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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

(Mark One)

OR

Commission File Number 000-22873

NUVELO, INC.

675 ALMANOR AVENUE, SUNNYVALE, CA 94085
(Address of Principal Executive Offices, including Zip Code)

408-215-4000
(Registrant’s Telephone Number, including Area Code)

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

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

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

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NUVELO, INC.

FORM 10-Q

FOR THE QUARTER ENDED JUNE 30, 2003

TABLE OF CONTENTS

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ITEM 1.   FINANCIAL STATEMENTS

NUVELO, INC.
Condensed Consolidated Balance Sheets
(unaudited)

See accompanying notes to condensed consolidated financial statements.

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NUVELO, INC.
Condensed Consolidated Statements Of Operations
(in thousands, except per share data)
(unaudited)

See accompanying notes to condensed consolidated financial statements.

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NUVELO, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
(unaudited)

See accompanying notes to condensed consolidated financial statements.

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NUVELO, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2003
(Unaudited)

1.   Basis of Presentation

     The accompanying unaudited condensed consolidated financial statements have been prepared by Nuvelo, Inc. (“Nuvelo,” the “Company,” “we,” “us,” or “our”) in accordance with accounting principles generally accepted in the United States of America for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States of America for complete financial statements. The accompanying financial information is unaudited, but includes all adjustments (consisting of normal recurring adjustments) which the Company considers necessary for a fair presentation of the financial position, operating results and cash flows for the periods presented. Unless otherwise indicated, the discussions in this report of the results of operations for the three and six months ended June 30, 2003 and financial condition at June 30, 2003 include the results of operations of Variagenics commencing from February 1, 2003. The condensed consolidated balance sheet as of December 31, 2002 is derived from the Company’s audited financial statements. The condensed consolidated financial statements include the accounts of the Company’s majority-owned subsidiary Callida Genomics, Inc. The results of operations for the interim period shown herein are not necessarily indicative of operating results expected for the entire year.

2.   Stock-Based Compensation

     In accordance with the provisions of Statement of Financial Accounting Standards No. 123 (SFAS No. 123), “Accounting for Stock-Based Compensation” as amended by SFAS No. 148 “Accounting for Stock-Based Compensation — Transition and Disclosure,” the Company has elected to account for stock-based compensation to employees under the provisions of Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees,” and its related interpretations, and to adopt the “disclosure only” alternative described in SFAS No. 123 as amended by SFAS No. 148. The Company’s pro forma information follows (in thousands, except for per share information):

3.   Segment Information

     The Company is engaged in research and development of novel biopharmaceutical protein-based products for the treatment of human disease from its collection of proprietary genes discovered using its high-throughput signature-by-hybridization platform. Reportable segments reflect the Company’s structure, reporting responsibilities to the chief executive officer and the nature of the products under development. Reportable segments are Nuvelo Inc., which develops and intends to market therapeutic drugs for the treatment of human diseases; and Callida Genomics, Inc., which develops and intends to commercialize the sequencing-by-hybridization (SBH) technology including the high-speed DNA sequencing chip. Segment operating results are measured based on net loss before tax. There are no inter-segment sales.

RECONCILIATION OF REPORTABLE SEGMENTS’ FINANCIAL INFORMATION
(in thousands)

     The primary sources of the Nuvelo segment revenues in 2003 are amortization of Affymetrix license fee revenue, the license revenue from Celera Diagnostics and the collaboration with Novartis. The primary sources of the Nuvelo segment revenues in 2002 are Affymetrix and BASF Plant Sciences. The source of the Callida segment revenues in 2003 and 2002 are primarily from the National Institute of Standards and Technology

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(NIST) grant and Agilent Technologies, respectively.

4.   Lease Amendment

     On October 25, 2002, the Company and its landlord entered into agreements to terminate the Company’s eleven-year lease for buildings located at 225, 249 and 257 Humboldt Court, Sunnyvale California (originally entered into June 23, 2000) and to grant the Company a six-month option to purchase these properties for a purchase price of $15.3 million. These agreements retroactively terminated the Company’s lease effective October 1, 2002. The Company paid a lease termination fee of $5.4 million (of which $3.1 million was already held by the landlord for prepaid rent and a security deposit). The Company paid approximately $4.5 million for the option to purchase the building, (of which $1.7 million was cash, $2.6 million was in the form of a six-month interest free promissory note guaranteed by Company’s Chairman, Dr. George B. Rathmann (Option Note), and approximately $200,000 was in the form of warrants issued to the landlord). The purchase option fee was creditable against the purchase price of the building if the option was ultimately exercised. Also, the Company was paying additional consideration of $95,000 per month commencing November 1, 2002 until the option was ultimately exercised by the Company or April 30, 2003, whichever occurred first.

     On May 9, 2003 the Company amended the lease termination agreement and terminated the option agreement. As part of this agreement the Company amended the promissory note such that the balance of $2.6 million guaranteed by the Company’s Chairman, Dr. George B. Rathmann, will be due and payable on May 1, 2005. Interest will accrue at an annual rate of 8% and the Company will pay the accrued interest of approximately $17,000 on a monthly basis. In addition, the Company provided to the landlord a warrant to purchase 200,000 shares of the Company’s common stock. The Company recognized lease termination costs totaling $3.5 million and expensed leasehold improvements of $1.5 million associated with this amended lease termination agreement in the second quarter of 2003.

5.   Merger with Variagenics, Inc

     On January 31, 2003, the Company completed its merger with Variagenics, Inc., a publicly traded company incorporated in Delaware. Variagenics developed molecular diagnostic tests by identifying genetic markers associated with response to cancer therapies, with the goal of optimizing patient care. Nuvelo and Variagenics merged because they believed the merger would benefit the stockholders of both companies by leveraging the companies’ assets and management to develop biotherapeutic, pharmacogenomic and molecular diagnostic products and accelerate revenue generation. As a result of the merger, Variagenics shareholders received 1.6451 shares of Company stock in exchange for each Variagenics share for a total of approximately 39.8 million Company shares, at an approximate purchase price of $48.6 million net of estimated transaction costs of $5.0 million which includes $2.3 million in severance and benefits expenses and $0.3 million in stock option expense for research and development and administrative employees terminated as part of the merger plan in accordance with Emerging Issues Task Force No 95-3 “Recognition of Liabilities in Connection with a Purchase Business Combination”. At June 30, 2003 the company had paid $1.2 million of the $2.3 million in accrued severance and benefits expense, resulting in an accrued severance of $1.1 million which is expected to be paid by December 15, 2003. In determining the Variagenics purchase price, Nuvelo (formerly Hyseq) used the estimated value of Hyseq common stock of approximately $1.16 per share based upon the average closing price of Hyseq common stock the two trading days before the merger announcement and the two trading days after the merger announcement.

     The following table summarizes the estimated fair value of the assets acquired and liabilities assumed at the date of acquisition. The allocation of the purchase price was based, in part, on a third party valuation of the fair value of identifiable intangible assets. The Company incurred additional liabilities of $1.2 million in the second quarter of 2003 for additional severance costs as part of its plan to shutdown the Cambridge facility and monetize non core assets acquired in the merger. The table has been updated to reflect these additional liabilities. The Company is in the process of evaluating the value of the property and equipment; thus, the allocation for the purchase price is subject to refinement.

     The fair value of the net assets acquired of $54.7 million exceeded the purchase price of $53.6 million resulting in negative goodwill of $1.1 million that has been proportionately allocated between property and equipment and intangible assets in the amount of $1.0 million and $0.1 million, respectively.

     The Company has accounted for this merger under the purchase method of accounting for business combinations in accordance with the provisions of Statement of Financial Accounting Standards (SFAS) No. 141 “Business Combinations”. The following unaudited pro forma financial information presents the combined results of the operations of Variagenics, and the Company as if the merger had occurred on January 1, 2003 and 2002:

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6.   Callida Restructuring

     On March 7, 2003, the Company restructured its Callida subsidiary, eliminating 18 of the subsidiary’s 25 employees. Under an ongoing severance plan, the company accrued severance related expenses of $315,000 in the first quarter of 2003, in accordance with SFAS 112 “Employers’ Accounting for Post Employment Benefits an Amendment of FASB Statement No. 5 and 43”. As of June 30, 2003 the Company has paid $277,000 in severance related expenses and has accrued severance related expenses of $38,000.

7.   Recent Accounting Pronouncements

     In July 2002, the FASB issued SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities” (SFAS 146). SFAS 146 requires recording costs associated with exit or disposal activities at their fair values when a liability has been incurred. Under previous guidance, certain exit costs were accrued upon management’s commitment to an exit plan, which is generally before an actual liability is incurred. Adoption of this statement is required for exit or disposal activities initiated after December 31, 2002. The adoption of SFAS 146 did not have a material impact on the Company’s financial position or results of operations.

     In November 2002, the Emerging Issues Task Force reached consensus on EITF 00-21, Accounting for Revenue Arrangements with Multiple Deliverables. EITF 00-21 sets out criteria for whether revenue on a deliverable can be recognized seperately from other deliverables in a multiple deliverable arrangement. The criteria considers whether the delivered item has stand-alone value to the customer, whether the fair value of the delivered item can be reliably determined and the rights of returns for the delivered item. EITF 00-21 must be adopted by the Company by July 1, 2003. The adoption of EITF 00-21 did not have a material impact on the Company’s financial position or results of operations.

     In May 2003, the FASB issued SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity” (SFAS No. 150), effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003. The impact upon adoption of SFAS No. 150 is not expected to have a material impact on the results of operations or the financial position of the Company.

8.   Subsequent Events

     On August 5, 2003, the Company and Dr. George Rathmann entered into a second amendment of the Amended and Restated Line of Credit Agreement to extend the expiration date set forth in the agreement in order to give the Company and Dr. Rathmann time to engage in discussions regarding potential modifications to the agreement. The original expiration date of August 5, 2003 was extended to September 5, 2003. All other terms under the Amended and Restated Line of Credit Agreement are unchanged.

