DIVERSA CORP - 10-K Annual Report

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

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (Section 229.405 of this chapter) is not contained herein, and will not be contained, to the best of Registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. ¨

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

The aggregate market value of the voting stock held by non-affiliates of the Registrant as of June 28, 2002 was $235.7 million.*

The number of shares outstanding of the Registrant’s common stock was 41,927,823 as of March 19, 2003.

Designated portions of the Registrant’s definitive Proxy Statement to be filed with the Securities and Exchange Commission (the “Commission”) pursuant to Regulation 14A in connection with the 2003 Annual Meeting of Stockholders to be held on May 14, 2003 (the “2003 Annual Meeting”) are incorporated herein by reference into Part III of this report. Such Proxy Statement will be filed with the Commission not later than 120 days after the Registrant’s year ended December 31, 2002.

This report contains statements that are “forward-looking” and involve a high degree of risk and uncertainty. These include statements related to investments in our core technologies, investments in our internal product candidates, our ability to enter into additional biodiversity access agreements, the discovery, development, and/or optimization of novel genes, enzymes, and other biologically active compounds, the development and commercialization of products and product candidates, the opportunities in our target markets, the benefits to be derived from our current and future strategic alliances, our plans for future business development activities, and our estimates regarding market sizes and opportunities, as well as our future revenue, profitability, and capital requirements, all of which are prospective. Such statements are only predictions and reflect our expectations and assumptions as of the date of this report based on currently available operating, financial, and competitive information. The actual events or results may differ materially from those projected in such forward-looking statements. Risks and uncertainties and the occurrence of other events could cause actual events or results to differ materially from these predictions. The risk factors set forth below at pages 24 to 34 should be considered carefully in evaluating us and our business. These forward-looking statements speak only as of the date of this report. We expressly disclaim any intent or obligation to update these forward-looking statements.

We use market data and industry forecasts throughout this report. We have obtained this information from internal surveys, market research, publicly available information, and industry publications. Industry publications generally state that the information they provide has been obtained from sources believed to be reliable, but that the accuracy and completeness of such information is not guaranteed. Similarly, we believe that the surveys and market research we or others have performed are reliable, but we have not independently verified this information. We do not represent that any such information is accurate.

DIVERSA^®, DirectEvolution^®, DiverseLibrary, DiverseLibraries, GeneReassembly, Gene Site Saturation Mutagenesis, GigaMatrix, GSSM, PathwayLibrary, PathwayLibraries, Pyrolase, SingleCell, SciLect, and Streptomyces diversa are trademarks of Diversa Corporation. ThermalAce is a trademark of Invitrogen Corporation. Phyzyme is a trademark of Danisco Animal Nutrition. This report also refers to trade names and trademarks of other organizations.

We are a leader in applying proprietary genomic technologies for the rapid discovery and optimization of novel products from genes and gene pathways. We are directing our integrated portfolio of technologies to the discovery, evolution, and production of commercially valuable molecules with pharmaceutical applications, such as monoclonal antibodies and orally active drugs, as well as enzymes and small molecules with agricultural, chemical, and industrial applications. In addition to our internal product development efforts, we have formed alliances and joint ventures with market leaders, such as The Dow Chemical Company, GlaxoSmithKline plc, Invitrogen Corporation, and affiliates of Syngenta AG.

Our goal is to be the leading provider of novel proteins and small molecules for use in pharmaceutical, agricultural, chemical processing, and industrial applications. The key elements of our strategy are to:

Deploy our technologies across diverse markets in order to maximize our return on investment. We are focusing on commercial solutions for a broad range of applications for the pharmaceutical, agricultural, chemical processing, and industrial markets. We believe that this multi-market approach gives us the ability to capitalize on short-term revenue opportunities in lower-risk markets and leverage our technologies and expertise to expand key pharmaceutical programs. Products and processes utilizing genes, proteins, antibodies, small molecules, gene

pathways, and other bioactive molecules are all potential targets. Discoveries or developments made for any particular market may find use in other applications and may result in enhanced revenues, more efficient use of corporate resources, and increased return on investment.

Pursue additional strategic alliances with market leaders to access funding and industry-specific expertise and to more efficiently develop and commercialize a larger product portfolio. We intend to continue to enter into strategic alliances with leading corporations in our target markets. The key components of the commercial terms of such arrangements typically include some combination of the following types of fees: exclusivity fees, technology access fees, technology development fees, research support payments, milestone payments, license or commercialization fees, and royalties or profit sharing income from the commercialization of products resulting from the strategic alliances.

Maximize the full potential of our current alliances and our dedicated business groups. We have formed key joint ventures and alliances to focus on certain key market segments. We have also organized internally to focus our employees with specific industry expertise on target markets. Within these target markets, we will determine which products to pursue independently based on various criteria, including: investment required, estimated time to market, regulatory hurdles, infrastructure requirements, and industry-specific expertise necessary for successful commercialization. Because we will retain commercial rights to independently developed products, we expect that these products will provide attractive margins.

Protect and enhance our technology leadership position. We are unique relative to our competitors in that we have an end-to-end product solution consisting of access to novel genetic material, several technologies capable of screening more than a billion genes per day, multiple evolution technologies for optimizing enzymes, small molecules, monoclonal antibodies, and protein therapeutics, and manufacturing expertise. We have protected our technologies with a substantial intellectual property estate, and we will continue to make investments in developing and protecting these assets.

We are developing products for a number of significant markets, including pharmaceutical, agricultural, chemical processing, and industrial applications. Our target markets provide both short-term and long-term product revenue opportunities. Chemical and industrial products have relatively short development and regulatory approval processes; agricultural products have intermediate term development and regulatory approval processes; and pharmaceutical products have longer development and regulatory approval processes. Within these broad markets we are targeting key segments where we believe our technologies and products will create high value and competitive advantages for our strategic partners and customers.

We apply proprietary technologies to discover and optimize novel gene-based products, including molecules with pharmaceutical applications, such as novel small molecule drugs and improved monoclonal antibodies, as well as enzymes and small molecules with agricultural, chemical, and industrial applications. Our balanced and diversified approach is reflected in our programs described below:

Our pharmaceutical program seeks to apply our technologies to the discovery and development of compounds for selected applications within the pharmaceutical market. Additionally, we continue to evaluate acquisition opportunities that represent a strategic fit to our anti-infectives focus, or would allow us to expand our capabilities further downstream in the drug development process.

Diversa’s Small Molecule Drug Discovery Program. Our proprietary DNA recovery technologies provide us with access to genetic material from the Earth’s untapped biodiversity. We believe our vast gene expression libraries, which include the complete genomes of more than 3 million microorganisms, will allow us to significantly speed the discovery and development of commercially valuable small molecule pharmaceuticals. We believe that our small molecule drug discovery methodologies can yield results superior to other approaches because natural pathways can yield more complex chemical structures compared to lab-based synthesis. In addition, by achieving bacterial clonal expression of novel chemical structures, we are able to manipulate genes encoding these novel compounds either by genetic modification of the pathways and corresponding chemical structures, and by molecular evolution of the gene components resulting in novel pathways. By employing several proprietary, ultra high-throughput screening technologies, we are using the large collection of genetic material captured in our PathwayLibrary^™ collections in our efforts to accelerate the discovery process. Thus, we believe this approach will accelerate the “hit-to-lead” process and will enable viable options for commercial production of the compounds.

Diversa’s Protein Therapeutics / Antibody Program. Our Protein Therapeutics / Antibody Program focuses on the application of our powerful DirectEvolution^® technologies to improve protein therapeutics and to generate novel antibodies. These proprietary technologies, coupled with our unique ultra high-throughput screening platforms, can be applied to genes encoding human proteins, environmental proteins, and antibodies, with the goal of creating next-generation human therapeutics with desired characteristics. The growing number of newly-discovered, genomics-derived disease targets presents attractive market opportunities for antibody development using our platform, which we believe will overcome limitations on current approaches by combining a unique approach to synthesizing and screening antibodies with our well-established protein engineering technologies. Monoclonal antibodies often have higher rates of success in clinical trials and shorter regulatory review timeframes and, thus, frequently can be less expensive to commercialize compared to other therapeutics. As such, our two primary goals for expanding our business in the therapeutic antibody field include (i) developing a de novo human antibody library and (ii) creating a platform for efficient antibody optimization. The main focus of the past year was the successful implementation of both of these technology platforms.

In the first half of 2002, we completed the first phase of the de novo human antibody program by cloning all variable regions, generating a library of all possible light chains, and expressing antibodies in mammalian cells. By the end of 2002, we had completed phase two in constructing, and then screening, a preliminary antibody library and successfully identifying a human antibody. The program combines the Gene Site Saturation Mutagenesis^™ (GSSM^™), Tunable GeneReassembly^™, and ultra high-throughput screening technologies with the ultimate goal of generating, in vitro, a large collection of human antibodies, without the limitations of hybridoma technologies or transgenic animals. In doing so, our strategy is to create fully-human antibodies with traits such as optimal stability, functionality, and diversity.

Substantial opportunity exists to optimize diagnostic and therapeutic antibodies for important properties like efficacy, expression, stability, assay sensitivity and specificity. In 2002, we made substantial progress toward validating the use of DirectEvolution^® technologies to improve antibody properties. A comprehensive experiment was conducted to demonstrate that our technologies can effectively improve the binding properties of target antibodies. The table below shows the results of an optimization experiment utilizing phage display libraries compared to what was accomplished using our patented GSSM technology to comprehensively test all single amino acid substitutions in less than six months. In this experiment, we not only confirmed the one region demonstrating improved binding shown in previous studies, but also identified numerous new sites for further improving antibody binding.

The growth of the agricultural market has been spurred by the world’s population growth. This growth has led to the demand for new technologies that improve productivity, reduce the environmental impact, and improve the quality, safety, and nutritional value of agricultural products. Animal feed crops, such as corn, wheat, barley, rye, oats, and soybean, can be improved through the selective development of value-added traits. We estimate that the animal feed market is currently $36 billion in annual revenue. In 2001 alone, over $8 billion was spent on animal feed additives that improve digestibility and increase nutritional value. The market for crop protection chemicals in 2001 was approximately $28 billion and genetically engineered crops are expected to contribute substantial value to the estimated $15 billion agriculture seeds market.

We have significant ongoing programs with affiliates of Syngenta AG for agricultural product discovery and development. Zymetrics, our joint venture with Syngenta Seeds AG, is developing novel enzymes designed to improve the efficiency and environmental sustainability of animal agriculture, as well as to enhance the quality and value of feed, food, and industrial products derived from crops, such as enzymes for baking and brewing applications and for efficient utilization of animal feed. Our alliance with Syngenta Biotechnology, Inc. entails a multi-project collaborative research and development agreement to develop products for crop enhancement and improved agronomic performance. These projects are focused on new genomic approaches designed to improve performance and quality traits in crops, as well as enhance production efficiency. In addition, under our most recent agreement with Syngenta Participations AG, we are focused on developing products for agribusiness applications, as well as for human and animal health markets. Under this minimum seven-year agreement, we are entitled to receive research funding of at least $118.0 million in addition to milestones and royalties.

We are utilizing our unique discovery, evolution, and screening technologies to identify and optimize genes and gene pathways for potential use in the areas of crop protection, crop production (targeted input and output traits), agricultural product processing, animal health, and animal nutrition. We are developing a variety of specialty enzymes, enhanced genes, and small molecules for use in the following applications:

We are developing enzymes to aid in the manufacture of both fine and high-performance chemicals. These enzymes are used to create manufacturing efficiencies, reduce production costs, and accelerate the generation of new chemical products and processes.

We have the ability to discover and improve biocatalysts that can provide economical and more effective alternatives to existing chemical routes. We are targeting opportunities in the pharmaceutical manufacturing industry, and specifically in the production of chiral intermediates and peptides. We are currently developing enzymes for the production of essential elements for the manufacture of chiral drugs, which include many of the leading revenue-generating drugs currently on the market. We believe these enzymes can improve performance, reduce production costs, and eliminate waste by-products associated with manufacturing. Chirally pure chemicals are preferred by the pharmaceutical industry because they may provide lower toxicity, higher efficacy, lower manufacturing costs, and patent life extensions. We are developing a variety of specialty enzymes for use in the following applications:

The global market for industrial and specialty enzymes was more than $2 billion in revenue for 2001. Today, it is estimated that fewer than 30 enzymes account for more than 90% of the industrial enzymes currently in use. Most industrial enzymes break down easily or become inactive in the industrial environment. Historically limited innovation in the industrial enzyme market presents an opportunity to utilize our discovery and evolution technologies to develop novel, superior enzymes. Our proprietary discovery and evolution strategies are designed to identify, and, if necessary, customize biomolecules to resist degradation and to remain stable at high temperatures or in the presence of organic solvents. Similarly, these capabilities enable us to address the demand for new enzyme activities for specialty applications. A number of applications within this market provide us with commercial opportunities for which we are currently developing a variety of enzymes:

Our product development strategy is to target high-value applications with an average of 70% gross margin, for which we believe our technologies can deliver superior, proprietary solutions. We have developed a pipeline of product candidates across multiple markets, both independently and in collaboration with strategic partners for applications such as feed and food additives, enzymes for baking and malting, flavor and fragrance ingredients, industrial enzymes for processing textiles and pulp and paper, as well as enzymes for peptide synthesis and for the production of chiral intermediates. In 2002, we advanced our product portfolio by licensing a pharmaceutical manufacturing enzyme, launching two fluorescent proteins, and delivering commercial quantities of phytase to Danisco in preparation for launch upon FDA approval. In March of 2003, we and Danisco received approval from the United States Food and Drug Administration, or FDA, to market our Phyzyme^™ XP Animal Feed Enzyme.

To date, we have commercialized the following products, either independently or in collaboration with our partners:

Enzymes and small molecules are examples of naturally occurring biomolecules. Virtually any product or process that utilizes proteins can be improved using novel, naturally occurring biomolecules. Consequently, naturally occurring biomolecules are potentially commercially applicable to a broad range of multi-billion dollar industries.

One of the most abundant sources for enzymes and small molecules can be found in the environment. Microbes, including bacteria and fungi, are among the world’s most diverse organisms and can be found in almost every ecosystem, including oceans, deserts, rain forests, and arctic regions. Through billions of years of natural selection in diverse environments, microbes have developed broader and more varied characteristics than those encountered in plants or animals. These characteristics, which include the ability to survive in extreme temperature, tolerate high or low pH, and endure high or low salt environments, are the result of the highly diverse genetic material found in the microbial world.

This genetic material, commonly known as DNA, is a fundamental molecule found in the cells of all living organisms and is composed of four different chemical bases called nucleotides. Nucleotides are arranged into units called genes, which are the elements of heredity. Genes carry the instructions for the production of molecules called proteins. Proteins are made up of functional building blocks called amino acids. One key class of proteins is known as enzymes. An enzyme is produced by the expression of a single gene inside a cell.

Enzymes carry out the chemical reactions that give each microbe its unique character. Further, multiple genes can also be expressed in concert inside cells to create other types of organic compounds called small molecules. These arranged genes are called biosynthetic pathways and are capable of producing small molecules, including antibiotics.

Countless microbes, each with their unique enzymes, influence our lives in a multitude of ways. For example, some microbes make the soil fertile, clean up the environment, and supply the atmosphere with oxygen, while others produce molecules that can be used to produce vitamins and drugs, or improve our food.

As a class, protein therapeutics include (1) naturally occurring human proteins, (2) proteins discovered from environmental sources, (3) recombinant versions of naturally occurring human proteins, (4) mutated or optimized versions of a naturally occurring human protein having higher efficiency, lower toxicity, and/or altered functionality, and (5) monoclonal antibodies. Conventional small molecule drugs generally function by binding to a disease-causing protein, thereby changing, eliminating, or decreasing the protein’s activity. While protein-based drugs, such as monoclonal antibodies, can be used to mimic the function of certain small molecule drugs, perhaps the greatest use of therapeutic proteins is in supplementing the human body when a specific protein of significant biological importance is made in an amount that is less than desirable. Recent advances in DNA manipulation and modification technologies, as well as protein production methods, have facilitated the synthesis of genes of various therapeutic proteins at therapeutically significant scales.

It has been estimated that roughly 10,000 proteins are secreted in human plasma. While an estimated 20-30% of these had been identified as of mid-2001, only a small number have been commercialized thus far for clinical or therapeutic use. Recent technological and scientific developments in the genomics and proteomics areas have significantly increased the discovery of proteins with clinical significance. Together with the knowledge of the draft sequence of the human genome, new bioinformatics tools and high-throughput assay technologies have cumulatively impacted the discovery of new proteins and identification of new therapeutic functions. The discovery of proteins with new functionalities promises to increase the dimension of protein therapeutics both in the areas of types of diseases and the degree of efficacy of novel protein-based therapeutics. As the functions of human genes continue to be discovered at a rapid rate and researchers’ understanding of the causes of disease steadily improves, the demand for proteins for therapeutic use and as target sources is anticipated to increase proportionately.

A subset of protein therapeutics, antibodies are an integral part of the human immune system that protect against disease-causing agents, or pathogens. Antibodies are comprised of protein subunits that are produced by a special type of cell within the immune system. Each antibody is capable of recognizing a specific molecule produced by, or on the surface of, a target pathogen, referred to as an antigen. An antibody can potentially neutralize a pathogen’s ability to cause infection and/or a toxin’s ability to cause cellular damage by binding to the associated antigen. Additionally, the process of antibody-antigen binding frequently triggers a secondary immune response to destroy the related pathogen. As a result of advances in molecular biology, opportunities have expanded for using antibodies as research tools, diagnostics, and ultimately therapeutics.

Antibodies can theoretically be generated by scientists to target any protein or protein subunit of interest. Antibodies that successfully bind to a protein of interest can then be used in further research to study the function of the protein, such as the cellular location of a protein, other molecules associated with a protein, and the effects of disturbing a protein’s function and interaction with other molecules. Antibodies have also been used successfully in the protein purification process, allowing the activity of a protein to be measured in vitro. All of these uses can be significant to determine the function of a protein or protein subunit of interest.

Perhaps the most important use of antibodies today, however, is as therapeutic agents. In a similar process by which one or more antibodies will bind to a specific pathogen or pathogenic toxin, an antibody can also target

a specific human protein that is implicated in a disease process. By binding to a target human protein, the function of such protein can frequently be disrupted, thereby ameliorating the cause or the harmful effects of a disease process. The effectiveness of an antibody as a therapeutic agent is largely dependent upon the antibody’s possessing a high specificity and affinity for a given target protein. However, the isotype of an antibody is also an important parameter for it to be effective as a therapeutic. The precise protein sequences of the constant and variable regions of an antibody generally determine the antibody’s affinity, specificity, and other therapeutically relevant parameters with respect to a specific antigen.

Traditional methods of discovering enzymes and other biologically active molecules do not utilize a DNA-based approach, but are accomplished by culturing and screening microorganisms, or by examining plant extracts. For small molecules, once scientists using the traditional culturing approach identify an activity of interest, they are faced with the problem of separating the activity from others potentially present in the sample. This process is traditionally followed by the difficult and time consuming task of determining the chemical structure of the molecule, which requires producing sufficient quantities of the compound by culturing a sample of the producing organism in the laboratory. Challenges with reproducibility and low levels of synthesis often make this a difficult task.

To date, modern biochemical science has characterized greater than 3,000 enzymes. Nearly all of such enzymes have been identified from organisms that have been successfully cultured in the laboratory. The scientific community has characterized enzymes from only a small fraction of the billions of different species of microorganisms living throughout the world. The reasons for this limited discovery effort include:

Accordingly, the universe of potentially useful compounds from biodiversity remains largely untapped.

Once an enzyme or small molecule of interest is discovered, the genetic sequence of the gene(s) encoding it can be studied and genetic variation can be introduced in an attempt to modify its function through a process of test tube evolution. Genetic variation is generated predominantly by two methods: mutation and recombination. Mutation is the introduction of changes into a gene. Mutation can be achieved by several methods, including forcing the DNA to replicate in a manner that intentionally causes random changes. Mutagenesis has been achieved by randomly introducing single nucleotide changes into a gene in an attempt to alter a single amino acid within the corresponding protein. Random methods have deficiencies that make it virtually impossible to generate all 19 possible amino acid changes at each position within the protein. The best method to generate all amino acid changes at each site requires multiple, appropriately positioned DNA base changes (non-random methods). Historically, on average, three or fewer changes are explored due to deficiencies in mutation and sampling methods. Recombination, or shuffling, the other method for producing genetic variation, is the mixing of two or more related genes to form hybrids. However, the generation of improved variants has, to date, been inefficient and laborious, or has allowed only closely related genes to be recombined.

Regardless of the method used to generate the variation, mutation, or recombination, the improved molecules must be selected from numerous unimproved or defective versions that are generated by these

methods. This selection process requires the ability to quickly screen large numbers of genes to distinguish the improved versions.

Once a desired gene is found and optimized, commercial production requires insertion of the gene into a production system or host. Almost all of the current commercial enzymes used in industrial applications today were derived from cultured microorganisms and produced in these or similar organisms. However, genes encoding unique biomolecules may not be able to be expressed and commercially produced in traditional systems. Thus, traditional methods present both the problem of novel biomolecule identification and the challenge of commercial production of any identified biomolecules.

The introduction of recombinant human insulin in 1982 for the treatment of diabetes represented the first commercial protein therapeutic. Since then, more than 60 protein therapeutics have been approved by the FDA. Non-antibody recombinant protein therapeutics are typically generated simply by cloning the naturally-occurring human gene sequence into a bacterium. As a result, while the protein encoded by the human gene may possess a favorable immunogenic profile, it may not function optimally for its intended use in the human body. For instance, the half-life of a non-optimized recombinant protein therapeutic may not be sufficient to be pharmacologically useful. The continued growth in the number of protein therapeutics presents increasing opportunities to apply our DirectEvolution technologies to optimize various parameters of several existing protein therapeutics, particularly those facing patent expiration over the next few years.

Currently, there are four different types of therapeutic monoclonal antibodies being generated: murine, chimeric, humanized, and human.

Antibodies that are of mouse origin and made using a hybridoma approach are referred to as “murine antibodies.” A significant limitation of the use of murine antibodies is that the human immune system usually detects the murine-derived antibody as foreign, often resulting in undesirable side effects, such as severe immunological responses.

Chimeric antibodies are generated by separating the variable regions of an antibody of mouse origin that has demonstrated therapeutic potential and attaching them to the constant regions of a human antibody. Although the variable regions of a murine antibody generally tend to be less immunogenic than the constant regions, they may still be detected as foreign by the human immune system and result in a neutralizing response similar to that induced by fully murine antibodies.

