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35 NORTHEAST INDUSTRIAL ROAD
BRANFORD, CONNECTICUT 06405
(Address of principal executive offices) (Zip Code)

(203) 488-8201
(Registrant's telephone number, including area code)

Securities registered pursuant to Section 12(b) of the Act:
None

Securities registered pursuant to Section 12(g) of the Act:
Common Stock, par value $.025 per share (the "Common Stock")
(Title of Class)

• Create a risk-balanced drug portfolio. To increase the probability of successful drug discovery and development efforts, Neurogen is pursuing multiple promising targets with multiple drug candidates for multiple disorders. The Company believes that the robustness of a drug portfolio should be based on the diversity and development risk of the programs in the pipeline. The Company is concentrating its efforts on key therapeutic areas (inflammation, pain, insomnia, depression and obesity) within which clinical indications may be developed for a variety of disorders, balancing risk against potential value. The Company believes that its ability to efficiently produce multiple generations of candidates in multiple programs using AIDD™ distinguishes Neurogen among drug discovery and development companies.
  
• Expand development capability. Neurogen possesses a powerful drug discovery capability which is closely linked to pharmaceutical development and clinical initiatives to continuously optimize drug properties. The Company believes this integrated medical feedback loop will aid in the development of compounds in the clinic, and is deploying additional resources to support the early clinical trials of lead drug candidates.
  
• Selectively partner drug programs. Neurogen's partnering strategy seeks to retain ownership and control of some programs – taking them further into human clinical testing – while partnering other programs at earlier stages, so that the Company’s financial risk is reduced while maximizing return for shareholders. Neurogen’s development capabilities enable the Company to pursue a flexible business model, of partnering programs when competitively and economically advantageous. When Neurogen partners programs, it seeks to collaborate with pharmaceutical leaders with demonstrated strengths and resources which complement the Company’s.
  
• Continually optimize the efficiency of the organization and control costs. Focused on both its scientific and business processes, Neurogen initiated its Operational Excellence program during 2002 to conserve resources without affecting strategy or major program output. The program has achieved improvements in organizational structure, reduced operating costs, and the installation of technology advancements for producing and selecting development candidates.

o The 2001 Aventis Agreement – covers our CRF1-based depression and anxiety program
  - Aventis paid $10 million for the licensing of Neurogen's CRF1 drug candidates and technology.
  - Neurogen receives committed research payments and is reimbursed for research expenses for three years from the effective date.
  - Neurogen will receive milestone payments if specified development and regulatory objectives are achieved.
  - Aventis received the exclusive worldwide license to manufacture, use and sell CRF1 receptor modulatory products developed in the collaboration.
  - Aventis is required to pay Neurogen royalties based on net sales levels, if any, for such products.

Neurogen incurred research and development costs (net of stock compensation) of $34,093,000, $34,494,000 and $28,048,000 for the years ending December 31, 2002, 2001 and 2000, respectively. During those same time periods, the Company recognized research and development revenue from its collaboration agreements (including the two agreements described above and other prior agreements), of $4,276,000, $3,056,000 and $9,205,000, respectively. Thus, during those time periods, overall research and development revenue as a percentage of total research and development costs (for both partnered and unpartnered programs) was 13%, 9% and 33%, respectively.

Patents and Proprietary Technology

Neurogen’s success depends, in part, on the Company’s ability to obtain and enforce patents, maintain trade secrets and operate without infringing the intellectual property rights of third parties. Neurogen files patent applications both in the United States and in foreign countries, as the Company deems appropriate, for protection of both products and processes. At December 31, 2002, Neurogen is the sole assignee of 204 issued United States patents and numerous foreign patents.

Neurogen is not currently engaged in any research based on any technology transfer that would obligate the Company to pay royalties to any third party.

The patent position of biotechnology and pharmaceutical firms is highly uncertain and involves many complex legal and technical issues. There is considerable uncertainty regarding the breadth of claims allowed in such cases and the degree of protection afforded under such patents. As a result, Neurogen cannot assure you that patent applications will be successful or that current or future patents will afford the Company protection against competitors. It is possible that Neurogen patents will be successfully challenged or that patents issued to others may preclude the Company from commercializing its products. Litigation to establish the validity of patents, to defend against infringement claims or to assert infringement claims against others can be lengthy and expensive, even if a favorable result is obtained. Moreover, much of the Company’s expertise and technology cannot be patented.

Neurogen also relies heavily on trade secrets and confidentiality agreements with collaborators, advisors, employees, consultants, vendors and other service providers. The Company cannot assure you that these agreements will not be breached or that trade secrets will not otherwise become known or be independently discovered by competitors. Neurogen’s business would be adversely affected if competitors were able to learn the Company’s secrets or if the Company were unable to protect its intellectual property.

Competition

The biopharmaceutical industry is highly competitive and subject to rapid and substantial technological change. Developments by others may render Neurogen’s drug candidates or technologies noncompetitive or obsolete, or we may be unable to keep pace with technological developments or other market factors. Technological competition in the industry from pharmaceutical and biotechnology companies, universities, governmental entities and others diversifying into the field is intense and is expected to increase. Many of these entities have significantly greater research and development capabilities than Neurogen, as well as substantially more marketing, manufacturing, financial and managerial resources. These entities represent significant competition. In addition, acquisitions of, or investments in, competing development-stage pharmaceutical or biotechnology companies by large corporations could increase such competitors' financial, marketing, manufacturing and other resources.

Competitors have developed or are in the process of developing products or technologies that are, or in the future may be, the basis for competitive products. The Company’s competitors may develop products that are safer, more effective or less costly than any Neurogen products or may be able to complete their development more quickly. Neurogen would be at a significant competitive disadvantage if a competitor developed and successfully commercialized a drug similar to a Neurogen drug candidate ahead of the Company’s efforts.

Manufacturing

Neurogen is currently relying, in part, on third-party manufacturers to produce large quantities of development candidate compounds for preclinical development and dosage forms of these candidates to support clinical trials.

Pfizer manufactures or will be responsible for manufacturing, drugs for clinical trials which are subject to the 1994 Pfizer Agreement and has the right to manufacture future products under this collaboration, if any, for commercialization.

Aventis will be responsible for manufacturing, or having manufactured, drugs for clinical trials which are subject to the Aventis Agreement, and has the right to manufacture future products under the collaboration, if any, for commercialization.

With respect to compounds not currently subject to collaborations, the Company currently utilizes third-party manufacturers for preclinical development and clinical trials.

Sales and Marketing

Neurogen's strategy is to market products either directly or through co-promotion arrangements or other licensing arrangements with large pharmaceutical or biotechnology companies. The Company does not expect to establish a direct sales capability for at least the next several years, though it may pursue such a capability in the future. Pfizer has the right to market worldwide future products, if any, resulting from the Pfizer Agreement. Aventis has the right to market worldwide future products, if any, resulting from the Aventis Agreement.

Government Regulation

The production and marketing of Neurogen’s products, as well as research and development activities are subject to regulation for safety, efficacy and quality by numerous governmental authorities in the United States and other countries. In the United States, drugs are subject to rigorous federal regulation (Food and Drug Administration or FDA) and, to a lesser extent, state regulation. The Federal Food, Drug and Cosmetic Act, as amended, and the regulations promulgated thereunder, and other federal and state statutes and regulations govern, among other things, the testing, manufacture, safety, efficacy, labeling, storage, record keeping, approval, advertising and promotion of our products. Product development and approval within this regulatory framework will take a number of years and involve the expenditure of substantial resources.

The steps required before a pharmaceutical agent may be marketed in the United States include:

1. Preclinical laboratory tests, in vivo preclinical studies and formulation studies,
2. The submission to the FDA of an Investigational New Drug Application (IND) for human clinical testing which must become effective before human clinical trials can commence,
3. Adequate and well-controlled human clinical trials to establish the safety and efficacy of the drug,
4. The submission of a New Drug Application (NDA) or Product License Application to the FDA, and
5. FDA approval of the NDA or Product License Application prior to any commercial sale or shipment of the drug.

In addition to obtaining FDA approval for each product, each domestic drug manufacturing establishment must be registered with, and approved by, the FDA. Domestic manufacturing establishments are subject to biennial inspections by the FDA and must comply with the FDA's Good Manufacturing Practices for both drugs and devices. To supply products for use in the United States, foreign manufacturing establishments must comply with Good Manufacturing Practices and are subject to periodic inspection by the FDA or by regulatory authorities in such countries under reciprocal agreements with the FDA.