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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

     This Management’s Discussion and Analysis of Financial Condition and Results of Operations contains “forward-looking statements” as that term is defined in the Private Securities Litigation Reform Act of 1995. Forward-looking statements may be identified by words including “anticipate,” “believe,” “intends,” “estimates,” “expect,” “should,” “may,” “potential” and similar expressions. Such statements are based on our management’s current expectations and involve risks and uncertainties. Actual results and performance could differ materially from those projected in the forward-looking statements as a result of many factors discussed herein and elsewhere including, in particular, those factors described under “Risk Factors” set forth below, and in our other periodic reports filed from time to time with the Securities and Exchange Commission, “SEC.” Actual results and performance could also differ materially from time to time from those projected in our filings with the SEC.

Acquisition of Variagenics, Inc.

     On January 31, 2003, the Company acquired all of the outstanding common stock of Variagenics, Inc. (Variagenics) in a transaction accounted for as a purchase business combination. Variagenics applied pharmacogenomics technology to the discovery, development and commercialization of personalized drugs and molecular diagnostic products. The acquisition of Variagenics, with its cash resources, is expected to further advance Nuvelo’s most promising biopharmaceutical discovery and development programs.

     Under terms of the merger agreement, each share of Variagenics common stock outstanding at January 31, 2003 was converted into 1.6451 shares of Nuvelo, Inc. (Nuvelo), formerly Hyseq, common stock. As a result, Nuvelo issued approximately 39.8 million shares of common stock to former Variagenics shareholders. Each employee stock option to purchase Variagenics common stock outstanding at January 31, 2003 was assumed by Nuvelo and converted into an option to purchase Nuvelo common stock based on the terms specified in the merger agreement. As a result, approximately 4.7 million options to purchase Nuvelo common stock were assumed, on an as converted basis. In addition, each warrant to purchase Variagenics common stock outstanding at January 31, 2003 was assumed by Nuvelo and converted into warrants to purchase Nuvelo common stock based on the terms specified in the merger agreement. As a result, warrants to purchase approximately 2.1 million shares of Nuvelo common stock were assumed, on an as converted basis. The acquisition is expected to qualify as a tax-free reorganization within the meaning of Section 368(a) of the Internal Revenue Code.

     We were originally incorporated as Hyseq, Inc. in Illinois in 1992 and reincorporated in Nevada in 1993. Upon completion of the merger with Variagenics, Inc., we changed our name to Nuvelo, Inc. Unless otherwise indicated, the discussions in this report of the results of operations for the three and six months ended June 30, 2003 and financial condition at June 30, 2003 include the results of operations of Variagenics commencing from February 1, 2003. Comparisons are made to the results of operations for the three and six months ended June 30, 2002 and financial condition as of December 31, 2002, which include only the historical results of Nuvelo (formerly Hyseq).

Company Overview

     Our Company is strategically focused on the discovery and development of novel biotherapeutics. This strategy resulted from a careful review of all assets and programs at both Hyseq and Variagenics following the close of our merger between the two companies on January 31, 2003.

     As part of this plan, we will dedicate our resources to advancing our most promising biopharmaceutical discovery and development programs, including alfimeprase, our novel acting thrombolytic which entered Phase II trials in the first half of this year.

     We will leverage our proprietary gene collection and opportunistic in-licensing and partnering strategy to build upon our pipeline of attractive therapeutic candidates. We also intend to out-license or partner our immunotherapeutics portfolio and monetize non-core assets including our microarray business, pharmacogenomic technology and molecular diagnostic programs, to further support our biopharmaceutical development programs. Our focus is on building a successful biopharmaceutical business. This strategic initiative reflects our commitment to creating a valuable product-focused company that leverages our drug discovery and development expertise. To execute on this strategy, we will align the company’s assets and resources and efficiently manage our finances to provide our key development programs with the greatest chance of success.

     Alfimeprase, our lead development program, successfully completed its Phase I trial in the first quarter, 2003. This trial was a multi-center, open label, dose-escalation study to evaluate the safety and pharmacokinetics of alfimeprase, and was completed in twenty patients across seven centers in the United States. The results show that alfimephase was safe and well-tolerated. There were no drug related adverse events. In addition we filed an investigational new drug (IND) application for a second indication in catheter occlusion. We initiated two Phase II programs with alfimeprase in the first half of this year in both peripheral arterial occlusion and catheter occlusion and anticipate completion of at least one of these Phase II “proof-of-concept” studies by the end of 2003.

     Our current cash and investment balances resulting from our merger, anticipated business development cash inflows and our line of credit are expected to fund our operations through 2004. As of June 30, 2003, we had approximately $29.2 million in cash, cash equivalents, short-term investments and restricted cash, consisting of $26.6 million cash and investment balances available for future operations and $2.6 million in restricted cash related to collateralization of letters of credit.

     On July 8, 2003, we filed a registration statement on Form S-3 with the Securities and Exchange Commission that allows for the sale of up to $50 million of debt securities, preferred stock and/or common stock. We have not set a date for a proposed sale but we are continually evaluating our financing requirements and expect a sale of one or more of these securities in the near future.

     Our headquarters address is 675 Almanor Avenue Sunnyvale, California 94085. Our telephone number is (408) 215-4000.

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RESULTS OF OPERATIONS

Contract Revenues

Comparison of the Three Months and Six Months Ended June 30, 2003 and 2002.

     Revenues decreased to $0.4 million for the three months ended June 30, 2003 from $6.7 million for the comparable period ended June 30, 2002 due to the completion of our agricultural gene discovery collaboration with BASF Plant Science LLC in January 2003 and conclusion of our collaborations with Chiron and Agilent in 2002, partially offset by increased revenue of $0.1 million from Variagenics’ contracts and $0.2 million from Callida’s new grant obtained from the National Institute of Standards and Technology (NIST) in December 2002 .

     Revenues decreased to $1.7 million for the six months ended June 30, 2003 from $11.9 million for the comparable period ended June 30, 2002 due to the completion of our agricultural gene discovery collaboration with BASF Plant Science LLC in January 2003, conclusion of our collaboration with Chiron and Agilent in 2002, and completion of the recognition of license fee revenue associated with our Affymetrix collaboration for the development of a high speed universal DNA sequencing chip, partially offset by increased revenue of $0.1 million from Variagenics’ contracts and $0.7 million from Callida’s new NIST grant.

     Revenues earned by our Nuvelo segment were $0.2 million and $1.0 million for the three and six months ended June 30, 2003, respectively, compared to $6.2 million and $11.4 million during the same periods of 2002. Our Callida segment had revenues of $0.2 million and $0.7 million for the three and six months ended June 30, 2003, respectively, compared to $0.5 million and $0.5 million in the same periods of 2002.

     Our revenues typically vary from quarter to quarter and may result in significant fluctuations in our operating results from year to year. We expect to add additional revenue generating collaborations in 2003, however, revenues for this year will be reduced substantially as a result of the accelerated completion of our collaboration with BASF, which was completed substantially in January 2003 and accounted for approximately $21.9 million in revenue in 2002. In the future, we may not be able to maintain existing collaborations, obtain additional collaboration partners or obtain revenue from other sources. The failure to maintain existing collaborations or the inability to enter into additional collaborative arrangements or obtain revenues from other sources could have a material adverse effect on our revenues, operating results, and cash flows.

Operating Expenses

Comparison of the Three Months and Six Months Ended June 30, 2003 and 2002.

     Research and development expenses decreased to $7.3 million for the three months ended June 30, 2003 from $10.7 million for the comparable period ended June 30, 2002. The decrease was due primarily to cost savings of approximately $2.2 million as a result of completion of the BASF collaboration in January 2003, rent savings of $1.0 million related to our facility lease termination for the facility on Humboldt Court in Sunnyvale California in October 2002, and general decrease in legal expense resulting from reduced patent activities.

     Research and development expenses decreased to $18.1 million for the six months ended June 30, 2003 from $31.8 million for the comparable period ended June 30, 2002. The decrease was due primarily to cost savings from the completion of our BASF collaboration, the $10.0 million non-cash charge for the fair value of warrants issued to Amgen, Inc. in the first quarter of 2002, rent savings of $1.9 million related to our facility lease termination in October 2002, and a general decrease in legal expense resulting from reduced patent activities.

     General and administrative expenses increased to $7.7 million for the three months ended June 30, 2003 from $3.2 million for the comparable period ended June 30, 2002. The increase in general and administrative expense was primarily due to $3.5 million lease transaction costs related to our decision to not exercise the Humboldt Court facility purchase option and additional staff–related, facilities and other outside costs, including legal and accounting costs, from our acquisition of Variagenics.

     General and administrative expenses increased to $11.5 million for the six months ended June 30, 2003 from $6.2 million for the comparable period ended June 30, 2002. The increase in general and administrative expense was primarily due to $3.5 million lease transaction costs related to our decision to not exercise the Humboldt Court facility purchase option and additional general and administraive costs associated with the addition of Variagenics’ facilities and personnel.

     Our Nuvelo segment had operating expenses of $13.8 million and $26.2 million for the three and six months ended June 30, 2003, respectively, as compared to $12.9 million and $35.4 in the same periods of 2002. Our Callida segment had operating expenses of $1.2 million and $3.4 million for the three and six months ended June 30, 2003, respectively, as compared to $1.6 million and $3.2 million in the same periods of 2002.

     We expect operating expenses during the remainder of 2003 to decrease as a result of streamlining our operations post closing of our merger between Hyseq and Variagenics and as a result of our other cost control efforts including a partial hiring freeze, a freeze on capital expenditures, delay of our facilities expansion plans, and deferral of as many of our contractual financial commitments as possible. We expect that these expense reductions will be partially or completely offset by higher costs of outside clinical research services for Phase II clinical trials for alfimeprase in the second half of 2003.