Humanized antibodies are similar to chimeric antibodies, with the exception that humanized antibodies retain only the complementarity-determining region (“CDR”) portion of the murine sequence, which is grafted onto the framework of a human antibody. One of the most significant challenges facing humanized antibodies is the distortion that occurs with CDR grafting, which can frequently result in some loss of binding affinity, decreased binding strength, and the alteration of the antibody’s specificity for the relevant antigen.

In contrast to murine, chimeric, and humanized antibodies, fully human monoclonal antibodies can frequently provide an enhanced safety profile, higher affinity, and potentially increased efficacy. Fully human monoclonal antibodies are currently generated through the use of transgenics and phage or cell display technologies. However, hybridoma processes required for transgenically generated antibodies tend to be very inefficient and typically do not capture many antibodies that are produced by the human immune system. Furthermore, transgenic mice engineered to generate human antibodies do not express all possible human antibody genes. A significant additional limitation on the use of transgenic animals is that the reconstituted immune system of a transgenic animal might not adequately control the animal’s own responses to a sufficient number of antigens to make it efficient enough for the production of human therapeutics. With respect to phage display, this process has historically been slower than transgenic processes of human antibody generation. In

addition, the phage biopanning process often limits the diversity of the antibodies generated. Finally, antibodies generated using phage display frequently require optimization to be of therapeutic value.

We have developed proprietary genomic methodologies and technologies to tap the commercial potential of uncultured microorganisms, which make up more than 99% of the Earth’s genetic diversity. We are able to identify product candidates efficiently utilizing our patented and proprietary ultra high-throughput screening technologies, which are capable of screening more than one billion genes per day. Today, we are the only company applying all of these capabilities to directly extract novel and potentially commercially valuable genes and gene pathways for applications across our target markets.

We also have the ability to selectively apply multiple evolution technologies for optimizing both environmentally derived genes and human genes. We believe the combination of these two methods is unique in the industry and provides us with a significant competitive advantage. Our Gene Site Saturation Mutagenesis^{^™} (GSSM^™) technology is a powerful, comprehensive point mutagenesis system designed to optimize characteristics such as enzyme stability or binding affinity, while minimizing immunogenicity.

We use an important complementary technology, Tunable GeneReassembly^™, to synthesize DNA fragments and reassemble them to create novel genes. This proprietary, next-generation method is superior to several existing technologies in that it does not require highly-related gene sequences to create significant improvements in product performance. These technologies represent powerful and complementary tools to overcome many existing product development barriers.

Our proprietary technologies and tools address the limitations of traditional approaches for the recovery and modification of novel genes and linked genes comprising novel gene pathways and the manufacture and commercialization of related products. Our fully integrated processes include the following steps:

Our discovery program begins with access to biodiversity. Biodiversity can be defined as the total variety of life on earth, including genes, species, ecosystems, and the complex interactions between them. We have collected microbial samples from virtually every ecosystem represented on earth, including such environments as geothermal and hydrothermal vents, acidic soils and boiling mud pots, alkaline springs, marine and freshwater sediments, savanna grasslands, rainforests, montane and subalpine landscapes, industrial sites, arctic tundra, and dry Antarctic valleys. We have also sampled microbial communities living in close association with insects, arachnids, and nematodes, as well as the symbionts residing within marine sponges and soft corals. All of our samples from the countries within our biodiversity access network have been acquired through legal agreements that permit broad access to biologically diverse environments within such countries. These agreements are generally with domestic land management agencies and scientific research institutions. Our relationships have been founded on the fundamental principles of the Convention on Biological Diversity: (1) conservation of biological diversity; (2) the sustainable use of its resources; and (3) the fair and equitable sharing of the benefits derived from the utilization of genetic resources.

We believe our ability to create expanded libraries using minute samples of genetic material collected from diverse environments is an important factor to our success. Our need to use only small environmental samples

results in minimal impact to the surrounding ecosystem, enabling us to enter into formal genetic resource access agreements. To date, we have obtained samples, under legal agreements, from Alaska, Australia, Bermuda, Costa Rica, Ghana, Hawaii, Iceland, Indonesia, Kenya, Mexico, the Meadowlands Superfund site, Russia, and South Africa. In addition, in 1997, we signed a Cooperative Research and Development Agreement with Yellowstone National Park, which was the first agreement of its kind for the U.S. National Park Service. We also access marine and terrestrial samples from Antarctica, as well as deep-sea hydrothermal vents off the shores of Costa Rica and the Pacific Northwest. Many of these samples are taken using deep-sea submersibles such as the ALVIN or remotely operated vehicles like the Jason and Ventana.

We intend to enter into additional agreements to further strengthen our biodiversity access program by expanding the network of countries from which we obtain samples. Using our proprietary techniques to recover the genes from these samples, we have constructed our DiverseLibrary collection. We intend to expand this DiverseLibrary collection, which we estimate currently contains the total genomes of over 3 million unique microorganisms. We are also making a significant effort to expand our collections of multi-gene pathways, our PathwayLibrary collections. We believe that the application of our proprietary technologies to this vast resource of genetic material will provide us with a myriad of product candidates for attractive commercial applications.

To successfully capture the enormous genetic diversity present in uncultured microbial community samples, we have developed a series of techniques, which enable substantial recovery of DNA from a wide range of sample types, while assuring DNA purity.

Our methods for analysis of environmental samples give scientists a rapid estimation of the total number of species present and the relative abundance of each species within a sample. DNA recovered from complex environmental samples often represents the genomes of thousands of different microbial species, some of which are generally more abundant than others. We estimate that there may be as much as a 100,000-fold difference in abundance between a dominant species and a rare species in a single sample. To access the genetic material of rare microbial species in a given sample, we have developed proprietary normalization technologies that result in a more equal representation of each species at the genetic level. Because current culturing techniques are generally incapable of capturing this underrepresented genetic material, this potentially valuable source of genetic information has historically not been available to commercialize. In addition we have developed high-throughput culturing methods that allow us to culture organisms in isolation or in consortia by creating nano-environments similar to the organisms’ natural habitats. Thus, organisms that have never before been grown in the laboratory, can be cultured and studied to augment our understanding of physiology and metabolic adaptation, and provide an abundance of potential sources for novel antibiotics, drugs, and microbial metabolites. This method for discovering products from the environment was described in the November 2002 issue of the Proceedings of the National Academy of Sciences.

DiverseLibrary Generation. We have developed proprietary methods for construction of complex, representative environmental gene libraries. A gene library is a stored collection of DNA fragments or genes. We store these genes in library form by cloning or splicing the DNA fragments into a vector, a piece of DNA that acts as a carrier or a transporter into a host cell. The DNA fragment spliced into the vector DNA is called a recombinant molecule or clone. A collection of clones representing the entire DNA isolated from the organisms in the sample is a representative gene library. In order to capture the complete genomic diversity present in these complex microbial samples, which may contain more than 5,000 distinct genomes, we prepare very large member libraries. The result is the creation of an additional gene library for our DiverseLibrary collection, which typically represents genomic coverage of these microorganisms. We estimate that our DiverseLibrary collection contains the complete genomes of over 3 million different microorganisms, which far exceeds the estimated 10,000 microorganisms which have been previously described in the scientific literature in the last 100 years.

PathwayLibrary Generation. We are also developing PathwayLibrary collections, comprised of multi-gene sets used in the discovery and production of small molecules. While a single gene is responsible for the production of an enzyme, the production of small molecules, such as antibiotics, typically requires multiple genes

working together in a coordinated fashion within a genetic pathway. In addition, whereas the genetic blueprint for the production of an enzyme is generally contained within approximately 1,000 nucleotides of DNA, the blueprint for the production of an antibiotic pathway is typically more than 25,000 nucleotides, and can be greater than 100,000 nucleotides. For this reason, we are improving specific molecular tools that can accommodate and stably maintain such large pieces of DNA in a library.

We have developed an array of automated, ultra high-throughput screening technologies and enrichment strategies. Our proprietary rapid screening capabilities are designed to discover novel biomolecules by screening for biological activity, known as expression-based screening, as well as by identifying specific DNA sequences of interest, known as sequence-based screening.

We have developed several hundred assays capable of expression-based screening from thousands to over 1 billion clones per day. Our key screening technologies include SingleCell^™ screening and high-throughput robotic-based screening. Our ultra high-throughput SingleCell screening system uses Fluorescence Activated Cell Sorting, or FACS, a technology that enables the rapid identification of biological activity within a single cell or individual organism. Our SingleCell screens have been developed to identify clones based on activity or DNA sequences. This system incorporates a laser with multiple wavelength capabilities and the ability to screen up to 50,000 clones per second, or over 1 billion clones per day. Our robotic screening systems use high-density (1536 wells) microtiter plates and are capable of screening and characterizing over 1 million clones per day.

If the clone expresses an activity or contains a DNA sequence of interest, we isolate it for further analysis.

We have also developed rapid methods for sequence-based screening for targeted genes directly from purified DNA. One of these methods, genomic biopanning, is a powerful alternative to traditional methods, especially when the gene is toxic or unstable, or when the expression assay is laborious and time consuming. Using our proprietary techniques, it is possible to screen billions of clones per day for DNA sequences of interest.

Because we conduct patented, activity-based screening, we are able to use gene sequences with known function from our proprietary database to identify the function of genes in public databases based on their sequences. These newly identified sequences are then added to the repertoire of proprietary sequences in our own database. As more microbial genomes are sequenced, our ability to associate gene sequence with enzyme function will be enhanced. This sequence database provides us with unique opportunities to find and patent more sequences with similar function and the potential to modify these sequences in order to create optimized catalysts and other biomolecules for various commercial applications.

Our GigaMatrix^™ platform is an ultra high-throughput screening platform that is the first system known to utilize plates with a 100,000-well density. Exponentially more efficient than standard 96-, 384-, or 1536-well screening systems, the GigaMatrix platform combines automated robotics and a 100,000-well format contained in the 3.3” x 5” footprint of a standard plate.

The GigaMatrix platform permits rapid screening of genes and gene pathways, and is expected to increase the productivity of our discovery programs for products such as novel enzymes and small molecule drugs. The screening platform is also being adapted to our antibody and protein therapeutic programs, which require rapid screening of the large numbers of antibody and protein variants created by our evolution technologies. In 2002, we developed the capability to screen in plates with one million wells and initiated screening in this ultra-high density format.

The GigaMatrix technology, employing over 12,000 wells per square centimeter, greatly expands the amount of molecular diversity that can be screened to discover products. The platform also dramatically reduces equipment and operator time through massively parallel dispensing and reading of biological samples. The GigaMatrix plates, with wells each about the diameter of a human hair, are reusable and require only miniscule volumes of reagents, making them highly cost effective.

The genetic code is structured such that a sequence of three nucleotides defines an amino acid. Nature uses 20 common amino acids in proteins arranged in a sequence, defining the protein structure and activity. Over the course of almost 4 billion years of evolution, nature has sampled countless sequence possibilities to evolve proteins to function optimally within the cell. However, when a protein is removed from its natural cellular environment and used to perform reactions, such as an enzyme used to catalyze a chemical process, its function may not be optimal. Laboratory methods can accelerate the evolutionary process of optimization outside of the cell by creating a large number of variants for screening. In the traditional method for improving proteins, called site-directed mutation, a single site is typically targeted for change based on prior knowledge of the protein structure. Other traditional techniques, including random mutation, typically produce single nucleotide changes which can only access a limited number of alternative amino acids, typically fewer than 3 of the possible 19 alternatives. These methods are limited by their inability to produce all DNA and amino acid sequence variations. Furthermore, the large number of resulting sequences presents formidable screening challenges.

We believe our techniques overcome the limitations of these traditional methods, not only because of our superior screening capabilities, but also by increasing the number and types of sequence variations we can create. Our evolution technologies used to modify the DNA sequence of the genes, our DirectEvolution technologies, include Gene Site Saturation Mutagenesis (GSSM) and Tunable GeneReassembly. Our GSSM technology is a patented method of creating a family of related genes that all differ from a parent gene by at least a single amino acid change at a defined position. By performing GSSM on a gene encoding a protein, we create all possible single, double, and/or triple amino acid codon substitutions within that protein, removing the need for prior knowledge about the protein structure and allowing all possibilities to be tested in an unbiased manner. The family of variant genes created using GSSM is then available to be screened for proteins with improved qualities, such as increased ability to work at high temperature, increased reaction rate, resistance to deactivating chemicals, or other properties important in a chemical process. Individual changes in the gene that cause improvements can then be combined to create a single highly improved version of the protein. Additionally, our patented GSSM methodology employs a more cost-effective approach than other methods of site-directed mutation.

In addition to altering single genes using our patented GSSM technique, we use our proprietary Tunable GeneReassembly technologies for the reassembly of related or unrelated genes from two or more different species or strains. Our Tunable GeneReassembly technologies recombine multiple genes to create a large population of new gene variants. The new genes created by Tunable GeneReassembly are then screened for one or more desired characteristics. This evolutionary process can be repeated on reassembled genes until new genes expressing the desired properties are identified. Tunable GeneReassembly technologies can be used to evolve properties which are coded for by single genes, multiple genes and entire genomes. While we have received a patent for one of our processes of gene shuffling based on interrupted DNA synthesis and reassembly, our suite of multiple, proprietary evolution technologies is not limited to traditional shuffling techniques. For instance, unlike widespread shuffling technologies that require highly related gene sequences to achieve successful recombination, our proprietary Tunable GeneReassembly technology also allows unrelated genes to be combined to maximize evolved improvements.

We believe that the ability to selectively apply our GSSM or Tunable GeneReassembly technologies to optimize proteins provides us with a distinct competitive advantage. GSSM is better suited in some situations, for example, in the optimization of a protein’s stability or its immune response characteristics. With respect to stability, applying GSSM may significantly improve temperature tolerance through combining amino acid alterations at defined positions, while maintaining the protein’s overall characteristics, such as specificity. In one program, we have used this technology to improve enzyme stability by a factor of 30,000. Similarly, adverse immune system responses may be avoided by the incremental changes created by GSSM. In contrast, random shuffling technologies, which cause block shifts in DNA structure, are more likely to reduce stability and create undesirable immune response characteristics. On the other hand, when optimizing for activity, expression, and

specificity, both GSSM and Tunable GeneReassembly can produce optimal results. Because we have multiple evolution technologies combined with optimal natural enzymes to which we apply these evolution methodologies, we believe that we are well-positioned to provide the best solutions to our customers.

We have developed leading edge, scientific computational tools for internal purposes: the SciLect and Adamas databases. Our SciLect system provides a secure, reliable, and accurate source for storage, retrieval and analysis of vast amounts of proprietary biological data. The SciLect 2.0 database has been fully developed and is now being used across the organization. New features are also being developed to allow visual data navigation of complex data and relationships. The Adamas system includes custom-developed and third-party bioinformatics software tools which assist in the acquisition and analysis of complex data relating to genes, proteins, sequence similarity to known genes, three-dimensional structure prediction, and biological pathways. This new tool will allow faster access to data than traditional and commercial tools that are available.

Utilizing the combination of SciLect and public databases, we are able to first verify that we have a unique gene. We are then able to mine public databases using Adamas for previously unidentified proteins that can be added to our portfolio of patented proteins. Publicly available databases of proteins and genomic data are imported daily to our secure environment. Through the use of these systems, we have assembled the world’s largest proprietary database of activity screened, and patent-protected, unique gene sequences.

Production of proteins and pathway products has historically been very challenging due to the difficulty of producing commercial quantities of these products in traditional host organisms. This problem can be overcome by finding or developing a more suitable host organism. In the past, random mutation has been used in an effort to create more efficient hosts. We believe our host cell optimization processes will accelerate this effort. We are working on a number of host organisms to improve their functionality as production hosts by:

As part of our host cell optimization and pharmaceutical programs, we have developed extensive DNA sequencing capabilities for sequencing the genomes of selected microorganisms, both internally and in collaboration with The Celera Genomics Group. As part of our internal sequencing efforts, we sequenced the entire genome of Aquifex aeolicus, which was later published as an article entitled “The complete genome of the hyperthermophilic bacterium Aquifex aeolicus.” This paper, published in Nature in 1997, represented an important achievement for our microbial genome sequencing program. When the Nature paper was published, the genome of A. aeolicus was the first high temperature bacterium sequenced and was one of the first complete genomes to be sequenced. This allowed scientists to compare its genome sequence, and the way its genes were organized, to those of other bacteria, to see how evolutionarily conserved different groups of genes were. Since its publication in Nature in 1997, this article has been cited in more than 250 scientific papers. In addition, under a DNA sequencing collaboration we entered into with The Celera Genomics Group in December 2000, we obtained the entire genome sequence of the Streptomyces diversa^{^™} microorganism, a proprietary discovery and production host microbe important to both our host cell and pharmaceutical programs. The availability of the genome sequence, together with the application of technologies permitting the global analysis of gene expression at both the RNA and protein levels, and the extensive array of tools available for the genetic manipulation of this organism, will enable us to fully utilize S. diversa for the production of novel compounds of potential pharmaceutical interest.

Our strategy includes pursuing strategic alliances with market leaders in our target markets. In exchange for selected rights to future products, these strategic alliances provide us funding and resources to develop and commercialize a larger product portfolio. In various instances, these strategic alliances allow us to leverage our partners’ established brand recognition, global market presence, established sales and distribution channels, and other industry-specific expertise. The key components of the commercial terms of such arrangements typically include some combination of the following types of fees: exclusivity fees, technology access fees, technology development fees, research support payments, milestone payments, license or commercialization fees, and royalties or profit sharing from the commercialization of products. As of February 28, 2003, past and committed future funding from corporate partners totaled over $265 million, excluding equity investments and future success-based payments, of which $111.0 million had been received as of such date.

Collaborative revenue accounted for 96% of total revenue for the year ended December 31, 2002, 97% of total revenue for the year ended December 31, 2001, and 94% of total revenue for the year ended December 31, 2000.

In January 1999, we entered the agricultural biotechnology arena through a strategic alliance with Syngenta Biotechnology, Inc. (formerly Syngenta Agribusiness Biotechnology Research, Inc.), referred to below as Syngenta Biotechnology. This alliance covers a multi-project collaborative research and development agreement to develop products for crop enhancement and improved agronomic performance. Under the terms of the agreement, we are utilizing our unique discovery and screening technologies to identify and optimize genes and gene pathways for use in transgenic crops. The initial projects focus on new genomic approaches that will provide improved performance and quality traits in crops and enhance production. In conjunction with the transaction, Syngenta Biotechnology purchased 5,555,556 shares of our Series E convertible preferred stock, paid a technology access fee, and provided project research funding to us, for aggregate total proceeds of $12.5 million. We recognized the research payments on a percentage of completion basis as research was performed. We recognized the technology access fee in 1999, as all the research required under the collaboration was completed by December 31, 1999. During 2000, we expanded our collaboration agreement with Syngenta Biotechnology to further develop and optimize novel synthesis routes to crop protection chemicals. Under the terms of the agreement, we will receive research payments, milestones, and product royalties. We receive additional funding as projects are added under this agreement.

In December 1999, we formed a five-year, renewable strategic alliance with Syngenta Seeds AG, referred to below as Syngenta Seeds. Through a contract joint venture, named Zymetrics, we are pursuing opportunities jointly with Syngenta Seeds in the field of animal feed and agricultural product processing. Both parties share in the management of the venture and fund a portion of its sales and marketing costs. Under the agreement, Syngenta Seeds receives exclusive, worldwide rights in the field of animal feed and project exclusive, worldwide rights in the field of agricultural product processing. Syngenta Seeds agreed to pay us $20.0 million for the rights granted under this agreement, of which $15.0 million was paid in February 2000 and $5.0 million was paid in June 2001. We initially recorded the amount due in June 2001 at its present value on the date of the agreement of $4.0 million. We are recognizing the technology access fee as revenue on a straight-line basis over the term of the agreement. We recognize research funding as the research is performed, and milestone payments are recognized as revenue when earned. We will receive a share of the profits in the form of royalties on any product sales.

Either party may terminate these agreements in the event a material breach remains uncured for 90 days. Syngenta Seeds and Syngenta Biotechnology may terminate these agreements within 60 days of a change of control of Diversa.

In February 2003, we completed a series of transactions with Syngenta Participations AG, or Syngenta, and its wholly-owned subsidiary, Torrey Mesa Research Institute, or TMRI. Under the transactions, the companies formed an extensive research collaboration whereby we are entitled to receive a minimum of $118.0 million in research and development funding over the initial seven-year term of the related research collaboration agreement, and will be eligible to receive certain milestone payments and royalties upon product development and commercialization. Additionally, we acquired certain property and equipment from TMRI and certain licenses from Syngenta to intellectual property rights used in activities conducted at TMRI that primarily involve tools, technologies and methods relating to proteomics, metabolomics, RNA dynamics, and bioinformatics and methods to analyze and link these components of genomics or that primarily relate to TMRI’s fungal program, for use outside of Syngenta’s exclusive field as defined in the related research collaboration agreement. In consideration, we issued to Syngenta and TMRI a total of 6,034,983 shares of common stock and a warrant to purchase 1,293,211 shares of common stock at $22.00 per share that is exercisable for ten years starting in 2008. The total value of the acquisition was approximately $74.0 million, including transaction fees.

The purchase price has been allocated, based upon a third party valuation, to tangible assets, consisting primarily of computer and lab equipment, and identifiable intangible assets, consisting of acquired in-process research and development, core technology, and the value associated with the research collaboration agreement. The tangible assets will be depreciated over estimated useful lives of three to five years, the core technology will be amortized over its estimated life of fifteen years, and the value associated with the research collaboration agreement will be amortized over its estimated useful life of seven years. The in-process research and development was recorded as expense upon closing of the transactions.

Either party may terminate our research collaboration agreement with Syngenta upon the other party’s material uncured breach or default in the performance of any of its obligations under the research collaboration agreement or in the event the other party becomes subject to voluntary or undismissed involuntary bankruptcy or similar proceedings. In addition, our research collaboration agreement with Syngenta may be terminated by Syngenta in the event that we undergo a change of control while we are performing research under the research collaboration agreement and either the change of control transaction is with or involving any entity that is a competitor of Syngenta or its affiliates or, as a result of the change of control, Syngenta reasonably determines in its sole judgement that such change of control would have an adverse effect on our ability or the ability of the surviving entity to perform the research collaboration agreement’s research program.

Revenue recognized under the Syngenta Biotechnology and Syngenta Seeds agreements was $13.5 million, $13.9 million, and $12.3 million for the years ended December 31, 2002, 2001, and 2000, respectively.

In July 1997, we entered into an alliance with The Dow Chemical Company. The alliance was for a project involving biocatalytic discovery and optimization for use in new and existing Dow processes. This initial project was directed towards the incorporation of a high performance enzyme into a modified chemical process. Our staff successfully optimized an enzyme for this project with significantly greater thermostability at a defined temperature, thereby meeting milestones specified in the agreement.