Preclinical testing includes laboratory evaluation of product chemistry and formulation, as well as animal studies to assess the potential safety and efficacy of the product. Preclinical safety tests must be conducted by laboratories that comply with FDA regulations regarding Good Laboratory Practices. The results of the preclinical testing are submitted to the FDA as part of an IND and are reviewed by the FDA prior to the commencement of human clinical trials. Unless the FDA objects to an IND, the IND will become effective 30 days following its receipt by the FDA.

Clinical trials involve the administration of the new drug to healthy volunteers or to patients under the supervision of a qualified principal investigator. Clinical trials must be conducted in accordance with Good Clinical Practices under protocols that detail the objectives of the study, the parameters to be used to monitor safety and the efficacy criteria to be evaluated. Each protocol must be submitted to the FDA as part of the IND. Further, each clinical study must be conducted under the auspices of an independent Institutional Review Board. The Institutional Review Board will consider, among other things, ethical factors, the safety of human subjects and the possible liability of the institution. Compounds must be formulated according to Good Manufacturing Practices.

Clinical trials are typically conducted in three sequential phases, but the phases may overlap. In Phase I, the initial introduction of the drug into healthy human subjects, the drug is tested for safety, absorption, dosage tolerance, metabolism, bio-distribution, excretion and pharmacodynamics (clinical pharmacology). Phase II typically involves studies in a limited patient population:

1. to determine the efficacy of the drug for specific, targeted indications,
2. to determine dosage tolerance and optimal dosage, and
3. to identify possible adverse side effects and safety risks.

When a compound is found to be effective and to have an acceptable safety profile in Phase II evaluations, Phase III trials are undertaken to further evaluate clinical efficacy and to test for safety within an expanded patient population at geographically dispersed clinical study sites. Neurogen or the FDA may suspend clinical trials at any time if it is believed that the individuals participating in such trials are being exposed to unacceptable health risks.

The results of the pharmaceutical development, preclinical studies and clinical studies are submitted to the FDA in the form of a NDA for approval of the marketing and commercial shipment of the drug. The testing and approval process is likely to require substantial time and effort. The approval process is affected by a number of factors, including the severity of the disease, the availability of alternative treatments and the risks and benefits demonstrated in clinical trials. Consequently, there can be no assurance that any approval will be granted on a timely basis, if at all. The FDA may deny an NDA if applicable regulatory criteria are not satisfied, require additional testing or information or require post-marketing testing and surveillance to monitor the safety of a company's products if it does not believe the NDA contains adequate evidence of the safety and efficacy of the drug. Notwithstanding the submission of such data, the FDA may ultimately decide that an NDA does not satisfy its regulatory criteria for approval. Moreover, if regulatory approval of a drug is granted, such approval may entail limitations on the indicated uses for which it may be marketed. Finally, product approvals may be withdrawn if compliance with regulatory standards is not maintained or if problems occur following initial marketing.

Among the conditions for NDA approval is the requirement that any prospective manufacturer's quality control and manufacturing procedures conform to Good Manufacturing Practices. In complying with standards set forth in these regulations, manufacturers must continue to expend time, money and effort in the area of production and quality control to ensure full technical compliance. Manufacturing establishments, both foreign and domestic, also are subject to inspections by or under the authority of the FDA and by other federal, state or local agencies.

Whether or not FDA approval has been obtained, approval of a product by regulatory authorities in foreign countries must be obtained prior to the commencement of commercial sales of the product in such countries. The requirements governing the conduct of clinical trials and product approvals vary widely from country to country, and the time required for approval may be longer or shorter than that required for FDA approval. Although there are some procedures for unified filings for certain European countries, in general, each country at this time has its own procedures and requirements.

In addition to regulations enforced by the FDA, Neurogen is also subject to regulation under the Occupational Safety and Health Act, the Environmental Protection Act, the Toxic Substances Control Act, the Resource Conservation and Recovery Act and other present and potential future federal, state or local regulations. The Company’s research and development involves the controlled use of hazardous materials, chemicals, and various low-level radioactive compounds. Although the Company believes that safety procedures for handling and disposing of such materials comply with the standards prescribed by state and federal regulations, the risk of accidental contamination or injury from these materials cannot be completely eliminated. In the event of any accident, Neurogen could be held liable for any damages that result and any such liability could exceed our resources.

Employees

As of December 31, 2002, the Company had 163 full-time employees, of which 121 persons were scientists and, of these scientists, 56 had Ph.D. degrees. None of the employees are covered by collective bargaining agreements, and the Company considers relations with employees to be good. All current scientific personnel have entered into confidentiality and non-competition agreements with the Company.

Research and Development Expenses

The Company incurred research and development expenses of $34,093,000, $34,494,000 and $28,048,000 in 2002, 2001, and 2000, which exclude non-cash stock compensation charges of $51,000, $901,000 and $4,637,000, respectively.

Available Information

The Company’s website address is www.neurogen.com. Neurogen makes available free of charge through its website all of the Company’s filings with the Securities and Exchange Commission (“SEC”), including its Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and all amendments to these reports. The Company’s filings are made available as soon as reasonably practicable after such material is electronically filed with the SEC. Copies are also available, without charge, from Neurogen Corporation, 35 Northeast Industrial Road, Branford, CT 06405.

ITEM 2. PROPERTIES

The Company conducts its operations in laboratory and administrative facilities on a single site located in Branford, Connecticut. The total facilities under ownership comprise approximately 148,000 square feet, of which 106,000 square feet is in use. Approximately 27,000 square feet has not yet been adapted for the Company’s research and development efforts.

In 1995, the Company leased approximately 24,000 square feet of a 39,000 square foot building under a ten-year agreement, which provided an option to purchase the entire facility effective after the fifth year of the original term of the lease. In January 2001, Neurogen elected to purchase the entire facility for $2.4 million. The additional space acquired of approximately 15,000 square feet continues to be leased through Neurogen to the third-party tenants who occupied the facilities at the time of purchase.

ITEM 3. LEGAL PROCEEDINGS

The Company knows of no material litigation or proceeding pending or threatened to which Neurogen is, or may become, a party.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

None.

CAUTIONARY STATEMENT FOR PURPOSES OF THE
"SAFE HARBOR" PROVISIONS OF THE PRIVATE SECURITIES
LITIGATION REFORM ACT OF 1995.

Except for historical matters, the matters discussed in this Form 10-K are" forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995 or any rules, regulations or releases of the Securities and Exchange Commission with respect thereto. Forward-looking statements in this Form 10K include, but are not limited to, statements in Item 1 under the caption "Business--Neurogen Drug Programs" with respect to the Company's various product development programs and statements in Item 7 under the caption "Management's Discussion and Analysis of Financial Condition and Results of Operations" with respect to the sufficiency of the Company's cash balance to fund planned operations. In addition, the Company may from time to time make forward-looking statements in the future.

Neurogen wishes to caution readers, and others to whom forward-looking statements are addressed, that any such forward-looking statements are not guarantees of future performance and that actual results may differ materially from estimates in the forward looking statements. In addition to the important factors described elsewhere in this Form 10-K and the Company's other filings with the Securities and Exchange Commission, the following important factors, among others, could affect Neurogen's actual future results and could cause such results to differ materially from estimates expressed in any forward-looking statements made by, or on behalf of, Neurogen:

• Failures, difficulties or delays in discovery, research, development, testing, regulatory approval, production and marketing of any of the Company's drug candidates, including without limitation any unanticipated pre-clinical or clinical failures, delays, delays in regulatory approvals, the failure to develop follow-on candidates in a given program, the failure to attract or retain scientific and management personnel, adverse side effects or inadequate therapeutic efficacy or inadequate drug properties which could prevent or slow product development efforts at any stage of product development by delaying or preventing clinical trials, delaying or preventing regulatory approval for commercialization or adversely affecting acceptance by the market. A very significant majority (estimated to be between 80 and 90 percent) of all drugs which enter human clinical trials fail to reach the market.



• Vigorous competition within the Company's anticipated product markets, including without limitation competition from fully-integrated pharmaceutical companies, specialty biotechnology companies and platform technology companies, many or all of which may have substantially greater capabilities, experience and resources than the Company.



• Risk that competitors will succeed in developing technologies (including drug discovery techniques) and products that are more effective than those of the Company or that are commercialized prior to similar technologies or products of the Company.



• Neurogen's dependence on its corporate partners with respect to research and development funding, pre-clinical evaluation of drug candidates, human clinical trials of drug candidates, regulatory filings and manufacturing and marketing expertise with respect to most of its most advanced compounds.



• Risk that Neurogen's interests will not coincide with those of its collaborators with respect to the timing or conduct of clinical development of compounds, the future production of developed products or strategies with respect to development and commercialization of such products.



