Financial information for the years ended 1998 - 2002 has been restated. See Note 2 of Notes to Consolidated Financial Statements for further discussion.

Tripos provides products and services to the pharmaceutical, biotechnology, and life science industries to support early stage research activities. Sales to the pharmaceutical industry represent 76% of Tripos total revenue. Tripos offerings are applied principally to assist research chemists to make decisions about the most productive new compounds to make and test as potential therapeutics. Through its own chemistry laboratories, Tripos can also make those compounds for its clients. Through strategic partnerships, Tripos can also test compounds for its clients.

The industries that Tripos serves are highly research driven. The mature pharmaceutical companies typically spend between 12% and 20% of their annual revenues on research in the search for new blockbuster drugs. This research process consists of several phases from early discovery of compounds of interest, through testing of the promising ones for activity and safety in animals, to final testing of these compounds in humans. The investment in the research activity increases dramatically in the second and third phases of the research activity. Tripos offerings are most relevant to the initial phase of this activity. Our products and services are designed and intended to provide our pharmaceutical and biotechnology customers with improved ways to identify and select the most promising drug candidates to take forward into the more expensive and time consuming stages of the drug development process. Depending on the number of compounds that a particular company has in different stages of their new therapeutic pipeline, they may reduce or increase investment in the other phases of research. Further, decisions by the pharmaceutical industry concerning their research investments are strongly influenced by decisions by the various governments of the world about drug pricing and regulation.

Tripos software products are sold on a renewable license basis, typically with term of one or three years. This business is generally predictable, with high renewal rates for licenses. Tripos management closely monitors license expirations and deploys sales staff to ensure the highest probability of renewals. Tripos service businesses, both informatics and chemistry, are much less predictable. The sales cycles for these offerings are typically long -- from six months to eighteen months -- and are highly influenced by factors in the macro-economic environment including the general state of the pharmaceutical industry and the political situations in various parts of the world. To forecast potential business in these areas, Tripos management strives to closely interact with the management of its customers and is closely involved in business development activities for service projects.

Large service contracts for pharmaceutical research, both informatics and chemistry, are complex and, because they are deployed in research applications where outcomes are uncertain, have a large risk component. Risk management in these projects begins with the definition of project requirements and continues through performance metrics and customer acceptance milestones. Due to the complexity of the projects and changing priorities within client organizations, it is typical that many decision points will arise that require management attention both at Tripos and at the client. To mitigate the project difficulties, Tripos has developed a process focus and management monitors milestones in the project plan according to the process workflow. Despite best efforts, however, some projects are of sufficient complexity that they present challenges that require revisions to the project plan and scope.

Having been a public company spinout in 1994 with limited capital, and limited additional capital raised over the past decade, the company has focused on profitability and cashflow. That said, the company has not always been profitable, but has achieved it in certain years. Major investments, say in the recent expansion of our chemistry research laboratories in England, have been funded by successful investments (i.e. Arena Pharmaceuticals), cash from operations, temporary use of debt capacity, and grant funding from the British government.

We license our discovery software products and post-contract support ("PCS") as either perpetual licenses or time-based licenses, typically one to three-year renewable contracts. The magnitude of these license fees is dependent on each customer's required usage levels, that is, the number of locations and individual users. Variations in licensing levels range from the low hundred-thousands up to several million dollars. The following are descriptions of our current sales models for discovery software:

Our integration of chemistry and biological data in the life sciences industries creates a revenue stream for enterprise software consulting. To serve this market, we maintain a staff of specialists who use our proprietary data integration framework, such as MetaLayer, Lithium, FormsBuilder, Tripos Electronic Notebook technologies, Registration Inventory & Ordering, and AUSPYX^TM to configure customized solutions for data management. Revenue may be generated on a billable rate per day, or upon achievement of milestones or deliverables and is recognized as production activities are performed. These contracts may also generate substantial license fee revenue for our proprietary software technologies. As with our discovery software products, licensing levels may range from the low hundred-thousands up to several million dollars.

We develop and manufacture general screening compound libraries for sale to the life sciences industry for a fee per compound delivered. This has created the opportunity to offer follow-up discovery research methods to customers for design and synthesis of focused libraries for lead optimization. We also market a comprehensive research process to our life sciences customers for rapid and cost effective discovery. This process combines advanced informatics, chemistry and biology products and services, and proprietary discovery technologies for efficient lead development, refinement, and optimization resulting in a tightly integrated process to facilitate synergies in drug discovery.

