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UNITED STATES

FORM 10-K

For the fiscal year ended December 31, 2002

OR

Commission file number 0-22570

LYNX THERAPEUTICS, INC.

25861 Industrial Blvd., Hayward, CA 94545
(Address of principal executive offices, including zip code)

(510) 670-9300
(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, $.01 par value per share

      Indicate by check mark whether the Registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities and Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [  ]

      Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of Registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [X]

      Indicate by check mark whether the Registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2). Yes [  ] No [X]

      State the aggregate market value of the voting and non-voting common equity held by non-affiliates of the Registrant computed by reference to the price at which the common equity was last sold, or the average bid and asked price of such common equity, as of the last business day of the registrant’s most recently completed second fiscal quarter: $22,543,575.¹

      The number of shares of common stock of the Registrant outstanding as of March 3, 2003, was 4,654,245. The aggregate market value of the common stock of the Registrant held by non-affiliates of the Registrant, based upon the closing price of the common stock reported on the Nasdaq National Market on March 3, 2003, was $5,527,055.²

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LYNX THERAPEUTICS, INC.

FORM 10-K ANNUAL REPORT
FOR THE FISCAL YEAR ENDED
DECEMBER 31, 2002

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PART I

Item 1. Business

     Except for the historical information contained herein, this report contains certain information that is forward-looking in nature. Examples of forward-looking statements include statements regarding Lynx’s future financial results, operating results, product successes, business strategies, projected costs, future products, competitive positions and plans and objectives of management for future operations. In some cases, you can identify forward-looking statements by terminology, such as “may,” “will,” “should,” “expects,” “plans,” “anticipates,” “believes,” “estimates,” “predicts,” “potential” or “continue” or the negative of such terms and other comparable terminology. In addition, statements that refer to expectations or other characterizations of future events or circumstances are forward-looking statements. These statements involve known and unknown risks and uncertainties that may cause Lynx’s or its industry’s results, levels of activity, performance or achievements to be materially different from those expressed or implied by the forward-looking statements. Factors that may cause or contribute to such differences include, among others, those discussed under the captions “Item 1. Business — Business Risks” and “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.” These and many other factors could affect the future financial and operating results of Lynx. Lynx undertakes no obligation to update any forward-looking statement to reflect events after the date of this report.

     Lynx, MPSS™, Megaclone™, Megasort™, Megatype™, Protein ProFiler™ and the Lynx logo are some of Lynx Therapeutics, Inc.’s trademarks and service marks.

     In January 2003, we received stockholder approval for, and effected, a reverse stock split of our common stock at a ratio of 1-for-7 (the “reverse stock split”). As a result of the reverse stock split, each outstanding share of common stock automatically converted into one-seventh of a share of common stock, with the par value of each share of common stock remaining at one cent ($.01) per share. Accordingly, common stock share and per share amounts for all periods presented have been adjusted to reflect the impact of the reverse stock split.

Overview

     We believe that Lynx Therapeutics, Inc. is a leader in the development and application of novel genomics analysis solutions that provide comprehensive and quantitative digital gene expression information important to modern systems biology research in the pharmaceutical, biotechnology and agricultural industries. Gene expression refers to the number of genes and the extent a cell or tissue expresses those genes, and represents a way to move beyond DNA sequence data to understand the function of genes, the proteins that they encode and the role they play in health and disease. Systems biology is an approach in which researchers seek to gain a complete molecular understanding of biological systems in health and disease.

     We believe that our Massively Parallel Signature Sequencing technology, or MPSS, generates a complete, accurate and quantitative analysis of the transcriptome (which is the full complement of activated genes, messenger RNAs or transcripts in a particular tissue at a particular time) to enable systems biology. Transcriptome analysis provides information about all the genes that are expressed in a biological sample. MPSS generates simultaneously, from a million or more Megaclone (our unique and proprietary cloning procedure) micro-beads, gene sequence information that uniquely identifies a sample’s DNA molecules without the need for individual conventional sequencing reactions and produces a comprehensive quantitative profile of gene expression in cells or tissues. MPSS is capable of finding and identifying genes that are expressed at low levels in the cell, beyond the normal sensitivity levels of microarrays (which are small glass or silicon wafers with tens of thousands of DNA molecules arrayed on the surface for subsequent analysis and are the current leading tool for gene expression analysis on the market). As a result, Lynx believes that MPSS provides a highly reproducible, quantitative digital readout for the activity of virtually every gene in a biological sample. Additionally, unlike microarrays, which are limited to the genes represented on them, MPSS does not require advance knowledge of genes or sequences and, therefore, has broad potential commercial applicability to humans, animals, plants and other commercially important organisms.

     Our current business model is primarily focused on providing genomics discovery services using MPSS. Our commercialization strategies, tactics and target customers for MPSS generally involve expanding our work with scientific thought leaders and genomics researchers and gaining additional customers in the pharmaceutical, biotechnology and agricultural industries. Additionally, our business development efforts include collaborating with information technology (IT) companies that we believe can help design the software and other tools to understand the large, complex MPSS-based data sets required to enable systems biology.

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     Megaclone, our unique and proprietary cloning procedure, is the foundation technology for MPSS. Megaclone transforms a biological sample containing millions of DNA molecules into one made up of millions of micro-beads, which are microscopic beads of latex, each of which carries approximately 100,000 copies of one of the DNA molecules in the sample. Megasort, the other technology that leverages the power of Megaclone and that we have developed and commercially applied, enables researchers to focus on potential target genes by permitting, from a single experiment, the direct physical isolation of nearly all the genes differentially expressed between samples.

     We were incorporated in Delaware in February 1992. Please see a discussion of our plans under Item 1. “Business — Business Risks” and Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Liquidity and Capital Resources.”

Industry Background

     The publication of the first draft sequence of the human genome was a milestone in the history of genetics and genomics. However, the remaining challenge for researchers in industry and academia alike is to explore the multitude of genomic variations and to discover, from the analysis of these differences, the functions of genes and their roles in health and disease. It is this work, post genome-sequencing, that is expected to lead to commercial opportunities and ultimately to the discovery of new therapies for unmet medical needs and to provide the basis for the emerging fields of pharmacogenomics (which is the identification and assessment of genes that are predictive of the efficacy and/or toxicity of drug compounds or that may correlate drug responses to the genotype, or genetic makeup, of an individual), and individualized patient therapy.

     Many diseases result from a malfunction of the genetically programmed protective response to insults, such as trauma, infection, stress or an inherited mutant gene. That malfunction may result in inadequate, misguided or exaggerated gene expression, unfolding a complex pathogenic process that may resolve itself, linger chronically or evolve with increasingly destructive effects in a manner quite removed from, and even independent of, the original insult. By analyzing which genes are expressed in a cell or tissue, the level of expression can illustrate which physiological pathways are active in the cell and to what degree. By understanding when and where abnormal gene expression occurs and the changes in expression that a drug can cause, the physiological pathways implicated in disease and drug action can be pinpointed. This knowledge could be used to help discover drug targets, screen drug leads, predict a compound’s toxic effects, anticipate pharmacological responses to drug leads and tailor clinical trials to the specific needs of subgroups within a population. By recognizing gene expression patterns, researchers, and ultimately physicians, may also be able to determine which treatments are likely to be effective for a specific condition and which may be ineffective or harmful.

     Genomic approaches to therapeutics seek to identify genes connected to the origin of a disease. Searches to identify such genes generally are laborious and involve a very large amount of conventional DNA sequencing to identify genes or gene fragments. This knowledge of genes is only a first step. While it may pave the way for the development of better diagnostics, it may not necessarily lead to a successful therapy. For example, while a particular gene, or absence of a gene, may predispose a person to a cancer, an entirely different set of genes is likely to govern the tumor and its metastases. Hence, in addition to understanding the cause of disease, it is important to understand entire networks of genes and their functions in both healthy and diseased states in order to identify the optimal targets for therapy.

     One approach to genomics research is based on the study of gene expression and regulation of gene expression in cells in differing states or conditions. Gene expression in a cell consists of transcription, the process that converts the genetic information encoded in the double-stranded DNA of a gene into mRNA, and translation, the process that converts the genetic information encoded in mRNA into a specific protein molecule. At any one time, any particular human cell expresses thousands of genes. A different number of copies of each mRNA type will be present in each biological sample depending upon the particular cell, its function and its environmental conditions at the time. Thus, a cell will contain, at any one time, tens of thousands of different mRNAs, in various quantities, for a total on the order of one million or more mRNA molecules.

     Elucidating gene function involves not only determining which genes are expressed in a healthy or diseased tissue, but also requires determining which of the altered gene expressions cause a disease rather than result from the disease. In general, only the most abundantly expressed genes are currently accessible using conventional methods. In addition, conventional methods are dependent on separating and cloning double-stranded copies of each individual mRNA, or cDNA, prior to analysis. Thus, by conventional methods, it is impractical to obtain a

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comprehensive, high-resolution analysis of gene expression across one million or more mRNA molecules in cells of interest to the researcher.

Our Solution

     We believe that MPSS generates a complete, accurate and quantitative analysis of the transcriptome to enable systems biology. Transcriptome analysis provides information about all the genes that are expressed in a biological sample. MPSS generates simultaneously, from a million or more Megaclone micro-beads, gene sequence information that uniquely identifies a sample’s DNA molecules without the need for individual conventional sequencing reactions and produces a comprehensive quantitative profile of gene expression in cells or tissues. MPSS is capable of finding and identifying genes that are expressed at low levels in the cell, beyond the normal sensitivity levels of microarrays. As a result, Lynx believes that MPSS provides a highly reproducible, quantitative digital readout for the activity of virtually every gene in a biological sample. Additionally, unlike microarrays, MPSS does not require advance knowledge of genes or sequences and, therefore, has broad potential commercial applicability to humans, animals, plants and other commercially important organisms.

Our Commercialization Strategies, Tactics and Target Customers

     Our commercialization strategies, tactics and target customers for MPSS generally involve expanding our work with scientific thought leaders and genomics researchers and gaining additional customers in the pharmaceutical, biotechnology and agricultural industries. Additionally, our business development efforts include collaborating with IT companies that we believe can help design the software and other tools to understand the large, complex MPSS-based data sets required to enable systems biology.

Expanding Our Genomics Discovery Services Business

     Our current business model is primarily focused on providing MPSS genomics discovery services to:

	Research Institutes

We believe that scientific thought leaders in research institutes can provide an immediate, significant and enduring source of revenue, both directly from their institutes and from access to labs doing genomics research in the larger scientific research community. More broadly, we believe that we will benefit by having MPSS data placed in the public domain by these researchers. The scientific thought leaders should provide public and very visible exposure and validation of MPSS through their commentary and publications in scientific journals.

	Pharmaceutical, Biotechnology and Agricultural Companies

Pharmaceutical, biotechnology and agricultural customers are an integral component of our business development focus and commercialization efforts. With the assumed accessibility to data sets containing gene expression information for cells or tissues for comparative purposes stemming from our work with scientific thought leaders and IT companies, we expect that pharmaceutical, biotechnology and agricultural companies will engage us to produce a comprehensive quantitative profile of gene expression in cells or tissues for their specific interests, such as in diseased, abnormal or induced states or conditions. In these arrangements, we could provide information content for each company’s specific internal programs.