In July 1999, we significantly expanded our existing strategic alliance with Dow to apply our discovery and optimization technologies for Dow to develop a variety of novel enzymes for multiple chemical processes on a reaction-exclusive basis. The research agreement involves multiple projects in the field of chemical processing. The agreements require Dow to make annual technology development payments, fund research costs, make milestone payments to us upon achievement of established objectives, and pay us license and commercialization fees for any resulting products. We will also receive royalties on sales of our royalty-bearing products sold or sublicensed by Dow. We amortized the technology development fees over the initial three-year period of the research agreement. In December 2000, we entered into an agreement with Dow to license several enzymes for early stage testing of further application for production of certain chemicals. Under the terms of the agreement,

we received license fees and are entitled to receive specified royalties upon commercialization of certain products using the licensed enzymes. Either party may terminate the research agreement upon failure to pay amounts due for 30 days or material breach if uncured within 60 days. The research agreement may also be terminated by Dow with 180 days written notice or upon a change of control to a Dow competitor with 30 days notice, in both cases upon the payment of defined penalties. We may terminate the license agreement in the event of a material breach if uncured for 30 days. Dow may terminate the license agreement with three months written notice.

In November 2000, we signed an agreement with Dow’s Custom and Fine Chemicals (formerly Contract Manufacturing Services) business unit to jointly market our respective abilities to pharmaceutical companies to develop and produce chiral compounds for active pharmaceutical ingredients, pharmaceutical intermediates, and other fine chemicals. Chiral technologies permit the separation of an active ingredient from its undesired counterpart. This affords lower toxicity, higher efficacy, lower manufacturing costs, and patent life extensions to the pharmaceutical industry. Under the terms of the agreement, we will receive technology access fees, research and development payments, milestone payments, and royalty payments from sales of end products by Dow. In October 2002, we announced that we licensed a product for improved enzymatic synthesis of a key pharmaceutical intermediate used in the manufacture of a multi-billion dollar drug to the Pharmaceutical Services business of Dow. We received license fees and are entitled to receive specified royalties on Dow’s sales of the intermediate manufactured using the licensed enzyme.

In June 2000, we formed a 50/50 joint venture with Dow, named Innovase LLC, to develop and commercialize innovative products for the industrial enzyme market segment. Under the various joint venture related agreements, we have received exclusivity fees, technology development fees, and research and development payments, and we believe we are entitled to additional technology development fees and research and development payments over the remainder of the initial five-year term. We are also required to fund certain operating expenses of the joint venture, excluding certain expenses for which Dow is responsible under the joint venture agreement.

In the course of recent discussions, we and Dow have expressed differing views regarding product development activities, commercial opportunities and funding obligations under the Innovase joint venture. In particular, Dow has indicated that it is unlikely to continue to provide research and development funding to us under the joint venture pending approval of further product development projects. We believe such funding is required by the terms of the Innovase agreements. Dow has paid all amounts due for work performed through the first calendar quarter of 2003. The minimum total amounts that we believe Dow has committed to paying us for the balance of 2003, 2004, and through June 2005 under the Innovase agreements represent less than ten percent of the total of at least $154.7 million that our strategic partners, including Dow, have committed to fund through 2010. Such committed funding excludes contingent or performance-based payments, such as milestone payments, license and commercialization fees, and royalties or profit sharing. To date, neither party has declared a breach under the Innovase agreements or provided notice of termination of any of the agreements.

We have initiated informal dispute resolution procedures under the Innovase agreements to attempt to resolve these issues. The informal dispute resolution procedures call for an executive officer from each company to meet and attempt to resolve the differences between the parties for a period of up to 60 days. If we and Dow are unable to resolve our differences through the informal dispute resolution process, either party may submit the matter to binding arbitration for resolution. During this informal dispute resolution period, we intend to continue to advance projects within the joint venture, which are subject to Dow funding obligations under the Innovase agreements. However, if the parties are not able to resolve their differences within the informal dispute resolution process, Dow has indicated its intent to reduce or eliminate its funding under the Innovase agreements, which would likely result in our initiating binding arbitration under the agreements. Although we intend to vigorously assert our rights under the Innovase agreements in any such arbitration, Dow’s ceasing to fund Innovase at the levels we believe are required under the Innovase agreements and the commencement of arbitration could

adversely affect our business. Furthermore, while we believe that we would prevail in any arbitration, there can be no assurance of the actual outcome of any arbitration, and an adverse result, including a result awarding an amount less than what we believe we are entitled to receive in committed funding under the Innovase agreements, could have an adverse affect on our business.

Revenue recognized under the Dow agreements was $16.1 million, $15.2 million, and $9.0 million for the years ended December 31, 2002, 2001, and 2000, respectively.

In May 1996, we entered into a collaboration agreement with Danisco Animal Nutrition (formerly Finnfeeds International Ltd) to jointly identify and develop a novel phytase enzyme that when used as an additive in animal feed applications allows higher utilization of phytic acid phosphates from the feed, thereby increasing its nutritional value. The addition of phytase to animal feed reduces the need for inorganic phosphorus supplementation and lowers the level of harmful phosphates that are introduced to the environment through animal waste, resulting in inorganic phosphate cost savings and a significant reduction in environmental pollution. Following the completion of the initial objectives of our agreement with Danisco, in December 1998, we entered into a license agreement with Danisco to commercialize an enzyme developed under the collaboration agreement. Under the terms of the license agreement, we granted Danisco an exclusive license to manufacture, use, and sell the developed enzyme. In consideration for the license, we will be paid a royalty on related product sales made by Danisco. Danisco can terminate this agreement at any time upon six months notice to us. We can terminate this agreement upon material breach by Danisco if uncured within 60 days. In March 2003, the FDA approved Phyzyme XP Animal Feed Enzyme, which we developed in collaboration with Danisco. Additionally, we entered into a manufacturing agreement with Danisco to supply commercial quantities of Phyzyme XP.

In December 2000, we entered into a drug discovery research collaboration with Glaxo Research and Development Limited, a wholly owned subsidiary of GlaxoSmithKline plc, to identify pharmaceuticals derived from our recombinant multi-gene PathwayLibrary^{^™} collections. Under this non-exclusive research agreement, we are performing research jointly with Glaxo to identify novel small molecules from our PathwayLibrary collections and to screen these molecules for specific pharmaceutical activity. Glaxo will receive exclusive worldwide rights to designated biomolecules selected for commercialization. The agreement may be terminated at any time upon mutual written consent of both parties or on 30 days’ notice by either party following the one-year anniversary of the agreement.

In addition to our strategic alliances, we have entered into various agreements whereby we have in-licensed patented technologies to supplement our internally developed methods, the most significant of which we have outlined below. The financial impact of these agreements to us is not significant.

In November 1999, we signed a royalty-free cross-license agreement with Terragen Discovery, Inc. granting non-exclusive, worldwide license rights for the life of specified patents. We granted rights to selected patents that protect accessing genomes of uncultured organisms for the discovery of pathways producing novel small molecules for pharmaceutical applications and Terragen granted us co-exclusive rights to patents protecting generation and screening of combinatorial libraries from mixed populations of organisms for all fields of use. Under the agreement, we paid Terragen a $2.5 million license fee and will pay annual maintenance fees for the remaining life of the patents. The term of the licenses we granted to Terragen and that Terragen granted to us will

continue until the expiration of all valid claims within the licensed patent rights. Either party may terminate this agreement in the event a material breach remains uncured for 60 days. Both parties have rights to terminate under special conditions.

In December 1997, we signed a license agreement with Mycogen Corporation, now Dow AgroScience LLC, for access to its proprietary expression system. Under the terms and conditions of the agreement, we have an exclusive, worldwide license to use the system for the production of enzymes in exchange for a license fee and royalties paid to Mycogen. The agreement can be terminated by either party upon material breach if uncured for 60 days.

Through formal genetic resource access agreements, we have obtained genetic material from Alaska, Australia, Bermuda, Costa Rica, Hawaii, Iceland, Ghana, Indonesia, Kenya, Russia, South Africa, and Yellowstone National Park. Pursuant to the terms of these agreements, we have obtained non-exclusive access to collect samples from diverse ecosystems, we own products developed and discoveries made from our use of the samples, and we pay a royalty to the other party on the sale of products derived from the samples. All of these agreements expire in 2007 or earlier, and they are all subject to earlier termination. We have voluntarily ceased collections of further samples in Yellowstone National Park pending their resolution of collection guidelines. If an access agreement terminates and a new agreement is not established, we will not collect any further materials from the specified location; however, we will retain the right to use any samples we have already collected. The financial impact of these agreements to us is not significant.

We are a leader in the field of biomolecule discovery and optimization from biodiversity. We are not aware of another company that has the scope and integration of technologies and processes that we have. There are, however, a number of competitors who are competent in various steps throughout our technology process. For example, Cubist Pharmaceuticals, Inc. is involved in accessing organisms from diverse environments. Maxygen, Inc., Evotec, Phylos, and Applied Molecular Evolution, Inc. have alternative evolution technologies. Integrated Genomics Inc., Myriad Genetics, Inc., ArQule, Inc., and Aurora Biosciences Corporation, a subsidiary of Vertex Pharmaceuticals Inc., perform screening, sequencing, and/or bioinformatics services. Novozymes A/S and Genencor International Inc. are involved in development, overexpression, fermentation, and purification of enzymes. Abgenix, Inc. and Medarex, Inc. are involved in the development of human monoclonal antibodies. There are also a number of academic institutions involved in various phases of our technology process. Some of these competitors have significantly greater financial and human resources than we do.

We believe that the principal competitive factors in our market are access to genetic material, technological experience and expertise, and proprietary position. We believe that we compete favorably with respect to the foregoing factors.

Any products that we develop will compete in multiple, highly competitive markets. Many of our potential competitors in these markets have substantially greater financial, technical, and marketing resources than we do and may succeed in developing products that would render our products or those of our strategic partners obsolete or noncompetitive. In addition, many of these competitors have significantly greater experience than we do in their respective fields. Our ability to compete successfully will depend on our ability to develop proprietary products that reach the market in a timely manner and are technologically superior to, and/or are less expensive than, other products on the market. Current competitors or other companies may develop technologies and products that are more effective than ours. Our technologies and products may be rendered obsolete or uneconomical by technological advances or entirely different approaches developed by one or more of our

competitors. The existing approaches of our competitors or new approaches or technology developed by our competitors may be more effective than those developed by us.

Our manufacturing strategy is to secure contract manufacturing relationships with qualified third parties possessing sufficient fermentation capacity to meet our commercial production requirements. We place our own technical personnel on site at contract manufacturing facilities to plan and supervise our production. Our employees have extensive experience in scale-up and production of fermentation products, including industrial enzymes. We have cleared regulatory requirements for our first three commercial enzymes, and are producing these products at commercial scale. We manufacture enzymes pursuant to arrangements with two third party entities that have the required manufacturing equipment and available capacity to manufacture products under our direction and oversight. We have our own pilot development facility that is used for developing new manufacturing processes, providing developmental quantities of products for internal and external use, and for producing commercial quantities of smaller-scale specialty products. We will continue to depend on third parties for large-scale commercial manufacturing.

We do not currently depend on any single supplier for the raw materials necessary for the operation of our business. However, we may become dependent on a single supplier in the future.

Many of our product opportunities, and all of our projects to date, have applications other than as regulated drug products. Non-drug biologically derived products are regulated, in the United States, based on their application, by either the FDA, the Environmental Protection Agency, or EPA, or, in the case of plants and animals, the United States Department of Agriculture, or USDA. In addition to regulating drugs, the FDA also regulates food and food additives, feed and feed additives, and GRAS (Generally Recognized As Safe) substances used in the processing of food. The EPA regulates biologically derived chemicals not within the FDA’s jurisdiction. Although the food and industrial regulatory process can vary significantly in time and expense from application to application, the timelines generally are shorter in duration than the drug regulatory process, ranging from six months to three years.

The European regulatory process for these classes of biologically derived products has undergone significant change in the recent past, as the EU attempts to replace country by country regulatory procedures with a consistent EU regulatory standard in each case. Some country-by-country regulatory oversight remains. Other than Japan, most other regions of the world generally accept either a United States or a European clearance together with associated data and information for a new biologically derived product.

In the United States, transgenic agricultural products may be reviewed, by the FDA, EPA, and USDA, depending on the plant and the trait engineered into it. The regulatory process for these agricultural products can take up to five years of field testing under USDA oversight, and up to another two years for applicable agencies to complete their reviews.

Outside of the United States, scientifically-based standards, guidelines and recommendations pertinent to transgenic and other products intended for the international marketplace are being developed by, among others, the representatives of national governments within the jurisdiction of the standard-setting bodies, including Codex Alimentarius, the International Plant Protection Convention, and the Office des International Epizooties. The use of the existing standard-setting bodies to address concerns about products of biotechnology is intended to harmonize risk-assessment methodologies and evaluation of specific products or classes of products.

Our intellectual property consists of patents, copyrights, trade secrets, know-how, and trademarks. Protection of our intellectual property is a strategic priority for our business. Our ability to compete effectively depends in large part on our ability to obtain patents for our technologies and products, to maintain trade secrets, to operate without infringing the rights of others, and to prevent others from infringing on our proprietary rights. As of February 28, 2003, we owned 76 issued patents relating to our technologies, had received notices of allowance with respect to 10 other patent applications and had over 410 patents pending. In addition, as of February 28, 2003, we had in-licensed 60 additional patents or patent applications that we believe strengthen our patent position.

The patent positions of biotechnology companies, including our patent position, involve complex legal and factual questions and, therefore, enforceability cannot be predicted with certainty. Patents, if issued, may be challenged, invalidated, or circumvented. We cannot be sure that relevant patents have not been issued that could block our ability to obtain patents or to operate as we would like to. Others may develop similar technologies or duplicate technologies developed by us. There may exist patents in some countries that, if valid, may block our ability to commercialize products in these countries if we are unsuccessful in circumventing or acquiring the rights to these patents. There also may exist claims in published patent applications in some countries that, if granted and valid, may also block our ability to commercialize products in these countries if we are unable to circumvent or license them.

The biotechnology industry is characterized by extensive litigation regarding patents and other intellectual property rights. Many biotechnology companies have employed intellectual property litigation as a way to gain a competitive advantage. Third parties may sue us in the future to challenge our patent rights or claim infringement of their patents. An adverse determination in litigation or interference proceedings to which we may become a party could subject us to significant liabilities to third parties, require us to license disputed rights from third parties, or require us to cease using the disputed technology. We are aware of a significant number of patents and patent applications relating to aspects of our technologies filed by, and issued to, third parties. Should any of our competitors have filed patent applications or obtain patents that claim inventions also claimed by us, we may have to participate in an interference proceeding declared by the relevant patent regulatory agency to determine priority of invention and, thus, the right to a patent for these inventions in the United States. Such a proceeding could result in substantial cost to us even if the outcome is favorable. Even if successful on priority grounds, an interference may result in loss of claims based on patentability grounds raised in the interference. Although patent and intellectual property disputes in the biotechnology area are often settled through licensing or similar arrangements, costs associated with these arrangements may be substantial and could include ongoing royalties. Furthermore, we cannot be certain that the necessary licenses would be available to us on satisfactory terms, if at all.

We also rely on trade secrets, technical know-how, and continuing invention to develop and maintain our competitive position. We have taken security measures to protect our trade secrets, proprietary know-how and technologies, and confidential data and continue to explore further methods of protection. Our policy is to execute confidentiality agreements with our employees and consultants upon the commencement of an employment or consulting arrangement with us. These agreements generally require that all confidential information developed or made known to the individual by us during the course of the individual’s relationship with us be kept confidential and not disclosed to third parties. These agreements also generally provide that inventions conceived by the individual in the course of rendering services to us shall be our exclusive property. There can be no assurance that proprietary information will not be disclosed, that others will not independently develop substantially equivalent proprietary information and techniques or otherwise gain access to our trade secrets, or that we can meaningfully protect our trade secrets.

As of December 31, 2002, we had 279 full-time employees, 86 of whom hold Ph.D. degrees. Of these employees, 228 were engaged in research and development and 51 were engaged in business development, finance and general administration. None of our employees are represented by labor unions or covered by collective bargaining agreements. We have not experienced any work stoppages and consider our employee relations to be good.

In February 2003, in conjunction with a series of transactions entered into with Syngenta Participations AG, we hired an additional 77 employees from Syngenta’s wholly-owned subsidiary, Torrey Mesa Research Institute. Of these employees, 71 were engaged in research and development and 6 were engaged in business development, finance and general administration.

We are subject to the information requirements of the Securities Exchange Act of 1934 (the “Exchange Act”). Therefore, we file periodic reports, proxy statements, and other information with the Securities and Exchange Commission (the “SEC”). Such reports, proxy statements, and other information may be obtained by visiting the Public Reference Room of the SEC at 450 Fifth Street, NW, Washington, DC 20549 or by calling the SEC at 1-800-SEC-0330. In addition, the SEC maintains an Internet site (http://www.sec.gov) that contains reports, proxy and information statements, and other information regarding issuers that file electronically.

Financial and other information about us is available on our website (http://www.diversa.com). We make available on our website, free of charge, copies of our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Exchange Act as soon as reasonably practicable after filing such material electronically or otherwise furnishing it to the SEC.

Except for the historical information contained or incorporated by reference herein, this annual report on Form 10-K and the information incorporated by reference contains forward-looking statements that involve risks and uncertainties. Our actual results may differ materially from those discussed here. Factors that could cause or contribute to differences in our actual results include those discussed in the following section, as well as those discussed in Part II, Item 7 entitled “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and elsewhere throughout this annual report. You should consider carefully the following risk factors, together with all of the other information included in this annual report on Form 10-K. Each of these risk factors could adversely affect our business, operating results and financial condition, as well as adversely affect the value of an investment in our common stock.

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

We have incurred net losses since our inception, including a net loss of approximately $28.0 million for the year ended December 31, 2002. As of December 31, 2002, we had an accumulated deficit of approximately $109.4 million. We expect to incur additional losses for at least the next two years as we continue to develop our technologies and fund internal product research and development. The extent of our future losses will depend, in part, on the rate of growth, if any, in our contract revenue and on the level of our expenses. To date, substantially all of our revenue has been derived from collaborations and grants, and we expect that substantially all of our revenue for 2003 will result from payments from collaborations and grants.

Future revenue from collaborations is uncertain because our ability to generate revenue will depend upon our ability to enter into new collaborations and to meet research, development, and commercialization objectives under new and existing agreements. We expect to spend significant amounts to fund research and development and enhance our core technologies. As a result, we expect that our operating expenses will increase in the near term, and, consequently, we will need to generate significant additional revenue to achieve profitability. In order for us to generate revenue, we must not only retain our existing collaborations and/or attract new ones and achieve milestones under them, but we must also develop products or technologies that our partners choose to commercialize and from which we can derive revenue through royalties. Even if we do achieve profitability, we may not be able to sustain or increase profitability on a quarterly or annual basis.

Because we are an early stage company developing and deploying new technologies, we may not be able to commercialize our technologies or products, which could cause us to be unprofitable or cease operations.

You must evaluate our business in light of the uncertainties and complexities affecting an early stage biotechnology company. Our existing proprietary technologies are new and in the early stage of development. We may not be successful in the commercial development of these or any further technologies or products. Successful products require significant development and investment, including testing, to demonstrate their cost-effectiveness prior to regulatory approval and commercialization. To date, we have commercialized only two products ourselves, Pyrolase^TM 160 enzyme and Pyrolase^TM 200 enzyme, and only two of our collaborative partners, Invitrogen Corporation and Danisco Animal Nutrition, have incorporated our technologies or inventions into their own commercial products from which we can generate royalties. Because of these uncertainties, our discovery process may not result in the identification of product candidates that we or our collaborative partners will successfully commercialize. If we are not able to use our technologies to discover new materials or products with significant commercial potential, we will not be able to achieve our objectives or build a sustainable or profitable business.

We are dependent on our collaborative partners, and our failure to successfully manage our existing and future collaboration relationships could prevent us from developing and commercializing many of our products and achieving or sustaining profitability.

We currently have strategic alliance agreements and/or collaboration agreements with The Dow Chemical Company, DuPont Bio-Based Materials, Givaudan Flavors Corporation, GlaxoSmithKline plc, Invitrogen Corporation, and affiliates of Syngenta AG. We have also formed a joint venture with Syngenta Seeds AG (named Zymetrics, Inc.). We expect to derive significant future revenue from these agreements and the joint venture. Since we do not currently possess the resources necessary to independently develop and commercialize all of the potential products that may result from our technologies, we expect to continue to enter into, and in the near-term derive additional revenue from, strategic alliance and collaboration agreements to develop and commercialize products. We will have limited or no control over the resources that any strategic partner or collaborator may devote to our products. Any of our present or future strategic partners or collaborators may fail to perform their obligations as expected. These strategic partners or collaborators may breach or terminate their agreements with us or otherwise fail to conduct their collaborative activities successfully and in a timely manner. We recently initiated informal dispute resolution proceedings with The Dow Chemical Company under our Innovase joint venture agreements. While we are seeking to enforce the terms of the Innovase joint venture agreements, including continuation of the related funding, there can be no assurances of the actual outcome of our informal dispute resolution procedures with Dow under the Innovase agreements or any arbitration that may occur and an adverse result, including a result awarding an amount less than what we believe we are entitled to receive in committed funding under the Innovase agreements, could have an adverse affect on our business. Further, our strategic partners or collaborators may not develop products arising out of our collaborative arrangements or devote sufficient resources to the development, manufacture, marketing, or sale of these products. If we fail to enter into or maintain strategic alliance or collaboration agreements, or if any of these events occur, we may not be able to commercialize our products, grow our business, or generate sufficient revenue to support our operations. Our present or future strategic alliance and collaboration opportunities could be harmed if:

Failure to retain former employees of Torrey Mesa Research Institute or attract and retain other key employees could diminish the benefits we expect to realize from our recent transactions with Syngenta Participations AG and Torrey Mesa Research Institute.

As part of the transactions among Syngenta Participations AG, or Syngenta, Torrey Mesa Research Institute, or TMRI, and us that were consummated on February 20, 2003, we hired 77 employees of TMRI. The success of our collaboration with Syngenta and the benefits that we otherwise expect to realize from our transactions with Syngenta and TMRI will depend significantly on our ability to retain these employees. If we are unable to retain these employees, or if we are otherwise unable to attract and retain other employees who may be critical to our collaboration with Syngenta or otherwise in connection with our transactions with Syngenta and TMRI, we could lose key information, expertise or know-how related to the collaboration, incur unanticipated additional recruiting and training costs and otherwise not realize the benefits we expect from those transactions.

