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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549



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Form 10-Q



(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, 2003.



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



Commission File number 000-29173



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DIVERSA CORPORATION

(Exact name of registrant as specified in its charter)



|Delaware                                                       |  | 22-3297375                             
|-------------------------------------------------------------- |  | ---------------------------------------
|(State or other jurisdiction of incorporation or organization) |  | (I.R.S. Employer Identification Number)



|4955 Directors Place, San Diego, California |  | 92121     
|------------------------------------------- |  | ----------
|(Address of principal executive offices)    |  | (Zip Code)



Registrants
telephone number, including area code is (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



The number of shares of the
Registrants Common Stock outstanding as of November 3, 2003 was 43,042,798.



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DIVERSA CORPORATION



INDEX



|                             |  |                                                                                                    |  | PageNo.
|---------------------------- |  | -------------------------------------------------------------------------------------------------- |  | -------
|PART IFINANCIAL INFORMATION |  |                                                                                                   
|                             |  |                                                                                                   
|Item 1.                      |  | Financial Statements (Unaudited)                                                                   |  |        
|                             |  |                                                                                                   
|                             |  | Condensed Balance Sheets as of September 30, 2003 and December 31, 2002                            |  | 3      
|                             |  |                                                                                                   
|                             |  | Condensed Statements of Operations for the three and nine months ended September 30, 2003 and 2002 |  | 4      
|                             |  |                                                                                                   
|                             |  | Condensed Statements of Cash Flows for the nine months ended September 30, 2003 and 2002           |  | 5      
|                             |  |                                                                                                   
|                             |  | Notes to Condensed Financial Statements                                                            |  | 6      
|                             |  |                                                                                                   
|Item 2.                      |  | Managements Discussion and Analysis of Financial Condition and Results of Operations              |  | 8      
|                             |  |                                                                                                   
|Item 3.                      |  | Quantitative and Qualitative Disclosures about Market Risk                                         |  | 23     
|                             |  |                                                                                                   
|Item 4.                      |  | Controls and Procedures                                                                            |  | 23     
|                             | 
|PART IIOTHER INFORMATION    |  |                                                                                                   
|                             |  |                                                                                                   
|Item 1.                      |  | Legal Proceedings                                                                                  |  | 23     
|                             |  |                                                                                                   
|Item 2.                      |  | Changes in Securities and Use of Proceeds                                                          |  | 24     
|                             |  |                                                                                                   
|Item 3.                      |  | Defaults Upon Senior Securities                                                                    |  | 24     
|                             |  |                                                                                                   
|Item 4.                      |  | Submission of Matters to a Vote of Securities Holders                                              |  | 24     
|                             |  |                                                                                                   
|Item 5.                      |  | Other Information                                                                                  |  | 24     
|                             |  |                                                                                                   
|Item 6.                      |  | Exhibits and Reports on Form 8-K                                                                   |  | 24     
|                             | 
|SIGNATURES                   |  | 26                                                                                                



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PART I - FINANCIAL INFORMATION



Item 1. Financial Statements



DIVERSA CORPORATION

CONDENSED BALANCE SHEETS

(In thousands, except share and per share data)



|                                                                                                                                                                                |  | SEPTEMBER 30, 2003 |          |   | DECEMBER 31, 2002 |  
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ------------------ | -------- | - | ----------------- | -
|                                                                                                                                                                                |  | (Unaudited)        |          |   | (Note)            |  
|ASSETS                                                                                                                                                                          |  |                    |          |   |                   |  
|Current assets:                                                                                                                                                                 |  |                    |          |   |                   |  
|Cash and cash equivalents                                                                                                                                                       |  | $                  | 8,313    |   |                   | $
|Short-term investments                                                                                                                                                          |  |                    | 122,485  |   |                   |  
|Accounts receivable                                                                                                                                                             |  |                    | 1,824    |   |                   |  
|Other current assets                                                                                                                                                            |  |                    | 2,523    |   |                   |  
|                                                                                                                                                                                |  |                    |          |   |                   |  
|Total current assets                                                                                                                                                            |  |                    | 135,145  |   |                   |  
|Property and equipment, net                                                                                                                                                     |  |                    | 31,861   |   |                   |  
|Acquired intangible assets, net                                                                                                                                                 |  |                    | 53,708   |   |                   |  
|Other assets                                                                                                                                                                    |  |                    | 1,274    |   |                   |  
|                                                                                                                                                                                |  |                    |          |   |                   |  
|Total assets                                                                                                                                                                    |  | $                  | 221,988  |   |                   | $
|                                                                                                                                                                                |  |                    |          |   |                   |  
|LIABILITIES AND STOCKHOLDERS EQUITY                                                                                                                                            |  |                    |          |   |                   |  
|Current liabilities:                                                                                                                                                            |  |                    |          |   |                   |  
|Accounts payable                                                                                                                                                                |  | $                  | 1,255    |   |                   | $
|Accrued liabilities                                                                                                                                                             |  |                    | 4,822    |   |                   |  
|Deferred revenue                                                                                                                                                                |  |                    | 11,719   |   |                   |  
|Current portion of capital lease obligations                                                                                                                                    |  |                    | 576      |   |                   |  
|Current portion of notes payable                                                                                                                                                |  |                    | 7,851    |   |                   |  
|                                                                                                                                                                                |  |                    |          |   |                   |  
|Total current liabilities                                                                                                                                                       |  |                    | 26,223   |   |                   |  
|Capital lease obligations, less current portion                                                                                                                                 |  |                    | 300      |   |                   |  
|Notes payable, less current portion                                                                                                                                             |  |                    | 8,322    |   |                   |  
|Deposit from sublessee                                                                                                                                                          |  |                    |         |   |                   |  
|Long-term deferred revenue                                                                                                                                                      |  |                    | 904      |   |                   |  
|Stockholders equity:                                                                                                                                                           |  |                    |          |   |                   |  
|Common stock, $0.001 par value, 65,000,000 shares authorized, 43,040,270 and 35,769,455 shares issued and outstanding at September
30, 2003 and December 31, 2002, respectively |  |                    | 43       |   |                   |  
|Additional paid-in capital                                                                                                                                                      |  |                    | 348,251  |   |                   |  
|Deferred compensation                                                                                                                                                           |  |                    | (2       | ) |                   |  
|Accumulated deficit                                                                                                                                                             |  |                    | (162,579 | ) |                   |  
|Accumulated other comprehensive income                                                                                                                                          |  |                    | 526      |   |                   |  
|                                                                                                                                                                                |  |                    |          |   |                   |  
|Total stockholders equity                                                                                                                                                      |  |                    | 186,239  |   |                   |  
|                                                                                                                                                                                |  |                    |          |   |                   |  
|Total liabilities and stockholders equity                                                                                                                                      |  | $                  | 221,988  |   |                   | $
|                                                                                                                                                                                |  |                    |          |   |                   |  



Note: The balance sheet at December
31, 2002 has been derived from the audited financial statements at that date but does not include all of the information and footnotes required by accounting principles generally accepted in the United States for complete financial statements.