     We believe that MPSS can become the technology of choice to: (1) accelerate drug discovery by identifying and validating drug targets and identifying pathways and mode of action; (2) accelerate drug development through lead (which is a representative of a compound series with sufficient potential to progress to a drug development program) qualification and optimization (which is the synthetic modification of a biologically active compound to fulfill all of the necessary properties required for clinical usefulness) by improving the success rate of getting products into clinical testing and to the market by patient group stratification (which is the division or arrangement of patients into representative subject populations within the clinical trial) and toxicology; and (3) enable discovery of biomarkers (which is a biochemical feature that can be used to measure the progress of disease or the effects of treatment) for diagnostics and pharmacogenomics. We believe that most of the important drug targets cannot be reliably monitored by gene expression methods other than MPSS.

     Our business development efforts to collaborate with IT companies are founded on the comprehensive, quantitative and digital nature of MPSS data. We envision performing genomics discovery services to provide the MPSS data content, while the IT companies design the software and other tools to understand the large, complex

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data sets required to enable systems biology. The IT companies would then market this MPSS-based data along with their hardware and analysis tools to pharmaceutical, biotechnology and agricultural companies and research institutes.

     The revenue sources from genomics discovery service arrangements may include technology access and services fees from performing MPSS analyses and providing MPSS data. Additionally, we have provided a license, as amended in December 2002, to Takara Bio Inc. (formerly Takara Shuzo Co. Ltd.) that provides Takara with the right to use our technologies to provide genomics discovery services and to manufacture and sell microarrays containing content identified by our technologies in specific geographic territories. In December 2002, Lynx sold to Takara two MPSS instruments for Takara’s use in providing genomics discovery services in their licensed territories.

Our Technologies and Applications

Massively Parallel Signature Sequencing Technology

     Our MPSS technology addresses the need to generate sequence information from millions of DNA fragments. At this extremely large scale, our MPSS approach eliminates the need for individual sequencing reactions and the physical separation of DNA fragments required by conventional sequencing methods. MPSS uses proprietary instruments and reagents developed by Lynx.

     MPSS enables the simultaneous identification of nearly all the DNA molecules in a sample. MPSS uses flow cells, which are glass plates that are micromachined, or fabricated, to very precise, small dimensions, to create a grooved chamber for immobilizing microbeads in a planar microarray, which is a two-dimensional, dense ordered array of DNA samples. With MPSS, one million or more Megaclone micro-beads are fixed in a single layer array in a flow cell, so solvents and reagents can be washed over the micro-beads in each cycle of the process. Our proprietary protocol elicits from the Megaclone micro-beads sequence-dependent fluorescent responses, which are recorded by a charged coupled device, or CCD, camera after each cycle. The process produces short 16- to 20-base-pair signature, or identifying, sequences, without requiring fragment separation and separate sequencing reactions as in conventional DNA sequencing approaches. We have developed proprietary instrumentation and software to automate the delivery of reagents and solutions used in our sequencing process and to compile, from the images obtained at each cycle, the signature sequences that result from each experiment.

     We believe MPSS has the following advantages over conventional DNA sequencing methods:

	•	it sequences DNA molecules on as many as one million or more Megaclone beads simultaneously;
	•	it eliminates the need for individual sequencing reactions and gels;
	•	it identifies each of the DNA molecules by a unique 16- to 20-base signature sequence;
	•	it produces a comprehensive quantitative profile of gene expression in cells or tissues of interest; and
	•	it identifies even the rarest expressed genes.

     We currently have over 20 operational proprietary MPSS instruments.

Megasort Technology

     Our Megasort technology provides a method to identify and physically extract essentially all genes that differ in expression levels between two samples. The novelty of Megasort is that the identification and extraction are performed in a single assay.

     Megasort compares two DNA samples, each containing millions of molecules, and extracts those DNA molecules that are present in different proportions in the samples. These extracted DNA molecules could be differentially expressed genes or DNA fragments that are found in one sample but not in the other. Because the comparison and sorting process requires no prior knowledge of the sequences of the genes present in either sample, Megasort can be used with samples isolated from tissues or organisms that are not well characterized. Megasort involves hybridizing (which is a molecular technique that uses one nucleic acid strand to locate another) two probes prepared separately, one from each of the samples to be compared, with a population of Megaclone micro-beads, each of which carries many copies of a single DNA fragment or gene derived from either of the samples. Because each probe is labeled with a different fluorescent marker, we can readily separate by a fluorescence activated cell

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sorter, also referred to as a FACS, genes or fragments that are under- or over-represented in either sample. Genes or fragments of interest can then be recovered from the sorted micro-beads for further study.

Megaclone Technology

     Megaclone, our unique and proprietary cloning procedure, forms the foundation of our technologies. Megaclone transforms a biological sample containing millions of DNA molecules into one made up of millions of micro-beads, which are microscopic beads of latex, each of which carries approximately 100,000 copies of one of the DNA molecules in the sample. In contrast to conventional cloning, in which an individual DNA molecule is selected from a sample and amplified into many copies for analysis or identification, we can capture on one set of micro-beads clones of nearly all the DNA sequences that characterize a sample. Once attached to the micro-beads, these clones can be handled and subjected to experiments and analyses all at the same time. Megaclone thereby enables many analyses or characterizations to be conducted that would otherwise be too cumbersome or onerous to conduct using conventional procedures where each clone must be addressed individually.

     Megaclone is a process that uses a proprietary library of approximately 16.7 million short synthetic DNA sequences, called tags, and their complementary anti-tags, to uniquely mark and process each DNA molecule in a sample. Each unique tag is a permanent identifier of the DNA molecule it is attached to, and all of the tagged molecules in a sample are amplified together to create multiple copies of the tagged molecules. We use another proprietary process to generate five-micron diameter micro-beads, each of which carries multiple copies of a short anti-tag DNA sequence complementary to one of the 16.7 million tags. Then, we collect the amplified tagged DNA molecules onto the micro-beads through hybridization of the tags to the complementary anti-tags. Each micro-bead carries on its surface enough complementary anti-tags to collect approximately 100,000 identical copies of the corresponding tagged DNA molecule.

     By this process, each tagged DNA molecule in the original sample is converted into a micro-bead carrying about 100,000 copies of the same sequence. Therefore, in a few steps, our Megaclone technology can transform a complex mixture of a million or more individual DNA molecules into a usable format that provides the following benefits:

	•	substantially all the different DNA molecules present in a sample (typically one million or more) are represented in the final micro-bead collection;
	•	these million or more DNA molecules can be analyzed simultaneously in various applications; and
	•	the need for storing and handling millions of individual DNA clones is eliminated.

     Megaclone is the foundation for our analytical applications, principally MPSS and Megasort.

Collaborations, Customers and Licensees

     We have derived substantially all of our revenues from corporate collaborations, customer agreements and licensing arrangements. For the year ended December 31, 2002, revenues from DuPont, Takara, Geron Corporation, Bayer CropScience and BASF accounted for 32%, 16%, 15%, 14% and 11%, respectively, of our total revenues. The following are summary descriptions of our current key collaborators, customers and licensees:

BASF AG

     In October 1996, we entered into an agreement with BASF AG, as amended in October 1998, to provide BASF with nonexclusive access to certain of our genomics discovery services. In connection with certain technology development accomplishments, BASF paid us a technology access fee of $4.5 million in the fourth quarter of 1999. BASF’s access to our genomics discovery services is for a minimum of two years and requires BASF to purchase services at a minimum rate of $4.0 million per year. At the end of the initial two-year service period in the fourth quarter of 2001, BASF exercised its right to carryover for an additional two-year period to the fourth quarter of 2003, a certain level of previously unrequested genomics discovery services. BASF paid Lynx $4.0 million in each of the fourth quarters of 1999 and 2000 for genomics discovery services to be performed by Lynx.

     Through December 31, 2002, we have received aggregate payments of $19.0 million from BASF under the agreement. We could receive additional payments from BASF over the remaining term of the agreement, which ends in the fourth quarter of 2003, from our performance of genomics discovery services in excess of those covered by the payments previously made by BASF.

E.I. DuPont de Nemours and Company

     In October 1998, Lynx entered into a research collaboration agreement with E.I. DuPont de Nemours and Company to apply our technologies on an exclusive basis to the study of certain crops and their protection. Under the terms of the agreement, we could receive payments over a five-year period for genomics discovery services, the achievement of specific technology milestones and the delivery of genomic maps of specified crops. We received an

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initial payment of $10.0 million for technology access at the execution of the agreement, with additional minimum service fees of $12.0 million to be received by us over a three-year period, which commenced in January 1999. DuPont subsequently elected to continue the agreement with us for a two-year period during which we should receive additional minimum service fees of $8.0 million through the fourth quarter of 2003. In the fourth quarter of 1999, we achieved a technology milestone under the agreement that resulted in a $5.0 million payment from DuPont.

     Through December 31, 2002, we have received aggregate payments of $32.0 million from DuPont under the agreement. We expect to receive minimum additional payments of $3.0 million from DuPont over the remaining term of the agreement, primarily from our continuing performance of genomics discovery services for DuPont.

Bayer CropScience (formerly Aventis CropScience GmbH)

     In March 1999, Aventis Pharmaceuticals, formerly Hoechst Marion Roussel, Inc., obtained nonexclusive access to certain of our genomics discovery services for the benefit of its affiliate, Aventis CropScience, which is now Bayer CropScience. We received an initial payment for genomics discovery services to be performed by us for Bayer CropScience. The service period was renewed in March 2000, extended in March 2002 for an additional five-year period, and amended in September 2002. Related to the five-year extension, Bayer CropScience and Lynx plan to jointly develop and commercialize a novel assay based on Lynx’s proprietary bead-based technologies. Lynx and Bayer CropScience will own the assay technology jointly. We will manufacture and sell the services or products based on the assay technology and will pay related royalties to Bayer CropScience. Additionally, we will derive revenues from performing genomics discovery services for Bayer CropScience during the development and commercialization phase of the agreement.

     Through December 31, 2002, we have received aggregate payments of $6.0 million from Bayer CropScience under the above agreements. We could receive additional payments from Bayer CropSciences from our performance of genomics discovery services in excess of those covered by the payments previously made by Bayer CropSciences or from the sales of services or products based on the assay technology to Bayer CropScience.

Takara Bio Inc. (formerly Takara Shuzo Co., Ltd.).

     In November 2000, we entered into a collaboration and license agreement with Takara Bio Inc. of Japan. The license, as amended in December 2002, provides Takara with the right in Japan, Korea and China, including Taiwan, to use our proprietary Megaclone, Megasort and MPSS technologies exclusively until the expiration of the relevant Lynx patents to provide genomics discovery services and to manufacture and sell microarrays containing content identified by our technologies. Under the terms of the original license agreement, Takara has a nonexclusive license right to manufacture and sell such microarrays elsewhere throughout the world. In connection with the amended collaboration, Takara was also granted a royalty-bearing, nonexclusive right to provide genomics discovery services to customers in France and Italy.

     At the end of three years from the effective date of the agreement, in the fourth quarter of 2003, Takara can terminate the agreement with no further payment obligations to us other than those accrued prior to the termination. Under the terms of the agreement, we will receive payments from Takara for technology access fees, royalties on sales of microarrays and revenues from genomics discovery services, the sale to Takara of proprietary instruments and reagents used in applying our technologies and purchases of Lynx common stock. In the event of improvements made by Takara that increase the efficiency of our technologies by a defined amount, Lynx and Takara have agreed to negotiate in good faith a limited reduction to the royalty rate applicable to the above royalties. In December 2002, Lynx sold two MPSS instruments to Takara for Takara’s use in providing genomics discovery services in licensed territories. As part of the amended collaboration, Takara accelerated its technology access fee payments to Lynx and equity purchases of Lynx common stock. The previously scheduled 2003 payment was made to Lynx in December 2002, and the previously scheduled 2004 and 2005 payments are now planned to be made to Lynx in 2003 and 2004, respectively.