Interest Income and Expense

Comparison of the Three Months and Six Months Ended June 30, 2003 and 2002.

     Our interest income increased to $151,000 and $300,000 during the three and six months ended June 30, 2003, respectively, compared with $40,000 and $70,000 during the same periods in 2002. The change in interest income was due to higher average cash and investment balances as a

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result of the cash infusion from our acquisition of Varigenics on January 31, 2003. Interest expense increased to $390,000 and $751,000 during the three and six months ended June 30, 2003, respectively, compared with $254,000 and $512,000 during the same periods in 2002. The increase in interest expense was due to an increase in the amount drawn on our line of credit from our chairman, and increased capital equipment leases assumed in our acquisiton of Variagenics.

Net Loss

Comparison of the Three Months and Six Months Ended June 30, 2003 and 2002.

     Since our inception, we have incurred operating losses, and as of June 30, 2003 we had an accumulated deficit of $183.3 million. We incurred a net loss for the three and six months ended June 30, 2003 of $16.3 million and $29.9 million, respectively, compared to a net loss of $8.1 million and $27.0 million in the same periods of 2002. Our Nuvelo segment had net losses of $15.3 million and $27.2 million for the three and six months ended June 30, 2003, respectively, as compared to $6.9 million and $24.3 million in the same periods of 2002. Callida had net losses of $1.0 million and $2.7 million for three and six months ended June 30, 2003, respectively, as compared to $1.1 million and $2.7 million in the same periods of 2002.

     The increased net loss resulted primarily from decreased revenue due to the completion of our collaboration with BASF Plant Sciences in the first quarter of 2003, and increased lease termination and related costs associated with one of our facilities. We expect to continue to incur significant operating losses for the foreseeable future, which may increase substantially as we further expand research and development of our potential biopharmaceutical product candidates and other operations, and as we prosecute and enforce our intellectual property rights.

LIQUIDITY AND CAPITAL RESOURCES

     Our liquidity and capital resources improved significantly as a result of our merger with Variagenics on January 31, 2003. Our cash and short-term investments balance as of June 30, 2003 totaled approximately $26.6 million and our restricted cash is approximately $2.6 million.

     To date our primary source of liquidity is cash from financing activities, from collaboration receipts and our merger with Variagenics. As a result of the completion of our merger with Variagenics we received cash and cash equivalents of $27.3 million and short term investment of $23.5 million for a total infusion of $50.8 million. Since our merger on January 31, 2003, we have incurred costs associated with combining the companies, severance payments to employees and discontinuing our operation in Cambridge Massachusetts. We expect to incur additional costs from discontinuing this operation, primarily related to facility lease termination.

     Our primary use of capital resources has been to fund operating activities and to acquire capital equipment and make leasehold improvements. We used cash of $24.4 million and $16.3 million for operating activities, and cash of $0.2 million and $1.6 million to acquire capital equipment and make leasehold improvements in the first half of 2003 and 2002, respectively.

Cash and Cash Equivalents, Short-Term Investments, and Cash on Deposit

     As of June 30, 2003, we had $26.6 million in cash and short-term investments. This amount reflects a net increase of $24.4 million from the $2.2 million in cash we had as of December 31, 2002.

     In addition, we have $2.6 million in total restricted cash on deposit. This restricted cash is security for a $1.1 million letter of credit in conjunction with a facility lease in our office at 675 Almanor Avenue in Sunnyvale, California and a $1.5 million letter of credit in conjunction with a facilties lease assumed from the Variagenics merger in Cambridge, Massachussetts. The cash on deposit in conjunction with these letters of credit is restricted and cannot be withdrawn. Provided that no default has occurred under the lease for the 675 Almanor facility , the letter of credit and the cash collateralizing it may be reduced by $0.5 million per year in the third quarter of 2003, and the third quarter 2004. We control the investment of the cash and receive the interest earned thereon.

     The primary objectives for our investment portfolio are liquidity and safety of principal. Investments are made to achieve the highest rate of return to us, consistent with these two objectives. Our investment policy limits investments to certain types of instruments issued by institutions with investment grade credit ratings and places restrictions on maturities and concentration by type and issuer.

Cash Used in Operating Activities

     Net cash used in operating activities increased $8.1 million to $24.4 million in the first half of 2003 compared to $16.3 million in the first half of 2002. The increase in cash used in operating activities for the first half of 2003 compared to the same period of 2002 was primarily due to expenses related to the merger with Variagenics, including additional staff–related costs, facilities costs and other outside costs, including legal and accounting costs; and a decrease in collaboration revenue, primarily BASF. As we continue our strategy of careful review of all assets and programs at both Hyseq and Variagenics following the close of our merger between the two companies, we may incur additional costs associated with lease termination at our remaining facilities.

     We expect operating expenses to decrease in the second half of 2003 as we continue to balance cost cutting measures with financing, licensing, or collaboration receipts to ensure our available cash will continue to fund our operating activities through 2004. Our strategic plan includes monetization of our non-core assets that we expect will generate additional cash. Not achieving these goals could significantly harm our results of operations, which may require us to delay and scale back one or more of our research or development programs, or relinquish greater rights to products at an earlier stage of development on less favorable terms than we would otherwise seek to obtain, which could materially adversely affect our long term business, our financial condition, and our operating results.

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Cash Provided by (Used in) Investing Activities

     Net cash provided by investing activities was $43.1 million during the first half of 2003, compared to cash used in investing activities of $1.6 million during the same period of 2002. The increase in net cash provided by investing activities was primarily a result of cash received in conjunction with the acquisition of Variagenics and maturities of short-term investments. A reduction in new capital equipment spending also contributed to the decrease in expenditures during 2003. Other than purchases and sales of short term investments, we expect net cash provided by and used in investing activities to stay at low levels for the foreseeable future.

Cash (Used in) Provided by Financing Activities

     We used cash of $0.4 million and generated cash of $17.4 million from financing activities in the first half of 2003 and 2002, respectively. Cash used in financing activities for Nuvelo in the first half of 2003 resulted from payments on our lease and loan obligations and an increase in our restricted cash associated with one of our facilities partially offset by a draw down of $1.0 million on our line of credit with our chairman, Dr. Rathmann and proceeds from exercise of stock options and from the employee stock purchase plan. Cash provided by financing activities in 2002 was a result of issuance of common stock in a private placement on April 5, 2002 with net proceeds of $14.3 million, a draw down on the line of credit with our chairman, Dr. Rathmann and proceeds from exercise of stock options and from the employee stock purchase plan partially offset by payments on our lease and loan obligations. As of July 31, 2003, $9.0 million was available under this line of credit. There was no cash generated by financing activities in the first half of 2003 and 2002 by Callida.

     As of June 30, 2003, 2,411,610 shares of our common stock were issuable upon repayment of our note held by Affymetrix. Affymetrix has the ability to declare all outstanding principal and interest under the note immediately due and payable in the event that our market capitalization is under $50 million and Affymetrix reasonably determines that the loan evidenced by the note is impaired, and we have an obligation to prepay amounts owing under the note to the extent that the amounts outstanding exceed 10% of our market capitalization.

     On July 8, 2003, we filed a registration statement on Form S-3 with the Securities and Exchange Commission that allows for the sale of up to $50 million of debt securities, preferred stock and/or common stock. We have not set a date for a proposed sale but we are continually evaluating our financing requirements and may propose a sale of one or more of these securities in the near future.

     Our future capital requirements and the adequacy of available funds will depend on many factors, including those set forth under “Risk Factors - We Must Be Able to Continue to Secure Additional Financing” below. We may not be able to secure additional financing to meet our funding requirements on acceptable terms, if at all. If we raise additional funds by issuing equity securities, substantial dilution to our existing stockholders may result. If we are unable to obtain additional funds we may have to additionally curtail the scope of our operations. We have implemented a plan to delay, scale back or eliminate some of our operating expenditures, including facilities expansion plans, in order to insure we can meet our cash commitments through 2004. This plan includes a partial hiring freeze, a reduction in capital expenditures and a deferral of as many of our contractual financial commitments as possible. We have also implemented a plan to monetize certain non-core assets through license arrangements or partnerships which will bring in additional cash to fund operations. If we are unable to generate sufficient funds through monetizing these non-core assets, we may seek to obtain third party financing prior to the end of 2004.

Operating Leases

     We lease four facilities under operating lease agreements, two that expire in June 2005, one that expires in May 2008 and one that expires in May 2011. The rent is being recognized as expense on a straight-line basis.

     Minimum future rental commitments under non-cancelable operating leases at June 30, 2003 are as follows (dollars in thousands):

Critical Accounting Policies and Estimates

     Our discussion and analysis of our operating results and financial condition is based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of the financial statements requires us to make estimates, judgments, and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent amounts. While we believe our estimates, judgments, and assumptions are reasonable, the inherent nature of estimates is that actual results will likely be different from the estimates made.

     We have not made changes to our critical accounting policies as presented in our Form 10-K filed on March 31, 2003.

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NEW ACCOUNTING PRONOUNCEMENTS

     In July 2002, the FASB issued SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities” (SFAS 146). SFAS 146 requires recording costs associated with exit or disposal activities at their fair values when a liability has been incurred. Under previous guidance, certain exit costs were accrued upon management’s commitment to an exit plan, which is generally before an actual liability is incurred. Adoption of this statement is required for exit or disposal activities initiated after December 31, 2002. The adoption of SFAS 146 did not have a material impact on our financial position or results of operations.