We also act as a reseller of computer hardware. Hardware sales are generally made to facilitate our software customers' access to hardware components and are not a primary focus of our sales activities. We act as an authorized reseller and order inventory on an "as needed" basis, and thus do not maintain any inventory. Accordingly, margins on these sales are relatively modest.

Quarterly expenses include the fixed costs of research and development for software development and new chemistry research. We believe that core selling and administrative costs will remain generally consistent as a percent of sales on an annual basis. Variability in quarterly expenses primarily occurs in relation to the level of revenues due to sales compensation, bonuses and staffing for selling, general and administrative functions and for periodic marketing activities such as appearances at trade exhibitions.

During 1998 and 1999, we applied our capital resources to fund investments in the building of chemistry production facilities, chemical compound library inventories, collaborative drug discovery programs, staffing new business opportunities, and investments in Arena Pharmaceuticals. In fiscal year 2000, we used cash available from an equity investment by LION to maintain capital infrastructure, reduce debt levels and conduct operations. In 2002 and 2003, we invested in a major expansion of our chemistry laboratory facilities in order to capture additional business opportunities, funded by our successful investment in Arena Pharmaceuticals, grants from the British government, capital leases and related forms of debt, and cash from operations.

Our revenues and expenses vary from quarter to quarter depending upon, among other things, the timing of customers' budget processes, the success of our sales efforts, the lengthy sales cycle and our ability to influence customers and prospective customers to make decisions to outsource portions of their discovery process, the size of the customers' capital expenditure budgets, the ability to produce compound libraries in a timely manner, market acceptance of new products and enhanced versions of existing products, the timing of new product introductions by us and other vendors, changes in pricing policies (ours, partners and other vendors), consolidation in customer base, client involvement in decision points in contracts related to project plans, our ability to accurately match contract costs to milestone or contract performance requirements on our larger collaborative arrangements, and changes in general economic and competitive conditions. See Note 1 of the Notes to Consolidated Financ ial Statements for a discussion of revenue recognition policies. Because much of our software license and PCS revenue along with our contracted discovery research revenue is recognized ratably over multiple periods, fluctuations in our quarterly revenues and earnings are caused principally by sales of compounds or by achievement of milestones on specific projects. Our management team monitors quarterly business activity with the aid of sales pipeline reports and monthly financial reports.

The following information is provided in order to illustrate which accounting policies management deems to be the most critical in the computation of the financial statements included later in this Form 10-K.

Revenue Recognition...the following are the revenue recognition policies for each of our offerings:

The following table sets forth, for the periods indicated, certain consolidated financial data as a percentage of net sales, (except costs of sales data, which is set forth as a percentage of the corresponding net sales data):

* As a percentage of the corresponding sales

List prices for our software products have had only modest price increases and have therefore remained relatively stable over the last few years. Due to the competitive nature of the software market in which we sell, pricing of our products will remain under pressure for the foreseeable future.

Total discovery software product and support sales increased 7% to $23.7 million from $22.2 million in 2002 which was up 11% from 2001's $20.1 million. In February 2004, we announced that we would recognize revenues from term and token software licenses ratably over the course of the license terms and accordingly restated our financial statements for fiscal years 1998-2002. Under this revised revenue recognition, the majority of our software licenses are time-based from which the corresponding revenue is recognized on a ratable basis over the length of each license term (typically 1 to 3 years). The revenue from time-based software arrangements in 2003 was over $12 million. In 2002, time-based software license revenues (including our global wide-area network contract with Pfizer) were over $11 million. By comparison, 2001's time-based software license revenues were just over $8 million. Revenue recognition from time-based software license arrangements will normally stretch into subsequent periods depending on the length of individual contract terms. As an illustration, the software revenue deferred from non-cancelable contracts initiated in recent fiscal years that will be recognized in 2004-2007 is projected to be over $17 million. The table presented in "Note 14. Time-based Software License Arrangements" presents the total amounts of deferred revenues from non-cancelable time-based software license arrangements.

