Note 1. Organization and Summary of Significant Accounting Policies

Paradigm Genetics, Inc. (the “Company” or “Paradigm”) was founded on September 9, 1997, and is a biotechnology company using proprietary systems biology to discover biomarkers to reduce cost, risk and time in the product development cycle as well as to discover inaccessible targets for small molecule discovery, both for its partners and for the Company. The Company is growing the business by partnering with life sciences companies in both healthcare and agriculture, while building its own portfolio of products. Additionally, the Company is leveraging their existing infrastructure to provide services that generate near-term revenue.

The accompanying financial statements have been prepared on a basis which assumes that the Company will continue as a going concern and which contemplates the realization of assets and the satisfaction of liabilities and commitments in the normal course of business. The Company had an accumulated deficit of $88.2 million as of March 31, 2004, incurred a net loss of $3.7 million for the three months then ended and expects to incur substantial additional losses for the remainder of 2004.

The Company has historically financed its operations through the sale of common and preferred stock, debt and capital lease financing, payments received from commercial partnerships and government grants. As of March 31, 2004, the Company had total cash and investments of $15.2 million, which is comprised of cash and cash equivalents of $9.1 million and short-term investments of $6.1 million.

The Company expects to continue expanding its operations through internal growth and, possibly, through strategic acquisitions. The Company expects these activities will be funded from existing cash, cash flow from operations, issuances of stock and borrowings under credit facilities. Management believes that these sources of liquidity will be sufficient to fund its operations into 2005. From time to time, the Company evaluates potential acquisitions and other growth opportunities, which might require additional external financing, and the Company may seek funds from public or private issuances of equity or debt securities.

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 of America for interim financial information and pursuant to the instructions to Form 10-Q and Article 10 of Regulation S-X of the Securities and Exchange Commission. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States of America for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring adjustments) considered necessary for a fair presentation have been included. Operating results for the three month period ended March 31, 2004 are not necessarily indicative of the results that may be expected for the year ending December 31, 2004 or for any future period. These financial statements and notes should be read in conjunction with the financial statements and notes thereto for the year ended December 31, 2003, included in the Company’s Form 10-K filed with the Securities and Exchange Commission on March 30, 2004.

Use of Estimates

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.

Reclassifications

Certain amounts in the 2003 financial statements have been reclassified to conform to the 2004 presentations, with no effect on previously reported net loss, stockholders’ equity, or net loss per share.

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Cash and Cash Equivalents

The Company considers all highly liquid investments with a maturity of three months or less at the date of purchase to be cash equivalents.

Restricted Cash

Restricted cash comprises cash held in escrow for security deposits on the Company’s facilities.

Property and Equipment

Property and equipment is primarily comprised of buildings, laboratory equipment, computer equipment, furniture, and leasehold improvements, which are recorded at cost and depreciated using the straight-line method over their estimated useful lives. Expenditures for maintenance and repairs are charged to operations as incurred; major expenditures for renewals and betterments are capitalized and depreciated. Property and equipment acquired under capital leases are being depreciated over their estimated useful lives or the respective lease term, if shorter.

Other Assets

Other assets include intangible assets, resulting the Company’s acquisition of TissueInformatics.Inc (See Note 2), deposits for building leases and other deferred costs.

Capitalized Software Costs

The Company accounts for the costs of development of software applications to be sold to or used by third parties in accordance with Statement of Financial Accounting Standards No. 86 “Accounting for the Costs of Computer Software to Be Sold, Leased or Otherwise Marketed.” Software development costs are required to be capitalized beginning when a product’s technological feasibility has been established and ending when a product is available for general release. To date, the establishment of technological feasibility has substantially coincided with the release of any software products developed. Accordingly, no costs have been capitalized.

Impairment of Long-Lived Assets

The Company evaluates the recoverability of its property and equipment and intangible assets in accordance with Statement of Financial Accounting Standards No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets” (“SFAS No. 144”). SFAS No. 144 requires long-lived assets to be reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. An impairment is recognized in the event that the net book value of an asset exceeds the future undiscounted cash flows attributable to such asset or the business to which such asset relates and the net book value exceeds fair value. The impairment amount is measured as the amount by which the carrying amount of a long-lived asset (or asset group) exceeds its fair value. No impairment loss was required to be recognized during the three months ended March 31, 2004 or 2003.

Income Taxes

The Company accounts for income taxes using the liability method, which requires the recognition of deferred tax assets or liabilities for the temporary differences between financial reporting and tax bases of the Company’s assets and liabilities and for tax carryforwards at enacted statutory rates in effect for the years in which the differences are expected to reverse. The effect on deferred taxes of a change in tax rates is recognized in income in the period that includes the enactment date. In addition, valuation allowances are established where necessary to reduce deferred tax assets to the amounts expected to be realized.