     In November 2002, the Emerging Issues Task Force reached consensus on EITF 00-21, Accounting for Revenue Arrangements with Multiple Deliverables. EITF 00-21 sets out criteria for whether revenue on a deliverable can be recognized seperately from other deliverables in a multiple deliverable arrangement. The criteria considers whether the delivered item has stand-alone value to the customer, whether the fair value of the delivered item can be reliably determined and the rights of returns for the delivered item. EITF 00-21 must be adopted by June 1, 2003. We are assessing the impact of EITF 00-21 on its consolidated financial position and results of operations.

     In May 2003, the FASB issued SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity” (SFAS No. 150), effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003. The impact upon adoption of SFAS No. 150 is not expected to have a material impact on the results of operations or the financial position of the Company.

RISK FACTORS

     We operate in a rapidly changing environment that involves a number of risks, some of which are beyond our control. The following discussion highlights some of these risks.

Our stock price has been volatile, is likely to continue to be volatile and could decline substantially.

     The price of our common stock has been, and is likely to continue to be, highly volatile. That price could fluctuate significantly for the following reasons:

	•		volatility and uncertainty in the capital markets in general;
	•		fluctuations in our results of operations;
	•		sales of our common stock by existing holders;
	•		loss of key personnel;
	•		economic and other external factors;
	•		announcements by governmental agencies that may have, or may be perceived to have, an impact on our potential products;
	•		changes in our earnings estimates;
	•		changes in accounting principles;
	•		lack of trading volume in our common stock;
	•		fluctuations within the biotechnology sector;
	•		announcements by competitors; and
	•		other factors not within our control.

     In addition, the stock market in general, and the market for biotechnology and other life science stocks in particular, has historically been subject to extreme price and volume fluctuations. This volatility has had a significant effect on the market prices of securities issued by many companies for reasons unrelated to the operating performance of these companies. In the past, following periods of volatility in the market price of a company’s securities, class action securities litigation has often been instituted against such a company. Any such litigation instigated against us could result in substantial costs and a diversion of management’s attention and resources, which could significantly harm our business, financial condition and operating results.

We are at risk of having our stock delisted from the Nasdaq National Market, which could have a material adverse impact on our stock price, the market for our stock and our ability to raise capital

     Our common stock is listed on the Nasdaq National Market, which has minimum quantitative listing criteria that are required to be maintained. Two of these criteria are a minimum stock price of one dollar per share and minimum stockholders’ equity of $10 million. For the period commencing on January 1, 2003 through June 30, 2003, the low and high closing sales price of our common stock as reported by the Nasdaq National Market was $0.71 and $2.60, respectively. If our stock price were to again decline to below one dollar per share, the Nasdaq Stock Market may take action to have our common stock delisted from the Nasdaq National Market. As of June 30, 2003, we had shareholders’ equity of approximately $15 million. If we do not continue to satisfy the $10 million shareholders’equity requirement and the other applicable continued

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listing requirements, our common stock may be delisted from the Nasdaq National Market. If this were to happen, it would be more difficult to purchase or sell our common stock or obtain accurate quotations as to its price, and the price of our common stock could suffer a material decline. In addition, any such delisting could have a materially adverse affect on our access to the capital markets, and the limited liquidity of our common stock could materially adversely affect our ability to raise capital through alternative financing sources on terms acceptable to us or at all.

Future sales of our common stock may depress our stock price.

     Sales in the public market of substantial amounts of our common stock could depress prevailing market prices of our common stock. As of June 30, 2003, we had 63,667,334 shares of our common stock outstanding. All of these shares are freely transferable without restriction or further registration under the Securities Act of 1933, as amended, or the Securities Act, except for shares held by our affiliates and unregistered shares held by non-affiliates. As of June 30, 2003 our affiliates held 12,401,669 shares of our common stock, which are transferable pursuant to Rule 144 or in some cases Rule 145, each as promulgated under the Securities Act. Although we do not believe that our affiliates have any present intentions to dispose of any shares of common stock owned by them, there can be no assurance that such intentions will not change in the future.

     As of June 30, 2003, warrants to purchase 6,389,718 shares of our common stock were outstanding. In addition, under registration statements on Form S-8 under the Securities Act, we have registered approximately 13,768,420 shares of our common stock for sale upon the exercise of outstanding options under our 2002 Equity Incentive Plan, 1995 Stock Option Plan, Non-Employee Director Stock Option Plan, Scientific Advisory Board/Consultants Stock Option Plan, and stock option agreements entered into outside of any of our stock option plans and under our Employee Stock Purchase Plan and the Variagenics, Inc. Amended 1997 Employee, Director and Consultant Stock Option Plan. Shares of our common stock acquired pursuant to these plans and agreements are available for sale in the open market. In addition, we have reserved approximately 2,243,160 shares of our common stock for issuance upon the exercise of outstanding options under stock option agreements entered into outside of any of our stock option plans. As of June 30, 2003, 1,062,205 of these 2,243,160 options were exercisable. Although these shares have not been registered under the Securities Act, and therefore are restricted securities within the meaning of Rule 144 under the Securities Act, we intend to register these shares on a registration statement on Form S-8 under the Securities Act. The exercise of those options or warrants, and the prompt resale of shares of our common stock received, may result in downward pressure on the price of our common stock. The existence of the currently outstanding warrants and options to purchase our common stock may negatively affect our ability to complete future equity financings at acceptable prices and on acceptable terms.

     As of June 30, 2003, 2,411,610 shares of our common stock were issuable upon repayment of our note held by Affymetrix. Affymetrix has the ability to declare all outstanding principal and interest under the note immediately due and payable in the event that our market capitalization is under $50 million and Affymetrix reasonably determines that the loan evidenced by the note is impaired, and we have an obligation to prepay amounts owing under the note to the extent that the amounts outstanding exceed 10% of our market capitalization. Moreover, we have registered for resale a portion of these shares on a registration statement that has been declared effective by the Securities and Exchange Commission, or SEC. If we decide to repay this note with our common stock, whether pursuant to acceleration of the note or otherwise, the prompt resale of shares of our common stock received by Affymetrix may also result in significant downward pressure on the price of our common stock and the possibility of this occurrence may also affect our ability to complete future equity financings at acceptable prices and on acceptable terms.

We have not achieved profitability and have recent and anticipated continuing losses.

     For the years ended December 31, 2002, 2001 and 2000, we had net losses of $45.0 million, $36.5 million and $22.3 million, respectively. As of June 30, 2003, we had an accumulated deficit of $183.3 million. For the years ended December 31, 2002, 2001 and 2000, Variagenics, a company we recently acquired, had net losses of $33.8 million, $25.3 million and $17.8 million, respectively. As of December 31, 2002, Variagenics had an accumulated deficit of $111.8 million.

     The process of developing our therapeutic protein candidates and our molecular diagnostic products will require significant additional research and development, preclinical testing, clinical trials and regulatory approvals. These activities, together with general administrative and other expenses, are expected to result in operating losses for the foreseeable future. We may never generate profits and as a result, the trading price of our common stock could decline. Moreover, utilization of our net operating loss carryforwards and credits may be subject to an annual limitation due to the “change in ownership” provisions of the Internal Revenue Code of 1986 and similar state law provisions. It is possible that certain transactions that we have entered into, including our merger with Variagenics, when considered in connection with other transactions, may result in a “change in ownership” for purposes of these provisions.

  We have a relatively short operating history.

     We have a short operating history, as did Variagenics when we merged with it. We commenced operations in the fourth quarter of 1994 with an initial business focused on gene discovery using our signature by hybridization platform, and applications of our sequencing-by-hybridization technology, including the HyChip system. In 1998, we began to transition our business strategy from gene discovery to research and development of potential therapeutic protein candidates. Variagenics commenced operations in 1992 and was in the early stage of commercializing its products and services when we merged with it. As a company with a relatively short operating history, we face risks and uncertainties frequently encountered by companies in new and rapidly evolving markets, including:

	•		the implementation and successful execution of our business strategy and our sales and marketing initiatives;
	•		retention of current customers and collaborators and attraction of new customers and collaborators;
	•		our ability to respond effectively to competitive and technological developments related to our technologies, products and services;
	•		our ability to attract, retain and motivate qualified personnel; and
	•		our ability to effectively managing our anticipated growth.

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     If we fail to address these risks and uncertainties successfully, our business, results of operations, financial condition and prospects will be materially adversely affected.

  We may face fluctuations in operating results.

     Our operating results may rise or fall significantly as a result of many factors, including:

	•		the amount of research and development we engage in;
	•		the progress we make with research and preclinical studies on our therapeutic protein candidates, and the number of candidates in research and preclinical studies;
	•		our ability to expand our facilities to support our operations;
	•		our ability to enter into new strategic relationships;
	•		the nature, effectiveness, size, timing or termination of our collaborative arrangements;
	•		the costs involved in preparing, filing, prosecuting, maintaining and enforcing patent claims;
	•		the possibility that others may have or obtain patent rights that are superior to ours;
	•		changes in government regulation; and
	•		release by our competitors of successful products into the market.

     Because substantially all of our potential products currently are in research or preclinical development, revenues from sales of any products will not occur for at least the next several years, if at all. We also have a high percentage of fixed costs such as lease obligations. As a result, we may experience fluctuations in our operating results from quarter to quarter and continue to generate losses. Quarterly comparisons of our financial results may not necessarily be meaningful and investors should not rely upon such results as an indication of our future performance.

  We will need to raise additional capital and such capital may be unavailable to us when we need it or may not be available on acceptable terms.

     We expect to take action to consolidate operations and prioritize projects with the goal of having sufficient cash to fund our operations through 2004. However, unanticipated expenses, or unanticipated opportunities that require financial commitments, could give rise to requirements for additional financing sooner than we expect. Financing may be unavailable when we need it or may not be available on acceptable terms. The unavailability of financing may require us to delay, scale back or eliminate expenditures for our research, development and marketing activities necessary to commercialize our potential biopharmaceutical products. We may also be required to grant rights to third parties to develop and market product candidates that we would prefer to develop and market on our own. If we were required to grant such rights, the ultimate value of these product candidates to us would be reduced.

