equity                                                                                                                                         |  |                    | 118,900  |   |                   |   | 150,946  |  
|                                                                                                                                                                   |  |                    |          |   |                   |   |          |  
|Total liabilities and stockholders equity                                                                                                                         |  | $                  | 151,086  |   |                   | $ | 184,056  |  
|                                                                                                                                                                   |  |                    |          |   |                   |   |          |  



Note: The balance sheet data at
December 31, 2004 has been derived from the audited consolidated financial statements at that date but does not include all of the information and footnotes required by U.S. generally accepted accounting principles for complete financial
statements.



See accompanying notes to unaudited condensed
consolidated financial statements.



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CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands, except per share data)

(Unaudited)



|                                                                                                                                                                                                               |  |                                 |         |   |                                |   |        |      |  |   |         |   |  |   |         |  
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ------------------------------- | ------- | - | ------------------------------ | - | ------ | ---- |  | - | ------- | - |  | - | ------- | -
|                                                                                                                                                                                                               |  | Three Months EndedSeptember 30, |         |   | Nine Months EndedSeptember 30, |  
|                                                                                                                                                                                                               |  | 2005                            |         |   | 2004                           |   |        | 2005 |  |   | 2004    |  
|Revenues:                                                                                                                                                                                                      |  |                                 |         |   |                                |   |        |      |  |   |         |   |  |   |         |  
|Collaborative revenue (including related party revenue of $5,989 and $6,925 for the three months ended September 30, 2005 and 2004;
$18,720 and $24,555 for the nine months ended September 30, 2005 and 2004) |  | $                               | 8,136   |   |                                | $ | 8,383  |      |  | $ | 26,342  |   |  | $ | 28,184  |  
|Grant revenue                                                                                                                                                                                                  |  |                                 | 2,562   |   |                                |   | 2,638  |      |  |   | 7,340   |   |  |   | 7,478   |  
|Product-related revenue                                                                                                                                                                                        |  |                                 | 2,075   |   |                                |   | 1,875  |      |  |   | 6,105   |   |  |   | 3,753   |  
|                                                                                                                                                                                                               |  |                                 |         |   |                                |   |        |      |  |   |         |   |  |   |         |  
|Total revenues                                                                                                                                                                                                 |  |                                 | 12,773  |   |                                |   | 12,896 |      |  |   | 39,787  |   |  |   | 39,415  |  
|                                                                                                                                                                                                               |  |                                 |         |   |                                |   |        |      |  |   |         |   |  |   |         |  
|Expenses:                                                                                                                                                                                                      |  |                                 |         |   |                                |   |        |      |  |   |         |   |  |   |         |  
|Cost of product-related revenue                                                                                                                                                                                |  |                                 | 2,772   |   |                                |   | 959    |      |  |   | 7,550   |   |  |   | 2,164   |  
|Research and development                                                                                                                                                                                       |  |                                 | 17,932  |   |                                |   | 17,748 |      |  |   | 55,555  |   |  |   | 53,691  |  
|Selling, general and administrative                                                                                                                                                                            |  |                                 | 3,286   |   |                                |   | 2,792  |      |  |   | 9,522   |   |  |   | 9,233   |  
|Amortization of acquired intangible assets                                                                                                                                                                     |  |                                 | 651     |   |                                |   | 650    |      |  |   | 1,952   |   |  |   | 1,952   |  
|Non-cash, stock-based compensation                                                                                                                                                                             |  |                                 | 231     |   |                                |   |       |      |  |   | 644     |   |  |   |        |  
|                                                                                                                                                                                                               |  |                                 |         |   |                                |   |        |      |  |   |         |   |  |   |         |  
|Total operating expenses                                                                                                                                                                                       |  |                                 | 24,872  |   |                                |   | 22,149 |      |  |   | 75,223  |   |  |   | 67,040  |  
|                                                                                                                                                                                                               |  |                                 |         |   |                                |   |        |      |  |   |         |   |  |   |         |  
|Loss from operations                                                                                                                                                                                           |  |                                 | (12,099 | ) |                                |   | (9,253 | )    |  |   | (35,436 | ) |  |   | (27,625 | )
|Interest and other income, net                                                                                                                                                                                 |  |                                 | 32      |   |                                |   | 24     |      |  |   | 406     |   |  |   | 226     |  
|                                                                                                                                                                                                               |  |                                 |         |   |                                |   |        |      |  |   |         |   |  |   |         |  
|Net loss                                                                                                                                                                                                       |  | $                               | (12,067 | ) |                                | $ | (9,229 | )    |  | $ | (35,030 | ) |  | $ | (27,399 | )
|                                                                                                                                                                                                               |  |                                 |         |   |                                |   |        |      |  |   |         |   |  |   |         |  
|Basic and diluted net loss per share                                                                                                                                                                           |  | $                               | (0.27   | ) |                                | $ | (0.21  | )    |  | $ | (0.80   | ) |  | $ | (0.63   | )
|                                                                                                                                                                                                               |  |                                 |         |   |                                |   |        |      |  |   |         |   |  |   |         |  
|Weighted average shares used in computing basic and diluted net loss per share                                                                                                                                 |  |                                 | 44,070  |   |                                |   | 43,505 |      |  |   | 43,965  |   |  |   | 43,318  |  
|                                                                                                                                                                                                               |  |                                 |         |   |                                |   |        |      |  |   |         |   |  |   |         |  



See accompanying notes
to unaudited condensed consolidated financial statements.



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CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

(Unaudited)



|                                                                            |  |                                 |          |   |      |   |         |  
|--------------------------------------------------------------------------- |  | ------------------------------- | -------- | - | ---- | - | ------- | -
|                                                                            |  | Nine Months Ended September 30, |         
|                                                                            |  | 2005                            |          |   | 2004 |  
|Operating activities:                                                       |  |                                 |          |   |      |   |         |  
|Net loss                                                                    |  | $                               | (35,030  | ) |      | $ | (27,399 | )
|Adjustments to reconcile net loss to net cash used in operating activities: |  |                                 |          |   |      |   |         |  
|Depreciation and amortization                                               |  |                                 | 13,430   |   |      |   | 13,498  |  
|Non-cash, stock-based compensation charges                                  |  |                                 | 644      |   |      |   |        |  
|Changes in operating assets and liabilities:                                |  |                                 |          |   |      |   |         |  
|Accounts receivable                                                         |  |                                 | (2,141   | ) |      |   | 1,057   |  
|Other assets                                                                |  |                                 | (850     | ) |      |   | (2,451  | )
|Accounts payable and accrued expenses                                       |  |                                 | 2,423    |   |      |   | (1,498  | )
|Deferred revenue                                                            |  |                                 | 266      |   |      |   | (9,202  | )
|                                                                            |  |                                 |          |   |      |   |         |  
|Net cash used in operating activities                                       |  |                                 | (21,258  | ) |      |   | (25,995 | )
|                                                                            |  |                                 |          |   |      |   |         |  
|Investing activities:                                                       |  |                                 |          |   |      |   |         |  
|Purchases of short-term investments                                         |  |                                 | (223,015 | ) |      |   | (39,256 | )
|Sales and maturities of short-term investments                              |  |                                 | 256,471  |   |      |   | 70,107  |  
|Purchases of property and equipment                                         |  |                                 | (5,703   | ) |      |   | (6,154  | )
|                                                                            |  |                                 |          |   |      |   |         |  
|Net cash provided by investing activities                                   |  |                                 | 27,753   |   |      |   | 24,697  |  
|                                                                            |  |                                 |          |   |      |   |         |  
|Financing activities:                                                       |  |                                 |          |   |      |   |         |  
|Net proceeds from sale of common stock                                      |  |                                 | 2,279    |   |      |   | 3,124   |  
|Principal payments on capital leases                                        |  |                                 | (190     | ) |      |   | (403    | )
|Principal payments on notes payable                                         |  |                                 | (7,992   | ) |      |   | (7,756  | )
|Advances under notes payable                                                |  |                                 | 4,568    |   |      |   | 7,915   |  
|                                                                            |  |                                 |          |   |      |   |         |  
|Net cash (used in) provided by financing activities                         |  |                                 | (1,335   | ) |      |   | 2,880   |  
|                                                                            |  |                                 |          |   |      |   |         |  
|Net increase in cash and cash equivalents                                   |  |                                 | 5,160    |   |      |   | 1,582   |  
|Cash and cash equivalents at beginning of period                            |  |                                 | 33,796   |   |      |   | 20,506  |  
|                                                                            |  |                                 |          |   |      |   |         |  
|Cash and cash equivalents at end of period                                  |  | $                               | 38,956   |   |      | $ | 22,088  |  
|                                                                            |  |                                 |          |   |      |   |         |  



See accompanying notes
to unaudited condensed consolidated financial statements.



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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)



|1. | Organization and Business
|-- | -------------------------



Diversa Corporation (the Company) applies proprietary genomic technologies for the rapid discovery and optimization of novel protein-based products, including
(a) enzymes, which are catalytic proteins, and (b) protein therapeutics, including antibodies, which are binding proteins. The Company is directing its integrated portfolio of technologies to the discovery, evolution, and production of
commercially valuable molecules with agricultural, chemical, and industrial applications, such as enzymes, as well as protein therapeutics with pharmaceutical applications.



|2. | Basis of Presentation
|-- | ---------------------



The accompanying unaudited condensed consolidated financial statements have been prepared by the Company in accordance with U.S. generally accepted accounting principles
for interim financial information. Accordingly, they do not include all the information and footnotes required by U.S. generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments,
consisting of normal recurring accruals, which are necessary for a fair presentation of the results of the interim periods presented, have been included. The results of operations for the interim periods are not necessarily indicative of results to
be expected for any other interim period or for the year as a whole. These unaudited condensed consolidated financial statements and footnotes thereto should be read in conjunction with the audited financial statements and footnotes thereto
contained in the Companys Annual Report on Form 10-K for the year ended December 31, 2004.



The preparation of financial statements in accordance with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect amounts reported in the condensed consolidated
financial statements and related footnotes. Changes in the estimates may affect amounts reported in future periods.



|3. | Revenue Recognition
|-- | -------------------



The Company recognizes revenue when all of its contractual obligations are satisfied and collection of the underlying receivable is reasonably assured, in accordance with Securities and Exchange Commission Staff
Accounting Bulletin (SAB) No. 104, Revenue Recognition. Billings to customers or payments received from customers are included in deferred revenue on the balance sheet until all revenue recognition criteria are
met.



Collaborative Revenue



Revenue from research funding under the Companys collaboration agreements is earned
and recognized on a percentage-of-completion basis as research hours are incurred in accordance with the provisions of each agreement. Fees received to initiate research projects are deferred and recognized over the life of the project. Fees
received for exclusivity in a field are deferred and recognized over the period of exclusivity. Milestone payments are recognized when earned, as evidenced by written acknowledgement from the collaborator, provided that (i) the milestone event
is substantive and its achievement was not reasonably assured at the inception of the agreement, and (ii) the Companys performance obligations after the milestone achievement will continue to be funded by the collaborator at a level
comparable to the level before the milestone achievement.



During the nine
months ended September 30, 2005 and 2004, the Company had collaborative research agreements that accounted for 66% and 72% of total revenue. One collaborator, a related party, accounted for 47% and 53% of total revenue during the three months
ended September 30, 2005 and 2004, and 47% and 63% of total revenue during the nine months ended September 30, 2005 and 2004 (See Note 5  Related Party Transactions).



Grant Revenue



Revenue from grants is recognized as related costs are incurred, as long as such costs are within the funding limits specified by the
underlying grant agreements.



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Product-Related Revenue



Product-related revenues are recognized at the time of shipment to the customer provided all other revenue recognition criteria have been met. The Company recognizes
revenue on product sales through third-party distribution agreements in accordance with the provisions set forth in Financial Accounting Standards Board Statement (FASB) No. 48, Revenue Recognition When Right of Return
Exists. Under FASB No. 48, the Company recognizes product revenues upon shipment to distributors, provided that (a) the price is substantially fixed and determinable at the time of sale; (b) the distributors obligation
to pay the Company is not contingent upon resale of the products; (c) title and risk of loss passes to the distributor at time of shipment; (d) the distributor has economic substance apart from that provided by the Company; (e) the
Company has no significant obligation to the distributor to bring about resale of the products; and (f) future returns can be reasonably estimated. For any sales that do not meet all of the above criteria, revenue is deferred until all such
criteria have been met.



The Company recognizes profit-sharing revenue during
the quarter in which such revenue is earned, based on estimates provided by the Companys profit-sharing partner. These estimates are adjusted for actual results in the subsequent quarter. Profit-sharing revenue is included in product-related
revenue in the statement of operations.



|4. | Computation of Net Loss per Share
|-- | ---------------------------------



Basic and diluted net loss per share has been computed using the weighted-average number of shares of common stock outstanding during the period. During February 2005,
the Company issued 601,510 restricted shares to employees. As of September 30, 2005, all outstanding restricted shares issued to employees were unvested, and, for purposes of the computation of net loss per share, are considered contingently
returnable shares under FASB No. 128, Earnings Per Share. Under FASB No. 128, contingently returnable shares are not considered outstanding common shares for purposes of computing net loss per share until all necessary
conditions are met that no longer cause the shares to be contingently returnable. The impact of these unvested shares on weighted average shares outstanding has been excluded for purposes of computing net loss per share.