• Risk that actual research and development costs and associated general and administrative costs may exceed budgeted amounts for a variety of reasons, including the uncertainty of product development in the pharmaceutical industry.



• Risk that drug targets pursued by the company may prove to be invalid after substantial investments by the Company.



• Inability to obtain sufficient funds through future collaborative arrangements, technology transfers, equity or debt financings or other sources to continue the operation of the Company's business which may require the Company to reduce substantially or eliminate expenditures for product development, to relinquish rights to certain of its technologies or potential products or to cease operations.



• Risk that the Company's patents and trade secrets and confidentiality agreements with collaborators, employees, consultants or vendors will be invalidated or not adequately protect the Company's intellectual property.



• Uncertainty of the scope and enforceability of patents in the pharmaceutical and biotechnology industries which purport to enable competitors to restrict others from pursuing certain drug targets.



• Risk that the Company may be prohibited or otherwise restricted from working on certain targets relevant to the Company's business.



• The Company's dependence upon third parties for the manufacture of its potential products and the Company's inexperience in manufacturing if the Company establishes internal manufacturing capabilities, each of which could adversely affect the Company's future profit margins, if any, and its ability to develop and manufacture products on a timely and competitive basis.



• Neurogen's dependence on third parties to market potential products and Neurogen's lack of sales and marketing capabilities, each of which could adversely affect the success of any sales and marketing efforts for the Company's products.



• Unavailability or inadequacy of medical insurance or other third-party reimbursement for the cost of purchases of the Company's products.



• Inability of the Company to attract and retain qualified management, employees and consultants.

PART II

ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS

The common stock of Neurogen is traded on the NASDAQ Stock Market under the symbol NRGN. As of February 28, 2003, there were approximately 209 holders of record of the Company's common stock. No dividends have been paid on the common stock to date, and the Company currently intends to retain any earnings for further development of the Company's business.

The following table sets forth the high and low closing bid prices for the common stock as reported by NASDAQ.

ITEM 6. SELECTED FINANCIAL DATA

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND

RESULTS OF OPERATIONS

OVERVIEW

Since its inception in September 1987, Neurogen has been engaged in the discovery and development of drugs. The Company has not derived any revenue from product sales and expects to incur significant losses in most years prior to deriving any such product revenues. Revenues to date have come from five collaborative research agreements, one license agreement and one technology transfer agreement.

The preparation of Neurogen's financial statements in conformity with generally accepted accounting principles requires management to make certain estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Management makes estimates in the areas of revenue recognition, income taxes, stock-based compensation and marketable securities and investments. Estimates are based on historical experience and on various other assumptions that management believes to be reasonable under the circumstances. Actual amounts could differ from those estimates.

The Company believes the following critical accounting policies affect management's more significant judgments and estimates used in the preparation of Neurogen's financial statements:

Revenue Recognition

Each of Neurogen’s collaborative research, licensing and technology transfer agreements are significant since the terms of such arrangements may cause the Company’s operating results to vary considerably from period to period.

The Company has entered into collaborative research agreements which provide for the partial funding of specified projects in exchange for the grant of certain rights related to potential discoveries. Revenue under these arrangements typically includes upfront non-refundable fees, ongoing payments for specified levels of staffing for research and milestone payments upon occurrence of certain events. The upfront fees are recognized as revenue ratably over the period of performance under the research agreement. The research funding is recognized as revenue as the related research effort is performed. Revenue derived from the achievement of milestones is recognized when the milestone event occurs and such event represents the achievement of a specific, substantive goal measuring a substantive stage of development towards a long-term goal, such as the filing of a New Drug Application with the Food and Drug Administration.

Neurogen has also entered into, and now completed, a technology transfer agreement under which revenue has been recognized when a contractual arrangement exists, fees are fixed and determinable, delivery of the technology has occurred and collectibility is reasonably assured. When customer acceptance was required, revenue was deferred until acceptance occurred. Where there were on-going services or obligations after delivery, revenue has been recognized over the related term of the service on a percentage of completion basis, unless such service was maintenance, in which case revenue has been recognized on a straight line basis. For a contract with multiple elements, total contract fees are allocated to the different elements based on evidence of fair value.

Income Taxes

The liability method of Statement of Financial Accounting Standards (“SFAS”) No. 109, “Accounting for Income Taxes”, is used to account for income taxes. Deferred tax assets and liabilities are determined based on net operating loss carryforwards and differences between financial reporting and income tax bases of assets and liabilities. Deferred items are measured using the enacted tax rates and laws that are expected to be in effect when the differences reverse. Deferred tax assets may be reduced by a valuation allowance to reflect the uncertainty associated with their ultimate realization. Any subsequently recognized tax benefits relating to the valuation allowance for deferred tax assets would be recorded as an income tax benefit in the Statement of Operations or a charge to Additional Paid-In Capital.

Stock-Based Compensation

The Company primarily grants qualified stock options for a fixed number of shares to employees with an exercise price equal to the fair market value of the shares at the date of grant. The Company has also issued restricted stock to key executives which vest over specified service periods. The Company has adopted the disclosure-only provisions of SFAS No. 123, “Accounting for Stock-Based Compensation” and therefore accounts for grants of stock options and restricted stock in accordance with Accounting Principles Board (“APB”) Opinion No. 25, "Accounting for Stock Issued to Employees." Accordingly, Neurogen recognizes no compensation expense for the options when the option grants to employees have an exercise price equal to the fair market value at the date of grant and other relevant terms are fixed or determinable. If compensation cost for the Company's grant of stock awards was determined based on the fair value at the grant date consistent with the provisions of SFAS No. 123, the Company's net loss and loss per share would be materially effected.

The Company occasionally grants stock option awards to consultants. Such grants are accounted for pursuant to 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”, and accordingly recognizes compensation expense equal to the fair value of such awards. The fair value of each award is estimated using the Black-Scholes model with certain weighted average assumptions (described in Note 7 to the consolidated financial statements).

Marketable Securities

The Company invests in U.S. government and corporate debt securities. The fair value of these securities is subject to volatility and change. The Company considers its investment portfolio to be available-for-sale securities as defined in SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities." Marketable securities at December 31, 2002 and 2001 consisted of debt securities with maturities of three months to six years. Available for sale securities are carried at fair value with the unrealized gains/losses reported as other comprehensive income. Realized gains and losses have been determined by the specific identification method and are included in investment income. Different classifications of the Company’s marketable securities pursuant to SFAS No. 115 would possibly result in material impacts to the valuation of the securities and investment income.

RESULTS OF OPERATIONS

Results of operations may vary from period to period depending on numerous factors, including the timing of income earned under existing or future collaborative research agreements, technology transfer agreements or joint ventures, the progress of the Company's partnered research and development projects, the size of the Company’s staff and the level of preclinical and clinical development spending on drug candidates in unpartnered programs. Neurogen believes its research and development costs may increase significantly over the next several years as its drug development programs progress. In addition, general and administrative expenses would be expected to increase to support any expanded research and development activities.

Years Ended December 31, 2002, 2001 and 2000

The Company's fiscal 2002 operating revenues increased 37 percent to $15.7 million from 2001 operating revenues of $11.5 million. The revenue increase consists of a $3.0 million increase in license fee revenues and a $1.2 million increase in research and development revenues. The $3.0 million increase in license fees is due to the recognition of a one-time $2.0 million payment from Pfizer to satisfy all obligations from Pfizer’s use of the AIDD™ technology as a part of the companies’ 1999 Technology Transfer Agreement (described below), a $1.8 million increase in license fees recognized from Aventis as part of the Aventis Agreement (described below) offset by a $0.8 million decrease in AIDD™ technology development and improvement services related to the Pfizer Technology Transfer Agreement. The increase in research revenues is due to a $4.1 million increase in research revenues from Aventis (to reflect a full year of research funding under the companies’ December 2001 collaboration agreement to develop drugs to treat depression and anxiety) offset in part by a $2.9 million decrease in revenues from Pfizer due to the scheduled conclusion in December 2001 of the companies’ joint research collaboration on GABA-based drugs.

Fiscal 2001 operating revenues decreased 44 percent from 2000 operating revenues of $20.4 million. This decrease was primarily due to a $5.9 million decrease in research and development revenues resulting from a scheduled reduction in the Company's staffing and related discovery research funding on GABA and neuropeptide Y (NPY) collaborative drug discovery programs with Pfizer which comprised $2.9 million of operating revenues in 2001 as compared to $8.8 million in 2000. The recognition of license fee revenues pursuant to the Pfizer Technology Transfer Agreement also decreased from $11.2 million in 2000 to $8.3 million in 2001.