     If we are unable to obtain additional financing when we need it, the perception in the capital markets that we may not be able to raise the amount of financing we desire, or on terms favorable to us, may have a negative effect on the trading price of our common stock. Additional equity financings could result in significant dilution of current stockholders’ equity interests. If sufficient capital is not available, we will delay, reduce the scope of, eliminate or divest one or more of our subsidiaries or our discovery, research or development programs. Any such action could significantly harm our business, financial condition and results of operations.

     Our future capital requirements and the adequacy of our currently available funds will depend on many factors, including, among others, the following:

	•		continued scientific progress in our research and development programs, including progress in our research and preclinical studies on our potential therapeutic protein candidates;
	•		the cost involved in any facilities expansion to support research and development of our potential therapeutic protein candidates;
	•		our ability and the ability of our subsidiary Callida to attract additional financing on favorable terms;
	•		the magnitude and scope of our research and development programs, including development of potential therapeutic protein candidates and Callida technology and applications;
	•		our ability to maintain, and the financial commitments involved in our existing collaborative and licensing arrangements;
	•		our ability to establish new corporate relationships with other biotechnology and pharmaceutical companies to share costs and expertise of identifying and developing product candidates;
	•		the cost of prosecuting and enforcing our intellectual property rights;

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	•		the cost of manufacturing material for preclinical, clinical and commercial purposes;
	•		The cost of manufacturing material by Amgen progress in our clinical studies of alfimeprase;
	•		the time and cost involved in obtaining regulatory approvals;
	•		our need to develop, acquire or license new technologies or products;
	•		competing technological and market developments;
	•		future funding commitments to our subsidiary Callida, and our ability to borrow funds from Affymetrix to fund our commitment, under the terms of the Affymetrix settlement;
	•		our ability to use our common stock to repay the outstanding note to Affymetrix and our line of credit with our Chairman, Dr. George B. Rathmann;
	•		legal and Nasdaq restrictions that impede our ability to raise funds from private placements of our common stock;
	•		future funding commitments to our collaborators;
	•		general conditions in the financial markets and in the biotech sector;
	•		the uncertain condition of the capital markets; and
	•		other factors not within our control.

Development of our products will take years; our products require approval before they can be sold.

     Because substantially all of our potential products currently are in research or preclinical or clinical development, revenues from sales of any products will not occur for at least the next several years, if at all. We cannot be certain that any of our products will be safe and effective or that we will obtain regulatory approvals. In addition, any products that we develop may not be economical to manufacture on a commercial scale. Even if we develop a product that becomes available for commercial sale, we cannot be certain that consumers will accept the product. We cannot predict whether we will be able to develop and commercialize any of our protein candidates successfully. If we are unable to do so, our business, results of operations and financial condition will be materially adversely affected.

     We do not yet have products in the commercial markets. We cannot apply for regulatory approval of our potential products until we have performed additional research and development and testing. We cannot be certain that we, or our strategic partners, will be permitted to undertake clinical testing of our potential products or continue clinical testing of alfimeprase and, if we are successful in initiating clinical trials, we may experience delays in conducting them. Our clinical trials may not demonstrate the safety and efficacy of our potential products, and we may encounter unacceptable side effects or other problems in the clinical trials. Should this occur, we may have to delay or discontinue development of the potential product that causes the problem. After a successful clinical trial, we cannot market products in the United States until we receive regulatory approval. Even if we are able to gain regulatory approval of our products after successful clinical trials and then commercialize and sell those products, we may be unable to manufacture enough products to maintain our business, which could have a negative impact on our financial condition.

   The success of our business depends on patents and other proprietary information.

     We currently have patents that cover some of our technological discoveries and patent applications that we expect to cover some of our gene, protein and technological discoveries. We have 20 issued patents relating to our gene and protein discoveries. We also currently have patents and patents pending which cover or describe, respectively, single nucleotide polymorpohisms and their application to pharmacogenetic studies, genotyping and haplotyping methods, and allele specific inhibitors. We own or have rights to 26 issued U.S. patents relating to these methods. We will continue to apply for patents for our discoveries. We cannot assure you that any of our applications will issue as patents, or that any patent issued to us will not be challenged, invalidated, circumvented or held unenforceable by way of an interference proceeding or litigation. The patent positions of biotechnology companies involve complex legal and factual questions. Even though we own patents, it is uncertain whether:

	•		the patents would be challenged;
	•		protection against competitors will be provided by such patents; or
	•		competitors will not independently develop similar products or design around the patents.

     We seek patents on:

	•		full-length gene sequences;
	•		partial gene sequences;
	•		proteins produced by those genes;

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	•		antibodies to those proteins;
	•		diagnostic and therapeutic methods involving such genes, proteins or antibodies;
	•		processes, devices and other technology that enhance our ability to develop and/or manufacture gene-based products;

     To obtain a patent on a novel gene, we need to identify a utility for the novel gene or the encoded protein we seek to protect by patent law. Identifying a utility may require significant research and development with respect to which we may incur a substantial expense and invest a significant amount of time.

     Finally, the timing of the grant of a patent cannot be predicted. Patent applications describing and seeking patent protection of methods, compositions, or processes relating to proprietary inventions involving human therapeutics could require us to generate data, which may involve substantial costs.

     We rely on trade secret protection for our confidential and proprietary information. Although our policy is to enforce security measures to protect our assets, trade secrets are difficult to protect. We expect to require all employees to enter into confidentiality agreements. However:

	•		competitors may independently develop substantially equivalent proprietary information and techniques;
	•		competitors may otherwise gain access to our trade secrets;
	•		persons with whom we have confidentiality agreements may disclose trade secrets; or
	•		we may be unable to protect our trade secrets meaningfully.

     Certain of the patent applications describing our proprietary methods are filed only in the United States. Even where we have filed our patent applications internationally, for some cases and in certain countries, we have chosen not to maintain foreign patent protection through failure to enter national phase or failure to pay maintenance annuities.

     We may be required to obtain licenses to patents or other proprietary rights of others in order to conduct research, development, or commercialization of some or all our programs. These required licenses may not, however, be made available on terms acceptable to us. If we do not obtain these licenses, we may encounter delays in product market introductions, incur substantial costs while we attempt to design around existing patents or not be able to develop, manufacture or sell products. Any of these obstacles could significantly harm our business, financial condition and operating results. Further, if we do obtain these licenses, the agreed terms may necessitate reevaluation of the potential commercialization of any one of our programs.

We may be subject to litigation and infringement claims that may be costly, divert management’s attention, and materially harm our business.

     Extensive litigation regarding patents and other intellectual property rights has been common in the genomics and biopharmaceutical industries. The defense and prosecution of intellectual property suits, United States Patent and Trademark Office interference proceedings, and related legal and administrative proceedings in the United States and internationally involve complex legal and factual questions. As a result, such proceedings are costly and time-consuming to pursue and their outcome is uncertain.

     Litigation may be necessary to:

	•		Assert claims of infringement;
	•		Enforce patents that we own or license;
	•		Protect our trade secrets or know-how; and
	•		Determine the enforceability, scope and validity of the proprietary rights of others.

     Regardless of merit or outcome, our involvement in any litigation, interference or other administrative proceedings could cause us to incur substantial expense and could significantly divert the efforts of our technical and management personnel. An adverse determination may subject us to the loss of our proprietary position or to significant liabilities, or require us to seek licenses that may include substantial cost and ongoing royalties. Licenses may not be available from third parties, or may not be obtainable on satisfactory terms. An adverse determination or a failure to obtain necessary licenses may restrict or prevent us from manufacturing and selling our products, if any. These outcomes could materially harm our business, financial condition and results of operations.

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   We lack manufacturing experience and intend to rely initially on contract manufacturers.

     We do not currently have significant manufacturing facilities. We are dependent on contract research and manufacturing organizations, and are subject to the risks of finalizing contractual arrangements, transferring technology and maintaining relationships with such organizations in order to file an Investigational New Drug application, or IND, with the Food and Drug Administration, or FDA, and proceed with clinical trials for any of our potential therapeutic protein candidates. We rely on Amgen, Inc. (Amgen) to manufacture our drug product, alfimeprase. The cost of manufacturing our drug product by Amgen is based upon a standard cost which has not been determined. This cost may be more than we are anticipating and may make it difficult or impossible to profitably market Alfimeprase. We are dependent on third-party contract research organizations to conduct certain research, including good laboratory practices toxicology studies in order to gather the data necessary to file INDs with the FDA for any of our potential therapeutic protein candidates. Our potential therapeutic protein candidates have never been manufactured on a commercial scale. Third-party manufacturers may not be able to manufacture such proteins at a cost or in quantities necessary to make them commercially viable. In addition, if any of our potential therapeutic protein candidates enter the clinical trial phase, initially we will be dependent on third-party contract manufacturers to produce the volume of current good manufacturing practices materials needed to complete such trials. We will need to enter into contractual relationships with these or other organizations in order to (1) complete the Good Laboratory Practices, or GLP, toxicology and other studies necessary to file an IND with the FDA, and (2) produce a sufficient volume of current Good Manufacturing Practices (cGMP) material in order to conduct clinical trials of our potential therapeutic protein candidates. We cannot be certain that we will be able to do so on a timely basis or that we will be able to obtain sufficient quantities of material on commercially reasonable terms. In addition, the failure of any of these relationships with third-party contract organizations may result in a delay of our filing for an IND, or our progress through the clinical trial phase. Any significant delay or interruption would have a material adverse effect on our ability to file an IND with the FDA and/or proceed with the clinical trial phase for any of our potential therapeutic protein candidates.

