##### Table of Contents

---

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549



---



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, 2004.



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



Commission File number 000-29173



---



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
October 22, 2004 was 43,683,517.



---



---

##### Table of Contents

DIVERSA CORPORATION

INDEX



|                               |  |                                                                                                    |  |         
|------------------------------ |  | -------------------------------------------------------------------------------------------------- |  | --------
|                               |  |                                                                                                    |  | Page No.
|PART I -
FINANCIAL INFORMATION |  |                                                                                                   
|                               |  |                                                                                                   
|Item 1.                        |  | Financial Statements (Unaudited)                                                                   |  |         
|                               |  |                                                                                                   
|                               |  | Condensed Balance Sheets as of September 30, 2004 and December 31, 2003                            |  | 3       
|                               |  | Condensed Statements of Operations for the three and nine months ended September 30, 2004 and 2003 |  | 4       
|                               |  | Condensed Statements of Cash Flows for the nine months ended September 30, 2004 and 2003           |  | 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                                         |  | 21      
|                               |  |                                                                                                   
|Item 4.                        |  | Controls and Procedures                                                                            |  | 21      
|                               | 
|PART II -
OTHER INFORMATION    |  |                                                                                                   
|                               |  |                                                                                                   
|Item 1.                        |  | Legal Proceedings                                                                                  |  | 21      
|Item 2.                        |  | Unregistered Sales of Equity Securities and Use of Proceeds                                        |  | 22      
|Item 3.                        |  | Defaults Upon Senior Securities                                                                    |  | 22      
|Item 4.                        |  | Submission of Matters to a Vote of Securities Holders                                              |  | 22      
|Item 5.                        |  | Other Information                                                                                  |  | 22      
|Item 6.                        |  | Exhibits and Reports on Form 8-K                                                                   |  | 22      
|                               |  |                                                                                                   
|SIGNATURES                     |  |                                                                                                    |  | 24      



2



---

##### Table of Contents

DIVERSA CORPORATION



PART I - FINANCIAL INFORMATION



Item 1. Financial Statements



DIVERSA CORPORATION

CONDENSED BALANCE SHEETS

(In thousands, except share and per share data)



|                                                                                                                                                                                |  |                   |          |   |                  |   |          |  
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ----------------- | -------- | - | ---------------- | - | -------- | -
|                                                                                                                                                                                |  | SEPTEMBER 30,2004 |          |   | DECEMBER 31,2003 |  
|                                                                                                                                                                                |  | (Unaudited)       |          |   | (Note)           |  
|ASSETS                                                                                                                                                                          |  |                   |          |   |                  |   |          |  
|Current assets:                                                                                                                                                                 |  |                   |          |   |                  |   |          |  
|Cash and cash equivalents                                                                                                                                                       |  | $                 | 22,088   |   |                  | $ | 20,506   |  
|Short-term investments                                                                                                                                                          |  |                   | 75,711   |   |                  |   | 106,977  |  
|Accounts receivable                                                                                                                                                             |  |                   | 4,359    |   |                  |   | 5,416    |  
|Other current assets                                                                                                                                                            |  |                   | 4,222    |   |                  |   | 1,459    |  
|                                                                                                                                                                                |  |                   |          |   |                  |   |          |  
|Total current assets                                                                                                                                                            |  |                   | 106,380  |   |                  |   | 134,358  |  
|Property and equipment, net                                                                                                                                                     |  |                   | 28,684   |   |                  |   | 32,123   |  
|Acquired intangible assets, net                                                                                                                                                 |  |                   | 48,502   |   |                  |   | 52,406   |  
|Other assets                                                                                                                                                                    |  |                   | 2,125    |   |                  |   | 2,436    |  
|                                                                                                                                                                                |  |                   |          |   |                  |   |          |  
|Total assets                                                                                                                                                                    |  | $                 | 185,691  |   |                  | $ | 221,323  |  
|                                                                                                                                                                                |  |                   |          |   |                  |   |          |  
|                                                                                                                                                                                |  |                  
|LIABILITIES AND STOCKHOLDERS EQUITY                                                                                                                                            |  |                   |          |   |                  |   |          |  
|Current liabilities:                                                                                                                                                            |  |                   |          |   |                  |   |          |  
|Accounts payable                                                                                                                                                                |  | $                 | 1,643    |   |                  | $ | 2,753    |  
|Accrued liabilities                                                                                                                                                             |  |                   | 5,441    |   |                  |   | 5,829    |  
|Deferred revenue                                                                                                                                                                |  |                   | 2,112    |   |                  |   | 11,314   |  
|Current portion of capital lease obligations                                                                                                                                    |  |                   | 300      |   |                  |   | 513      |  
|Current portion of notes payable                                                                                                                                                |  |                   | 9,786    |   |                  |   | 9,340    |  
|                                                                                                                                                                                |  |                   |          |   |                  |   |          |  
|Total current liabilities                                                                                                                                                       |  |                   | 19,282   |   |                  |   | 29,749   |  
|Capital lease obligations, less current portion                                                                                                                                 |  |                   |         |   |                  |   | 190      |  
|Notes payable, less current portion                                                                                                                                             |  |                   | 9,655    |   |                  |   | 9,941    |  
|                                                                                                                                                                                |  |                  
|Stockholders equity:                                                                                                                                                           |  |                   |          |   |                  |   |          |  
|Common stock, $0.001 par value, 90,000,000 shares authorized, 43,686,687 and 43,051,027 shares issued and outstanding at September 30, 2004
and December 31, 2003, respectively |  |                   | 44       |   |                  |   | 43       |  
|Additional paid-in capital                                                                                                                                                      |  |                   | 351,402  |   |                  |   | 348,279  |  
|Accumulated deficit                                                                                                                                                             |  |                   | (194,470 | ) |                  |   | (167,072 | )
|Accumulated other comprehensive income (loss)                                                                                                                                   |  |                   | (222     | ) |                  |   | 193      |  
|                                                                                                                                                                                |  |                   |          |   |                  |   |          |  
|Total stockholders equity                                                                                                                                                      |  |                   | 156,754  |   |                  |   | 181,443  |  
|                                                                                                                                                                                |  |                   |          |   |                  |   |          |  
|Total liabilities and stockholders equity                                                                                                                                      |  | $                 | 185,691  |   |                  | $ | 221,323  |  
|                                                                                                                                                                                |  |                   |          |   |                  |   |          |  



Note: The balance sheet at December
31, 2003 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.