See accompanying notes to condensed financial statements.



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DIVERSA CORPORATION

CONDENSED STATEMENTS OF OPERATIONS

(In thousands, except per share data)

(Unaudited)



|                                                                               |  | THREE MONTHSENDEDSEPTEMBER 30, |         |   | NINE MONTHSENDED SEPTEMBER 30, |  
|------------------------------------------------------------------------------ |  | ------------------------------ | ------- | - | ------------------------------ | -
|                                                                               |  | 2003                           |         |   | 2002                           |  
|Revenue:                                                                       |  |                                |         |   |                                |  
|Collaborative                                                                  |  | $                              | 9,345   |   |                                | $
|Grant and product                                                              |  |                                | 1,873   |   |                                |  
|                                                                               |  |                                |         |   |                                |  
|Total revenue                                                                  |  |                                | 11,218  |   |                                |  
|                                                                               |  |                                |         |   |                                |  
|Operating expenses:                                                            |  |                                |         |   |                                |  
|Research and development                                                       |  |                                | 18,814  |   |                                |  
|Write-off of acquired in-process research and development                      |  |                                | 8,714   |   |                                |  
|Selling, general and administrative                                            |  |                                | 3,266   |   |                                |  
|Amortization of acquired intangible assets                                     |  |                                | 649     |   |                                |  
|Non-cash, stock-based compensation                                             |  |                                | 20      |   |                                |  
|                                                                               |  |                                |         |   |                                |  
|Total operating expenses                                                       |  |                                | 31,463  |   |                                |  
|                                                                               |  |                                |         |   |                                |  
|Loss from operations                                                           |  |                                | (20,245 | ) |                                |  
|Interest and other income, net                                                 |  |                                | 562     |   |                                |  
|Equity in loss of joint venture                                                |  |                                |        |   |                                |  
|                                                                               |  |                                |         |   |                                |  
|Net loss                                                                       |  | $                              | (19,683 | ) |                                | $
|                                                                               |  |                                |         |   |                                |  
|Net loss per share, basic and diluted                                          |  | $                              | (0.46   | ) |                                | $
|Weighted average shares used in computing basic and diluted net loss per share |  |                                | 42,766  |   |                                |  



See accompanying notes
to condensed financial statements.



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DIVERSA CORPORATION

CONDENSED STATEMENTS OF CASH FLOWS

(In thousands)

(Unaudited)



|                                                                            |  | NINE MONTHS ENDEDSEPTEMBER, |         
|--------------------------------------------------------------------------- |  | --------------------------- | --------
|                                                                            |  | 2003                        |         
|Operating activities:                                                       |  |                             |         
|Net loss                                                                    |  | $                           | (53,203 
|Adjustments to reconcile net loss to net cash used in operating activities: |  |                             |         
|Depreciation and amortization                                               |  |                             | 12,155  
|Non-cash, stock based compensation charges                                  |  |                             | 129     
|Unrealized loss on warrants held by the Company                             |  |                             |        
|Write-off of acquired in-process research and development                   |  |                             | 19,478  
|Changes in operating assets and liabilities:                                |  |                             |         
|Accounts receivable                                                         |  |                             | 168     
|Other assets                                                                |  |                             | (1,753  
|Accounts payable and accrued expenses                                       |  |                             | (2,454  
|Deferred revenue                                                            |  |                             | 548     
|                                                                            |  |                             |         
|Net cash used in operating activities                                       |  |                             | (24,932 
|                                                                            |  |                             |         
|Investing activities:                                                       |  |                             |         
|Purchases of short-term investments                                         |  |                             | (100,863
|Sales and maturities of short-term investments                              |  |                             | 120,251 
|Purchases of property and equipment                                         |  |                             | (5,758  
|Other                                                                       |  |                             | (270    
|                                                                            |  |                             |         
|Net cash provided by (used in) investing activities                         |  |                             | 13,360  
|                                                                            |  |                             |         
|Financing activities:                                                       |  |                             |         
|Net proceeds from sale of common stock                                      |  |                             | 1,731   
|Principal payments on capital leases                                        |  |                             | (780    
|Principal payments on notes payable                                         |  |                             | (4,973  
|Advances under notes payable                                                |  |                             | 3,794   
|                                                                            |  |                             |         
|Net cash provided by (used in) financing activities                         |  |                             | (228    
|                                                                            |  |                             |         
|Net decrease in cash and cash equivalents                                   |  |                             | (11,800 
|Cash and cash equivalents at beginning of period                            |  |                             | 20,113  
|                                                                            |  |                             |         
|Cash and cash equivalents at end of period                                  |  | $                           | 8,313   
|                                                                            |  |                             |         



See accompanying notes
to condensed financial statements.



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DIVERSA CORPORATION

NOTES TO CONDENSED FINANCIAL STATEMENTS

(Unaudited)



1. Organization and Business



Diversa Corporation (the Company) was incorporated under the laws of the State of Delaware on December 21, 1992 and received initial funding to commence its
operations in May 1994. The Company is directing its integrated portfolio of proprietary genomic technologies to the discovery, evolution, and production of commercially valuable molecules with pharmaceutical applications, such as monoclonal
antibodies and orally active drugs, as well as enzymes and small molecules with agricultural, chemical, and industrial applications.



2. Basis of Presentation



The accompanying unaudited condensed financial statements have been prepared by the Company in accordance with accounting principles generally accepted in the United
States for interim financial information. Accordingly, they do not include all the information and footnotes required by accounting principles generally accepted in the United States 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 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, 2002.



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



3. 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.



The following table presents the calculation of basic and diluted net loss per share:



(In thousands, except per share data)



|                                                                               |  | THREE MONTHSENDEDSEPTEMBER 30, |         |   | NINE MONTHSENDED SEPTEMBER 30, |  
|------------------------------------------------------------------------------ |  | ------------------------------ | ------- | - | ------------------------------ | -
|                                                                               |  | 2003                           |         |   | 2002                           |  
|Net loss                                                                       |  | $                              | (19,683 | ) |                                | $
|Net loss per share, basic and diluted                                          |  | $                              | (0.46   | ) |                                | $
|Weighted average shares used in computing basic and diluted net loss per share |  |                                | 42,766  |   |                                |  



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



4. Comprehensive Loss



Comprehensive income (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 income (loss) in its statements of stockholders equity.



