GENAISSANCE PHARMACEUTICALS INC - 10-Q Quarterly Report

Back to GetFilings.com

================================================================================

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549

FORM 10-Q

|X| QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934

FOR THE QUARTERLY PERIOD ENDED JUNE 30, 2002

|_| TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934

FOR THE TRANSITION PERIOD FROM ________________ TO ________________

COMMISSION FILE NO. 000-30981

GENAISSANCE PHARMACEUTICALS, INC.
(Exact Name of Registrant as Specified in its Charter)

DELAWARE 06-1338846
(STATE OR OTHER JURISDICTION OF (I.R.S. EMPLOYER
INCORPORATION OR ORGANIZATION) IDENTIFICATION NO.)

FIVE SCIENCE PARK, NEW HAVEN, CONNECTICUT 06511
(Address of principal executive office and zip code)

(203) 773-1450
(Registrant's telephone number, including area code)

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|_|

The number of shares outstanding of the Registrant's common stock as of
August 6, 2002 was 22,827,353.

================================================================================

GENAISSANCE PHARMACEUTICALS, INC.

For the Quarter Ended June 30, 2002

INDEX

Part 1: Financial Information

Item 1 - Financial Statements:

GENAISSANCE PHARMACEUTICALS, INC.
Balance Sheets
(In thousands, except per share data)

THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THESE FINANCIAL STATEMENTS.

1

GENAISSANCE PHARMACEUTICALS, INC.

Balance Sheets
(In thousands, except per share data)

THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THESE FINANCIAL STATEMENTS.

2

GENAISSANCE PHARMACEUTICALS, INC.

Statements of Operations
(Unaudited)
(In thousands, except per share data)

THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THESE FINANCIAL STATEMENTS.

3

GENAISSANCE PHARMACEUTICALS, INC.

Statements of Cash Flows
(Unaudited)
(In thousands)

THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THESE FINANCIAL STATEMENTS.

4

GENAISSANCE PHARMACEUTICALS, INC.

Notes to Unaudited Financial Statements
For the Quarter Ended June 30, 2002
(In thousands)

(1) BASIS OF PRESENTATION

Genaissance Pharmaceuticals, Inc. is seeking to create personalized
medicines through the integration of gene variation into drug
development. We discover inherited differences, or genomic markers, that
exist in human genes. We use our technological capabilities and methods
as well as our clinical genetic development skills to identify the
genomic markers that appear to define a patient population that responds
best to a medication and has a superior safety profile. We market our
technology and our predictive genomic markers to the pharmaceutical and
biotechnology industries as a means to improve the development, marketing
and prescribing of drugs. We also intend to use our predictive genomic
markers to create new therapeutic products for specific patient
populations by completing the development of drugs through joint ventures
and license agreements.

We have prepared the accompanying financial statements without audit,
pursuant to the rules and regulations of the Securities and Exchange
Commission. Certain information and footnote disclosures normally
included in financial statements prepared in accordance with accounting
principles generally accepted in the United States have been condensed or
omitted pursuant to such rules and regulations. These financial
statements should be read in conjunction with our audited financial
statements and related footnotes for the year ended December 31, 2001
thereto included in our Annual Report on Form 10-K (File No. 000-30981).
The unaudited financial statements include, in the opinion of management,
all adjustments (consisting only of normal recurring adjustments)
necessary to present fairly our financial position as of June 30, 2002,
and the results of our operations for the three and six month periods
ended June 30, 2002 and 2001. The results of operations for such interim
periods are not necessarily indicative of the results to be achieved for
the full year.

(2) EARNINGS PER SHARE

We compute and present net loss per share in accordance with SFAS No.
128, EARNINGS PER SHARE. For the three and six months ended June 30, 2002
and 2001, there is no difference in basic and diluted net loss per common
share as the effect of stock options and warrants would be anti-dilutive
for all periods presented. The outstanding stock options and warrants
(prior to application of the treasury stock method) would entitle holders
to acquire 3,735 and 3,157 shares of common stock at June 30, 2002 and
2001, respectively.

(3) REVENUE RECOGNITION

We earn our revenues primarily through the licensing of our HAP(TM)
Technology and by providing HAP(TM) Typing services. We have also
entered into agreements which provide for future milestones and
royalty payments. We recognize revenue in accordance with Staff
Accounting Bulletin No. 101, REVENUE RECOGNITION IN FINANCIAL
STATEMENTS (SAB 101), and in accordance with Statement of Position
97-2, SOFTWARE REVENUE RECOGNITION (SOP 97-2), as amended by Statement
of Position 98-9. In accordance therewith, we recognize annual license
and subscription fees over the term of the agreement and service fees
as the services are performed. Future milestones and royalty payments,
if any, will be recognized when received provided that the milestone
is substantive and a culmination of the earnings process has occurred.

(4) IMPAIRMENT OF FIXED ASSETS

In August 2001, the Financial Accounting Standards Board (FASB) issued
Statement of Financial Standards No. 144, ACCOUNTING FOR THE IMPAIRMENT
OR DISPOSAL OF LONG-LIVED ASSETS (SFAS No. 144), effective for fiscal
years beginning after December 15, 2001. SFAS No. 144 establishes a
single accounting model, based on the framework established in Statement
of Financial Accounting Standards No. 121 (SFAS No. 121), for long-

5

GENAISSANCE PHARMACEUTICALS, INC.

Notes to Unaudited Financial Statements
For the Quarter Ended June 30, 2002
(In thousands)

lived assets to be held for use. SFAS No. 144 retains the fundamental
provisions of SFAS No. 121 for recognition and measurement of the
impairment of long-lived assets. We assess the impairment of long-lived
assets whenever events or changes in circumstances indicate that the
carrying value may not be recoverable. Factors we consider important,
which could trigger an impairment review, include, among others, the
following:

o a significant adverse change in the extent or manner in which a
long-lived asset is being used;

o a significant adverse change in the business climate that could
affect the value of a long-lived asset; and

o a significant decrease in market value of assets.

If we determine that the carrying value of long-lived assets may not be
recoverable, based upon the existence of one or more of the above
indicators of impairment, we compare the carrying value of the asset
group to its undiscounted cash flows expected to be generated by the
group. If the carrying value exceeds the undiscounted cash flows, we then
compare the carrying value of the asset group to its fair value to
determine whether an impairment charge is required. We determine the fair
value of the fixed assets by discounting expected future cash flow using
a discount rate determined by our management to be commensurate with the
risk inherent in our current business. If the fair value is less than the
carrying value, such amount is recognized as an impairment charge.

During the quarter ended June 30, 2002, we determined that certain
conditions had arisen which triggered the need to review our long-lived
assets for potential impairment. The conditions included, but were not
limited to, the overall business climate, in which we operate, and a
significant change in the manner in which we were utilizing our DNA
sequencing facility and related assets. Our review concluded that the
carrying value of the long-lived assets exceeded their fair value by
approximately $6.0 million. The impairment charge includes the write-down
of sequencing equipment, computer hardware and software and leasehold
improvements and is being allocated to the individual assets on a
pro-rata basis.

(5) CASH, CASH EQUIVALENTS AND MARKETABLE SECURITIES

We consider all highly liquid debt instruments purchased with an original
maturity of three months or less to be cash equivalents.

We classify our marketable securities as "available for sale" and,
accordingly, carry these investments at their aggregate fair value. Our
marketable securities as of June 30, 2002 and December 31, 2001 consisted
principally of corporate bonds. As of June 30, 2002, these securities had
a maximum maturity of less than 12 months.