Our discovery informatics service activities were significantly impacted by the overall slow down in spending by the pharmaceutical industry that started in mid-2002 and continued into late 2003. We noticed that fewer custom informatics projects were being initiated by major pharmaceutical firms over this period. During the late stages of 2003, the industry started to show signs of recovery in its outsource spending activity in terms of new projects being put out for bid. Discovery informatics service revenues declined by 59% to $3.2 million in 2003 from $8.0 million in 2002. This decline is a result of fewer significant informatics-consulting contracts in 2003 along with an adjustment in the fourth quarter of $802,000 in the revenue recognized on our contract with Schering AG. Tripos achieved a significant data migration milestone under this contract, however, the two companies are in talks regarding the specifications and financial arrangements necessary to complete the development and d eployment of the production version of the agreed technology. This would require a scope change to the existing contract. Because these discussions are not finalized, Tripos recorded a charge in 2003 for the estimated project costs in excess of the revenues that it could expect under the current contract terms. In calculating the amount of the charge to be recorded, Tripos assumed that the project would not continue past delivery and rollout of the current production system in mid-2004. This assumption led to a corresponding reduction of approximately $802,000 in the total revenues available under the contract through the expected mid-2004 delivery. Tripos is required to write off these costs and make this adjustment to revenues so that its year-end financial statements fairly reflect the project status and contractual terms as of December 31, 2003. This adjustment assumes completion of the mid-2004 deployment only. It does not include any additional revenues that may be received as a result of the renegotia tion to cover functionality and time that were not anticipated in the original contract for full implementation of this project. The 2002 decline of 24% from 2001 in discovery informatics service revenue is primarily due to the lack of new contracts to replace completed ones along with the delay of a key milestone on a major contract with another customer that ultimately reduced our potential revenue from that contract.

We derive discovery research revenues from our compound library product, LeadQuest®, and discovery research activities. Discovery research sales increased 46% to $26.2 million in 2003 from $18.0 million in 2002, which was 50% higher than the $12.0 million recognized in 2001. The primary reason for the increases was initiation of work in January 2002 on a four-year $100 million contract with Pfizer, Inc. to design and synthesize chemical compounds. The project plan called for a ramp-up in the production and delivery of the custom compounds for Pfizer. Revenue is recognized in accordance with SOP 81-1, under the percentage of completion method using an output measure for revenue recognition (units of delivery method). The original contract called for a minimum two-year commitment from Pfizer. Upon completing the first two years of the contract in 2003, the relationship was amended in early 2004 to reflect a reduction in compound collection production and a corresponding move into next-st age hit follow-up work between Tripos and Pfizer. The amendment also reflects a further minimum commitment through 2004 and a revised expected 4-year revenue total of $90 million.

Hardware revenues grew 2% in 2003 to just under $1.0 million compared just over $900,000 in 2002, a decrease of 73% from $3.5 million in 2001. We do not aggressively promote hardware due to its low-margin, but merely provide access to product as a convenience to customers. The high-end server and workstation equipment that we traditionally have recommended to our customers continues to face growing competition from lower cost alternatives. This change, combined with the fact that we do not actively pursue or market hardware products, is reflected in the trend of an overall decrease in sales of these products in recent years.

Cost of Sales. Total cost of sales increased 27% to $26.2 million in 2003 from $20.6 million in 2002, which in turn was up 35% from $15.2 million in 2001. These costs represent 48%, 42% and 33% of total net sales, respectively.

Costs of software products and support represented 17%, 16% and 14% of software license and support sales in 2003, 2002 and 2001, respectively. Costs of software products and support consist of amortization of capitalized software, royalties to third-party developers, commissions to Pacific Rim distributors, the cost of software product packaging and media, the costs related to staffing telephone support functions, packaging for updates/upgrades, and updates to documentation. Staffing costs are expected to increase in future periods at or near the rates of cost of living increases. The increases in cost as a percent to sales in 2003 and 2002 resulted from a change in the mix of internal versus third-party products sold, thus resulting in higher royalty payments. The effective rate of royalties has risen in recent years, however, it is expected to stabilize over future periods.

Costs of discovery informatics services (DIS) represented 111%, 86% and 47% of discovery informatics service revenues in 2003, 2002 and 2001, respectively. Costs of DIS are direct charges for staff, travel and overhead required to develop custom software solutions for clients. 2003 cost of DIS exceeded revenues due to the additional anticipated losses under our contract with Schering AG. As stated above in the discussion of DIS revenues, Tripos is involved in negotiations with Schering to amend the specifications and financial arrangements necessary to complete the development and deployment of the production version of the previously agreed technology. Because these discussions are not finalized, Tripos recorded a charge of approximately $813,000 for the estimated project costs in excess of the total project revenues that it could expect under the current contract terms. In calculating the amount of the charge to be recorded, Tripos was required to utilize the existing contract terms, and could not assume that the project would continue past delivery and rollout of the current production system in mid-2004. Tripos is required to accrue these excess costs so that its year-end financial statements fairly reflect the project status as of December 31, 2003.