3



---

##### Table of Contents

CONDENSED STATEMENTS OF OPERATIONS

(In thousands, except per share data)

(Unaudited)



|                                                                               |  |                                 |        |   |                                |   |         |      |  |   |         |   |  |   |         |  
|------------------------------------------------------------------------------ |  | ------------------------------- | ------ | - | ------------------------------ | - | ------- | ---- |  | - | ------- | - |  | - | ------- | -
|                                                                               |  | Three Months EndedSeptember 30, |        |   | Nine Months EndedSeptember 30, |  
|                                                                               |  | 2004                            |        |   | 2003                           |   |         | 2004 |  |   | 2003    |  
|Revenues:                                                                      |  |                                 |        |   |                                |   |         |      |  |   |         |   |  |   |         |  
|Collaborative revenue                                                          |  | $                               | 8,383  |   |                                | $ | 9,345   |      |  | $ | 28,184  |   |  | $ | 25,867  |  
|Grant revenue                                                                  |  |                                 | 2,638  |   |                                |   | 974     |      |  |   | 7,478   |   |  |   | 2,170   |  
|Product-related revenue                                                        |  |                                 | 1,875  |   |                                |   | 899     |      |  |   | 3,753   |   |  |   | 1,554   |  
|                                                                               |  |                                 |        |   |                                |   |         |      |  |   |         |   |  |   |         |  
|Total revenues                                                                 |  |                                 | 12,896 |   |                                |   | 11,218  |      |  |   | 39,415  |   |  |   | 29,591  |  
|                                                                               |  |                                 |        |   |                                |   |         |      |  |   |         |   |  |   |         |  
|Expenses:                                                                      |  |                                 |        |   |                                |   |         |      |  |   |         |   |  |   |         |  
|Cost of goods sold                                                             |  |                                 | 959    |   |                                |   | 1,252   |      |  |   | 2,164   |   |  |   | 1,804   |  
|Research and development                                                       |  |                                 | 17,748 |   |                                |   | 17,562  |      |  |   | 53,691  |   |  |   | 51,483  |  
|Write-off of acquired in-process research and development                      |  |                                 |       |   |                                |   | 8,714   |      |  |   |        |   |  |   | 19,478  |  
|Selling, general and administrative                                            |  |                                 | 2,792  |   |                                |   | 3,266   |      |  |   | 9,233   |   |  |   | 9,141   |  
|Amortization of acquired intangible assets                                     |  |                                 | 650    |   |                                |   | 649     |      |  |   | 1,952   |   |  |   | 1,600   |  
|Non-cash, stock-based compensation                                             |  |                                 |       |   |                                |   | 20      |      |  |   |        |   |  |   | 129     |  
|                                                                               |  |                                 |        |   |                                |   |         |      |  |   |         |   |  |   |         |  
|Total operating expenses                                                       |  |                                 | 22,149 |   |                                |   | 31,463  |      |  |   | 67,040  |   |  |   | 83,635  |  
|                                                                               |  |                                 |        |   |                                |   |         |      |  |   |         |   |  |   |         |  
|Loss from operations                                                           |  |                                 | (9,253 | ) |                                |   | (20,245 | )    |  |   | (27,625 | ) |  |   | (54,044 | )
|                                                                               |  |                                 |        |  
|Interest and other income, net                                                 |  |                                 | 24     |   |                                |   | 562     |      |  |   | 226     |   |  |   | 2,096   |  
|Equity in loss of joint venture                                                |  |                                 |       |   |                                |   |        |      |  |   |        |   |  |   | (1,255  | )
|                                                                               |  |                                 |        |   |                                |   |         |      |  |   |         |   |  |   |         |  
|Net loss                                                                       |  | $                               | (9,229 | ) |                                | $ | (19,683 | )    |  | $ | (27,399 | ) |  | $ | (53,203 | )
|                                                                               |  |                                 |        |   |                                |   |         |      |  |   |         |   |  |   |         |  
|Basic and diluted net loss per share                                           |  | $                               | (0.21  | ) |                                | $ | (0.46   | )    |  | $ | (0.63   | ) |  | $ | (1.30   | )
|                                                                               |  |                                 |        |  
|Weighted average shares used in computing basic and diluted net loss per share |  |                                 | 43,505 |   |                                |   | 42,766  |      |  |   | 43,318  |   |  |   | 41,081  |  



See accompanying notes
to condensed financial statements.