6

ITEM 2--MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS

The following discussion and analysis of our financial condition and the results
of operations should be read in conjunction with the financial statements and
related notes appearing elsewhere in this quarterly report on Form 10-Q. This
report on Form 10-Q contains forward-looking statements within the meaning of
Section 21E of the Securities Exchange Act of 1934, as amended, that involve
risks and uncertainties, including, but not limited to, statements about
management's expectations as to costs and our liquidity position. These
expectations are based on certain assumptions regarding our research and
development activities, projected expenditures, the ability of our technologies
to improve the drug development process, significant growth in our revenues and
other factors relating to our business. These expectations may not materialize
if development efforts are delayed or suspended or if other assumptions prove
incorrect. These factors are more fully discussed below under the heading
"Factors Affecting Future Operating Results" and in our other filings with the
Securities and Exchange Commission. Readers are cautioned not to place undue
reliance on these or other forward-looking statements, which reflect
management's analysis, judgment, belief or expectation only as of the date on
which they are made. While we may elect to update forward-looking statements at
some time in the future, we specifically disclaim any obligation to do so, even
if our estimates change.

OVERVIEW

Since our inception, we have incurred significant operating losses, and, as
of June 30, 2002, we had an accumulated deficit of $183.0 million. The
majority of our operating losses have resulted from costs we incurred
developing our HAP(TM) Technology and our clinical trials. We expect to
dedicate a significant portion of our resources for the foreseeable future to
maintain our HAP(TM) Technology, to service our current and future partners
and to expand and intensify our commercialization activities. To date, our
revenue has been primarily from licensing and service fees from our
agreements with Biogen, Inc. (Biogen), AstraZeneca UK Limited (AstraZeneca),
Pfizer, Inc., Janssen Research Foundation, a Johnson & Johnson Company (J&J),
and Gene Logic, Inc. (GLI), as well as a sublicensing agreement with Visible
Genetics, Inc. and government grants.

On August 5, 2002, we announced a restructuring and cost reduction program to
revise our business focus and to align better our operating cost structure
with our current and projected partner needs and projected revenues from our
current and projected partners. The cost reduction program included a
realignment of management responsibilities, a reduction in our workforce, and
a decision to seek partners for all internal product development programs.
The workforce was reduced by 20 percent to 110 employees in our third fiscal
quarter with the majority of the workforce reductions occurring in the DNA
sequencing facility and related informatics support. We will incur a charge
for severance related costs of less than $200,000, which will be recorded in
operating results in the third fiscal quarter.

As a result of the restructuring and cost reduction program, we expect future
operating expenses to decrease, primarily in research and development expenses.
In addition to reducing expenses, our plans and projections reflect a measurable
reduction in our negative operating cash flow. These reductions in our negative
operating cash flow assume significant year over year increases in revenues.
There can be no assurance that revenues will continue to increase or that there
will continue to be a decrease in the level of cash used to fund operations. If
we are not successful in increasing revenues or reducing expenses, as planned,
we may not be able to maintain our operations at planned levels.

CRITICAL ACCOUNTING POLICIES

Our critical accounting policies are as follows:

o Revenue recognition

o Valuation of long-lived assets

REVENUE RECOGNITION. We earn our revenues primarily through the licensing
of our HAP(TM) Technology and by

7

providing HAP(TM) Typing services. We have also entered into agreements
which provide for future milestones and royalty payments. We recognize
revenue in accordance with Staff Accounting Bulletin No. 101, REVENUE
RECOGNITION IN FINANCIAL STATEMENTS (SAB 101), and in accordance with
Statement of Position 97-2, SOFTWARE REVENUE RECOGNITION (SOP 97-2), as
amended by Statement of Position 98-9. In accordance therewith, we
recognize annual license and subscription fees over the term of the
agreement and service fees as the services are performed. Future
milestones and royalty payments, if any, will be recognized when received
provided that the milestone is substantive and a culmination of the
earnings process has occurred.

VALUATION OF LONG-LIVED ASSETS. We assess the impairment of long-lived
assets whenever events or changes in circumstances indicate that the
carrying value may not be recoverable. Factors we consider important
which could trigger an impairment review include, among others, the
following:

o a significant adverse change in the extent or manner in which a
long-lived asset is being used;

o a significant adverse change in the business climate that could
affect the value of a long-lived asset; and

o a significant decrease in the market value of assets.

If we determine that the carrying value of long-lived assets may not be
recoverable, based upon the existence of one or more of the above
indicators of impairment, we compare the carrying value of the asset
group to the undiscounted cash flows expected to be generated by the
group. If the carrying value exceeds the undiscounted cash flows an
impairment charge is recorded. To determine the amount of the impairment
charge, we compare the carrying value of the applicable fixed assets to
their fair value. We determine the fair value of the fixed assets by
discounting expected future cash flow using a discount rate determined by
our management to be commensurate with the risk inherent in our current
business. If the fair value is less than the carrying value, such
amount is recognized as an impairment charge.

RESULTS OF OPERATIONS

THREE MONTHS ENDED JUNE 30, 2002 AND 2001

License and service revenue consisted primarily of proceeds received in
connection with the licensing of our HAP(TM) Technology and the sublicensing
of a patent. Revenue increased to approximately $1.9 million in the three
months ended June 30, 2002 from $1.1 million in the three months ended June
30, 2001. The increase in license revenue is primarily attributable to the
commercialization of our HAP(TM) Technology Partnership program and our
HAP(TM) Drug-Specific Partnership program, including agreements entered into
with Biogen in 2002, Pfizer in August 2001, and J&J during 2000. We are
recognizing annual license and subscription fees over the term of the
agreements and the service fees as the services are performed. Future
milestone and royalty payments, when and if received, will be recognized when
earned. Revenue also includes the amortization, over the remaining life of
the sublicensed patent, of upfront payments received in connection with the
sublicensing of a patent.

Research and development expenses consisted primarily of payroll and benefits
for research and development personnel, material and reagent costs, costs
incurred in connection with clinical trials, depreciation and maintenance
costs for equipment used for HAP(TM) Marker discovery and HAP(TM) Typing, and
facility-related costs. We expense our research and development costs as
incurred. Research and development expenses decreased to approximately $6.6
million in the three months ended June 30, 2002 from approximately $11.5
million in the three months ended June 30, 2001. The decrease in expenses is
primarily attributable to the completion of our clinical trials and a
decrease in material and reagent costs associated with the discovery of new
HAP(TM) Markers.

General and administrative expenses consisted primarily of payroll and benefits
for executive, business development, finance, public affairs and other
administrative personnel, as well as facility-related costs and outside
professional fees incurred in connection with corporate development and general
legal and financial matters. General and administrative expenses decreased to
approximately $2.5 million in the three months ended June 30, 2002 from

8

approximately $3.1 million in the three months ended June 30, 2001. The decrease
is primarily attributable to a decrease in professional service fees incurred in
connection with business development and marketing activities.

The impairment of fixed assets charge relates to sequencing equipment, computer
hardware and software and leasehold improvements in our DNA sequencing facility.
During the quarter ended June 30, 2002, our management determined that certain
conditions had arisen during the quarter that triggered the need for a review of
our long-lived assets for potential impairment. These conditions included, but
were not limited to, the overall business climate in which we operate, and a
significant change in the manner in which we were utilizing our DNA sequencing
facility and related assets. In particular, during the quarter ended June 30,
2002, we determined that our sequencing production capacity significantly
exceeded our forecasted demand for the foreseeable future, which resulted in our
decision to remove from production the majority of our ABI Prism(R)3700 DNA
Analyzers. Accordingly, we performed an impairment review of our sequencing
long-lived assets. As a result of our review, we determined that the carrying
value of the assets was in excess of the projected undiscounted cash flows to be
generated by the asset group. To determine the impairment charge, we compared
the carrying value of the applicable fixed assets to their fair value. We
determined the fair value of the fixed assets by discounting expected future
cash flows using a discount rate determined by our management to be commensurate
with the risk inherent in our current business. As a result of our analysis, we
determined that the carrying value of the assets was in excess of discounted
future cash flow to be generated by the asset group and we recorded a write-down
of $6.0 million. The impairment charge is being allocated to the individual
assets on a pro-rata basis. The revised carrying value of the assets will be
depreciated over two years, the average remaining life of the primary asset of
the group.