Costs of discovery research products and services represented 68%, 53% and 35% of discovery research sales in 2003, 2002 and 2001, respectively. The cost of the discovery research business is represented by the raw material, direct labor and overhead costs to produce compound libraries and to deliver on contracted research projects. Discovery research contracts may also include third-party costs for production of larger quantities of intermediate or scale-up materials. As a result, variability in cost of sales may be attributed to the mix of compound products and discovery research revenues. The increases in cost of sales of discovery research activities in 2003 and 2002 are attributable to the ramp up in production for the Pfizer compound design and synthesis contract. Increased costs were primarily the result of the required outsourcing to successfully deliver against the contract, combined with the financial impact of the decline of the US dollar against the Great Britain Pound Sterling where the operation is based. See the discussion of discovery research revenues above for additional information on this contract. In 2001, two large compound orders had the significant effect of lowering the average cost of sales for the year.

Costs of hardware represented 86%, 88%, and 91% of hardware sales in 2003, 2002 and 2001, respectively. Cost of hardware consists of the direct costs of hardware sold. We expect the cost of hardware as a percentage of hardware sales to remain relatively stable in future periods.

Gross Profit was $27.9 million in 2003, $28.5 million in 2002 and $30.9 million in 2001, which represents gross profits of 52%, 58% and 67%, respectively. The decreases in gross margin are attributable to the increase in the effective rate of royalties on software products, cost overruns on two major informatics contracts and the ramp-up on the Pfizer compound file enrichment project. The rate of decrease in gross profit is expected to slow in future periods but is dependent on costs of chemical materials and overhead, the mix of internal versus third-party software product sales, foreign exchange rates and the company's ability to successfully deliver on informatics contracts.

Research and Development Expenses increased 28% to $12.9 million in 2003 from $10.1 million in 2002, which was up 13% from $8.9 million in 2001. R&D costs represented 24%, 21%, and 19% of net sales in 2003, 2002 and 2001, respectively. The increased spending for R&D reflects additional chemistry research staff at Tripos Receptor Research and software development work that is not directly related to customer contracts or is for product development that has not yet qualified for capitalization under FAS 86.

Research and development expenses, including the amount of capitalized costs were $14.2 million in 2003, $13.8 million in 2002 and $10.3 million in 2001. In accordance with Statement of Financial Accounting Standards No. 86, the Company capitalizes software development costs for external use. Tripos anticipates that its investment in new product research will continue to be significant as we develop new software modules each year, work on funded software research contracts with customers, develop new technologies for use in our informatics consulting work, and pursue novel compound templates for inclusion in our LeadQuest® libraries. Costs associated with researching novel compound templates are classified as R&D up until such time as the base reaction is validated, after which costs are captured in inventory.

General and Administrative Expenses increased 5% to $7.2 million in 2003 from $6.9 million in 2002 which was down by 8% from $7.5 million in 2001. G&A expenses represented 13%, 14% and 15% of net sales for 2003, 2002 and 2001, respectively. The increase in G&A expense in 2003 is a primarily the result of legal fees to defend against the class action lawsuit, additions to staff, increased costs from new securities regulations and higher corporate insurance premiums. The decrease in G&A expense in 2002 was principally due to a reduction in bonus expense. We expect general and administrative expenses to remain relatively stable as a percentage of sales in the future.

Interest Income was $208,000 in 2003, $216,000 in 2002 and $322,000 in 2001 reflecting a decreasing average amount of cash on hand year over year and lower interest rates. Previously, interest income included the amount of imputed interest calculated from effectively discounting the extended accounts receivable generated from multi-year software license contracts. Imputed interest has been reclassified back to software license revenue under the restatement.

Interest Expense of $516,000 in 2003, $376,000 in 2002 and $599,000 in 2001 was from interest due on the long-term note payable for the corporate building, the line-of-credit, and interest on capital leases. Interest expense has varied commensurate with the change in average outstanding debt balances. The Company's mortgage loan had a fixed interest rate in 2001, 2002 and through the first four months of 2003 at a rate in excess of 7.4%. Upon expiration of the fixed interest rate period, the floating rate incurred by the Company averaged 3.4% for the remainder of 2003.