The following table presents the calculation of basic and diluted net loss per share (in
thousands, except per share data):



|                                                                               |  |                                 |         |   |                                |   |        |      |  |   |         |   |  |   |         |  
|------------------------------------------------------------------------------ |  | ------------------------------- | ------- | - | ------------------------------ | - | ------ | ---- |  | - | ------- | - |  | - | ------- | -
|                                                                               |  | Three Months EndedSeptember 30, |         |   | Nine Months EndedSeptember 30, |  
|                                                                               |  | 2005                            |         |   | 2004                           |   |        | 2005 |  |   | 2004    |  
|Weighted average shares outstanding during the period                          |  |                                 | 44,672  |   |                                |   | 43,505 |      |  |   | 44,469  |   |  |   | 43,318  |  
|Less: Weighted average unvested restricted shares outstanding                  |  |                                 | (602    | ) |                                |   |       |      |  |   | (504    | ) |  |   |        |  
|                                                                               |  |                                 |         |   |                                |   |        |      |  |   |         |   |  |   |         |  
|Weighted average shares used in computing basic and diluted net loss per share |  |                                 | 44,070  |   |                                |   | 43,505 |      |  |   | 43,965  |   |  |   | 43,318  |  
|                                                                               |  |                                 |         |   |                                |   |        |      |  |   |         |   |  |   |         |  
|Net loss                                                                       |  | $                               | (12,067 | ) |                                | $ | (9,229 | )    |  | $ | (35,030 | ) |  | $ | (27,399 | )
|                                                                               |  |                                 |         |   |                                |   |        |      |  |   |         |   |  |   |         |  
|Net loss per share, basic and diluted                                          |  | $                               | (0.27   | ) |                                | $ | (0.21  | )    |  | $ | (0.80   | ) |  | $ | (0.63   | )
|                                                                               |  |                                 |         |   |                                |   |        |      |  |   |         |   |  |   |         |  



The Company has excluded all
outstanding stock options and warrants from the calculation of diluted net loss per share because these securities are anti-dilutive for all periods presented.



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|5. | Related Party Transactions
|-- | --------------------------



Syngenta AG



On February 20, 2003, the Company entered into a research collaboration with Syngenta AG (Syngenta), a greater-than 10% owner of the Companys outstanding common stock. Under the collaboration,
which was amended in May 2004, the Company is entitled to receive a minimum of $118.0 million in research and development funding over the initial seven-year term of the related research collaboration agreement and is eligible to receive certain
milestone payments and royalties upon product development and commercialization.



The Company recognized collaborative revenue from Syngenta and its affiliates of $6.0 million and $6.9 million during the three months ended September 30, 2005 and 2004, and $18.7 million and $24.6 million during the nine months ended
September 30, 2005 and 2004. Accounts receivable due from Syngenta were $1.7 million and $1.5 million, and deferred revenue associated with Syngenta was $5.5 million and $5.3 million at September 30, 2005 and December 31, 2004.



Notes Receivable from Officers



In February 2000, the Company initiated a loan program for nine employees to pay personal
tax liabilities resulting from the failure to file Form 83(b) elections with the Internal Revenue Service related to those employees exercise of incentive and non-qualified stock options during 1999. This failure to timely file the Form 83(b)
elections exposed the employees to significant personal tax liabilities. To limit the tax exposure, the Company elected to accelerate the vesting of the approximately 207,000 unvested options, and agreed to loan the employees up to $1.6 million in
full recourse promissory notes. As of September 30, 2005 and December 31, 2004, the Company had a remaining loan balance due from four individuals aggregating $0.6 million, which amounts are included in other assets on the balance sheet.
The notes bear interest at 4.94%, are due in April 2006, and contain certain mandatory prepayment provisions.



|6. | Comprehensive Loss
|-- | ------------------



Comprehensive loss is defined as the change in equity of a business enterprise during a period from transactions and other events and circumstances from non-owner sources, including unrealized gains and losses on
marketable securities. The Company presents comprehensive loss in its statements of stockholders equity.



For the three and nine months ended September 30, 2005 and 2004, the comprehensive loss consisted of (in thousands):



|                                      |  |                                  |         |   |                                 |   |        |      |  |   |         |   |  |   |         |  
|------------------------------------- |  | -------------------------------- | ------- | - | ------------------------------- | - | ------ | ---- |  | - | ------- | - |  | - | ------- | -
|                                      |  | Three Months Ended September 30, |         |   | Nine Months Ended September 30, |  
|                                      |  | 2005                             |         |   | 2004                            |   |        | 2005 |  |   | 2004    |  
|Net loss                              |  | $                                | (12,067 | ) |                                 | $ | (9,229 | )    |  | $ | (35,030 | ) |  | $ | (27,399 | )
|Other comprehensive gain (loss):      |  |                                  |         |   |                                 |   |        |      |  |   |         |   |  |   |         |  
|Unrealized gain (loss) on investments |  |                                  | (23     | ) |                                 |   | 121    |      |  |   | 61      |   |  |   | (415    | )
|                                      |  |                                  |         |   |                                 |   |        |      |  |   |         |   |  |   |         |  
|Comprehensive loss                    |  | $                                | (12,090 | ) |                                 | $ | (9,108 | )    |  | $ | (34,969 | ) |  | $ | (27,814 | )
|                                      |  |                                  |         |   |                                 |   |        |      |  |   |         |   |  |   |         |  



|7. | Contingencies
|-- | -------------



In June 2004, the Company executed a formal settlement agreement with the plaintiffs in a class action lawsuit filed in December 2002 in a U.S. federal district court (the Court). This lawsuit is part of a
series of related lawsuits in which similar complaints were filed by plaintiffs against hundreds of other public companies that conducted IPOs of their common stock in 2000 and the late 1990s. On February 15, 2005, the Court issued a
decision certifying a class action for settlement purposes and granting preliminary approval of the settlement subject to modification of certain orders contemplated by the settlement. On August 31, 2005, the Court reaffirmed class
certification and preliminary approval of the modified settlement in a comprehensive order. In addition, the Court approved the form of notice to be sent to members of the settlement classes, which will be published and mailed beginning
November 15, 2005. The Court has set a final settlement fairness hearing on the settlement for April 24, 2006. The settlement is still subject to statutory notice requirements as well as final judicial approval. The Company is covered
by a claims-made liability insurance policy which it believes will satisfy the Companys insurers pro-rata liability under this settlement.



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|8. | Commitments
|-- | -----------



On September 30, 2005, the Company entered into a $14.6 million Loan and Security Agreement (the Bank Agreement) with a commercial bank (the Bank). The Bank Agreement provides for a
one-year credit facility for up to $10.0 million in financing for qualified equipment purchases in the United States and Mexico (the Equipment Advances) and a $4.6 million letter of credit sub-facility (the Letter of Credit
Sublimit). Borrowings under the Equipment Advances will be structured as promissory notes which are secured by qualified equipment purchases and repaid over 36 to 48 months, depending on the location of the equipment financed. Borrowings
will bear interest at the Banks prime rate plus 0.75% (7.50% at September 30, 2005). Amounts outstanding under the Letter of Credit Sublimit are unsecured, and are subject to an annual fee of 1.25%.



The Bank Agreement contains standard affirmative and negative covenants and restrictions on
actions by the Company including, but not limited to, activity related to the Companys common stock repurchases, liens, investments, indebtedness, and fundamental changes in, or dispositions of, the Companys assets. Certain of these
actions may be taken by the Company with the consent of the Bank. In addition, the Company is required to meet certain financial covenants, primarily a minimum balance of unrestricted cash, cash equivalents, and investments in marketable securities
of $25.0 million, including $15.0 million maintained in accounts at the Bank or its affiliates.



On September 30, 2005, the Company completed a drawdown of approximately $0.6 million under the Equipment Advances. At September 30, 2005, there was approximately $0.6 million in outstanding borrowings under
the Equipment Advances and a letter of credit for approximately $4.6 million under the Letter of Credit Sublimit, as required under the Companys facilities leases. The Company leases approximately 140,000 square feet of space in San Diego,
California under two separate operating leases. Under the terms of the leases, the Company is required to maintain an irrevocable standby letter of credit from a bank in lieu of a cash security deposit. The amount of the letter of credit is based
upon certain financial covenants requiring minimum market capitalization or working capital.



As of September 30, 2005, the Company was in compliance with all debt covenants under its various financing agreements.



|9. | Stock-Based Compensation
|-- | ------------------------



The Company measures compensation expense for stock options granted to employees in accordance with Accounting Principles Board Opinion (APB) No. 25,
using the intrinsic value method, under which it recognizes no compensation expense for options granted with exercise prices equal to or greater than the fair value of the Companys common stock on the date of the grant.



Compensation expense for options granted to non-employees has been determined in accordance
with Financial Accounting Standards Board Statement (FASB) No. 123, Accounting for Stock-Based Compensation, and Emerging Issues Task Force (EITF) 96-18, Accounting for Equity Instruments That Are Issued to
Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services, as the fair value of the consideration received or the fair value of the equity instruments issued, whichever is more reliably measured. Deferred charges for
options granted to non-employees are periodically re-measured as the underlying shares vest.



Pro forma information regarding net loss and net loss per share has been determined as if the Company had accounted for its employee stock options and stock purchase plan under the fair value method of FASB
No. 123. For the three months ended September 30, 2005 and 2004, the fair value of these options was estimated using the Black-Scholes model with the following assumptions: risk-free interest rates ranging from 3.98% to 4.15% and 3.29% to
3.56%; dividend yield of 0%; volatility factor of 52% and 51%; and a weighted-average expected life of the options of 3.5 years.



For the nine months ended September 30, 2005 and 2004, the fair value of these options was estimated using the Black-Scholes model with the following assumptions:
risk-free interest rates ranging from 3.58% to 4.18% and 2.65% to 3.96%; dividend yield of 0%; volatility factor of 56% and 60%; and a weighted-average expected life of the options of 2.0 years and 3.0 years.



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For purposes of pro forma disclosures, the estimated fair value of the options is amortized to expense over the vesting
period. The Companys pro forma information is as follows (in thousands, except per share data):



|                                                                                                                |  |                                 |         |   |                                |   |         |      |  |   |         |   |  |   |         |  
|--------------------------------------------------------------------------------------------------------------- |  | ------------------------------- | ------- | - | ------------------------------ | - | ------- | ---- |  | - | ------- | - |  | - | ------- | -
|                                                                                                                |  | Three Months EndedSeptember 30, |         |   | Nine Months EndedSeptember 30, |  
|                                                                                                                |  | 2005                            |         |   | 2004                           |   |         | 2005 |  |   | 2004    |  
|Net loss, as reported                                                                                           |  | $                               | (12,067 | ) |                                | $ | (9,229  | )    |  | $ | (35,030 | ) |  | $ | (27,399 | )
|Add: Stock-based employee compensation expense included in reported net loss                                    |  |                                 | 231     |   |                                |   |        |      |  |   | 644     |   |  |   |        |  
|Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards |  |                                 | (1,305  | ) |                                |   | (2,322  | )    |  |   | (4,905  | ) |  |   | (7,771  | )
|                                                                                                                |  |                                 |         |   |                                |   |         |      |  |   |         |   |  |   |         |  
|Pro forma net loss                                                                                              |  | $                               | (13,141 | ) |                                | $ | (11,551 | )    |  | $ | (39,291 | ) |  | $ | (35,170 | )
|                                                                                                                |  |                                 |         |   |                                |   |         |      |  |   |         |   |  |   |         |  
|Basic and diluted net loss per share, as reported                                                               |  | $                               | (0.27   | ) |                                | $ | (0.21   | )    |  | $ | (0.80   | ) |  | $ | (0.63   | )
|Pro forma basic and diluted net loss per share                                                                  |  | $                               | (0.30   | ) |                                | $ | (0.27   | )    |  | $ | (0.89   | ) |  | $ | (0.81   | )



|10. | Impact of Recently Issued Accounting Standards
|--- | ----------------------------------------------



In November 2004, the Financial Accounting Standards Board issued FASB No. 151, Inventory Costs, which clarifies the accounting for abnormal amounts of idle
facility expense, freight, handling costs, and wasted material. FASB No. 151 will be effective for inventory costs incurred during fiscal years beginning after June 15, 2005. The Company does not believe the adoption of FASB No. 151
will have a material impact on its financial statements.