     Moreover, contract manufacturers that we may use must continually adhere to current cGMP regulations enforced by the FDA through a facilities inspection program. If the facilities of such manufacturers cannot pass a pre-approval plant inspection, the FDA premarket approval of our products will not be granted.

   We are dependent upon collaborative arrangements.

     We will focus on new collaborative arrangements where we would share costs of identifying, developing and marketing product candidates. There can be no assurance that we will be able to negotiate new collaboration arrangements of this type on acceptable terms, or at all.

     The success of our business is dependent, in significant part, upon our ability to enter into multiple collaboration arrangements and to manage effectively the numerous issues that arise from such collaborations. Management of our relationships with our collaboration partners will require:

	•		our management team to devote a significant amount of time and effort to the management of these relationships;
	•		effective allocation of our resources to multiple projects; and
	•		an ability to obtain and retain management, scientific and other personnel.

     Our need, including the need of our direct and indirect subsidiaries, to manage simultaneously a number of collaboration arrangements may not be successful, and the failure to manage effectively such collaborations would significantly harm our business, financial condition and results of operations.

FDA regulatory approval of our products is uncertain; we face heavy government regulation.

     Products such as those proposed to be developed by us or our collaboration partners, typically will be subject to an extensive regulatory process by federal, state and local governmental authorities, including the FDA, and comparable agencies in other countries before we may market and sell such products. In order to obtain regulatory approval of a drug product, we or our collaboration partners must demonstrate to the satisfaction of the applicable regulatory agency, among other things, that such product is safe and effective for its intended uses. In addition, we must show that the manufacturing facilities used to produce the products are in compliance with cGMP requirements. In the event we or our collaboration partners, develop products classified as drugs, we and our collaboration partners will be required to obtain appropriate approvals as well.

     The process of obtaining FDA and other required regulatory approvals and clearances is lengthy and will require us to expend substantial capital and resources. We may not ultimately be able to obtain the necessary approvals and clearances. Moreover, if and when our products do obtain such approval or clearances, the marketing, distribution and manufacture of such products would remain subject to extensive ongoing regulatory requirements. Failure to comply with applicable regulatory requirements can result in:

	•		warning letters;
	•		fines;
	•		civil penalties;
	•		recall or seizure of products;
	•		total or partial suspension of production;
	•		refusal of the government to grant approvals, premarket clearance or premarket approval; or
	•		withdrawal of approvals and criminal prosecution.

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     We also are subject to numerous federal, state and local laws, regulations and recommendations relating to safe working conditions, laboratory and manufacturing practices, the experimental use of animals, the environment and the use and disposal of hazardous substances used in connection with our discovery, research and development work, including radioactive compounds and infectious disease agents. In addition, we cannot predict the extent of government regulations or the impact of new governmental regulations that might significantly harm the discovery, development, production and marketing of our products. We may be required to incur significant costs to comply with current or future laws or regulations and we may be adversely affected by the cost of such compliance.

     Any delay or failure by us or our collaboration partners to obtain regulatory approvals for our products:

	•		would adversely affect our ability to generate product and royalty revenues;
	•		could impose significant additional costs on us or our collaboration partners;
	•		could diminish competitive advantages that we may attain; and
	•		would adversely affect the marketing of our products.

We face intense competition.

     The genomics and biopharmaceutical industries are intensely competitive. Our strategy as a biopharmaceutical company is to find the genes of the human genome that are most likely to be involved in a disease condition and to focus on identifying product candidates from the proteins produced by genes. There are a finite number of genes in the human genome, virtually all of which have been or will soon be identified. Our competitors include major pharmaceutical, biotechnology and diagnostic firms, not-for-profit entities and United States and foreign government-financed programs, many of which have substantially greater research and product development capabilities and financial, scientific, marketing and human resources than we do. As a result, they may succeed in identifying genes and determining their functions or developing products earlier than we or our current or future collaboration partners do. They also may obtain patents and regulatory approvals for such products more rapidly than we or our current or future collaboration partners, or develop products that are more effective than those proposed to be developed by us or our collaboration partners. Further, any potential products based on genes we identify ultimately will face competition from other companies developing gene-based products as well as from companies developing other forms of treatment for diseases which may be caused by, or related to, the genes we identify.

     In addition, our technologies have undergone and are expected to continue to undergo rapid and significant change. Our competitors may make rapid technological developments which may result in products or technologies becoming obsolete, before we can recover the expenses incurred. The introduction of less expensive or more effective drug discovery and development technologies, including technologies that may be unrelated to genomics, may also make our products and services obsolete. We may not be able to make the necessary enhancements to our technology to compete successfully with newly emerging technologies.

     Many of the companies developing competing products have significantly greater financial resources than we have. Many such companies also have greater expertise than we or our collaboration partners have in discovery, research and development, manufacturing, preclinical and clinical testing, obtaining regulatory approvals and marketing. Other smaller companies may also prove to be significant competitors, particularly through collaborative arrangements with large and established companies. Academic institutions, government agencies and other public and private research organizations may also conduct research, seek patent protection and establish collaborative arrangements for discovery, research, clinical development and marketing of products similar to our products. These companies and institutions compete with us in recruiting and retaining qualified scientific and management personnel as well as in acquiring technologies complementary to our programs. We will face competition with respect to:

	•		product efficacy and safety;
	•		the timing and scope of regulatory approvals;
	•		availability of resources;
	•		reimbursement coverage; and
	•		price and patent position, including potentially dominant patent positions of others.

     There can be no assurance that research and development by others will not render the products that we may develop obsolete or uneconomical, or result in treatments or cures superior to any therapy or diagnostic developed by us or that any therapy we develop will be preferred to any existing or newly developed technologies. While we believe that our technology provides a significant competitive advantage, any one of our competitors may discover and establish a patent position in one or more genes, proteins or antibodies which we designate as a product candidate, before we do.

   We lack marketing experience for biopharmaceutical products.

     We have no sales, marketing or distribution capability. For the foreseeable future, we intend to rely primarily on collaboration partners or licensees, if any, to market our products. Such collaboration partners, however, may not have effective sales forces and distribution systems. If we are unable to maintain or establish such relationships and are required to market any of our products directly, we will have to develop our own marketing and sales force with the appropriate technical expertise and with supporting distribution capabilities. We may not be able to maintain or establish

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such relationships with third parties or develop in-house sales and distribution capabilities. To the extent that we may depend on our collaboration partners or third parties for marketing and distribution, any revenues we receive will depend upon the efforts of such collaboration partners or third parties. Such efforts may not be successful, and we will not be able to control the amount and timing of resources that such collaboration partners or third parties devote to our products.

   Our products may not be accepted in the marketplace.

     Even if they are approved for marketing, products we develop may never achieve market acceptance. Our products, if successfully developed, will compete with a number of traditional drugs and therapies manufactured and marketed by major pharmaceutical and other biotechnology companies. Our products will also compete with new products currently under development by such companies and others. The degree of market acceptance of any products developed by us, alone, or in conjunction with our collaboration partners, will depend on a number of factors, including:

	•		the establishment and demonstration of the clinical efficacy and safety of the products;
	•		our products’ potential advantage over alternative treatment methods; and
	•		reimbursement policies of government and third-party payors.

     Physicians, patients or the medical community in general may not accept and utilize any of the products that we alone, or in conjunction with our collaboration partners, develop. The lack of such market acceptance would significantly harm our business, financial condition and results of operations.

     We may develop diagnostic testing products in the future. Our success in diagnostics will depend in large part upon our ability to obtain customers and upon the ability of these customers to market genetic tests performed with our technology properly. Genetic tests may be difficult to interpret and may lead to misinformation or misdiagnosis. Ethical concerns about genetic testing may adversely affect market acceptance of our technology for diagnostic applications. Impaired market acceptance of our technology could significantly harm our business, financial condition and operating results.

   We face uncertainty with respect to pricing, third-party reimbursements and health care reform.

     Our ability to collect significant royalties from our products may depend on our ability, and the ability of our collaboration partners or customers, to obtain adequate levels of reimbursement from third-party payors such as:

	•		government health administration authorities;
	•		private health insurers;
	•		health maintenance organizations;
	•		pharmacy benefit management companies; and
	•		other health care related organizations.

     Currently, third-party payors are increasingly challenging the prices charged for medical products and services, and the overall availability of third-party reimbursement is limited and uncertain for genetic predisposition tests. Third-party payors may deny their insured reimbursement if they determine that a prescribed device or diagnostic test has not received appropriate clearances from the FDA or other government regulators, is not used in accordance with cost-effective treatment methods as determined by the third-party payor, or is experimental, unnecessary or inappropriate. If third-party payors routinely deny reimbursement, we may not be able to market our products effectively. We also face the risk that we will have to offer our diagnostic products at prices lower than anticipated as a result of the current trend in the United States towards managed health care through health maintenance organizations. Prices could be driven down by health maintenance organizations that control or significantly influence purchases of health care services and products. Legislative proposals to reform health care or reduce government insurance programs could also adversely affect prices of our products. The cost containment measures that health care providers are instituting and the results of potential health care reforms may prevent us from maintaining prices for our products that are sufficient for us to realize profits and may otherwise significantly harm our business, financial condition and operating results.

   The success of our potential products in pre-clinical studies does not guarantee that these results will be replicated in humans.

     Even though some of our therapeutic protein candidates have shown results in preclinical studies, these results may not be replicated in our clinical trials with humans. Human clinical results could be different from our expectations following our preclinical studies. Consequently, there is no assurance that the results in our preclinical studies are predictive of the results that we will see in our clinical trials with humans. Also, while we have demonstrated some evidence that our therapeutic protein candidates have utility in preclinical studies, these results do not mean that the resulting products will be safe and effective in humans. Our therapeutic protein candidates may have undesirable and unintended side effects or other characteristics that may prevent or limit their use.