Net cash used by operating activities in 2003 was $1.4 million. Sources of operating funds for 2003 were net income of $2.1 million, net collections of accounts receivable of $0.2 million, changes in net deferred tax position of $2.7 million, additions to accounts payable & accrued expenses of $1.7 million, increased deferred revenue of $1.8 million plus the add-back of non-cash depreciation and amortization expenses of a combined $3.7 million. Uses of operating funds in 2003 were increases to inventory of $5.4 million (includes approximately $3.0 million of product awaiting shipment to Pfizer) and an increase in prepaid expenses of $0.5 million. In addition, we backed out the effect of gains on sales of shares of Arena Pharmaceuticals of $6.7 million and the appreciation in our foreign currency forward contracts of $0.9 million. Depreciation expense has grown over the past two years as a result of our capital investments in the U.K. which lead to another increase in 2004 as we pla ce our expanded laboratory into service and complete the acquisitions of scientific equipment. Inventory levels are expected to remain at or below current levels as we have achieved optimum production levels for our delivery commitments to Pfizer.

In 2002, net cash used by operating activities was $5.5 million. The use of funds was attributable to increases in inventories of $2.8 million, increased prepaid expenses of $0.7 million, net increase in deferred tax expense of $2.9 million along with decreases in accounts payable and accrued expenses of $0.8 million. Sources of operating cash were net collections of accounts receivable of $0.8 million and increases to deferred revenue of $1.8 million. The non-cash depreciation and amortization expenses of $2.0 million and $0.7 million, respectively are added back to net income of $32,000. Inventory growth in 2002 was primarily attributable to production ramp up for the Pfizer compound design and synthesis contract. The gain on the sale of shares of Arena Pharmaceuticals of $3.6 million was backed out of the net loss to show the effect operations on our cash position. The growth in deferred revenue is principally attributable to the prepayments received in our Discovery Research contracts.

Investing activities in 2003 consumed a net of $3.4 million. We spent $10.8 million on our U.K. laboratory facility building and equipment along with $1.3 million for the development of our Registration, Inventory and Ordering software technology to be released in 2004. These expenditures were substantially funded by the $8.8 million of proceeds from the sale of shares in Arena Pharmaceuticals. As of December 31, 2003, we have 31,000 shares (market value of $192) of Arena remaining. Additionally, we made investments in A.M. Pappas Life Science II fund of $0.4 million in 2003, however, we took a combined write-down of our investment in Signase, Inc. and the Life Science II fund of $0.2 million as discussed in Notes 17 and 18 below.

Net cash used for investing activities was $5.4 million in 2002. The primary investments were in fixed assets of $8.0 million, principally related to the expansion of our chemistry laboratories in the U.K., capitalized software development costs for laboratory research support systems of $1.4 million along with a net combined investments in Signase, Inc. and the Life Science II fund of $0.6 million as part of our strategic efforts to obtain access to more collaboration partners. These investments were partially offset by the $4.6 million of proceeds from the sale of 619,000 shares of Arena Pharmaceuticals.

Financing activities yielded a net $9.6 million of cash in 2003. We financed $5.4 million of capital equipment and fixtures at our chemistry laboratory through capital leases. Our outstanding borrowings on bank lines of credit increased net $5.3 million. Payments on capital leases were $1.5 million. We also received $0.4 million from shares issued under employee stock plans.

Net cash provided by financing activities in 2002 was $5.8 million. This funding was in the form of $3.0 million from the issuance of stock to participants in our stock purchase and stock option plans along with $4.7 million of debt financing from our credit facilities with LaSalle Bank. During 2002, we made payments on capital leases and long-term debt of $1.0 million and paid a cash dividend on preferred shares of $0.9 million to LION Bioscience AG upon conversion of their holdings of preferred shares to common stock.

In 2004, we will be funding the completion of our laboratory expansion project at our U.K. research facility. We estimate that we will expend approximately $5 million for capital to complete the project (balance of payments on the building and remaining equipment requirements net of government grants). Additionally, over the next 12 to 18 months, we will be required to fund the remainder of our investment commitment ($1.0 million) to the Life Science II Investment Fund.