If we are not successful in integrating TMRI’s intellectual property rights and related assets, some of the anticipated benefits to us of our recent transactions with Syngenta and TMRI may not be realized.

If we and our stockholders are to realize the anticipated benefits of our transactions with Syngenta and TMRI that were consummated on February 20, 2003, the intellectual property rights and related assets we licensed and acquired from Syngenta and TMRI must be integrated and combined efficiently with our own assets and operations. We cannot assure you that the integration will be successful or that we will realize the anticipated benefits of our transactions with Syngenta and TMRI. Similarly, we cannot assure you that our stockholders will realize greater value through our transactions with Syngenta and TMRI than they would have realized without them.

The difficulties of integration may be increased by the need to integrate personnel with disparate scientific, technical and business backgrounds and combine different corporate cultures and approaches. We cannot assure you that there will not be substantial costs associated with the integration process, that integration activities will not negatively impact our operating results or result in a decrease in the value of our common stock, or that there will not be other material adverse effects to our business or operations from our integration efforts.

We do not have the capacity to manufacture products on a commercial scale. If we are unable to access the capacity to manufacture products in sufficient quantity, we may not be able to commercialize our products or generate significant sales.

We have only limited experience in enzyme manufacturing, and we do not have our own capacity to manufacture products on a commercial scale. We expect to be dependent to a significant extent on third parties for commercial scale manufacturing of our products. We have arrangements with third parties that have the

required manufacturing equipment and available capacity to manufacture Pyrolase 160 enzyme, Pyrolase 200 enzyme, and Phyzyme^™ XP under our direction and oversight. While we have our own pilot development facility, we continue to depend on third parties for large-scale commercial manufacturing. Any difficulties or interruptions of service with our third party manufacturers or our own pilot manufacturing facility could disrupt our research and development efforts, delay our commercialization of products, and harm our relationships with our strategic partners, collaborators or customers.

We have only limited experience in independently developing, manufacturing, marketing, selling, and distributing commercial products.

We intend to pursue some product opportunities independently. We currently have only limited resources and capability to develop, manufacture, market, sell, or distribute products on a commercial scale. We will determine which products to pursue independently based on various criteria, including: investment required, estimated time to market, regulatory hurdles, infrastructure requirements, and industry-specific expertise necessary for successful commercialization. At any time, we may modify our strategy and pursue collaborations for the development and commercialization of some products that we had intended to pursue independently. We may pursue products that ultimately require more resources than we anticipate or which may be technically unsuccessful. In order for us to commercialize these products directly, we would need to establish or obtain through outsourcing arrangements the capability to develop, manufacture, market, sell, and distribute products. If we are unable to successfully commercialize products resulting from our internal product development efforts, we will continue to incur losses. Even if we successfully develop a commercial product, we may not generate significant sales and achieve profitability.

Ethical, legal, and social concerns about genetically engineered products could limit or prevent the use of our products and technologies and limit our revenue.

Some of our anticipated products are genetically engineered. If we and/or our collaborators are not able to overcome the ethical, legal, and social concerns relating to genetic engineering, our products may not be accepted. Any of the risks discussed below could result in expenses, delays, or other impediments to our programs or the public acceptance and commercialization of products dependent on our technologies or inventions. Our ability to develop and commercialize one or more of our technologies and products could be limited by the following factors:

The subject of genetically modified organisms has received negative publicity, which has aroused public debate. The adverse publicity could lead to greater regulation and trade restrictions on imports of genetically altered products.

If we are unable to continue to collect genetic material from diverse natural environments, our research and development efforts and our product development programs could be harmed.

We collect genetic material from organisms found in diverse environments. We collect material from government-owned land in foreign countries and in areas of the United States under formal resource access agreements, and from private lands under individual agreements with private landowners. If our access to materials under biodiversity access agreements or other arrangements is reduced or terminates, it could harm our internal and our collaborative research and development efforts. We also collect samples from other environments where agreements are currently not required, such as the deep sea. All of our agreements with foreign countries expire in 2007 or earlier, and they are all subject to earlier termination. We have voluntarily ceased collections of further samples in Yellowstone National Park pending the park’s resolution of collection guidelines.

Our ability to compete may decline if we do not adequately protect our proprietary technologies or if we lose some of our intellectual property rights due to becoming involved in expensive lawsuits or administrative proceedings.

Our success depends in part on our ability to obtain patents and maintain adequate protection of our other intellectual property for our technologies and products in the United States and other countries. The laws of some foreign countries do not protect proprietary rights to the same extent as the laws of the United States, and many companies have encountered significant problems in protecting their proprietary rights in these foreign countries. These problems can be caused by, for example, a lack of rules and methods for defending intellectual property rights.

Our commercial success depends in part on not infringing patents and proprietary rights of third parties, and not breaching any licenses or other agreements that we have entered into with regard to our technologies, products, and business. The patent positions of biotechnology companies, including our patent position, involve complex legal and factual questions and, therefore, enforceability cannot be predicted with certainty. We will apply for patents covering both our technologies and products as we deem appropriate. Patents, if issued, may be challenged, invalidated, or circumvented. We cannot be sure that relevant patents have not been issued that could block our ability to obtain patents or to operate as we would like. Others may develop similar technologies or duplicate technologies developed by us. There may be patents in some countries that, if valid, may block our ability to commercialize products in these countries if we are unsuccessful in circumventing or acquiring the rights to these patents. There also may be claims in published patent applications in some countries that, if granted and valid, may also block our ability to commercialize products in these countries if we are unable to circumvent or license them.

We are not currently a party to any litigation with regard to our patent position. However, the biotechnology industry is characterized by extensive litigation regarding patents and other intellectual property rights. Many biotechnology companies have employed intellectual property litigation as a way to gain a competitive advantage. If we became involved in litigation or interference proceedings declared by the United States Patent and Trademark Office, or oppositions or other intellectual property proceedings outside of the United States, to defend our intellectual property rights or as a result of alleged infringement of the rights of others, we might have to spend significant amounts of money. We are aware of a significant number of patents and patent applications relating to aspects of our technologies filed by, and issued to, third parties. Should any of our competitors have filed patent applications or obtained patents that claim inventions also claimed by us, we may have to participate in an interference proceeding declared by the relevant patent regulatory agency to determine priority of invention and, thus, the right to a patent for these inventions in the United States. Such a proceeding could result in substantial cost to us even if the outcome is favorable. Even if successful on priority grounds, an interference may result in loss of claims based on patentability grounds raised in the interference. The litigation or proceedings could divert our management’s time and efforts. Even unsuccessful claims could result in significant legal fees and other expenses, diversion of management time, and disruption in our business. Uncertainties resulting from initiation and continuation of any patent or related litigation could harm our ability to compete.

An adverse ruling arising out of any intellectual property dispute, including an adverse decision as to the priority of our inventions, would undercut or invalidate our intellectual property position. An adverse ruling could also subject us to significant liability for damages, prevent us from using processes or products, or require us to negotiate licenses to disputed rights from third parties. Although patent and intellectual property disputes in the biotechnology area are often settled through licensing or similar arrangements, costs associated with these arrangements may be substantial and could include ongoing royalties. Furthermore, necessary licenses may not be available to us on satisfactory terms, if at all.

We may encounter difficulties managing our growth, which could adversely affect our results of operations.

Our strategy includes entering into and working on simultaneous projects across multiple industries. We increased the average number of our full-time employees from 231 during 2001 to 278 during 2002. We expect to increase our headcount to meet our strategic objectives, and, in February 2003, in conjunction with a series of transactions entered into with Syngenta, we hired an additional 77 employees from TMRI. If our growth continues, it may continue to place a strain on us. Our ability to effectively manage our operations, growth, and various projects requires us to continue to improve our operational, financial and management controls, reporting systems and procedures and to attract and retain sufficient numbers of talented employees. We may not be able to successfully implement improvements to our management information and control systems in an efficient or timely manner. In addition, we may discover deficiencies in existing systems and controls.

Confidentiality agreements with employees and others may not adequately prevent disclosure of trade secrets and other proprietary information.

In order to protect our proprietary technology and processes, we also rely in part on trade secret protection for our confidential and proprietary information. We have taken security measures to protect our trade secrets and proprietary information. These measures may not provide adequate protection for our trade secrets or other proprietary information. Our policy is to execute confidentiality agreements with our employees and consultants upon the commencement of an employment or consulting arrangement with us. These agreements generally require that all confidential information developed by the individual or made known to the individual by us during the course of the individual’s relationship with us be kept confidential and not disclosed to third parties. These agreements also generally provide that inventions conceived by the individual in the course of rendering services to us shall be our exclusive property. There can be no assurance that proprietary information will not be disclosed, that others will not independently develop substantially equivalent proprietary information and techniques or otherwise gain access to our trade secrets, or that we can meaningfully protect our trade secrets. Costly and time-consuming litigation could be necessary to enforce and determine the scope of our proprietary rights, and failure to obtain or maintain trade secret protection could adversely affect our competitive business position.

Many potential competitors who have greater resources and experience than we do may develop products and technologies that make ours obsolete.

The biotechnology industry is characterized by rapid technological change, and the area of gene research is a rapidly evolving field. Our future success will depend on our ability to maintain a competitive position with respect to technological advances. Rapid technological development by others may result in our products and technologies becoming obsolete.

We face, and will continue to face, intense competition. We are not aware of another company that has the scope and integration of technologies and processes that we have. There are, however, a number of companies who compete with us in various steps throughout our technology process. For example, Cubist Pharmaceuticals, Inc. is involved in accessing organisms from diverse environments for pharmaceutical applications. A number of companies are performing high-throughput screening of molecules. Maxygen, Inc., Applied Molecular

Evolution, Inc., and Evotech have alternative evolution technologies. Integrated Genomics, Inc., Myriad Genetics, Inc., ArQule, Inc., and Vertex Pharmaceuticals (San Diego) LLC, formerly known as Aurora Biosciences Corporation, a subsidiary of Vertex Pharmaceuticals Inc., perform screening, sequencing, and/or bioinformatics services. Novozymes A/S and Genencor International, Inc. are involved in the development, overexpression, fermentation, and purification of enzymes. Abgenix, Inc. and Medarex, Inc. are involved in the development of human monoclonal antibodies. There are also a number of academic institutions involved in various phases of our technology process. Many of these competitors have significantly greater financial and human resources than we do. These organizations may develop technologies that are superior alternatives to our technologies. Further, our competitors may be more effective at implementing their technologies for modifying DNA to develop commercial products.

Any products that we develop through our technologies will compete in multiple, highly competitive markets. Many of our potential competitors in these markets have substantially greater financial, technical, and marketing resources than we do and may succeed in developing products that would render our products or those of our collaborators obsolete or noncompetitive. In addition, many of these competitors have significantly greater experience than we do in their respective fields. Our ability to compete successfully will depend on our ability to develop proprietary products that reach the market in a timely manner and are technologically superior to and/or are less expensive than other products on the market. Current competitors or other companies may develop technologies and products that are more effective than ours. Our technologies and products may be rendered obsolete or uneconomical by technological advances or entirely different approaches developed by one or more of our competitors. The existing approaches of our competitors or new approaches or technology developed by our competitors may be more effective than those developed by us.

Stringent laws and required government approvals could delay our introduction of products.

All phases, especially the field testing, production, and marketing, of our potential products are subject to significant federal, state, local, and/or foreign governmental regulation. Regulatory agencies may not allow us to produce and/or market our products in a timely manner or under technically or commercially feasible conditions, or at all, which could harm our business.

In the United States, products for our target markets are regulated based on their application, by either the Food and Drug Administration, or FDA, the Environmental Protection Agency, or EPA, or, in the case of plants and animals, the United States Department of Agriculture, or USDA. The FDA regulates drugs, food, and feed, as well as food additives, feed additives, and substances generally recognized as safe that are used in the processing of food or feed. While substantially all of our projects to date have focused on non-human applications of our technologies and products outside of the FDA’s review, in the future we may pursue collaborations for further research and development of drug products for humans that would require FDA approval before they could be marketed in the United States. In addition, any drug product candidates must also be approved by the regulatory agencies of foreign governments before any product can be sold in those countries. Under current FDA policy, our products, or products of our collaborative partners incorporating our technologies or inventions, to the extent that they come within the FDA’s jurisdiction, may be subject to lengthy FDA reviews and unfavorable FDA determinations if they raise safety questions which cannot be satisfactorily answered, if results from pre-clinical or clinical trials do not meet regulatory requirements or if they are deemed to be food additives whose safety cannot be demonstrated. An unfavorable FDA ruling could be difficult to resolve and could prevent a product from being commercialized. Even after investing significant time and expenditures, we may not obtain regulatory approval for any drug products. We have not submitted an investigational new drug application for any product candidate, and no drug product candidate developed with our technologies has been approved for commercialization in the United States or elsewhere. The EPA regulates biologically derived chemical substances not within the FDA’s jurisdiction. An unfavorable EPA ruling could delay commercialization or require modification of the production process resulting in higher manufacturing costs, thereby making the product uneconomical. In addition, the USDA may prohibit genetically engineered plants from being grown and transported except under an exemption, or under controls so burdensome that commercialization becomes impracticable. Our future products may not be exempted by the USDA.

The European regulatory process for these classes of biologically derived products has been in a state of flux in the recent past, as the EU attempts to replace country by country regulatory procedures with a consistent EU regulatory standard in each case. Some country-by-country regulatory oversight remains. Other than Japan, most other regions of the world generally find adequate either a United States or a European clearance together with associated data and information for a new biologically derived product.

If we require additional capital to fund our operations, we may need to enter into financing arrangements with unfavorable terms or which could adversely affect the ownership interest and rights of our common stockholders as compared to our other stockholders. If such financing is not available, we may need to cease operations.

We currently anticipate that our available cash resources, short-term investments, receivables, and committed funding from collaborative partners will be sufficient to meet our capital requirements for the foreseeable future.

If additional capital is required to operate our business, we cannot assure you that additional financing will be available on terms favorable to us, or at all. If adequate funds are not available or are not available on acceptable terms, our ability to fund our operations, take advantage of opportunities, develop products or technologies, or otherwise respond to competitive pressures could be significantly limited. In addition, if financing is not available, we may need to cease operations.

If we raise additional funds through the issuance of equity securities, the percentage ownership of our stockholders will be reduced, stockholders may experience additional dilution or such equity securities may provide for rights, preferences or privileges senior to those of the holders of our common stock. If we raise additional funds through the issuance of debt securities, such debt securities would have rights, preferences and privileges senior to holders of common stock and the terms of such debt could impose restrictions on our operations.

We expect that our quarterly results of operations will fluctuate, and this fluctuation could cause our stock price to decline, causing investor losses.

Our quarterly operating results have fluctuated in the past and are likely to do so in the future. These fluctuations could cause our stock price to fluctuate significantly or decline. For example, our revenue for the quarter ended December 31, 2002 was $9.1 million, as compared to $10.0 million for the quarter ended December 31, 2001. Revenue in future periods may be greater or less than revenue in the immediately preceding period or in the comparable period of the prior year. Some of the factors that could cause our operating results to fluctuate include:

If revenue declines or does not grow as anticipated due to the expiration of strategic alliance or collaboration agreements, failure to obtain new agreements or grants, lower than expected royalty payments, or other factors, we may not be able to correspondingly reduce our operating expenses. A large portion of our expenses, including expenses for facilities, equipment and personnel, are relatively fixed. In addition, we plan to significantly increase operating expenses during 2003. Failure to achieve anticipated levels of revenue could therefore significantly harm our operating results for a particular fiscal period.

Due to the possibility of fluctuations in our revenue and expenses, we believe that quarter-to-quarter comparisons of our operating results are not a good indication of our future performance. Our operating results in some quarters may not meet the expectations of stock market analysts and investors. In that case, our stock price would probably decline.

If we lose our key personnel or are unable to attract and retain qualified personnel as necessary, it could delay our product development programs and harm our research and development efforts.

Our success depends to a significant degree upon the continued contributions of our executive officers, management, and scientific staff. If we lose the services of one or more of these people, we may be unable to achieve our business objectives or our stock price could decline. We may not be able to attract or retain qualified employees in the future due to the intense competition for qualified personnel among biotechnology and other technology-based businesses, particularly in the San Diego area. If we are not able to attract and retain the necessary personnel to accomplish our business objectives, we may experience constraints that will adversely affect our ability to meet the demands of our collaborative partners in a timely fashion or to support our internal research and development programs. In particular, our product development programs depend on our ability to attract and retain highly skilled scientists, including molecular biologists, biochemists, and engineers. Although we believe we will be successful in attracting and retaining qualified personnel, competition for experienced scientists and other technical personnel from numerous companies and academic and other research institutions may limit our ability to do so on acceptable terms. All of our employees are at-will employees, which means that either the employee or we may terminate their employment at any time.

Our planned activities will require additional expertise in specific industries and areas applicable to the products developed through our technologies. These activities will require the addition of new personnel, including management, and the development of additional expertise by existing management personnel. The inability to acquire these services or to develop this expertise could impair the growth, if any, of our business.

If we engage in any additional acquisitions, we will incur a variety of costs and may potentially face numerous other risks that could adversely affect our business operations.

We recently consummated a series of transactions with Syngenta and TMRI that involved, in part, our acquiring certain property and equipment from TMRI. If appropriate opportunities become available, we may consider acquiring additional businesses, assets, technologies, or products that we believe are a strategic fit with our business. We currently have no commitments or agreements with respect to any material acquisitions. If we do pursue such a strategy, we could

We may not be able to successfully integrate any businesses, assets, products, technologies, or personnel that we might acquire in the future without a significant expenditure of operating, financial, and management resources, if at all. In addition, future acquisitions might negatively impact our business relations with our collaborative partners. Further, recent accounting changes could result in a negative impact on our results of operations as well as the resulting cost of the acquisition. Any of these adverse consequences could harm our business.

We may be held liable if any product we develop, or any product which is made with the use of any of our technologies, causes injury or is found otherwise unsuitable during product testing, manufacturing, marketing, or sale. We currently have limited product liability insurance that may not fully cover our potential liabilities. In addition, if we attempt to obtain additional product liability insurance coverage, this additional insurance may be prohibitively expensive, or may not fully cover our potential liabilities. Inability to obtain sufficient insurance coverage at an acceptable cost or otherwise to protect against potential product liability claims could prevent or inhibit the commercialization of products developed by us or our collaborative partners. If we are sued for any injury caused by our products, our liability could exceed our total assets.

We are subject to anti-takeover provisions in our certificate of incorporation, bylaws, and Delaware law and have adopted a shareholder rights plan that could delay or prevent an acquisition of our company, even if the acquisition would be beneficial to our stockholders.

Provisions of our certificate of incorporation, our bylaws and Delaware law could make it more difficult for a third party to acquire us, even if doing so would be beneficial to our stockholders. In addition, we adopted a share purchase rights plan that has anti-takeover effects. The rights under the plan will cause substantial dilution to a person or group that attempts to acquire us on terms not approved by our board of directors. The rights should not interfere with any merger or other business combination approved by our board, since the rights may be amended to permit such an acquisition or may be redeemed by us. These provisions in our charter documents, under Delaware law, and in our rights plan could discourage potential take-over attempts and could adversely affect the market price of our common stock. Because of these provisions, our common stockholders might not be able to receive a premium on their investment.

Our stock price has been and may continue to be particularly volatile because of the industry we are in.

The stock market, from time to time, has experienced significant price and volume fluctuations that are unrelated to the operating performance of companies. The market prices of technology companies, particularly life science companies, have been highly volatile. Our stock has been and may continue to be affected by this type of market volatility, as well as by our own performance. The following factors, among other risk factors, may have a significant effect on the market price of our common stock:

Concentration of ownership among our existing officers, directors and principal stockholders may prevent other stockholders from influencing significant corporate decisions and depress our stock price.

Our officers, directors, and stockholders with at least 5% of our stock together controlled approximately 41.8% of our outstanding common stock as of March 20, 2003. If these officers, directors, and principal stockholders act together, they will be able to exert a significant degree of influence over our management and affairs and over matters requiring stockholder approval, including the election of directors and approval of mergers or other business combination transactions. In addition, as of March 20, 2003, Syngenta and its affiliates controlled approximately 19% of our outstanding common stock, and by themselves will be able to exert a significant degree of influence over our management and affairs and over matters requiring stockholder approval. The interests of this concentration of ownership may not always coincide with our interests or the interests of other stockholders. For instance, officers, directors, and principal stockholders, acting together, could cause us to enter into transactions or agreements that we would not otherwise consider. Similarly, this concentration of ownership may have the effect of delaying or preventing a change in control of our company otherwise favored by our other stockholders. This concentration of ownership could depress our stock price.

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

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

Our executive offices and research and development facilities are currently located in adjacent 75,000 and 60,000 square foot buildings in San Diego, California. The facilities are leased through November 2015 and March 2017, respectively. In March 2002, we entered into an agreement to sublease approximately 27,000 square feet of our 60,000 square foot facility. The sublease was effective April 1, 2002 and will continue for a period of three years with an option that the sublessee may exercise for an additional year. We believe that our current facilities are adequate to meet our requirements.

On or about December 6, 2002, a lawsuit was filed in the U.S. District Court for the Southern District of New York against us, two of our executive officers, the chairman of our board of directors, and the underwriters of our initial public offering of common stock. The complaint is purportedly filed on behalf of purchasers of our common stock between February 14, 2000 and December 6, 2000, and alleges claims under Sections 11 and 15 of the Securities Act of 1933 and Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 and Rule 10b-5 promulgated thereunder. The complaint is among the so-called “laddering” cases that have been commenced against many companies that had public offerings of securities prior to or during December 2000, and the complaint has been transferred to the District Court Judge who is handling the ongoing litigation against over 300 companies involving complaints of a similar nature. Those complaints are being coordinated as part of one proceeding denominated In re Initial Public Offering Securities Litigation. Among other allegations, the complaint alleges that, in connection with our February 14, 2000 initial public offering, the defendant underwriters conditioned share allocations on customers agreeing to purchase additional shares in the aftermarket at pre-arranged prices and/or to pay the underwriters excessive and undisclosed compensation representing a material portion of the customers’ profits from aftermarket sales of their initial public offering share allocations. The complaint alleges that the failure to disclose these alleged arrangements made our registration statement for our initial public offering and the related prospectus materially false and misleading. The complaint, which seeks unspecified damages, asserts claims under the Securities Act Sections 11 and 15 and Exchange Act Sections 10(b) and 20.

On February 19, 2003, the District Court decided several motions to dismiss in In re Initial Public Offering Securities Litigation that were filed before the complaint was filed against us. Nevertheless, as part of its decision, the District Court dismissed the Exchange Act Section 10(b) claims against us, one of our executives and the chairman of our board of directors, and dismissed the Exchange Act Section 20 claims in their entirety. The District Court, however, did not dismiss the Securities Act Sections 11 and 15 claims as against any of the defendants named in the complaint.