In December 2004, the
Financial Accounting Standards Board issued FASB No. 123(R), Share-Based Payment, which is a revision of FASB No. 123, Accounting for Stock-Based Compensation. FASB No. 123(R) supersedes APB No. 25 and amends FASB
No. 95, Statement of Cash Flows. Generally, the approach in FASB No. 123(R) is similar to the approach described in FASB No. 123. However, FASB No. 123(R) requires all share-based payments to employees, including grants of
employee stock options, to be recognized in the income statement based on their fair values. Pro forma disclosure, which has previously been used by the Company, is no longer an alternative. FASB No. 123(R) permits companies to adopt its
requirements using either a modified prospective method, or a modified retrospective method. Under the modified prospective method, compensation cost is recognized in the financial statements beginning with the
effective date, based on the requirements of FASB 123(R) for all share-based payments granted after that date, and based on the requirements of FASB 123 for all unvested awards granted prior to the effective date of FASB No. 123(R). Under the
modified retrospective method, the requirements are the same as under the modified prospective method, but entities are permitted to restate financial statements of previous periods based on pro forma disclosures made in
accordance with FASB No. 123. The Company currently expects to adopt FASB No. 123(R) effective January 1, 2006; however, it has not yet determined which adoption method it will use. The Company believes that the adoption of this
statement will have a significant impact on its financial statements.



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|Item 2. | Managements Discussion and Analysis of Financial Condition and Results of Operations
|------- | -------------------------------------------------------------------------------------



The statements in this quarterly report that are not descriptions of historical facts may be forward-looking statements that are subject to
risks and uncertainties. These include statements related to investments in our core technologies, the discovery, development, and/or optimization of novel genes, enzymes, antibodies, and other biologically active compounds, the development and
commercialization of products and product candidates, the benefits to be derived from our current and future strategic alliances, and our estimates regarding future revenue, profitability, equipment costs, committed funding, liquidity and capital
requirements, all of which are prospective. Such statements are only predictions, and actual events or results may differ materially from those projected in such forward-looking statements. Factors that could cause or contribute to differences
include, but are not limited to, risks involved with our new and uncertain technologies, risks associated with our dependence on patents and proprietary rights, risks associated with our protection and enforcement of our patents and proprietary
rights, our dependence on existing collaborations and our ability to achieve milestones under existing and future collaboration agreements, our ability to commercialize products (including by obtaining any required regulatory approvals) using our
technologies and the timing for launching any commercialized products, the development or availability of competitive products or technologies, and our future ability to enter into and/or maintain collaboration and joint venture agreements and
licenses, as well as other risks and uncertainties identified below and in the section of this report entitled Risk Factors Related to Our Business and in our other publicly available documents. These forward-looking statements speak
only as of the date of this report. We expressly disclaim any intent or obligation to update any of these forward-looking statements after the filing of this quarterly report to reflect actual results, changes in our expectations, or otherwise.



The following information should be read in conjunction with the condensed
consolidated financial statements and the notes thereto included in Item 1 of Part I of this quarterly report. We also urge readers to review and consider our disclosures describing various factors that affect our business set forth in the
section of this report entitled Risk Factors Related to Our Business, as well as in our Annual Report on Form 10-K for the year ended December 31, 2004, including the disclosures under the captions Managements Discussion
and Analysis of Financial Condition and Results of Operations and Risk Factors Related to Our Business, as well as the audited financial statements and notes thereto contained in such report.



Overview



We were incorporated in December 1992 and began operations in May 1994. We are a leader in applying proprietary genomic technologies for the
rapid discovery and optimization of novel protein-based products, including (a) enzymes, which are catalytic proteins, and (b) protein therapeutics, including antibodies, which are binding proteins. We are directing our integrated
portfolio of technologies to the discovery, evolution, and production of commercially valuable molecules with agricultural, chemical, and industrial applications, such as enzymes, as well as protein therapeutics and orally active drugs with
pharmaceutical applications. Our key areas of focus for internal product development are for the large markets in animal care, fiber modification, oil and nutrition, and optimized, second-generation monoclonal antibody therapeutics. In addition to
our internal product development efforts, we have alliances with market leaders, such as BASF, Bayer Animal Health, Cargill Health and Food Technologies, DSM Pharma Chemicals, DuPont Bio-Based Materials, Medarex, Merck, Syngenta AG, and Xoma.



We have dedicated substantial resources to the development of our proprietary
technologies, which include capabilities for sample collection from the worlds microbial populations, generation of environmental libraries and human antibody gene libraries, screening of these libraries using ultra high-throughput methods
capable of analyzing more than one billion genes per day, and optimization based on our gene evolution technologies.



Our revenues have historically fluctuated from period to period and likely will continue to fluctuate substantially in the future based upon the timing and composition of
funding under existing and future collaboration agreements, regulatory approval timelines for new products, and an expected increase in product-related revenue based upon new product introductions.



Our collaborators often pay us before we recognize the revenue, and these payments are
deferred until earned. As of September 30, 2005, we had deferred revenue totaling $6.2 million.



We have incurred net losses since our inception. As of September 30, 2005, our accumulated deficit was $235.5 million. We expect to incur additional losses for at least the next two years as we continue to
develop independent products, and as a result of our potential additional investment in our sales and marketing infrastructure to support anticipated growth in product revenues. Our results of operations have fluctuated from period to period and
likely will continue to fluctuate substantially in the future based upon the factors affecting our revenue described above, as well as the initiation and expansion of research and development programs and the potential acquisition of new
technologies and proprietary rights. Results of operations for any period may be unrelated to results of operations for any other period. We believe that our historical results are not a good



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indicator of our future operating results. In addition, our interim results are not necessarily indicative of our anticipated results for the full fiscal
year.



Recent Events



On October 5, 2005, Jay M. Short, Ph.D. resigned as our President and Chief Executive
Officer, and our Board of Directors appointed Edward T. Shonsey, our Executive Vice President of Internal Development, as our Chief Executive Officer on an interim basis. Mr. Shonsey is working with existing management to review all of our
programs and operations with the goal to accelerate the development and commercialization of products which we believe have the greatest potential while we reduce unnecessary expenditures. We believe that this will enable us to better position
ourselves to reduce our loss and cash usage while we realize the greatest value from our programs and move us toward profitability. As a result of this review, we may incur additional charges in the near-term.



Results of Operations



Three Months Ended September 30, 2005 and 2004



Revenues



Revenues decreased 1.0%, or $0.1 million, to $12.8 million for the quarter ended September 30, 2005 from $12.9 million for the same period in 2004.



Revenue from collaborations decreased 3.0%, or $0.3 million, to $8.1 million from $8.4
million and accounted for 64% and 65% of total revenue for the quarters ended September 30, 2005 and 2004.



Product-related revenue for the quarter ended September 30, 2005 increased 10.7% to $2.1 million from $1.9 million for the same quarter in 2004. This increase was
attributable primarily to increased revenue and profit sharing associated with PhyzymeXP phytase sold through
our collaboration with Danisco Animal Nutrition, or Danisco.



Our revenues have
historically fluctuated from period to period and likely will continue to fluctuate substantially in the future based upon the timing and composition of funding under existing and future collaboration agreements, regulatory approval timelines for
new products, and an expected increase in product-related revenue based upon new product introductions. We anticipate that our revenue mix will continue to shift toward a higher percentage of product-related revenue.



Cost of Product-Related Revenue



Cost of product-related revenue includes both fixed and variable costs including materials
and supplies, labor, facilities and other overhead costs associated with our product-related revenues. For the quarter ended September 30, 2005, these costs increased $1.8 million to $2.8 million, or 189.0%, compared to $1.0 million for the
same quarter in the prior year. This increase resulted from an increase in fixed costs related to expanded manufacturing capacity to support anticipated growth in product-related revenues, an increase in product-related revenues, and charges for
inventory obsolescence. Cost of product-related revenue was 134% of product-related revenues in the quarter ended September 30, 2005, compared to 51% of product-related revenues for the same quarter in 2004. We expect that the cost of
product-related revenue will decrease as a percentage of product-related revenue once we have completed our manufacturing ramp-up and have achieved a scalable volume of product sales. However, our gross margins are dependent upon the mix of
product-related sales as the cost of goods sold varies from product to product.



Research and Development Expenses



Research and development
expenses consist primarily of costs associated with internal development of our technologies and our product candidates and costs associated with research activities performed on behalf of our collaborators. We track our researchers time by
type of project. However, we do not track other research and development costs by project; rather, we track these costs by the type of cost incurred.



For the quarter ended September 30, 2005, we estimate that approximately 55% of our research and development personnel costs, based upon hours incurred, were spent
on research activities funded by our collaborators and grants, and that 45% were spent on internal product and technology development. Our research and development expenses increased 1.0%, or $0.2 million, to $17.9 million for the quarter ended
September 30, 2005 from $17.7 million for the same quarter in 2004. The



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increase was primarily due to an increase in laboratory and supplies expense, offset in part by a decrease in personnel costs for direct research and
development. Our direct research and development staff decreased to 248 at September 30, 2005 from 307 at September 30, 2004. The decrease in staff was primarily due to a realignment of our workforce in late 2004 to more closely focus on
the sales and marketing of our new and existing products and the development of other product candidates.



Research and development costs by type of project and unallocated costs incurred during the quarters ended September 30, 2005 and 2004 were as follows (in thousands):



|                     |  |                                 |        |      |   |       
|-------------------- |  | ------------------------------- | ------ | ---- | - | ------
|                     |  | Three Months EndedSeptember 30,
|                     |  | 2005                            |        | 2004
|Collaborations:      |  |                                 |        |      |   |       
|Syngenta             |  | $                               | 1,523  |      | $ | 1,428 
|Other                |  |                                 | 1,238  |      |   | 1,033 
|                     |  |                                 |        |      |   |       
|Total collaborations |  |                                 | 2,761  |      |   | 2,461 
|Grants               |  |                                 | 1,197  |      |   | 1,385 
|Internal development |  |                                 | 2,137  |      |   | 2,871 
|Unallocated          |  |                                 | 11,837 |      |   | 11,031
|                     |  |                                 |        |      |   |       
|                     |  | $                               | 17,932 |      | $ | 17,748
|                     |  |                                 |        |      |   |       



Research and development costs based
upon type of cost incurred for the quarters ended September 30, 2005 and 2004 were as follows (in thousands):



|                               |  |                                 |        |      |   |       
|------------------------------ |  | ------------------------------- | ------ | ---- | - | ------
|                               |  | Three Months EndedSeptember 30,
|                               |  | 2005                            |        | 2004
|Personnel related              |  | $                               | 6,095  |      | $ | 6,717 
|Laboratory and supplies        |  |                                 | 3,119  |      |   | 2,370 
|Outside services               |  |                                 | 2,595  |      |   | 2,475 
|Equipment and depreciation     |  |                                 | 2,342  |      |   | 2,240 
|Facilities, overhead and other |  |                                 | 3,781  |      |   | 3,946 
|                               |  |                                 |        |      |   |       
|                               |  | $                               | 17,932 |      | $ | 17,748
|                               |  |                                 |        |      |   |       



We have only recently launched our
first products. Additionally, we have several product candidates in various stages of development related to collaborations and grants as well as internally developed products. It can take many years from the initial decision to perform research
through development until products, if any, are ultimately marketed. The outcome of research is unknown until each stage of testing is completed, up through and including clinical trials and regulatory approvals, if needed. Accordingly, we are
unable to predict which potential product candidates we may proceed with, the time and costs to complete development, and ultimately whether we will have any products approved by the appropriate regulatory bodies. The various risks associated with
our research and development activities are discussed more fully in our risk factors. While we anticipate that we will continue to dedicate significant resources to development of future products, we expect that our total research and development
costs will decrease in future periods as we position the Company to reduce its loss and cash usage.



Selling, General and Administrative Expenses



Selling, general and administrative expenses increased 18.0%, or $0.5 million, to $3.3 million from $2.8 million for the same quarter in 2004. This increase was primarily related to headcount costs to support sales and marketing for our new
and existing products. We expect our sales and marketing expenses to remain at comparable levels, or increase, in future periods as we introduce new products and invest in the necessary infrastructure to support our anticipated increase in product
revenue.



Non-cash, Stock-based Compensation



We recorded stock-based deferred compensation of approximately $4.4 million during the first
quarter of 2005 related to the granting of restricted stock awards to employees. We amortize the deferred compensation balance to expense on a straight-line



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basis over the vesting period of the awards, which is generally four years. We recorded net expense of $0.2 million related to the amortization of deferred
stock-based compensation during the quarter ended September 30, 2005.



Amortization of Acquired Intangible Assets



Amortization of
acquired intangible assets, which aggregated $0.7 million for each of the quarters ended September 30, 2005 and 2004, results primarily from the acquisition, in February 2003, of certain intellectual property rights licensed from Syngenta that
we are amortizing over 15 years.



Interest and Other Income, Net



Interest and other income, net, for the quarter ended September 30,
2005 was $32,000, compared to $24,000 for the same period in 2004. The increase was primarily due to a decrease in interest expense due to lower debt balances as compared to 2004. This increase was offset in part by a decrease in interest income
resulting for lower average cash balances during the quarter ended September 30, 2005 as compared to same period in 2004.



Nine Months Ended September 30, 2005 and 2004



Revenues



Revenues increased 0.9%, or $0.4 million, to $39.8 million for the nine months ended September 30, 2005 from $39.4 million for the same period in 2004.