4



---

##### Table of Contents

CONDENSED STATEMENTS OF CASH FLOWS

(In thousands)

(Unaudited)



|                                                                            |  |                            |         |   |      |   |          |  
|--------------------------------------------------------------------------- |  | -------------------------- | ------- | - | ---- | - | -------- | -
|                                                                            |  | NINE MONTHS ENDEDSEPTEMBER |        
|                                                                            |  | 2004                       |         |   | 2003 |  
|Operating activities:                                                       |  |                            |         |   |      |   |          |  
|Net loss                                                                    |  | $                          | (27,399 | ) |      | $ | (53,203  | )
|Adjustments to reconcile net loss to net cash used in operating activities: |  |                            |         |   |      |   |          |  
|Depreciation and amortization                                               |  |                            | 13,498  |   |      |   | 12,155   |  
|Non-cash, stock based compensation charges                                  |  |                            |        |   |      |   | 129      |  
|Write-off of acquired in-process research and development                   |  |                            |        |   |      |   | 19,478   |  
|Changes in operating assets and liabilities:                                |  |                            |         |   |      |   |          |  
|Accounts receivable                                                         |  |                            | 1,057   |   |      |   | 168      |  
|Other assets                                                                |  |                            | (2,451  | ) |      |   | (1,753   | )
|Accounts payable and accrued expenses                                       |  |                            | (1,498  | ) |      |   | (2,454   | )
|Deferred revenue                                                            |  |                            | (9,202  | ) |      |   | 548      |  
|                                                                            |  |                            |         |   |      |   |          |  
|Net cash used in operating activities                                       |  |                            | (25,995 | ) |      |   | (24,932  | )
|                                                                            |  |                            |         |   |      |   |          |  
|Investing activities:                                                       |  |                            |         |   |      |   |          |  
|Purchases of short-term investments                                         |  |                            | (39,256 | ) |      |   | (100,863 | )
|Sales and maturities of short-term investments                              |  |                            | 70,107  |   |      |   | 120,251  |  
|Purchases of property and equipment                                         |  |                            | (6,154  | ) |      |   | (5,758   | )
|Other                                                                       |  |                            |        |   |      |   | (270     | )
|                                                                            |  |                            |         |   |      |   |          |  
|Net cash provided by (used in) investing activities                         |  |                            | 24,697  |   |      |   | 13,360   |  
|                                                                            |  |                            |         |   |      |   |          |  
|Financing activities:                                                       |  |                            |         |   |      |   |          |  
|Net proceeds from sale of common stock                                      |  |                            | 3,124   |   |      |   | 1,731    |  
|Principal payments on capital leases                                        |  |                            | (403    | ) |      |   | (780     | )
|Principal payments on notes payable                                         |  |                            | (7,756  | ) |      |   | (4,973   | )
|Advances under notes payable                                                |  |                            | 7,915   |   |      |   | 3,794    |  
|                                                                            |  |                            |         |   |      |   |          |  
|Net cash provided by (used in) financing activities                         |  |                            | 2,880   |   |      |   | (228     | )
|                                                                            |  |                            |         |   |      |   |          |  
|Net increase (decrease) in cash and cash equivalents                        |  |                            | 1,582   |   |      |   | (11,800  | )
|Cash and cash equivalents at beginning of period                            |  |                            | 20,506  |   |      |   | 20,113   |  
|                                                                            |  |                            |         |   |      |   |          |  
|Cash and cash equivalents at end of period                                  |  | $                          | 22,088  |   |      | $ | 8,313    |  
|                                                                            |  |                            |         |   |      |   |          |  



See accompanying notes
to condensed financial statements.



5



---

##### Table of Contents

NOTES TO CONDENSED FINANCIAL STATEMENTS

(Unaudited)



1. Organization and Business



The Company is a leader in applying proprietary genomic technologies for the rapid discovery
and optimization of novel protein-based products, including (a) enzymes, which are catalytic proteins, (b) small molecules, made by pathways of proteins, and (c) antibodies, which are binding proteins. The Company is directing its integrated
portfolio of technologies to the discovery, evolution, and production of commercially valuable molecules with 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, 2003.



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. Revenue Recognition



Revenue from research funding under the Companys collaboration agreements is earned
and recognized on a percentage of completion basis as research hours are incurred in accordance with the provisions of each agreement. Fees received to initiate research projects are deferred and amortized over the life of the project. Fees received
for exclusivity in a field are deferred and recognized over the period of exclusivity. Milestone payments are recognized when earned, as evidenced by written acknowledgement from the collaborator, provided that (i) the milestone event is substantive
and its achievement was not reasonably assured at the inception of the agreement, and (ii) the Companys performance obligations after the milestone achievement will continue to be funded by the collaborator at a level comparable to the level
before the milestone achievement. Revenue from grants is recognized on a percentage of completion basis as related costs are incurred. Revenue from product sales is recognized at the time of shipment to the customer. Product-related revenue includes
product sales, manufacturing revenue, milestone and license payments related to commercialization of products, and royalties and profit sharing related to sales of products. The Company recognizes revenue only on payments that are non-refundable and
defers recognition until performance obligations have been completed.



During
the nine months ended September 30, 2004 and 2003, the Company had collaborative research agreements that accounted for 72% and 87%, respectively, of total revenue. Additionally, during the nine months ended September 30, 2004 and 2003, one
collaborator accounted for 63% and 68%, respectively, of total revenue.



4.
Computation of Net Loss Per Share



Basic and diluted net loss per share
has been computed using the weighted-average number of shares of common stock outstanding during the period.



6



---

##### Table of Contents

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





|                                                                               |  |                                 |        |   |                                |   |         |      |  |   |         |   |  |   |         |  
|------------------------------------------------------------------------------ |  | ------------------------------- | ------ | - | ------------------------------ | - | ------- | ---- |  | - | ------- | - |  | - | ------- | -
|                                                                               |  | THREE MONTHS ENDEDSEPTEMBER 30, |        |   | NINE MONTHS ENDEDSEPTEMBER 30, |  
|(In thousands, except per share data)                                          |  | 2004                            |        |   | 2003                           |   |         | 2004 |  |   | 2003    |  
|Net loss                                                                       |  | $                               | (9,229 | ) |                                | $ | (19,683 | )    |  | $ | (27,399 | ) |  | $ | (53,203 | )
|Net loss per share, basic and diluted                                          |  | $                               | (0.21  | ) |                                | $ | (0.46   | )    |  | $ | (0.63   | ) |  | $ | (1.30   | )
|Weighted average shares used in computing basic and diluted net loss per share |  |                                 | 43,505 |   |                                |   | 42,766  |      |  |   | 43,318  |   |  |   | 41,081  |  



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.