We strongly deny any liability in connection with this lawsuit and intend to vigorously defend against it. We have notified our insurance carriers of the lawsuit, and are requesting indemnification and/or contribution from the underwriters of our initial public offering of common stock.

No matters were submitted to a vote of security holders during the quarter ended December 31, 2002.

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

(a) Our common stock is traded on the Nasdaq National Market under the symbol DVSA. The following table sets forth the high and low sale prices for our common stock for the periods indicated, as reported on the Nasdaq National Market. Such quotations represent inter-dealer prices without retail markup, markdown, or commission and may not necessarily represent actual transactions.

As of March 20, 2003, there were approximately 203 holders of record of our common stock. We have never declared or paid any cash dividends on our capital stock. On March 20, 2003, the last sale price reported on the Nasdaq National Market for our common stock was $9.33 per share. We currently intend to retain future earnings, if any, for development of our business and, therefore, do not anticipate that we will declare or pay cash dividends on our capital stock in the foreseeable future.

(b) The effective date of our first registration statement, filed on Form S-1 under the Securities Act (No. 333-92853) relating to our initial public offering of common stock, was February 11, 2000. In addition, in accordance with Rule 462(b) under the Securities Act, we filed a subsequent registration statement on Form S-1 (No. 333-30290) that related to the first registration statement that we had filed for our initial public offering of common stock, and the effective date of that subsequent registration statement was February 14, 2000. Under the two registration statements, we sold a total of 8,337,500 shares of our common stock at a price of $24.00 per share to an underwriting syndicate led by Bear, Stearns & Co. Inc., Chase H&Q, and Deutsche Banc Alex. Brown. Of these 8,337,500 shares, 1,087,500 were issued upon exercise of the underwriters’ over-allotment option. The initial public offering resulted in gross proceeds of $200.1 million, $14.0 million of which was applied toward the underwriting discount. Expenses related to the offering totaled approximately $1.6 million. Net proceeds to us were approximately $184.5 million. From the time of receipt through December 31, 2002, approximately $17.7 million of the net proceeds had been used to purchase property and equipment and approximately $3.7 million had been used for general corporate purposes. The balance is invested in cash equivalents and short-term investments.

For information concerning prior stockholder approval of and other matters relating to our equity incentive plans, see Part III, Item 12 entitled “Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters” in this annual report on Form 10-K.

The selected financial data set forth below with respect to our statements of operations for the years ended December 31, 2002, 2001, and 2000, and with respect to our balance sheets at December 31, 2002 and 2001 are derived from our financial statements that have been audited by Ernst & Young LLP, which are included elsewhere in this report, and are qualified by reference to such financial statements. The statement of operations data for the years ended December 31, 1999 and 1998 and the balance sheet data as of December 31, 2000, 1999, and 1998 are derived from our audited financial statements that are not included in this report. The selected financial information set forth below should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our financial statements and related notes appearing elsewhere in this report.

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion of our financial condition and results of operations should be read in conjunction with the financial statements and the notes to those statements included elsewhere in this report.

Except for the historical information contained herein, the following discussion contains forward-looking statements that involve risks and uncertainties. These statements speak only as of the date on which they are made, and we undertake no obligation to update any forward-looking statement. Forward-looking statements include statements related to investments in our core technologies, investments in our internal product candidates, our future net losses, and our future capital requirements, all of which are prospective. Such statements are only predictions, and the actual events or results may differ materially from those projected in the forward-looking statements. Factors that could cause or contribute to differences include, but are not limited to, risks involved with our new and uncertain technologies, risks associated with our dependence on patents and proprietary rights, risks associated with our protection and enforcement of our patents and proprietary rights, our dependence on existing collaborations, our ability to enter into and/or maintain collaboration and joint venture agreements, our ability to commercialize products directly and through our collaborators, the timing of anticipated product launches, and the development or availability of competitive products or technologies, as well as other risks and uncertainties set forth below and in the section of this report entitled “Risk Factors Related to Our Business.”

We were incorporated in December 1992 and began operations in May 1994. We are a leader in applying proprietary genomic technologies for the rapid discovery and optimization of novel products from genes and gene pathways. We are directing our integrated portfolio of technologies to the discovery, evolution, and production of commercially valuable molecules with pharmaceutical applications, such as monoclonal antibodies and orally active drugs, as well as enzymes and small molecules with agricultural, chemical, and industrial applications. We have formed alliances with market leaders, such as The Dow Chemical Company, DuPont Bio-Based Materials, GlaxoSmithKline plc, Invitrogen Corporation, and affiliates of Syngenta AG. Our product-related revenues to date are comprised of research kits, enzymes used in oil and gas recovery, and royalties from sales of licensed products.

We have dedicated substantial resources to the development of our proprietary technologies, which include capabilities for sample collection from the world’s microbial populations, generation of environmental libraries and human antibody gene libraries, screening of these libraries using ultra high-throughput methods capable of analyzing more than one billion genes per day, and optimization based on our gene evolution technologies.

For the year ended December 31, 2002, revenue decreased 12% compared to the year ended December 31, 2001. The decrease in revenue was primarily due to lower research funding received as a result of the timing and number of research projects under our collaboration agreements. Our revenues have historically fluctuated from period to period and likely will continue to fluctuate substantially in the future based upon the timing and composition of funding under existing and future collaboration agreements and grants. Our strategic partners often pay us before we recognize the revenue, and these payments are deferred until earned. As of December 31, 2002, we had current and long-term deferred revenue totaling $12.1 million.

We have incurred net losses since our inception. As of December 31, 2002, our accumulated deficit was $109.4 million. We expect to incur additional losses over at least the next two years as we continue to develop our technologies and fund internal research and development efforts. Our results of operations have fluctuated from period to period and likely will continue to fluctuate substantially in the future based upon the factors affecting our revenue described above, as well as the initiation and expansion of research and development

programs and the acquisition of new technologies and proprietary rights. Results of operations for any period may be unrelated to results of operations for any other period. In addition, we believe that our historical results are not a good indicator of our future operating results.

Our revenue decreased $4.3 million to $31.7 million for the year ended December 31, 2002 from $36.0 million for the year ended December 31, 2001. This decrease was primarily due to lower research funding received as a result of the timing and number of research projects under our collaboration agreements. Collaborative revenue accounted for 96% of total revenue for the year ended December 31, 2002 and 97% of total revenue for the year ended December 31, 2001. We expect our revenue to increase significantly in 2003 as a result of our recent research collaboration with Syngenta under which we are entitled to receive a minimum of $118 million in research and development funding over the initial seven-year term of the related research collaboration agreement, and will be eligible to receive certain milestone payments and royalties upon product development and commercialization.

Research and development expenses consist primarily of costs associated with internal development of our technologies and our product candidates and costs associated with research activities performed on behalf of our collaborators. We track our researchers’ time by project. However, we generally do not track our other research and development costs by project; rather, we track such costs by the type of cost incurred.

For the year ended December 31, 2002, we estimate that approximately 50% of our research and development expenditures was spent on research activities funded by our collaborators and that 50% was spent on internal product and technology development. Our research and development expenses increased $2.1 million to $50.3 million for the year ended December 31, 2002 from $48.2 million for the year ended December 31, 2001. The increase was primarily due to the net effect of the following costs:

Personnel Costs. Costs for research and development personnel for the year ended December 31, 2002 increased by $2.5 million over the year ended December 31, 2001. Our research staff increased from an average of 189 for the year ended December 31, 2001 to an average of 227 for the year ended December 31, 2002. The increase in staff was primarily to support our internal investment in two distinct pharmaceutical platforms, our small molecule program and our protein therapeutic/antibody program.

Research Supplies. Costs for research supplies for the year ended December 31, 2002 decreased by $1.9 million compared to the year ended December 31, 2001. The decrease was primarily attributable to cost savings realized as a result of discount and inventory stocking programs implemented with suppliers.

Facility Costs. Facility costs for the year ended December 31, 2002 increased $3.3 million over the year ended December 31, 2001. The increase was primarily attributable to higher depreciation and maintenance costs as a result of increased capital equipment to support our internal product and technology development, as well as costs related to our second research and development facility, which we occupied in April 2002.

Outside Services. Outside service costs for the year ended December 31, 2002 decreased $1.0 million compared to the year ended December 31, 2001. The decrease was primarily attributable to lower sequencing costs as a result of our increased internal sequencing capabilities, as well as decreased costs associated with contract employees.

Research and development expenses for the years ended December 31, 2002 and 2001 are net of non-cash stock-based compensation charges of $0.2 million and $0.4 million, respectively. We expect our research and development expenses to increase significantly in 2003 as we hired an additional 77 employees in conjunction with the transactions that we completed with Syngenta in February 2003.

Our selling, general and administrative expenses increased $0.2 million to $10.3 million for the year ended December 31, 2002 from $10.1 million for the year ended December 31, 2001. This increase was primarily attributable to the expansion of business development activities to focus on identifying and entering into new collaborations. Selling, general and administrative expenses for the years ended December 31, 2002 and 2001 are net of non-cash, stock-based compensation charges of $0.5 million and $2.1 million, respectively.

Deferred compensation for options granted to employees has been determined as the difference between the exercise price and the fair value of our common stock, as estimated by us for financial reporting purposes, on the date such options were granted. Deferred compensation for options granted to consultants has been determined in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 123, Accounting for Stock-Based Compensation, as the fair value of the equity instruments issued and is periodically remeasured as the underlying options vest.

For the year ended December 31, 2002, we recorded amortization of deferred compensation of approximately $0.6 million compared to $1.4 million for the year ended December 31, 2001. We also recorded aggregate non-cash compensation charges of $0.1 million and $1.1 million for the years ended December 31, 2002 and 2001, respectively, for stock options granted to consultants.

Interest income on cash and short-term investments was $6.5 million for the year ended December 31, 2002 compared to $10.9 million for the year ended December 31, 2001. The decrease was primarily due to a decline in short-term interest rates and, to a lesser extent, lower cash balances. Also included in interest income for the year ended December 31, 2001 was $0.8 million of amortization related to the discount on a receivable that was collected in June 2001. Interest expense was $1.5 million and $1.2 million for the years ended December 31, 2002 and 2001, respectively. The increase in interest expense was due to interest on increased borrowings under our equipment financing lines of credit.

We recorded other expense of $0.8 million for the year ended December 31, 2002 compared to other income of $0.5 million for the same period in 2001. The increase in other expense was related to the $0.9 million write-off of our investment in warrants we hold to purchase 700,000 shares of stock of IntraBiotics Pharmaceuticals, Inc. as a result of a significant decline in the market value for IntraBiotics Pharmaceuticals, Inc.’s common stock.

We are required to fund certain operating expenses of Innovase LLC, our industrial enzyme joint venture with The Dow Chemical Company (“Dow”) formed in June 2000. Our share of the net income or loss of Innovase LLC, excluding certain expenses for which Dow is solely responsible under the joint venture agreement, is recorded utilizing the equity method of accounting. We recorded equity in the loss of Innovase LLC in the amount of $2.5 million for the year ended December 31, 2002 compared to $1.8 million for the same period in 2001. The increase is primarily due to increased marketing and administrative costs incurred by Innovase LLC.

Costs related to Zymetrics, Inc., our contract joint venture with Syngenta Seeds AG, are recorded as selling, general and administrative expense as incurred, as we do not have an ownership interest in Zymetrics, Inc.

For the years ended December 31, 2002 and 2001, we incurred net operating losses and, accordingly, did not record a provision for income taxes. As of December 31, 2002, we had federal net operating loss carryforwards of approximately $79.5 million, which begin to expire in 2011 unless utilized. The net operating loss carryforwards for state tax purposes were approximately $40.5 million, which will begin to expire in 2006 unless utilized. We also had federal and state tax credit carryforwards of approximately $2.9 million and $1.9 million, respectively, which begin to expire in 2011 unless utilized. Our utilization of the net operating losses and credits may be subject to substantial annual limitations pursuant to Section 382 of the Internal Revenue Code, and similar state provisions, as a result of changes in our ownership structure. The annual limitations may result in the expiration of a portion of our net operating loss carryforwards and credits prior to utilization.

Our revenue increased $11.7 million to $36.0 million for the year ended December 31, 2001 from $24.3 million for the year ended December 31, 2000. This increase was primarily attributable to additional research funding received under our collaborative agreements as well as $2.4 million in milestone and non-recurring payments. Collaborative revenue accounted for 97% of total revenue for the year ended December 31, 2001 and 94% of total revenue for the year ended December 31, 2000.

For the year ended December 31, 2001, we estimate that approximately 60% of our research and development expenditures was spent on research activities funded by our collaborators and that 40% was spent on internal product and technology development. Our research and development expenses increased $21.8 million to $48.2 million for the year ended December 31, 2001 from $26.4 million for the year ended December 31, 2000. The increase was primarily due to costs associated with the following:

Personnel Costs. Costs for research and development personnel for the year ended December 31, 2001 increased by $6.8 million over the year ended December 31, 2000. Our research staff increased from 163 at December 31, 2000 to 226 at December 31, 2001. The increase in staff was to support the increased level of funded research activities as well as our internal investment in two distinct pharmaceutical platforms, our small molecule program and our protein therapeutic/antibody program.

Research Supplies. Costs for research supplies for the year ended December 31, 2001 increased by $2.3 million over the year ended December 31, 2000. The increase in supplies was due to the increase in our staffing as well as the development of internal technologies that utilize an increased amount of supplies.

Facility Costs. Facility costs for the year ended December 31, 2001 increased $7.0 million over the year ended December 31, 2000. The increase was primarily attributable to higher rent, utilities, and depreciation as a result of our move into a larger facility in November 2000 to accommodate our headcount growth.

Outside Services. Outside service costs for the year ended December 31, 2001 increased $1.8 million over the year ended December 31, 2000. The increase was primarily attributable to increased legal costs associated with expanding our intellectual property portfolio, as well as increased costs associated with contract employees.

Research and development expenses for the years ended December 31, 2001 and 2000 are net of non-cash stock-based compensation charges of $0.4 million and $2.1 million, respectively.

Our selling, general and administrative expenses increased $3.0 million to $10.1 million for the year ended December 31, 2001 from $7.1 million for the year ended December 31, 2000. This increase was primarily attributable to the expansion of our business development and marketing activities to support the advancement of our products towards commercialization. Additionally, administrative infrastructure costs increased as a result of our growth over the prior year. Selling, general and administrative expenses for the years ended December 31, 2001 and 2000 are net of non-cash, stock-based compensation charges of $2.1 million and $7.7 million, respectively.

For the year ended December 31, 2001, we recorded amortization of deferred compensation of approximately $1.4 million compared to $3.4 million for the year ended December 31, 2000. We also recorded aggregate non-cash compensation charges of $1.1 million and $2.4 million for the years ended December 31, 2001 and 2000, respectively, for common stock, stock options, and warrants granted to consultants. For the year ended December 31, 2000, we also recorded $4.1 million in non-cash compensation in conjunction with the acceleration of vesting for stock options held by certain employees.

Interest income on cash and short-term investments was $10.9 million for the year ended December 31, 2001 compared to $11.7 million for the year ended December 31, 2000. The decrease was due to a decline in short-term interest rates. Also included in interest income for the year ended December 31, 2001 was $0.8 million of amortization related to the discount on a receivable that was collected in June 2001. Interest expense was $1.2 million and $0.6 million for the years ended December 31, 2001 and 2000, respectively. The increase in interest expense was due to interest on borrowings under our equipment financing line of credit.

We recorded other income of $484,000 for the year ended December 31, 2001 compared to other expense of $34,000 for the same period in 2000. The increase in other income was due to an increase in the value of warrants that we hold to purchase 700,000 shares of stock of IntraBiotics Pharmaceuticals, Inc. During 2002, we wrote off the remaining value of these warrants due to a significant decline in the market value for IntraBiotics Pharmeceuticals, Inc.’s common stock.

We recorded equity in the loss of Innovase LLC in the amount of $1.8 million for the year ended December 31, 2001 compared to $76,000 for the same period in 2000. The increase was primarily due to personnel and regulatory costs incurred by Innovase LLC.

For the year ended December 31, 2001, we incurred a net operating loss and, accordingly, did not record a provision for income taxes. For the year ended December 31, 2000, we recorded no provision for income taxes, as we utilized approximately $7.1 million and $6.7 million in federal and state net operating loss carryforwards, respectively, to offset taxable income resulting from up-front payments received from our collaborators.

Since inception, we have financed our business primarily through the sale of common and preferred stock and funding from strategic partners and government grants. Our strategic partners have provided us with $111.0 million in funding from our inception through December 31, 2002, and, including our most recent collaboration with Syngenta Participations AG which became effective in February 2003, are also committed to fund at least an additional $154.7 million through 2010 subject to our performance under existing agreements, excluding milestone payments, license and commercialization fees, and royalties or profit sharing. As previously discussed, we are in informal dispute resolution proceedings with The Dow Chemical Company under our Innovase joint venture agreements. For more information concerning these informal dispute resolution proceedings with The Dow Chemical Company under our Innovase joint venture agreements, see Part I, Item 1, entitled “Business—Current Alliances And Other Agreements” in this annual report on Form 10-K.

As of December 31, 2002, we had cash, cash equivalents, and short-term investments of approximately $163.1 million. Our short-term investments as of such date consisted of U.S. Treasury and government agency obligations and investment-grade corporate obligations. Historically, we have funded our capital equipment purchases through available cash, capital leases and equipment financing line of credit agreements. In December 2002, we entered into a new equipment financing line of credit with a lender to finance up to $6.0 million in equipment purchases through June 2003. As of December 31, 2002, we had $3.6 million available under the existing arrangement.

During 2002, we entered into a manufacturing agreement with a company to provide us with commercial quantities of certain enzyme products. Under the terms of the agreement, we are required to fund certain equipment required for fermentation and downstream processing of the products. As of December 31, 2002, we had incurred costs of approximately $1.1 million for equipment related to the manufacturing agreement. During 2003, we anticipate funding approximately $0.9 million in additional equipment costs related to the manufacturing agreement. Additionally, as we continue to develop our pharmaceutical platforms, we will be required to purchase additional capital equipment. During 2003, we anticipate that we will purchase approximately $2.5 million of equipment related to the development of our pharmaceutical platforms.

In February 2003, in conjunction with a series of transactions entered into with Syngenta, we hired an additional 77 employees. We anticipate the cost of capital equipment required to integrate these employees, as well as the cost of equipment required to support the ongoing needs of our existing employees, will be approximately $6.0 million in 2003.

We anticipate funding our capital requirements in 2003 through our existing line of credit, with new financing arrangements, if available on satisfactory terms, and with available cash.

Our operating activities used cash of $22.7 million for the year ended December 31, 2002 compared to $9.3 million in the year ended December 31, 2001. Our cash used by operating activities consisted primarily of cash used to fund operations.

Our investing activities used cash of $29.9 million for the year ended December 31, 2002 primarily to purchase short-term investments and property and equipment. For the year ended December 31, 2001, our investing activities provided cash of $8.1 million primarily from the sales and maturities of short-term investments.

Our financing activities provided cash of $3.3 million for the year ended December 31, 2002 compared to $8.2 million for the year ended December 31, 2001. Our financing activities consisted primarily of borrowings

under notes payable and proceeds from the sale of common stock under our Employee Stock Purchase Plan and from the exercise of stock options, partially offset by payments on notes payable.

The following table summarizes our contractual obligations at December 31, 2002.

We expect that our current cash and cash equivalents, short-term investments, and funding from existing collaborations and grants will be sufficient to fund our working and other capital requirements for the foreseeable future, including amounts required to fund internal research and development and enhancements of our core technologies as well as the potential costs of acquiring businesses, technologies, or products that we believe are a strategic fit with our business. In particular, we are evaluating acquisition opportunities that represent a strategic fit to our anti-infectives focus, or would allow us to expand our capabilities further downstream in the drug development process. This estimate is a forward-looking statement that involves risks and uncertainties. Our future capital requirements and the adequacy of our available funds will depend on many factors, including scientific progress in our research and development programs, the magnitude of those programs, our ability to maintain our collaborations and achieve milestones under them and our ability to establish new collaborative relationships, our ability, alone or with our collaborative partners, to commercialize products successfully, and competing technological and market developments. Therefore, it is possible that we may seek additional financing in the future, whether through private or public equity offerings, debt financings, or collaborations, which may not be available on terms favorable to us, if at all. In addition, if we enter into financing arrangements in the future, such arrangements could dilute our stockholders’ ownership interests and adversely affect their rights.

Our discussion and analysis of our financial condition and results of operations is based upon our financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires management to make estimates and judgments that affect the reported amounts of assets, liabilities, revenue and expenses, and related disclosures. On an ongoing basis, we evaluate these estimates, including those related to revenue recognition, long-lived assets, accrued liabilities, and income taxes. These estimates are based on historical experience, information received from third parties, and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

We believe the following critical accounting policies affect the significant judgments and estimates used in the preparation of our financial statements.

Revenue from research funding under our collaboration agreements is earned and recognized on a percentage of completion basis as research hours are incurred in accordance with the provisions of each

agreement. Fees received to initiate research projects are deferred and recognized over the project period. Fees received for exclusivity in a field are deferred and recognized over the period of exclusivity. Milestone payments are recognized when earned, as evidenced by written acknowledgement from the collaborator, provided that (i) the milestone event is substantive and its achievement was not reasonably assured at the inception of the agreement, and (ii) our performance obligations after the milestone achievement will continue to be funded by the collaborator at a level comparable to the level before the milestone achievement. Revenue from exclusivity fees, technology development fees, milestone payments, and research activities performed on behalf of our joint ventures is included in “Collaborative” revenue in our Statements of Operations. The percentage of completion basis of accounting requires us to estimate the number of hours remaining to complete each of our research projects under our collaborative agreements. Actual results could differ from those estimates, which may affect the timing of the revenue we record from period to period.

We review long-lived assets, including leasehold improvements, property and equipment, and acquired technology rights for impairment whenever events or changes in business circumstances indicate that the carrying amount of the assets may not be fully recoverable. This requires us to estimate future cash flows related to these assets. Actual results could differ from those estimates, which may affect the carrying amount of assets and the related amortization expense. As of December 31, 2002, we had long-lived assets with a net book value of $29.4 million.

We record a valuation allowance to reduce our deferred tax assets to the amount that is more likely than not to be realized. While we have considered future taxable income and ongoing tax planning strategies in assessing the need for the valuation allowance, in the event we were to determine that we would be able to realize our deferred tax assets in the future in excess of their net recorded amounts, an adjustment to the deferred tax assets would increase our income in the period such determination was made. Likewise, should we determine that we would not be able to realize all or part of our net deferred tax assets in the future, an adjustment to the deferred tax assets would be charged to income in the period such determination was made. As of December 31, 2002, we had $41.3 million in gross deferred tax assets, which were fully offset by a valuation allowance.