Stock-based and other non-cash compensation expense relates to options granted
to employees and options granted to scientific advisory board members and
consultants. Stock options granted to employees are accounted for in accordance
with APB No. 25. The accounting for scientific advisory board members requires
us to record periodic charges for unvested options based on an increase in the
fair value of our common stock and the related vesting of the options. Stock
based compensation decreased to approximately $97,000 in the three months ended
June 30, 2002 from approximately $160,000 in the three months ended June 30,
2001.

Interest income (expense), net decreased to an expense of approximately
($210,000) in the three months ended June 30, 2002 from an income of
approximately $463,000 in the three months ended June 30, 2001. The decrease is
primarily the result of higher cash, cash equivalents and short-term investment
balances in 2001 and the lower interest rates on investments after the second
quarter of 2001.

SIX MONTHS ENDED JUNE 30, 2002 AND 2001

Revenue increased to approximately $3.8 million in the six months ended June
30, 2002 from $2.1 million in the six months ended June 30, 2001. The
increase in license revenue is attributable to the commercialization of our
HAP(TM) Technology Partnership program and our HAP(TM) Drug-Specific
Partnership program, including agreements entered into with Biogen in 2002,
Pfizer and AstraZeneca in 2001, as well as the agreement entered into with
J&J during 2000.

Research and development expenses decreased to approximately $14.8 million in
the six months ended June 30, 2002 from approximately $21.4 million in the six
months ended June 30, 2001. The decrease in expenses is primarily attributable
to the completion of our clinical trials and a decrease in material and reagent
costs associated with the discovery of new HAP(TM) Markers.

General and administrative expenses decreased to approximately $4.9 million
in the six months ended June 30, 2002 from approximately $6.0 million in the
six months ended June 30, 2001. The decrease is primarily attributable to a
decrease in professional service fees incurred in connection with business
development and marketing activities.

The impairment of fixed assets charge relates to sequencing equipment, computer
hardware and software and leasehold improvements in our DNA sequencing facility.
During the quarter ended June 30, 2002, our management determined that certain
conditions had arisen during the quarter that triggered the need for a review of
our long-lived assets for potential impairment. These conditions included, but
were not limited to, the overall business climate in

9

which we operate and a significant change in the manner in which we were
utilizing our DNA sequencing facility and related assets. In particular, during
the quarter ended June 30, 2002, we determined that our sequencing production
capacity significantly exceeded our forecasted demand for the foreseeable
future, which resulted in our decision to remove from production the majority of
our ABI Prism(R) 3700 DNA Analyzers, the primary asset of the group.
Accordingly, we performed an impairment review on our sequencing long-lived
assets. As a result of our review, we determined that the carrying value of the
assets was in excess of the projected undiscounted cash flows to be generated by
the asset group. To determine the impairment charge, we compared the carrying
value of the applicable fixed assets to their fair value. We determined the fair
value of the fixed assets by discounting expected future cash flows using a
discount rate determined by our management to be commensurate with the risk
inherent in our current business. As a result of our analysis, we determined
that the carrying value of the assets was in excess of discounted future cash
flow to be generated by the asset group and we recorded a write-down of $6.0
million. The impairment charge is being allocated to the individual assets on a
pro-rata basis. The revised carrying value of the assets will be depreciated
over two years, the average remaining life of the primary asset of the group.

Stock based compensation decreased to approximately $207,000 in the six months
ended June 30, 2002 from approximately $285,000 in the six months ended June 30,
2001.

Interest income (expense), net decreased to an expense of approximately
($383,000) in the six months ended June 30, 2002 from an income of approximately
$1.2 million in the six months ended June 30, 2001.

LIQUIDITY AND CAPITAL RESOURCES

We have financed our operations primarily through the sale of common and
preferred stock, government research grants, payments under licensing
agreements, loans and capital leases. From inception through June 30, 2002, we
have received aggregate gross proceeds of approximately $163.1 million from
issuance of common and preferred stock. In addition, through June 30, 2002, we
have received $4.5 million of government research grants and $13.4 million from
license and service fees, royalties and research contracts. We have also
received $26.2 million from capital lease financing arrangements and $8.2
million from other loans. We have acquired, through June 30, 2002, $41.8 million
of property and equipment. The majority of these assets were financed through
capital lease financing arrangements and other loans.

We expect to continue to finance our operations in the short-term from cash we
received in 2000 from the sale of our common and preferred stock and revenue
from our HAP(TM) Technology Partnership program and our HAP(TM) Drug-Specific
Partnership program. Our business strategy depends on entering into partnership
agreements with pharmaceutical and biotechnology companies. If we are
unsuccessful in marketing our partnership programs, we may not generate
sufficient revenues to sustain our operations at planned levels.

Cash used in operations for the six months ended June 30, 2002 was $13.7 million
compared with $21.9 million for the same period in 2001. The cash used in
operations for the six months ended June 30, 2002 resulted primarily from a net
loss of $22.5 million and a $2.9 million decrease in accounts payable and
accrued liabilities, partially offset by $10.8 million of non-cash charges for
depreciation and amortization expense, non-cash stock based compensation and
impairment of fixed assets. Cash used in operations for the six months ended
June 30, 2001 resulted primarily from a net loss of $24.4 million and a $2.3
million decrease in accounts payable, partially offset by $4.3 million of
non-cash charges for depreciation and amortization expense and non-cash stock
based compensation.

Cash provided by investing activities for the six months ended June 30, 2002 was
$17.8 million compared with $7.1 million for the same period in 2001. Proceeds
from the sale of marketable securities totaled $17.9 million for the six months
ended June 30, 2002 compared to $10.6 million for the same period in 2001.
During the six months ended June 30, 2002, we used $70,000 of cash for the
purchase of property and equipment compared to $3.5 million for the same period
in 2001.

Cash used for financing activities for the six months ended June 30, 2002 was
$3.6 million compared with $2.9 million for the same period in 2001. The primary
use of cash from financing activities for the six months ended June 30, 2002 and
2001 was the repayment of capital lease obligations.

10

Our contractual cash obligations as of June 30, 2002, are as follows:

* Payment of our long-term debt and capital lease obligations could be
accelerated if we fail to maintain compliance with certain financial and
non-financial covenants, including absence of material adverse change and
other covenants.

Long-term debt consists primarily of three financing agreements with Connecticut
Innovations Inc. (CII), a stockholder of ours, used to finance certain leasehold
improvements and other costs associated with our facility expansion. The
agreements bear interest at 6.5%. The agreements provide for interest only with
principal payments based on a 120-month amortization beginning April 2001
through October 2002, with final balloon payments due in April 2009 through June
2011. Borrowings under the agreements are secured by the related leasehold
improvements. We have borrowed all available amounts under these agreements.

Capital lease obligations, related to equipment, consist principally of
arrangements with four equipment leasing companies. The leases have terms
ranging from two to four years with installments ending between August 2003
and February 2005, and bear interest at rates ranging from 8.15% to 12.46%.
Borrowings under these agreements are secured by the underlying leased
equipment. We have borrowed all available amounts under these agreements. The
capital lease arrangements allow for the purchase of the related equipment at
the completion of the lease term, as defined in the agreements.

