Liquidity and Capital Resources

        Since our inception in March of 2000, we have funded our operations principally through the private placement of equity securities, which provided aggregate net cash proceeds of approximately $88.8 million. We have also generated funds from debt financing. As of December 31, 2004, we had cash, cash equivalents and short-term investments of approximately $35.1 million. Our funds are currently invested in investment grade and United States government securities.

        Our operating activities used cash of $18.0 million, $ 14.1 million and $13.1 million in the years ended December 31, 2004, 2003 and 2002, respectively. The use of cash in all periods was primarily due to increases in our losses from operations resulting from increased research and development expenses and changes in our working capital accounts.

        During the year ended December 31, 2004, our investing activities used cash of $29.9 million compared to providing cash of $20.4 million for the year ended December 31, 2003. The cash used by investment activities in the year ended December 31, 2004 resulted from the purchase of securities. Our investing activities provided cash of $20.4 million in the year ended December 31, 2003 by the liquidation of securities to fund current operations. Our investment activities consisted of purchases of property and equipment, primarily lab equipment, and purchases and maturities of marketable securities. We may have an increase in capital expenditures for the 2005 fiscal year principally related to leasehold improvements for a new facility, but the amount of such capital expenditures cannot be determined until we execute a definitive lease agreement.

        During the year ended December 31, 2004, financing activities provided cash of $32.5 million compared to $ 126,000 in the year ended December 31, 2003. Our financing activities provided $39.5 million in the year ended December 31, 2002. The cash provided in 2004 is a result of the sale and issuance of 8.3 million shares of Series D redeemable convertible preferred stock in February and March 2004. No funds were raised in 2003 compared to $39.4 million from the sale and issuance of 10.7 million shares of Series C redeemable convertible preferred stock in 2002. Our financing activities since inception consisted primarily of the sale of preferred stock to private investors in the net amount of $88.8 million and net proceeds from our equipment lines of credit in the amount of $2.7 million.

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        In July 2004, we refinanced our equipment line of credit. Under the new arrangement with General Electric Capital Corporation, we borrowed $3 million in July 2004. Amounts borrowed under the facility are repayable over 36 months and bear interest at 8.42% per annum. Once drawdowns under the facility are repaid, they may not be reborrowed. In connection with the financing, the lender received a warrant to purchase 15,561 shares of our Series D redeemable convertible preferred stock at an exercise price of $3.8558. As of December 31, 2004, there was $2.7 million outstanding under this line of credit, and no further amounts were available. Through December 31, 2004 we had repaid $269,000 of the amounts borrowed under the facility, and no warrants had been exercised.

        In September 2004, we obtained an additional line of credit with Lighthouse Capital Partners which permits borrowings of up to $10 million through September 2005. Borrowings under the line are repayable over 48 months and bear interest at a rate of the prime interest rate plus 1.5% until September 30, 2005 and thereafter will bear interest at an interest rate fixed as the prime interest rate on September 30, 2005 plus 1.5%. In addition, a fee of 14% of actual drawdowns is due at final payment. In connection with the financing, the lender received a warrant to purchase 90,772 shares of Series D redeemable convertible preferred stock at an exercise price of $3.8558, and is entitled to additional warrants equal to 3.25% of actual drawdowns up to a maximum of 84,288 additional warrants. As of December 31, 2004, the entire $10 million was available for future drawdowns.

(1)

Our equipment line of credit agreement with General Electric Capital Corporation contains a subjective acceleration clause which provides the lender the ability to demand repayment of the loan upon a material adverse event.

(2)

We have signed a non-binding letter of intent and are engaged in discussions with a third party regarding the lease of new office space. Because we have not yet reached a definitive agreement, we are not currently able to estimate the expected increase. In addition, the table above excludes accrued dividends payable to holders of the Company's redeemable convertible preferred stock. As such instruments automatically convert into common stock of the Company upon the completion of an initial public offering and holders of preferred stock forego accrued dividends on such conversion, the Company will have no cash obligations related to these instruments.

        In connection with our agreement with the Spinal Muscular Atrophy Foundation, or SMA Foundation, if our revenues from any drug candidates developed under the agreement exceed on a cumulative basis more than $100 million we are obligated to donate an amount equal to 200% of all payments received from the SMA Foundation to the SMA Foundation or another not-for-profit entity designated by them. We have received $190,000 under this agreement through December 31, 2004. Because of the uncertainty over when, if ever, such payment must be made, it is not included in the above table.

        Based on our operating plans, we expect the proceeds of this offering, together with our existing resources, to be sufficient to fund our planned operations, including our continued research and drug development, for at least 30 months from the date of this prospectus. However, we may require

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significant additional funds earlier than we currently expect to conduct additional clinical trials and seek regulatory approval of our product candidates. We may seek additional funding through collaboration agreements and public or private financings. Additional funding may not be available to us on acceptable terms or at all. In addition, the terms of any financing may adversely affect the holdings or the rights of our stockholders. For example, if we raise additional funds by issuing equity securities, further dilution to our existing stockholders may result. If we are unable to obtain funding on a timely basis, we may be required to significantly curtail one or more of our research or development programs. We also could be required to seek funds through arrangements with collaborators or others that may require us to relinquish rights to some of our technologies or product candidates which we would otherwise pursue on our own.