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   Our ability to commercialize gene-based products is unproven.

     We have not developed any therapeutic or diagnostic products using proteins produced by the genes we have discovered. Before we make any products available to the public, we or our collaboration partners will need to conduct further research and development and complete laboratory testing and animal and human studies. Moreover, with respect to biopharmaceutical products, we or our collaboration partners will need to obtain regulatory approval before releasing any such products. We have spent, and expect to continue to spend, significant amounts of time and money in determining the function of genes and the proteins they produce, using our own capabilities and those of our collaboration partners. Such determination process constitutes the first step in developing commercial products. We also have spent and will continue to spend significant amounts of time and money in developing processes for manufacturing of our recombinant proteins under pre-clinical development, yet we may not be able to produce sufficient protein for preclinical studies. A commercially viable product may never be developed from our gene discoveries.

     Our development of gene-based products is subject to several risks, including but not limited to:

	•		the possibility that a product is toxic, ineffective or unreliable;
	•		failure to obtain regulatory approval for the product;
	•		the product may be difficult to manufacture on a large scale, or may not be economically feasible to market;
	•		competitors may develop a superior product; or
	•		other persons’ or companies’ patents may preclude our marketing of a product.

     Our internally developed biopharmaceutical development programs are currently in the research stage or in preclinical development. None of our potential therapeutic protein candidates from our own portfolio have advanced to Phase I clinical trials. Our programs may not move beyond their current stages of development. Even if our research does advance, we will need to engage in certain additional preclinical development efforts to determine whether a product is sufficiently safe and efficacious to enter clinical trials. We have little experience with these activities and may not be successful in developing or commercializing products.

     Under our collaboration arrangement with Chiron in the solid tumor cancer field, Chiron maintains responsibility for the development of a product. Under our collaboration arrangement with Kirin Brewery Company, Ltd., Kirin has primary responsibility for clinical development in its territory and we have primary responsibility in our territory. Under our collaboration arrangement with Deltagen, we share responsibility for development of a product. With respect to these arrangements, we run the risk that Chiron or Kirin may not pursue clinical development in a timely or effective manner, if at all, and that Deltagen may not cooperate with us in pursuing clinical development in a timely or effective manner.

     If a product receives approval from the FDA to enter clinical trials, Phases I, II, and III of those trials include multi-phase, multi-center clinical studies to determine the product’s safety and efficacy prior to marketing. We cannot predict the number or extent of clinical trials that will be required or the length of the period of mandatory patient follow-up that will be imposed. Assuming clinical trials of any product are successful and other data appear satisfactory to us, we or our applicable collaboration partner will submit an application to the FDA and appropriate regulatory bodies in other countries to seek permission to market the product. Typically, the review process at the FDA is not predictable and can take up to several years. Upon completion of such review, the FDA may not approve our or our collaboration partner’s application or may require us to conduct additional clinical trials or provide other data prior to approval. Furthermore, even if our products or our collaboration partner’s products receive regulatory approval, delays in the approval process could significantly harm our business, financial condition and results of operations.

     In addition, we may not be able to produce any products in commercial quantities at a reasonable cost or may not be able to market successfully such products. If we do not develop a commercially viable product, then we would suffer significant harm to our business, financial condition and operating results.

   Our subsidiary Callida may not be able to raise third party financing.

     In October 2001, we formed Callida to develop and commercialize our sequencing-by-hybridization or SBH technology. We recognized 90% of Callida’s operating losses in our consolidated results of operations up to the point where Affymetrix’s initial minority interest investment was depleted in the first quarter of 2002. Beyond that point, we absorb 100% of the net losses until Callida generates net income. There is no guarantee, however, that Callida will meet its technical milestone and other requirements to obtain additional funding through Affymetrix and us. There is also no assurance that Callida will be able to obtain any third party financing or that any such financing that Callida obtains will be on favorable terms or that the funding from outside sources will be sufficient to fund Callida’s operations. We cannot assure the success of Callida, and if Callida is unable to obtain sufficient funding from outside sources, we may reduce projects and/or bear the costs of financing Callida ourselves, which will divert our resources from biopharmaceutical projects. In March 2003, Callida reduced its number of employees from 25 to seven in order to preserve cash. As of June 30, 2003, Callida and it’s subsidiary, N-Mer, Inc. had approximately $386,000 in cash and investments balances available for future operations.

   We face uncertainties related to SBH technology applications.

     We have developed applications of our SBH technology, currently in our subsidiary, Callida, including the chip component to be used with the HyChip system. As Callida continues development of SBH technology applications, it may discover problems in the functioning of these applications, including the HyChip system. Callida may be unable to improve applications of our SBH technology enough to be able to market them successfully. Further, SBH technology applications compete against other DNA analysis tools and well-established technologies. The failure of Callida to successfully develop and market applications of SBH technology could result in significant harm to our business, financial condition and operating results.

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   Many corporate actions will be controlled by our officers and directors regardless of the opposition of other stockholders or the desire of other stockholders to pursue an alternative course of action.

     Our executive officers and directors beneficially own, in the aggregate, approximately 24.3% of our common stock outstanding as of June 30, 2003. For purposes of this paragraph, beneficial ownership is determined in accordance with Rule 13d-3 under the Securities Exchange Act of 1934, as amended, or the Exchange Act. If they act together, these stockholders will be able to exercise substantial influence and control over all matters requiring approval by our stockholders, including the election of directors and approval of significant corporate transactions. This concentration of ownership may also have the effect of delaying or preventing a change in our control.

   We face product liability exposure and potential unavailability of insurance.

     We risk financial exposure to product liability claims in the event that the use of products developed by us or our collaboration partners, if any, result in personal injury. We may experience losses due to product liability claims in the future. We have obtained limited product liability insurance coverage. Such coverage, however, may not be adequate or may not continue to be available to us in sufficient amounts or at an acceptable cost, or at all. We may not be able to obtain commercially reasonable product liability insurance for any product approved for marketing. A product liability claim or other claim, product recalls, as well as any claims for uninsured liabilities or in excess of insured liabilities, may significantly harm our business, financial condition and results of operations.

   We use hazardous materials, chemicals and patient samples in our business and any disputes relating to improper handling, storage or disposal of these materials could be time consuming and costly.

     Our research and development, production and service activities involve the controlled use of hazardous or radioactive materials, chemicals, including oxidizing and reducing reagents, and patient tissue and blood samples. We are subject to federal, state and local laws and regulations governing the use, storage, handling and disposal of these materials and certain waste products. We could be liable for accidental contamination or discharge or any resultant injury from hazardous materials, conveyance, processing, and storage of and data on patient samples. If we fail to comply with applicable laws or regulations, we could be required to pay penalties or be held liable for any damages that result and this liability could exceed our financial resources. Further, future changes to environmental health and safety laws could cause us to incur additional expense or restrict our operations.

     In addition, our collaborators may be working with these types of hazardous materials, including viruses and hazardous chemicals, in connection with our collaborations. In the event of a lawsuit or investigation, we could be held responsible for any injury caused to persons or property by exposure to, or release of, these patient samples that may contain viruses and hazardous materials. The cost of this liability could exceed our resources.

   We are dependent on key personnel.

     The success of our business is highly dependent on the principal members of our scientific and management staff, including our chairman and senior management team. The loss of the services of any such individual might significantly delay or prevent us from achieving our scientific or business objectives.

   We must attract and retain qualified employees and consultants.

     Our success will depend on our ability to attract and retain qualified employees to help develop our potential products and execute our research and development strategy. We have programs in place to retain personnel, including programs to create a positive work environment and competitive compensation packages. Because competition for employees in our field is intense, however, we may be unable to retain our existing personnel or attract additional qualified employees. Our success also depends on the continued availability of outside scientific collaborators to perform research and develop processes to advance and augment our internal research efforts. Competition for collaborators is intense. If we do not attract and retain qualified personnel and scientific collaborators, and if we experience turnover or difficulties recruiting new employees, our research and development programs could be delayed and we could experience difficulties in generating sufficient revenue to maintain our business.

   Risk of natural disasters and power blackouts.

     Our facilities are located in Sunnyvale, California and Cambridge, Massachusetts. In the event that a fire or other natural disaster (such as an earthquake) disrupts our research or development efforts, our business, financial condition and operating results could be materially, adversely affected. Some of our landlords maintain earthquake coverage for our facilities. Although we maintain personal property and business interruption coverage, we do not maintain earthquake coverage for personal property or resulting business interruption.

   We may merge with or acquire other companies and our failure to receive the anticipated benefits in these transactions could harm our business.

     We recently entered into a merger with Variagenics, and may merge with or acquire other companies in the future. The success of any merger or acquisition depends, in part, on our ability to realize the anticipated synergies, cost savings and growth opportunities from integrating the business of the merged or acquired company with our business. The integration of two independent companies is a complex, costly and time-consuming process. The difficulties of combining the operations of the companies include, among others:

	•		consolidating research and development operations;
	•		retaining key employees;
	•		consolidating corporate and administrative infrastructures;

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	•		preserving the research and development and other important relationships of the companies;
	•		integrating and managing the technology of two companies;
	•		using the merged or acquired company’s liquid capital assets efficiently to develop the business of the combined company;
	•		minimizing the diversion of management’s attention from ongoing business concerns; and
	•		coordinating geographically separate organizations.

     Moreover, we have assumed the costs of defending against litigation claims asserted against Variagenics, and anytime we merge with or acquire another company, we will be exposed to similar costs. In addition, we may be exposed to a number of other risks in connection with future transactions, including:

	•		we may experience unbudgeted expenses in attempting to complete the transaction and integration process; and
	•		exposure to unknown liabilities of the merged or acquired business; and
	•		our stock price may suffer if the former stockholders of the merged or acquired entity dispose of significant numbers of shares of our common stock that they receive in the transaction within a short period of time.