5. 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, 2004 and 2003, the comprehensive loss consisted of:



|                                      |  |                                 |        |   |                                |   |         |      |  |   |         |   |  |   |         |  
|------------------------------------- |  | ------------------------------- | ------ | - | ------------------------------ | - | ------- | ---- |  | - | ------- | - |  | - | ------- | -
|                                      |  | THREE MONTHS ENDEDSEPTEMBER 30, |        |   | NINE MONTHS ENDEDSEPTEMBER 30, |  
|(In thousands, except per share data) |  | 2004                            |        |   | 2003                           |   |         | 2004 |  |   | 2003    |  
|Net loss                              |  | $                               | (9,229 | ) |                                | $ | (19,683 | )    |  | $ | (27,399 | ) |  | $ | (53,203 | )
|Other comprehensive gain (loss):      |  |                                 |        |   |                                |   |         |      |  |   |         |   |  |   |         |  
|Unrealized gain (loss) on investments |  |                                 | 121    |   |                                |   | (457    | )    |  |   | (415    | ) |  |   | (1,110  | )
|                                      |  |                                 |        |   |                                |   |         |      |  |   |         |   |  |   |         |  
|Comprehensive loss                    |  | $                               | (9,108 | ) |                                | $ | (20,140 | )    |  | $ | (27,814 | ) |  | $ | (54,313 | )
|                                      |  |                                 |        |   |                                |   |         |      |  |   |         |   |  |   |         |  



6. 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, 2004 and 2003, the fair value of these options was estimated using the Black-Scholes
model with the following assumptions: risk-free interest rates ranging from 3.29% to 3.56% and 2.87% to 3.37%, respectively; dividend yield of 0%; volatility factor of 51% and 65%, respectively; and a weighted-average expected life of the options of
3.5 and 3.4 years respectively. For the nine months ended September 30, 2004 and 2003, the fair value of these options was estimated using the Black-Scholes model with the following assumptions: risk-free interest rates ranging from 2.65% to 3.96%
and 2.26% to 3.37%, respectively; dividend yield of 0%; volatility factor of 60%; and a weighted-average expected life of the options of 3.0 years and 3.4 years, respectively.



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:



|                                                                                                                |  |                                 |         |   |                                |   |         |      |  |   |         |   |  |   |         |  
|--------------------------------------------------------------------------------------------------------------- |  | ------------------------------- | ------- | - | ------------------------------ | - | ------- | ---- |  | - | ------- | - |  | - | ------- | -
|                                                                                                                |  | THREE MONTHS ENDEDSEPTEMBER 30, |         |   | NINE MONTHS ENDEDSEPTEMBER 30, |  
|(In thousands, except per share data)                                                                           |  | 2004                            |         |   | 2003                           |   |         | 2004 |  |   | 2003    |  
|Net loss, as reported                                                                                           |  | $                               | (9,229  | ) |                                | $ | (19,683 | )    |  | $ | (27,399 | ) |  | $ | (53,203 | )
|Add: Stock-based employee compensation expense included in reported net loss                                    |  |                                 |        |   |                                |   | 20      |      |  |   |        |   |  |   | 129     |  
|Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards |  |                                 | (2,322  | ) |                                |   | (2,266  | )    |  |   | (7,771  | ) |  |   | (6,669  | )
|                                                                                                                |  |                                 |         |   |                                |   |         |      |  |   |         |   |  |   |         |  
|Pro forma net loss                                                                                              |  | $                               | (11,551 | ) |                                | $ | (21,929 | )    |  | $ | (35,170 | ) |  | $ | (59,743 | )
|                                                                                                                |  |                                 |         |   |                                |   |         |      |  |   |         |   |  |   |         |  
|Basic and diluted net loss per share, as reported                                                               |  | $                               | (0.21   | ) |                                | $ | (0.46   | )    |  | $ | (0.63   | ) |  | $ | (1.30   | )
|Pro forma basic and diluted net loss per share                                                                  |  | $                               | (0.27   | ) |                                | $ | (0.51   | )    |  | $ | (0.81   | ) |  | $ | (1.45   | )



7



---

##### Table of Contents

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 and the related markets for our products, 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.



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, 2003, including the disclosures under the captions Managements Discussion and Analysis of Financial Condition and Results of Operations and Risk Factors Related to Our Business, as well
as the audited financial statements and notes thereto contained in such report.



Overview



We were incorporated in December 1992 and began
operations in May 1994. We are a leader in applying proprietary genomic technologies for the rapid discovery and optimization of novel protein-based products, including (a) enzymes, which are catalytic proteins, (b) small molecules, made by pathways
of catalytic proteins, and (c) antibodies, which are binding proteins. 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. While our technologies have the potential to serve many large markets, our key areas of focus for
internal product development are for the large markets in animal care, fiber processing, nutritional oils, and anti-infective therapies. In addition to our internal product development efforts, we have formed alliances with market leaders, such as
Amgen, BASF, Bayer Animal Health, The Dow Chemical Company, DSM Pharma Chemicals, Dupont Bio-Based Materials, Givaudan Flavors Corporation, GlaxoSmithKline plc, Invitrogen Corporation, Medarex, and Xoma. We have also formed a broad strategic
relationship with Syngenta AG, a world-leading agribusiness company.