In June 2002, the Financial Accounting Standards Board (“FASB”) issued FASB Statement No. 146 (“SFAS 146”), Accounting for Costs Associated with Exit or Disposal Activities. SFAS 146 requires that we record 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 has been incurred. SFAS 146 will be effective for exit or disposal activities that are initiated after December 31, 2002. We do not expect the adoption of SFAS 146 to have a material impact on our operating results or financial position.

In December 2002, the FASB issued SFAS 148, Accounting for Stock-Based Compensation—Transition and Disclosure an amendment of FASB Statement No. 123. SFAS 148 amends SFAS 123, Accounting for Stock-Based Compensation, to provide alternative methods of transition for an entity that voluntarily changes to the fair value based method of accounting for stock-based employee compensation. It also amends the disclosure provisions of SFAS 123 to require prominent disclosure about the effects on reported net income of an entity’s accounting policy decisions with respect to stock-based employee compensation. Finally, SFAS 148 amends APB Opinion No. 28 Interim Financial Reporting, to require disclosure about those effects in interim financial information. We intend to continue to account for stock-based compensation based on the provisions of APB Opinion No. 25. SFAS 148’s amendment of the transition and annual disclosure provisions of SFAS 123 are effective for fiscal years ending after December 15, 2002, and the disclosure requirements for interim financial

statements are effective for interim periods beginning after December 15, 2002. We have adopted the annual disclosure provisions and will adopt the interim disclosure provisions of SFAS 148 beginning in the quarter ending March 31, 2003.

In November 2002, the Emerging Issues Task Force (“EITF”) finalized its tentative consensus on EITF Issue 00-21, Revenue Arrangements with Multiple Deliverables, which provides guidance on the timing and method of revenue recognition for sales arrangements that include the delivery of more than one product or service. EITF 00-21 is effective prospectively for arrangements entered into in fiscal periods beginning after June 15, 2003. We are reviewing EITF 00-21 and have not yet determined the impact this issue will have on our future operating results and financial position.

Our exposure to market risk is limited to interest rate risk. Our exposure to changes in interest rates relates primarily to the increase or decrease in the amount of interest income we can earn on our investment portfolio and on the increase or decrease in the amount of interest expense we must pay with respect to our various outstanding debt instruments. Our risk associated with fluctuating interest expense is limited to our future financings, including our equipment financing line of credit agreements, the interest rates under which are expected to be closely tied to market rates. Our risk associated with fluctuating interest income is limited to our investments in interest rate sensitive financial instruments. Under our current policies, we do not use interest rate derivative instruments to manage exposure to interest rate changes. We ensure the safety and preservation of our invested principal funds by limiting default risk, market risk, and reinvestment risk. We mitigate default risk by investing in short-term investment grade securities and limiting the amount invested in any single security. We mitigate market risk by maintaining an average maturity of less than one year for our investments. A hypothetical 100 basis point adverse move in interest rates along the entire interest rate yield curve would have decreased the fair value of our interest sensitive financial instruments at December 31, 2002 and 2001 by $1.4 million and $1.0 million, respectively. Declines in interest rates over time will reduce our interest income, while increases in interest rates over time will increase our interest expense.

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

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

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

Diversa Corporation (the “Company”) was incorporated under the laws of the State of Delaware on December 21, 1992 and received initial funding to commence its operations in May 1994. The Company is directing its integrated portfolio of proprietary genomic technologies to the discovery, evolution, and production of commercially valuable molecules with pharmaceutical applications, such as monoclonal antibodies and orally active drugs, as well as enzymes and small molecules with agricultural, chemical, and industrial applications.

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

The Company considers cash equivalents to be only those investments which are highly liquid, readily convertible to cash and which mature within three months from the date of purchase.

Based on the nature of the assets held by the Company and management’s investment strategy, the Company’s investments have been classified as available-for-sale. Management determines the appropriate classification of debt securities at the time of purchase. Securities classified as available-for-sale are carried at estimated fair value, as determined by quoted market prices, with unrealized gains and losses reported as a separate component of comprehensive income. At December 31, 2002, the Company had no investments that were classified as trading or held-to-maturity as defined by the Statement of Financial Accounting Standards (“SFAS”) No. 115, Accounting for Certain Investments in Debt and Equity Securities. The amortized cost of debt securities classified as available-for-sale is adjusted for amortization of premiums and accretion of discounts to maturity. Such amortization is included in interest income. Realized gains and losses on sales of available-for-sale securities are computed based upon initial cost adjusted for any other than temporary declines in fair value and are included in interest income. The cost of securities sold is based on the specific identification method. Interest on securities classified as available-for-sale is included in interest income.

At December 31, 2002, all of the Company’s investments mature within three years with an average maturity of less than one year.

Gross realized gains from the sale of cash equivalents and marketable securities were approximately $541,000, $548,000, and $84,000 for the years ended December 31, 2002, 2001 and 2000, respectively. Gross realized losses from the sale of cash equivalents and marketable securities were approximately $155,000 and $19,000 for the years ended December 31, 2002 and 2001, respectively. There were no realized losses related to such sales for the year ended December 31, 2000.

Financial instruments which potentially subject the Company to concentrations of credit risk consist primarily of cash, cash equivalents, and short-term investments. The Company limits its exposure to credit loss by placing its cash with high credit quality financial institutions. The Company generally invests its excess cash in U.S. Treasury and government agency obligations and investment-grade corporate securities.

During the years ended December 31, 2002, 2001, and 2000, the Company had collaborative research agreements that accounted for 96%, 97%, and 94%, respectively, of total revenue.

Property and equipment are stated at cost and depreciated over the estimated useful lives of the assets (generally three to seven years) using the straight-line method. Amortization of leasehold improvements is computed over the shorter of the lease term or the estimated useful life of the related assets. For the years ended December 31, 2002, 2001, and 2000, the Company recorded depreciation expense of $8,975,000, $5,819,000, and $2,279,000, respectively.

In accordance with Accounting Principles Board Opinion (“APB”) No. 17, Accounting for Intangible Assets, technology rights acquired by the Company are recorded at cost. The technology rights acquired in 1999 from Terragen Discovery, Inc. related to patents (see Note 3) and are being amortized over the remaining life of the

patents at acquisition (sixteen years). For purposes of evaluating impairment of the acquired technology rights, the Company compares the carrying values and estimated future cash flows of both the acquired rights and the Company’s internally developed technologies on a combined basis. Acquired technology rights are presented net of accumulated amortization of $482,000 and $325,000 as of December 31, 2002 and 2001, respectively.

In accordance with SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, if indicators of impairment exist, the Company assesses the recoverability of the affected long-lived assets by determining whether the carrying value of such assets can be recovered through undiscounted future operating cash flows. If impairment is indicated, the Company measures the amount of such impairment by comparing the carrying value of the asset to the present value of the expected future cash flows associated with the use of the asset. The Company believes the future cash flows to be received from the long-lived assets will exceed the assets’ carrying value, and, accordingly, the Company has not recognized any impairment losses through December 31, 2002.

Financial instruments, including cash and cash equivalents, accounts receivable, accounts payable, and accrued liabilities, are carried at cost, which management believes approximates fair value because of the short-term maturity of these instruments.

The Company’s revenue recognition policies are in compliance with SEC Staff Accounting Bulletin No. 101 (“SAB 101”), Revenue Recognition in Financial Statements. SAB 101 provides guidance related to revenue recognition based on interpretations and practices followed by the SEC. Revenue from research funding under the Company’s collaboration agreements is earned and recognized on a percentage of completion basis as research hours are incurred in accordance with the provisions of each agreement. Fees received to initiate research projects are deferred and amortized over the project period. Fees received for exclusivity in a field are deferred and recognized over the period of exclusivity. Milestone payments are recognized when earned, as evidenced by written acknowledgement from the collaborator, provided that (i) the milestone event is substantive and its achievement was not reasonably assured at the inception of the agreement, and (ii) the Company’s performance obligations after the milestone achievement will continue to be funded by the collaborator at a level comparable to the level before the milestone achievement. Revenue from grants is recognized on a percentage of completion basis as related costs are incurred. Revenue from product sales is recognized at the time of shipment to the customer. The Company recognizes revenue only on payments that are non-refundable and defers recognition until performance obligations have been completed.

Research and development expenses, including direct and allocated expenses, consist of independent research and development costs, as well as costs associated with sponsored research and development. Research and development costs are expensed as incurred.

Current income tax expense (benefit) is the amount of income taxes expected to be payable (receivable) for the current year. A deferred income tax asset or liability is computed for the expected future impact of

differences between the financial reporting and tax bases of assets and liabilities, as well as the expected future tax benefit to be derived from tax loss and credit carryforwards. Deferred income tax expense is generally the net change during the year in the deferred income tax assets and liabilities. Valuation allowances are established when realizability of deferred tax assets is uncertain. The effect of tax rate changes is reflected in income tax expense (benefit) during the period in which such changes are enacted. The Company has provided a full valuation allowance against any deferred tax assets.

The Company measures compensation expense for stock options granted to employees using the intrinsic value method and, thus, recognizes no compensation expense for options granted with exercise prices equal to or greater than the fair value of the Company’s common stock on the date of the grant.

Compensation expense for options granted to non-employees has been determined in accordance with SFAS No. 123, Accounting for Stock-Based Compensation, and Emerging Issues Task Force (“EITF”) 96-18, Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services, as the fair value of the consideration received or the fair value of the equity instruments issued, whichever is more reliably measured. Deferred charges for options granted to non-employees are periodically remeasured as the underlying options vest (see Note 8).

Pro forma information regarding net loss and net loss per share has been determined as if the Company had accounted for its employee stock options and stock purchase plan under the fair value method of SFAS No. 123. For 2002, 2001, and 2000, the fair value of these options was estimated using the Black-Scholes model with the following assumptions: risk-free interest rates ranging from 2.86% to 4.80%, 3.90% to 4.99%, and 5.24% to 6.76%, respectively; dividend yield of 0%; volatility factor of 61%, 73%, and 60%, respectively; and a weighted-average expected life of the options of five years.

For purposes of pro forma disclosures, the estimated fair value of the options is amortized to expense over the vesting period. The Company’s pro forma information is as follows:

In connection with the grant of certain stock options to employees, the Company recorded deferred stock compensation, representing the difference between the exercise price and the fair value of the Company’s common stock as estimated by the Company’s management for financial reporting purposes on the date such stock options were granted. Deferred compensation is included as a reduction of stockholders’ equity and is being amortized to expense over the vesting period of the options in accordance with FASB Interpretation No. 28, which permits an accelerated amortization methodology. During the years ended December 31, 2002, 2001, and 2000, the Company recorded amortization of deferred stock compensation expense of approximately $0.6 million, $1.4 million, and $3.4 million, respectively.

Comprehensive income (loss) is defined as the change in equity of a business enterprise during a period from transactions and other events and circumstances from non-owner sources, including foreign currency

translation adjustments and unrealized gains and losses on marketable securities. The Company presents comprehensive income (loss) in its statements of stockholders’ equity (deficit).

Basic and diluted net loss per share has been computed using the weighted-average number of shares of common stock outstanding during the period, less shares subject to repurchase.

The following table presents the calculation of basic and diluted net loss per share:

The Company has excluded all convertible preferred stock and outstanding stock options and warrants from the calculation of diluted net loss per share because all such securities are antidilutive for all applicable periods presented. The total number of shares excluded from the calculations of diluted net loss per share, prior to application of the treasury stock method for options and warrants, was 5,248,000, 5,021,000, and 4,151,000, for the years ended December 31, 2002, 2001, and 2000, respectively. Such securities, had they been dilutive, would have been included in the computation of diluted net loss per share.

The Company has determined that it operates in only one segment. Accordingly, no segment disclosures have been included in the accompanying notes to the financial statements.

In June 2002, the Financial Accounting Standards Board (“FASB”) issued FASB Statement No. 146 (“SFAS 146”), Accounting for Costs Associated with Exit or Disposal Activities. SFAS 146 requires that costs associated with exit or disposal activities are recorded 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 has been incurred. SFAS 146 will be effective for exit or disposal activities that are initiated after December 31, 2002. The Company does not expect the adoption of SFAS 146 to have a material impact on its operating results or financial position.

In December 2002, the FASB issued SFAS 148, Accounting for Stock-Based Compensation — Transition and Disclosure an amendment of FASB Statement No. 123. SFAS 148 amends SFAS 123, Accounting for Stock-Based Compensation, to provide alternative methods of transition for an entity that voluntarily changes to the fair value based method of accounting for stock-based employee compensation. It also amends the disclosure provisions of SFAS 123 to require prominent disclosure about the effects on reported net income of an entity’s accounting policy decisions with respect to stock-based employee compensation. Finally, SFAS 148 amends APB Opinion No. 28, Interim Financial Reporting, to require disclosure about those effects in interim financial information. The Company intends to continue to account for stock-based compensation based on the provisions of APB Opinion No. 25. SFAS 148’s amendment of the transition and annual disclosure provisions of SFAS 123

are effective for fiscal years ending after December 15, 2002, and the disclosure requirements for interim financial statements are effective for interim periods beginning after December 15, 2002. The Company has adopted the annual disclosure provisions and will adopt the interim disclosure provisions of SFAS 148 beginning in the quarter ending March 31, 2003.

In November 2002, the Emerging Issues Task Force (“EITF”) finalized its tentative consensus on EITF Issue 00-21, Revenue Arrangements with Multiple Deliverables, which provides guidance on the timing and method of revenue recognition for sales arrangements that include the delivery of more than one product or service. EITF 00-21 is effective prospectively for arrangements entered into in fiscal periods beginning after June 15, 2003. The Company is reviewing EITF 00-21 and has not yet determined the impact this issue will have on its future operating results and financial position.

In January 1999, the Company entered into a strategic alliance with Syngenta Biotechnology, Inc. (formerly Syngenta Agribusiness Biotechnology Research, Inc.) (“Syngenta Biotechnology”). Under the agreement, the Company received research funding from Syngenta Biotechnology to conduct multiple independent research projects with the intention of identifying and developing biomolecules that meet the scientific specifications of Syngenta Biotechnology. In conjunction with the transaction, Syngenta Biotechnology purchased 5,555,556 shares of Series E convertible preferred stock (see Note 7), paid a technology access fee, and provided project research funding to the Company, for aggregate total proceeds of $12.5 million. The Company recognized the research payments on a percentage of completion basis as research was performed. The technology access fee was recognized in 1999, as all the research required under the collaboration was completed by December 31, 1999. During 2000, the Company expanded its collaboration agreement with Syngenta Biotechnology to further develop and optimize novel synthesis routes to crop protection chemicals. Under the terms of the agreement, the Company receives research payments for work performed and is also eligible to receive milestones and product royalties.

In December 1999, the Company formed a five-year, renewable strategic alliance with Syngenta Seeds AG (“Syngenta Seeds”). Through a contract joint venture, named Zymetrics, Inc., the Company and Syngenta Seeds are jointly pursuing opportunities in the field of animal feed and agricultural product processing. Both parties share in the management of the venture and fund a portion of the sales and marketing costs of this venture. Under the agreement, Syngenta Seeds receives exclusive, worldwide rights in the field of animal feed and project exclusive, worldwide rights in the field of agricultural product processing. Syngenta Seeds agreed to pay $20.0 million for the rights granted under this agreement, of which $15.0 million was paid in February 2000 and $5.0 million was paid in June 2001. The Company initially recorded the amount due in June 2001 at its present value on the date of the agreement of $4.0 million. The technology access fee is being recognized as revenue on a straight-line basis over the term of the agreement. Research funding is recognized as the research is performed, and milestone payments are recognized as revenue when earned. The Company will receive a share of the profits in the form of royalties on any product sales. As the Company does not have an ownership interest in Zymetrics, the Company records expenses associated with the joint venture as a component of selling, general, and administrative expenses as they are incurred.

In February 2003, the Company completed a series of transactions with Syngenta Partipations AG and its wholly-owned subsidiary, Torrey Mesa Research Institute (see Note 11).

In July 1999, the Company expanded its existing strategic alliance with The Dow Chemical Company (“Dow”) to identify and develop enzymes that could be utilized by Dow to manufacture chemical compounds. The Company will receive royalties on any product sales. In December 2000, the Company entered into an agreement with Dow to license several enzymes for early stage testing of further application for production of certain chemicals. Under the terms of the agreement, the Company received license fees and is entitled to receive specified royalties upon commercialization of certain products using the licensed enzymes.

In November 2000, the Company and Dow, through its Custom and Fine Chemicals (formerly Contract Manufacturing Services) business unit, signed an agreement to jointly market their respective abilities to pharmaceutical companies to develop and produce chiral compounds for active pharmaceutical ingredients,

pharmaceutical intermediates, and other fine chemicals. Under the terms of the agreement, the Company receives technology access fees and research and development payments. The Company is also eligible to receive milestone payments and royalty payments from sales of end products by Dow. In November 2001, the agreement was expanded to identify additional biocatalytic processes to replace traditional and costly multi-step chemical synthesis. In October 2002, the Company announced that it licensed a product for improved enzymatic synthesis of a key pharmaceutical intermediate used in the manufacture of a drug to the Pharmaceutical Services business of Dow. The Company received license fees and is entitled to receive specified royalties on Dow’s sales of the intermediate manufactured using the licensed enzyme.

In June 2000, the Company formed a 50/50 joint venture with Dow, named Innovase LLC (“Innovase”), to develop and commercialize innovative products for certain fields in the industrial enzyme market. Under the various joint venture related agreements, the Company received exclusivity fees, technology development fees, and research and development payments, and the Company believes it is entitled to additional technology development fees and research and development payments over the remainder of the initial five-year term. The Company is amortizing the exclusivity and technology development fees over the period of the agreements. Research funding is recognized as the research is performed. Revenues earned from the exclusivity and technology development fees and from the research activities performed on behalf of Innovase are included in “Collaborative” revenue in the accompanying statements of operations. The Company is also required to fund certain operating expenses of the joint venture. The Company’s share of the net income (loss) of Innovase, excluding certain expenses for which Dow is solely responsible under the joint venture agreement, is recorded utilizing the equity method of accounting and is included in the accompanying statements of operations. For the years ended December 31, 2002, 2001, and 2000, the Company recorded expenses of $2.5 million, $1.8 million and $0.1 million, respectively, related to the Company’s equity in the loss of the joint venture.

Revenue recognized under the Dow agreements was $16.1 million, $15.2 million, and $9.0 million for the years ended December 31, 2002, 2001, and 2000, respectively.

In January 2001, the Company entered into a drug discovery, development, and licensing agreement with IntraBiotics Pharmaceuticals, Inc. (“IntraBiotics”). Under the terms of the agreement, the companies worked together to identify and develop novel small molecule drugs derived from the Company’s recombinant natural product libraries that demonstrate antibacterial or antifungal properties.

In June 2001, the Company signed a term sheet releasing IntraBiotics from all obligations under the discovery, development and license agreement. Under the term sheet and subsequent definitive release agreement signed in July 2001, IntraBiotics made additional payments totaling $2.5 million to the Company, which were recorded as revenue when received. The Company also received warrants to purchase 700,000 shares of IntraBiotics’s common stock at an exercise price of $2.00 per share. The warrants were exercisable immediately and expire in four years. Upon receipt of the warrants, the Company recorded $431,000 of revenue, which was equal to the estimated fair value of the warrants using the Black-Scholes option pricing model with the following assumptions: risk free interest rate of 6%; dividend yield of zero; expected volatility factor of 63%; and an expected life of two years. In September 2002, the Company wrote-off its investment in the warrants as a result of a significant decline in the market value for IntraBiotics’s common stock. For the year ended December 31, 2001, the Company recorded $452,000 of other income related to the increase in the fair market value of these warrants. For the year ended December 31, 2002, the Company recorded $883,000 of other expense related to the write-off of the warrants.

Revenue recognized under the IntraBiotics agreement was $4.3 million for the year ended December 31, 2001.

In December 2000, the Company entered into a drug discovery research collaboration with Glaxo Research and Development Limited (“Glaxo”), a wholly owned subsidiary of GlaxoSmithKline plc, to identify pharmaceuticals derived from the Company’s recombinant multi-gene PathwayLibrary^™ collections. Under this non-exclusive research agreement, the Company and Glaxo are jointly performing research to identify novel small molecules from the Company’s PathwayLibrary collections, and to screen these molecules for specific pharmaceutical activity. Glaxo will receive exclusive worldwide rights to designated biomolecules selected for commercialization.

In May 1996, the Company entered into a strategic alliance with Danisco Animal Nutrition (“Danisco”) (formerly Finnfeeds International Ltd) to jointly discover new enzymes for the animal feed market. In December 1998, the Company and Danisco entered into a license agreement to commercialize an enzyme developed under the strategic alliance. Under the terms of the agreement, the Company granted Danisco an exclusive license to manufacture, use and sell the developed enzyme. In consideration for the license, the Company will be paid a royalty on related product sales made by Danisco.

In November 1999, the Company signed a license agreement with Terragen Discovery Inc. (“Terragen”) under which Terragen and the Company agreed to cross license certain technologies. The Company entered into the agreement to obtain exclusive, non-transferrable access to a Terragen technology which could be valuable to competitors. Terragen obtained an exclusive, non-transferable license to certain Diversa technology relating to screening from the environment for small molecules. Under the terms of the agreement, the Company made an initial payment of $2.5 million in 1999 and agreed to make annual payments of $100,000 to Terragen to maintain the patent rights over the remaining patent life. The Terragen license was acquired to enhance the Company’s intellectual property position in combinational libraries. The Company believes the benefits associated with preventing competitors from licensing the Terragen technology exceed the financial costs of the agreement. These benefits include certain marketing advantages as well as increased protection from potential litigation, although there had never been any asserted or unasserted claims against the Company related to this technology. The Company has capitalized the initial payment as an intangible asset, which is being amortized over the sixteen year patent life.

The Company has signed various agreements with research institutions, as well as governmental and commercial entities. Generally, these agreements call for the Company to pay research support, cost reimbursement, and, in some cases, subsequent royalty payments in the event a product is commercialized. The financial impact of these agreements on the Company is not significant.

The Company has entered into various equipment financing line of credit agreements with lenders to finance equipment purchases. Under the terms of the credit agreements, equipment purchases are structured as notes and are to be repaid over periods ranging from 36 to 48 months at interest rates ranging from 7.41% to 9.35%. The notes are secured by the related equipment. As of December 31, 2002, the Company had $3.6 million available under the existing lines of credit.