Research and development expenses, excluding non-cash stock compensation charges, remained stable for fiscal 2002 at $34.1 million as compared to $34.5 million in 2001, and increased 23 percent in 2001 from $28.0 million in 2000. External development costs related to potential drug candidates decreased from $5.5 million in 2001 to $3.5 million in 2002 in part due to the assumption by Aventis commencing in December 2001 of the costs of developing potential drug candidates from the Company’s collaborative efforts. This decrease was offset by an overall increase in the Company’s ongoing investment in scientific personnel and research supplies. The increase in 2001 was primarily due to external development costs related to potential drug candidates which increased to $5.5 million from $1.4 million in 2000. The increase was also driven by the Company's continued expansion of its AIDD™ program for the discovery of new drug candidates. Research and development expenses represented 84 percent, 84 percent and 83 percent of total operating expenses (excluding non-cash stock compensation charges) for the years ended December 31, 2002, 2001 and 2000, respectively.

The Company expenses all research and development costs as incurred. While the Company maintains a system to record the level of staffing time spent on its research and development projects, it does not maintain a historical cost accounting system with sufficient accuracy to reliably estimate its research and development costs on a specific project-by-project basis. A significant portion of the Company’s research and development expenses (such as laboratory supplies, travel, information systems and services and facilities costs) benefit multiple projects and are not individually tracked to a specific project. Further, the Company’s staff timekeeping system does not account for differences in compensation costs between lower level technicians and more senior scientists.

General and administrative expenses, excluding non-cash stock compensation charges, remained stable at $6.7 million in 2002 as compared to $6.6 million in 2001, and increased 15 percent in 2001 from $5.7 million in 2000. The increase in 2001 was attributed to additional administrative and technical services and personnel to support the protection of Neurogen's growing intellectual property estate and to support Neurogen's expanding research pipeline.

Total stock compensation expenses were $0.6 million in 2002 compared to $1.5 million in 2001 and $7.1 million in 2000. The 2002 compensation expense is primarily composed of continuing non-cash charges for grants of certain stock awards in 1997, 2001 and 2002 to certain officers of the Company. The 2001 expense included non-cash charges to income for grants of certain stock awards in 1997 and 2001, as well as one-time non-cash charges totaling $1.0 million for the modification of certain stock options held by two executive officers. In 2000 the Company recorded $6.5 million in stock compensation expense for the vesting of restricted stock granted to certain employees in prior years. A portion of the stock compensation charges (those relating to the 1997 awards) are variable and as a result may fluctuate significantly in the future.

Other income was $1.7 million in 2002 compared to $4.5 million in 2001 and $5.5 million in 2000. The decrease in 2002 is primarily due to an increase in interest expense of $1.0 million associated with a $17.5 million first mortgage debt financing the Company entered into in December 2001. The remainder of the decrease in 2002, as well as the decrease in 2001, was due to a decrease in investment income due to lower overall returns on invested funds. This was a result of lower average cash and marketable securities balances as well as a reduction in prevailing market interest rates.

For the years ended December 31, 2002 and 2001, the Company recorded Connecticut income tax benefits of $0.3 million and $1.2 million, respectively, in the Statement of Operations. The Company recognized total income tax benefits of $0.6 million and $2.0 million for the years ended December 31, 2002 and 2001, respectively, a portion of which has been recorded to Additional Paid-In Capital. The benefits are the result of Connecticut legislation which allowed certain companies to obtain cash refunds from the State of Connecticut at an exchange rate of 65% of their research and development credits in exchange for foregoing the carryforward of these credits into future tax years.

The Company recognized a net loss of $23.7 million for the year ended December 31, 2002, $25.4 million for the year ended December 31, 2001, and $15.5 million for the year ended December 31, 2000. The decrease in the 2002 net loss is primarily due to the increase in operating revenues. The increase in the 2001 net loss is primarily due to the decrease in revenues and the increase in research and development and general and administrative expenses described above.

In December 1999, the staff of the Securities and Exchange Commission issued its Staff Accounting Bulletin ("SAB") No. 101, Revenue Recognition in Financial Statements. SAB No. 101, as amended by SAB No. 101A and 101B, provides guidance on the measurement and timing of revenue recognition in financial statements of public companies. SAB No. 101 permits application of its guidance to be treated as a change in accounting principle in accordance with Accounting Principles Board (“APB”) Opinion No. 20, Accounting Changes.

The Company adopted the guidance of SAB No. 101 in the fourth quarter of 2000, retroactive to January 1, 2000, and reflected a cumulative effect of change in accounting principle on prior years of $0.5 million, related to timing of revenue recognition on certain non-refundable up-front payments previously recognized on a technology transfer agreement.

LIQUIDITY AND CAPITAL RESOURCES

At December 31, 2002 and 2001, cash, cash equivalents (including restricted cash of $1.5 million in 2001) and marketable securities in the aggregate were $79.4 million and $106.8 million, respectively. A total amount of $44.8 million of the marketable securities at December 31, 2002 have maturities greater than one year. However, the Company can and may liquidate such investments prior to maturity to meet its strategic and/or investment objectives. The Company's cash and other short-term investment levels decreased ratably throughout 2002 due primarily to continued operating expenses, as well as purchases of property, plant and equipment of $2.1 million and scheduled payments on outstanding loans (described below) of $2.5 million. This decrease was partially offset by the receipt of $9.2 million in research funding and license fees and $2.6 million in income tax benefits from the State of Connecticut as described below. The levels of cash, cash equivalents and marketable securities have fluctuated significantly in the past and are expected to do so in the future as a result of the factors described below. The Company plans to use its cash, cash equivalents and marketable securities for its research and development activities, working capital and general corporate purposes.

Neurogen's cash requirements to date have been met by the proceeds of its equity financing activities, amounts received pursuant to collaborative research, licensing or technology transfer arrangements, certain debt arrangements and interest earned on invested funds. The Company's equity financing activities have included underwritten public offerings of common stock, private placement offerings of common stock and private sales of common stock in connection with collaborative research and licensing agreements. Total funding received from these financing activities was approximately $146.6 million. The Company's expenditures have been primarily to fund research and development and general and administrative expenses and to construct and equip its research and development facilities.

The Company is in the early stage of product development. It has not derived any product revenues from product sales and does not expect to derive any product revenues for at least the next several years, if at all. Prior to deriving any such product revenues, the Company expects to incur significant losses and negative cash flows which in the aggregate could exceed the Company’s existing cash resources. To provide cash to fund its operations until such time as it achieves sustainable revenues, the Company relies extensively on its ability to develop drug discovery programs of sufficient value to either partner the programs with pharmaceutical companies or raise capital through equity financings.

To the extent that drug candidates progress in the Company’s currently unpartnered programs, such as its program for the treatment of inflammatory disorders or earlier stage programs, such progress could lead to the opportunity to partner on terms which provide capital, revenues and cash flows to the Company or the opportunity to raise capital through equity offerings. If unpartnered programs do not progress or do not progress on schedule, such opportunities would be delayed or may not materialize at all.

To the extent that drug candidates progress in the Company’s partnered programs, such as the Company’s insomnia program partnered with Pfizer or its depression and anxiety program partnered with Aventis, such progress could result in milestone payments and additional research and development funding to the Company under the respective collaboration agreements. Such progress could also provide the opportunity to raise capital through equity offerings. If partnered programs do not progress or do not progress on schedule, such opportunities would be delayed or may not materialize at all.

Lack of progress, scheduling delays or failures in any of the Company’s major programs could significantly reduce the Company’s levels of revenues, cash flows and cash available to fund its business. It could also significantly increase the Company’s cost of capital and limit its ability to raise equity capital. All of the Company’s compounds in development, whether in human clinical trials or not, will require significant additional research, development and testing before they can be commercialized. Furthermore, the scope, magnitude and timing of future research and development expenses, as well as anticipated project completion dates, are a series of steps, ranging from preclinical testing to clinical studies in humans. Each step in the process is typically more expensive than the previous step, but actual timing and cost for completion depends on the specific progress of each product being tested.

While the Company cannot accurately predict the time required or the cost involved in commercializing any one of its candidates, new drug development typically takes many years and tens or hundreds of millions of dollars. In addition, developing new drugs is an extremely uncertain process where most candidates fail and uncertain developments such as clinical or regulatory delays, side effects, undesirable drug properties or ineffectiveness of a drug candidate would slow or prevent the development of a product. If we or our partners are unable to commercialize one or more of our drug products, we will never achieve product revenues and may eventually be unable to continue our operations. This result would cause our shareholders to lose all or a substantial portion of their investment.