For the three and nine months ended September 30, 2003 and 2002, the comprehensive loss consisted of (in thousands):



|                                      |  | THREE MONTHSENDEDSEPTEMBER 30, |         |   | NINE MONTHSENDED SEPTEMBER 30, |  
|------------------------------------- |  | ------------------------------ | ------- | - | ------------------------------ | -
|                                      |  | 2003                           |         |   | 2002                           |  
|Net loss                              |  | $                              | (19,683 | ) |                                | $
|Other comprehensive gain (loss):      |  |                                |         |   |                                |  
|Unrealized gain (loss) on investments |  |                                | (457    | ) |                                |  
|                                      |  |                                |         |   |                                |  
|Comprehensive loss                    |  | $                              | (20,140 | ) |                                | $
|                                      |  |                                |         |   |                                |  



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5. Stock-Based Compensation



The Company measures compensation expense for stock options granted to employees using the intrinsic value method and, thus, 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.



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 SFAS No. 123. For the three months ended September 30, 2003 and 2002, the fair value of these options was estimated using the Black-Scholes model with the following assumptions:
risk-free interest rates ranging from 2.87% to 3.37% and 2.86% to 3.93%, respectively; dividend yield of 0%; volatility factor of 65% and 61%, respectively; and a weighted-average expected life of the options of 3.4 years. For the nine months ended
September 30, 2003 and 2002, the fair value of these options was estimated using the Black-Scholes model with the following assumptions: risk-free interest rates ranging from 2.26% to 3.37% and 2.86% to 4.65%, respectively; dividend yield of 0%;
volatility factor ranging from 49% to 65% and 61%, respectively; and a weighted-average expected life of the options of 3.4 years.



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 MONTHSENDEDSEPTEMBER 30, |         |   | NINE MONTHSENDED SEPTEMBER 30, |  
|--------------------------------------------------------------------------------------------------------------- |  | ------------------------------ | ------- | - | ------------------------------ | -
|                                                                                                                |  | 2003                           |         |   | 2002                           |  
|Net loss, as reported                                                                                           |  | $                              | (19,683 | ) |                                | $
|Add: Stock-based employee compensation expense included in reported net loss                                    |  |                                | 20      |   |                                |  
|Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards |  |                                | (2,266  | ) |                                |  
|                                                                                                                |  |                                |         |   |                                |  
|Pro forma net loss                                                                                              |  | $                              | (21,929 | ) |                                | $
|                                                                                                                |  |                                |         |   |                                |  
|Basic and diluted net loss per share, as reported                                                               |  | $                              | (0.46   | ) |                                | $
|Pro forma basic and diluted net loss per share                                                                  |  | $                              | (0.51   | ) |                                | $



In connection with the grant of
certain stock options to employees, the Company recorded deferred stock compensation, representing the difference between the exercise price and the fair value of the Companys common stock as estimated by the Companys management for
financial reporting purposes on the date such stock options were granted. Deferred compensation is included as a reduction of stockholders equity and is being amortized to expense over the vesting period of the options in accordance with FASB
Interpretation No. 28, which permits an accelerated amortization methodology.



6. Acquisitions



Syngenta



On February 20, 2003, the Company completed a series of transactions with Syngenta
Participations AG (Syngenta) and its wholly-owned subsidiary, Torrey Mesa Research Institute (TMRI). Under the transactions, the companies formed an extensive research collaboration whereby the Company is entitled to receive
a minimum of $118 million in research and development funding over the initial seven-year term of the related research collaboration agreement and will be eligible to receive certain milestone payments and royalties upon product development and
commercialization. Additionally, the Company acquired certain intellectual property rights licenses from Syngenta used in activities conducted at TMRI that primarily involve tools, technologies and methods relating to proteomics, metabolomics, RNA
dynamics, and bioinformatics and methods to analyze and link these components of genomics or that primarily relate to TMRIs fungal program, for use outside of Syngentas exclusive field as defined in the research collaboration agreement.
The Company also purchased certain property and equipment from TMRI.



Upon
closing, the Company issued to Syngenta and TMRI a total of 6,034,983 shares of common stock and a warrant to purchase 1,293,211 shares of common stock at $22 per share that is exercisable for ten years starting in 2008. The total value of the
acquisition was (in thousands):



|Fair value of Diversa shares issued  |  | $ | 69,016
|------------------------------------ |  | - | ------
|Fair value of Diversa warrant issued |  |   | 3,647 
|Transaction costs                    |  |   | 1,196 
|                                     |  |   |       
|Total                                |  | $ | 73,859
|                                     |  |   |       



The value of the Companys shares
used in determining the purchase price was $11.44 per share based on the average of the closing prices of its common stock for a range of five trading days  two days prior to, two days subsequent to, and the announcement date



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for the transactions of December 4, 2002. The value of the warrant issued was determined by a valuation performed by a
third party. The transaction has been accounted for as an asset purchase under accounting principles generally accepted in the United States.



The following table summarizes the estimated fair values and useful lives of the assets acquired as of the acquisition date (in thousands):



|                                    |  | Amount |        | EstimatedUseful Life
|----------------------------------- |  | ------ | ------ | --------------------
|Property and equipment              |  | $      | 8,211  |                     
|In-process research and development |  |        | 10,766 |                     
|Identifiable intangible assets:     |  |        |        |                     
|Core technology                     |  |        | 36,632 |                     
|Research collaboration              |  |        | 18,250 |                     
|                                    |  |        |        |                     
|Net assets                          |  | $      | 73,859 |                     
|                                    |  |        |        |                     



Approximately $10.8 million of the
purchase price represents the estimated fair value of projects that, as of the acquisition date, had not reached technological feasibility and had no alternative future use. Accordingly, this amount was immediately expensed in February 2003.



Glaxo Wellcome, S.A.



In July 2003, the Company acquired an antifungal program consisting of preclinical compounds
from Glaxo Wellcome, S.A. In consideration for the antifungal program, the Company issued an aggregate of 806,873 shares of its Common Stock to Glaxo Group Limited, an affiliate of Glaxo Wellcome, S.A. Under the terms of the agreement, the Company
received worldwide rights to the program, which consists of preclinical antifungal compounds and lead candidates for development, marketing, and distribution. Based upon the closing price of the Companys Common Stock immediately preceding
consummation of the transaction, the fair value of the compounds and lead candidates was $8.7 million. As of the acquisition date, these compounds and lead products had not reached technological feasibility and had no alternative future use.
Accordingly, the Company recorded $8.7 million as a write-off of acquired in-process research and development.



7. Recently Issued Accounting Standards



In January 2003, the Financial Accounting Standards Board (FASB) issued FASB Interpretation No. 46 (FIN 46), Consolidation of Variable Interest Entities. FIN 46 requires a variable interest entity to be
consolidated by a company if that company is subject to a majority of the risk of loss from the variable interest entitys activities or entitled to receive a majority of the entitys residual returns or both. A variable interest entity is
an entity that (i) does not have equity investors with voting rights or (ii) has equity investors that do not provide sufficient financial resources to the entity to support its activities. FIN 46 is effective immediately for all new variable
interest entities created or acquired after January 31, 2003. For variable interest entities created or acquired prior to February 1, 2003, the provisions of FIN 46 must be applied for the first interim or annual period beginning after December 15,
2003. The Company is evaluating the adoption of FIN 46 and its impact on the Companys financial statements.