     In both September and December 2002, in connection with the collaboration agreement, we issued and sold 291,545 shares of common stock, at a purchase price of $3.43 per share, to Takara in private placements pursuant to the terms and conditions of common stock purchase agreements. In October 2001, in connection with the collaboration agreement, we issued and sold 45,787 shares of common stock, at a purchase price of $21.84 per share, to Takara in a private placement pursuant to the terms and conditions of a common stock purchase agreement.

     Through December 31, 2002, we have received aggregate payments of $11.2 million, net of foreign withholding taxes, from Takara under the collaboration agreement. We could receive additional payments from Takara of

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approximately $4.0 million over the remaining term of the agreement from technology access fees and purchases of Lynx common stock. Also, we may receive payments from Takara for royalties on sales of microarrays and revenues from genomics discovery services and the sale to Takara of proprietary instruments and reagents used in applying our technologies.

Axaron Bioscience AG, formerly BASF-LYNX Bioscience AG

     In 1996, Lynx and BASF established Axaron Bioscience AG, a joint venture company in Heidelberg, Germany. Axaron began operations in 1997 and is employing our technologies in its neuroscience, toxicology and microbiology research programs. Upon the establishment of Axaron, we contributed access to our technologies to Axaron in exchange for an initial 49% equity ownership. BASF, by committing to provide research funding to Axaron of DM50 million (or approximately $26.6 million based on a December 2002 exchange rate) over a five-year period beginning in 1997, received an initial 51% equity ownership in Axaron. In 1998, BASF agreed to provide an additional $10.0 million in research funding to Axaron, of which $4.3 million was paid to us for technology assets related to a central nervous system program.

     In June 2001, we extended our technology licensing agreement with Axaron. The license extends Axaron’s right to use our proprietary MPSS and Megasort technologies nonexclusively in Axaron’s neuroscience, toxicology and microbiology programs until December 31, 2007. The agreement also positions Axaron to apply our technologies to specific disorders in the neuroscience field. Under the terms of the agreement, we received a $5.0 million technology license fee from Axaron. We intend to furnish to Axaron, initially without charge and later for a fee, Megaclone technology micro-beads, other reagents and additional MPSS instruments for use in Axaron’s research programs.

     In 2001, Lynx and BASF agreed to continue their support of Axaron’s growth, including an increase in the capital of Axaron. We made an additional investment of $4.5 million in Axaron, which maintained our ownership interest in Axaron at approximately 40%. Given our ownership share of Axaron and our ability to exercise significant influence over Axaron’s operating and accounting policies, we have accounted for the investment under the equity method in accordance with Accounting Principles Board No. 18, The Equity Method of Accounting for Investments in Common Stock.

     Through December 31, 2002, we have received aggregate payments of $9.3 million from Axaron under all related agreements. We recorded revenue of $0.8 million in 2002 and $0.4 million in 2001 from Axaron, as the technology license fee from Axaron is being recognized as revenue on a straight-line basis over the noncancelable term of the technology licensing agreement. We did not recognize any revenue from Axaron in 2000. We may receive additional payments from Axaron over the remaining term of the technology licensing agreement from the sale to Axaron of proprietary reagents and additional MPSS instruments for use in Axaron’s research programs.

Competition

     Competition among entities attempting to identify the genes associated with specific diseases and to develop products based on such discoveries is intense. We face, and will continue to face, competition from pharmaceutical, biotechnology and agricultural companies, such as Affymetrix, Inc., Celera Genomics Group, Incyte Genomics, Inc., Gene Logic, Inc., Genome Therapeutics Corporation and Hyseq, Inc., academic and research institutions and government agencies, both in the United States and abroad. Several entities are attempting to identify and patent randomly sequenced genes and gene fragments, while others are pursuing a gene identification, characterization and product development strategy based on positional cloning. We are aware that certain entities are using a variety of gene expression analysis methodologies, including chip-based systems, to attempt to identify disease-related genes. In addition, numerous pharmaceutical companies are developing genomic research programs, either alone or in partnership with our competitors. Competition among such entities is intense and is expected to increase. In order to successfully compete against existing and future technologies, we will need to demonstrate to potential customers that our technologies and capabilities are superior to those of our competitors.

     Many of our competitors have substantially greater capital resources, research and development staffs, facilities, manufacturing and marketing experience, distribution channels and human resources than we do. These competitors may discover, characterize or develop important genes, drug targets or drug leads, drug discovery technologies or drugs in advance of our customers or us or that are more effective than those developed by our collaborators and customers or us. They may also obtain regulatory approvals for their drugs more rapidly than our collaborators or

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customers will, any of which could have a material adverse effect on our business. Moreover, our competitors may obtain patent protection or other intellectual property rights that could limit our rights or our collaborators’ and customers’ abilities to use our technologies or commercialize therapeutic, diagnostic or agricultural products. We also face competition from these and other entities in gaining access to cells, tissues and nucleic acid samples for use in our discovery programs.

Intellectual Property

     We are pursuing a strategy designed to obtain United States and foreign patent protection for our core technologies. Our long-term commercial success will be dependent in part on our ability to obtain commercially valuable patent claims and to protect our intellectual property portfolio. As of December 31, 2002, we owned or controlled 72 issued patents and 113 pending patent applications in the United States and foreign countries relating to our genomics and proteomics technologies.

     In addition to acquiring patent protection for our core analysis technologies, as part of our business strategy, we may file for patent protection on sets of genes, both known and newly discovered, that have diagnostic or prognostic applications, novel genes that may serve as drug development targets, genetic maps and sets of genetic markers, such as SNPs, that are associated with traits or conditions of medical or economic importance. However, there is substantial uncertainty regarding the availability of such patent protection.

     Patent law relating to the scope of claims in the technology field in which we operate is still evolving. The degree to which we will be able to protect our technology with patents, therefore, is uncertain. Others may independently develop similar or alternative technologies, duplicate any of our technologies and, if patents are licensed or issued to us, design around the patented technologies licensed to or developed by us. In addition, we could incur substantial costs in litigation if we are required to defend ourselves in patent suits brought by third parties or if we initiate such suits.

     With respect to proprietary know-how that is not patentable and for processes for which patents are difficult to enforce, we rely on trade secret protection and confidentiality agreements to protect our interests. We intend to maintain several important aspects of our technology platform as trade secrets. While we require all employees, consultants, collaborators, customers and licensees to enter into confidentiality agreements, we cannot be certain that proprietary information will not be disclosed or that others will not independently develop substantially equivalent proprietary information.

Research and Development Expenditures

     We have devoted our efforts primarily to research and development. Research and development expenses were $20.8 million for the year ended December 31, 2002, $24.7 million for the year ended December 31, 2001 and $19.8 million for the year ended December 31, 2000.

Scientific Advisor

     Sydney Brenner, M.B., D.Phil., our principal scientific advisor, is a distinguished Professor at the Salk Institute of Biological Studies in La Jolla, California. From July 1996 to January 2001, Dr. Brenner served as Director and President of The Molecular Sciences Institute, a non-profit research institute in Berkeley, California. Until his retirement in 1996, Dr. Brenner was Honorary Professor of Genetic Medicine, University of Cambridge School of Clinical Medicine, Cambridge, England. Dr. Brenner is known for his work on genetic code and the information transfer from genes to proteins and for his pioneering research on the genetics and development of the nematode. Dr. Brenner is the principal inventor of Lynx’s bead-based technologies. Dr. Brenner is a Fellow of the Royal Society (1995) and a Foreign Associate of the U.S. National Academy of Sciences (1977) and has received numerous awards of recognition, including the Nobel Prize in Physiology or Medicine for 2002, the Albert Lasker Medical Research Award (2000 and 1991), the Genetics Society of America Medal (1987) and the Kyoto Prize (1990).

Employees

     As of December 31, 2002, we employed 128 full-time employees, of which 109 were engaged in production and research and development activities. In January 2003, we announced a reduction of approximately 25% of our workforce, or 32 people. The groups affected primarily by this action included research and development personnel based at Lynx GmbH in Germany, and those working in our proteomics group in California.

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The workforce reduction was intended to further focus our financial and human resources on expanding the commercial use of MPSS. We believe we have been successful in attracting skilled and experienced scientific personnel; however, competition for such personnel is intense. None of our employees are covered by collective bargaining agreements, and management considers relations with our employees to be good.

Available Information

     We maintain a site on the World Wide Web at www.lynxgen.com; however, information found on our website is not incorporated by reference into this report. We make available free of charge on or through our website our annual report of Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Exchange Act as soon as reasonably practicable after we electronically file such material with, or furnish it to, the SEC.

     In 2003, we intend to adopt a code of ethics that applies to our principal executive officer, principal financial officer, principal accounting officer or controller, or persons performing similar functions. We intend to post the text of our code of ethics on our website at www.lynxgen.com in connection with “Investor Resources” materials. In addition, we intend to promptly disclose (1) the nature of any amendment to our code of ethics that applies to our principal executive officer, principal financial officer, principal accounting officer or controller, or persons performing similar functions and (2) the nature of any waiver, including an implicit waiver, from a provision of our code of ethics that is granted to one of these specified officers, the name of such person who is granted the waiver and the date of the waiver on our website in the future.

Business Risks

     Our business faces significant risks. These risks include those described below and may include additional risks of which we are not currently aware or which we currently do not believe are material. If any of the events or circumstances described in the following risks actually occurs, our business, financial condition or results of operations could be materially adversely affected. These risks should be read in conjunction with the other information set forth in this report.

We have a history of net losses. We expect to continue to incur net losses, and we may not achieve or maintain profitability.

     We have incurred net losses each year since our inception in 1992, including net losses of approximately $15.5 million in 2002, $16.7 million in 2001 and $13.3 million in 2000. As of December 31, 2002, we had an accumulated deficit of approximately $98.9 million. Net losses may continue for at least the next several years. The presence and size of these potential net losses will depend, in part, on the rate of growth, if any, in our revenues and on the level of our expenses. Our research and development expenditures and general and administrative costs have exceeded our revenues to date. Research and development expenses may increase due to spending for ongoing technology development and implementation, as well as new applications. We will need to generate significant additional revenues to achieve profitability. Even if we do increase our revenues and achieve profitability, we may not be able to sustain profitability.

     Our ability to generate revenues and achieve profitability depends on many factors, including:

	•	our ability to continue existing customer relationships and enter into additional corporate collaborations and agreements;
	•	our ability to expand the scope of our products and services into new areas of pharmaceutical, biotechnology and agricultural research;
	•	our customers’ and collaborators’ abilities to develop diagnostic, therapeutic and other commercial products from the application of our technologies; and
	•	the successful clinical testing, regulatory approval and commercialization of such products by our customers and collaborators.

The time required to reach profitability is highly uncertain. We may not achieve profitability on a sustained basis, if at all.

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We will need additional funds in the future, which may not be available to us.