At December 31, 2003, Tripos was in violation of its minimum shareholders' equity covenant under our $6.0 million line of credit and mortgage loans with LaSalle Bank. In response to this violation and the changes arising from the restatement, on March 24, 2004 the Company and LaSalle Bank entered into a commitment letter providing for alternative financing structures. Upon execution of an amendment to the existing facility, the modified facility, which remains at $6.0 million for the revolving line of credit, would become a one-year commitment with fewer covenants (interest coverage and minimum shareholders' equity), a clean-down provision and a slight increase in associated fees. The maturity date on the mortgage loan remains unchanged (December 2005). The expected change in the line of credit portion of the facility better addresses the Company's reduced requirement to fund capital expenditures through bank debt while meeting the expected working capital funding needs in 2004. At December 31, 2003, we had outstanding borrowings of $6.0 million on the line of credit that were classified as short-term debt. In addition, we had $2.4 million of borrowings outstanding on the temporary line of credit. The temporary line of credit was paid in full prior to its expiration in early February 2004 along with payments of $1.2 million on the regular line of credit. Completion of this alternative financing structure is subject to a number of customary contingencies, including negotiation and execution of definitive documentation. The Company expects to complete the amendment early in the second quarter of 2004, but can provide no assurance that the amendment will be completed or that LaSalle Bank will not require additional terms adverse to the Company. In the event that the Company is unable to amend its credit facility on appropriate terms, the Company's capital resources and liquidity would be adversely affected.

We are in final stages of negotiation and documentation to obtain additional capital and operating lease financing to fund a portion of our remaining 2004 capital expenditure requirements for the laboratory. The remainder of operating needs and capital expenditures are expected to be funded through operations. We have made reductions in staff (14) in early 2004 along with continued controls on spending to help achieve this goal. Activities over and above normal operations may require additional sources of funding that are not presently identified. However, we believe that with our cash, accounts receivable balances, projected cash flows from operations, access to available borrowings from LaSalle Bank, if any, and incremental capital leases, we will be able to meet our liquidity needs and capital expenditure requirements for at least the next twelve months. See Note 12 of the Notes to Consolidated Financial Statements for a discussion of the credit facilities available to us. We expect that our capital expenditure requirements will drop substantially upon completion of the chemistry laboratory expansion in 2004. As a result, the current need for external funding will be reduced in future periods.

Due to the capital needs inherent to our business and despite current capital markets uncertainties, we may decide to seek additional financing to support our objectives to enhance product development, expand existing markets and enter new markets, expand our chemistry research laboratories, fund participation in new therapeutic collaborations, or enhance our capital base for other purposes. In making decisions regarding access to additional capital, we will consider the availability and terms of financing alternatives, as well as our objective to maintain financial flexibility to support planned and opportunistic growth of our business. Additional capital may be in the form of equity or debt securities, and may be raised in public offering or private placement transactions.

Our foreign operations transact the majority of their business in their respective local currencies and are generally not exposed to material foreign currency gains or losses. Under certain circumstances, selected contracts may expose Tripos to substantial foreign exchange risk. At times we may experience some positive and/or negative impact from foreign currency translations. For example, under the terms of our contract with Pfizer to perform discovery research services, we are currently being paid in US Dollars and incurring related costs in Great Britain Pounds Sterling, which has had a negative impact on our gross margins in this business area in 2003. Overall, however, due to the relative stability of the currency of the countries in which we operate and the level of investment in each country, our current intent is to retain assets within our foreign operations to fund those operations.

On July 30, 2002 President Bush signed into law the Sarbanes-Oxley Act of 2002 (the "Act"). Certain provisions of the Act are currently applicable to Tripos, but many other provisions do not become applicable until future dates. Tripos is currently reviewing the steps that will need to be taken to assure compliance with the Act and related requirements of the SEC and NASDAQ.

Section 401 of the Act (effective for periods ending after December 15, 2002) requires companies to disclose all material off-balance sheet transactions, arrangements, obligations and other relationships. For the periods ending December 31, 2003 and 2002, Tripos had no off-balance sheet transactions or arrangements other than ordinary operating leases that are further discussed in Note 8 of Tripos' consolidated financial statements contained in this Form 10-K. In prior years we used a Foreign Sales Corporation ("FSC") for certain tax benefits arising from our foreign sales activities. Due to tax law changes, we have ceased use of this tax strategy and dissolved the FSC entity on December 31, 2002.

The table that follows summarizes existing contractual obligations by type:

* Interest rates on the floating rate long-term debt are assumed to be constant for the purposes of this table. For this table, we have assumed that the full amount of the $6,000,000 revolving credit facility is outstanding throughout 2004 and the first half of 2005 that would generate an interest payable of $352,500 at a constant rate of 3.9%. For the mortgage loan we have assumed an interest rate of 3.4% until maturity in December 2005.