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, 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, and capital requirements, all of which are prospective. Such statements are only predictions and
reflect our expectations and assumptions as of the date of this report based on currently available operating, financial, and competitive information. The actual events or results may differ materially from those projected in such forward-looking
statements due to a number of factors, including 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, our ability to enter into and/or maintain collaboration and joint venture agreements, our ability to commercialize products directly and through our collaborators, the timing of
anticipated product launches, and the development or availability of competitive products or technologies 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.



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The following information should be read in conjunction with the condensed financial statements and the notes thereto
included in Item 1 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, 2002, 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 products from genes and gene
pathways. We are directing our integrated portfolio of technologies to the discovery, evolution, and production of commercially valuable molecules with pharmaceutical applications, such as monoclonal antibodies and orally active drugs, as well as
enzymes and small molecules with agricultural, chemical, and industrial applications. To date, we have formed alliances with market leaders, such as The Dow Chemical Company, DuPont Bio-Based Materials, GlaxoSmithKline plc, Invitrogen Corporation,
and affiliates of Syngenta AG. Our product-related revenues to date are comprised of research kits, enzymes used in oil and gas recovery, a phytase feed enzyme, and royalties from sales of licensed products.



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.



In February 2003, we completed a series of transactions with Syngenta. Under the transactions, we formed an extensive research collaboration whereby we are entitled to receive a minimum of $118 million in research and
development funding over the initial seven-year term of the agreement and will be eligible to receive certain milestone payments and royalties upon product development and commercialization. Additionally, we acquired certain intellectual property
rights licenses used in activities that primarily involve tools, technologies and methods relating to proteomics, metabolomics, RNA dynamics, and bioinformatics and methods to analyze and link these components of genomics or that primarily relate to
their fungal program, for use outside of Syngentas exclusive field as defined in the research collaboration agreement. We also purchased certain property and equipment.



In July 2003, we acquired an antifungal program consisting of preclinical compounds from Glaxo Wellcome, S.A. In consideration for the
antifungal program, we issued an aggregate of 806,873 shares of our Common Stock to Glaxo Group Limited, an affiliate of Glaxo Wellcome, S.A. Under the terms of the agreement, we received worldwide rights to the program, which consists of
preclinical antifungal compounds and lead candidates for development, marketing, and distribution.



For the quarter ended September 30, 2003, revenue increased 37% compared to the quarter ended September 30, 2002. This increase was primarily attributable to additional research funding as a result of our most recent
collaboration agreement with Syngenta, increased grant revenue, and new product revenue.



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 and grants. Our strategic partners often pay us before we recognize the revenue, and these payments are deferred until earned. As of September 30, 2003, we had current and long-term deferred revenue totaling $12.6 million.



We have incurred net losses since our inception. As of September 30, 2003, our
accumulated deficit was $162.6 million. We expect to incur additional losses at least through 2005 as we continue to develop independent products and as a result of our anticipated investment in additional preclinical and clinical infrastructure, as
well as added research and manufacturing development expenses for our internal product candidates. 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 acquisition of new technologies and proprietary rights. Results of operations for any period may be unrelated to
results of operations for any other period. In addition, we believe that our historical results are not a good indicator of our future operating results.



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Results of Operations



Three Months Ended September 30, 2003 and 2002



Revenue



Revenue increased $3.0 million to $11.2 million for the quarter ended September 30, 2003 from $8.2 million for the same period in 2002. This increase was primarily due to our latest collaboration with Syngenta,
increased grant revenue, and new product revenue. 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. Revenue from collaborations accounted for 83% and 94% of total revenue for the quarters ended September 30, 2003 and 2002, respectively.



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 project. However, we generally do not track our other research and development costs by project; rather, we
track such costs by the type of cost incurred.



For the quarter ended September
30, 2003, we estimate that 50% of our research and development expenditures were related to research activities funded by our collaborators and that approximately 50% were associated with internal product and technology development. Our research and
development expenses increased $6.6 million to $18.8 million for the quarter ended September 30, 2003 from $12.2 million for the quarter ended September 30, 2002. The increase was primarily due to costs associated with the following:



Personnel Costs.Costs for research and development personnel for the quarter ended
September 30, 2003 increased by $2.6 million over the quarter ended September 30, 2002. Our research staff increased from 224 at September 30, 2002 to 305 at September 30, 2003. The increase in research staff was primarily related to us hiring 71
additional researchers in conjunction with the February 2003 Syngenta transactions.



Facility Costs.Facility costs for the quarter ended September 30, 2003 increased $2.2 million over the quarter ended September 30, 2002. The increase was primarily attributable to higher depreciation and maintenance costs as a
result of increased capital equipment to support our additional researchers and internal product and technology development.



Research Supplies Costs.Costs for research supplies for the quarter ended September 30, 2003 increased by $0.8 million over the quarter ended September 30, 2002.
The increase was primarily attributable to an increase in the amount of supplies required to support the additional 71 researchers we hired in conjunction with the February 2003 Syngenta transactions.



Write-off of Acquired In-Process Research and Development



For the three months ended September 30, 2003, in connection with our July 2003
acquisition of an antifungal program from Glaxo Wellcome, S.A., we recorded a write-off of acquired in-process research and development of approximately $8.7 million related to the estimated fair value of compounds and lead candidates that, as of
the acquisition date, had not reached technological feasibility and had no alternative future use.



Selling, General and Administrative Expenses



Selling, general and administrative expenses increased $0.5 million to $3.3 million for the quarter ended September 30, 2003 from $2.8 million for the same period in
2002. This increase was primarily attributable to headcount costs to support our growth, as well as measures undertaken by us to implement new corporate governance initiatives required of public companies.



Amortization of Acquired Intangible Assets



For the quarter ended September 30, 2003, we recorded amortization of acquired intangible
assets of approximately $0.6 million, compared to $39,000 for the quarter ended September 30, 2002. The increase was associated with the February 2003 acquisition of intellectual property rights licenses from Syngenta.



Interest and Other Income, Net



Interest and other income, net for the quarter ended September 30, 2003 was $0.6 million,
compared to $0.9 million for the same period in 2002. During the quarter ended September 30, 2002, we recorded $0.4 million of other expense associated with the write-off of the remaining balance of our investment in warrants we hold to purchase
58,333 shares of stock of IntraBiotics Pharmaceuticals, Inc., following a 1-for-12 reverse stock split by IntraBiotics. Interest income decreased for the quarter ended September 30, 2003, compared to the same period in 2002, as a result of the
maturity of interest-earning investments that were reinvested at the current lower rates, as well as lower cash balances.