     We have invested significant capital in our scientific and business development activities. Our future capital requirements will be substantial as we conduct our operations, and will depend on many factors including:

	•	the progress and scope of our research and development projects;
	•	payments received under our customer, license and collaborative agreements;
	•	our ability to establish and maintain customer, license and collaborative arrangements;
	•	the progress of the development and commercialization efforts under our customer, license and collaborative agreements;
	•	the costs associated with obtaining access to samples and related information; and
	•	the costs involved in preparing, filing, prosecuting, maintaining and enforcing patent claims and other intellectual property rights.

     We believe that our current cash and cash equivalents and funding anticipated to be received from customers, collaborators and licensees will enable us to maintain our operations through at least December 31, 2003. Changes to our current operating plan may require us to consume available capital resources significantly sooner than we expect. If our capital resources are insufficient to meet future capital requirements, we will have to raise additional funds. We do not know if we will be able to raise sufficient additional capital on acceptable terms, or at all. If we raise additional capital by issuing equity or convertible debt securities, our existing stockholders may experience substantial dilution. If we fail to obtain adequate funds on reasonable terms, we may have to curtail operations significantly or obtain funds, if such funds are at all available, by entering into financing or collaborative agreements on unattractive terms, or we will not be able to fund our operations.

Our technologies are new and unproven and may not allow our customers, collaborators or us to identify genes, proteins or targets for drug discovery.

     You must evaluate us in light of the uncertainties and complexities affecting an early stage genomics company. Our technologies are new and unproven. The application of these technologies is in too early a stage to determine whether it can be successfully implemented. These technologies assume that information about gene expression and gene sequences may enable scientists to better understand complex biological processes. Our technologies also depend on the successful integration of independent technologies, each of which has its own development risks. Relatively few therapeutic products based on gene discoveries have been successfully developed and commercialized. Our technologies may not enable our customers, collaborators or us to identify genes, proteins or targets for drug discovery. To date, neither our customers nor we have identified any targets for drug discovery based on our technologies.

We are dependent on our customers and collaborators and will need to find additional customers and collaborators in the future to develop and commercialize diagnostic or therapeutic products.

     Our strategy for the development and commercialization of our technologies and potential products includes entering into collaborations, customer agreements or licensing arrangements with pharmaceutical, biotechnology and agricultural companies and research institutes. We do not have the resources to develop or commercialize diagnostic or therapeutic products on our own. If we cannot negotiate additional collaborative arrangements or contracts on acceptable terms, or at all, or such collaborations or relationships are not successful, we may never become profitable.

     We have derived substantially all of our revenues from corporate collaborations, customer agreements and licensing arrangements. Revenues from such agreements depend upon continuation of the related relationships, our performance of genomics discovery services, the achievement of milestones and royalties derived from future products developed from our research and technologies. To date, we have received a significant portion of our revenues from a small number of collaborators, customers and licensees. For the year ended December 31, 2002, revenues from DuPont, Takara, Geron Corporation, Bayer CropScience and BASF accounted for 32%, 16%, 15%, 14% and 11%, respectively, of our total revenues. For the year ended December 31, 2001, revenues from DuPont, BASF, Takara and the Institute of Molecular and Cell Biology accounted for 37%, 24%, 12% and 12%, respectively, of our total revenues. For the year ended December 31, 2000, revenues from DuPont, BASF and Bayer CropScience accounted for 51%, 29% and 11%, respectively, of our total revenues. If we fail to perform genomics

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discovery services or successfully achieve milestones or our collaborators fail to develop successful products, we will not earn the revenues contemplated under such agreements. If our collaborators, customers or licensees do not renew existing agreements, we lose one of these collaborators, customers or licensees, we do not attract new collaborators, customers or licensees or we are unable to enter into new collaborative, customer or license agreements on commercially acceptable terms, our revenues may decrease, and our activities may fail to lead to commercialized products.

     Our dependence on collaborations with third parties subjects us to a number of risks. We have limited or no control over the resources that our collaborators may choose to devote to our joint efforts. Our collaborators may breach or terminate their agreements with us or fail to perform their obligations thereunder. Further, our collaborators may elect not to develop products arising out of our collaborative arrangements or may fail to devote sufficient resources to the development, manufacture, marketing or sale of such products. While we do not currently compete directly with any of our customers and collaborators, some of our customers and collaborators could become our competitors in the future if they internally develop DNA analysis technologies or if they acquire other genomics companies and move into the genomics industry. We will not earn the revenues contemplated under our customer and collaborative arrangements, if our customers and collaborators:

	•	do not develop commercially successful products using our technologies;
	•	develop competing products;
	•	preclude us from entering into collaborations with their competitors;
	•	fail to obtain necessary regulatory approvals; or
	•	terminate their agreements with us.

We depend on a single supplier to manufacture flow cells used in our MPSS technology.

     Flow cells are glass plates that are micromachined, or fabricated to very precise, small dimensions, to create a grooved chamber for immobilizing micro-beads in a planar microarray, which is a two-dimensional, dense ordered array of DNA samples. We use flow cells in our MPSS technology. We currently purchase the flow cells used in our MPSS technology from a single supplier, although the flow cells are potentially available from multiple suppliers. While we believe that alternative suppliers for flow cells exist, identifying and qualifying new suppliers could be an expensive and time-consuming process. Our reliance on outside vendors involves several risks, including:

	•	the inability to obtain an adequate supply of required components due to manufacturing capacity constraints, a discontinuance of a product by a third-party manufacturer or other supply constraints;
	•	reduced control over quality and pricing of components; and
	•	delays and long lead times in receiving materials from vendors.

We operate in an intensely competitive industry with rapidly evolving technologies, and our competitors may develop products and technologies that make ours obsolete.

     The biotechnology industry is highly fragmented and is characterized by rapid technological change. In particular, the area of genomics research is a rapidly evolving field. Competition among entities attempting to identify genes and proteins associated with specific diseases and to develop products based on such discoveries is intense. Many of our competitors have substantially greater research and product development capabilities and financial, scientific and marketing resources than we do.

     We face, and will continue to face, competition from pharmaceutical, biotechnology and agricultural companies, as well as academic research institutions, clinical reference laboratories and government agencies. Some of our competitors, such as Affymetrix, Inc., Celera Genomics Group, Incyte Genomics, Inc., Gene Logic, Inc., Genome Therapeutics Corporation and Hyseq, Inc., may be:

	•	attempting to identify and patent randomly sequenced genes and gene fragments and proteins;
	•	pursuing a gene identification, characterization and product development strategy based on positional cloning, which uses disease inheritance patterns to isolate the genes that are linked to the transmission of disease from one generation to the next; and

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•

using a variety of different gene and protein expression analysis methodologies, including the use of chip-based systems, to attempt to identify disease-related genes and proteins.

     In addition, numerous pharmaceutical, biotechnology and agricultural companies are developing genomics and proteomics research programs, either alone or in partnership with our competitors. Our future success will depend on our ability to maintain a competitive position with respect to technological advances. Rapid technological development by others may make our technologies and future products obsolete.

     Any products developed through our technologies will compete in highly competitive markets. Our competitors may be more effective at using their technologies to develop commercial products. Further, our competitors may obtain intellectual property rights that would limit the use of our technologies or the commercialization of diagnostic or therapeutic products using our technologies. As a result, our competitors’ products or technologies may render our technologies and products, and those of our collaborators, obsolete or noncompetitive.

If we fail to adequately protect our proprietary technologies, third parties may be able to use our technologies, which could prevent us from competing in the market.

     Our success depends in part on our ability to obtain patents and maintain adequate protection of the intellectual property related to our technologies and products. The patent positions of biotechnology companies, including our patent position, are generally uncertain and involve complex legal and factual questions. We will be able to protect our proprietary rights from unauthorized use by third parties only to the extent that our proprietary technologies are covered by valid and enforceable patents or are effectively maintained as trade secrets. The laws of some foreign countries do not protect proprietary rights to the same extent as the laws of the U.S., and many companies have encountered significant problems in protecting and defending their proprietary rights in foreign jurisdictions. We have applied and will continue to apply for patents covering our technologies, processes and products as and when we deem appropriate. However, third parties may challenge these applications, or these applications may fail to result in issued patents. Our existing patents and any future patents we obtain may not be sufficiently broad to prevent others from practicing our technologies or from developing competing products. Furthermore, others may independently develop similar or alternative technologies or design around our patents. In addition, our patents may be challenged or invalidated or fail to provide us with any competitive advantage.

     We also rely on trade secret protection for our confidential and proprietary information. However, trade secrets are difficult to protect. We protect our proprietary information and processes, in part, with confidentiality agreements with employees, collaborators and consultants. However, third parties may breach these agreements, we may not have adequate remedies for any such breach or our trade secrets may still otherwise become known by our competitors. In addition, our competitors may independently develop substantially equivalent proprietary information.

Litigation or third-party claims of intellectual property infringement could require us to spend substantial time and money and adversely affect our ability to develop and commercialize our technologies and products.

     Our commercial success depends in part on our ability to avoid infringing patents and proprietary rights of third parties and not breaching any licenses that we have entered into with regard to our technologies. Other parties have filed, and in the future are likely to file, patent applications covering genes, gene fragments, proteins, the analysis of gene expression and protein expression and the manufacture and use of DNA chips or microarrays, which are tiny glass or silicon wafers on which tens of thousands of DNA molecules can be arrayed on the surface for subsequent analysis. We intend to continue to apply for patent protection for methods relating to gene expression and protein expression and for the individual disease genes and proteins and drug discovery targets we discover. If patents covering technologies required by our operations are issued to others, we may have to rely on licenses from third parties, which may not be available on commercially reasonable terms, or at all.

     Third parties may accuse us of employing their proprietary technology without authorization. In addition, third parties may obtain patents that relate to our technologies and claim that use of such technologies infringes these patents. Regardless of their merit, such claims could require us to incur substantial costs, including the diversion of management and technical personnel, in defending ourselves against any such claims or enforcing our patents. In the event that a successful claim of infringement is brought against us, we may need to pay damages and obtain one or more licenses from third parties. We may not be able to obtain these licenses at a reasonable cost, or at all. Defense of any lawsuit or failure to obtain any of these licenses could adversely affect our ability to develop and commercialize our technologies and products and thus prevent us from achieving profitability.

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We have limited experience in sales and marketing and thus may be unable to further commercialize our technologies and products.

     Our ability to achieve profitability depends on attracting collaborators and customers for our technologies and products. There are a limited number of pharmaceutical, biotechnology and agricultural companies and research institutes that are potential collaborators and customers for our technologies and products. To market our technologies and products, we must develop a sales and marketing group with the appropriate technical expertise. We may not successfully build such a sales force. If our sales and marketing efforts fail to be successful, our technologies and products may fail to gain market acceptance.

Our sales cycle is lengthy, and we may spend considerable resources on unsuccessful sales efforts or may not be able to enter into agreements on the schedule we anticipate.

     Our ability to obtain collaborators and customers for our technologies and products depends in significant part upon the perception that our technologies and products can help accelerate their drug discovery and genomics efforts. Our sales cycle is typically lengthy because we need to educate our potential collaborators and customers and sell the benefits of our products to a variety of constituencies within such companies. In addition, we may be required to negotiate agreements containing terms unique to each collaborator or customer. We may expend substantial funds and management effort without any assurance that we will successfully sell our technologies and products. Actual and proposed consolidations of pharmaceutical companies have negatively affected, and may in the future negatively affect, the timing and progress of our sales efforts.