We lease our operating facilities located in New Haven, Connecticut. The lease
agreements currently require annual lease payments of approximately $980,000 per
year, increasing to $1.1 million per year over the original term, which expires
in 2004. We have two five-year renewal options to extend the lease agreements
beyond the initial term. We are recording the expense associated with the leases
on a straight-line basis over the expected term of the leases. In addition to
the operating lease agreements for our current facility, we also have operating
leases for certain of our office equipment.

In addition, we periodically enter into agreements with third parties to obtain
exclusive or non-exclusive licenses for certain technologies. The terms of
certain of these agreements require us to make future royalty payments and
certain milestone payments based on product sales or sublicense income generated
from applicable technologies, if any. The amount of such payments will depend
upon successful commercialization of applicable technologies, if any. The future
minimum payments (assuming non-termination of these agreements) are included in
the minimum license obligations above.

Based on our current business plans, capital expenditures are not expected to
exceed $0.25 million for each of fiscal 2002 and 2003.

Our cash requirements will vary depending upon a number of factors, many of
which are beyond our control, including:

o the demand for our HAP(TM) Technology Partnership program and our
HAP(TM) Drug-Specific Partnership program;

o the efforts and success of our partnership program;

11

o the commercialization of intellectual property derived from our
internal programs;

o the level of competition we face;

o our ability to maintain our HAP(TM) Technology; and

o our ability to effectively manage operating expenses.

On June 30, 2002, cash, cash equivalents and short-term investments totaled
$42.2 million compared to approximately $59.7 million at December 31, 2001. Our
cash reserves are held in interest-bearing high-grade corporate bonds and money
market accounts. We believe that our existing cash reserves will be sufficient
to support our expected net losses, debt obligations and capital expenditures
for at least 24 months. To execute our business plan and continue to have cash
reserves for at least 24 months, we will need to grow our revenues significantly
each year. There can be no assurance that we will be able to obtain new partners
or to generate the increased revenues required to meet our business plan
objectives. In addition, to execute our business plan, we may need to consider
seeking additional funding through public or private equity offerings, debt
financings or commercial partners. We cannot assure you that we will obtain
additional partners or capital funding on acceptable terms, if at all. If we are
unable to generate sufficient revenues or access capital on acceptable terms, we
may not be able to achieve our objectives under our business plan or sustain our
operations at planned levels.

INCOME TAXES

We have not generated any taxable income to date and, therefore, have not paid
any federal income taxes since inception. At December 31, 2001, we had available
unused net operating loss carryforwards of approximately $94.6 million, which
may be available to offset future federal taxable income and approximately $93.6
million, which may be available to offset future state taxable income. Use of
our federal and state net operating loss carryforwards, which will begin to
expire in 2007 and 2002, respectively, may be subject to limitations. The future
utilization of these carryforwards may be limited due to changes within our
current and future ownership structure as defined within the income tax code. We
have recorded a full valuation allowance against our deferred tax asset, which
consists primarily of net operating loss carryforwards, because of uncertainty
regarding its recoverability, as required by Financial Accounting Standard No.
109, ACCOUNTING FOR INCOME TAXES.

RECENT ACCOUNTING PRONOUNCEMENTS

In July 2001, the Financial Accounting Standards Board issued SFAS No. 141,
BUSINESS COMBINATIONS (SFAS No. 141), and SFAS No. 142, GOODWILL AND OTHER
INTANGIBLE ASSETS (SFAS No. 142). SFAS No. 141 and SFAS No. 142 significantly
impact the accounting and disclosures for business combinations. The adoption of
SFAS No. 141 and SFAS No. 142 had no historical impact on our results of
operations or financial position.

FACTORS AFFECTING FUTURE OPERATING RESULTS

THIS QUARTERLY REPORT ON FORM 10-Q CONTAINS "FORWARD-LOOKING STATEMENTS" WITHIN
THE MEANING OF SECTION 21E OF THE SECURITIES EXCHANGE ACT OF 1934, AS AMENDED.
THESE STATEMENTS ARE SUBJECT TO RISKS AND UNCERTAINTIES AND ARE BASED ON THE
BELIEFS AND ASSUMPTIONS OF OUR MANAGEMENT BASED ON INFORMATION CURRENTLY
AVAILABLE TO OUR MANAGEMENT. USE OF WORDS, SUCH AS "BELIEVES," "EXPECTS,"
"ANTICIPATES," "INTENDS," "PLANS," "ESTIMATES," "SHOULD," "LIKELY" OR SIMILAR
EXPRESSIONS, INDICATE A FORWARD-LOOKING STATEMENT. FORWARD-LOOKING STATEMENTS
INVOLVE RISKS, UNCERTAINTIES AND ASSUMPTIONS. CERTAIN OF THE INFORMATION
CONTAINED IN THIS ANNUAL REPORT ON FORM 10-K CONSISTS OF FORWARD-LOOKING
STATEMENTS. IMPORTANT FACTORS THAT COULD CAUSE ACTUAL RESULTS TO DIFFER
MATERIALLY FROM THE FORWARD-LOOKING STATEMENTS INCLUDE THE FOLLOWING:

WE ARE AN EARLY STAGE COMPANY THAT MAY NEVER BE PROFITABLE.

12

We have incurred substantial operating losses since our inception. As of June
30, 2002, we have generated only minimal revenue from our HAP(TM) Technology
Partnership program and our HAP(TM) Drug-Specific Partnership program, and we
do not expect to generate significant revenues for several years, if ever.
From inception through June 30, 2002, we had an accumulated deficit of
approximately $183.0 million. Our losses to date have resulted principally
from costs we incurred in the development of our HAP(TM) Technology, in our
clinical trials and from general and administrative costs associated with
operations. We expect to devote our resources to service our HAP(TM)
Technology Partnership program and our HAP(TM) Drug-Specific Partnership
program and to maintain our HAP(TM) Technology.

We expect to incur additional losses this year and in future years, and we
may never achieve profitability. In addition, pharmaceutical and
biotechnology companies are only now beginning to use products such as ours
in their drug development or marketing efforts and, accordingly, they may not
choose to use our HAP(TM) Technology. We do not expect our losses to be
substantially mitigated by revenues from our HAP(TM) Technology Partnership
program, our HAP(TM) Drug-Specific Partnership program, or from our STRENGTH
and CARING programs for a number of years, if ever.

TO GENERATE SIGNIFICANT REVENUES, WE MUST OBTAIN CUSTOMERS FOR OUR
HAP(TM) TECHNOLOGY PARTNERSHIP PROGRAM AND OUR HAP(TM) DRUG-SPECIFIC
PARTNERSHIP PROGRAM.

Our strategy depends on entering into agreements with pharmaceutical and
biotechnology companies for our HAP(TM) Technology Partnership program and
our HAP(TM) Drug-Specific Partnership program. To date, we have three
partners for our HAP(TM) Technology Partnership program and one partner for
our HAP(TM) Drug-Specific Partnership program, and we may not obtain
additional partners for our HAP(TM) Technology Partnership program or our
HAP(TM) Drug-Specific Partnership program or find partners for our STRENGTH
and CARING programs. We currently do not have any partners for our STRENGTH
and CARING programs. If we are unsuccessful in marketing our HAP(TM)
Technology and finding partners for our STRENGTH and CARING programs, we may
never generate sufficient revenues to sustain our operations. In addition, we
expect that some of our future HAP(TM) Technology Partnership program
collaborations and that some of our HAP(TM) Drug-Specific Partnership program
collaborations will be limited to specific, limited-term projects or that
some of these collaborations may not be renewed. Accordingly, we must
continually obtain new customers to be successful.