Funding Requirements

        We expect to use the net proceeds from this offering principally for the continued development of our existing portfolio of clinical stage product candidates and for further development of our preclinical product candidates. We plan to use the remaining net proceeds to fund the discovery and development of additional product candidates, for further development of our drug discovery technology and for working capital, capital expenditures and other general corporate purposes. We may also use a portion of the net proceeds for in-licensing of products or technologies or the possible acquisition of complementary businesses, but we have no current agreements relating to any types of these transactions.

        We expect to incur substantial costs and losses as we continue to advance our product candidates into preclinical and clinical trials and as we expand our research and development activities. Our funding requirements will depend on numerous factors, including:

•

the progress of our research and development programs, including the completion of our preclinical and clinical trials for our current product candidates and the nature of the results from these studies;



•

the number of product candidates we advance into later stage clinical trials and the scope of our research and development programs;



•

our ability to discover additional product candidates using our drug discovery technology and advance them into clinical development;



•

the costs involved in preparing, filing, prosecuting, maintaining and enforcing patent claims for our drug discovery technology and product candidates and avoiding the infringement of intellectual property of others;



•

the time and costs involved in obtaining regulatory approvals for our product candidates;



•

our ability to establish and maintain collaborative arrangements;



•

the potential in-licensing of other products or technologies or the acquisition of complementary businesses;



•

the cost of manufacturing, marketing and sales activities, if any; and



•

the timing, receipt and amount of revenues if any, from our product candidates.

        We do not expect to generate significant revenues, other than payments that we receive from our current collaboration partners or other similar collaborations we may enter into in the future, until we successfully obtain marketing approval for, and begin selling one or more of our product candidates. We believe the key factors that will affect our internal and external sources of cash are:

•

the success of our preclinical and clinical development programs;

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•

our ability to successfully develop, manufacture, obtain regulatory approval for and commercialize our product candidates;



•

our ability to enter into strategic collaborations with corporate collaborators and the success of such collaborations; and



•

the receptivity of the capital markets to financings by biotechnology companies.

Off-Balance Sheet Arrangements

        We do not have any off-balance sheet arrangements or relationships with unconsolidated entities of financial partnerships, such as entities often referred to as structured finance or special purpose entities.

Tax Loss Carryforwards and Other Deferred Tax Assets

        We had net operating loss carryforwards available to offset future federal and state taxable income of $28.2 million and $27.3 million, respectively, as of December 31, 2004, as well as federal and state research and development tax credit carryforwards of $1.2 million and $791,000, respectively, available to offset future taxes. The net operating loss and credit carryforwards expire at various dates through 2024. Under the provisions of the Internal Revenue Code, certain substantial changes in the Company's ownership may result in a limitation on the amount of net operating loss carryforwards and research and development carryforwards which could be utilized annually to offset future taxable income and taxes payable.

        We have provided a valuation allowance for the full amount of these net operating loss carryforwards and tax credit carryforwards, as well as for the full amount of our other deferred tax assets, since realization of any future benefit from these deferred tax assets cannot be sufficiently assured.

Critical Accounting Policies and Estimates

        Our discussion and analysis of our financial condition and results of operations are based on our financial statements, which have been prepared in accordance with United States generally accepted accounting principles, or GAAP. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting periods. On an ongoing basis, we evaluate our estimates and judgments, including those related to revenue, accrued expenses and the fair value of our common stock. We base our estimates on historical experience, known trends and events and various other factors 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 our more significant judgments and estimates used in the preparation of our financial statements.

Revenue

        We record revenue as it is earned if there is persuasive evidence of an arrangement, the fee is fixed or determinable and there is reasonable assurance that the related amounts are collectible in accordance with Staff Accounting Bulletin No. 104 Revenue Recognition . Revenues received in advance of performance obligations or in cases where we have a continuing obligation to perform services, are deferred and recognized over the performance period. Revenues from milestone payments that are

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deemed to be substantive and represent the culmination of a separate earnings process are recorded when the milestone is achieved. Contract revenues are recorded as the services are performed. The periods over which revenue should be recognized are subject to estimates by management and may change over the course of the collaborative agreement.

Accrued Expenses

        As part of the process of preparing financial statements, we are required to estimate accrued expenses. This process involves identifying services which have been performed on our behalf, and estimating the level of service performed and the associated cost incurred for such service as of each balance sheet date in our financial statements. Examples of estimated expenses for which we accrue estimated liabilities include contract service fees paid to contract manufacturers in conjunction with the production of clinical drug supplies and to contract research organizations in connection with our preclinical and clinical trials. In connection with such service fees, our estimates are most affected by our understanding of the status and timing of services provided relative to the actual levels of services incurred by such service providers. The majority of our service providers invoice us monthly in arrears for services performed. In the event that we do not identify certain costs, which have begun to be incurred, or we under- or over-estimate the level of services performed or the costs of such services, our reported expenses for such period would be too low or too high. The date on which certain services commence, the level of services performed on or before a given date and the cost of such services are often determined based on subjective judgments. We make these judgments based upon the facts and circumstances known to us in accordance with GAAP.