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



Our revenues have historically fluctuated from period to period and likely will continue to
fluctuate substantially in the future based upon the timing and composition of funding under existing and future collaboration agreements and grants, regulatory approval timelines for new products, and an expected increase in product-related revenue
based upon new product introductions. Our strategic partners often pay us before we recognize the revenue, and these payments are deferred until earned. As of September 30, 2004, we had deferred revenue totaling $2.1 million.



We have incurred net losses since our inception. As of September 30, 2004, our accumulated
deficit was $194.5 million. We expect to incur additional losses for at least the next two years as we continue to develop independent products and as a result of our anticipated investment in 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.



8



---

##### Table of Contents

Results of Operations



Three Months Ended September 30, 2004 and 2003



Revenue



Revenue increased $1.7 million to $12.9 million for the quarter ended September 30, 2004 from $11.2 million for the same period in 2003. This increase was primarily attributable to increased grant revenue and new
product-related 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, regulatory approval timelines for new products, and an expected increase in product-related revenue based upon new product introductions. Revenue from collaborations accounted for 65% and 83% of total revenue for the quarters
ended September 30, 2004 and 2003, 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, 2004, we estimate that approximately 60% of our research and development expenditures were related to research activities funded by
our collaborators and government grants and that approximately 40% were associated with internal product and technology development. Our research and development expenses increased $0.1 million to $17.7 million for the quarter ended September 30,
2004 from $17.6 million for the quarter ended September 30, 2003. The slight increase was primarily due to the net effect of the following:



Personnel Costs.Costs for research and development personnel for the quarter ended September 30, 2004 decreased by $0.5 million compared to the quarter ended
September 30, 2003. The decrease was due to reduced expectations for employee bonuses and lower benefit costs resulting from a change in insurance coverage.



Outside Services.Costs for outside services for the quarter ended September 30, 2004 increased by $1.6 million compared to the quarter ended September 30, 2003.
The increase was primarily due to legal costs for protection and maintenance of intellectual property as well as costs associated with regulatory and grant activities.



Facility Costs.Facility costs for the quarter ended September 30, 2004 decreased $0.2 million compared to the quarter ended
September 30, 2003. The decrease was primarily attributable to a reduction in computer and related support costs.



Research Supplies Costs.Costs for research supplies for the quarter ended September 30, 2004 decreased by $0.5 million compared to the quarter ended September 30,
2003. The decrease was primarily attributable to price and usage efficiencies realized as a result of changes in our procurement system.



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 decreased $0.5 million to $2.8 million for the
quarter ended September 30, 2004 from $3.3 million for the same period in 2003. The decrease was primarily attributable to reduced expectations for employee bonuses and lower administrative costs associated with Zymetrics, Inc., our former contract
joint venture, which is now managed exclusively by Syngenta.



Amortization
of Acquired Intangible Assets



For each of the quarters ended September
30, 2004 and 2003, we recorded amortization of acquired intangible assets of approximately $0.7 million related to the February 2003 acquisition of intellectual property rights licenses from Syngenta.



9



---

##### Table of Contents

Interest and Other Income, Net



Interest and other income, net for the quarter ended September 30, 2004 was $24,000, compared to $0.6 million for the same period in 2003.
The 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 and lower cash balances, as well as increased interest expense as a result of
additional borrowings.



Nine Months Ended September 30, 2004 and 2003



Revenue



Revenue increased $9.8 million to $39.4 million for the nine months ended September 30, 2004
from $29.6 million for the same period in 2003. This increase was primarily attributable to additional research funding from collaborations, increased grant revenue, new product-related revenue, and milestones earned under our collaboration with
Syngenta. Revenue from collaborations accounted for 72% and 87% of total revenue for the nine months ended September 30, 2004 and 2003, respectively.



Research and Development Expenses



For the nine months ended September 30, 2004, we estimate that approximately 60% of our research and development expenditures were associated with research activities
funded by our collaborators and that 40% were related to internal product and technology development. Our research and development expenses increased $2.2 million to $53.7 million for the nine months ended September 30, 2004 from $51.5 million for
the nine months ended September 30, 2003. 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, 2004 increased by $1.0 million compared to the nine months
ended September 30, 2003. The increase was primarily due to an increase in our research staff from an average of 295 for the nine months ended September 30, 2003 to an average of 304 for the nine months ended September 30, 2004 as a result of us
hiring an additional 71 researchers in conjunction with the February 2003 Syngenta transactions, as well as annual salary adjustments. We expect our personnel costs to decrease in 2005, as we reduced our research staff by 22 in October 2004 to
realign our workforce and financial resources to more closely focus on the sales and marketing of our new and existing products and the development of our numerous late-stage product candidates.



Outside Services.Costs for outside services for the nine months ended September 30,
2004 increased by $1.4 million compared to the nine months ended September 30, 2003. The increase was primarily due to costs associated with regulatory and grant activities.



Facility Costs.Facility costs for the nine months ended September 30, 2004 increased by $0.4 million compared to the nine months
ended September 30, 2003. The increase was primarily attributable to higher rent and utilities costs.



Research Supplies Costs.Costs for research supplies for the nine months ended September 30, 2004 decreased by $0.3 million compared to the nine months ended September 30, 2003. The decrease was primarily
attributable to price and usage efficiencies realized as a result of changes in our procurement system.



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 $0.1 million to $9.2 million for the
nine months ended September 30, 2004 from $9.1 million for the same period in 2003. This increase was primarily attributable to headcount costs in business development to support our product launches, offset by lower administrative costs associated
with Zymetrics, Inc., our former contract joint venture, which is now managed exclusively by Syngenta.