At December 31, 2002, the Company’s future minimum principal payments under the equipment financing arrangements are as follows:

In February 2000, the Company initiated a loan program for six employees to pay personal tax liabilities resulting from the failure to file Form 83(b) elections with the Internal Revenue Service related to those employees’ exercise of incentive and non-qualified stock options during 1999. This failure to timely file the Form 83(b) elections exposed the employees to significant personal tax liabilities. To limit the tax exposure, the Company elected to accelerate the vesting of the approximately 207,000 unvested options, and agreed to loan the employees up to $1.6 million in full recourse promissory notes. The acceleration of the unvested options resulted in a non-cash compensation charge to the Company of approximately $4.1 million. Additionally, the Company agreed to directly compensate two individuals a total of approximately $240,000 in cash. As of December 31, 2002 and 2001, the Company had a remaining loan balance of $885,000 and $1,024,000, respectively, for these employees. The notes bear interest at 4.94%, are due in April 2006, and contain certain mandatory prepayment provisions.

The Company leases office and laboratory space as well as equipment under noncancelable leases as follows:

In November 2000, the Company relocated its San Diego operations to a 75,000 square foot facility. In April 2002, the Company occupied an additional 66,000 square foot research and development facility located in San Diego. The operating leases for the Company’s two facilities expire in November 2015 and March 2017, respectively.

In March 2002, the Company entered into an agreement to sublease approximately 27,000 square feet of its new facility. The sublease was effective April 1, 2002 and will continue for a period of three years with an option to extend for an additional year, which the sublessee may exercise. During the year ended December 31, 2002, the Company received $608,000 of rental income under its sublease, which was recorded as a reduction of rent expense. For the years ending December 31, 2003, 2004, and 2005, the Company is expected to receive approximately $774,000, $798,000, and $200,000 respectively, of rental income under its sublease.

For the years ended December 31, 2002, 2001, and 2000, rent and administrative service expense under operating leases was approximately $3,526,000, $3,290,000, and $1,428,000, respectively, net of rental income.

Under the terms of the facility operating leases, the Company is required to obtain an irrevocable standby letter of credit from a bank. The amount of the letter of credit is based upon certain financial covenants. As a condition of the letter of credit, the bank requires the Company to invest an equal amount of funds in the form of a 90-day time deposit. As of December 31, 2002, the amount of the letter of credit and related time deposit was $100,000. The letter of credit expires in January 2004 and is automatically renewable.

Equipment acquired under capital leases is included in property and equipment and amounted to $7,207,000 (net of accumulated amortization of $6,897,000 and $6,477,000) as of December 31, 2002 and December 31, 2001. The Company’s capital lease obligations mature at various dates through April 2005, with interest rates ranging from 9.5% to 15.4%.

On or about December 6, 2002, a lawsuit was filed in the U.S. District Court for the Southern District of New York against the Company, two of its executive officers, the chairman of its board of directors, and the underwriters of its initial public offering of common stock. The complaint is purportedly filed on behalf of purchasers of the Company’s common stock between February 14, 2000 and December 6, 2000, and alleges claims under Sections 11 and 15 of the Securities Act of 1933 and Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 and Rule 10b-5 promulgated thereunder. The complaint is among the so-called “laddering” cases that have been commenced against many companies that had public offerings of securities prior to or during December 2000, and the complaint has been transferred to the District Court Judge who is handling the ongoing litigation against over 300 companies involving complaints of a similar nature. Those complaints are being coordinated as part of one proceeding denominated In re Initial Public Offering Securities Litigation. Among other allegations, the complaint alleges that, in connection with the Company’s February 14, 2000 initial public offering, the defendant underwriters conditioned share allocations on customers agreeing to purchase additional shares in the aftermarket at pre-arranged prices and/or to pay the underwriters excessive and undisclosed compensation representing a material portion of the customers’ profits from aftermarket sales of their initial public offering share allocations. The complaint alleges that the failure to disclose these alleged arrangements made the Company’s registration statement for its initial public offering and the related prospectus materially false and misleading. The complaint, which seeks unspecified damages, asserts claims under the Securities Act Sections 11 and 15 and Exchange Act Sections 10(b) and 20.

The Company strongly denies any liability in connection with this lawsuit and intends to vigorously defend against it. The Company has notified its insurance carriers of the lawsuit, and is requesting indemnification and/or contribution from the underwriters of its initial public offering of common stock.

The Company is also, from time to time, subject to legal proceedings and claims which arise in the normal course of its business. In the opinion of management, the amount of ultimate liability with respect to these actions will not have a material adverse effect on the Company’s financial position, results of operations, or cash flows.

In February 2000, the Company effected a 1-for-2.8806 reverse stock split of the Company’s common stock. All share data have been retroactively restated to reflect the reverse stock split. In conjunction with the reverse stock split, the certificate of incorporation was amended to authorize 65,000,000 shares of common stock and 5,000,000 shares of preferred stock.

On February 17, 2000, the Company completed its initial public offering of 8,337,500 shares of common stock at $24.00 per share, which included 1,087,500 shares of common stock issued pursuant to the underwriters’ exercise of their over-allotment option. The combined gross proceeds raised by the Company from the offering and over-allotment option were $200.1 million.

In January 1999, in conjunction with a strategic alliance signed with Syngenta Biotechnology (see Note 3), the Company sold 5,555,556 shares of Series E convertible preferred stock. The terms of the stock purchase

agreement designate a portion of the proceeds as a technology access fee, a portion of the proceeds as advance payments for research support under the collaboration agreement, and $7.3 million for the Series E convertible preferred stock ($1.32 per share).

From December 21, 1999 through the date of the Company’s initial public offering, the Series A, B, and D preferred stockholders were entitled to a 5% dividend per annum. In February 2000, the Company issued 15,641 shares of common stock for payment of $376,000 of dividends payable to preferred stockholders.

Concurrent with the Company’s initial public offering, all of the Company’s redeemable and convertible shares of preferred stock were converted into 22,834,042 shares of common stock.

On December 13, 2000, the Board of Directors of the Company approved the adoption of a shareholder rights plan (the “Rights Plan”). Under the Rights Plan, the Board of Directors declared a dividend of one right to purchase one one-hundredth of a share of Series A junior participating preferred stock (a “Right”) for each share of Company common stock outstanding as of December 22, 2000. The exercise price of each Right is $125.00.

Initially, the Rights trade with the Company’s common stock and are not separately transferable. However, subject to certain exceptions, the Rights will become exercisable (i) at such time that a person (or group of affiliated persons) acquires beneficial ownership of 15% or more of the outstanding Company common stock (an “Acquiring Person”) or (ii) on the tenth business day after a person or entity commences, or expresses an intention to commence, a tender or exchange offer that would result in such person acquiring 15% or more of the outstanding Company common stock. In December 2002, in connection with the Company’s entering into a series of agreements with Syngenta Participations AG and Torrey Mesa Research Institute, the Company amended the Rights Plan to provide that, with respect to Syngenta and its affiliates and associates, the threshold will be 22% rather than 15% for the aggregate beneficial ownership of the Company’s common stock that their holdings may not exceed without the Rights becoming exercisable.

In the event a person becomes an Acquiring Person, each Right held by all persons other than the Acquiring Person will become the right to acquire one share of Company common stock at a price equal to 50% of the then-current market value of the Company common stock. Furthermore, in the event an Acquiring Person effects a merger of the Company, each Right will entitle the holder thereof to purchase one share of common stock of the Acquiring Person or the Acquiring Person’s ultimate parent at a price equal to 50% of the then-current market value of the Acquiring Person’s or the Acquiring Person’s ultimate parent’s common stock.

The Board of Directors can redeem the Rights at any time prior to a person becoming an Acquiring Person at a redemption price of $0.01 per Right. In addition, the Board of Directors may, after any time a person becomes an Acquiring Person, exchange each Right for one share of common stock of the Company. The Rights will expire on December 12, 2010 if not redeemed prior to such date.

In December 1999, the Board of Directors adopted the 1999 Employee Stock Purchase Plan (the “Purchase Plan”). As of December 31, 2002, a total of 426,000 shares of the Company’s common stock have been reserved for issuance under the Purchase Plan. The Purchase Plan permits eligible employees to purchase common stock at a discount, but only through payroll deductions, during defined offering periods. The price at which stock is

purchased under the Purchase Plan is equal to 85% of the fair market value of the common stock on the first or last day of the offering period, whichever is lower. The Purchase Plan provides for annual increases of shares available for issuance under the Purchase Plan.

In December 1999, the Company adopted the 1999 Non-Employee Directors Stock Option Plan (the “Non-Employee Director Plan”) and reserved a total of 278,000 shares of common stock for issuance thereunder. Each non-employee director who becomes a director of the Company will be automatically granted a non-qualified stock option to purchase 20,000 shares of common stock on the date on which such person first becomes a director. On the day following each annual meeting of stockholders, each non-employee director will automatically be granted a non-qualified option to purchase 5,000 shares of common stock. The exercise price of options under the Non-Employee Director Plan will be equal to the fair market value of the common stock on the date of grant. The maximum term of the options granted under the Non-Employee Director Plan is ten years. Each grant under the Non-Employee Director Plan will vest in equal monthly installments over three years from the date of grant.

In August 1997, the Company adopted the 1997 Equity Incentive Plan (the “1997 Plan”), which provides for the granting of incentive or non-statutory stock options, stock bonuses, and rights to purchase restricted stock to employees, directors, and consultants as administered by the compensation and non-officer stock option committees of the Board of Directors. Unless terminated sooner by the Board of Directors, the 1997 Plan will terminate in August 2007.

The incentive and non-statutory stock options are granted with an exercise price of not less than 100% and 85%, respectively, of the estimated fair value of the underlying common stock as determined by the Board of Directors. The 1997 Plan allows the purchase of restricted stock at a price that is not less than 85% of the estimated fair value of the Company’s common stock as determined by the Board of Directors.

Options granted under the 1997 Plan vest over periods ranging up to four years and are exercisable over periods not exceeding ten years. As of December 31, 2002, the aggregate number of shares which may be awarded under the 1997 Plan is 8,983,000 with 2,356,000 available for grant.

The Restated 1994 Employee Incentive and Non-Qualified Stock Option Plan (the “1994 Plan”) provided for the granting of incentive or non-qualified stock options to employees and consultants as administered by the human resources committee of the Board of Directors. The incentive stock options were granted with an exercise price of not less than the estimated fair value of the underlying common stock as determined by the Board of Directors. The non-qualified stock options were granted with an exercise price of not less than $0.03.

Options granted under the 1994 Plan vest over periods ranging up to four years and are exercisable over periods not exceeding ten years. Options to purchase 952,000 shares have been granted under the 1994 Plan, and 12,000 options remain outstanding related to the 1994 Plan. In August 1997, the 1994 Plan was terminated, and there are no options available for future grant.

Information with respect to all of the Company’s stock option plans is as follows:

At December 31, 2002, options to purchase 3,433,000 shares were exercisable, and approximately 2,514,000 shares remain available for grant.

Following is a further breakdown of the options outstanding as of December 31, 2002:

The weighted-average fair value of options granted during 2002, 2001, and 2000 was $4.85, $9.43, and $13.63, respectively. As of December 31, 2002, 2,947,000 options were vested.

The Company has granted non-qualified stock options to certain non-employees in connection with consulting agreements. During the years ended December 31, 2002, 2001, and 2000, the Company recorded non-cash, stock-based compensation charges of approximately $0.1 million, $1.1 million, and $2.4 million,

respectively, relating to these grants. Unvested options are re-valued as they vest in accordance with SFAS No. 123 and EITF 96-18 using the Black-Scholes model. The options re-valued in 2002 were valued using the following assumptions: risk-free interest rate of 2.01%; dividend yield of 0%; volatility factor of 75%; and a weighted-average expected life of the options of two years.

In August 2000, the Company issued 10,795 shares of common stock and warrants to purchase 21,552 shares of common stock at a weighted-average exercise price of $32.45 per share for payment of consulting services with an estimated fair value of $700,000. As of December 31, 2002, warrants to purchase 42,000 shares of common stock at exercise prices ranging from $0.03 to $38.39 per share were outstanding. All warrants are exercisable and expire at various dates through April 2006.

In connection with the closing of a series of transactions with Syngenta Participations AG in February 2003, the Company issued to Syngenta a warrant to purchase 1,293,211 shares of common stock at $22 per share that is exercisable for ten years starting in 2008 (see Note 11).

At December 31, 2002, the Company has reserved shares of common stock for future issuance as follows:

The Company has a 401(k) plan which allows participants to defer a portion of their income through contributions. Such deferrals are fully vested and are not taxable to the participant until distributed from the plan upon termination, retirement, permanent disability, or death. The Company matches a portion of the employee contributions and may, at its discretion, make additional contributions. During the years ended December 31, 2002, 2001, and 2000, the Company made cash contributions of approximately $498,000, $360,000, and $80,000, respectively.

Significant components of the Company’s deferred tax assets are shown below. A valuation allowance of $41.3 million and $28.4 million has been recognized to offset the deferred tax assets at December 31, 2002 and 2001, respectively, as realization of such assets is uncertain.

At December 31, 2002, the Company has federal and California net operating loss carryforwards of approximately $79.5 million and $40.5 million, respectively. The federal net operating loss carryforwards will begin to expire in 2011 unless utilized. The California net operating loss carryforwards will begin to expire in 2006 unless utilized. The Company also has federal and California tax credits of approximately $2.9 million and $1.9 million, respectively, which begin to expire in 2011 unless utilized.

Pursuant to Sections 382 and 383 of the Internal Revenue Code, annual use of the Company’s net operating loss and credit carryforwards may be limited due to cumulative changes in ownership of more than 50%.

On February 20, 2003, the Company completed a series of transactions with Syngenta Participations AG (“Syngenta”) and its wholly-owned subsidiary, the Torrey Mesa Research Institute (“TMRI”). Under the transactions, the companies have formed an extensive research collaboration whereby the Company is entitled to receive a minimum of $118.0 million in research and development funding over the initial seven-year term of the related research collaboration agreement and will be eligible to receive certain milestone payments and royalties upon product development and commercialization. Additionally, the Company acquired certain intellectual property rights licenses from Syngenta used in activities conducted at TMRI that primarily involve tools, technologies and methods relating to proteomics, metabolomics, RNA dynamics, and bioinformatics and methods to analyze and link these components of genomics or that primarily relate to TMRI’s fungal program, for use outside of Syngenta’s exclusive field as defined in the research collaboration agreement. The Company also purchased certain property and equipment from TMRI and assumed certain miscellaneous liabilities under equipment maintenance contracts.

Upon closing, the Company issued to Syngenta and TMRI a total of 6,034,983 shares of common stock and a warrant to purchase 1,293,211 shares of common stock at $22.00 per share that is exercisable for ten years starting in 2008. The total value of the acquisition is approximately $74.0 million, including transaction fees. The

value of the Company’s shares used in determining the purchase price was $11.44 per share based on the average of the closing prices of its common stock for a range of five trading days — two days prior to, two days subsequent to, and the announcement date for the transactions of December 4, 2002. The value of the warrant issued has been determined by a third party valuation. The transaction is to be accounted for as an asset purchase under accounting principles generally accepted in the United States.

On February 19, 2003, the District Court decided several motions to dismiss in In re Initial Public Offering Securities Litigation that were filed before the complaint was filed against the Company. Nevertheless, as part of its decision, the District Court dismissed the Exchange Act Section 10(b) claims against the Company, one of its executives and the chairman of its board of directors, and dismissed the Exchange Act Section 20 claims in their entirety. The District Court, however, did not dismiss the Securities Act Sections 11 and 15 claims as against any of the defendants named in the complaint (see Note 6).

The Company and The Dow Chemical Company (“Dow”) have differing views regarding product development activities, commercial opportunities and funding obligations under their Innovase joint venture. In particular, Dow has indicated that it is unlikely to continue to provide research and development funding to the Company under the joint venture pending approval of further product development projects. Neither party has declared a breach under the Innovase agreements or provided notice of termination of any of the agreements. However, the Company has initiated informal dispute resolution procedures under the Innovase agreements to attempt to resolve these issues. If the Company and Dow are unable to resolve their differences through the informal dispute resolution process, either party may submit the matter to binding arbitration for resolution. During this informal dispute resolution period, the Company intends to continue to advance projects within the joint venture, which are subject to Dow funding obligations under the Innovase agreements. However, if the parties are not able to resolve their differences within the informal dispute resolution process, Dow has indicated its intent to reduce or eliminate its funding under the Innovase agreements, which would likely result in the Company’s initiating binding arbitration under the agreements. Future revenue will be recognized based on management’s assessment of the collectibility. Although the Company intends to vigorously assert its rights under the Innovase agreements in any such arbitration, Dow’s ceasing to fund Innovase at the levels the Company believes are required under the Innovase agreements and the commencement of arbitration could adversely affect the Company’s business. Furthermore, while the Company believes that it would prevail in any arbitration, there can be no assurance of the actual outcome of any arbitration and an adverse result, including a result awarding an amount less than what the Company believes it is entitled to receive in committed funding under the Innovase agreements, could have an adverse affect on the Company’s business.

The following tables set forth certain unaudited quarterly information for each of the eight fiscal quarters in the two year period ended December 31, 2002. This quarterly information has been prepared on a consistent basis with the audited financial statements and, in the opinion of management, includes all adjustments, consisting only of normal recurring adjustments, necessary for a fair presentation of the information for the periods presented. Our quarterly operating results may fluctuate significantly as a result of a variety of factors, and operating results for any quarter are not necessarily indicative of results for a full fiscal year or future quarters.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURES

The information required by this item with respect to executive officers and directors is incorporated by reference from the information under the captions of “Election of Directors,” “Executive Officers,” and “Security Ownership of Certain Beneficial Owners and Management—Section 16(a) Beneficial Ownership Reporting Compliance” contained in the proxy statement to be filed with the SEC pursuant to Regulation 14A in connection with our 2003 annual meeting.

The information required by this item is incorporated by reference to the information under the captions “Election of Directors—Compensation of Directors,” “Executive Compensation” (through and including the information under the caption “Executive Compensation—Employment Agreements”) and “Report of the Compensation Committee of the Board of Directors on Executive Compensation—Compensation Committee Interlocks and Insider Participation” contained in the proxy statement for our 2003 annual meeting of stockholders.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS

The information required by this item is incorporated by reference to the information under the caption “Security Ownership of Certain Beneficial Owners and Management” contained in the proxy statement for our 2003 annual meeting of stockholders.

The information required by this item is incorporated by reference to the information under the caption “Certain Transactions” contained in the proxy statement for our 2003 annual meeting of stockholders.

Evaluation of Disclosure Controls and Procedures. Our chief executive officer and chief financial officer have evaluated the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-14(c) and 15d-14(c) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)) as of a date within 90 days prior to the filing date of this annual report (the “Evaluation Date”). Based on such evaluation, such officers have concluded that, as of the Evaluation Date, our disclosure controls and procedures are effective in alerting them on a timely basis to material information relating to us that is required to be included in our reports filed or submitted under the Exchange Act.

Changes in Internal Controls. Since the Evaluation Date, there have not been any significant changes in our internal controls or in other factors that could significantly affect such controls.

(a)(2) Financial Statement Schedules: All schedules have been omitted because they are not applicable or required, or the information required to be set forth therein is included in the Consolidated Financial Statements or notes thereto included in Item 8 (“Financial Statements and Supplementary Data”).

We filed a Current Report on Form 8-K on December 4, 2002 (i) including a press release announcing our entry into a series of transactions with Syngenta Participations AG and Torrey Mesa Research Institute and (ii) reporting an amendment to our shareholder rights plan, in connection with the announced transactions, to provide that with respect to Syngenta Participations AG, Syngenta Seeds AG and their respective affiliates, the threshold will be 22% rather than 15%% for the aggregate beneficial ownership of our common stock that their holdings may not exceed without triggering the separation of the rights under the rights agreement from our common stock.

We filed a Current Report on Form 8-K on December 16, 2002, reporting that a lawsuit was filed in the U.S. District Court for the Southern District of New York against us, two of our executive officers, the chairman of our board of directors, and the underwriters of our initial public offering of common stock. The complaint is purportedly filed on behalf of purchasers of our common stock between February 14, 2000 and December 6, 2000, and alleges claims under Sections 11 and 15 of the Securities Act of 1933 and Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 and Rule 10b-5 promulgated thereunder. We strongly deny any liability in connection with this lawsuit and intend to vigorously defend against it. We have notified our insurance carriers of the lawsuit, and are requesting indemnification and/or contribution from the underwriters of our initial public offering of common stock.

The financial statement schedules required by this item are listed under Item 15(a)(2).

Pursuant to the requirements of Section 13 or 15(d) 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.

DIVERSA CORPORATION

By:		/s/ KARIN EASTHAM
		Karin Eastham Senior Vice President, Finance and Chief Financial Officer

KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints Karin Eastham and Jay M. Short, Ph.D., and each of them, as his or her true and lawful attorneys-in-fact and agents, with full power of substitution and resubstitution, for him or her and in his or her name, place, and stead, in any and all capacities, to sign any and all amendments to this Report, and to file the same, with all exhibits thereto, and other documents in connection therewith, with the Securities and Exchange Commission, granting unto said attorneys-in-fact and agents, and each of them, full power and authority to do and perform each and every act and thing requisite and necessary to be done in connection therewith, as fully to all intents and purposes as he or she might or could do in person, hereby ratifying and confirming all that said attorneys-in-fact and agents, or any of them or their or his substitute or substituted, may lawfully do or cause to be done by virtue hereof.

Pursuant to the requirements of the Securities Exchange Act of 1934, this Report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.

/s/ JAY M. SHORT

President and Chief Executive Officer

/s/ KARIN EASTHAM

Senior Vice President, Finance and Chief Financial Officer

Delaware		22-3297375
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification No.)