The debt agreements entered into by the Company to date include the commercial term mortgage loan financing in December 2001 with Webster Bank, and a construction loan entered into in October 1999 with Connecticut Innovations, Inc. (“CII”). Total proceeds received under these agreements were $22.5 million, which are repayable through monthly installments over a maximum term of 15 years, bearing various interest rates which approximated 3.9%-7.5% from 1999 through 2002. Of these amounts received, $21.0 million remained outstanding as of December 31, 2002. An approximate aggregate amount of $1.4 million is due and payable in each of the next five years. Thereafter, approximately $14.0 million is payable in regular installments until the scheduled maturity dates, including a balloon payment of $5.9 million on the mortgage loan upon maturity in December 2011. The loan with CII contains certain subjective acceleration clauses, which upon occurrence of certain events, may cause amounts due under the agreement to become immediately due and payable. The Company has no indication that it is in default of any such clauses and therefore has classified its debt based on the dates regular payments are due. As of December 31, 2002, Neurogen is not engaged in any significant lease or capital expenditure commitments.

In October 2002, as a part of its Operational Excellence program, Neurogen reorganized certain departments and eliminated 24 employee positions, representing approximately 10% of its total workforce. The Company recorded a charge of approximately $0.3 million in the fourth quarter of 2002 for employee termination costs, such as severance pay, continuation of benefits and personal outplacement support. Restructuring payments of a minimal amount are expected to end in the first quarter of 2003.

Neurogen anticipates that under the restructured operating program, its current cash balance, as supplemented by research funding pursuant to its collaborative research agreement with Aventis, will be sufficient to fund its current and planned operations into at least early 2005. However, Neurogen's funding requirements may change and will depend upon numerous factors, including but not limited to: the progress of the Company's research and development programs; the timing and results of preclinical testing and clinical studies; the timing of regulatory approvals; technological advances; determinations as to the commercial potential of its proposed products; the status of competitive products and the ability of the Company to establish and maintain collaborative arrangements with others for the purpose of funding certain research and development programs; conducting clinical studies; obtaining regulatory approvals and, if such approvals are obtained, manufacturing and marketing products. Many of these factors could significantly increase the Company's expenses and use of cash. The Company anticipates that it may augment its cash balance through financing transactions, including the issuance of debt or equity securities and further corporate alliances. The Company has filed an S-3 registration statement which became effective in February 2003, under which the Company may issue debt, common or preferred stock or warrants of up to $75 million in total financing within two years of the effective date. No assurances can be given that adequate levels of additional funding can be obtained on favorable terms, if at all.

As of December 31, 2002, the Company had approximately $112.5 million and $7.1 million of net operating loss and research and development credit carryforwards, respectively, available for federal income tax purposes, which expire in the years 2004 through 2022. The Company also had approximately $99.0 million and $4.5 million of Connecticut state tax net operating loss and research and development credit carryforwards, respectively, which expire in the years 2003 through 2022. In September 2002, the Company applied to exchange 2001 Connecticut research and development credits for cash proceeds under Connecticut tax law provisions effective at that time (as mentioned above), resulting in the receipt of a $0.4 million payment from the State of Connecticut in November 2002. Neurogen also received a payment of $2.2 million in April 2002 for the exchange of 2000 research and development credits. Because of "change in ownership" provisions of the Tax Reform Act of 1986, the Company's utilization of its net operating loss and research and development credit carryforwards may be subject to an annual limitation in future periods.

COLLABORATIVE RESEARCH AGREEMENTS

In December 2001, Neurogen entered into a collaboration and license agreement with Aventis pursuant to which Aventis made an initial payment of $10 million and agreed, among other things, to fund a specified level of resources for three years for Neurogen's program for the discovery and research of CRF-1 receptor-based drugs for a broad range of applications, including the therapeutic treatment of depression and anxiety disorders. Aventis has the option to extend the discovery and research effort for up to an additional two years or terminate the collaboration prior to its scheduled conclusion and transfer all rights to the collaborative program to Neurogen. As of December 31, 2002, the Company has received $3.6 million of research funding from Aventis. Neurogen is also eligible to receive milestone payments if certain compound discovery, product development or regulatory objectives are achieved subject to the collaboration. In return, Aventis received the exclusive worldwide rights to develop, manufacture and market collaboration drugs that act through the CRF-1 receptor, for all therapeutic indications for which the drugs may be used. Aventis will pay Neurogen royalties based upon net sales levels, if any, for collaboration products. Also under the agreement, Aventis is responsible for funding the cost of development, including clinical trials, manufacturing and marketing of collaboration products, if any.

In June 1999, Neurogen and Pfizer entered into the Pfizer Technology Transfer Agreement. Under the terms of this agreement, Pfizer agreed to pay Neurogen up to a total of $27.0 million over a three year period for the licensing and transfer to Pfizer of certain of Neurogen's AIDD™ technologies for the discovery of new drugs, along with the installation of an AIDD™ system. Additional payments were also possible upon Pfizer's successful utilization of this technology. Pfizer received a non-exclusive license to certain AIDD™ intellectual property and the right to employ this technology in its own drug discovery programs. As of December 31, 2002, Pfizer had provided $29.0 million pursuant to the Pfizer Technology Transfer Agreement, which terminated on schedule in June 2002. Total fees include a $2.0 million one-time payment in December 2002 to satisfy all obligations from Pfizer’s use of the AIDD™ technology.

RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS

In August 2001, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets." SFAS No. 144 supercedes SFAS No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of," in that it excludes goodwill from its impairment scope and allows for different approaches in cash flow estimation. However, SFAS No. 144 retains the fundamental provisions of SFAS No. 121 for recognition and measurement of the impairment of (a) long-lived assets to be held and used and (b) long-lived assets to be disposed of other than by sale. Neurogen adopted the provisions of SFAS No. 144 as of January 1, 2002. The implementation of this standard did not have any impact on the Company’s results of operations and financial position.

In July 2002, the Financial Accounting Standards Board issued SFAS No. 146, "Accounting for Costs Associated with Exit or Disposal Activities". SFAS No. 146 addresses financial accounting and reporting for costs associated with exit or disposal activities and nullifies EITF Issue No. 94-3, "Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring)." The provisions of SFAS No. 146 are effective for exit or disposal activities initiated after December 31, 2002. However, as encouraged in the statement, the Company has early adopted SFAS No. 146 and has applied its respective provisions to the exit activity undertaken in 2002 (described in Note 12 to the consolidated financial statements).

In December 2002, the Financial Accounting Standards Board issued SFAS No. 148, "Accounting for Stock-Based Compensation – Transition and Disclosure". SFAS No. 148 amends SFAS No. 123 to address alternative methods of transition for a voluntary change from the intrinsic to the fair value method of accounting for stock-based employee compensation. The statement also amends certain disclosure provisions in SFAS No. 123. Neurogen continues to utilize the intrinsic value method to account for stock-based employee compensation. However, the disclosure provisions of SFAS No. 148 have been implemented in the 2002 consolidated financial statements.

In November 2002, the Financial Accounting Standards Board issued FIN No. 45, "Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others”, which elaborates on the disclosures to be made by a guarantor in its interim and annual financial statements about its obligations under certain guarantees that it has issued. The Company has indemnification agreements with three employees as of December 31,2002 for contingent payments which may be required under provisions that exist in such employees' employment agreements with prior employers. The maximum amount of this potential obligation is approximately $3.0 million, however the Company believes the likelihood of payment of any amounts under such indemnifications is remote.

In January 2003, the Financial Accounting Standards Board issued EITF Issue No. 00-21, “Revenue Arrangements with Multiple Deliverables”. EITF 00-21 addresses, for arrangements with multiple deliverables, how the arrangement consideration should be measured, whether the arrangement should be divided into separate units of accounting and how the arrangement consideration should be allocated among the separate units of accounting. The guidance in EITF 00-21 is effective for revenue arrangements entered into in fiscal periods beginning after June 15, 2003, and therefore does not have any impact on the 2002 consolidated financial statements. The consensus in this EITF pronouncement may affect how the Company recognizes revenue under future collaboration and technology transfer arrangements since these often include multiple elements such as non-refundable upfront fees, ongoing payments for specified levels of staffing for research and milestone payments.

ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Interest rate risk. The Company's investment portfolio includes investment grade debt instruments. These securities are subject to interest rate risk, and could decline in value if interest rates fluctuate. Due to the short duration and conservative nature of these instruments, the Company does not believe that it has a material exposure to interest rate risk. Additionally, funds available from investment activities are dependent upon available investment rates. These funds may be higher or lower than anticipated due to interest rate volatility.

Capital market risk. The Company currently has no product revenues and is dependent on funds raised through other sources. One source of funding is through further equity offerings. The ability of the Company to raise funds in this manner is dependent upon capital market forces affecting the stock price of the Company.