Amortization of Acquired Intangible Assets



For the nine months ended September 30, 2004, we recorded amortization of acquired intangible assets of approximately $2.0 million, compared to $1.6 million for the nine months ended September 30, 2003. The increase was associated with the
February 2003 acquisition of intellectual property rights licenses from Syngenta.



10



---

##### Table of Contents

Interest and Other Income, Net



Interest and other income, net for the nine months ended September 30, 2004 was $0.2 million, compared to $2.1 million for the same period
in 2003. 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 and lower cash balances, as well as increased interest expense as a result
of additional borrowings.



Equity in Loss of Joint Venture



Our subsidiary, Innovase LLC, was formed in June 2000 and was formerly an
industrial enzyme joint venture between us and The Dow Chemical Company (Dow). Under the terms of the joint venture agreement, we were required to fund certain operating expenses of Innovase LLC. Our share of the net income or loss of
Innovase LLC, excluding certain expenses for which Dow was solely responsible under the joint venture agreement, was recorded utilizing the equity method of accounting. In December 2003, we signed a definitive agreement with Dow to restructure the
Innovase joint venture, and all joint venture related agreements involving Dow and us were terminated. As a result, Innovase is no longer accounted for under the equity method of accounting. We recorded equity in the loss of Innovase LLC in the
amount of $1.3 million for the nine months ended September 30, 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 $180.0 million in funding from our
inception through September 30, 2004, and are also committed to fund at least an additional $89.8 million through 2010, subject to our performance under existing agreements. This future committed funding excludes all milestone payments, license and
commercialization fees, and royalties or profit sharing. Our future committed funding is concentrated within a limited number of collaborators. Our failure to successfully maintain our relationship with these collaborators could have a material
adverse impact on our operating results and financial condition.



As of
September 30, 2004, we had cash, cash equivalents, short-term investments, and receivables of approximately $102.2 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 2003, we entered into an equipment financing line of credit
with a lender to finance up to $9.8 million in equipment purchases through December 2004. As of September 30, 2004, we had utilized $8.6 million under this arrangement. Also, in June 2004, we entered into an additional equipment financing line of
credit with a lender to finance up to $7.0 million in equipment purchases in Mexico related to our manufacturing agreement with Fermic, S.A. de C.V. As of September 30, 2004, we had utilized $4.7 million under this arrangement.



During 2002, we entered into a manufacturing agreement with Fermic, S.A. de C.V. to provide
us with commercial quantities of certain enzyme products. Under the terms of the agreement, we are required to fund certain equipment required for fermentation and downstream processing of the products. Through September 30, 2004, we had incurred
costs of approximately $6.2 million for equipment related to the manufacturing agreement. During the remainder of 2004, we anticipate funding approximately $2.0 million in additional equipment costs related to the manufacturing agreement.
Additionally, as we continue to develop internal products and our pharmaceutical platforms, we will be required to purchase additional capital equipment. We currently have 282 researchers working on partnered and internally funded projects. We
anticipate the cost of capital equipment required to support the ongoing needs of our existing researchers will be approximately $2.0 million for the remainder of 2004.



We anticipate funding our capital requirements for the remainder of 2004 with new financing arrangements, if available on satisfactory
terms, and with available cash.



Our operating activities used cash of $26.0
million for the nine months ended September 30, 2004. Our cash used by operating activities consisted primarily of cash used to fund our net loss of $27.4 million, payments against liabilities of $1.5 million, and a decrease in deferred revenue of
$9.2 million, partially offset by non-cash charges of $13.5 million.



Our
investing activities provided cash of $24.7 million for the nine months ended September 30, 2004. Our investing activities consisted primarily of a net decrease in short-term investments of $30.9 million to fund operations, offset by purchases of
property and equipment of $6.2 million.



Our financing activities provided cash
of $2.9 million for the nine months ended September 30, 2004. Our financing activities consisted primarily of borrowings under notes payable of $7.9 million and proceeds from the sale of common stock under our Employee Stock Purchase Plan and from
the exercise of stock options of $3.1 million, partially offset by payments on notes payable and capital leases of $8.2 million.



11



---

##### Table of Contents

The following table summarizes our contractual obligations at September 30, 2004 (in thousands).



|                                |  |       |        |                 |   |           |  |           |        |              |   |        |  |   |       
|------------------------------- |  | ----- | ------ | --------------- | - | --------- |  | --------- | ------ | ------------ | - | ------ |  | - | ------
|                                |  | Total |        | Less Than1 Year |   | 1-3 Years |  | 3-5 Years |        | After 5Years
|Contractual Obligations         |  |       |        |                 |   |           |  |           |        |              |   |        |  |   |       
|Long-term debt                  |  | $     | 19,441 |                 | $ | 9,786     |  | $         | 8,994  |              | $ | 661    |  | $ |      
|Capital lease obligations       |  |       | 300    |                 |   | 300       |  |           |       |              |   |       |  |   |      
|Operating leases                |  |       | 60,680 |                 |   | 4,420     |  |           | 9,215  |              |   | 9,860  |  |   | 37,185
|License and research agreements |  |       | 17,113 |                 |   | 4,463     |  |           | 9,610  |              |   | 2,640  |  |   | 400   
|                                |  |       |        |                 |   |           |  |           |        |              |   |        |  |   |       
|Total Contractual Obligations   |  | $     | 97,534 |                 | $ | 18,969    |  | $         | 27,819 |              | $ | 13,161 |  | $ | 37,585
|                                |  |       |        |                 |   |           |  |           |        |              |   |        |  |   |       



We expect that our current cash and
cash equivalents, short-term investments, and funding from existing collaborations and grants as well as new product sales 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.