Stock-Based Compensation

        We have elected to follow Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees , and related interpretations, in accounting for our stock-based compensation plans, rather than the alternative fair value method provided for under Statement of Financial Accounting Standards (SFAS) No. 123, Accounting for Stock-Based Compensation . In 2003 and 2004, certain grants of stock options were made at exercise prices less than the deemed fair value of our common stock and, as a result, we recorded deferred stock compensation. This deferred compensation will be amortized to expense it over the vesting period of the stock options. In the notes to our financial statements, we provide pro forma disclosures in accordance with SFAS No. 123 that reflect the effect on net loss as if the Company had applied the fair value provisions of SFAS No. 123. We account for transactions in which services are received from non-employees in exchange for equity instruments based on the fair value of such services received or of the equity instruments issued, whichever is more reliably measured, in accordance with SFAS No. 123 and the Emerging Issues Task Force (EITF) Issue No. 96-18, Accounting for Equity Instruments that Are Issued to Other than Employees for Acquiring, or in Conjunction with Selling, Goods or Services .

        Accounting for equity instruments granted or sold by us under APB Opinion No. 25, SFAS No. 123 and EITF Issue No. 96-18 requires fair value estimates of the equity instrument granted or sold. If our estimates of the fair value of these equity instruments are too high or too low, our expenses may be over or under stated. We estimated the fair value of the equity instruments based upon consideration of factors which we deemed to be relevant at the time. Because shares of our common stock have not been publicly traded, market factors historically considered in valuing stock and stock option grants include comparative values of public companies discounted for the risk and limited liquidity provided for in the shares we are issuing, pricing of private sales of our redeemable convertible preferred stock, prior valuations of stock grants and the effect of events that have occurred between the time of such grants, economic trends, and the comparative rights and preferences of the security being granted compared to the rights and preferences of our other outstanding equity.

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        The fair value of our common stock is determined by our board of directors. In the absence of a public trading market for our common stock, our board of directors considers objective and subjective factors in determining the fair value of our common stock. During 2003 and 2004, the board of directors evaluated events that provided indicators of the fair value of our common stock including (1) the fair value of our Series D redeemable convertible preferred stock that was issued in February and March 2004, and its relation to the value of our common stock, (2) the liquidation preferences, dividend rights and voting control attributable to our then outstanding redeemable convertible preferred stock and primarily (3) the impact of our proposed offering of common stock. These factors indicated that the options granted to employees during 2003 and 2004 had a deemed fair value that was higher than the exercise price. This caused us to record deferred compensation of $795,000 during 2003 and $13.8 million during the year ended December 31, 2004. We also recognized related compensation expense of $632,000 and $80,000 in the years ended December 31, 2004 and 2003, respectively. The deferred compensation will be recorded as an expense over the vesting period of the underlying stock options in accordance with the method prescribed by the Financial Accounting Standards Board (FASB) Interpretation No. (FIN) 28, Accounting for Stock Appreciation Rights and Other Variable Stock Options and Award Plans . We expect to record amortization of this deferred compensation of $3.7 million during 2005, $3.7 million in 2006, $3.5 million in 2007 and $2.9 million in 2008, subject to employee terminations.

Recently Issued Accounting Pronouncements

        In January 2003, the FASB issued FIN 46, Consolidation of Variable Interest Entities , and in December 2003, issued a revision to FIN 46 (FIN 46R). This interpretation addresses the requirements for business enterprises to consolidate related entities in which they are determined to be the primary beneficiary as a result of their variable economic interest. The interpretation is intended to provide guidance in judging multiple economic interests in an entity and in determining the primary beneficiary. The interpretation outlines disclosure requirements for Variable Interest Entities in existence prior to January 31, 2003, and outlines consolidation requirements for Variable Interest Entities created after January 31, 2003. The Company does not have any entities that require disclosure or entities that would require consolidation under FIN 46 so the interpretation did not have an impact on the Company's financial statements.

        In May 2003, the FASB issued SFAS No. 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity . SFAS No. 150 establishes standards for classifying and measuring certain financial instruments with characteristics of both liabilities and equity. SFAS No. 150 requires that an issuer classify a financial instrument that is within its scope as a liability (or an asset in some circumstances) because that financial instrument embodies an obligation of the issuer. SFAS No. 150 is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective for public companies during the first interim period beginning after June 15, 2003. The adoption of this pronouncement did not have a material impact on the Company's financial position, results of operations or liquidity.

        On December 16, 2004 the FASB issued SFAS No. 123(R), "Share-Based Payment." Statement 123(R) replaces SFAS 123 and supersedes APB 25 and requires that stock grants be accounted for using a fair-valued-based method and the resulting cost recognized in our financial statements. This new standard is effective for awards that are granted, modified or settled in cash in interim periods beginning after June 15, 2005. The Company will adopt this new standard effective for the third quarter of 2005. The Company has not yet determined which option pricing model will be used when it adopts the statement or the impact on the results of operations.

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