The loss of key personnel or the inability to attract and retain additional personnel could impair the growth of our business.

     We are highly dependent on the principal members of our management and scientific staff. The loss of any of these persons’ services might adversely impact the achievement of our objectives and the continuation of existing customer, collaborative and license agreements. In addition, recruiting and retaining qualified scientific personnel to perform future research and development work will be critical to our success. There is currently a shortage of skilled executives and employees with technical expertise, and this shortage is likely to continue. As a result, competition for skilled personnel is intense and turnover rates are high. Competition for experienced scientists from numerous companies, academic and other research institutions may limit our ability to attract and retain such personnel. We depend on our President and Chief Executive Officer, Kevin P. Corcoran, the loss of whose services could have a material adverse effect on our business. Although we have an employment agreement with Mr. Corcoran in place, currently we do not maintain “key person” insurance for him or any other key personnel.

We use hazardous chemicals and radioactive and biological materials in our business. Any claims relating to improper handling, storage or disposal of these materials could be time consuming and costly.

     Our research and development processes involve the controlled use of hazardous materials, including chemicals and radioactive and biological materials. Our operations produce hazardous waste products. We cannot eliminate the risk of accidental contamination or discharge and any resultant injury from these materials. We may be sued for any injury or contamination that results from our use or the use by third parties of these materials, and our liability may exceed our insurance coverage and our total assets. Federal, state and local laws and regulations govern the use, manufacture, storage, handling and disposal of hazardous materials. Compliance with environmental laws and regulations may be expensive, and current or future environmental regulations may impair our research, development and production efforts.

Ethical, legal and social issues may limit the public acceptance of, and demand for, our technologies and products.

     Our collaborators and customers may seek to develop diagnostic products based on genes or proteins. The prospect of broadly available gene-based diagnostic tests raises ethical, legal and social issues regarding the appropriate use of gene-based diagnostic testing and the resulting confidential information. It is possible that discrimination by third-party payors, based on the results of such testing, could lead to the increase of premiums by such payors to prohibitive levels, outright cancellation of insurance or unwillingness to provide coverage to individuals showing unfavorable gene or protein expression profiles. Similarly, employers could discriminate against employees with gene or protein expression profiles indicative of the potential for high disease-related costs and lost employment time. Finally, government authorities could, for social or other purposes, limit or prohibit the

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use of such tests under certain circumstances. These ethical, legal and social concerns about genetic testing and target identification may delay or prevent market acceptance of our technologies and products.

     Although our technology does not depend on genetic engineering, genetic engineering plays a prominent role in our approach to product development. The subject of genetically modified food has received negative publicity, which has aroused public debate. Adverse publicity has resulted in greater regulation internationally and trade restrictions on imports of genetically altered agricultural products. Claims that genetically engineered products are unsafe for consumption or pose a danger to the environment may influence public attitudes and prevent genetically engineered products from gaining public acceptance. The commercial success of our future products may depend, in part, on public acceptance of the use of genetically engineered products, including drugs and plant and animal products.

If we develop products with our collaborators, and if product liability lawsuits are successfully brought against us, we could face substantial liabilities that exceed our resources.

     We may be held liable, if any product we develop with our collaborators causes injury or is otherwise found unsuitable during product testing, manufacturing, marketing or sale. Although we have general liability and product liability insurance, this insurance may become prohibitively expensive or may not fully cover our potential liabilities. Inability to obtain sufficient insurance coverage at an acceptable cost or to otherwise protect us against potential product liability claims could prevent or inhibit our ability to commercialize products developed with our collaborators.

Healthcare reform and restrictions on reimbursements may limit our returns on diagnostic or therapeutic products that we may develop with our collaborators.

     If we successfully validate targets for drug discovery, products that we develop with our collaborators based on those targets may include diagnostic or therapeutic products. The ability of our collaborators to commercialize such products may depend, in part, on the extent to which reimbursement for the cost of these products will be available from government health administration authorities, private health insurers and other organizations. In the U.S., third-party payors are increasingly challenging the price of medical products and services. The trend towards managed healthcare in the U.S., legislative healthcare reforms and the growth of organizations such as health maintenance organizations that may control or significantly influence the purchase of healthcare products and services, may result in lower prices for any products our collaborators may develop. Significant uncertainty exists as to the reimbursement status of newly approved healthcare products. If adequate third-party coverage is not available in the future, our collaborators may fail to maintain price levels sufficient to realize an appropriate return on their investment in research and product development.

Our facilities are located near known earthquake fault zones, and the occurrence of an earthquake or other catastrophic disaster could cause damage to our facilities and equipment, which could require us to cease or curtail operations.

     Our facilities are located near known earthquake fault zones and are vulnerable to damage from earthquakes. We are also vulnerable to damage from other types of disasters, including fire, floods, power loss, communications failures and similar events. If any disaster were to occur, our ability to operate our business at our facilities would be seriously, or potentially completely, impaired. In addition, the unique nature of our research activities could cause significant delays in our programs and make it difficult for us to recover from a disaster. The insurance we maintain may not be adequate to cover our losses resulting from disasters or other business interruptions. Accordingly, an earthquake or other disaster could materially and adversely harm our ability to conduct business.

Our stock price may be extremely volatile.

     We believe that the market price of our common stock will remain highly volatile and may fluctuate significantly due to a number of factors. The market prices for securities of many publicly-held, early-stage biotechnology companies have in the past been, and can in the future be expected to be, especially volatile. For example, during the two-year period from January 1, 2001 to December 31, 2002, the closing sales price of our common stock as quoted on the Nasdaq National Market fluctuated from a low of $2.73 to a high of $105.91 per share. In addition, the securities markets have from time to time experienced significant price and volume fluctuations that may be unrelated to the operating performance of particular companies. The following factors and events may have a significant and adverse impact on the market price of our common stock:

•

fluctuations in our operating results;

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	•	announcements of technological innovations or new commercial products by us or our competitors;
	•	release of reports by securities analysts;
	•	developments or disputes concerning patent or proprietary rights;
	•	developments in our relationships with current or future collaborators, customers or licensees; and
	•	general market conditions.

     Many of these factors are beyond our control. These factors may cause a decrease in the market price of our common stock, regardless of our operating performance.

If we are unable to maintain our Nasdaq National Market listing, the liquidity of our common stock would be seriously impaired and we would become subject to various statutory requirements, which would likely harm our business.

     On September 12, 2002, we received a letter from Nasdaq advising us that our common stock had not met Nasdaq’s minimum $1.00 closing bid price requirement for 30 consecutive trading days and that, if we were unable to demonstrate compliance with this requirement during the 90-calendar day grace period ending December 9, 2002, our common stock may be subject to delisting from the Nasdaq National Market. We failed to regain compliance with the minimum bid price requirement during the 90-day grace period, and subsequently received a delisting letter from Nasdaq on December 13, 2002. On December 20, 2002, we requested an oral hearing before a Nasdaq Listing Qualifications Panel to appeal our potential delisting. At the oral hearing on January 23, 2003, we informed Nasdaq that we believed we had regained compliance with the Nasdaq National Market continued listing requirements following a 1-for-7 reverse split of our common stock effected on January 15, 2003.

     On February 21, 2003, we received a letter from Nasdaq advising us that the Nasdaq Listing Qualifications Panel acknowledged that we had regained compliance with the requirements for continued listing on the Nasdaq National Market. The Nasdaq Listing Qualifications Panel determined to continue the listing of our securities on the Nasdaq National Market provided that we file our annual report on Form 10-K for the fiscal year ended December 31, 2002 with the Securities and Exchange Commission and Nasdaq evidencing shareholders’ equity of at least $10,000,000 and that we demonstrate compliance with all requirements for continued listing on the Nasdaq National Market at that time. At December 31, 2002, we had total stockholders’ equity of $12,056,000. The Nasdaq Listing Qualifications Panel reserves the right to modify or terminate this decision upon a review of our reported financial results. In the event that we fail to comply with any terms of this decision, our securities may be transferred to the Nasdaq SmallCap Market, provided we are able to demonstrate compliance with all applicable maintenance criteria and an ability to sustain long-term compliance. In the event we are unable to do so, our securities will be delisted from the Nasdaq Stock Market.

     Transferring to the Nasdaq SmallCap Market would make us subject to certain adverse consequences as described below. In addition, we would still be required to satisfy various listing maintenance standards for our common stock to be quoted on the Nasdaq SmallCap Market, including the minimum bid price requirement. If we fail to meet such standards, our common stock would likely be delisted from the Nasdaq SmallCap Market and trade on the over-the-counter bulletin board, commonly referred to as the “pink sheets.” Such alternatives are generally considered less efficient markets and would seriously impair the liquidity of our common stock and limit our potential to raise future capital through the sale of our common stock, which could materially harm our business.

     If we are delisted from the Nasdaq National Market, we will face a variety of legal and other consequences that would likely negatively affect our business including, without limitation, the following:

	•	we may lose our exemption from the provisions of Section 2115 of the California Corporations Code, which imposes aspects of California corporate law on certain non-California corporations operating within California. As a result, (i) our stockholders would be entitled to cumulative voting and (ii) we would be subject to more stringent stockholder approval requirements and more stockholder-favorable dissenters’ rights in connection with certain strategic transactions;
	•	the state securities law exemptions available to us would be more limited, and, as a result, future issuances of our securities may require time-consuming and costly registration statements and qualifications;

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	•	due to the application of different securities law exemptions and provisions, we may be required to amend our stock option and stock purchase plans and comply with time-consuming and costly administrative procedures;
	•	the coverage of Lynx by securities analysts may decrease or cease entirely; and
	•	we may lose current or potential investors.

Anti-takeover provisions in our charter documents and under Delaware law may make it more difficult to acquire us or to effect a change in our management, even though an acquisition or management change may be beneficial to our stockholders.

     Under our certificate of incorporation, our board of directors has the authority, without further action by the holders of our common stock, to issue 2,000,000 additional shares of preferred stock from time to time in series and with preferences and rights as it may designate. These preferences and rights may be superior to those of the holders of our common stock. For example, the holders of preferred stock may be given a preference in payment upon our liquidation or for the payment or accumulation of dividends before any distributions are made to the holders of common stock.

     Any authorization or issuance of preferred stock, while providing desirable flexibility in connection with financings, possible acquisitions and other corporate purposes, could also have the effect of making it more difficult for a third party to acquire a majority of our outstanding voting stock or making it more difficult to remove directors and effect a change in management. The preferred stock may have other rights, including economic rights senior to those of our common stock, and, as a result, an issuance of additional preferred stock could lower the market value of our common stock. Provisions of Delaware law may also discourage, delay or prevent someone from acquiring or merging with us.

Item 2. Properties

     In February 1998, we entered into a noncancelable operating lease for facilities space of approximately 111,000 square-feet in two buildings in Hayward, California. Currently, our corporate headquarters, principal research and development facilities and production facilities are located in one of the two buildings. The remaining space will be developed and occupied in phases, depending on our growth. The lease runs through December 2008. We have an option to extend the lease for an additional five-year period, subject to certain conditions. We have leased approximately 37,000 square feet of additional space in one of the buildings for further expansion purposes.