     We cannot assure you that we will receive all of the anticipated benefits of our merger with Variagenics or any mergers or acquisitions in the future, or that any of the risks described above will not occur. Our failure to receive anticipated benefits, and our exposure to inherent risks, in any such merger or acquisition transaction could significantly harm our business, financial condition and operating results.

We have incurred costs in connection with discontinuing operations of Variagenics and expect to incur additional costs in the future.

     As a result of our merger with Variagenics, we have incurred costs assocated with combining the companies, severance payments to employees and discontinuing our operation in Cambridge, Massachusetts. We expect to incur additional costs from discontinuing operations of Variagenics, primarily related to the facility lease termination. We may incur similar costs in connection with other mergers and acquisitions in the future.

   Some of our third-party agreements and some of those of Variagenics have change of control or termination provisions.

     Some of our agreements and some of those of Variagenics with third parties have change of control or termination provisions that may be triggered by our merger with Variagenics, but have not yet been waived. These third parties may elect to terminate those agreements as a result of the merger.

   Variagenics was a defendant in a class action suit and defending this litigation could hurt our business.

     Variagenics was a defendant in a securities class action lawsuit alleging the failure to disclose additional and excessive commissions purportedly solicited by and paid to underwriters also named in the lawsuit in exchange for allocating shares of Variagenics’ stock to preferred customers and alleged agreements among the underwriters named in the lawsuit and preferred customers tying the allocation of initial public offering shares to agreements to make additional aftermarket purchases at pre-determined prices. As a result of our merger with Variagenics, we are obligated to continue to defend against this litigation. Currently we are in the process of approving a settlement by and between the issuers that are defendants in the lawsuit, the insurers of those issuers, and the plaintiffs. We believe that any loss or settlement amount will not be material to our financial position or results of operation, and that any settlement payment and attorneys’ fees accrued with respect to the suit will be paid by our insurance provider. However, we cannot assure you that this will be the case until a final settlement is approved.

   We have implemented anti-takeover provisions that may reduce the market price of our common stock.

     Our by-laws provide that members of our board of directors serve staggered three-year terms. Our articles of incorporation provide that all stockholder action must be effected at a duly called meeting and not by a consent in writing. The by-laws provide, however, that our stockholders may call a special meeting of stockholders only upon a request of stockholders owning at least 50% of our capital stock. These provisions of our articles of incorporation and our by-laws could discourage potential acquisition proposals and could delay or prevent a change in control. These provisions are intended to enhance the likelihood of continuity and stability in the composition of our board of directors and in the policies formulated by our board of directors. We also intended these provisions to discourage certain types of transactions that may involve an actual or threatened change of control. We designed these provisions to reduce our vulnerability to unsolicited acquisition proposals and to discourage certain tactics that may be used in proxy fights. These provisions, however, could also have the effect of discouraging others from making tender offers for our shares. As a consequence, they also may inhibit fluctuations in the market price of our shares that could result from actual or rumored takeover attempts. Such provisions also may have the effect of preventing changes in our management.

     We are permitted to issue shares of our preferred stock without stockholder approval upon such terms as our board of directors determines. Therefore, the rights of the holders of our common stock are subject to, and may be adversely affected by, the rights of the holders of our preferred stock that may be issued in the future. In addition, the issuance of preferred stock could have a dilutive effect on the holdings of our current stockholders.

     On June 5, 1998, our board of directors adopted a rights plan and declared a dividend with respect to each share of our common stock then outstanding. This dividend took the form of a right, which entitles the holders to purchase one-one thousandth of a share of our Series B junior participating preferred stock at a purchase price of $175, subject to adjustment from time to time. These rights have also been issued in connection with each share of our common stock issued after June 15, 1998. The rights are exercisable only if a person or entity or affiliated group of persons or entities acquires, or has announced its intention to acquire, 15% (27.5% in the case of certain approved stockholders) or more of our outstanding

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common stock. The adoption of the rights plan makes it more difficult for a third party to acquire control of us without the approval of our board of directors.

     Nevada Revised Statutes Sections 78.411 through 78.444 prohibit an “interested stockholder,” under certain circumstances, from entering into specified combination transactions with a Nevada corporation, unless certain conditions are met. Under the statute, an “interested stockholder” is a person who beneficially owns, directly or indirectly, 10% or more of a corporation’s voting stock or an affiliate or associate of a corporation who at any time within the prior three years beneficially owned, directly or indirectly, 10% or more of a corporation’s voting stock. According to the statute, we may not engage in a combination within three years after an interested stockholder acquires our shares, unless (i) our board of directors approves the combination prior to the interested stockholder becoming an interested stockholder or (ii) holders of a majority of voting power not beneficially owned by the interested stockholder approve the combination at a meeting called no earlier than three years after the date the interested stockholder became an interested stockholder.

     Nevada Revised Statutes Sections 78.378 through 78.3793 further prohibit an acquirer, under certain circumstances, from voting shares of a target corporation’s stock after crossing certain threshold ownership percentages, unless the acquirer obtains the approval of the target corporation’s stockholders. This statute only applies to Nevada corporations that do business directly or indirectly in Nevada. We do not intend to do business in Nevada within the meaning of the statute. Therefore, it is unlikely that the statute will apply to us.

     The provisions of our governing documents, our existing agreements and current Nevada law may, collectively:

	•		lengthen the time required for a person or entity to acquire control of us through a proxy contest for the election of a majority of our board of directors;
	•		discourage bids for our common stock at a premium over market price; and
	•		generally deter efforts to obtain control of us.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

     We are exposed to market risk, including changes in interest rates and short term investment prices. We do not use derivative financial instruments in our investment portfolio. We place our investments with high quality issuers and, by policy, limit the amount of credit exposure to any one issuer. We are averse to principal loss and ensure the safety and preservation of our invested funds by limiting default, market and reinvestment risk.

     We also have exposure to changes in interest rates in our line of credit with our Chairman, which bears interest at the prime rate plus one percent. Our interest rate exposure is mitigated by our ability to repay amounts outstanding under the line of credit with our common stock.

     Changes in interest rates do not affect interest income on our restricted cash as it is maintained in commercial paper with fixed rates and maturities of less than 90 days. Changes in interest rates do not affect interest expense on our lease obligations as they bear fixed rates of interest. Changes in interest rates do not affect our note payable as it bears a fixed rate of interest.

     There were no significant changes in our market risk exposures through the second quarter 2003.

ITEM 4. CONTROLS AND PROCEDURES

     We maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed in the reports that we file under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in the rules and forms of the Securities and Exchange Commission, and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. In designing and evaluating the disclosure controls and procedures, management recognized that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management necessarily was required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.

     As required by Rule 13a-15(b) of the Securities Exchange Act of 1934, we carried out an evaluation, under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures as of the end of the quarter covered by this report. Based on the foregoing, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were effective at the reasonable assurance level.

     There has been no change in our internal controls over financial reporting during our most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, our internal controls over financial reporting.

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PART II. OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

On or about December 6, 2001, Variagenics was sued in a complaint filed in the United States District Court for the Southern District of New York naming it and certain of its officers and underwriters as defendants. The complaint purportedly is filed on behalf of persons purchasing the Company’s stock between July 21, 2000 and December 6, 2000, and alleges violations of Sections 11, 12(a)(2) and 15 of the Securities Act of 1933, as amended and Section 10(b) of the Securities Exchange Act of 1934, as amended, and Rule 10b-5 promulgated thereunder.

The complaint alleges that, in connection with Variagenics, July 21, 2000 initial public offering, the defendants failed to disclose additional and excessive commissions purportedly solicited by and paid to the underwriter defendants in exchange for allocating shares of Variagenics’ stock to preferred customers and alleged agreements among the underwriter defendants and preferred customers tying the allocation of IPO shares to agreements to make additional aftermarket purchases at predetermined prices. Plaintiffs claim that the failure to disclose these alleged arrangements made Variagenics’ registration statement on Form S-1 filed with the SEC in July 2000 and the prospectus, a part of the registration statement, materially false and misleading. Plaintiffs seek unspecified damages. On or about April 19, 2002 an amended complaint was filed which makes essentially the same allegations. On or about July 15, 2002, Variagenics and the individuals filed a motion to dismiss. We are involved in this litigation as a result of our merger with Variagenics in January 2003.

On July 16, 2003, the Nuvelo Board approved a settlement proposal initiated by the plaintiffs. The final terms of the settlement are still being negotiated.

ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS

Not applicable.

ITEM 3. DEFAULTS UPON SENIOR SECURITIES

Not applicable.

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

     The Company held its Annual Meeting of Stockholders on June 19, 2003. At that meeting, a quorum was present and four proposals were voted upon.

1. The following persons were nominees for election as Class I Directors, each to hold office for a term as outlined in the proxy statement or until his or her successor is duly elected and qualified, and at the Annual Meeting of Stockholders on June 19, 2003, each such Director received the number of votes set opposite his respective name and was elected as Class I Director for the term set forth in the proxy statement:

2. Approval of the reincorporation of Nuvelo from the State of Nevada to the State of Delaware, including the merger agreement by which the reincorporation will occur:

3. Approval of the amendments to Nuvelo’s amended and restated articles of incorporation to effect a reverse stock split of all of the outstanding shares of our common stock, whereby each outstanding 3, 4, 5 or 6 shares would be reclassified and changed into one share of common stock:

4. Ratification of the selection of KPMG, LLP as our independent auditors for the fiscal year 2003:

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ITEM 5. OTHER INFORMATION

Not applicable.

ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K

(a) Exhibits

(b) Reports on form 8-K

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SIGNATURE

     Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

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EXHIBIT INDEX

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