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 grants is recognized on a percentage of completion basis as related costs are incurred. Revenue from product sales is recognized at the time of shipment to the customer.
Product-related revenue includes product sales, manufacturing revenue, milestone and license payments related to commercialization of products, and royalties and profit sharing related to sales of products. 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. As of September 30, 2004, we had long-lived assets with a net book value of $77.2 million.



12



---

##### Table of Contents

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.



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 $9.2 million for the quarter ended September 30, 2004. As of September 30, 2004, we had an accumulated deficit of approximately $194.5 million. We expect to incur additional losses for at least the next two years as we continue to
develop independent products and as a result of our anticipated investment in additional preclinical and clinical infrastructure, as well as added research and manufacturing development expenses for our internal product candidates. The extent of our
future losses will depend, in part, on the rate of growth, if any, in our contract revenue, future product sales at profitable margins, and on the level of our expenses. To date, most of our revenue has been derived from collaborations and grants,
and we expect that a significant portion of our revenue for the remainder of 2004 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 we or our partners choose to commercialize and that are commercially successful 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 seven products ourselves,
Pyrolase160 enzyme, Pyrolase200 enzyme, Cottonase enzyme, Luminase enzyme, Bayovac® SRS, and blue and green fluorescent proteins, and three of our collaborative partners, Invitrogen Corporation, Danisco Animal Nutrition, and Zymetrics, Inc., 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 Amgen,
BASF, Bayer Animal Health, The Dow Chemical Company, DSM Pharma Chemicals, DuPont Bio-Based Materials, Givaudan Flavors Corporation, GlaxoSmithKline plc,



13



---

##### Table of Contents

Invitrogen Corporation, Medarex, and Xoma. We have also formed a broad strategic relationship with Syngenta AG, a
world-leading agribusiness company. For the nine months ended September 30, 2004, approximately 63% of our revenue was from affiliates of Syngenta AG. We expect to derive significant future revenue from our collaboration agreements. Since we do not
currently possess the resources necessary to independently develop and commercialize all of the potential products that may result from our technologies, we expect to continue to enter into, and in the near-term derive additional revenue from,
strategic alliance and collaboration agreements to develop and commercialize products. We will have limited or no control over the resources that any strategic partner or collaborator may devote to our partnered products. Any of our present or
future strategic partners or collaborators may fail to perform their obligations as expected. These strategic partners or collaborators may breach or terminate their agreements with us or otherwise fail to conduct their collaborative activities
successfully and in a timely manner. Further, our strategic partners or collaborators may not develop products arising out of our collaborative arrangements or devote sufficient resources to the development, manufacture, marketing, or sale of these
products. If 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;
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | 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 from the antifungal program we acquired from Glaxo Wellcome,
S.A. in 2003, some of the anticipated benefits of the acquisition may not be realized.



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



| |  | 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.



14



---

##### Table of Contents

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



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



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 in 2007 or earlier, are renewable, and 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.



15



---

##### Table of Contents

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.



As disclosed in our Form 10-K for the year ended December, 31, 2003, an interference proceeding was recently declared in the U.S. Patent and Trademark Office between a
U.S. patent assigned to us and a pending U.S. patent owned by another company with allowable claims directed to optimization of immunomodulatory genetic vaccines. Other than this interference proceeding, we are not currently a party to any
litigation with regard to our patent position. However, the biotechnology industry is characterized by extensive litigation regarding patents and other intellectual property rights. Many biotechnology companies have employed intellectual property
litigation as a way to gain a competitive advantage. If we became involved in litigation or interference proceedings declared by the 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, like the one described above, could result in substantial
cost to us even if the outcome is favorable. Even if successful on priority grounds, an interference may result in loss of claims based on patentability grounds raised in the interference. The litigation or proceedings could divert our
managements time and efforts. Even unsuccessful claims could result in significant legal fees and other expenses, diversion of management time, and disruption in our business. Uncertainties resulting from initiation and continuation of any
patent or related litigation could harm our ability to compete.



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



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



Our strategy includes entering into and working on
simultaneous projects across multiple industries. We increased the average number of our full-time employees from 295 for the nine months ended September 30, 2003 to 304 for the nine months ended September 30, 2004. While we do not expect to
significantly increase our headcount in the near future, 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 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.



16



---

##### Table of Contents

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. has been involved in accessing organisms from diverse environments for pharmaceutical applications. A number of companies are performing high-throughput screening of molecules.
Maxygen, Inc. has 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, in the future we expect to pursue collaborations for further research and development of drug products for humans that would require FDA approval before they could be marketed in the United States. In
addition, any drug product candidates must also be approved by the regulatory agencies of foreign governments before any product can be sold in those countries. Under current FDA policy, our products, or products of our collaborative partners
incorporating our technologies or inventions, to the extent that they come within the FDAs jurisdiction, may be subject to lengthy FDA reviews and unfavorable FDA determinations if they raise safety questions which cannot be satisfactorily
answered, if results from pre-clinical or clinical trials do not meet regulatory requirements or if they are deemed to be food additives whose safety cannot be demonstrated. An unfavorable FDA ruling could be difficult to resolve and could prevent a
product from being commercialized. Even after investing significant time and expenditures, we may not obtain regulatory approval for any drug products. We have not submitted an investigational new drug application for any product candidate, and no
drug product candidate developed with our technologies has been approved for commercialization in the United States or elsewhere. The EPA regulates biologically derived chemical substances not within the FDAs jurisdiction. An unfavorable EPA
ruling could delay commercialization or require modification of the production process resulting in higher manufacturing costs, thereby making the product 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 other 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.