IF THE ESTIMATES WE MAKE, AND THE ASSUMPTIONS ON WHICH WE RELY, IN
PREPARING OUR FINANCIAL STATEMENTS PROVE INACCURATE, OUR ACTUAL RESULTS
MAY VARY FROM THESE REFLECTED IN OUR PROJECTIONS AND ACCRUALS.

Our financial statements have been prepared in accordance with accounting
principles generally accepted in the United States of America. The preparation
of these financial statements requires us to make estimates and judgments that
affect the reported amounts of our assets, liabilities, revenues and expenses,
the amounts of charges accrued by us, such as those made in connection with our
restructurings, and related disclosure of contingent assets and liabilities. We
base our estimates on historical experience and on various other assumptions
that we believe to be reasonable under the circumstances. There can be no
assurance, however, that our estimates or the assumptions underlying them, will
be correct.

OUR HAP(TM) TECHNOLOGY MAY NOT ALLOW OUR PARTNERS OR US TO DEVELOP
COMMERCIAL PRODUCTS OR TO INCREASE SALES OF THEIR CURRENTLY MARKETED
PRODUCTS.

We base our HAP(TM) Technology on the assumption that information about gene
association and genomic variation may help drug development professionals
better understand the drug response of particular populations and complex
disease processes. Although the pharmaceutical and biotechnology industry is
increasing its use of genomics in analyzing drug response and diseases, we
are unaware of any successful drug development program applying population
genomics.

We discover HAP(TM) Markers for pharmaceutically relevant genes. If we are
unable to find HAP(TM) Markers for important pharmaceutically relevant genes
in a timely manner, our potential partners may lose confidence in our HAP(TM)
Technology and our company, and this loss in confidence could decrease our
ability to generate revenues. Even if we are able to discover the HAP(TM)
Markers for important pharmaceutically relevant genes, this information may
not prove to be superior to genomic variation information discovered by our

13

competitors. Furthermore, pharmaceutical and biotechnology companies may not
choose our HAP(TM) Technology over competing technologies.

Our DECOGEN(R) Informatics System may also be less effective than we expect
or may not allow our partners or us to determine a correlation between
genomic variation and drug response. Furthermore, even if our partners or we
are successful in identifying a specific correlation between genomic
variation and drug response based on our HAP(TM) Technology, neither our
partners or us may be able to develop or sell commercially viable products
nor may our partners be able to increase the sales of their existing
products. Accordingly, our HAP(TM) Markers and HAP(TM) Technology may not
improve the development, marketing and prescribing of drugs developed by our
HAP(TM) Technology Partnership program customers and our HAP(TM)
Drug-Specific Partnership program customers.

WE MAY NOT BE ABLE TO OBTAIN SUFFICIENT ADDITIONAL FUNDING TO MEET OUR
CAPITAL REQUIREMENTS.

We have used substantial amounts of cash to fund our research and development
activities. We will continue to spend funds to service our HAP(TM) Technology
Partnership program and our HAP(TM) Drug-Specific Partnership program and to
maintain our HAP(TM) Technology. We plan to pay for these activities with
funds from:

o our existing cash and investment securities; and

o income that we may receive from our HAP(TM) Technology Partnership
program, our HAP(TM) Drug-Specific Partnership program and service
fees.

We intend to rely on current HAP(TM) Technology Partnership program customers
and future customers, if any, and our current HAP(TM) Drug-Specific
Partnership program customer and future customers, if any for significant
funding in the future to support our development efforts. We cannot be
certain when we will begin to receive additional income, if at all, from our
HAP(TM) Technology Partnership program and our HAP(TM) Drug-Specific
Partnership program and income, if any, from our STRENGTH and CARING
programs. If we do not receive this income or do not receive it as rapidly as
we expect, we would spend our existing cash and investment securities more
rapidly than we currently plan. We believe that existing cash and investment
securities will be sufficient to fund our expected net losses, debt
obligations and capital expenditures for at least 24 months. We have
based this belief on assumptions that may prove wrong.

To service our HAP(TM) Technology Partnership program and our HAP(TM)
Drug-Specific Partnership program and to support the maintenance of our
HAP(TM) Technology, we may need to seek additional funding through public or
private equity offerings, debt financings or commercial partners. Additional
financing may not be on terms favorable to our stockholders or us.
Stockholders' ownership will be diluted if we raise additional capital by
issuing equity securities. If we raise additional funds through partnership
or other licensing arrangements, we may have to relinquish rights to some of
our technologies or grant licenses on unfavorable terms.

We believe that our existing cash reserves will be sufficient to support our
expected net losses, debt obligations and capital expenditures for at least
24 months. To execute our business plan and continue to have cash reserves
for at least 24 months, we will need to grow our revenues significantly each
year. There can be no assurance that we will be able to obtain new partners
or to generate the increased revenues required to meet our business plan
objectives. In addition, to execute our business plan, we may need to
consider seeking additional funding through public or private equity
offerings, debt financings or commercial partners. We cannot assure you that
we will obtain additional partners or capital funding on acceptable terms, if
at all. If we are unable to generate sufficient revenues or access capital on
acceptable terms, we may not be able to achieve our objectives under our
business plan or sustain our operations at planned levels.

IF WE ARE UNABLE TO OBTAIN INTELLECTUAL PROPERTY PROTECTION FOR OUR
HAP(TM) TECHNOLOGY, TRADE SECRETS OR KNOW HOW, WE MAY NOT BE ABLE TO
OPERATE OUR BUSINESS PROFITABLY.

Our success depends, in part, on our ability to protect our HAP(TM)
Technology, the associations that we find between genetic variation and
clinical outcomes and any other proprietary software, methods and
technologies that we develop, either as a trade secret or under the patent
and other intellectual property laws of the United States and other
countries, so that we can prevent unauthorized entities from using our
inventions and proprietary information. Because patent applications that were
filed prior to November 29, 2000 in the United States are confidential until

14

patents issue, third parties may have filed patent applications for technology
covered by our pending patent applications without our being aware of those
applications, and our patent applications may not have priority over any patent
applications of others. We are aware that there are other firms or individuals
who have discovered, or are currently discovering information similar to the
information we are discovering, who may have filed, and in the future are likely
to file, patent applications that are similar or identical to our HAP(TM)
Technology patent applications.

Our pending patent applications may not result in issued patents. The patent
positions of pharmaceutical and biotechnology companies, including ours, are
generally uncertain as a result of the uncertain state of the patent law in the
biotechnology field. There is no uniform, worldwide policy regarding the subject
matter and scope of claims granted or allowable in biotechnology patents,
particularly those involving genomics.

IF WE ARE UNABLE TO PREVENT OTHERS FROM UNAUTHORIZED USE OF, OR ARE
UNABLE TO DEFEND OUR USE OF, OUR HAP(TM) TECHNOLOGY, TRADE SECRETS OR
KNOW HOW, WE MAY NOT BE ABLE TO OPERATE OUR BUSINESS PROFITABLY.

Despite our efforts to protect our proprietary rights, unauthorized parties may
be able to obtain and use information that we regard as proprietary. The mere
issuance of a patent does not guarantee that it is valid or enforceable; thus
even if we obtain patents, they may not be valid or enforceable against third
parties.

We also rely upon unpatented trade secrets and improvements, unpatented know-how
and continuing technological innovation to develop and maintain our competitive
position. We generally protect this information with reasonable security
measures, including confidentiality agreements signed by our employees, academic
collaborators and consultants that provide that all confidential information
developed or made known to others during the course of the employment,
consulting or business relationship will be kept confidential except in
specified circumstances. Agreements with employees, consultants and
collaborators generally provide that all inventions conceived by the individual
while employed by us are our exclusive property. If employees, consultants or
collaborators do not honor these agreements, we may not have adequate remedies
for breach. Furthermore, our trade secrets may otherwise become known or be
independently discovered by competitors.