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Equity in Loss of Joint Venture



For the three months ended September 30, 2003, we recorded no equity in the loss of Innovase LLC, our industrial enzymes joint venture with
Dow, compared to $0.7 million for the three months ended September 30, 2002. This decrease was as a result of our signing of a non-binding term sheet in July 2003 with Dow agreeing, in principle, to restructure our Innovase joint venture. We will
continue to collaborate with Dow on specific projects in the industrial enzyme field as well as on other projects of mutual interest. The restructuring of Innovase LLC and the modifications to the other agreements between the parties are subject to
our entering into binding agreements with Dow consistent with the non-binding term sheet. Under the proposed restructuring, we expect to continue to develop several enzymes in Innovases current pipeline. As part of the restructuring, Dow has
agreed to make payments to us totaling $5.0 million, of which $2.0 million was received in July 2003.



Nine Months Ended September 30, 2003 and 2002



Revenue



Revenue increased $7.0 million
to $29.6 million for the nine months ended September 30, 2003 from $22.6 million for the same period in 2002. This increase was primarily due to our most recent collaboration with Syngenta, increased grant revenue, and new product revenue. Revenue
from collaborations accounted for 87% and 97% of total revenue for the nine months ended September 30, 2003 and 2002, respectively.



Research and Development Expenses



For the nine months ended September 30, 2003, we estimate that approximately 45% of our research and development expenditures were associated with research activities
funded by our collaborators and that 55% were related to internal product and technology development. Our research and development expenses increased $16.3 million to $53.3 million for the nine months ended September 30, 2003 from $37.0 million for
the nine months ended September 30, 2002. The increase was primarily due to costs associated with the following:



Personnel Costs.Costs for research and development personnel for the nine months ended September 30, 2003 increased by $6.4 million over the nine months ended
September 30, 2002. Our research staff increased from 224 at September 30, 2002 to 305 at September 30, 2003. The increase in research staff was primarily related to us hiring 71 additional researchers in conjunction with the February 2003 Syngenta
transactions.



Facility Costs.Facility costs for the nine months ended
September 30, 2003 increased $6.0 million over the nine months ended September 30, 2002. The increase was primarily attributable to higher depreciation and maintenance costs as a result of increased capital equipment to support our headcount growth
and our internal product and technology developments, as well as costs related to our second research and development facility, which we began to occupy in April 2002.



Outside Services Costs.Outside services costs for the nine months ended September 30, 2003 increased $1.0 million over the nine
months ended September 30, 2002. The increase was primarily attributable to increased legal costs associated with protecting our intellectual property portfolio.



Research Supplies Costs.Costs for research supplies for the nine months ended September 30, 2003 increased by $1.7 million over the
nine months ended September 30, 2002. The increase was primarily attributable to an increase in the amount of supplies required to support the additional 71 researchers we hired in conjunction with the February 2003 Syngenta transactions.



Write-off of Acquired In-Process Research and Development



For the nine months ended September 30, 2003, we recorded a write-off of
acquired in-process research and development of approximately $19.5 million. Of this amount, $10.8 million related to our February 2003 acquisition of intellectual property rights licenses from Syngenta and property and equipment from TMRI, and $8.7
million related to the acquisition of an antifungal program from GlaxoSmithKline in July 2003.



Selling, General and Administrative Expenses



Selling, general and administrative expenses increased $1.1 million to $9.1 million for the nine months ended September 30, 2003 from $8.0 million for the same period in 2002. This increase was primarily attributable to headcount costs to
support our growth, as well as measures undertaken by us to implement new corporate governance initiatives required of public companies.



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Amortization of Acquired Intangible Assets



For the nine months ended September 30, 2003, we recorded amortization of acquired
intangible assets of approximately $1.6 million, compared to $0.1 million for the nine months ended September 30, 2002. The increase was associated with the February 2003 acquisition of intellectual property rights licenses from Syngenta.



Interest and Other Income, Net



Interest and other income, net for the nine months ended September 30, 2003 was $2.1
million, compared to $3.1 million for the same period in 2002. This decrease was primarily due to lower interest income as a result of the maturity of interest earning investments that were reinvested at the current lower rates, as well as lower
cash balances. Additionally, during the nine months ended September 30, 2002, we recorded $0.9 million of other expense related to the write-off of the remaining balance of our investment in warrants we hold to purchase 58,333 shares of stock of
IntraBiotics Pharmaceuticals, Inc., following a 1-for-12 reverse stock split by IntraBiotics.



Equity in Loss of Joint Venture



Equity
in the loss of Innovase LLC, our joint venture with Dow, decreased to $1.3 million for the nine months ended September 30, 2003 from $1.7 million for the same period in 2002. This decrease was as a result of us signing a non-binding term sheet in
July 2003 with Dow agreeing, in principle, to restructure our Innovase joint venture. We will continue to collaborate with Dow on specific projects in the industrial enzyme field as well as on other projects of mutual interest. The restructuring of
Innovase LLC and the modifications to the other agreements between the parties are subject to our entering into binding agreements with Dow consistent with the non-binding term sheet. Under the proposed restructuring, we expect to continue to
develop several enzymes in Innovases current pipeline. As part of the restructuring, Dow has agreed to make payments to us totaling $5.0 million, of which $2.0 million was received in July 2003.



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 funding from grants have provided us with $139.9 million in funding from our inception through September 30, 2003, and are also committed to fund
at least an additional $121.2 million through 2010, giving effect to the Innovase restructuring discussed below and subject to our performance under existing agreements, and excluding milestone payments, license and commercialization fees, and
royalties or profit sharing. As discussed in our Annual Report on Form 10-K for the year ended December 31, 2002, we had initiated informal dispute resolutions with Dow under our Innovase joint venture agreements due to differing views regarding
product development activities, commercial opportunities, and funding obligations under such agreements. In July 2003, we signed a non-binding term sheet with Dow agreeing, in principle, to restructure Innovase and make modifications to certain
other agreements between the parties. We will continue to collaborate with Dow on specific projects in the industrial enzyme field as well as on other projects of mutual interest. The restructuring of Innovase LLC and the modifications to the other
agreements between the parties are subject to our entering into binding agreements with Dow consistent with the non-binding term sheet. Under the proposed restructuring, we will continue to develop several enzymes in Innovases current
pipeline. We expect to commercialize at least one of these industrial enzyme product candidates in 2004. As part of the restructuring, Dow has agreed to make payments to us totaling $5.0 million, of which $2.0 million was received in July 2003.