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Revenue Recognition

Revenues are derived from commercial partnerships and services and government contracts and grants. Payments from our commercial contracts are generally related to refundable or nonrefundable fees, milestone achievements or assay deliveries. Payments for refundable and nonrefundable fees and milestone achievements are recognized as revenues on a progress to completion basis over the term of the respective commercial partnership, except with respect to refundable fees for which revenue recognition does not commence until the refund right expires. Payments related to assay deliveries are recognized as revenues when accepted by the other party. Payments received under the Company’s commercial partnerships and government contracts and grants are generally non-refundable regardless of the outcome of the future research and development activities to be performed by the Company. Payments from government contracts and grants are recognized as revenues as related expenses are incurred over the term of each contract or grant.

Progress to completion under commercial partnerships is measured based on a comparison of the number of genes analyzed to the total number of genes to be analyzed, on a contract by contract basis. To the extent payments received exceed revenue recognized for each contract or grant the excess portion of such payments are recorded as deferred revenues. To the extent revenues recognized exceed payments received for each contract or grant the excess of such revenues are recorded as accounts receivable. The Company recognizes revenue in accordance with Staff Accounting Bulletin No. 104 (“SAB 104”) issued by the Securities and Exchange Commission.

Research and Development

Research and development costs include personnel costs, costs of supplies, facility costs, license fees, consulting fees, the recording of deferred compensation and depreciation of laboratory equipment. These costs were incurred by the Company to develop its proprietary GeneFunction Factory ^® platform and metabolic profiling platform, perform required services under commercial partnerships and government grants and perform research and development on internal projects. Research and development costs are expensed as incurred.

Stock-Based Compensation

The Company accounts for stock-based compensation based on the provisions of Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB No. 25”) which states that no compensation expense is recorded for stock options or other stock-based awards to employees that are granted with an exercise price equal to or above the estimated fair value of the Company’s common stock on the grant date. In the event that stock options are granted with an exercise price below the estimated fair value of the Company’s common stock at the grant date, the difference between the fair value of the Company’s common stock and the exercise price is recorded as deferred compensation. The Company reversed $0 and $1,665 of deferred compensation related to the cancellation of unvested options during the three months ended March 31, 2004 and 2003, respectively. Deferred compensation is amortized to compensation expense over the vesting period of the related stock option. The Company recognized $1,806 and $112,721 in non-cash compensation expense related to amortization of deferred compensation during the three months ended March 31, 2004 and 2003, respectively. During the three months ended March 31, 2003, the Company also accrued $172,375 in stock-based compensation related to stock grants that were made as part of the 2002 bonuses. The stock grants were paid in shares on June 27, 2003. The fair market value of the stock granted was $0.65 per share on March 31, 2003.

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Had compensation costs for the two plans been determined based on the fair value at the grant date for awards under the plans, consistent with the methods of Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation,” (“SFAS No. 123”), as amended, the Company’s net loss and net loss per share (basic and diluted) for the three months ended March 31, 2004 and 2003, would have been increased to the pro forma amounts indicated below:

The per share weighted average fair value of stock options granted during the three months ended March 31, 2004 and 2003 was estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted average assumptions for 2004 and 2003: expected dividend yield of 0%; risk free interest rates of 3.0% in 2004 and 3.82% in 2003; expected option lives of approximately four years in 2004 and 2003; and volatility factors of 105% in 2004 and 111% in 2003.

Concentration of Credit Risk

Financial instruments, which potentially subject the Company to a concentration of credit risk, consist principally of cash, investments, and accounts receivables. The Company primarily places its cash, short-term and long-term investments with high-credit quality financial institutions which invest primarily in U.S. Government securities, commercial paper of prime quality and certificates of deposit guaranteed by banks which are members of the FDIC. Cash deposits are all in financial institutions in the United States. The Company performs ongoing credit evaluations to reduce credit risk and requires no collateral from its customers. Management estimates the allowance for uncollectible accounts based on their historical experience and credit evaluation.

The Company has three commercial partnerships, a contract with the United States federal government, and a grant, which accounted for 56%, 9%, 4%, 17% and 11%, respectively, of the Company’s total revenue for the three months ended March 31, 2004. The Company had two commercial partnerships and a contract with the United States federal government, which accounted for 71%, 12% and 10%, respectively, of the Company’s total revenue for the three months ended March 31, 2003. Of the total accounts receivable balance at March 31, 2004 and 2003, 44% and 76%, respectively, is comprised of receivables from one of the commercial partnerships.