     In June 1998, Lynx GmbH entered into a noncancelable operating lease for facilities space of approximately 6,300 square-feet in Heidelberg, Germany, to house its operations. The lease terminates in June 2005. Axaron is currently subleasing a portion of this space. With the workforce reduction at Lynx GmbH in January 2003, we are evaluating alternative uses for the facilities space, which include subleasing all or a significant portion of the vacant space to a new tenant or terminating the lease. In the event of lease termination, we will be obliged to make the monthly lease payments on the facilities space for up to six months if the space remains without a new lessee and to pay the remaining unamortized balance of tenant improvements financed by the landlord over the term of the lease. Additionally, we may be required to pay up to EURO 51,000 (or approximately $54,000 based on a December 31, 2002 exchange rate) for the costs necessary to alter the facilities space to permit or enable another party to lease such space. If we choose to terminate the lease, we estimate that the total payments, including possible alteration costs, will be approximately $150,000.

     In August 1993, we entered into a noncancelable operating lease, which expires on July 31, 2003, for another facility. In 1998, we entered into an agreement to sublease a portion of this space, and in 1999, through a subsequent agreement, subleased the remaining portion of the facility. The term of the sublease runs through July 2003. Rent from the sublease is sufficient to cover the rent and other operating expenses incurred by Lynx under the terms of the 1993 lease.

Item 3. Legal Proceedings

     We are not a party to any material legal proceedings.

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

     At Lynx’s 2002 Special Meeting of Stockholders held on January 14, 2003, Lynx stockholders voted on the following matter:

	Proposal I — Approval of amendments to Lynx’s Amended and Restated Certificate of Incorporation to effect a reverse stock split of Lynx’s common stock:

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PART II

Item 5. Market For Registrant’s Common Equity and Related Stockholder Matters

     Our common stock trades on the Nasdaq National Market under the symbol LYNX. The following table sets forth, for the periods indicated, the high and low closing bid information for our common stock as reported by the Nasdaq National Market, as adjusted to reflect the effect of a 1-for-7 reverse split of our common stock effected on January 15, 2003:

     As of March 3, 2003, there were approximately 1,600 stockholders of record of our common stock. On March 3, 2003, the last reported sale price of our common stock was $2.17.

     We have never declared or paid any cash dividends on our common stock. We currently intend to retain earnings to support the development of our business and do not anticipate paying cash dividends for the foreseeable future. Any future determination to pay dividends will be at the discretion of our board of directors.

Securities Authorized for Issuance Under Equity Compensation Plans

     The following table provides certain information with respect to all of our equity compensation plans in effect as of December 31, 2002:

Equity Compensation Plan Information

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Recent Sales of Unregistered Securities

     On December 26, 2002, Lynx sold 291,545 newly issued shares of our common stock at a purchase price of $3.43 per share to Takara Bio Inc. (formerly Takara Shuzo Co., Ltd.) in a private placement, for an aggregate purchase price of approximately $1.0 million. Lynx issued the shares of common stock in connection with the collaboration agreement, dated as of October 1, 2000, as amended, with Takara and in reliance upon an exemption from the registration requirements of the Securities Act by virtue of Section 4(2) thereof and Regulation D promulgated thereunder.

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Item 6. Selected Financial Data

     This section presents our selected consolidated historical financial data. You should read carefully the consolidated financial statements and the related notes included in this report and Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

     The consolidated statement of operations data for the years ended December 31, 2000, 2001 and 2002 and the consolidated balance sheet data as of December 31, 2001 and 2002 have been derived from our audited consolidated financial statements included elsewhere in this report. The consolidated statement of operations data for the years ended December 31, 1998 and 1999 and the consolidated balance sheet data as of December 31, 1998, 1999 and 2000 have been derived from our audited financial statements that are not included in this report. Historical results are not necessarily indicative of future results. See the notes to consolidated financial statements for an explanation of the method used to determine the number of shares used in computing basic and diluted net loss per share, which have been adjusted in the consolidated statement of operations table to reflect the effect of a 1-for-7 reverse split of our common stock effected on January 15, 2003:

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Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations

     Except for the historical information contained herein, the following discussion contains forward-looking statements that involve risks and uncertainties. When used herein, the words “believe,” “anticipate,” “expect,” “estimate” and similar expressions are intended to identify such forward-looking statements. There can be no assurance that these statements will prove to be correct. Our actual results could differ materially from those discussed here. Factors that could cause or contribute to such differences include, but are not limited to, those discussed in this section as well as in Item 1. “Business — Business Risks.” We undertake no obligation to update any of the forward-looking statements contained herein to reflect any future events or developments.

Overview

     We believe that Lynx Therapeutics, Inc. is a leader in the development and application of novel genomics analysis solutions that provide comprehensive and quantitative digital gene expression information important to modern systems biology research in the pharmaceutical, biotechnology and agricultural industries. These solutions are based on Megaclone and Massively Parallel Signature Sequencing, or MPSS, Lynx’s unique and proprietary cloning and sequencing technologies. Gene expression refers to the number of genes and the extent a cell or tissue expresses those genes, and represents a way to move beyond DNA sequence data to understand the function of genes, the proteins that they encode and the role they play in health and disease. Systems biology is an approach in which researchers seek to gain a complete molecular understanding of biological systems in health and disease.

     We have incurred net losses each year since our inception in 1992. As of December 31, 2002, we had an accumulated deficit of approximately $98.9 million. Net losses may continue for at least the next several years. The size of these losses will depend on the rate of growth, if any, in our revenues and on the level of our expenses.

     To date, we have received, and expect to continue to receive in the future, a significant portion of our revenues from a small number of collaborators, customers and licensees. For the year ended December 31, 2002, revenues from DuPont, Takara, Geron Corporation, Bayer CropScience and BASF accounted for 32%, 16%, 15%, 14% and 11%, respectively, of our total revenues. For the year ended December 31, 2001, revenues from DuPont, BASF, Takara and the Institute of Molecular and Cell Biology accounted for 37%, 24%, 12% and 12%, respectively, of our total revenues. For the year ended December 31, 2000, revenues from DuPont, BASF and Bayer CropScience accounted for 51%, 29% and 11%, respectively, of our total revenues.

     Revenues in each quarterly and annual period have in the past, and could in the future, fluctuate due to: the timing and amount of any technology access fees and the period over which the revenue is recognized; the level of service fees, which is tied to the number and timing of biological samples received from our collaborators and customers, as well as our performance of the related genomics discovery services on the samples; the timing of achievement of milestones and the amount of related payments to us; and the number, type and timing of new, and the termination of existing, agreements with collaborators, customers and licensees.

     Our operating costs and expenses include cost of service fees, research and development expenses and general and administrative expenses. Cost of services fees includes the costs of direct labor, materials and supplies, outside expenses, equipment and overhead incurred by us in performing our genomics discovery services for our collaborators, customers and licensees. Research and development expenses include the costs of personnel, materials and supplies, outside expenses, equipment and overhead incurred by us in our technology and application development and process improvement efforts. Research and development expenses may increase due to spending for ongoing technology development and implementation, as well as new applications, primarily for MPSS. General and administrative expenses include the costs of personnel, materials and supplies, outside expenses, equipment and overhead incurred by us primarily in our administrative, business development, legal and investor relations activities. General and administrative expenses may increase in support of our research and development, commercial and business development efforts.

     We account for our investment in Axaron Bioscience AG, a company owned primarily by BASF AG and us, using the equity method. Prior to our cash capital contribution of approximately $4.5 million in 2001, such investment had a carrying value of zero in the financial statements. Since September 1, 2001, we have recognized our share of Axaron’s operating results in the accompanying statements of operations. For the year ended December 31, 2002, our pro-rata share of Axaron’s losses was approximately $2.5 million.

     As of December 31, 2002, we employed 128 full-time employees, of which 109 were engaged in production and research and development activities. In January 2003, we announced a reduction of approximately 25% of our total

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workforce, or 32 people. The groups affected primarily by this action included research and development personnel based at Lynx GmbH in Germany and our proteomics group in California. The workforce reduction was intended to further focus our financial and human resources on expanding the commercial use of MPSS.

Critical Accounting Policies

     The preparation of our consolidated financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the amounts reported in our financial statements and accompanying notes. The items in our financial statements requiring significant estimates and judgments include determining the useful lives of fixed assets for depreciation and amortization calculations, assumptions for valuing options and warrants and estimated lives of license and collaborative agreements related to deferred revenue. Actual results could differ materially from these estimates.

Revenue Recognition

     Technology access fees have generally resulted from upfront payments from collaborators, customers and licensees who are provided access to Lynx’s technologies for specified periods. We receive service fees from collaborators and customers for genomics discovery services performed by us on the biological samples they send to Lynx. Collaborative research revenues are payments received under various agreements and include such items as milestone payments. Milestone payments are recognized as revenue pursuant to collaborative agreements upon the achievement of specified technology developments, representing the culmination of the earnings process. Other revenues include the proceeds from the sale of technology assets, the sale of proprietary instruments and reagents, and grant revenue.

     Technology access and license fees are deferred and recognized as revenue on a straight-line basis over the noncancelable term of the agreement to which they relate. Payments for services and/or materials provided by Lynx are recognized as revenues when earned over the period in which the services are performed and/or materials are delivered, provided that no other obligations, refunds or credits to be applied to future work exist. Revenues from the sale of technology assets are recognized upon the transfer of the assets to the purchaser. Revenues from the sales of instruments and reagents are recognized upon shipment to the customer.

Investments in Equity Securities

     As of December 31, 2002, we held an approximate 40% equity interest in Axaron Bioscience AG. We account for our equity investment in Axaron using the equity method because our ownership is greater than 20% and we have the ability to exercise significant influence over the operating, investing and financing decisions of Axaron. Under the equity method, we record our pro-rata share of Axaron’s income or losses and adjust the basis of our investment accordingly.

     Although we have the ability to exercise significant influence over the operations of Axaron, we may choose not to exercise such influence or may not have influence over certain operating matters. Consequently, Axaron’s operating results could differ significantly from our expectations and our pro rata share of Axaron’s income or losses that we record in the future could be material.

Results of Operations

Years Ended December 31, 2002 and 2001

Revenues

     We had total revenues of $17.4 million for the year ended December 31, 2002, compared to $19.3 million for the year ended December 31, 2001. Revenues for 2002 included technology access fees and service fees of $13.0 million, license fees of $0.8 million from Axaron, a related party, and $3.6 million of collaborative research and other revenue, primarily from the sale of certain of Lynx’s technology assets to Geron Corporation and the sale of MPSS instruments to Takara. Revenues for 2001 included technology access fees and service fees of $18.4 million, license fees of $0.5 million from Axaron, a related party, and $0.4 million of collaborative research and other revenue. Our revenues have historically fluctuated from quarter to quarter and year to year and may continue to fluctuate in future periods due primarily to our service fees, which are impacted principally by the timing and number of biological samples received from existing customers and collaborators, as well as our performance of

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related services on these samples. Additionally, the number, type and timing of new collaborations and agreements and the related demand for, and delivery of, our services or products will impact the level of future revenues.

Operating Costs and Expenses

     Our total operating costs and expenses were $31.1 million for the year ended December 31, 2002, compared to $36.3 million for the year ended December 31, 2001. Cost of services fees and other were $3.5 million for the year ended December 31, 2002, compared to $4.1 million for the year ended December 31, 2001, and reflect the costs of providing our genomics discovery services and the cost of the MPSS instruments sold to Takara. Research and development expenses were $20.8 million in 2002 and $24.7 million in 2001. The decrease in research and development expenses in 2002 reflects a decrease in materials consumed in research and development efforts and lower personnel expenses, primarily resulting from the workforce reduction that occurred in the second quarter of 2002. Our efforts in 2002 were directed primarily toward the expansion of the commercial applications of, and process improvements for, our genomics technologies and the continued development of our proteomics technology. Research and development expenses may increase due to planned spending for ongoing technology development and implementation, as well as new applications, primarily for MPSS.