Further, a patent does not provide the patent holder with freedom to operate in
a way that infringes the patent rights of others. A third party may sue us for
infringing on its patent rights. Likewise, we may need to resort to litigation
to enforce a patent issued to us or to determine the scope and validity of third
party proprietary rights. The cost to us of any litigation or other proceeding
relating to intellectual property rights, even if resolved in our favor, could
be substantial, and the litigation would divert our management's efforts. Some
of our competitors may be able to sustain the costs of complex patent litigation
more effectively than we can because they have substantially greater resources.
Uncertainties resulting from the initiation and continuation of any litigation
could limit our ability to continue our operations.

If any party should successfully claim that the creation or use of our
HAP(TM) Technology or HAP(TM) Marker association data infringes upon their
intellectual property rights, in addition to any damages we might have to
pay, a court could require us to stop the infringing activity or obtain a
license on unfavorable terms. Moreover, any legal action against us or our
HAP(TM) Technology Partnership program customers, or our HAP(TM)
Drug-Specific Partnership program customers or any STRENGTH or CARING program
partners claiming damages or seeking to enjoin commercial activities relating
to the affected products and processes could, in addition to subjecting us to
potential liability for damages, require us or our HAP(TM) Technology
Partnership program customers, our HAP(TM) Drug-Specific Partnership program
customers or any STRENGTH or CARING program partners to obtain a license in
order to continue to manufacture or market the affected products and
processes. Any license required under any patent may not be made available on
commercially acceptable terms, if at all. In addition, some licenses may be
non-exclusive, and, therefore, our competitors may have access to the same
technology licensed to us. If we fail to obtain a required license or are
unable to design around a patent, we may be unable to market effectively some
of our HAP(TM) Technology, which could limit our profitability and possibly
prevent us from generating revenue sufficient to sustain our operations.

WE MAY BE UNABLE TO DEVELOP OR COMMERCIALIZE OUR HAP(TM) TECHNOLOGY IF
WE CANNOT ESTABLISH COLLABORATIVE RELATIONSHIPS, AND WE WILL DEPEND ON
OUR PARTNERS TO DEVELOP OR TO CO-DEVELOP PRODUCTS.

15

We currently have three HAP(TM) Technology Partnership program customers, one
HAP(TM) Drug-Specific Partnership program customer and no partners for our
STRENGTH or CARING programs. Under our current strategy, and for the
foreseeable future, we do not expect to develop or market pharmaceutical
products on our own. As a result, our current and future revenues, in part
will depend on payments from our current HAP(TM) Technology Partnership
program customers, our current HAP(TM) Drug-Specific Partnership program
customer, and our future HAP(TM) Technology Partnership program customers,
our future HAP(TM) Drug-Specific Partnership program customers and the future
STRENGTH and CARING program partners, if any, for either the new products
they may develop, or for increased sales of their existing products, made
possible through the use of our HAP(TM) Technology, or from STRENGTH or
CARING program partners, if any, for the products that these partners may
develop and sell. If we are unable to attract new HAP(TM) Technology
Partnership program customers, new HAP(TM) Drug-Specific Partnership program
customers or any partners for our STRENGTH and CARING programs, we may never
generate sufficient revenues to sustain our operations.

Our customers for our HAP(TM) Technology Partnership program and our HAP(TM)
Drug-Specific Partnership program and our partners, if any, for our STRENGTH
and CARING program partner, will be responsible for pre-clinical study and
clinical development of therapeutic and diagnostic products and for
regulatory approval, manufacturing and marketing of any products or enhanced
marketing claims that result from the application of our HAP(TM) Technology.
We anticipate that our agreements with customers for our HAP(TM) Technology
Partnership program, our HAP(TM) Drug-Specific Partnership program and with
partners, if any, for our STRENGTH or CARING programs will allow them
significant discretion in pursuing these activities. We cannot control the
amount and timing of resources that our current HAP(TM) Technology
Partnership program customers, our current HAP(TM) Drug-Specific Partnership
program customer and any future HAP(TM) Technology Partnership program
customers and any future HAP(TM) Drug-Specific Partnership program customers
will devote to our programs or potential products. Our HAP(TM) Technology
Partnership program and our HAP(TM) Drug-Specific Partnership program
arrangements may also have the effect of limiting the areas of research that
we may pursue either alone or with others. Because part of our revenues will
be dependent on the successful commercialization or development of our
customers' products, if, for any reason, a HAP(TM) Technology Partnership
program customer or a HAP(TM) Drug-Specific Partnership program customer
delays or abandons its development or commercialization of a product
developed using our HAP(TM) Technology, we may receive reduced royalty or
other payments or no royalty or other payments at all. In addition, because
part of our future revenues will be dependent on the successful
commercialization of our STRENGTH and CARING programs with partners, if, for
any reason, a partner delays or abandons its development or commercialization
of our STRENGTH or CARING programs, we may receive reduced royalty or other
payments or no royalty or other payments at all.

Although we intend to retain the rights to all HAP(TM) Markers, which we
discover as well as to HAP(TM) Markers discovered jointly with our HAP(TM)
Technology Partnership program customers and our HAP(TM) Drug-Specific
Partnership program customers, we may not always be able to negotiate the
retention of these rights. Furthermore, disputes may arise in the future over
the ownership of rights to HAP(TM) Markers as well as any other technology we
develop with our HAP(TM) Technology Partnership program customers and our
HAP(TM) Drug-Specific Partnership program customers. These and other possible
disagreements between our HAP(TM) Technology Partnership program customers
and us and between our HAP(TM) Drug-Specific Partnership program customers
and us could lead to delays in the research, development or commercialization
of their products. These disagreements could also result in litigation or
require arbitration to resolve. Any of these events could prevent us from
effectively marketing our HAP(TM) Technology.

WE INVEST CONSIDERABLE AMOUNTS OF TIME, EFFORT, AND MONEY TO SELL OUR
HAP(TM) TECHNOLOGY; AND IF WE ARE UNABLE TO SELL OUR TECHNOLOGY, WE
MAY NOT GENERATE SUFFICIENT REVENUE TO SUSTAIN OUR OPERATIONS.

Our ability to obtain customers for our HAP(TM) Technology and our STRENGTH
and CARING programs will depend in significant part upon the pharmaceutical
and biotechnology industry's acceptance that our HAP(TM) Technology can help
accelerate or improve their drug development and marketing efforts. To
achieve this market acceptance, we must continue to educate the
pharmaceutical and biotechnology industry and the public in general as to the
potential benefits of our HAP(TM) Technology and our STRENGTH and CARING
programs. Most importantly, we must convince

16

the research and development, clinical and marketing departments of
pharmaceutical and biotechnology companies that our HAP(TM) Technology can
accelerate and improve the processes for developing, marketing, and
prescribing drugs and that our STRENGTH and CARING programs will be
commercially viable. Given the amount of time and effort necessary to educate
our potential partners, if we fail to gain this acceptance, we may never
generate sufficient revenues to sustain our operations. In addition, each
HAP(TM) Technology Partnership program agreement, each HAP(TM) Drug-Specific
Partnership program agreement and each STRENGTH or CARING agreement, if any,
will likely involve the negotiation of agreements containing terms that may
be unique to the partner involved. We may expend substantial funds and
management effort to market our HAP(TM) Technology and STRENGTH and CARING
programs, without any resulting sales.