Revenue from collaborations decreased 7.0%, or $1.9 million, to $26.3 million from $28.2
million and accounted for 66% and 72% of total revenue for the nine months ended September 30, 2005 and 2004. The decrease in collaborative revenues was primarily attributable to revenue earned in 2004 under the Companys former Zymetrics
contract joint venture agreements with Syngenta, which were not repeated in the current periods. Under this agreement, the Company earned revenue from milestones and exclusivity fees aggregating $6.5 million during the nine months ended
September 30, 2004. This decrease in collaborative revenue was offset by increased revenue from new or expanded partnerships in 2005, including Merck and Cargill.



Product-related revenue for the nine months ended September 30, 2005 increased 63.0% to $6.1 million from $3.8 million for the same
period in 2004. This increase was attributable primarily to increased revenue and profit sharing associated with PhyzymeXP phytase sold through our collaboration with Danisco.



Cost of Product-Related Revenue



For the nine months ended
September 30, 2005, our cost of goods sold increased $5.4 million to $7.6 million, or 249.0%, compared to $2.2 million for the same period in the prior year. Cost of goods sold was 124% of product-related revenues in the nine months ended
September 30, 2005, compared to 58% of product-related revenues for the same period in 2004. This increase resulted from an increase in fixed costs related to expanded manufacturing capacity to support anticipated growth in product-related
revenues, increased product-related revenues, and to a lesser extent, charges for inventory obsolescence.



Research and Development Expenses



For
the nine months ended September 30, 2005, we estimate that approximately 62% of our research and development personnel costs, based upon hours incurred, were spent on research activities funded by our collaborators and grants, and that 38% were
spent on internal product and technology development. Our research and development expenses increased $1.9 million, or 4.0%, to $55.6 million for the nine months ended September 30, 2005 from $53.7 million for the same period in 2004. The
increase was primarily due to an increase in outside services costs under our Syngenta collaboration and costs during the first half of 2005 associated with our internal pharmaceutical development programs, as well as an increase in costs to support
our internal product development efforts, including increases in laboratory and supplies expense, third party outside services costs, indirect support personnel, depreciation and facilities and overhead-related costs. These increases were offset in
part by a decrease in personnel costs for direct research and development. Our direct research and development staff decreased to 248 at September 30, 2005 from 307 at September 30, 2004. The decrease in staff was primarily due to a
realignment of our workforce in late 2004 to more closely focus on the sales and marketing of our new and existing products and the development of other product candidates.



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Research and development costs by type of project and unallocated costs incurred during the nine months ended
September 30, 2005 and 2004 were as follows (in thousands):



|                     |  |                                |        |      |   |       
|-------------------- |  | ------------------------------ | ------ | ---- | - | ------
|                     |  | Nine Months EndedSeptember 30,
|                     |  | 2005                           |        | 2004
|Collaborations:      |  |                                |        |      |   |       
|Syngenta             |  | $                              | 4,605  |      | $ | 6,217 
|Other                |  |                                | 3,932  |      |   | 2,481 
|                     |  |                                |        |      |   |       
|Total collaborations |  |                                | 8,537  |      |   | 8,698 
|Grants               |  |                                | 3,582  |      |   | 4,129 
|Internal development |  |                                | 7,243  |      |   | 9,407 
|Unallocated          |  |                                | 36,193 |      |   | 31,457
|                     |  |                                |        |      |   |       
|                     |  | $                              | 55,555 |      | $ | 53,691
|                     |  |                                |        |      |   |       



Research and development costs based
upon type of cost incurred for the nine months ended September 30, 2005 and 2004 were as follows (in thousands):



|                               |  |                                |        |      |   |       
|------------------------------ |  | ------------------------------ | ------ | ---- | - | ------
|                               |  | Nine Months EndedSeptember 30,
|                               |  | 2005                           |        | 2004
|Personnel related              |  | $                              | 19,362 |      | $ | 22,234
|Laboratory and supplies        |  |                                | 7,676  |      |   | 7,054 
|Outside services               |  |                                | 8,208  |      |   | 5,615 
|Equipment and depreciation     |  |                                | 7,056  |      |   | 6,643 
|Facilities, overhead and other |  |                                | 13,253 |      |   | 12,145
|                               |  |                                |        |      |   |       
|                               |  | $                              | 55,555 |      | $ | 53,691
|                               |  |                                |        |      |   |       



While we anticipate that we will
continue to dedicate significant resources to development of future products, we expect that our total research and development costs will decrease in future periods as we position the Company to reduce its loss and cash usage.



Selling, General and Administrative Expenses



Selling, general and administrative expenses increased 3.0% to $9.5 million for the nine
months ended September 30, 2005 from $9.2 million for the same period in 2004. This increase was primarily related to headcount cost to support sales and marketing for new and existing products. We expect our sales and marketing expenses to
remain at comparable levels, or increase, in future periods as we introduce new products and invest in the necessary infrastructure to support our anticipated increase in product revenue.



Non-cash, Stock-based Compensation



We recorded deferred compensation expense of approximately $4.4 million during the first quarter of 2005 related to the granting of restricted stock awards to employees.
We amortize the deferred compensation balance to expense on a straight-line basis over the vesting period of the awards, which is generally four years. We recorded net expense of $0.6 million related to the amortization of deferred stock-based
compensation during the nine months ended September 30, 2005.



Amortization of Acquired Intangible Assets



Amortization of
acquired intangible assets, which aggregated $2.0 million for each of the nine months ended September 30, 2005 and 2004, results primarily from the acquisition, in February 2003, of certain intellectual property rights licensed from Syngenta
that are being amortized over 15 years.



Interest and Other Income, Net



Interest and other income, net, for the nine months ended
September 30, 2005 was $0.4 million, compared to $0.2 million for the same period in 2004. The increase was primarily due to a decrease in interest expense due to lower debt balances as



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compared to 2004. This increase was offset in part by a decrease in interest income resulting for lower average cash balances during the nine months ended
September 30, 2005 as compared to the same period in 2004.



Liquidity
and Capital Resources



Since inception, we have financed our business
primarily through the sale of common and preferred stock and funding from strategic partners and government grants. Our strategic partners and grant funding agencies have provided us with more than $225.0 million in funding from our inception
through September 30, 2005, and are also committed to provide approximately $78.0 million in additional funding through 2010, of which $6.2 million is included in deferred revenue. Future committed funding is subject to our performance
under existing agreements, and excludes milestone payments, license and commercialization fees, and royalties or profit sharing. Our future committed funding is concentrated within a limited number of collaborators. Our failure to successfully
maintain our relationship with these collaborators could have a material adverse impact on our operating results and financial condition.



As of September 30, 2005, we had cash, cash equivalents, and short-term investments of approximately $70.0 million. Our short-term investments as of such date
consisted primarily of U.S. Treasury and government agency obligations and investment-grade corporate obligations. Historically, we have funded our capital equipment purchases through available cash, capital leases and equipment financing line of
credit agreements.



During 2002, we entered into a manufacturing agreement with
Fermic, S.A. de C.V., or Fermic, to provide us with commercial quantities of certain enzyme products. Under the terms of the agreement, we are required to fund certain equipment required for fermentation and downstream processing of the products.
Through September 30, 2005, we had incurred costs of approximately $11.3 million for equipment related to this agreement. During the remainder of 2005, we anticipate funding as much as $2.2 million in additional equipment costs related to the
manufacturing agreement. As we continue to develop our commercial manufacturing platforms, we will be required to purchase additional capital equipment under this agreement.



Pursuant to our agreement with Fermic, we are also obligated to reimburse monthly costs related to manufacturing activities. These costs
scale up as our projected manufacturing volume increases. As of September 30, 2005, we are committed to pay Fermic an estimated $15.1 million in such costs through 2008.



We purchased capital equipment totaling $5.7 million during the first nine months of 2005, and financed approximately $4.6 million of these
purchases through our existing financing arrangements. We anticipate the cost of capital equipment required to support the ongoing needs of our existing research could be as much as $2.3 million for the remainder of 2005. We anticipate funding our
capital requirements for the remainder of 2005 with our existing bank credit facility, and with available cash.



Our operating activities used cash of $21.3 million for the nine months ended September 30, 2005. Our cash used by operating activities consisted primarily of cash
used to fund our net loss of $35.0 million, partially offset by depreciation and amortization of $13.4 million.



Our investing activities provided cash of $27.8 million for the nine months ended September 30, 2005. Our investing activities consisted primarily of a net decrease
in short-term investments of $33.5 million to fund operations, partially offset by purchases of property and equipment of $5.7 million.



Our financing activities used cash of $1.3 million for the nine months ended September 30, 2005. Our financing activities consisted primarily of borrowings under
notes payable of $4.6 million and proceeds from the sale of common stock under our Employee Stock Purchase Plan and from the exercise of stock options of $2.3 million, partially offset by payments on notes payable and capital leases of $8.2 million.



The following table summarizes our contractual obligations at
September 30, 2005 (in thousands):



|                                |  |       |        |                 |   |          |  |          |        |               |   |        |  |   |       
|------------------------------- |  | ----- | ------ | --------------- | - | -------- |  | -------- | ------ | ------------- | - | ------ |  | - | ------
|                                |  | Total |        | Less Than1 Year |   | 1-3Years |  | 3-5Years |        | After 5 Years
|Contractual Obligations         |  |       |        |                 |   |          |  |          |        |               |   |        |  |   |       
|Long-term debt                  |  | $     | 14,194 |                 | $ | 7,024    |  | $        | 6,699  |               | $ | 471    |  | $ |      
|Operating leases                |  |       | 57,597 |                 |   | 4,622    |  |          | 9,744  |               |   | 10,426 |  |   | 32,805
|Manufacturing costs to Fermic   |  |       | 15,120 |                 |   | 5,940    |  |          | 9,180  |               |   |       |  |   |      
|License and research agreements |  |       | 2,001  |                 |   | 442      |  |          | 759    |               |   | 375    |  |   | 425   
|                                |  |       |        |                 |   |          |  |          |        |               |   |        |  |   |       
|Total Contractual Obligations   |  | $     | 88,912 |                 | $ | 18,028   |  | $        | 26,382 |               | $ | 11,272 |  | $ | 33,230
|                                |  |       |        |                 |   |          |  |          |        |               |   |        |  |   |       



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On September 30, 2005 we entered into a $14.6 million Loan and Security Agreement, or the Bank Agreement, with a
commercial bank, or the Bank. The Bank Agreement provides for a one-year credit facility for up to $10.0 million in financing for qualified equipment purchases, or the Equipment Advances, in the United States and Mexico, and a $4.6 million
letter of credit sub-facility, or the Letter of Credit Sublimit. Borrowings under the Equipment Advances will be structured as promissory notes which are secured by qualified equipment purchases and repaid over 36 to 48 months, depending on the
location of the equipment financed. Borrowings will bear interest at the Banks prime rate plus 0.75% (7.50% at September 30, 2005). Amounts outstanding under the Letter of Credit Sublimit are unsecured, and are subject to an annual fee of
1.25%.



The Bank Agreement contains standard affirmative and negative covenants
and restrictions on actions by us, including, but not limited to, activity related to our common stock repurchases, liens, investments, indebtedness, and fundamental changes in, or dispositions of, our assets. Certain of these actions may be taken
by us with the consent of the Bank. In addition, we are required to meet certain financial covenants, primarily a minimum balance of unrestricted cash, cash equivalents, and investments in marketable securities of $25.0 million, including $15.0
million maintained in accounts at the Bank or its affiliates.



On
September 30, 2005, we completed a drawdown of approximately $0.6 million under the Equipment Advances. At September 30, 2005, there was approximately $0.6 million in outstanding borrowings under the Equipment Advances and a letter of
credit for approximately $4.6 million under the Letter of Credit Sublimit, as required under our facilities leases. We lease approximately 140,000 square feet of space in San Diego, California under two separate operating leases. Under the terms of
the leases, we are required to maintain an irrevocable standby letter of credit from a bank in lieu of a cash security deposit. The amount of the letter of credit is based upon certain financial covenants requiring minimum market capitalization or
working capital.



We are currently reviewing all of our programs and operations
with the goal to accelerate the development and commercialization of products which we believe have the greatest potential while we reduce unnecessary expenditures. We believe that this will enable us to better position ourselves to reduce our loss
and cash usage while we realize the greatest value from our programs and move us toward profitability. As a result of this review, we may incur additional charges in the near-term. While we expect to reduce our cash usage in 2006, we anticipate that
our sales and marketing expenses will remain at comparable levels, or increase, in future periods as we introduce new products and invest in the necessary infrastructure to support an anticipated increased level of product revenue.



We expect that our current cash and cash equivalents, short-term investments, and funding
from existing collaborations and grants will be sufficient to fund our working and other capital requirements for at least the next two years, including amounts required to fund internal research and development and enhancements of our core
technologies, as well as the potential costs of acquiring businesses, technologies, or products that we believe are a strategic fit with our business. This estimate is a forward-looking statement that involves risks and uncertainties. Our future
capital requirements and the adequacy of our available funds will depend on many factors, including scientific progress in our research and development programs, the magnitude of those programs, our ability to maintain our collaborations and achieve
milestones under them and our ability to establish new collaborative relationships, our ability, alone or with our collaborative partners, to commercialize products successfully, and competing technological and market developments. Therefore, it is
possible that we may seek additional financing in the future, whether through private or public equity offerings, debt financings, or collaborations, which may not be available on terms favorable to us, if at all. In addition, if we enter into
financing arrangements in the future, such arrangements could dilute our stockholders ownership interests and adversely affect their rights.