Section 402 of the Act prohibits any new loans to officers and directors and renewals of existing loans to officers and directors, except in specific circumstances. During 2001 we made a 30-month loan to Douglas A. Danne, our then Senior Vice President-Commercial Operations in the amount of $175,000 of which $137,400 remained outstanding at December 31, 2002. Mr. Danne left the Company in late 2002. No payments were received during 2003 although we are continuing to take steps to collect the remaining amount outstanding. However, due to Mr. Danne's personal financial situation, the Company took a charge in the first quarter of 2003 for the probability that the amount remaining due would not be repaid.

Periodic reports on Form 10-Q, Form 10-K and other filings with the Securities and Exchange Commission ("SEC") on Form 8-K and S-8, can be found on the Tripos web site at www.tripos.com under the heading Investor Relations - SEC Filings.

Our future results could differ materially from those discussed in this Annual Report. Factors that could contribute to such differences, include, but are not limited to, the following:

We cannot be certain that our sales strategy will be effective in achieving additional sales of our products. Our strategy of providing direct integration of sophisticated information technology with the experimental sciences in the form of chemical laboratories to produce faster, more cost-effective new product discovery has not yet garnered widespread commercial acceptance. This integrated approach requires our sales force to broaden its existing knowledge base in selling discovery software to include selling software consulting and discovery research. We cannot be certain that our sales force will be able to efficiently widen its knowledge base and then apply that information to make additional sales. There can be no assurance that the market will accept our integrated approach or that competitors will not offer other approaches that gain greater technological acceptance.

We face uncertainty in raising additional capital that may be necessary to fund our operations. We may seek to raise additional capital through additional public or private debt or equity financings, collaborative arrangements, borrowings or other available sources. There can be no assurance that additional funding will be available on terms that are favorable to the Company and its stockholders, if at all. If additional capital is raised through the sale of equity or securities convertible into equity, the issuance of these securities could result in dilution to our existing stockholders. If we cannot obtain additional financing when needed, we could be forced to curtail some of our current activities or delay implementation of other initiatives.

We face intense competition. We compete globally with the research departments of pharmaceutical companies, biotechnology companies, combinatorial chemistry companies, contract research companies and research and academic institutions in size, relative expertise and sophistication, speed and costs of identifying and optimizing potential lead compounds and developing and optimizing chemical processes. These competitors may have greater financial and other resources and more experience than we have in certain research and development methods. In addition, internal departments of corporations may be resistant to outsourcing software development, because it could reduce those departments' budgets. Moreover, our competitors may, in the future, offer broader product lines or technologies or products that are more commercially attractive than our current or future products or that may render our technologies or products obsolete.

We may incur significant costs in protecting our intellectual property rights or responding to claims of infringement from others. Our success will depend, in part, on our ability to obtain and enforce patents, protect trade secrets and copyrights, enforce restrictive licenses granted to third parties, obtain licenses to technology owned by third parties when necessary or developed in collaboration with us, and conduct our business without infringing the proprietary rights of others. We currently rely upon a combination of trademark, patent, copyright and trade secret laws, employee and third party non-disclosure agreements and other contracts to protect our proprietary rights. Nevertheless, our efforts to protect our intellectual property may be inadequate and we may be unable to prevent others from offering products and services substantially similar to ours. We also need to secure and maintain adequate protection of our intellectual property outside of the United States, beca use our sales are global. 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 engaging in international business have encountered considerable difficulties in safeguarding their proprietary rights in foreign jurisdictions.

Moreover, third parties may claim that our current or future products or services infringe upon their intellectual property. Litigation over these issues could be a significant distraction and we may incur significant costs, including several damages. In the event that it is determined that one of our products infringe upon another's proprietary rights, we may be required to obtain a license in order to continue selling our products. That license may not be available to us on favorable terms, or at all.

Our quarterly operating results could vary significantly. We have historically experienced fluctuations in our quarterly results. Quarterly operating results may continue to fluctuate as a result of a number of factors, including lengthy sales cycles, market acceptance of new products and upgrades, timing of new product introductions, changes in pricing policies, changes in general economic and competitive conditions, seasonal slowdowns, and the timing and integration of acquisitions. We also expect to continue to experience fluctuations in quarterly operating results due to general and industry specific economic conditions that may affect the research and development expenditures of pharmaceutical and biotechnology companies. Due to the possibility of fluctuations in our revenues and expenses, we believe that quarter-to-quarter comparisons of our operating results are not a good indication of our future performance.