ITEM 8. CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

Consolidated Balance Sheets at December 31, 2002 and 2001

Consolidated Statements of Operations for the years ended December 31, 2002, 2001 and 2000

Consolidated Statements of Stockholders' Equity for the years ended December 31, 2002, 2001 and 2000

Consolidated Statements of Cash Flows for the years ended December 31, 2002, 2001 and 2000

Notes to Consolidated Financial Statements

Report of Independent Accountants

NEUROGEN CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

BUSINESS--Neurogen Corporation ("Neurogen" or the "Company") is a company engaged in the discovery and development of new drugs for a broad range of pharmaceutical uses. Neurogen is focused on discovering new small molecule drugs (e.g. drugs which can be taken orally as a pill) where existing therapies achieve limited therapeutic effects or produce unsatisfactory side effects. The Company has not derived any revenue from product sales to date.

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 liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Management makes estimates in the valuation of marketable securities and investments, revenue recognition, collaboration costs, income taxes, accruals and stock compensation. Actual amounts could differ from those estimates.

CASH EQUIVALENTS AND MARKETABLE SECURITIES--The Company considers cash equivalents to be only those investments which are highly liquid, readily convertible to cash and which mature within three months from date of purchase. The carrying values of cash equivalents at December 31, 2002 and 2001 were approximately $11,940,000 and $50,774,000, respectively.

The Company considers its investment portfolio to be available-for-sale securities as defined in SFAS No. 115, “Accounting for Certain Investments in Debt and Equity Securities”. Marketable securities at December 31, 2002 and 2001 consist of debt securities with maturities of three months to six years. Available-for-sale securities are carried at fair value with the unrealized gains/losses reported as other comprehensive income. Realized gains and losses have been determined by the specific identification method and are included in investment income. The Company recognized gross realized gains of $392,000, $103,000, and $84,000 in 2002, 2001, and 2000, respectively. Gross realized losses were $65,000, $6,000, and $69,000 in 2002, 2001, and 2000, respectively.

PROPERTY, PLANT AND EQUIPMENT--Property, plant and equipment are stated at cost. Depreciation is provided using the straight-line method over the estimated useful lives of the assets, which are as follows:

REVENUE RECOGNITION--The Company has entered into collaborative research agreements which provide for the partial funding of specified projects in exchange for the grant of certain rights related to discoveries. Revenue under these arrangements typically includes upfront non-refundable fees, ongoing payments for specified levels of staffing for research and milestone payments upon the occurrence of certain events.

Since the adoption of SAB No. 101, “Revenue Recognition in Financial Statements”, the upfront fees are recognized as revenue ratably over the period of performance under the research agreement. The research funding is recognized as revenue as the related research effort is performed. Each of the Company’s collaborative research agreements specifies a level of funding for each annual full-time equivalent (“FTE”) scientist working on a given project. An FTE is the equivalent of one person working a certain number of research hours per year. The Company recognizes its research revenue under such collaborative research agreements based on the number of FTEs that worked on the project, subject to a maximum number of FTEs, multiplied by the level of funding per FTE defined in the agreement.

Revenue derived from the achievement of milestones is recognized when the milestone event occurs. Each such event represents the achievement of a specific, substantive goal measuring a substantive stage of development towards a long-term goal, such as the filing of a New Drug Application with the Food and Drug Administration.

Neurogen has entered into one technology transfer agreement, spanning a three year period, which is accounted for as a multiple element arrangement where the contract fee is allocated to the different elements based on evidence of fair value. The Company identified three specific elements within the contract, each of which has a separate earnings process. These elements are: (1) the construction, delivery, installation and maintenance of a specified number of AIDD™ (Accelerated Intelligent Drug Discovery) systems (some specifically contracted for and some to be delivered, at the option of the recipient, at no additional cost); (2) AIDD™ technology development and improvement services to be incurred in the second and third years of the contract and (3) the delivery of specified AIDD™ improvements during the third year of the agreement.

Each element is considered to be separate as: (1) the AIDD™ systems could be sold by Neurogen unaccompanied by any of the other elements; (2) similar development and improvement services have been provided by the Company in the past to several other collaborative partners and (3) the separately stated fee for the delivery of the specified improvements is payable upon an acceptance scheduled at the termination of the agreement. None of the above elements requires delivery of subsequent elements in order to be functional.

Based upon contract provisions, each AIDD™ system must be accepted by the recipient, and after delivery, Neurogen has an obligation to provide specified maintenance on the system for eight months. Therefore, the fee associated with each system is recognized as revenue ratably over the period beginning at the date of acceptance through the end of the maintenance period. If the customer elects to not have any of the optional systems delivered, the fee allocated to such undelivered systems will be recognized upon contract termination. The contract fee associated with the AIDD™ technology development and improvement services is recognized as revenue on a percentage-of-completion basis over the term of service. The contract fee for the delivery of specified AIDD™ improvements will be recognized upon acceptance by the recipient.

Revenue resulting from up-front, non-refundable fees under collaborative research agreements and all fees under the technology transfer agreement are recorded as License Fees revenues for purposes of the financial statements. Research funding for the Company's staffing on projects and milestone payments under collaborative agreements are recorded as Research and Development revenues. Deferred revenue arises from the payments received for research and development to be conducted in future periods or for licenses of Neurogen's rights or technology where Neurogen has continuing involvement.

In December 1999, the staff of the Securities and Exchange Commission issued SAB No. 101. This SAB, as amended by SAB No. 101A and 101B, provides guidance on the measurement and timing of revenue recognition in financial statements of public companies. SAB No. 101 permits application of its guidance to be treated as a change in accounting principle in accordance with APB Opinion No. 20, Accounting Changes. The Company adopted the guidance of SAB No. 101 in the fourth quarter of 2000, retroactive to January 1, 2000 and reflected a cumulative effect of the change in accounting principle on prior years of $500,000, related to timing of revenue recognition on certain non-refundable up-front payments previously recognized on a technology transfer agreement.

RESEARCH AND DEVELOPMENT--All research and development costs, which primarily include scientific salaries and benefits, laboratory supplies, external research studies, compound formulation and manufacturing and overhead facilities expenses, are expensed as incurred.

PRINCIPLES OF CONSOLIDATION--The consolidated financial statements include the accounts of the parent company and a wholly-owned subsidiary, Neurogen Properties LLC, after elimination of intercompany transactions.

SEGMENT INFORMATION--SFAS No. 131, “Disclosures about Segments of an Enterprise and Related Information”, requires that an enterprise report financial and descriptive information about each of its reportable operating segments. The Company operates in one segment: drug discovery and pharmaceutical development.

STOCK-BASED COMPENSATION--The Company primarily grants qualified stock options for a fixed number of shares to employees with an exercise price equal to the fair market value of the shares at the date of grant. The Company has also issued restricted stock to key executives which vest over specified service periods. The Company accounts for grants of stock options and restricted stock in accordance with APB Opinion No. 25, "Accounting for Stock Issued to Employees," and, accordingly, recognizes no compensation expense for the options when the option grants have an exercise price equal to the fair market value at date of grant. The Company has adopted the disclosure only provisions of SFAS No. 123, "Accounting for Stock-Based Compensation", as amended by SFAS No. 148, “Accounting for Stock-Based Compensation – Transition and Disclosure”.

In December 2002, the Financial Accounting Standards Board issued SFAS No. 148 to address alternative methods of transition for a voluntary change from the intrinsic to the fair value method of accounting for stock-based employee compensation. The statement also amends certain disclosure provisions in SFAS No. 123. Neurogen continues to utilize the intrinsic value method to account for stock-based employee compensation. However, the disclosure provisions of SFAS No. 148 have been implemented in the 2002 financial statements.

The Company occasionally grants stock option awards to consultants. Such grants are accounted for pursuant to 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”, and accordingly recognizes compensation expense equal to the fair value of such awards.

As of December 31, 2002 compensation expense has not been recognized for the stock option plans, except as noted above. Had compensation cost for the Company's stock option plans been determined based on the fair value at the grant date for awards in 2002, 2001 and 2000 consistent with the provisions of SFAS No. 123, the Company's net loss and loss per share would have been adjusted to the pro forma amounts indicated below (in thousands, except per share data):

As additional options are expected to be granted in future years and as the options vest over several years, the above pro forma results are not necessarily indicative of future pro forma results.

INCOME TAXES--The liability method of SFAS No. 109, “Accounting for Income Taxes”, is used to account for income taxes. Deferred tax assets and liabilities are determined based on net operating loss carryforwards and differences between financial reporting and income tax bases of assets and liabilities. Deferred items are measured using the enacted tax rates and laws that are expected to be in effect when the differences reverse. Deferred tax assets may be reduced by a valuation allowance to reflect the uncertainty associated with their ultimate realization.