Critical Accounting Policies



Our discussion and analysis of our financial condition and results of operations is based upon our consolidated financial statements, which have been prepared in
accordance with U.S. generally accepted accounting principles. The preparation of these consolidated financial statements requires management to make estimates and judgments that affect the reported amounts of assets, liabilities, revenue and
expenses, and related disclosures. On an ongoing basis, we evaluate these estimates, including those related to revenue recognition, long-lived assets, accrued liabilities, and income taxes. These estimates are based on historical experience,
information received from third parties, and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that
are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.



We believe the following critical accounting policies affect the significant judgments and estimates used in the preparation of our consolidated financial statements.



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Revenue Recognition



We follow the provisions as set forth by current accounting rules, which primarily include Staff Accounting Bulletin No. 104, or SAB 104,, Revenue
Recognition.



We generally recognize revenue when we have satisfied
all contractual obligations and we are reasonably assured of collecting the resulting receivable. We are often entitled to bill our customers and receive payment from our customers in advance of recognizing the revenue under current accounting
rules. In those instances where we have billed our customers or received payment from our customers in advance of recognizing revenue, we include the amounts in deferred revenue on the balance sheet.



We generate revenue from research collaborations generally through funded research, up-front
fees to initiate research projects, fees for exclusivity in a field, and milestones. We recognize revenue from research funding on a percentage-of-completion basis, as research hours are incurred under each agreement. We recognize fees to initiate
research over the life of the project. We recognize revenue from exclusivity fees over the period of exclusivity. Our collaborations often include contractual milestones. When we achieve these milestones, we are entitled to payment, as defined by
the underlying agreements. We recognize revenue for milestone payments when earned, as evidenced by written acknowledgement from the collaborator, provided that (i) the milestone event is substantive and its achievement was not reasonably
assured at the inception of the agreement, and (ii) our performance obligations after the milestone achievement will continue to be funded by the collaborator at a level comparable to the level before the milestone achievement.



We recognize revenue from grants as related costs are incurred, as long as such costs are
within the funding limits specified by the underlying grant agreements.



We
recognize revenue related to the sale of our inventory as we ship or deliver products, provided all other revenue recognition criteria have been met. We recognize revenue from products sold through distributors or other third-party arrangements upon
shipment of the products, provided that (a) the price is substantially fixed and determinable at the time of sale; (b) the distributors obligation to pay us is not contingent upon resale of the products; (c) title and risk of
loss passes to the distributor at time of shipment; (d) the distributor has economic substance apart from that provided by us; (e) we have no significant obligation to the distributor to bring about resale of the products; and
(f) future returns can be reasonably estimated. For any sales that do not meet all of the above criteria, revenue is deferred until all such criteria have been met. We include our profit-sharing revenues in product-related revenues on the
statement of operations. We recognize profit-sharing revenues during the quarter in which such profit sharing revenues are earned, based on estimates provided by our profit-sharing partner. We adjust these estimates for actual results in the
subsequent quarter. We include profit-sharing revenues in product-related revenues on the statement of operations. To date, we have generated a substantial portion of our product-related revenues, including profit-sharing revenues, through our
agreements with Danisco.



Long-Lived Assets



We review long-lived assets, including leasehold improvements, property and equipment, and
acquired intangible assets for impairment whenever events or changes in business circumstances indicate that the carrying amount of the assets may not be fully recoverable. This requires us to estimate future cash flows related to these assets.
Actual results could differ from those estimates, which may affect the carrying amount of assets and the related amortization expense. As of September 30, 2005, we had long-lived assets with a net book value of $66.5 million.



Income Taxes



We record a valuation allowance to reduce our deferred tax assets to the amount that is more likely than not to be realized. While we have
considered future taxable income and ongoing tax planning strategies in assessing the need for the valuation allowance, in the event we were to determine that we would be able to realize our deferred tax assets in the future in excess of their net
recorded amounts, an adjustment to the deferred tax assets would increase our income in the period such determination was made. Likewise, should we determine that we would not be able to realize all or part of our net deferred tax assets in the
future, an adjustment to the deferred tax assets would be charged to income in the period such determination was made. As of December 31, 2004, we had $80.0 million in gross deferred tax assets, which were fully offset by a valuation allowance.



Inventories



We value inventory at the lower of cost (first in, first out) or market value and, if
necessary, reduce the value by an estimated allowance for excess and obsolete inventories. The determination of the need for an allowance is based on our review of



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inventories on hand compared to estimated future usage and sales, as well as, judgments, quality control testing data, and assumptions about the likelihood
of obsolescence.



Purchase Price Allocation



The purchase price for certain intellectual property rights licenses acquired from Syngenta
and certain property and equipment acquired from Torrey Mesa Research Institute, or TMRI, was allocated to the tangible and identifiable intangible assets acquired based on their estimated fair values at the acquisition date. An independent
third-party valuation firm was engaged to assist in determining the fair values of in-process research and development, identifiable intangible assets, and certain property, plant, and equipment. Such a valuation requires significant estimates and
assumptions, including but not limited to: determining the timing and expected costs to complete the in-process projects, estimating future cash flows from product sales resulting from in-process projects, and developing appropriate discount rates
and probability rates by project. We believe the fair values assigned to the assets acquired and liabilities assumed are based on reasonable assumptions.



Segment Reporting



Effective for fiscal 2005, we have determined that we operate in two segments: bioscience products and pharmaceuticals. Pursuant to the provisions of FASB No. 131, Disclosures about Segments of an Enterprise
and Related Information, we will be required to report separate financial and descriptive information about our reportable operating segments in our Form 10-K for the fiscal year ended December 31, 2005. Operating segments are components of
an enterprise about which separate financial information is available that is evaluated regularly by the chief operating decision maker in deciding how to allocate resources and in assessing performance. Generally, financial information is required
to be reported on the basis that it is used internally for evaluating segment performance and deciding how to allocate resources to segments. FASB No. 131 does not apply to interim financial statements in the initial year of its application,
but comparative information for interim periods in the initial year of application shall be reported in financial statements for interim periods in the second year of application. As such, no segment disclosures have been included in the
accompanying notes to the condensed consolidated financial statements for the quarter and nine months ended September 30, 2005.



RISK FACTORS RELATED TO OUR BUSINESS



Except for the historical information contained herein this quarterly report on Form 10-Q contains forward-looking statements that involve risks and uncertainties. Our
actual results may differ materially from those discussed here. Factors that could cause or contribute to differences in our actual results include those discussed in the following section, as well as those discussed in Part I, Item 2 entitled
Managements Discussion and Analysis of Financial Condition and Results of Operations and elsewhere throughout this quarterly report. You should consider carefully the following risk factors, together with all of the other
information included in this quarterly report on Form 10-Q. Each of these risk factors could adversely affect our business, operating results and financial condition, as well as adversely affect the value of an investment in our common stock.



We have a history of net losses, we expect to continue to incur net
losses, and we may not achieve or maintain profitability.



We have
incurred net losses since our inception, including a net loss of approximately $12.1 million and $35.0 million for the quarter and nine months ended September 30, 2005. As of September 30, 2005, we had an accumulated deficit of
approximately $235.5 million. We expect to incur additional losses for at least the next two years as we continue to develop independent products, and as a result of our anticipated investment in our sales and marketing infrastructure to support
anticipated growth in product sales. The extent of our future losses will depend, in part, on the rate of growth, if any, in our contract revenue, future product sales at profitable margins, and on the level of our expenses. To date, most of our
revenue has been derived from collaborations and grants, and we expect that a significant portion of our revenue for the remainder of 2005 will result from the same sources.



Future revenue from collaborations is uncertain because our ability to generate revenue will depend upon our ability to maintain our current
collaborations, enter into new collaborations, and to meet research, development, and commercialization objectives under new and existing agreements. While we expect to reduce our cash usage in 2006, we anticipate that our sales and marketing
expenses will remain at comparable levels, or increase, in future periods as we introduce new products and invest in the necessary infrastructure to support an anticipated increased level of product revenues. We will need to generate significant
additional revenue to achieve profitability. In order for us to generate revenue, we must not only retain our existing collaborations and/or attract new ones and achieve milestones under them, but we must also develop products or technologies that
we or our partners choose to commercialize and that are commercially successful and from which we can



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derive revenue through royalties. Even if we do achieve profitability, we may not be able to sustain or increase profitability on a quarterly or annual
basis.



Because we are an early stage company developing and deploying new
technologies, we may not be able to commercialize our technologies or products, which could cause us to be unprofitable or cease operations.



You must evaluate our business in light of the uncertainties and complexities affecting an early stage biotechnology company. Our existing proprietary technologies are
new and in the early stage of development. We may not be successful in the commercial development of these or any further technologies or products. Successful products require significant development and investment, including testing, to demonstrate
their cost-effectiveness prior to regulatory approval and commercialization. To date, we have commercialized only eight of our own products: Pyrolase160 enzyme, Pyrolase200 enzyme, Cottonaseenzyme, LuminasePB-100 enzyme, Bayovac®SRS, Ultra-Thin
enzyme, and blue and green fluorescent proteins. In addition four of our collaborative partners, Invitrogen Corporation, Danisco Animal Nutrition, Givaudan Flavors Corporation, and Syngenta Animal Nutrition (formerly known as Zymetrics, Inc.), have
incorporated our technologies or inventions into their own commercial products from which we can generate royalties. Our products and technologies have generated only modest revenues to date. Because of these uncertainties, our discovery process may
not result in the identification of product candidates that we or our collaborative partners will successfully commercialize. If we are not able to use our technologies to discover new materials or products with significant commercial potential, we
will not be able to achieve our objectives or build a sustainable or profitable business.



We are dependent on our collaborative partners, and our failure to successfully manage our existing and future collaboration relationships could prevent us from developing and commercializing many of our products
and achieving or sustaining profitability.



We currently have license
agreements, strategic alliance agreements and/or collaboration agreements with BASF, Bayer Animal Health, Cargill Health and Food Technologies, , DSM Pharma Chemicals, DuPont Bio-Based Materials, Medarex, Merck and Xoma. We also have formed a broad
strategic relationship with Syngenta AG, a world-leading agribusiness company. For the quarter and nine months ended September 30, 2005, approximately 47% of our revenue was from affiliates of Syngenta AG and a major portion of our future
committed funding is also to be received from affiliates of Syngenta AG. We expect that a significant portion of any future revenue will be derived from our collaboration agreements. Since we do not currently possess the resources necessary to
independently develop and commercialize all of the potential products that may result from our technologies, we expect to continue to enter into, and in the near-term derive additional revenue from, strategic alliance and collaboration agreements to
develop and commercialize products. We will have limited or no control over the resources that any strategic partner or collaborator may devote to our partnered products. Any of our present or future strategic partners or collaborators may fail to
perform their obligations as expected. These strategic partners or collaborators may breach or terminate their agreements with us or otherwise fail to conduct their collaborative activities successfully and in a timely manner. Further, our strategic
partners or collaborators may not develop products arising out of our collaborative arrangements or devote sufficient resources to the development, manufacture, marketing, or sale of these products. If any of these events occur, or we fail to enter
into or maintain strategic alliance or collaboration agreements, we may not be able to commercialize our products, grow our business, or generate sufficient revenue to support our operations. Our present or future strategic alliance and
collaboration opportunities could be harmed if:



| |  |  | We do not achieve our research and development objectives under our strategic alliance and collaboration agreements;
| | - |  | --------------------------------------------------------------------------------------------------------------------



| |  |  | We develop products and processes or enter into additional strategic alliances or collaborations that conflict with the business objectives of our strategic partners or
collaborators;
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | We disagree with our strategic partners or collaborators as to rights to intellectual property we develop, or their research programs or commercialization activities;
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | We are unable to successfully manage multiple simultaneous strategic alliances or collaborations;
| | - |  | -------------------------------------------------------------------------------------------------



| |  |  | Our strategic partners or collaborators become competitors of ours or enter into collaborative agreements with our competitors;
| | - |  | -------------------------------------------------------------------------------------------------------------------------------



| |  |  | Our strategic partners or collaborators become less willing to expend their resources on research and development due to general market conditions or other circumstances beyond our
control;
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Consolidation in our target markets limits the number of potential strategic partners or collaborators; or
| | - |  | ----------------------------------------------------------------------------------------------------------



| |  |  | We are unable to negotiate additional agreements having terms satisfactory to us.
| | - |  | ---------------------------------------------------------------------------------



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The identification and development of potential drug candidates under our pharmaceutical programs is subject to
uncertainties, many of which are beyond our control. If we fail to successfully identify and/or develop potential drug candidates, we may be adversely affected.