     Lynx’s research and development expenses of $20.8 million for 2002 were comprised of $4.4 million in research expenses related primarily to internal discovery projects and $16.4 million in development expenses, including $0.9 million for the Megatype technology and $1.6 million for the Protein ProFiler technology.

     In April 2002, we discontinued our development effort on Megatype, a technology that was being developed to permit the comparison of collected genomes of two populations and enable the detection and recovery of DNA fragments with the single nucleotide polymorphisms, or SNPs, that distinguish these two populations. SNPs are single nucleotide variations, or differences occurring in a single subunit of DNA or RNA, in the genetic code that occur on average at every 1,000 bases along the three billion nucleotides in the human genome. In January 2003, we discontinued our development work on our proteomics technology, Protein ProFiler, which was intended to provide high-resolution analysis of complex mixtures of proteins from cells or tissues. Proteomics is the study of the number of proteins and the extent to which they are expressed in cells or tissues. The primary reason for discontinuing our development efforts on both Megatype and Protein ProFiler was to focus our financial and human resources on expanding the commercial use of MPSS, which we believe will have the greatest commercial value to us.

     We anticipate that our research and development efforts in the future will be directed primarily toward the expansion of the commercial applications of, and process improvements for, our genomics technologies, principally MPSS. These technologies assume that information about gene expression and gene sequences may enable scientists to better understand complex biological processes. Our technologies also depend on the successful integration of independent technologies, each of which has its own development risks. Relatively few therapeutic products based on gene discoveries have been successfully developed or commercialized. Because of these risks and uncertainties, we cannot predict when or whether we will successfully complete the development of these technologies or the ultimate costs of such efforts.

     General and administrative expenses were $6.3 million for the year ended December 31, 2002, compared to $7.5 million for the year ended December 31, 2001. The decrease in general and administrative expenses from the 2001 period to the 2002 period reflects lower personnel expenses and lower outside service costs. The restructuring charge of $0.5 million in the year ended December 31, 2002, was comprised primarily of severance charges for former Lynx employees who were part of Lynx’s workforce reduction of approximately 30% of our domestic workforce, or 45 people, in the second quarter of 2002. The group affected primarily by this action was research and development personnel in California. The workforce reduction was intended to focus our financial and human resources on expanding the commercial use of MPSS. In terms of compensation, benefits and employer taxes that would have been paid to, and on behalf of, such former employees had they remained employed by Lynx, we anticipate annualized cost savings of approximately $3.0 million. General and administrative expenses may increase in support of our research and development, commercial and business development efforts.

Interest and Other Income

     Net interest expense was $0.3 million in the year ended December 31, 2002, compared to $0.1 million for the year ended December 31, 2001. The 2002 net interest expense reflects primarily increased expense incurred on equipment-related debt outstanding in 2002 and a decrease in interest income due to the decline in interest rates during 2002 as compared to the 2001 period. Other income was $0.9 million for the year ended December 31, 2002, compared to $0.5 million for the year ended December 31, 2001. The 2002 other income was related primarily to the

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gain on the sale of our equity investment in Inex Pharmaceuticals Corporation. In 2001, other income was due primarily to a gain of $1.1 million from the receipt of shares of common stock from Inex, as part of the proceeds related to the March 1998 sale of our former antisense program, and a realized gain of $1.1 million from the sale of previously held Inex shares, partially offset by an other-than-temporary write down in the value of previously held Inex shares of $1.6 million.

Equity Share of Loss of Related Party

     The equity share of loss of related party of $2.5 million for the year ended December 31, 2002 reflects Lynx’s pro-rata share of the net loss of Axaron, a joint venture investee, for the same period. Lynx’s pro-rata share of Axaron’s losses was immaterial for 2001.

Income Taxes

     Income tax benefit was $98,000 in the year ended December 31, 2002, compared to the provision for income taxes of $81,000 for the year ended December 31, 2001. The 2002 income tax benefit related primarily to a refund received for federal alternative minimum taxes paid in prior periods, offset by foreign withholding tax due on payments received from our licensee, Takara. The 2001 income tax provision consisted entirely of foreign withholding tax on a payment received from our licensee, Takara.

     As of December 31, 2002, we had a federal net operating loss carryforward of approximately $63.0 million, which will expire at various dates from 2010 through 2022, if not utilized. We had a state net operating loss carryforward of approximately $2.0 million, which will expire in the years 2004 through 2012.

     As of December 31, 2002, we also had federal and California research and development and other tax credit carryforwards of approximately $2.7 million and $2.6 million, respectively. The federal research and development credit will expire at various dates from 2018 through 2021, if not utilized.

     Utilization of our net operating loss may be subject to substantial annual limitation due to the ownership change limitations provided by the Internal Revenue Code and similar state provisions. Such an annual limitation could result in the expiration of the net operating loss before utilization.

Subsequent Events

     In January 2003, we announced a reduction of approximately 25% of our workforce, or 32 people. The groups affected primarily by this action include research and development personnel based at Lynx Therapeutics GmbH in Germany and in our proteomics group in California. The workforce reduction is intended to further focus our financial and human resources on expanding the commercial use of MPSS. We estimate the portion of the charge related to severance payments to our former employees to be approximately $0.3 million and will be recorded in the first quarter of 2003. In terms of compensation, benefits and employer taxes that would have been paid to, and on behalf of, such former employees had they remained employed by Lynx, we anticipate annualized cost savings of approximately $2.0 million.

Years Ended December 31, 2001 and 2000

Revenues

     We had total revenues of $19.3 million for the year ended December 31, 2001, compared to $12.6 million for the year ended December 31, 2000. The increase in revenues from 2000 to 2001 was due primarily to higher service fees from the greater number of biological samples received from and analyzed for our customers and collaborators, including from new service agreements entered into or activated during 2001. Revenues for 2001 included technology access fees and service fees of $18.4 million, license fees of $0.5 million from Axaron, a related party, and $0.4 million of collaborative research and other revenue. Revenues for 2000 included technology access fees and service fees of $12.4 million and collaborative research and other revenue of $0.2 million.

Operating Costs and Expenses

     Our total operating costs and expenses were $36.3 million for the year ended December 31, 2001, compared to $29.6 million for the year ended December 31, 2000. Cost of services fees were $4.1 million for the year ended December 31, 2001, compared to $3.7 million for the year ended December 31, 2000, and reflect the costs of providing our genomics discovery services. Research and development expenses were $24.7 million in 2001 and $19.8 million in 2000. The increase in research and development expenses in 2001, as compared to 2000, was due

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primarily to higher personnel-related and facilities expenses and an increase in materials consumed in research and development efforts. Our efforts in 2001 were directed toward the expansion of the commercial applications of our genomics technologies and the continued development of our proteomics technology. These activities included work under new collaborations and other agreements and on internal discovery projects.

     Lynx’s research and development expenses of $24.7 million for 2001 were comprised of $5.3 million in research expenses related to internal discovery projects and $19.4 million in development expenses, including $2.4 million for the Megatype technology and $1.6 million for the Protein ProFiler technology.

     General and administrative expenses were $7.5 million for the year ended December 31, 2001, compared to $6.2 million for the year ended December 31, 2000. The increase was primarily due to higher personnel-related expenses and increased costs for outside services related to business development activities and marketing programs.

Interest and Other Income

     Net interest expense was $0.1 million in the year ended December 31, 2001, compared to net interest income of $0.9 million for the year ended December 31, 2000. The decrease was primarily due to lower average cash, cash equivalents and investment balances during 2001, as compared to 2000, and increased interest expense incurred on equipment-related debt outstanding in 2001. Other income was $0.5 million for the year ended December 31, 2001, compared to $3.3 million for the year ended December 31, 2000. In 2001, other income was due primarily to a gain of $1.1 million from the receipt of shares of common stock from Inex, as part of the proceeds related to the March 1998 sale of our former antisense program, and a gain of $1.1 million from the sale of previously held Inex shares, partially offset by a $1.6 million write down in the value of previously held Inex shares. In 2000, other income was due primarily to a gain of $3.1 million from the receipt of shares of common stock from Inex, as part of the proceeds related to the March 1998 sale of our former antisense program.

Income Taxes

     The provisions for income taxes of approximately $81,000 and $500,000 for 2001 and 2000, respectively, consisted entirely of foreign withholding tax due on a payment received from our licensee, Takara.

Liquidity and Capital Resources

     Cash and cash equivalents held at December 31, 2002 totaled $11.7 million. Net cash used in operating activities was $16.2 million for the year ended December 31, 2002, as compared to $15.4 million for fiscal year 2001. The change between 2002 and 2001 was due primarily to a higher decrease in deferred revenues and a decrease, rather than an increase, in accounts payable and other liabilities during 2002 as compared to 2001, partially offset by a lower net loss, excluding the impact of depreciation and amortization and the non-cash gains and losses. The amount of net cash used in operating activities differed from the 2002 net loss due primarily to decreases in deferred revenue and accounts payable, offset partially by depreciation and amortization of fixed assets and leasehold improvements, the net impact of certain non-cash gains and losses and a decrease in inventory. Net cash used in operating activities was $15.4 million for the year ended December 31, 2001, as compared to $9.0 million for fiscal year 2000. The change between 2001 and 2000 was due primarily to a higher decrease in deferred revenues, a lower decrease in accounts receivable and a lower increase in accounts payable and other liabilities during 2001 as compared to 2000. The amount of net cash used in operating activities differed from the 2001 net loss due primarily to the depreciation and amortization of fixed assets and leasehold improvements, the amortization of deferred compensation and the write down of an equity investment, partially offset by a decrease in deferred revenue and a gain on the sale of the antisense business. The amount of net cash used in operating activities differed from the 2000 net loss due primarily to the depreciation and amortization of fixed assets and leasehold improvements and the collection of accounts receivable.

     Net cash provided by investing activities of $1.4 million for the year ended December 31, 2002 was due primarily to proceeds from the sale of equity investments and repayment of notes receivable from employees, partially offset by expenditures for capital equipment. Net cash used in investing activities of $0.4 million for the year ended December 31, 2001, was due primarily to expenditures for capital equipment and leasehold improvements and our investment in Axaron, partially offset by proceeds from the sale of Inex securities and net maturities of short-term investments. Net cash used in investing activities of $2.3 million for the year ended December 31, 2000, was due primarily to expenditures for capital equipment and leasehold improvements, partially offset by net maturities of short-term investments.

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     Net cash provided by financing activities in 2002 of $23.3 million was due primarily to the issuance of Lynx common stock in three private placements. Net cash provided by financing activities in 2001 of $11.1 million was due primarily to the issuance of Lynx common stock in two private placements. Net cash provided by financing activities in 2000 of $1.1 million was due primarily to the issuance of Lynx common stock from the exercise of employee stock options.

     In both September and December 2002, in connection with our collaboration agreement with Takara, we issued and sold 291,545 shares of common stock, at a purchase price of $3.43 per share, to Takara in private placements pursuant to the terms and conditions of common stock purchase agreements.