EARNINGS (LOSS) PER SHARE (“EPS”)--Basic EPS is calculated in accordance with SFAS No. 128, “Earnings per Share”, by dividing income or loss attributable to common stockholders by the weighted average common shares outstanding. Diluted EPS is calculated in accordance with SFAS No. 128 by adjusting weighted average common shares outstanding by assuming conversion of all potentially dilutive shares. In periods where a net loss is recorded, no effect is given to potentially dilutive securities, since the effect would be antidilutive.

FAIR VALUE OF FINANCIAL INSTRUMENTS--The carrying value of long-term debt approximates its fair value based upon currently available debt instruments having similar interest rates and maturities. The carrying amounts of the Company's other financial instruments approximate their fair value.

RECENT PRONOUNCEMENTS--In August 2001, the Financial Accounting Standards Board issued SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets." SFAS No. 144 supercedes SFAS No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of," in that it excludes goodwill from its impairment scope and allows for different approaches in cash flow estimation. However, SFAS No. 144 retains the fundamental provisions of SFAS No. 121 for recognition and measurement of the impairment of (a) long-lived assets to be held and used and (b) long-lived assets to be disposed of other than by sale. Neurogen adopted the provisions of SFAS No. 144 as of January 1, 2002. The implementation of this standard did not have any impact on the Company’s results of operations and financial position.

In July 2002, the Financial Accounting Standards Board issued SFAS No. 146, "Accounting for Costs Associated with Exit or Disposal Activities". SFAS No. 146 addresses financial accounting and reporting for costs associated with exit or disposal activities and nullifies Emerging Issues Task Force Issue No. 94-3, "Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring)." The provisions of SFAS No. 146 are effective for exit or disposal activities initiated after December 31, 2002. However, as encouraged in the statement, the Company has early adopted SFAS No. 146 and has applied its respective provisions to the exit activity undertaken in 2002 (described in Note 12).

In November 2002, the Financial Accounting Standards Board issued FIN No. 45, "Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others”, which elaborates on the disclosures to be made by a guarantor in its interim and annual financial statements about its obligations under certain guarantees that it has issued. The Company has indemnification agreements with three employees as of December 31,2002 for contingent payments which may be required under provisions that exist in such employees' employment agreements with prior employers. The maximum amount of this potential obligation is approximately $3.0 million, however the Company believes the likelihood of payment of any amounts under such indemnifications is remote.

In January 2003, the Financial Accounting Standards Board issued EITF Issue No. 00-21, “Revenue Arrangements with Multiple Deliverables”. EITF 00-21 addresses, for arrangements with multiple deliverables, how the arrangement consideration should be measured, whether the arrangement should be divided into separate units of accounting and how the arrangement consideration should be allocated among the separate units of accounting. The guidance in EITF 00-21 is effective for revenue arrangements entered into in fiscal periods beginning after June 15, 2003, and therefore does not have any impact on the 2002 consolidated financial statements. The consensus in this EITF pronouncement may affect how the Company recognizes revenue under future collaboration and technology transfer arrangements since these often include multiple elements such as non-refundable upfront fees, ongoing payments for specified levels of staffing for research and milestone payments.

2. CORPORATE PARTNER AGREEMENTS

AVENTIS

In December 2001, Neurogen entered into a collaboration and license agreement with Aventis (the "Aventis Agreement") pursuant to which Aventis made an initial payment of $10 million and agreed, among other things, to fund a specified level of resources for three years for Neurogen's program for the discovery and research of CRF-1 receptor-based drugs for a broad range of applications, including the therapeutic treatment of depression and anxiety disorders. Aventis has the option to extend the discovery and research effort for up to an additional two years or to terminate the collaboration prior to its scheduled conclusion and transfer all rights to the collaborative program to Neurogen. As a result of the option to extend, the Company is recognizing the initial payment ratably over five years and is recognizing the funding for research by its scientists as such work is performed. Revenue pertaining to such research amounted to $4,276,000 and $176,000 during 2002 and 2001, respectively.

Neurogen is also eligible to receive milestone payments if certain compound discovery, product development or regulatory objectives are achieved subject to the collaboration. In return, Aventis received the exclusive worldwide rights to develop, manufacture and market collaboration drugs that act through the CRF-1 receptor, for all therapeutic indications for which the drugs may be used. Aventis will pay Neurogen royalties based upon net sales levels, if any, for collaboration products. Also under the agreement, Aventis is responsible for funding the cost of development, including clinical trials, manufacturing and marketing of collaboration products, if any. For the years ended December 31, 2002 and 2001, the Company recognized $6,276,000 and $291,000 in revenue, respectively, under the Aventis Agreement.

PFIZER

In June of 1999, Neurogen and Pfizer entered into the Pfizer Technology Transfer Agreement. Under the terms of this agreement, Pfizer agreed to pay Neurogen up to a total of $27,000,000 over a three year period for the licensing and transfer to Pfizer of certain of Neurogen's AIDD™ technologies for the discovery of new drugs, along with the installation of an AIDD™ system. Additional payments were also possible upon Pfizer's successful utilization of this technology. Pfizer received a non-exclusive license to certain AIDD™ intellectual property, and the right to employ this technology in its own drug development programs. As of December 31, 2002, the company had received $29,000,000 in license fees pursuant to the Pfizer Technology Transfer Agreement, which terminated per schedule in June 2002, of which $9,449,000, $8,343,000 and $11,208,000 has been recognized as revenue in 2002, 2001 and 2000, respectively. The fees recognized in 2002 include a $2,000,000 one-time payment to satisfy all obligations from Pfizer’s use of the AIDD™ technology.

COLLABORATION COSTS

While the Company does not currently maintain a historical cost accounting system to accurately track costs on an individual project basis, it does maintain a system to record the level of staffing time spent on its research and development projects. Based primarily on the amount of staffing time spent on collaboration projects obtained from this system, the Company estimates the approximate aggregate amounts of research and development costs incurred in connection with all of the Company’s research collaborations were $4,460,000, $4,200,000 and $9,250,000 in 2002, 2001 and 2000, respectively. These collaborations generated $4,276,000, $3,056,000 and $9,205,000 of research and development revenues in the aggregate in 2002, 2001 and 2000, respectively.

3. MARKETABLE SECURITIES

The following tables summarize the Company's marketable securities (in thousands):

December 31, 2002

December 31, 2001

The following table summarizes investment maturities at December 31, 2002 (in thousands):

4. ACCOUNTS PAYABLE AND ACCRUED EXPENSES

Accounts payable and accrued expenses at December 31 are summarized as follows (in thousands):

5. LOANS PAYABLE

On December 21, 2001, Neurogen entered into a commercial term mortgage loan agreement collateralized by the Company's facilities at 15 and 35 Northeast Industrial Road, Branford, CT, whereby the lender provided gross proceeds of $17,500,000. The Company expects to use these proceeds for general corporate purposes. The loan is repayable in monthly principal installments of approximately $97,000 over 10 years plus interest at a floating rate tied to the one month LIBOR rate. The effective interest rate at December 31, 2002 was 3.9%. A final balloon payment of $5,931,000 is due and payable on the maturity date of December 21, 2011.

Neurogen was required to maintain $1,000,000 of the mortgage proceeds in a cash collateral account as collateral for the loan until the outstanding principal balance reached $16,500,000. Another $500,000 of the proceeds was held in another cash collateral account until Neurogen completed specified, committed site work at the secured property. These two conditions were met in 2002, enabling the $1,500,000 in total proceeds to no longer be classified as restricted cash in current assets.

In October of 1999, Neurogen entered into a financing arrangement with Connecticut Innovations, Inc. (CII) collateralized by the property at 45 Northeast Industrial Road, whereby CII agreed to loan up to $5,000,000 to Neurogen for the purchase and development of a new building to create additional laboratory space. CII advanced Neurogen $1,912,280 for the purchase of the building in October 1999. The remainder of the loan was advanced when renovation was substantially completed in July 2001. The loan is repayable in monthly installments of approximately $46,500 over 15 years, bearing interest at an annual rate of 7.5%. Total interest payments capitalized during the building construction approximated $111,000 in 2001 and $155,000 in 2000. The loan with CII contains certain subjective acceleration clauses, which upon occurrence of certain events, may cause amounts due under the agreement to become immediately due and payable. The Company has no indication that it is in default of any such clauses and therefore has classified its debt based on the dates regular payments are due.