Potential products based on our sordarins anti-infective candidates or our therapeutic antibody optimization and generation technologies
will require, dependent upon the specific drug candidate, extensive research and development, preclinical testing, clinical testing, regulatory approval and substantial additional investment before we can market them. We cannot assure you that we
will successfully identify drug candidates that have a sufficiently attractive profile to warrant additional development. In addition, even if we successfully identify one or more drug candidates with such a profile, we cannot assure you that any of
such drug candidates will:



| |  |  | be successfully developed;
| | - |  | --------------------------



| |  |  | prove to be safe and effective in clinical trials;
| | - |  | --------------------------------------------------



| |  |  | meet applicable United States or international regulatory standards;
| | - |  | --------------------------------------------------------------------



| |  |  | be capable of being produced in commercial quantities at acceptable costs;
| | - |  | --------------------------------------------------------------------------



| |  |  | be commercially viable;
| | - |  | -----------------------



| |  |  | be eligible for third party reimbursement from governmental or private insurers; or
| | - |  | -----------------------------------------------------------------------------------



| |  |  | achieve market acceptance.
| | - |  | --------------------------



If we are not successful in developing a commercial pharmaceutical product from the sordarins anti-infective program we acquired from Glaxo Wellcome, S.A. in 2003, some of the anticipated benefits of the
acquisition may not be realized.



The process of developing a commercial
pharmaceutical product from the anti-infective compounds we acquired from Glaxo Wellcome, S.A. in 2003 requires additional preclinical testing and clinical trials, all of which are significantly expensive and time-consuming and may not result in a
commercial product. We may experience numerous unforeseen events during or as a result of the testing process that could delay or prevent testing or commercialization of any product, including the following:



| |  |  | We, our collaborators, if any, or regulators may suspend or terminate clinical trials if the participating subjects or patients are being exposed to unacceptable health risks;
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | We may have to delay clinical trials as a result of scheduling conflicts with participating clinicians and clinical institutions, or difficulties in identifying and enrolling
patients who meet trial eligibility criteria;
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Safety and efficacy results attained in preclinical studies or early human clinical trials may not be conclusive or indicative of results that are obtained in later clinical trials;
and
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | The effects our anti-infective compounds have may not be the desired effects or may include undesirable side effects or other characteristics that preclude regulatory approval or
limit their market acceptance and commercial use if ever approved.
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



If any of these events lead to a delay in, or lead us to discontinue, further development or commercialization of any product candidate, the anticipated benefits of our acquisition of the anti-infective program would not be realized.



We do not have the capacity to manufacture products on a commercial scale.
If we are unable to access the capacity to manufacture products in sufficient quantity, we may not be able to commercialize our products or generate significant sales.



We have only limited experience in enzyme manufacturing, and we do not have our own capacity to manufacture products on a commercial scale.
We expect to be dependent to a significant extent on third parties for commercial scale manufacturing of our products. We have arrangements with third parties that have the required manufacturing equipment and available capacity to manufacture
Pyrolase160 enzyme, Pyrolase200 enzyme, Quantum phytase, PhyzymeXP, Cottonaseenzyme, LuminasePB-100 enzyme, and Ultra-Thin enzyme under our direction and oversight. While we have our own pilot development facility, we continue to depend on third
parties for large-scale commercial manufacturing. Additionally, one of our primary third-party manufacturers is located in a foreign country. Any difficulties or interruptions of service with our third-party manufacturers or our own pilot
manufacturing facility could disrupt our research and development efforts, delay our commercialization of products, and harm our relationships with our strategic partners, collaborators or customers.



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We have only limited experience in independently developing, manufacturing, marketing, selling, and distributing
commercial products.



We intend to pursue some product opportunities
independently. We currently have only limited resources and capability to develop, manufacture, market, sell, or distribute products on a commercial scale. We will determine which products to pursue independently based on various criteria,
including: investment required, estimated time to market, regulatory hurdles, infrastructure requirements, and industry-specific expertise necessary for successful commercialization. At any time, we may modify our strategy and pursue collaborations
for the development and commercialization of some products that we had intended to pursue independently. We may pursue products that ultimately require more resources than we anticipate or which may be technically unsuccessful. In order for us to
commercialize these products directly, we would need to establish or obtain through outsourcing arrangements the capability to develop, manufacture, market, sell, and distribute products. If we are unable to successfully commercialize products
resulting from our internal product development efforts, we will continue to incur losses. Even if we successfully develop a commercial product, we may not generate significant sales and achieve profitability.



Environmental and social concerns about genetically engineered products could limit or
prevent the use of our products and technologies and limit our revenue.



Some of our anticipated products are genetically engineered. If we and/or our collaborators are not able to overcome the environmental and social concerns relating to genetic engineering, our products may not be accepted. Any of the risks
discussed below could result in expenses, delays, or other impediments to our programs or the public acceptance and commercialization of products dependent on our technologies or inventions. Our ability to develop and commercialize one or more of
our technologies and products could be limited by the following factors:



| |  |  | Public attitudes about the safety and environmental hazards of, and ethical concerns over, genetic research and genetically engineered products, which could influence public
acceptance of our technologies and products;
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Public attitudes regarding, and potential changes to laws governing, ownership of genetic material, which could harm our intellectual property rights with respect to our genetic
material and discourage collaborative partners from supporting, developing, or commercializing our products and technologies; and
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Governmental reaction to negative publicity concerning genetically modified organisms, which could result in greater government regulation of genetic research and derivative
products, including labeling requirements.
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



The subject of
genetically modified organisms has received negative publicity, which has aroused public debate. The adverse publicity could lead to greater regulation and trade restrictions on imports of genetically altered products.



If we are unable to continue to collect genetic material from diverse natural
environments, our research and development efforts and our product development programs could be harmed.



We collect genetic material from organisms found in diverse environments. We collect material from government-owned land in foreign countries and in areas of the United States under formal resource access agreements
and from private lands under individual agreements with private landowners. If our access to materials under biodiversity access agreements or other arrangements is reduced or terminates, it could harm our internal and our collaborative research and
development efforts. We also collect samples from other environments where agreements are currently not required, such as the deep sea. All of our agreements with foreign countries expire in 2008 or earlier, are renewable, and are all subject to
earlier termination. We have voluntarily ceased collections of further commercial research samples in Yellowstone National Park pending the parks resolution of collection guidelines.



Our ability to compete may decline if we do not adequately protect our proprietary
technologies or if we lose some of our intellectual property rights due to becoming involved in expensive lawsuits or administrative proceedings.



Our success depends in part on our ability to obtain patents and maintain adequate protection of our other intellectual property for our technologies and products in the
United States and other countries. The laws of some foreign countries do not protect proprietary rights to the same extent as the laws of the United States, and many companies have encountered significant problems in protecting their proprietary
rights in these foreign countries. These problems can be caused by, for example, an absence of rules and methods for defending intellectual property rights.



Our commercial success depends in part on not infringing patents and proprietary rights of third parties, and not breaching any licenses or other agreements that we have
entered into with regard to our technologies, products, and business. The patent positions of biotechnology companies, including our patent position, involve complex legal and factual questions and, therefore, enforceability cannot be predicted with
certainty. We will apply for patents covering both our technologies and products as we deem appropriate. Patents, if issued, may be challenged, invalidated, or circumvented. We cannot be sure that relevant patents have not been issued that could
block our ability to obtain patents or to operate as we would like. Others may develop similar technologies or duplicate technologies developed by us. There may be patents in some countries that, if valid,



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may block our ability to commercialize products in these countries if we infringe these patents or are unsuccessful in acquiring rights to them. There also
may be claims in published patent applications in some countries that, if granted and valid, may block our ability to commercialize products in these countries if we infringe these patent claims or are unable to license them.



As disclosed in our Annual Report on Form 10-K for the year ended December, 31, 2004, an
interference proceeding was declared in the U.S. Patent and Trademark Office in 2004 between a U.S. patent assigned to us and a pending U.S. patent owned by another company with allowable claims directed to optimization of immunomodulatory genetic
vaccines. Other than this interference proceeding, we are not currently a party to any litigation with regard to our patent position. However, the biotechnology industry is characterized by extensive litigation regarding patents and other
intellectual property rights. Many biotechnology companies have employed intellectual property litigation as a way to gain a competitive advantage. If we became involved in litigation or interference proceedings declared by the U.S. Patent and
Trademark Office, or oppositions or other intellectual property proceedings outside of the United States, to defend our intellectual property rights or as a result of alleged infringement of the rights of others, we might have to spend significant
amounts of money. We are aware of a significant number of patents and patent applications relating to aspects of our technologies filed by, and issued to, third parties. Should any of our competitors have filed patent applications or obtained
patents that claim inventions also claimed by us, we may have to participate in an interference proceeding declared by the relevant patent regulatory agency to determine priority of invention and, thus, the right to a patent for these inventions in
the United States. Such a proceeding, like the one described above, could result in substantial cost to us even if the outcome is favorable. Even if successful on priority grounds, an interference may result in loss of claims based on patentability
grounds raised in the interference. The litigation or proceedings could divert our managements time and efforts. Even unsuccessful claims could result in significant legal fees and other expenses, diversion of management time, and disruption
in our business. Uncertainties resulting from initiation and continuation of any patent or related litigation could harm our ability to compete.



An adverse ruling arising out of any intellectual property dispute, including an adverse decision as to the priority of our inventions, would undercut or invalidate our
intellectual property position. An adverse ruling could also subject us to significant liability for damages, prevent us from using processes or products, or require us to negotiate licenses to disputed rights from third parties. Although patent and
intellectual property disputes in the biotechnology area are often settled through licensing or similar arrangements, costs associated with these arrangements may be substantial and could include ongoing royalties. Furthermore, necessary licenses
may not be available to us on satisfactory terms, if at all.



We may
encounter difficulties managing our growth, which could adversely affect our results of operations.



Our strategy includes entering into and working on simultaneous projects across multiple industries. As of September 30, 2005, we had 302 full-time employees. While we do not expect to increase our headcount in
the near future, if we add more projects, it may place a strain on us. Our ability to effectively manage our operations, growth, and various projects requires us to continue to improve our operational, financial and management controls, reporting
systems and procedures and to attract and retain sufficient numbers of talented employees. We may not be able to successfully implement improvements to our management information and control systems in an efficient or timely manner. In addition, we
may discover deficiencies in existing systems and controls.



Confidentiality
agreements with employees and others may not adequately prevent disclosure of trade secrets and other proprietary information.



In order to protect our proprietary technology and processes, we also rely in part on trade secret protection for our confidential and proprietary information. We have
taken security measures to protect our trade secrets and proprietary information. However, these measures may not provide adequate protection for our trade secrets or other proprietary information. Our policy is to execute confidentiality agreements
with our employees and consultants upon the commencement of an employment or consulting arrangement with us. These agreements generally require that all confidential information developed by the individual or made known to the individual by us
during the course of the individuals relationship with us be kept confidential and not disclosed to third parties. These agreements also generally provide that inventions conceived by the individual in the course of rendering services to us
shall be our exclusive property. There can be no assurance that our proprietary information will not be disclosed, that others will not independently develop substantially equivalent proprietary information and techniques or otherwise gain access to
our trade secrets, or that we can meaningfully protect our trade secrets. Costly and time-consuming litigation could be necessary to enforce and determine the scope of our proprietary rights, and failure to obtain or maintain trade secret protection
could adversely affect our competitive business position.



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Many potential competitors who have greater resources and experience than we do may develop products and technologies
that make ours obsolete.



The biotechnology industry is characterized by
rapid technological change, and the area of gene research is a rapidly evolving field. Our future success will depend on our ability to maintain a competitive position with respect to technological advances. Rapid technological development by others
may result in our products and technologies becoming obsolete.



We face, and
will continue to face, intense competition. We are not aware of another company that has the scope and integration of technologies and processes that we have. There are, however, a number of companies who compete with us in various steps throughout
our technology process. For example, Codexis, Maxygen, Inc., Evotec, and Xencor, Inc. have alternative evolution technologies. Integrated Genomics Inc., Myriad Genetics, Inc., and ArQule, Inc. perform screening, sequencing, and/or bioinformatics
services. AB Enzymes, Dyadic International, and Genencor (a subsidiary of Danisco A/S), Iogen and Novozymes A/S are involved in development, overexpression, fermentation, and/or purification of enzymes. Abgenix, Inc., Cambridge Antibody Technology,
Genentech, Medarex, Inc., and Morphosys AG are involved in the development of human monoclonal antibodies. A number of companies are marketing and selling anti-fungal therapeutics and/or have anti-fungal therapies under clinical development,
including, but not limited to, Bristol-Myers Squibb, Fujisawa Pharmaceutical Company, Johnson & Johnson, Novartis, Pfizer, Schering-Plough, Connetics Corporation, Demegen, Gilead Sciences, Intermune, and Vicuron Pharmaceuticals. There are
also a number of academic institutions involved in various phases of our technology process. Many of these competitors have significantly greater financial and human resources than we do. These organizations may develop technologies that are
superior alternatives to our technologies. Further, our competitors may be more effective at implementing their technologies for modifying DNA to develop commercial products. Any products that we develop through our technologies will compete in
multiple, highly competitive markets. Many of our potential competitors in these markets have substantially greater financial, technical, and marketing resources than we do and may succeed in developing products that would render our products or
those of our collaborators obsolete or noncompetitive. In addition, many of these competitors have significantly greater experience than we do in their respective fields. Our ability to compete successfully will depend on our ability to develop
proprietary products that reach the market in a timely manner and are technologically superior to and/or are less expensive than other products on the market. Current competitors or other companies may develop technologies and products that are more
effective than ours. Our technologies and products may be rendered obsolete or uneconomical by technological advances or entirely different approaches developed by one or more of our competitors. The existing approaches of our competitors or new
approaches or technology developed by our competitors may be more effective than those developed by us.