Comprehensive Income (Loss)

Statement of Financial Accounting Standards No. 130, “Reporting Comprehensive Income” established standards for reporting and display of comprehensive income and its components in the financial statements. Comprehensive income, as defined, includes all changes in equity during a period from non-owner sources. The Company’s total comprehensive loss for the three month periods ended March 31, 2004 and 2003 was $3,629,843 and $3,919,398, respectively. The Company’s other comprehensive loss consisted of unrealized gains on investments of $41,770 and $197,397 for the three months ended March 31, 2004 and 2003, respectively.

Net Loss Per Common Share

The Company computes net loss per common share in accordance with Statement of Financial Accounting Standards No. 128, “Earnings Per Share,” (“SFAS No. 128”). Under the provisions of SFAS No. 128, basic net loss per common share is computed by dividing net loss attributable to common stockholders by the weighted average number of common shares outstanding. Diluted net loss per common share is computed by dividing net loss attributable to common stockholders by the weighted average number of common shares and dilutive potential common share equivalents then outstanding. Potential common shares consist of shares issuable upon the exercise of stock options and warrants.

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The following table sets forth potential shares of common stock that are not included in the diluted net loss per share because to do so would be antidilutive for the periods indicated:

Segment Reporting

Statement of Financial Accounting Standards No. 131, “Disclosures About Segments of an Enterprise and Related Information,” (“SFAS No. 131”) requires companies to report information about operating segments in interim and annual financial statements. It also requires segment disclosures about products and services, geographic areas and major customers. The Company has determined that it operated in only one segment.

Internal Use Software

Statement of Position No. 98-1, “Accounting for the Costs of Computer Software Developed or Obtained for Internal Use,” (“SOP No. 98-1”) provides guidance regarding when software developed or obtained for internal use should be capitalized. The predominant portion of the software applications used by the Company were purchased from third parties. The Company expenses the cost of accumulating and preparing data for use in its database applications as such costs are incurred.

Discontinued Operations

In November 2002, the Company decided to close the operations of ParaGen, its plant genotyping business. At December 31, 2002, all of the goodwill and associated assets were written down to their fair value less cost to sell and reported in the loss from discontinued operations. In February 2003 the ParaGen business assets were sold to DNA Landmarks for $300,000 and potential future royalties between 10% and 15%, over the next three years, of revenues from certain identified customers.

The operating results from ParaGen are reported in discontinued operations. For the three months ended March 31, 2004 and 2003, these operations reported a gain of $22,725 and $24,669, respectively. ParaGen was purchased in 2001 from Celera Genomics for 422,459 shares of our common stock.

Note 2. Acquisition

On March 11, 2004, the Company purchased all of the outstanding common and preferred stock of TissueInformatics.Inc, in exchange for the issuance of 3,402,832 shares of the Company’s common stock with a total fair value of $4,614,250, based on the average closing price of the common stock of $1.36 for the two-day period immediately preceding and following the date of the announcement of the acquisition. In addition, subject to the achievement of performance milestones by December 31, 2004, the Company could be obligated to issue another 2.7 million shares.

The Company assumed approximately $0.6 million in net liabilities and incurred costs of approximately $0.5 million related to this acquisition. The Company also assumed TissueInformatics’s obligations under its qualified employee incentive stock option plan for TissueInformatics employees. At closing, approximately 200,000 shares were reserved to satisfy this obligation. Subject to the achievement of performance milestones by December 31, 2004, an additional 200,000 shares may need to be reserved for the incentive stock option plan. The acquisition has been accounted for using the purchase method of accounting and, accordingly, the initial purchase price of approximately $7.2 million was allocated to the assets acquired and liabilities assumed based on estimated fair values. This purchase price includes $2.6 million for the contingent purchase consideration that may be payable if certain performance milestones are achieved. The fair value assigned to intangible assets acquired was based on a preliminary valuation prepared by management of the Company. The Company is in the process of obtaining a valuation of these intangible assets and, as such, are subject to change.

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Of the total purchase price, $3.5 million was allocated to the tangible assets, which were comprised of cash, property and equipment and prepaid and other assets, $4.2 million has been allocated to intangible assets and $0.6 million has been allocated to liabilities. The intangible assets are being amortized over a period of five years.

The Company’s consolidated results of operations for the three-month period ended March 31, 2004 include the results of TissueInformatics operations from the day after the closing date of the acquisition, March 12, 2004, to March 31, 2004.

The following unaudited pro forma consolidated financial information reflects the results of operations of the Company for the three-month periods ended March 31, 2004 and 2003 as if the acquisition of TissueInformatics had occurred on January 1, 2004 and 2003, respectively. These pro forma results are not necessarily indicative of what the Company’s operating results would have been had the acquisition actually taken place on January 1, 2004 or 2003, and may not be indicative of future operating results.

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