4955 Directors Place, San Diego, California		92121
(Address of principal executive offices)		(Zip Code)

	Part I.	Page
Item 1.	Business	1
Item 2.	Properties	35
Item 3.	Legal Proceedings	35
Item 4.	Submission of Matters to a Vote of Security Holders	35

	Part II.
Item 5.	Market for Registrant’s Common Equity and Related Stockholder Matters	36
Item 6.	Selected Financial Data	37
Item 7.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	38
Item 7A.	Quantitative and Qualitative Disclosures About Market Risk	46
Item 8.	Financial Statements and Supplementary Data	47
Item 9.	Changes in and Disagreements with Accountants on Accounting and Financial Disclosures	70

	Part III.
Item 10.	Directors and Executive Officers of the Registrant	71
Item 11.	Executive Compensation	71
Item 12.	Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters	71
Item 13.	Certain Relationships and Related Transactions	71
Item 14.	Controls and Procedures	71

	Part IV.
Item 15.	Exhibits, Financial Statement Schedules and Reports on Form 8-K	72
	Signatures	76
	Certifications	77

	Our GSSM Technology	Traditional Phage Display
Improved Binding Sites	17	1
Sites Tested	229	19
Sites Not Tested	0	110

Phyzyme^™ XP Animal Feed Enzyme		• Developed in collaboration with Danisco Animal Nutrition • Allows higher utilization of naturally occurring phosphorus in feed • Increases nutritional value of feed • Reduces pollution

Enzyme for Manufacture of Key Pharmaceutical Intermediate		• Licensed to the Pharmaceutical Services business of The Dow Chemical Company • Optimized enzyme that can eliminate several processing steps • Enzyme for the synthesis of a key intermediate used in manufacturing a multi-billion dollar drug

Green Fluorescent Protein and Cyan Fluorescent Protein		• Applications in drug discovery, commercial screening, and academic research • Enhanced brightness for more sensitive drug discovery screens and fast maturation time for rapid screening

ThermalAce^™ Enzyme		• Thermostable DNA polymerase for the molecular biology research supply market • Commercialized under a license agreement with Invitrogen • We are entitled to receive royalties on sales of the enzyme, while retaining rights to the diagnostics market

Pyrolase^™ 200 Enzyme		• Second-generation oil field product that functions at a wider temperature range • Commercialized in 2000

Pyrolase^™ 160 Enzyme		• Used in oil and gas well-fracturing operations to increase productivity of wells • Sales commenced in January 1999, only two years after project initiation

2002	High		Low
First Quarter	$	14.65	$	9.50
Second Quarter		13.05		9.22
Third Quarter		10.51		6.99
Fourth Quarter		11.90		6.86
2001		High		Low
First Quarter	$	26.25	$	9.50
Second Quarter		21.00		13.19
Third Quarter		20.49		7.85
Fourth Quarter		14.95		8.55

	Year Ended December 31,
	2002			2001			2000			1999			1998
	(in thousands, except per share data)
Statement of Operations Data:
Collaborative revenue	$	30,276		$	34,936		$	22,883		$	9,166		$	625
Grant and product revenue		1,379			1,103			1,418			1,106			722

Total revenue		31,655			36,039			24,301			10,272			1,347
Operating expenses:
Research and development		50,318			48,228			26,427			11,275			10,165
Selling, general and administrative		10,269			10,102			7,094			4,121			3,371
Non-cash, stock-based compensation		701			2,544			9,869			4,110			1,665

Total operating expenses		61,288			60,874			43,390			19,506			15,201
Operating loss		(29,633	)		(24,835	)		(19,089	)		(9,234	)		(13,854	)
Other income		1,646			9,171			11,025			215			344

Net loss		(27,987	)		(15,664	)		(8,064	)		(9,019	)		(13,510	)
Dividends payable to preferred stockholders		—			—			(310	)		(66	)		—
Net loss applicable to common stockholders	$	(27,987	)	$	(15,664	)	$	(8,374	)	$	(9,085	)	$	(13,510	)

Net loss per share, basic and diluted	$	(0.79	)	$	(0.44	)	$	(0.27	)	$	(3.86	)	$	(7.64	)

Weighted average shares outstanding		35,650			35,243			30,836			2,353			1,768

	As of December 31,
	2002		2001		2000		1999			1998
	(in thousands)
Balance Sheet Data:
Cash, cash equivalents and short-term investments	$	163,096	$	190,700	$	211,256	$	5,084		$	5,552
Working capital		142,394		172,049		199,223		13,902			2,470
Total assets		197,197		227,678		235,261		31,072			8,706
Long-term debt, less current portion		11,884		12,421		8,182		2,677			2,202
Redeemable convertible preferred stock		—		—		—		48,402			48,402
Stockholders’ equity (deficit)		157,315		183,614		194,074		(42,813	)		(45,738	)

	Total		Less Than 1 Year		1-3 Years		3-5 Years		After 5 Years
Contractual Obligations
Long-term debt	$	17,351,000	$	6,170,000	$	10,755,000	$	426,000	$	—
Capital lease obligations		1,847,000		1,086,000		761,000		—		—
Operating leases		70,486,000		5,005,000		8,887,000		9,303,000		47,291,000
License and research agreements		2,843,000		703,000		829,000		561,000		750,000

Total Contractual Obligations	$	92,527,000	$	12,964,000	$	21,232,000	$	10,290,000	$	48,041,000

	December 31,
	2002			2001
ASSETS
Current assets:
Cash and cash equivalents	$	20,113,000		$	69,390,000
Short-term investments		142,983,000			121,310,000
Accounts receivable		1,992,000			2,908,000
Other current assets		822,000			1,461,000

Total current assets		165,910,000			195,069,000
Property and equipment, net		27,427,000			28,345,000
Acquired technology rights, net		2,018,000			2,174,000
Other assets		1,842,000			2,090,000

Total assets	$	197,197,000		$	227,678,000


LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable	$	4,133,000		$	4,444,000
Accrued liabilities		4,397,000			7,047,000
Deferred revenue		7,863,000			6,848,000
Current portion of capital lease obligations		953,000			1,032,000
Current portion of notes payable		6,170,000			3,649,000

Total current liabilities		23,516,000			23,020,000

Capital lease obligations, less current portion		703,000			1,656,000
Notes payable, less current portion		11,181,000			10,765,000
Deposit from sublessee		270,000			—
Long-term deferred revenue		4,212,000			8,623,000

Commitments and contingencies (Note 6)
Stockholders’ equity:
Common stock–$0.001 par value; 65,000,000 shares authorized, 35,769,455 and 35,500,802 shares issued and outstanding at December 31, 2002 and 2001, respectively		36,000			36,000
Additional paid-in capital		265,150,000			263,626,000
Deferred compensation		(131,000	)		(734,000	)
Accumulated deficit		(109,376,000	)		(81,389,000	)
Accumulated other comprehensive income		1,636,000			2,075,000

Total stockholders’ equity		157,315,000			183,614,000

Total liabilities and stockholders’ equity	$	197,197,000		$	227,678,000

	Years Ended December 31,
	2002			2001			2000
Revenue:
Collaborative	$	30,276,000		$	34,936,000		$	22,883,000
Grant and product		1,379,000			1,103,000			1,418,000

Total revenue		31,655,000			36,039,000			24,301,000
Operating expenses:
Research and development (net of non-cash, stock-based compensation charges of $175,000, $407,000, and $2,137,000 in 2002, 2001, and 2000, respectively)		50,318,000			48,228,000			26,427,000
Selling, general and administrative (net of non-cash, stock-based compensation charges of $526,000, $2,137,000, and $7,732,000 in 2002, 2001, and 2000, respectively)		10,269,000			10,102,000			7,094,000
Non-cash, stock-based compensation		701,000			2,544,000			9,869,000

Total operating expenses		61,288,000			60,874,000			43,390,000

Loss from operations		(29,633,000	)		(24,835,000	)		(19,089,000	)
Other income (expense)		(770,000	)		484,000			(34,000	)
Equity in loss of joint venture (Note 3)		(2,532,000	)		(1,839,000	)		(76,000	)
Interest income		6,459,000			11,697,000			11,735,000
Interest expense		(1,511,000	)		(1,171,000	)		(600,000	)

Net loss		(27,987,000	)		(15,664,000	)		(8,064,000	)
Dividends payable to preferred stockholders		—			—			(310,000	)

Net loss applicable to common stockholders	$	(27,987,000	)	$	(15,664,000	)	$	(8,374,000	)

Net loss per share, basic and diluted	$	(0.79	)	$	(0.44	)	$	(0.27	)

Shares used in calculating net loss per share, basic and diluted		35,650,000			35,243,000			30,836,000

	Series E Convertible Preferred Stock					Common Stock			Additional Paid-In Capital		Deferred Compensation			Notes Receivable from Stockholders			Accumulated Deficit			Accumulated Other Comprehensive Income (Loss)			Total Stockholders’ Equity (Deficit)
	Shares		Amount			Shares	Amount		Additional Paid-In Capital		Deferred Compensation			Notes Receivable from Stockholders			Accumulated Deficit			Accumulated Other Comprehensive Income (Loss)			Total Stockholders’ Equity (Deficit)
Balance at December 31, 1999	5,555,556		$	6,000		2,945,390	$	3,000	$	20,102,000	$	(5,520,000	)	$	(36,000	)	$	(57,351,000	)	$	(17,000	)	$	(42,813,000	)
Comprehensive income (loss):
Net loss	—			—		—		—		—		—			—			(8,064,000	)		—			(8,064,000	)
Unrealized gain on available-for-sale securities	—			—		—		—		—		—			—			—			989,000			989,000

Comprehensive loss	—			—		—		—		—		—			—			—			—			(7,075,000	)
Issuance of common stock, net of issuance costs of $15,584,000	—			—		8,337,500		8,000		184,516,000		—			36,000			—			—			184,560,000
Conversion of convertible preferred stock to common stock upon completion of initial public offering	(5,555,556	)		(6,000	)	22,834,042		23,000		48,385,000		—			—			—			—			48,402,000
Issuance of common stock for payment of dividends to preferred stockholders	—			—		15,641		—		376,000		—			—			(310,000	)		—			66,000
Issuance of common stock under stock plans	—			—		747,438		1,000		1,064,000		—			—			—			—			1,065,000
Issuance of common stock and warrants for services	—			—		10,795		—		700,000		—			—			—			—			700,000
Non-cash compensation related to stock options	—			—		—		—		5,786,000		—			—			—			—			5,786,000
Amortization of deferred compensation	—			—		—		—		—		3,383,000			—			—			—			3,383,000

Balance at December 31, 2000	—			—		34,890,806		35,000		260,929,000		(2,137,000	)		—			(65,725,000	)		972,000			194,074,000
Comprehensive income (loss):
Net loss	—			—		—		—		—		—			—			(15,664,000	)		—			(15,664,000	)
Unrealized gain on available-for-sale securities	—			—		—		—		—		—			—			—			1,103,000			1,103,000

Comprehensive loss																								(14,561,000	)
Issuance of common stock under stock plans	—			—		609,996		1,000		1,556,000		—			—			—			—			1,557,000
Non-cash compensation related to stock options	—			—		—		—		1,141,000		—			—			—			—			1,141,000
Amortization of deferred compensation	—			—		—		—		—		1,403,000			—			—			—			1,403,000

Balance at December 31, 2001	—			—		35,500,802		36,000		263,626,000		(734,000	)		—			(81,389,000	)		2,075,000			183,614,000
Comprehensive income (loss):
Net loss	—			—		—		—		—		—			—			(27,987,000	)		—			(27,987,000	)
Unrealized loss on available-for-sale securities	—			—		—		—		—		—			—			—			(439,000	)		(439,000	)

Comprehensive loss																								(28,426,000	)
Issuance of common stock under stock plans	—			—		268,653		—		1,426,000		—			—			—			—			1,426,000
Non-cash compensation related to stock options	—			—		—		—		98,000		—			—			—			—			98,000
Amortization of deferred compensation	—			—		—		—		—		603,000			—			—			—			603,000

Balance at December 31, 2002	—		$	—		35,769,455	$	36,000	$	265,150,000	$	(131,000	)	$	—		$	(109,376,000	)	$	1,636,000		$	157,315,000

	Amortized Cost		Market Value		Unrealized Gain
December 31, 2002
Corporate debt securities	$	68,657,000	$	69,431,000	$	774,000
U.S. Government and agency obligations		72,690,000		73,552,000		862,000

	$	141,347,000	$	142,983,000	$	1,636,000


	Amortized Cost		Market Value		Unrealized Gain
December 31, 2001
Corporate debt securities	$	61,140,000	$	62,040,000	$	900,000
U.S. Government and agency obligations		58,095,000		59,270,000		1,175,000

	$	119,235,000	$	121,310,000	$	2,075,000

Year ending December 31:
2003	$	6,170,000
2004		7,004,000
2005		3,751,000
2006		426,000
Thereafter		—

		17,351,000
Less current portion		(6,170,000	)

	$	11,181,000

	Capital Leases			Operating Leases
Year ending December 31:
2003	$	1,086,000		$	5,005,000
2004		566,000			4,452,000
2005		195,000			4,435,000
2006		—			4,557,000
2007		—			4,746,000
Thereafter		—			47,291,000

Total minimum lease payments		1,847,000		$	70,486,000

Amount representing interest		191,000

Present value of minimum capital lease obligations		1,656,000
Less current portion		(953,000	)

Long-term capital lease obligations	$	703,000

	Shares		Weighted-Average Exercise Price
Balance at December 31, 1999	3,125,000		$	1.73
Granted	1,435,000		$	23.84
Exercised	(537,000	)	$	1.11
Cancelled	(68,000	)	$	2.07

Balance at December 31, 2000	3,955,000		$	9.85
Granted	1,509,000		$	13.06
Exercised	(394,000	)	$	1.68
Cancelled	(91,000	)	$	19.22

Balance at December 31, 2001	4,979,000		$	11.30
Granted	527,000		$	10.61
Exercised	(119,000	)	$	1.67
Cancelled	(181,000	)	$	18.29

Balance at December 31, 2002	5,206,000		$	11.20

Range of Exercise Prices	Options Outstanding	Weighted- Average Remaining Life in Years	Weighted- Average Exercise Price		Options Exercisable	Weighted- Average Exercise Price of Options Exercisable
$ 0.42—$ 1.73	1,231,000	5.5	$	0.76	1,231,000	$	0.76
$ 2.02—$10.90	1,348,000	7.8	$	6.39	873,000	$	4.65
$11.05—$19.38	1,315,000	9.0	$	13.71	322,000	$	14.41
$19.50—$88.63	1,312,000	7.7	$	23.43	1,007,000	$	24.52

$ 0.42—$88.63	5,206,000	7.5	$	11.20	3,433,000	$	10.00

Employee Stock Purchase Plan		426,000
Stock Option Plans		7,720,000
Warrants		42,000

		8,188,000

2002 Quarter Ended	Dec. 31			Sep. 30			June 30			Mar. 31
	(in thousands, except per share data)
Total revenue	$	9,079		$	8,164		$	7,224		$	7,188
Operating expenses		15,548			15,121			15,460			15,159
Net loss applicable to common stockholders		(6,263	)		(6,697	)		(8,064	)		(6,962	)
Basic and diluted net loss per common share		(0.18	)		(0.19	)		(0.23	)		(0.20	)

2001 Quarter Ended		Dec. 31			Sep. 30			June 30			Mar. 31
	(in thousands, except per share data)
Total revenue	$	10,002		$	9,060		$	8,762		$	8,215
Operating expenses		19,342			14,378			14,417			12,737
Net loss applicable to common stockholders		(7,500	)		(3,882	)		(2,929	)		(1,354	)
Basic and diluted net loss per common share		(0.21	)		(0.11	)		(0.08	)		(0.04	)

		Page
Report of Ernst & Young LLP, Independent Auditors		47

Balance Sheets		48

Statements of Operations		49

Statements of Stockholders’ Equity (Deficit)		50

Statements of Cash Flows		51

Notes to Financial Statements		52

Exhibit Number		Description of Exhibit
2.1		Transaction Agreement dated as of December 3, 2002 among Syngenta Participations AG, Torrey Mesa Research Institute and the Company.(11)

3.1		Amended and Restated Certificate of Incorporation.(1)

3.2		Amended and Restated Bylaws.(1)

4.1		Form of Common Stock Certificate of the Company.(2)

4.2		Rights Agreement by and between the Company and American Stock Transfer and Trust Company, as Rights Agent, dated as of December 13, 2000 (including the Form of Certificate of Designation of Series A Junior Participating Preferred Stock attached thereto as Exhibit A, the Form of Right Certificate attached thereto as Exhibit B, and the Summary of Rights to Purchase Preferred Shares attached thereto as Exhibit C).(3)

4.3		The Company’s Certificate of Designation of Series A Junior Participating Preferred Stock.(3)

4.4		Warrant issued by the Company to Syngenta Participations AG.(11)

4.5		Registration Rights Agreement dated as of December 3, 2002 among Syngenta Participations AG, Torrey Mesa Research Institute, Syngenta Seeds AG and the Company.(11)

10.1		Form of Indemnity Agreement entered into between the Company and its directors and executive officers.(4)

10.2*		1994 Employee Incentive and Non-Qualified Stock Option Plan, as amended.(4)

10.3*		Form of Stock Option Agreement under the 1994 Employee Incentive and Non-Qualified Stock Option Plan.(4)

10.4*		1997 Equity Incentive Plan.(10)

10.5*		Form of Stock Option Grant Notice and Stock Option Agreement under the 1997 Equity Incentive Plan.(4)

10.6*		1999 Non-Employee Directors’ Stock Option Plan.(4)

10.7*		Form of Stock Option Grant Notice and Related Stock Option Agreement under the 1999 Non-Employee Directors’ Stock Option Plan.(4)

10.8*		1999 Employee Stock Purchase Plan.(4)

10.9†		Amended and Restated Stockholders’ Agreement by and among the Company and the Stockholders identified therein, dated January 25, 1999.(4)

10.10		Form of Warrant Agreement to purchase Series A Preferred Stock (with schedule of holders attached).(4)

10.11		Form of Warrant Agreement to purchase Common Stock (with schedule of holders attached).(4)

10.12		Form of Warrant Agreement to purchase Common Stock (with schedule of holders attached).(4)

10.13		Multi-Tenant Office R&D Building Lease by and between the Company and Sycamore/San Diego Investors, dated September 24, 1996.(4)

10.14		Master Lease Agreement by and between the Transamerica Business Credit Corporation and the Company, dated April 4, 1997.(4)

10.15†		License Agreement by and between the Company and The Dow Chemical Company, dated July 20, 1997 and July 22, 1997.(4)

10.16†		Collaborative Research Agreement by and between the Company and The Dow Chemical Company, dated July 20, 1999 and July 22, 1999.(4)

10.17†		License Agreement by and between the Company and Finnfeeds International Limited, dated December 1, 1998.(4)

Exhibit Number		Description of Exhibit

10.18†		Collaboration Agreement by and between the Company and Novartis Agribusiness Biotechnology Research, Inc., dated January 25, 1999, as amended.(4)

10.19†		Stock Purchase Agreement by and between the Company and Novartis Agribusiness Biotechnology Research, Inc., dated January 25, 1999.(4)

10.20†		Collaboration Agreement by and between the Company and Rhone-Poulenc Animal Nutrition S.A., dated June 28, 1999.(4)

10.21†		License Agreement by and between the Company and Invitrogen Corporation, dated March 29, 1999.(4)

10.22†		License Agreement by and between the Company and Mycogen Corporation, dated December 1997, as amended on March 6, 1998 and December 19, 1997.(4)

10.23†		Patent Cross-License Agreement by and between the Company and Terragen Discovery Inc., dated November 18, 1999.(4)

10.24†		Joint Venture Agreement by and between the Company and Novartis Seeds AG, dated December 1, 1999.(4)

10.25†		Research Lease by and between the Company and One Cell Systems, Inc., dated February 16, 1999.(4)

10.26†		Research and Development Agreement by and between the Company and Novartis Enzymes, Inc., dated December 1, 1999.(4)

10.27*		Employment Offer Letter to Patrick Simms, dated February 3, 1997.(4)

10.28*		Employment Offer Letter to Jay Short, dated August 30, 1994.(4)

10.29*		Employment Offer Letter to Karin Eastham, dated April 2, 1999.(4)

10.30*		Employment Offer Letter to William H. Baum, dated July 31, 1997.(4)

10.31*		Separation Agreement by and between the Company and Terrance J. Bruggeman, effective as of April 12, 1999.(4)

10.32*		Separation Agreement by and between the Company and Kathleen H. Van Sleen, effective as of May 10, 1999.(4)

10.33*		Letter Agreement by and between the Company and Jay M. Short, Ph.D., dated June 25, 1998.(4)

10.34		Lease Agreement, dated February 11, 2000, by and between the Company and KR—Gateway Partners, LLC.(1)

10.35		Lease Agreement, dated February 11, 2000, by and between the Company and KR—Gateway Partners, LLC.(1)

10.36†		Limited Liability Company Agreement of New Venture LLC, dated June 29, 2000(5)

10.37†		Industrial Enzymes Research Agreement by and between New Venture LLC and the Company, dated June 29, 2000.(5)

10.38†		Industrial Enzyme License Agreement by and between New Venture LLC and the Company, dated June 29, 2000.(5)

10.39†		Addendum to the “Collaboration Agreement” between Novartis Agribusiness Biotechnology Research, Inc. and the Company, dated September 1, 2000.(6)

10.40†		Master Collaboration Agreement by and between the Company and The Dow Chemical Company, effective as of September 30, 2000.(7)

10.41†		Project Agreement by and between The Dow Chemical Company and the Company, effective as of September 30, 2000.(7)

Exhibit Number		Description of Exhibit

10.42†		Collaboration Agreement by and between the Company, Glaxo Research and Development Limited, and Glaxo Group Limited, made as of December 8, 2000.(7)

10.43†		Drug Discovery, Development, and License Agreement between the Company and IntraBiotics Pharmaceuticals, Inc. dated January 6, 2001.(8)

10.44†		Release Agreement between the Company and IntraBiotics Pharmaceuticals, Inc. dated July 27, 2001.(9)

10.45†		Amended and Restated Research Collaboration Agreement dated as of January 3, 2003 between the Company and Syngenta Participations AG. (11)

10.46		Intellectual Property Rights License dated as of December 3, 2002 between the Company and Syngenta Participations AG. (11)

23.1		Consent of Ernst & Young LLP, Independent Auditors.

24.1		Power of Attorney. Reference is made to page 69.

99.1		Certification of Chief Executive Officer and Chief Financial Officer.

Signatures	Title	Date
/s/ JAY M. SHORT, PH.D. Jay M. Short, Ph.D.	President, Chief Executive Officer, Chief Technology Officer, and Director (Principal Executive Officer)	March 31, 2003

/s/ KARIN EASTHAM Karin Eastham	Senior Vice President, Finance and Chief Financial Officer (Principal Financial and Accounting Officer)	March 31, 2003

/s/ JAMES H. CAVANAUGH, PH.D. James H. Cavanaugh, Ph.D.	Director	March 31, 2003

/s/ WAYNE T. HOCKMEYER, PH.D. Wayne T. Hockmeyer, Ph.D.	Director	March 31, 2003

/s/ PETER JOHNSON Peter Johnson	Director	March 31, 2003

/s/ DONALD D. JOHNSTON Donald D. Johnston	Director	March 31, 2003

/s/ MARK LESCHLY Mark Leschly	Director	March 31, 2003

/s/ MELVIN I. SIMON, PH.D. Melvin I. Simon, Ph.D.	Director	March 31, 2003