Scheduled maturities of total loans payable at December 31, 2002 are:

In 1995, the Company entered into a ten year operating lease agreement to lease 24,000 square feet of space at 15 Northeast Industrial Road. The Company had an option to purchase the building after the fifth year of the lease which it exercised on January 11, 2001 for $2,437,500, thereby terminating the lease. Unamortized leasehold improvement costs were capitalized into the cost basis of the building at time of purchase. Prior to the purchase, rent expense approximated $4,000 and $140,000 in 2001 and 2000, respectively.

6. COMMON STOCK

On June 30, 2000, the Company entered into a private placement agreement with certain institutional investors, pursuant to which the Company issued 1,638,000 shares of its common stock for net proceeds of $38,698,000. Such shares were registered in a Form S-3 Registration Statement in July 2000.

7. STOCK OPTIONS AND RESTRICTED STOCK

The Company has various stock incentive plans, under which it has awarded incentive and non-qualified stock options and restricted stock. Stock options are primarily granted at fair market value at the date of grant, vest over one to five years and expire up to ten years after grant. Under all plans, there were 6,375,352 shares of common stock reserved for future issuance (of which 5,304,913 are for options outstanding and 1,070,439 are for options available for future grant) as of December 31, 2002.

Options

The following table presents the combined activity of its stock option plans for the years ended December 31, as follows:

With respect to certain remaining options of 31,250 shares granted on December 31, 1997, if the recipient remains employed with the Company for a period of seven years from the date of grant, the exercise price for any of such options which have not been exercised at the end of the ten year term of such option, shall become zero and the options will be exercised and the shares will be conveyed to the respective optionees. The exercise price for any of such options exercised prior to the end of such ten-year term shall be $13.50 per share, the market price of the common stock on the date of grant. These options are subject to variable plan accounting and the deferred compensation is being amortized over the seven year service period required for these options to vest. The unamortized balance related to this grant at December 31, 2002 was $32,000, which has been adjusted since 1997 for certain officers that terminated their employment. The Company recognized stock compensation (benefit) expense of $(232,000), $57,000, and $356,000 for 2002, 2001, and 2000, respectively, relating to these options. The benefit in 2002 was due to a reversal of expense driven by a decline in the Company’s stock price which reduced the value of these awards.

The Company recorded $0, $23,000 and $34,000 as compensation expense for grants made prior to shareholder approval of the respective option plan and $45,000, $52,000 and $200,000 as expense for option grants made to consultants in 2002, 2001 and 2000, respectively. The expense recorded in 2002 related to a grant in January 2002 to a director of the Company of 15,000 options to purchase common stock at the exercise price of $14.30 for consulting services to be performed. In addition, $977,000 was recorded as expense in 2001 for modifications to stock options made upon termination of employment of two former officers. The modifications included acceleration of vesting for one officer and extension of option expiration after termination of employment for the other officer.

The following table presents weighted average price and life information about significant option groups outstanding at December 31, 2002:

The estimated fair value at the date of grant for options granted in 2002, 2001 and 2000 was $4.14, $12.81 and $21.87, respectively, using the Black-Scholes model with the following weighted average assumptions:

Restricted Stock

In 1998, 137,625 shares of restricted stock were granted to certain employees. The grant stipulated that if the stock price closed at or above $45.00 per share within four years from the date of such grant the restriction would be removed and the stock would fully vest to the employee with no restriction. If the Company's stock price did not reach $45.00 the shares would be forfeited. On February 18, 2000, Neurogen stock closed the trading day at $47.25, thereby removing the restriction and vesting the stock immediately. A charge to income of $6,503,000 was recorded in the first quarter of 2000.

In September 2001, 150,000 shares of restricted stock were granted to certain officers. Of the total shares granted, 10,000 shares vested immediately, 70,000 shares vest in four years and 70,000 shares vest in five years. In 2002, 145,000 shares of restricted stock were granted to certain officers of which 72,500 shares vest in four years and 72,500 shares vest in five years. In connection with the grants of restricted stock in 2001 and 2002, the Company recorded deferred compensation totaling $4,320,150. The portion of the compensation associated with the shares that vested immediately was recognized as expense while the remaining deferred compensation is being amortized ratably over the five year service period. A total of $802,000 and $392,000 was recorded as compensation expense in 2002 and 2001, respectively.

8. INCOME TAXES

The difference between the Company's "expected" tax benefit, as computed by applying the U.S. federal corporate tax rate of 34% to income (loss) before provision for income taxes, and actual tax is reconciled below (in thousands):

The tax effect of temporary differences that give rise to significant portions of the deferred tax assets and deferred tax liabilities at December 31, 2002 and 2001 are presented below (in thousands):

The valuation allowance increased by $10,661,000 during 2002, which is attributable to the current year tax provision and is due primarily to the increase in net operating loss and research and development tax credit carryforwards. The Company has provided a valuation allowance for the full amount of the net deferred tax asset, since management has not determined that these future benefits will more likely than not be realized as of December 31, 2002.

Any subsequently recognized tax benefits relating to the valuation allowance for deferred tax assets as of December 31, 2002 and 2001 would be allocated as follows (in thousands):

As of December 31, 2002, the Company had approximately $112,500,000 and $7,091,000 of net operating loss and research and development credit carryforwards, respectively, available for federal income tax purposes, which expire in the years 2004 through 2022. The Company also had approximately $98,975,000 and $4,485,000 of Connecticut state tax net operating loss and research and development credit carryforwards, respectively, which expire in the years 2003 through 2022. Because of "change in ownership" provisions of the Tax Reform Act of 1986, the Company's utilization of its net operating loss and research and development credit carryforwards may be subject to an annual limitation in future periods.

For the years ended December 31, 2002 and 2001, the Company recorded Connecticut income tax benefits of $638,000 and $1,976,000, respectively, as the result of Connecticut tax law provisions which allowed certain companies to obtain cash refunds at an exchange rate of 65% of their research and development credits, in exchange for foregoing the carryfoward of these credits into future tax years. The Company filed claims to exchange their 2001 and 2000 research and development credits for cash and as a result recorded benefits of $288,000 and $1,211,000 in the Statement of Operations for 2002 and 2001, respectively. Benefits of $350,000 and $765,000 were also recorded to additional paid-in capital in 2002 and 2001, respectively, for research and development qualifying expenditures resulting from stock option exercises.

9. COMMITMENTS AND CONTINGENCIES

The Company has granted Pfizer certain registration rights with respect to 2,846,000 shares of common stock and limited preemptive rights with respect to future public offerings pursuant to stock purchase agreements entered into in connection with the Pfizer Agreements. The Company has granted certain registration rights to American Home Products with respect to 37,442 shares of common stock purchased in connection with entering into a licensing agreement in 1996.

10. BENEFIT PLANS

The Company maintains a 401(k) plan under which all of the Company's employees are eligible to participate. Each year the Company may, but is not required to, make a discretionary matching contribution to the plan. The Company currently matches 100% of employee contributions of up to 6% of an employee's salary. For the fiscal years 2002, 2001 and 2000, one third of the match was made in cash and two thirds of the match was made in Company stock. Contributions to the 401(k) plan totaled approximately $812,000, $772,000 and $600,000 in 2002, 2001 and 2000, respectively.

The Company has made loans to certain officers and employees subject to various compensation agreements. Certain loans will be forgiven and recognized as compensation expense ratably over defined service periods for each employee ranging from three to seven years. The amount of loans outstanding at December 31, 2002 and 2001 was $593,000 and $481,000 of which $174,000 and $110,000 was short-term, respectively.

11. RELATED PARTIES

As of December 31, 2002, Pfizer held 2,846,000 shares of common stock in the Company, which represented 16% of total outstanding shares. Pfizer has been a partner with Neurogen in several collaborative research agreements since 1992 and one technology transfer agreement since 1999.

12. REDUCTION IN FORCE

In October 2002, the Company announced a reduction in force as part of its Operational Excellence program to further enhance the efficiency of its drug discovery platform, reduce costs and to more closely align the Company’s investment of resources with long-term business goals. As part of this plan, Neurogen reorganized certain departments and eliminated 24 employee positions inclusive of both administrative and research functions, representing approximately 10% of its total workforce. The reduction in force was communicated to respective employees and severance agreements were executed in October 2002. Severance payments are expected to be completed by March 2003. The total amount of costs incurred was $350,000, which includes $303,000 in one-time termination benefits and $47,000 in associated costs, which is included in Total Operating Expenses ($252,000 in Other Research and Development and $98,000 in Other General and Administrative expenses) in the 2002 Statement of Operations.

The following table summarizes the activity recorded in the employee termination cost accrual during 2002 (in thousands):