Stringent laws and required government approvals could delay our introduction of products.



All phases, especially the field testing, production, and marketing, of our potential products are subject to significant federal, state, local, and/or foreign
governmental regulation. Regulatory agencies may not allow us to produce and/or market our products in a timely manner or under technically or commercially feasible conditions, or at all, which could harm our business. For example, we are currently
waiting for United States Food and Drug Administration, or FDA, approval of our Quantum phytase product. We believe that the delay in approval of this product has negatively impacted our anticipated revenues during the first nine months of 2005.



In the United States, products for our target markets are regulated based on
their application, by either the FDA, the Environmental Protection Agency, or EPA, or, in the case of plants and animals, the United States Department of Agriculture, or USDA. The FDA regulates drugs, food, and feed, as well as food additives, feed
additives, and substances generally recognized as safe that are used in the processing of food or feed. While substantially all of our projects to date have focused on non-human applications of our technologies and products outside of the FDAs
review, in the future we expect to pursue collaborations for further research and development of drug products for humans that would require FDA approval before they could be marketed in the United States. In addition, any drug product candidates
must also be approved by the regulatory agencies of foreign governments before any product can be sold in those countries. Under current FDA policy, our products, or products of our collaborative partners incorporating our technologies or
inventions, to the extent that they come within the FDAs jurisdiction, may be subject to lengthy FDA reviews and unfavorable FDA determinations if they raise safety questions which cannot be satisfactorily answered, if results from
pre-clinical or clinical trials do not meet regulatory requirements or if they are deemed to be food additives whose safety cannot be demonstrated. An unfavorable FDA ruling could be difficult to resolve and could prevent a product from being
commercialized. Even after investing significant time and expenditures, we may not obtain regulatory approval for any drug products. We have not submitted an investigational new drug application for any product candidate, and no drug product
candidate developed with our technologies has been approved for commercialization in the United States or elsewhere. The EPA regulates biologically derived chemical substances not within the FDAs jurisdiction. An unfavorable EPA ruling could
delay commercialization or require modification of the production process resulting in higher manufacturing costs, thereby making the product



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uneconomical. In addition, the USDA may prohibit genetically engineered plants from being grown and transported except under an exemption, or under controls
so burdensome that commercialization becomes impracticable. Our future products may not be exempted from regulation by the USDA.



The European regulatory process for these classes of biologically derived products has been in a state of flux in the recent past, as the European Union attempts to
replace country-by-country regulatory procedures with a consistent European Union regulatory standard in each case. Some country-by-country regulatory oversight remains. Other than Japan, most other regions of the world generally find adequate for
commercialization either United States or a European clearance together with associated data and information for a new biologically derived product.



If we require additional capital to fund our operations, we may need to enter into financing arrangements with unfavorable terms or which could adversely affect the
ownership interest and rights of our common stockholders as compared to our other stockholders. If such financing is not available, we may need to cease operations.



We currently anticipate that our available cash resources, short-term investments, receivables, and committed funding from collaborative
partners and government grants will be sufficient to meet our capital requirements for at least the next two years. However, we would use a significant amount of our cash to successfully develop a compound into a marketed drug.



Our capital requirements depend on several factors, including:



| |  |  | The level of research and development investment required to maintain our technology leadership position;
| | - |  | ---------------------------------------------------------------------------------------------------------



| |  |  | Costs for pre-clinical and clinical development;
| | - |  | ------------------------------------------------



| |  |  | Our ability to enter into new agreements with collaborative partners or to extend the terms of our existing collaborative agreements, and the terms of any agreement of this type;
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | The success rate of our discovery efforts associated with milestones and royalties;
| | - |  | -----------------------------------------------------------------------------------



| |  |  | Our ability to successfully commercialize products developed independently and the demand for such products;
| | - |  | ------------------------------------------------------------------------------------------------------------



| |  |  | The timing and willingness of strategic partners and collaborators to commercialize our products that would result in royalties;
| | - |  | --------------------------------------------------------------------------------------------------------------------------------



| |  |  | Costs of recruiting and retaining qualified personnel; and
| | - |  | ----------------------------------------------------------



| |  |  | Our need to acquire or license complementary technologies or acquire complementary businesses.
| | - |  | ----------------------------------------------------------------------------------------------



If additional capital is required to operate our business, we cannot assure you that additional financing will be available on terms
favorable to us, or at all. If adequate funds are not available or are not available on acceptable terms, our ability to fund our operations, take advantage of opportunities, develop products or technologies, or otherwise respond to competitive
pressures could be significantly limited. In addition, if financing is not available, we may need to cease operations.



If we raise additional funds through the issuance of equity securities, the percentage ownership of our stockholders will be reduced, stockholders may experience
additional dilution or such equity securities may provide for rights, preferences or privileges senior to those of the holders of our common stock. If we raise additional funds through the issuance of debt securities, such debt securities would have
rights, preferences and privileges senior to holders of common stock and the terms of such debt could impose restrictions on our operations.



We expect that our quarterly results of operations will fluctuate, and this fluctuation could cause our stock price to decline, causing investor losses.



Our quarterly operating results have fluctuated in the past and are
likely to do so in the future. These fluctuations could cause our stock price to fluctuate significantly or decline. Revenue in future periods may be greater or less than revenue in the immediately preceding period or in the comparable period of the
prior year. Some of the factors that could cause our operating results to fluctuate include:



| |  |  | Termination or restructuring of strategic alliances and collaborations;
| | - |  | -----------------------------------------------------------------------



| |  |  | The success rate of our discovery efforts associated with milestones and royalties;
| | - |  | -----------------------------------------------------------------------------------



| |  |  | The ability and willingness of strategic partners and collaborators to commercialize, market, and sell royalty-bearing products on expected timelines;
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------



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| |  |  | Our ability to enter into new agreements with strategic partners and collaborators or to extend the terms of our existing strategic alliance agreements and collaborations, and the
terms of any agreement of this type;
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Our ability to successfully satisfy all pertinent regulatory requirements;
| | - |  | --------------------------------------------------------------------------



| |  |  | Our ability to successfully commercialize products developed independently and the demand for such products; and
| | - |  | ----------------------------------------------------------------------------------------------------------------



| |  |  | General and industry specific economic conditions, which may affect our collaborative partners research and development expenditures.
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------



If revenue declines or does not grow as anticipated due to the expiration of strategic
alliance or collaboration agreements, failure to obtain new agreements or grants, lower than expected product sales or royalty payments, or other factors, we may not be able to correspondingly reduce our operating expenses. A large portion of our
operating expenses, including expenses for facilities, equipment and personnel, and manufacturing costs, are relatively fixed. Failure to achieve anticipated levels of revenue could therefore significantly harm our operating results for a particular
fiscal period.



Due to the possibility of fluctuations in our revenue and
expenses, we believe that quarter-to-quarter comparisons of our operating results are not a good indication of our future performance. Our operating results in some quarters may not meet the expectations of stock market analysts and investors. In
that case, our stock price would probably decline.



If we lose our key
personnel or are unable to attract and retain qualified personnel as necessary, it could delay our product development programs and harm our research and development efforts.



Our success depends to a significant degree upon the continued contributions of our executive officers, management, and scientific staff. If
we lose the services of one or more of these people, we may be unable to achieve our business objectives and our stock price could decline. We may not be able to attract or retain qualified employees in the future due to the intense competition for
qualified personnel among biotechnology and other technology-based businesses, particularly in the San Diego area. If we are not able to attract and retain the necessary personnel to accomplish our business objectives, we may experience constraints
that will adversely affect our ability to meet the demands of our collaborative partners in a timely fashion or to support our internal research and development programs. In particular, our product development programs depend on our ability to
attract and retain highly skilled scientists, including molecular biologists, biochemists, and engineers. Although we believe we will be successful in attracting and retaining qualified personnel, competition for experienced scientists and other
technical personnel from numerous companies and academic and other research institutions may limit our ability to do so on acceptable terms. All of our employees are at-will employees, which means that either the employee or we may terminate their
employment at any time.



Our planned activities will require additional
expertise in specific industries and areas applicable to the products developed through our technologies. These activities will require the addition of new personnel, including management, and the development of additional expertise by existing
management personnel. The inability to acquire these services or to develop this expertise could impair the growth, if any, of our business.



If we engage in any acquisitions, we will incur a variety of costs and may potentially face numerous other risks that could adversely affect our business operations.



During 2003, we consummated a series of transactions with Syngenta and
TMRI that involved, in part, our acquiring certain property and equipment from TMRI, and we purchased an antifungal program from Glaxo Wellcome, S.A. If appropriate opportunities become available, we may consider acquiring businesses, assets,
technologies, products, or personnel that we believe are a strategic fit with our business. We currently have no commitments or agreements with respect to any material acquisitions. If we do pursue such a strategy, we could:



| |  |  | Issue equity securities which would dilute current stockholders percentage ownership;
| | - |  | --------------------------------------------------------------------------------------



| |  |  | Incur substantial debt; or
| | - |  | --------------------------



| |  |  | Assume liabilities.
| | - |  | -------------------



We may not be able to successfully integrate any businesses, assets, technologies, products, or personnel that we might acquire in the future without a significant expenditure of operating, financial, and management
resources, if at all. In addition, future acquisitions might negatively impact our business relations with our collaborative partners. Further, recent accounting changes could result in a negative impact on our results of operations, as well as the
resulting cost of the acquisition. Any of these adverse consequences could harm our business.



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We may be sued for product liability.



We may be held liable if any product we develop, or any product which is made with the use of any of our technologies, causes injury or is
found otherwise unsuitable during product testing, manufacturing, marketing, or sale. We currently have limited product liability insurance that may not fully cover our potential liabilities. In addition, if we attempt to obtain additional product
liability insurance coverage, this additional insurance may be prohibitively expensive, or may not fully cover our potential liabilities. Inability to obtain sufficient insurance coverage at an acceptable cost or otherwise to protect against
potential product liability claims could prevent or inhibit the commercialization of products developed by us or our collaborative partners. If we are sued for any injury caused by our products, our liability could exceed our total assets.



We are subject to anti-takeover provisions in our certificate of
incorporation, bylaws, and Delaware law and have adopted a shareholder rights plan that could delay or prevent an acquisition of our company, even if the acquisition would be beneficial to our stockholders.



Provisions of our certificate of incorporation, our bylaws and Delaware law could make it
more difficult for a third party to acquire us, even if doing so would be beneficial to our stockholders. In addition, we adopted a share purchase rights plan that has anti-takeover effects. The rights under the plan will cause substantial dilution
to a person or group that attempts to acquire us on terms not approved by our board of directors. The rights should not interfere with any merger or other business combination approved by our board, since the rights may be amended to permit such an
acquisition or may be redeemed by us. These provisions in our charter documents, under Delaware law, and in our rights plan could discourage potential takeover attempts and could adversely affect the market price of our common stock. Because of
these provisions, our common stockholders might not be able to receive a premium on their investment.



Our stock price has been and may continue to be particularly volatile.



The stock market, from time to time, has experienced significant price and volume fluctuations that are unrelated to the operating performance of companies. The market prices of technology companies, particularly life
science companies, have been highly volatile. Our stock has been and may continue to be affected by this type of market volatility, as well as by our own performance. The following factors, among other risk factors, may have a significant effect on
the market price of our common stock:



| |  |  | Developments in our relationships with current or future strategic partners and collaborators;
| | - |  | ----------------------------------------------------------------------------------------------



| |  |  | Announcements of technological innovations or new products by us or our competitors;
| | - |  | ------------------------------------------------------------------------------------



| |  |  | Developments in patent or other proprietary rights;
| | - |  | ---------------------------------------------------



| |  |  | Our ability to access genetic material from diverse ecological environments and practice our technologies;
| | - |  | ----------------------------------------------------------------------------------------------------------



| |  |  | Future royalties from product sales, if any, by our collaborative partners;
| | - |  | ---------------------------------------------------------------------------



| |  |  | Fluctuations in our operating results;
| | - |  | --------------------------------------



| |  |  | Litigation;
| | - |  | -----------



| |  |  | Developments in domestic and international governmental policy or regulation; and
| | - |  | ---------------------------------------------------------------------------------



| |  |  | Economic and other external factors or other disaster or crisis.
| | - |  | ----------------------------------------------------------------



Concentration of ownership among our executive officers, directors and principal stockholders may prevent other stockholders from influencing significant corporate
decisions and depress our stock price.