     In April 2002, we completed a private placement of common stock and warrants to purchase common stock. The financing included the sale of 2.1 million newly issued shares of common stock, at a purchase price of $10.85 per share, resulting in gross proceeds of $22.6 million, pursuant to a common stock purchase agreement between Lynx and certain investors. In connection with this transaction, Lynx issued warrants to purchase up to 0.8 million shares of common stock at an exercise price of $13.58 per share. Additionally, Lynx issued a warrant to purchase up to an aggregate of 41,714 shares of common stock at an exercise price of $10.85 per share to Friedman, Billings, Ramsey & Co., Inc. (FBR), as partial consideration, in addition to other customary fees, for services rendered by FBR as sole manager for the private equity financing.

     In October 2001, in connection with our collaboration agreement with Takara, we issued and sold 45,787 shares of common stock, at a purchase price of $21.84 per share, to Takara in a private placement pursuant to the terms and conditions of a common stock purchase agreement.

     In May 2001, we completed a private placement of common stock and warrants to purchase common stock. The financing included the sale of 249,605 newly issued shares of common stock, at a purchase price of $44.59 per share, resulting in net proceeds of $10.5 million, pursuant to a common stock purchase agreement between Lynx and certain investors. In connection with this transaction, we issued warrants to purchase up to 62,399 shares of common stock at an exercise price of $ 64.41 per share.

     In October 2002, we entered into a loan and security agreement with a financial institution, Comerica Bank-California, for an equipment line of credit of up to $2.0 million with a draw-down period of one year. Under the initial advance, we drew down $1.6 million in November 2002 related to the purchase of equipment made in previous periods. Lynx granted Comerica Bank-California a security interest in all items Lynx financed under this agreement. The initial advance under the loan to finance the purchase of equipment made in previous periods has a term of 24 months from the date of advance and bears interest at a rate of 7.25%. Pursuant to the terms of the agreement, we are required to maintain a minimum cash balance of unrestricted cash and cash equivalents in an account at Comerica Bank-California of at least $5.0 million until Comerica Bank-California receives payment in full of all outstanding obligations, and there is a liquidity requirement that we have a balance of unrestricted cash at each month’s end that is greater than our net decrease in cash during the preceding four months. As of December 31, 2002, the principal balance under loans outstanding under this agreement was $1.5 million. We believe that we are in compliance with all terms of the agreement.

     In late 1998, we entered into a financing agreement with a financial institution, Transamerica Business Credit Corporation, under which we drew down $4.8 million during 1999 for the purchase of equipment and certain other capital expenditures. We granted the lender a security interest in all items financed by it under this agreement. Each draw down under the loan has a term of 48 months from the date of the draw down. As of December 31, 2002, the principal balance under loans outstanding under this agreement was $1.8 million. The draw down period under the agreement expired on March 31, 2000.

     Our contractual obligations for the next five years and thereafter are as follows:

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     We plan to use available funds for ongoing commercial and research and development activities, working capital and other general corporate purposes and capital expenditures. We expect capital investments during 2003 will be less than $1.0 million and will be comprised primarily of equipment purchases required in the normal course of business. We intend to invest our excess cash in investment-grade, interest-bearing securities.

     We have obtained funding for our operations primarily through sales of preferred and common stock, payments under contractual arrangements with customers, collaborators and licensees and interest income. Consequently, investors in our equity securities and our customers, collaborators and licensees are significant sources of liquidity for us. Therefore, our ability to maintain liquidity is dependent upon a number of uncertain factors, including but not limited to the following: our ability to advance and commercialize further our technologies; our ability to generate revenues through expanding existing collaborations, customer and licensee arrangements and obtaining significant new customers, collaborators and licensees; and the receptivity of capital markets toward our equity or debt securities. The cost, timing and amount of funds required for specific uses by us cannot be precisely determined at this time and will be based upon the progress and the scope of our commercial and research and development activities; payments received under customer, collaborative and license agreements; our ability to establish and maintain customer, collaborative and license agreements; costs of protecting intellectual property rights; legal and administrative costs; additional facilities capacity needs, and the availability of alternate methods of financing.

     We have experienced operating losses since our inception of $98.9 million, including a net loss of $15.5 million for the year ended December 31, 2002. Net losses may continue as Lynx proceeds with the commercialization and additional development of our technologies. Our cash and cash equivalents were $11.7 million at December 31, 2002. We believe that our current cash and cash equivalents and funding anticipated to be received from customers, collaborators and licensees will enable us to maintain our operations through at least December 31, 2003. Changes to our current operating plan may require us to consume available capital resources significantly sooner than we expect. If our capital resources are insufficient to meet future capital requirements, we will have to raise additional funds. We may seek additional financing, as needed, through arrangements with customers, collaborators and licensees and equity or debt offerings. We do not know if we will be able to raise sufficient additional capital on acceptable terms, or at all. If we raise additional capital by issuing equity or convertible debt securities, our existing stockholders may experience substantial dilution. If we are unable to secure additional financing on reasonable terms, or are unable to generate sufficient new sources of revenue through arrangements with customers, collaborators and licensees, management may be forced to take substantial restructuring actions, which may include significantly reducing Lynx's anticipated level of expenditures, the sale of some or all of our assets, or obtaining funds by entering into financing or collaborative agreements on unattractive terms, or we will not be able to fund operations.

Recent Accounting Pronouncements

     In July 2001, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standard No. 141, Business Combinations (SFAS 141). SFAS 141 establishes new standards for accounting and reporting for business combinations initiated after June 30, 2001. Use of the pooling-of-interests method is prohibited. We adopted this statement during the first quarter of fiscal 2002, and the adoption did not have a material effect on our operating results or financial position.

     In July 2001, the FASB issued Statement of Financial Accounting Standard No. 142, Goodwill and Other Intangible Assets (SFAS 142), which supercedes APB Opinion No. 17, Intangible Assets. SFAS 142 establishes new standards for goodwill, including the elimination of goodwill amortization to be replaced with methods of periodically evaluating goodwill for impairment. We adopted this statement during the first quarter of fiscal 2002, and the adoption did not have a material effect on our operating results or financial position.

     In August 2001, the FASB issued Statement of Financial Accounting Standard No. 143, Accounting for Asset Retirement Obligations (SFAS 143). SFAS 143 requires entities to record the fair value of a liability for an asset retirement obligation in the period in which it is incurred. We adopted this statement during the first quarter of fiscal 2002, and the adoption did not have a material effect on our operating results or financial position.

     In October 2001, the FASB issued Statement of Financial Accounting Standard No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets (SFAS 144), which supersedes FASB Statement No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed of. SFAS 144 establishes a single accounting model for long-lived assets to be disposed of and is applicable to financial statements issued for fiscal years beginning after December 31, 2001 (January 2002 for calendar year-end companies) with transition provisions for certain matters. We adopted this statement during the first quarter of fiscal 2002, and the adoption did not have a material effect on our operating results or financial position.

     In June 2002, the FASB issued Statement of Financial Accounting Standard No. 146, Accounting for Costs Associated with Exit or Disposal Activities (SFAS 146). SFAS 146 addresses financial accounting and reporting for costs associated with exit or disposal activities and nullifies Emerging Issues Task Force (EITF) Issue No. 94-3, Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including

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Certain Costs Incurred in a Restructuring). SFAS 146 is effective for exit and disposal activities initiated after December 31, 2002. We expect to adopt this statement during the first quarter of fiscal 2003 and do not believe that SFAS 146 will have a material effect on our operating results or financial position.

     In November 2002, the FASB issued FASB Interpretation (FIN) No. 45, Guarantor’s Disclosure Requirements for Guarantees, Including Indirect Guarantees of Others. FIN No. 45 clarifies the guarantor’s requirements relating to the guarantor’s accounting for, and disclosure of, the issuance of certain types of guarantees and requires the guarantor to recognize at the inception of a guarantee a liability for the fair value of the guarantee obligation. The provisions for the initial recognition and measurement of guarantees are effective on a prospective basis for guarantees that are issued or modified after December 31, 2002. The accounting profession and regulatory agencies continue to discuss various provisions of this pronouncement with the objective of providing additional guidance on its application. These discussions and the issuance of any new interpretations, once finalized, could lead to an unanticipated impact on our future financial results. Therefore, although we currently do not believe these provisions will have a material effect on our operating results or financial position, we will continue to evaluate the impact of FIN 45.

     In December 2002, the FASB issued Statement of Financial Accounting Standard No. 148, Accounting for Stock-Based Compensation—Transition and Disclosure—an amendment of FASB Statement No. 123 (SFAS 148). SFAS 148 amends FASB Statement No. 123, Accounting for Stock-Based Compensation (SFAS 123), to provide alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. In addition, SFAS 148 amends the disclosure requirements of SFAS 123 to require expanded and more prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. While SFAS 148 does not amend SFAS 123 to require companies to account for employee stock options using the fair value method, the disclosure provisions of SFAS 148 are applicable to all companies with stock-based employee compensation, regardless of whether they account for that compensation using the fair value method of SFAS 123 or the intrinsic value method of APB 25. Since we account for our stock-based compensation under APB 25, and have no current plans to switch to SFAS 123, the impact of SFAS 148 will be limited to the interim reporting of the effects on net loss and loss per share if we accounted for stock-based compensation under SFAS 123. SFAS 148 is effective for fiscal years ending after December 15, 2002.

Item 7A. Quantitative and Qualitative Disclosures about Market Risk

Short-Term Investments

     The primary objective of our investment activities is to preserve principal while, at the same time, maximizing yields without significantly increasing risk. To achieve this objective, we invest in highly liquid and high-quality debt securities. Our investments in debt securities are subject to interest rate risk. To minimize the exposure due to adverse shifts in interest rates, we invest in short-term securities and maintain an average maturity of less than one year. As a result, we do not believe we are subject to significant interest rate risk.

Foreign Currency Rate Fluctuations

     The functional currency for our German subsidiary is the Euro. Our German subsidiary’s accounts are translated from the Euro to the U.S. dollar using the current exchange rate in effect at the balance sheet date, for balance sheet accounts, and using the average exchange rate during the period, for revenues and expense accounts. The effects of translation are recorded as a separate component of stockholders’ equity, and to date, have not been material. Our German subsidiary conducts its business primarily in Euros. Exchange gains and losses arising from these transactions are recorded using the actual exchange differences on the date of the transaction. We have not taken any action to reduce our exposure to changes in foreign currency exchange rates, such as options or futures contracts, with respect to transactions with our German subsidiary or transactions with our European collaborators and customers.

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Item 8. Consolidated Financial Statements and Supplementary Data

Index to Consolidated Financial Statements

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Report of Ernst & Young LLP, Independent Auditors

The Board of Directors and Stockholders
Lynx Therapeutics, Inc.

     We have audited the accompanying consolidated balance sheets of Lynx Therapeutics, Inc. as of December 31, 2002 and 2001, and the related consolidated statements of operations, stockholders’ equity and cash flows for each of the three years in the period ended December 31, 2002. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.

     We conducted our audits in accordance with auditing standards generally accepted in the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

     In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Lynx Therapeutics, Inc. at December 31, 2002 and 2001, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 2002, in conformity with accounting principles generally accepted in the United States.

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LYNX THERAPEUTICS, INC.

CONSOLIDATED BALANCE SHEETS

See accompanying notes.

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LYNX THERAPEUTICS, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

See accompanying notes.

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LYNX THERAPEUTICS, INC.

CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY
(in thousands, except share amounts)