As of September 30, 2003, we had cash, cash equivalents, and short-term
investments of approximately $130.8 million. Our short-term investments as of such date consisted 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. In December 2002, we entered into a new equipment financing line of credit with a lender to finance up to $6.0 million in equipment purchases through
September 2003. As of September 30, 2003, we had utilized all amounts under the existing arrangement.



During 2002, we entered into a manufacturing agreement with a company 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. As of September 30, 2003, we had incurred costs of approximately $2.3 million for equipment related to the manufacturing agreement. During the remainder of 2003, we anticipate
funding approximately $1.7 million in additional equipment costs related to the manufacturing agreement. Additionally, as we continue to develop our pharmaceutical platforms, we will be required to purchase additional capital equipment. During the
remainder of 2003, we anticipate that we will purchase approximately $0.5 million of equipment related to the development of our pharmaceutical platforms.



In February 2003, in conjunction with a series of transactions entered into with Syngenta and its affiliates, we hired an additional 77 employees. We anticipate the
capital equipment required to integrate these employees, as well as the equipment required to support the ongoing needs of our existing employees, will be approximately $1.9 million for the remainder of 2003.



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We anticipate funding our capital requirements for the remainder of 2003 with new financing arrangements, if available on
satisfactory terms, and with available cash.



In July 2003, we acquired an
antifungal program consisting of preclinical compounds from Glaxo Wellcome, S.A. In consideration for the antifungal program, we issued approximately $8.7 million of our common stock to Glaxo Group Limited, an affiliate of Glaxo Wellcome, S.A. Under
the terms of the agreement, we received worldwide rights to the program, which consists of preclinical antifungal compounds and lead candidates for development, marketing, and distribution. In order to successfully develop these pharmaceutical
candidates, we expect our investment in research and development, as well as the clinical infrastructure associated with these compounds, to increase over the next few years.



Our operating activities used cash of $24.9 million for the nine months ended September 30, 2003. Our cash used by operating activities
consisted primarily of cash used to fund our internal research and development programs.



Our investing activities provided cash of $13.4 million for the nine months ended September 30, 2003. Our investing activities consisted primarily of sales and maturities of short-term investments, offset by purchases
of short-term investments and property and equipment.



Our financing activities
used cash of $0.2 million for the nine months ended September 30, 2003. Our financing activities consisted primarily of borrowings under notes payable and proceeds from the sale of common stock under our Employee Stock Purchase Plan and from the
exercise of stock options, offset by payments on notes payable and capital leases.



The following table summarizes our contractual obligations at September 30, 2003 (in thousands).

|                                |  | Total |        | Less Than1 Year |   | 1-3 Years |  | 3-5 Years |        | After 5Years
|------------------------------- |  | ----- | ------ | --------------- | - | --------- |  | --------- | ------ | ------------
|Contractual Obligations         |  |       |        |                 |   |           |  |           |        |             
|Long-term debt                  |  | $     | 16,173 |                 | $ | 7,851     |  | $         | 7,798  |             
|Capital lease obligations       |  |       | 957    |                 |   | 644       |  |           | 313    |             
|Operating leases                |  |       | 65,354 |                 |   | 4,549     |  |           | 8,509  |             
|License and research agreements |  |       | 4,021  |                 |   | 1,148     |  |           | 1,768  |             
|                                |  |       |        |                 |   |           |  |           |        |             
|Total Contractual Obligations   |  | $     | 86,505 |                 | $ | 14,192    |  | $         | 18,388 |             
|                                |  |       |        |                 |   |           |  |           |        |             



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 the foreseeable future, 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.



Summary of Critical Accounting Policies



Our discussion and analysis of our financial condition and results of operations is based upon our financial statements, which have been prepared in accordance with
accounting principles generally accepted in the United States for interim financial information. The preparation of these 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 financial statements.



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Revenue Recognition



Revenue from research funding under our 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 project period. 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) 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. Revenue from exclusivity fees, technology
development fees, milestone payments, and research activities performed on behalf of our joint ventures is included in Collaborative revenue in our Statements of Operations. The percentage of completion basis of accounting requires us to
estimate the number of hours remaining to complete each of our research projects under our collaborative agreements. Actual results could differ from those estimates, which may affect the timing of the revenue we record from period to period.



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. In February 2003, we acquired intellectual property rights licenses from Syngenta and property and equipment from
TMRI. As a result of these transactions, we recorded approximately $8.2 million of property and equipment and approximately $54.9 million of acquired intangible assets. As of September 30, 2003, we had long-lived assets with a net book value of
$85.6 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 decrease our income in the period such determination was made.



Purchase Price Allocation



The purchase price for certain intellectual property rights licenses acquired from Syngenta and certain property and equipment acquired from 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.



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 $19.7 million for the quarter ended September 30,
2003. As of September 30, 2003, we had an accumulated deficit of approximately $162.6 million. We expect to incur additional losses at least through 2005 as we continue to develop independent products and as a result of our anticipated investment in
additional preclinical and clinical infrastructure, as well as added research and manufacturing development expenses for several Innovase product candidates. The extent of our future losses will depend, in part, on the rate of growth, if any, in our
contract revenue and on



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the level of our expenses. To date, substantially all of our revenue has been derived from collaborations and grants, and
we expect that substantially all of our revenue for 2003 will result from payments from collaborations and grants.



Future revenue from collaborations is uncertain because our ability to generate revenue will depend upon our ability to enter into new collaborations and to meet
research, development, and commercialization objectives under new and existing agreements. We expect to spend significant amounts to fund research and development and enhance our core technologies. As a result, we expect that our operating expenses
will increase in the near term, and, consequently, 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 our partners choose to commercialize and from which we can 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 two products ourselves, Pyrolase 160 enzyme and Pyrolase 200 enzyme, and only two of our collaborative partners, Invitrogen
Corporation and Danisco Animal Nutrition, have incorporated our technologies or inventions into their own commercial products from which we can generate royalties. 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 strategic alliance agreements and/or
collaboration agreements with The Dow Chemical Company, DuPont Bio-Based Materials, Givaudan Flavors Corporation, GlaxoSmithKline plc, Invitrogen Corporation, and affiliates of Syngenta AG. We have also formed a joint venture with Syngenta Seeds AG
(named Zymetrics, Inc.). We expect to derive significant future revenue from these agreements and the joint venture. 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 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. As discussed in our Annual Report on Form 10-K for the year ended December 31, 2002, we
had initiated informal dispute resolutions with Dow under our Innovase joint venture agreements due to differing views regarding product development activities, commercial opportunities, and funding obligations under such agreements. In July 2003,
we signed a non-binding term sheet with Dow agreeing, in principle, to restructure Innovase and make modifications to certain other agreements between the parties. The restructuring of Innovase LLC and the modifications to the other agreements
between the parties are subject to our entering into binding agreements with Dow consistent with the non-binding term sheet. There can be no assurance that we will enter into binding agreements on terms consistent with the non-binding term sheet or
other terms that are acceptable to us that provide for resolution of the settlement discussions between us and Dow involving Innovase and other licensing matters. 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 we fail to enter into or maintain strategic alliance or collaboration agreements, or if any of these events
occur, 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;
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------



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



| |  |  | Our strategic partners or collaborators become competitors of ours or enter into 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.
| | - |  | ---------------------------------------------------------------------------------



If we are not successful in developing a commercial pharmaceutical product related to our recent acquisition of an antifungal program
from Glaxo Wellcome, S.A., some of the anticipated benefits of the acquisition may not be realized.