REGULATORY OVERSIGHT OF OUR HAP(TM) TECHNOLOGY AND PUBLIC OPINION
REGARDING ETHICAL ISSUES SURROUNDING THE USE OF GENETIC INFORMATION
MAY ADVERSELY AFFECT OUR ABILITY TO MARKET OUR HAP(TM) TECHNOLOGY.

Currently, there is limited FDA regulation of genetic tests. The Secretary's
Advisory Committee on Genetic Testing, an advisory panel to the Secretary of
the U.S. Department of Health and Human Services, has recommended that the
FDA expand its regulation of genetic testing to require FDA approval for all
new genetic tests and labeling of genetic tests. If the FDA adopts this
recommendation, it may require that we, or our partners, apply for FDA
approval as a prerequisite to marketing genetic tests that incorporate our
HAP(TM) Technology. If the FDA were to deny any application of this kind, it
could adversely affect our business and we may be unable to generate
sufficient revenues to sustain our operations.

Moreover, our success will depend in part on the FDA's and other regulatory
agencies' acceptance of genomic variation analysis as part of the drug
approval process and, more specifically, the validity of our HAP(TM)
Technology as a basis for identifying genomic variation and for correlating
drug response with genomic variation. Without this acceptance, we may be
unable to market effectively our HAP(TM) Technology and we may not generate
sufficient revenues to sustain our operations. To date, the FDA has not
required, in connection with approving any drug, that a physician must have
genomic variation information determined about a patient before the doctor
prescribes a drug. However, the FDA, in one instance, has required that a
physician must have gene expression information about a patient before the
doctor prescribes the drug.

Within the field of personalized health and medicine, governmental and other
entities may enact patient privacy and healthcare laws and regulations that
may limit the use of genomic variation data. To the extent that these laws
and regulations limit the use of our HAP(TM) Technology or impose additional
costs on our partners, we may be unable to market effectively our HAP(TM)
Technology and STRENGTH and CARING programs and we may not generate
sufficient revenues to sustain our operations.

Additionally, public opinion on ethical issues related to the confidentiality
and appropriate use of genetic testing results may influence governmental
authorities to call for limits on, or regulation of the use of, genetic
testing. In addition, governmental authorities or other entities may call for
limits on, or regulation of the use of, genetic testing or prohibit testing
for genetic predisposition to certain conditions, particularly for those that
have no known cure. The occurrence of any of these events could reduce the
potential markets for our HAP(TM) Technology, which could prevent us from
generating sufficient revenues to sustain our operations.

Furthermore, we may be directly subject to regulations as a provider of
diagnostic information. To the extent that these regulations restrict the
sale of our HAP(TM) Technology or impose other costs, we may be unable to
provide our HAP(TM) Technology to our customers on terms sufficient to
recover our expenses.

IF OUR PARTNERS DO NOT SEEK, OR DO NOT RECEIVE, MARKETING APPROVAL FOR
PRODUCTS DEVELOPED, IF ANY, USING OUR HAP(TM) TECHNOLOGY, WE MAY RECEIVE
DELAYED ROYALTY OR OTHER PAYMENTS OR NO ROYALTY OR OTHER PAYMENTS AT ALL.

Any new drug, biologic, or new drug or biologic indication our partners or we
develop using our HAP(TM) Technology must undergo an extensive regulatory
review process in the United States and other countries before a new product
or indication of this kind could be marketed. This regulatory process can
take many years and require substantial

17

expense. Changes in FDA policies and the policies of similar foreign
regulatory bodies can prolong the regulatory review of each new drug or
biologic license application or prevent approval of the application. We
expect similar delays and risks in the regulatory review process for any
diagnostic product, whenever this regulatory review is required. Even if a
product obtains marketing clearance, a marketed product and its manufacturer
are subject to continuing review. A manufacturer may be forced to withdraw a
product from the market if a previously unknown problem with a product
becomes apparent. Because our future revenues will be largely dependent on
the successful commercialization or development of products using our HAP(TM)
Technology, any delay in obtaining, failing to obtain, or failing to maintain
regulatory approval for a product developed using our HAP(TM) Technology may
delay our receipt of royalty or other payments or prevent us from receiving
royalty or other payments sufficient to recover our expenses.

IF OUR PARTNERS OR WE ARE UNABLE TO OBTAIN FDA APPROVAL FOR THERAPEUTIC
OR DIAGNOSTIC PRODUCTS DEVELOPED USING OUR HAP(TM) TECHNOLOGY, THE LACK
OF REGULATORY APPROVAL WILL DIMINISH THE VALUE OF OUR HAP(TM) TECHNOLOGY.

To date, no one has developed or commercialized any therapeutic or diagnostic
products using our HAP(TM) Technology. We expect to rely on our customers for
our HAP(TM) Technology Partnership program and our HAP(TM) Drug-Specific
Partnership program and our partners, if any, for our STRENGTH and CARING
programs to file these applications and generally direct the regulatory
review process and obtain FDA acceptance of our HAP(TM) Technology and our
STRENGTH and CARING programs. Our customers for our HAP(TM) Technology
Partnership program and our HAP(TM) Drug-Specific Partnership program or our
partners, if any, for our STRENGTH and CARING programs, may not submit an
application for regulatory review. Even if they do submit applications, they
may not be able to obtain marketing clearance for any products on a timely
basis, if at all. If our partners fail to obtain required governmental
clearances for therapeutic or diagnostic products, they will not be able to
market these products unless and until they obtain these clearances. As a
result, we may not receive royalty or other payments from our customers. The
occurrence of any of these events may prevent us from generating revenues
sufficient to sustain our operations.

IF WE DO NOT SUCCESSFULLY DISTINGUISH AND COMMERCIALIZE OUR HAP(TM)
TECHNOLOGY, WE MAY BE UNABLE TO COMPETE SUCCESSFULLY WITH OUR COMPETITORS
OR TO GENERATE REVENUE SIGNIFICANT TO SUSTAIN OUR OPERATIONS.

Numerous entities are attempting to identify genomic variation predictive of
specific diseases and drug response and to develop products and services based
on these discoveries. We face competition in these areas from pharmaceutical,
biotechnology and diagnostic companies, academic and research institutions and
government or other publicly-funded agencies, both in the United States and
abroad, most of which have substantially greater capital resources, research and
development staffs, facilities, manufacturing and marketing experience,
distribution channels and human resources than we do.

These competitors may discover, characterize or develop important
technologies applying population genomics before us or our customers for our
HAP(TM) Technology Partnership program and our HAP(TM) Drug-Specific
Partnership program that are more effective than those technologies which we
develop or which our customers for our HAP(TM) Technology Partnership program
and our HAP(TM) Drug-Specific Partnership program develop, or these
competitors may obtain regulatory approvals of their drugs more rapidly than
our customers for our HAP(TM) Technology Partnership program and our HAP(TM)
Drug-Specific Partnership program do, any of which could limit our ability to
market effectively our HAP(TM) Technology.

Some companies and governments are marketing or developing a number of databases
and informatics tools to assist participants in the healthcare industry and
academic researchers in the management and analysis of genomic data. Entities
such as Celera Genomics Group, Incyte Genomics, Inc., National Human Genome
Research Institute, Perlegen Sciences and Variagenics, Inc. have developed or
plan to develop databases containing gene sequence, gene expression, genomic
variation or other genomic information and are marketing or plan to market their
data to pharmaceutical companies or plan to make freely available their
databases. In addition, numerous pharmaceutical companies, such as
GlaxoSmithKline plc, either alone or in partnership with our competitors, are
developing genomic research programs that involve the use of information that
can be found in these databases.