Our executive officers, directors,
and stockholders with at least 5% of our stock together beneficially owned approximately 53.6% of our outstanding common stock as of September 30, 2005. If these officers, directors, and principal stockholders act together, they will be able to
exert a significant degree of influence over our management and affairs and over matters requiring stockholder approval, including the election of directors and approval of mergers or other business combination transactions. As of September 30,
2005, Syngenta and its affiliates owned approximately 17.8% of our outstanding common stock, and by themselves will be able to exert a significant degree of influence over our management and affairs and over matters requiring stockholder approval.
The interests of this concentration of ownership may not always coincide with our interests or the interests of other stockholders. For instance, executive officers, directors, and principal stockholders, acting together, could cause us to enter
into transactions or agreements that we would not otherwise consider. Similarly, this



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concentration of ownership may have the effect of delaying or preventing a change in control of our company otherwise favored by our other stockholders. This
concentration of ownership could depress our stock price.



We use hazardous
materials in our business and any claims relating to improper handling, storage, or disposal of these materials could be time consuming and costly.



Our research and development processes involve the controlled use of hazardous materials, including chemical, radioactive, and biological materials. Our operations also
produce hazardous waste products. We cannot eliminate entirely the risk of accidental contamination or discharge and any resultant injury from these materials. Federal, state, and local laws and regulations govern the use, manufacture, storage,
handling, and disposal of these materials. We may be sued for any injury or contamination that results from our use or the use by third parties of these materials, and our liability may exceed our total assets. In addition, compliance with
applicable environmental laws and regulations may be expensive, and current or future environmental regulations may impair our research, development, or production efforts.



|Item 3. | Quantitative and Qualitative Disclosures about Market Risk
|------- | ----------------------------------------------------------



Our exposure to market risk is limited to interest rate risk and, to a lesser extent, foreign currency risk. Our exposure to changes in interest rates relates primarily
to the increase or decrease in the amount of interest income we can earn on our investment portfolio and on the increase or decrease in the amount of interest expense we must pay with respect to our various outstanding debt instruments. Our risk
associated with fluctuating interest expense is limited to our future financings, including any future equipment financing line of credit agreements, the interest rates under which are expected to be closely tied to market rates. Our risk associated
with fluctuating interest income is limited to our investments in interest rate sensitive financial instruments. Under our current policies, we do not use interest rate derivative instruments to manage exposure to interest rate changes. We ensure
the safety and preservation of our invested principal funds by limiting default risk, market risk, and reinvestment risk. We mitigate default risk by investing in short-term investment grade securities and limiting the amount invested in any single
security. We mitigate market risk by maintaining an average maturity of less than one year for our investments. We mitigate reinvestment risk by investing in securities with varying maturity dates. A hypothetical 100 basis point adverse move in
interest rates along the entire interest rate yield curve would have decreased the fair value of our interest sensitive financial instruments at September 30, 2005 and December 31, 2004 by $0.3 million. Declines in interest rates over time
will reduce our interest income, while increases in interest rates over time will increase our interest expense. In connection with one of our research collaborations, we engage third parties to provide various services. Certain of these services
result in obligations that are denominated in other than U.S. dollars. Foreign currency risk is minimized because the amount of such obligations is not material. Additionally, the collaboration under which such services are performed provides for
reimbursement of such costs in U.S. dollars.



|Item 4. | Controls and Procedures
|------- | -----------------------



Conclusion Regarding the Effectiveness of Disclosure Controls and Procedures. Under the supervision and with the participation of our management, including our
Chief Executive Officer (CEO), who is our principal executive officer, and Chief Financial Officer (CFO), who is our principal financial officer, we conducted an evaluation of our disclosure controls and procedures, as such
term is defined under Rules 13a-15(e) and 15d-15(e) promulgated under the Securities Exchange Act of 1934, as amended (the Exchange Act), as of the end of the period covered by this Quarterly Report on Form 10-Q. Based on this
evaluation, our CEO and CFO concluded that our disclosure controls and procedures were effective as of the end of the period covered by this Quarterly Report on Form 10-Q. There are inherent limitations in the effectiveness of any internal control,
including the possibility of human error and the circumventions or overriding of controls. Consequently, even effective internal controls can only provide reasonable assurances with respect to any disclosure controls and procedures and internal
control over financial statement preparation and presentation.



Changes in
Internal Control over Financial Reporting. Our CEO and CFO also evaluated whether a change had occurred in our internal controls over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during our most recent
fiscal quarter that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting. Based on such evaluation, such officers have concluded that there was no change in our internal control over
financial reporting that occurred during our most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.



Subsequent to September 30, 2005, we experienced changes in our senior management,
including the departure of our Chief Executive Officer and appointment of a new Chief Executive Officer. We do not believe that any of these changes has materially affected, or is reasonably likely to materially affect, our internal control over
financial reporting.



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PART II - OTHER INFORMATION



|Item 1. | Legal Proceedings
|------- | -----------------



In December 2002, we and certain of our current and former officers and directors were named as defendants in a class action shareholder complaint filed in the United States District Court for the Southern District of
New York, now captioned In re Diversa Corp. Initial Public Offering Sec. Litig., Case No. 02-CV-9699. In the amended complaint, the plaintiffs allege that we and certain of our officers and directors, and the underwriters (the
Underwriters) of our initial public offering (the IPO), violated Sections 11 and 15 of the Securities Act of 1933, as amended, based on allegations that our registration statement and prospectus prepared in connection with
our IPO failed to disclose material facts regarding the compensation to be received by, and the stock allocation practices of, the Underwriters. The complaint also contains claims for violation of Sections 10(b) and 20 of the Exchange Act based on
allegations that this omission constituted a deceit on investors. The plaintiffs seek unspecified monetary damages and other relief. This action is related to In re Initial Public Offering Sec. Litig., Case No. 21 MC 92, in which similar
complaints were filed by plaintiffs (the Plaintiffs) against hundreds of other public companies (collectively, the Issuers) that conducted IPOs of their common stock in the late 1990s and 2000 (collectively, the IPO
Cases). On January 7, 2003, the IPO Case against us was assigned to United States Judge Shira Scheindlin of the Southern District of New York, before whom the IPO Cases have been consolidated for pretrial purposes.



In February 2003, the Court issued a decision denying our motion to dismiss the Sections 11
and 15 claims against us and our officers and directors, and granting our motion to dismiss the Section 10(b) claim against us without leave to amend. The Court similarly dismissed the Sections 10(b) and 20 claims against two of our officers
and directors without leave to amend, but denied the motion to dismiss these claims against one officer/director.



In June 2003, Issuers and Plaintiffs reached a tentative settlement agreement and entered into a memorandum of understanding providing for, among other things, a
dismissal with prejudice and full release of the Issuers and their officers and directors from all further liability resulting from Plaintiffs claims, and the assignment to Plaintiffs of certain potential claims that the Issuers may have
against the Underwriters. The tentative settlement also provides that, in the event that Plaintiffs ultimately recover less than a guaranteed sum of $1 billion from the Underwriters in the IPO Cases and related litigation, Plaintiffs would be
entitled to payment by each participating Issuers insurer of a pro rata share of any shortfall in the Plaintiffs guaranteed recovery. In the event, for example, that Plaintiffs recover nothing from the Underwriter defendants in the IPO
Cases and the Issuers insurers therefore become liable to the Plaintiffs for an aggregate of $1 billion pursuant to the settlement proposal, the pro rata liability of our insurers, with respect to us, would be approximately $4 million,
assuming that 250 issuers participate in the settlement. We are covered by a claims-made liability insurance policy which we believe would satisfy our insurers pro rata liability described in this hypothetical example.



In June 2004, we executed a formal settlement agreement with the plaintiffs pursuant to the
terms of the memorandum of understanding. On February 15, 2005, the Court issued a decision certifying a class action for settlement purposes and granting preliminary approval of the settlement subject to modification of certain bar orders
contemplated by the settlement. On August 31, 2005, the Court reaffirmed class certification and preliminary approval of the modified settlement in a comprehensive order. In addition, the Court approved the form of notice to be sent to members
of the settlement classes, which will be published and mailed beginning November 15, 2005. The court has set a final settlement fairness hearing on the settlement for April 24, 2006. The settlement is still subject to
statutory notice requirements and final judicial approval.



We are also, from
time to time, subject to legal proceedings and claims which arise in the normal course of its business. In our opinion, the amount of ultimate liability with respect to these actions will not have a material adverse effect on our consolidated
financial position, results of operations, or cash flows.



|Item 2. | Unregistered Sales of Equity Securities and Use of Proceeds
|------- | -----------------------------------------------------------



Our Registration Statements on Form S-1 (File Nos. 333-92853 and 333-30290) relating to the initial IPO were declared effective by the Securities and Exchange Commission
on February 11 and February 14, 2000, respectively. Upon completion of our initial public offering, we received net proceeds of $184.5 million after underwriting discounts and expenses. Through September 30, 2005, approximately $15.9
million of the net proceeds had been used to purchase property and equipment and approximately $98.8 million had been used for general corporate purposes. The balance is invested in cash equivalents and short-term investments.



|Item 3. | Defaults Upon Senior Securities
|------- | -------------------------------



None.



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|Item 4. | Submission of Matters to a Vote of Security Holders
|------- | ---------------------------------------------------



None.



|Item 5. | Other Information
|------- | -----------------



None.



|Item 6. | Exhibits
|------- | --------



(a)



|               |  |                                                                                                                                                                                                                                                                                                                                                                                                                                   
|-------------- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit Number |  | Description of Exhibit                                                                                                                                                                                                                                                                                                                                                                                                            
|3.1            |  | Amended and Restated Certificate of Incorporation.(1)                                                                                                                                                                                                                                                                                                                                                                             
|               | 
|3.2            |  | Amended and Restated Bylaws.(1)                                                                                                                                                                                                                                                                                                                                                                                                   
|               | 
|4.1            |  | Form of Common Stock Certificate of the Company.(2)                                                                                                                                                                                                                                                                                                                                                                               
|               | 
|4.2            |  | Rights Agreement by and between the Company and American Stock Transfer and Trust Company, as Rights Agent, dated as of December 13, 2000 (including the Form of Certificate of Designation of
Series A Junior Participating Preferred Stock attached thereto as Exhibit A, the Form of Right Certificate attached thereto as Exhibit B, and the Summary of Rights to Purchase Preferred Shares attached thereto as Exhibit C).(3)
|               | 
|4.3            |  | First Amendment to Rights Agreement by and between the Company and American Stock Transfer and Trust Company, as Rights Agent, dated as of December 2, 2002.(4)                                                                                                                                                                                                                                                                   
|               | 
|4.4            |  | The Companys Certificate of Designation of Series A Junior Participating Preferred Stock.(3)                                                                                                                                                                                                                                                                                                                                     
|               | 
|10.1           |  | Loan and Security Agreement by and between the Company and Comerica Bank dated September 30, 2005 (5)                                                                                                                                                                                                                                                                                                                             
|               | 
|31.1           |  | Certification of Chief Executive Officer pursuant to Rules 13a-14(a) and 15d-14(a) promulgated under the Securities and Exchange Act of 1934, as amended.                                                                                                                                                                                                                                                                         
|               | 
|31.2           |  | Certification of Chief Financial Officer pursuant to Rules 13a-14(a) and 15d-14(a) promulgated under the Securities and Exchange Act of 1934, as amended.                                                                                                                                                                                                                                                                         
|               | 
|32             |  | Certification of Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                                                                    

---

|(1) | Filed as an exhibit to the Companys Quarterly Report on Form 10-Q for the quarter ended March 31, 2000, filed with the Securities and Exchange Commission on May 12,
2000, and incorporated herein by reference.
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|(2) | Filed as an exhibit to the Companys Registration Statement on Form S-1 (File No. 333-92853) originally filed with the Securities and Exchange Commission on
December 21, 1999, as amended, and incorporated herein by reference.
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|(3) | Filed as an exhibit to the Companys Current Report on Form 8-K, filed with the Securities and Exchange Commission on December 15, 2000, and incorporated herein by
reference.
|--- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|(4) | Filed as an exhibit to the Companys Current Report on Form 8-K, filed with the Securities and Exchange Commission on December 4, 2002, and incorporated herein by
reference.
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|(5) | Filed as an exhibit to the Companys Current Report on Form 8-K, filed with the Securities and Exchange Commission on October 6, 2005, and incorporated herein by
reference.
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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##### Table of Contents



SIGNATURES



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



|                       |  |  |  |                                                           
|---------------------- |  |  |  | ----------------------------------------------------------
|                       |  |  |  | DIVERSA CORPORATION                                       
|                       |  | 
|Date: October 28, 2005 |  |  |  | /s/ ANTHONY E. ALTIG                                      
|                       |  |  |  | Anthony E. Altig                                          
|                       |  |  |  | Senior Vice President, Finance and Chief Financial Officer
|                       |  |  |  | (Principal Financial Officer)                             



31