The process of developing a commercial pharmaceutical product from the antifungal compounds we recently acquired from Glaxo Wellcome, S.A. 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:



| |  |  | The results of additional preclinical studies that we intend to undertake may be inconclusive, or they may not be indicative of results that will be obtained in human clinical
trials;
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | 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 indicative of results that are obtained in later clinical trials; and
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | The effects our antifungal compounds have may not be the desired effects or may include undesirable side effects or other characteristics that preclude regulatory approval or limit
their 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, the anticipated benefits of our acquisition of the antifungal program would not be realized.



Failure to retain former employees of TMRI or attract and retain other key employees could
diminish the benefits we expect to realize from our recent transactions with Syngenta and TMRI.



As part of the transactions among Syngenta, TMRI, and us that were consummated on February 20, 2003, we hired 77 employees of TMRI. The success of our collaboration with Syngenta and the benefits that we otherwise
expect to realize from our transactions with Syngenta and TMRI will depend significantly on our ability to retain these employees. If we are unable to retain these employees, or if we are otherwise unable to attract and retain other employees who
may be critical to our collaboration with Syngenta or otherwise in connection with our transactions with Syngenta and TMRI, we could lose key information, expertise or know-how related to the collaboration, incur unanticipated additional recruiting
and training costs and otherwise not realize the benefits we expect from those transactions.



If we are not successful in integrating TMRIs intellectual property rights and related assets, some of the anticipated benefits to us of our recent transactions with Syngenta and TMRI may not be realized.



If we and our stockholders are to realize the anticipated benefits of our
transactions with Syngenta and TMRI that were consummated on February 20, 2003, the intellectual property rights and related assets we licensed and acquired from Syngenta and TMRI must be integrated and combined efficiently with our own assets and
operations. We cannot assure you that the integration will be successful or that we will realize the anticipated benefits of our transactions with Syngenta and TMRI. Similarly, we cannot assure you that our stockholders will realize greater value
through our transactions with Syngenta and TMRI than they would have realized without them.



The difficulties of integration may be increased by the need to integrate personnel with disparate scientific, technical and business backgrounds and combine different corporate cultures and approaches. We cannot
assure you that there will not be substantial costs



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associated with the integration process, that integration activities will not negatively impact our operating results or
result in a decrease in the value of our common stock, or that there will not be other material adverse effects to our business or operations from our integration efforts.



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 large-scale manufacturing equipment and available capacity to manufacture Pyrolase 160 enzyme, Pyrolase 200 enzyme, and Phyzyme XP 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. 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.



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.



Ethical, legal, 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 ethical, legal, 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



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in 2007 or earlier, and they are all subject to earlier termination. We have voluntarily ceased collections of further
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, a lack 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, may block our ability to commercialize products in these countries if we are unsuccessful in circumventing or acquiring the rights to these patents. There also may
be claims in published patent applications in some countries that, if granted and valid, may also block our ability to commercialize products in these countries if we are unable to circumvent or license them.



We are not currently a party to any litigation with regard to our patent portfolio. 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 United States 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 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. We increased the number of our full-time employees from 284 at September 30, 2002 to 358 at September 30, 2003. We expect to continue to increase our headcount to meet our strategic objectives. If our growth continues, it may continue to
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. These measures



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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 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.



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, Cubist Pharmaceuticals, Inc. is involved in
accessing organisms from diverse environments for pharmaceutical applications. A number of companies are performing high-throughput screening of molecules. Maxygen, Inc., Applied Molecular Evolution, Inc., and Evotech have alternative evolution
technologies. Integrated Genomics, Inc., Myriad Genetics, Inc., ArQule, Inc., and Vertex Pharmaceuticals (San Diego) LLC, formerly known as Aurora Biosciences Corporation, a subsidiary of Vertex Pharmaceuticals Inc., perform screening, sequencing,
and/or bioinformatics services. Novozymes A/S and Genencor International, Inc. are involved in the development, overexpression, fermentation, and purification of enzymes. Abgenix, Inc. and Medarex, Inc. are involved in the development of human
monoclonal antibodies. 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.



In the United States, products for our target markets are regulated based on their
application, by either the Food and Drug Administration, or 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, we are now conducting 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



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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 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 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 EU attempts to replace country
by country regulatory procedures with a consistent EU regulatory standard in each case. Some country-by-country regulatory oversight remains. Other than Japan, most regions of the world generally find adequate either a 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 will be sufficient to
meet our capital requirements for the foreseeable future.



However, our capital
requirements depend on several factors, including:



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



| |  |  | 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. For example, our revenue for the quarter ended September 30, 2003 was $11.2 million, as compared to $8.2 million for the quarter
ended September 30, 2002. 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 of strategic alliances and collaborations;
| | - |  | ------------------------------------------------------



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



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



| |  |  | 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 or termination of
strategic alliance or collaboration agreements, failure to obtain new agreements or grants, lower than expected royalty payments, or other factors, we may not be able to correspondingly reduce our operating expenses. A large portion of our expenses,
including expenses for facilities, equipment and personnel, are relatively fixed. In addition, we plan to continue to increase operating expenses during 2003. 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 or 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 additional acquisitions, we will incur a variety of costs and may
potentially face numerous other risks that could adversely affect our business operations.



In July 2003, we acquired an antifungal program consisting of preclinical compounds from Glaxo Wellcome S.A., and in February 2003, we consummated a series of transactions with Syngenta and TMRI that involved, in
part, our acquiring certain property and equipment from TMRI. If appropriate opportunities become available, we may consider acquiring additional businesses, assets, technologies, or products 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.
| | - |  | -------------------



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We may not be able to successfully integrate any businesses, assets, products, technologies, 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.



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 take-over 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 because of the industry we are in.



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 existing officers, directors and principal stockholders may prevent other stockholders from influencing significant corporate
decisions and depress our stock price.



Our officers, directors, and
stockholders with at least 5% of our stock together controlled approximately 44.3% of our outstanding common stock as of November 3, 2003. 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



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election of directors and approval of mergers or other business combination transactions. In addition, as of November 3,
2003, Syngenta and its affiliates controlled approximately 18.5% 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, officers, directors, and principal stockholders, acting together, could cause us to enter
into transactions or agreements that we would not otherwise consider. Similarly, this 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. 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. 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
our 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, 2003 and December 31, 2002 by $1.0 million and $1.4 million, respectively. Declines in interest rates over time will reduce our interest income, while increases in interest rates over
time will increase our interest expense.