18

In order to compete against existing and future technologies, we will need to
demonstrate to potential HAP(TM) Technology Partnership program customers and
to potential HAP(TM) Drug-Specific Partnership program customers the value of
our HAP(TM) Technology and that our HAP(TM) Technology and capabilities are
superior to competing technologies. Although we believe that our focus on
gene-based HAP(TM) Markers, rather than random genomic SNPs, differentiates
our HAP(TM) Technology from other technologies our competitors are
developing, any HAP(TM) Technology improvements we create may fail to achieve
greater market acceptance than the technologies developed by our competitors.

Moreover, our competitors may obtain patent protection or other intellectual
property rights that would limit our rights or our partners' ability to use
our HAP(TM) Technology to commercialize therapeutic or diagnostic products.
If we are unable to protect our proprietary methods and our HAP(TM)
Technology, we may not be able to commercialize our HAP(TM) Technology and we
may not be able to generate sufficient revenue to sustain our operations. If
the United States and foreign patent offices do not grant patents for our
applications, our competitors may obtain rights to commercialize our
discoveries, which would severely limit our ability to compete.

Furthermore, if the pharmaceutical and biotechnology industry accepts our
approach based on identifying HAP(TM) Markers, our competitors may adopt
approaches similar to ours. Also, our competitors' customers may be more
successful than our customers in their drug development and marketing
efforts. If the pharmaceutical and biotechnology industry does not accept our
approach or if our competitors are more successful than we are, we may be
unable to market effectively our HAP(TM) Technology and, as a result, we may
be unable to generate revenues sufficient to sustain our operations.

Genomic technologies have undergone, and are expected to continue to undergo,
rapid and significant change. Our future success will depend in large part on
maintaining a competitive position in the genomics field. Others may rapidly
develop new technologies that may result in products or technologies becoming
obsolete before we recover the expenses we incur in connection with our
development. Our HAP(TM) Technology could become obsolete if our competitors
offer less expensive or more effective drug discovery and development
technologies, including technologies that may be unrelated to genomics.

IF WE FAIL TO MAINTAIN OUR COMPUTER HARDWARE, SOFTWARE AND RELATED
INFRASTRUCTURE, WE COULD EXPERIENCE LOSS OF, OR DELAY IN, REVENUES AND
MARKET ACCEPTANCE.

Because our business requires manipulating and analyzing large amounts of data,
we depend on the continuous, effective, reliable and secure operation of our
computer hardware, software and related infrastructure. To the extent that our
hardware or software malfunctions, we will experience reduced productivity. We
protect our computer hardware through physical and software safeguards. However,
our computer hardware is still vulnerable to fire, weather, earthquake, or other
natural disaster and power loss, telecommunications failures, physical or
software break-ins, and similar events. In addition, the software and
algorithmic components of our DECOGEN(R) Informatics System are complex and
sophisticated, and as such, could contain data, design or software errors that
could be difficult to detect and correct. Users of our system may find software
defects in current or future products. If we fail to maintain the necessary
computer capacity and data to support our computational needs and our customers'
drug discovery and development efforts, we could experience a loss in revenues,
or a delay in receiving revenues, and a delay in obtaining market acceptance for
our technology.

OUR OPERATING RESULTS MAY FLUCTUATE SIGNIFICANTLY AND ANY FAILURE TO MEET
FINANCIAL EXPECTATIONS MAY DISAPPOINT SECURITIES ANALYSTS OR INVESTORS
AND RESULT IN A DECLINE IN OUR COMMON STOCK PRICE.

Our operating results have fluctuated in the past and we expect they will
fluctuate in the future. These fluctuations could cause our common stock price
to decline. Some of the factors that could cause our operating results to
fluctuate include:

o recognition of non-recurring revenues due to receipt of license
fees, achievement of milestones, completion of contracts or other
revenues;

19

o demand for and market acceptance of our HAP(TM) Technology
Partnership program and our HAP(TM) Drug-Specific Partnership
program;

o timing of the execution of agreements on our HAP(TM) Technology
Partnership program and our HAP(TM) Drug-Specific Partnership
program or other material contracts;

o our competitors' announcements or introduction of new products,
services or technological innovations;

o disputes regarding patents or other intellectual property rights;

o securities class actions or other litigation;

o adverse changes in the level of economic activity in the United
States and other major regions in which we do business; and

o general and industry-specific economic conditions, which may affect
our partners' use of our HAP(TM) Technology.

Due to volatile and unpredictable revenues and operating expenses, we believe
that period-to-period comparisons of our results of operations may not be a good
indication of our future performance. It is possible that, in some future
periods, our operating results may be below the expectations of securities
analysts or investors. In this event, the market price of our common stock could
fluctuate significantly or decline.

20

ITEM 3--QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Our exposure to market risk is principally confined to our cash equivalents and
investments, all of which have maturities of less than two years. We maintain a
non-trading investment portfolio of investment grade, liquid debt securities
that limit the amount of credit exposure to any one issue, issuer or type of
instrument. In view of the nature and mix of our total portfolio, a 10% movement
in market interest rates would not have a significant impact on the total value
of our investment portfolio as of June 30, 2002.

PART II--OTHER INFORMATION

ITEM 2--CHANGES IN SECURITIES AND USE OF PROCEEDS.

CHANGES IN SECURITIES

Not applicable

USE OF PROCEEDS

The proceeds from our initial public offering have been invested in
interest-bearing high-grade corporate bonds and money market accounts.

From the closing of our initial public offering through June 30, 2002, we
have used the proceeds for research and development activities, capital
expenditures, working capital and other general corporate purposes. We will
continue to spend funds to service our HAP(TM) Technology Partnership program
customer and our HAP(TM) Drug-Specific Partnership program customers, to
obtain customers for both programs and to maintain our HAP(TM) Technology. As
of June 30, 2002, $42.2 million of the net proceeds remain available and are
primarily invested in short-term marketable securities.

21

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

At our 2002 annual meeting of stockholders (the "Annual Meeting") held on May
22, 2002, the following matters were acted upon by the stockholders of the
company:

1. The election of Jurgen Drews, M.D., Kevin Rakin and Christopher Wright as
Class II directors to serve for the ensuing three years; and

2. Approval of an amendment to our 2000 Amended and Restated Equity
Incentive Plan increasing the number of shares of common stock issuable
thereunder from 3,557,375 to 4,287,375.

The number of shares of common stock outstanding and entitled to vote at the
Annual Meeting was 22,792,987. The other directors of the company, whose terms
of office as directors continued after the Annual Meeting, are Harry H. Penner,
Jr., Gualberto Ruano, M.D., Ph.D. and Seth Rudnick, M.D. The results of the
voting on each of the matters presented to stockholders at the Annual Meeting
are set forth below:

ITEM 6--EXHIBITS AND REPORTS ON FORM 8-K.

(a) Exhibits

See Index to Exhibits attached hereto.

(b) Reports on Form 8-K

The company filed the following report on Form 8-K during the quarter ended
June 30, 2002:

During the quarter ended June 30, 2002, the company filed one Current Report on
Form 8-K. The June 5, 2002 report disclosed the change in the company's
certifying accountant to PricewaterhouseCoopers LLP.

22

GENAISSANCE PHARMACEUTICALS, INC.

SIGNATURE

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

GENAISSANCE PHARMACEUTICALS, INC.

Date: August 14, 2002 By: /s/ JOSEPH KEYES
-----------------------------------
Joseph Keyes
Vice President and Chief
Financial Officer
(Principal Financial and Accounting
Officer)

23

Index To Exhibits
-----------------

10.1 2000 Amended and Restated Equity Incentive Plan (filed as Appendix A
to the Registrant's Definitive Proxy Statement on Schedule 14A for
the Registrant's Annual Meeting of Stockholders held May 22, 2002
(File No. 000-30981), incorporated herein by reference)

99.1 Statement pursuant to 18 U.S.C. Section 1350