17



---

##### Table of Contents

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



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



Our capital requirements depend on
several factors, including:



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



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



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



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



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



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



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



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



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



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



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



Our quarterly operating results have fluctuated in the past and are
likely to do so in the future. These fluctuations could cause our stock price to fluctuate significantly or decline. For example, our revenue for the quarter ended September 30, 2004 was $12.9 million, as compared to $11.2 million for the quarter
ended September 30, 2003. 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;
| | - | -----------------------------------------------------------------------------------



| |  | The ability and willingness of strategic partners and collaborators to commercialize, market, and sell 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.
| | - | --------------------------------------------------------------------------------------------------------------------------------------



18



---

##### Table of Contents

If revenue declines or does not grow as anticipated due to the expiration of strategic alliance or collaboration
agreements, failure to obtain new agreements or grants, lower than expected 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. 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 acquisitions, we will incur a variety of costs and may potentially face numerous other risks that could adversely affect our business operations.



During 2003, we consummated a series of transactions with Syngenta and TMRI that involved,
in part, our acquiring certain property and equipment from TMRI, and we purchased an antifungal program from Glaxo Wellcome, S.A. If appropriate opportunities become available, we may consider acquiring businesses, assets, technologies, 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.
| | - | -------------------



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.



19



---

##### Table of Contents

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



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



Our stock price has
been and may continue to be particularly volatile 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 51.6% of our outstanding common stock as of September 30, 2004. If these officers, directors, and principal stockholders act together, they will be able to exert a
significant degree of influence over our management and affairs and over matters requiring stockholder approval, including the election of directors and approval of mergers or other business combination transactions. In addition, as of September 30,
2004, Syngenta and its affiliates controlled approximately 18.2% 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.



20



---

##### Table of Contents

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, 2004 and December 31, 2003 by $0.5 million and $0.8 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.



Sarbanes-Oxley 404 Compliance.We have begun a detailed assessment of our internal controls as called for by the
Sarbanes-Oxley Act of 2002. We have identified what may be control deficiencies in our system of internal controls. We are currently in the testing phase of our project, and we expect to validate these potential control deficiencies and to assess
whether or not they rise to the level of significant deficiencies or material weaknesses. In the meantime, we have established a series of remediation teams to investigate these potential control deficiencies, and, where appropriate, to remediate
them. To ensure that we address these issues thoroughly, effectively, and timely, we have supplemented our internal project team with the services of several outside specialists. Although we have made this project a top priority for the Company,
there can be no assurances that all control deficiencies identified and validated will be remediated before the end of the Companys fiscal year or that the remaining unresolved control deficiencies will not rise to the level of significant
deficiencies or material weaknesses.



PART II - OTHER INFORMATIO
N



Item 1. Legal Proceeding
s



In December 2002, we and certain of our
officers and directors were named as defendants in a class action shareholder complaint filed in the United States District Court for the Southern District of New York, captioned Muller v. Diversa Corp., et al., Case No. 02-CV-9699. In the
complaint, the plaintiffs allege that we and certain of our officers and directors, and the underwriters (the Underwriters) of our initial public offering, or IPO, violated Sections 11 and 15 of the Securities Act of 1933, as amended,
based on allegations that our registration statement and prospectus prepared in connection with our IPO failed to disclose material facts regarding the compensation to be received by, and the stock allocation practices of, the Underwriters. The
complaint also contains claims for violation of Sections 10(b) and 20 of the Securities Exchange Act of 1934, as amended, 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 by plaintiffs (the Plaintiffs) against hundreds of other public companies
(collectively, the Issuers) that conducted IPOs of their common stock in the late 1990s (collectively, the IPO Cases). On January 7, 2003, the IPO Case against us was assigned to United States Judge Shira Scheindlin of the
Southern District of New York, before whom the IPO Cases have been consolidated for pretrial purposes.



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



In June 2003, Issuers and Plaintiffs reached a tentative
settlement agreement and entered into a memorandum of understanding providing for, among other things, a dismissal with prejudice and full release of the Issuers and their officers and directors from all



21



---

##### Table of Contents

further liability resulting from Plaintiffs claims, and the assignment to Plaintiffs of certain potential claims
that the Issuers may have against the Underwriters. The tentative settlement also provides that, in the event that Plaintiffs ultimately recover less than a guaranteed sum of $1 billion from the IPO underwriters, Plaintiffs would be entitled to
payment by each participating Issuers insurer of a pro rata share of any shortfall in the Plaintiffs guaranteed recovery. In June 2004, we executed a settlement agreement with the plaintiffs pursuant to the terms of the memorandum of
understanding. The settlement is subject to a number of conditions, including action by the Court certifying a class action for settlement purposes and formally approving the settlement. The Underwriters have opposed both the certification of the
class and the judicial approval of the settlement.



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



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



Our Registration Statements on Form S-1 (File Nos. 333-92853 and 333-30290) relating to the initial 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, 2004, approximately $14.5
million of the net proceeds had been used to purchase property and equipment and approximately $72.4 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)



|              |  |                                                                                                                                                                                                                                                                                                                                                                                                                                   
|------------- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|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.(4)                                                                                                                                                                                                                                                                   
|              | 
|4.4           |  | The Companys Certificate of Designation of Series A Junior Participating Preferred Stock.(3)                                                                                                                                                                                                                                                                                                                                     
|              | 
|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.
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



22



---

##### Table of Contents

|(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 December 4, 2002, and incorporated herein by reference
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------



23



---

##### 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 3, 2004 |  | /s/ EDWARD SHONSEY                                                                                                                                                                  
|                       |  | Edward Shonsey Executive Vice President, Internal
Development and Chief Financial Officer (on behalf of the
Company and as the Companys principal financial and accounting officer)



24