Item 4. Controls and Procedures



Evaluation of
Disclosure Controls and Procedures. Our chief executive officer and chief financial officer have evaluated the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act
of 1934, as amended (the Exchange Act)), as of the end of the period covered by this report (the Evaluation Date). Based on such evaluation, such officers have concluded that, as of the Evaluation Date, our disclosure
controls and procedures were effective in alerting them on a timely basis to material information relating to us that is required to be included in our reports filed or submitted under the Exchange Act.



Changes in Internal Control over Financial Reporting. Our chief executive officer and
chief financial officer 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.



PART IIOTHER INFORMATION



Item 1. Legal Proceedings



On or about December 6,
2002, a lawsuit was filed in the U.S. District Court for the Southern District of New York against us, two of our executive officers and the chairman of our board of directors (collectively, the Diversa Defendants), and the underwriters
of our initial public offering (IPO). The complaint was purportedly filed on behalf of purchasers of our common stock between February 14, 2000, and December 6, 2000, and is captioned Muller v. Diversa Corp., et al., Case No. 02-CV-9699.
In the complaint, the plaintiffs allege that the Diversa Defendants and the underwriters of our IPO violated Sections 11 and 15 of the Securities Act of 1933



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based on allegations that our registration statement and prospectus failed to disclose material facts regarding the
compensation to be received by, and the stock allocation practices of, the IPO underwriters. The complaint also contains claims for violation of sections 10(b) and 20 of the Securities Exchange Act of 1934 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 Securities Litigation, Case No. 21 MC 92, in which similar complaints were filed against
hundreds of other public companies (Issuers) that conducted IPOs of their common stock in the late 1990s and 2000 (the IPO Cases). On January 7, 2003, this case 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 on the motion to dismiss filed by the Issuers (among others). In this decision, the Court denied the motion to dismiss the Section 11 and 15 claims against the Diversa
Defendants and almost all of the other Issuers, and granted the motion to dismiss the Section 10(b) claim against us. The Court dismissed the Section 10(b) claim against us without leave to amend. The Court similarly dismissed the Section 10(b) and
20 claims against one of our officers and the Chairman of our board of directors without leave to amend, but denied the motion to dismiss these claims against one of our officers.



In June 2003, Issuers and Plaintiffs reached a tentative settlement agreement that would, among other things, result in the dismissal with
prejudice of all claims against the Issuers and their officers and directors in the IPO Lawsuits. In addition, the tentative settlement guarantees that, in the event that the Plaintiffs recover less than $1 billion in settlement or judgment against
the Underwriter defendants in the IPO Lawsuits, the Plaintiffs will be entitled to recover the difference between the actual recovery and $1 billion from the insurers for the Issuers. Over 250 Issuers have indicated that they will enter into the
settlement proposal. In the event, for example, the Plaintiffs recover nothing in judgment against the Underwriter defendants in the IPO Lawsuits 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 $4 million, assuming that 250 Issuers which approved the settlement proposal, and their insurers, were operating and financially viable as of
the settlement date. We currently carry liability insurance which would cover our insurers pro rata liability described in this hypothetical. Although we have approved this settlement proposal in principle, it remains subject to a number of
procedural conditions, as well as formal approval by the Court.



Item 2. Changes in Securities and Use of Proceeds



On July 18, 2003, we acquired an antifungal program consisting of preclinical compounds from Glaxo Wellcome, S.A. In consideration for the antifungal program, we issued an aggregate of 806,873 shares of our Common Stock to Glaxo Group
Limited, an affiliate of Glaxo Wellcome, S.A. We issued the common stock to Glaxo Group Limited in reliance on the exemption from registration permitted under Regulation D of the Securities Act of 1933, as amended, based on investment
representations made by the Glaxo Group Limited.



Our Registration Statements
on Form S-1 (File Nos. 333-92853 and 333-30290) relating to the initial public offering of our common stock 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 $184.7 million after underwriting discounts and expenses. Of the net offering proceeds, through September 30, 2003, approximately $19.7 million of the net proceeds had been used to purchase
property and equipment and approximately $34.2 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.



Item 4. Submission of Matters to a Vote of Securities Holders



None.



Item 5. Other Information



None.



Item 6. Exhibits and Reports on Form 8-K



(a)



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##### Table of Contents

|ExhibitNumber |  | 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.(5)                                                                                                                                                                                                                                                                   
|              | 
|4.4           |  | The Companys Certificate of Designation of Series A Junior Participating Preferred Stock.(3)                                                                                                                                                                                                                                                                                                                                     
|              | 
|4.5           |  | Warrant issued by the Company to Syngenta Participations AG.(4)                                                                                                                                                                                                                                                                                                                                                                   
|              | 
|4.6           |  | Registration Rights Agreement dated as of December 3, 2002 among Syngenta Participations AG, Torrey Mesa Research Institute,
Syngenta Seeds AG and the Company.(4)                                                                                                                                                                                                                                                                
|              | 
|4.7          |  | Registration Rights Agreement dated as of July 18, 2003 by and between Glaxo Group Limited and the
Company.(6)                                                                                                                                                                                                                                                                                                                    
|              | 
|10.46        |  | Asset Sale Agreement made as of July 18, 2003 by and between Glaxo Wellcome, S.A. and the Company.(6)                                                                                                                                                                                                                                                                                                                             
|              | 
|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 (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 January 6, 2003, 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 December 4, 2002, and incorporated herein by reference
|--- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(6) |  | Filed as an exhibit to the Companys Quarterly Report on Form 10-Q for the quarter ended June 30, 2003, filed with the Securities and Exchange Commission on August 14, 2003,
and incorporated herein by reference.
|--- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | Confidential treatment has been requested with respect to portions of this exhibit. A complete copy of the agreement, including the redacted terms, has been separately filed with
the Securities and Exchange Commission.
|- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



(b) We filed a Current
Report on Form 8-K on July 22, 2003 to file as an exhibit the Companys press release announcing financial results for the quarter ended June 30, 2003 pursuant to Item 12. Results of Operations and Financial Condition of Form 8-K in
accordance with SEC Release Nos. 33-8216 and 34-47583.



We filed a Current
Report on Form 8-K on July 28, 2003 to file as an exhibit the Companys press release announcing that the Company had acquired an antifungal program consisting of preclinical compounds from Glaxo Wellcome, S.A., a corporation organized under
the laws of Spain, pursuant to an Asset Sale Agreement dated July 18, 2003.



25



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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: November 13, 2003 |  |  |  | /s/    KARIN EASTHAM
|                        |  |  |  |                     



26