Our business and operating results could be adversely affected by our inability to accurately estimate the revenue or costs on a contract. We seek to enter into long-term contracts with our customers, which generally are accounted for on a percentage-of-completion basis. This methodology requires the ability to accurately estimate total costs to be incurred in order to match revenues accordingly. If we are unable to accurately estimate the costs of these projects, we may be required to defer costs and revenues on these contracts until milestone delivery events are achieved (costs are assured). Profitability on these contracts may be driven by the extent of utilization of our billable personnel and our ability to control project costs. Accounting for a contract requires judgment relative to assessing the contract's estimated risks, revenue and costs, and on making judgments on other technical issues. Due to the size and nature of many of our contracts, the estimation of overal l risk, revenue and cost at completion is complicated and subject to many variables. Changes in underlying assumptions, circumstances, or estimates may also adversely affect future period financial performance.

Our business is dependent upon the extent to which pharmaceutical and biotechnology companies collaborate with drug discovery companies for one or more aspects of their drug discovery process. Our commercial success depends on our ability to enter into joint venture or other collaborative arrangements with third parties. To date, we have entered into numerous such arrangements with large pharmaceutical companies and emerging biotechnology companies. There can be no assurance that we will be able to continue to establish these collaborations, that any such collaborations will be on favorable terms, or that current or future collaborations will ultimately be successful.

Our ability to convince pharmaceutical and biotechnology companies to use our drug discovery capabilities, rather than develop them internally, will depend on many factors, including our ability to:

• provide scientists and technologies that are of the highest caliber;
• develop drug discovery technologies that will result in the identification of higher quality drug candidates;
• achieve expected results within our customers' timeframes, meeting quality and cost guidelines; and
• design, create and manufacture sufficient quantities of our chemical compounds for our customers.

Even if we are able to address these factors, these customers may nevertheless determine to perform these activities internally or with other companies that provide services similar to ours.

We are dependent on Dr. John McAlister, among others, and the loss of their services could affect our ability to be successful. Our future success depends to a significant degree upon the continued service of key senior management personnel, in particular, our President and Chief Executive Officer, Dr. John P. McAlister, as well as key technical personnel within the software, consulting and chemistry operations. We believe that Dr. McAlister's reputation and prominence in the field provide us with a competitive advantage. None of our key personnel is bound by an employment agreement or covered by an insurance policy where Tripos is the beneficiary. The loss of one or more key members could have a material adverse effect on our business and results of operations.

We may not be able to recruit and retain the experienced scientists we need to compete in our industry. We compete with the research departments of pharmaceutical companies, biotechnology companies, combinatorial chemistry companies, contract research companies and academic institutions for new scientific personnel. We compete with consulting companies for experienced computer programmers to carry out our software consulting contracts. We cannot be assured that we will continue to be successful in attracting and retaining qualified personnel should the worldwide demand for these skilled individuals increase. We believe that there is a shortage of, and significant competition for, scientists with the skills and experience in the sciences necessary to perform the services we offer. In addition, our inability to hire additional qualified personnel may require an increase in the workload for both existing and new personnel. We may not be successful in attracting new scientists or sales personnel or in retaining or motivating our existing personnel.

Pharmaceutical and health care reform could reduce the amounts that pharmaceutical and biotechnology companies have available to retain our services. We expect that a substantial portion of revenues in the foreseeable future will be derived from services provided to the pharmaceutical and biotechnology industries. If legislative proposals or reforms are adopted that have a material adverse effect on the businesses, financial condition, and results of operations of pharmaceutical and biotechnology companies that are actual or prospective customers, our business, financial condition and results of operations could be materially and adversely effected as well. For example, future legislation could limit the prices pharmaceutical and biotechnology companies can charge for the drugs they market. This would have the effect of reducing the resources that these companies can devote to the research and development of new drugs, which would in turn reduce the amount of services that we perfor m and our resulting revenues.

Our exposure to market risks is limited to foreign exchange variances and fluctuations in interest rates. To date, interest rate exposure has not resulted in a material impact. During 2003, the Company did experience a significant impact from foreign exchange. The costs to perform the custom design and synthesis contract with Pfizer are incurred in British pounds sterling while we are compensated in U.S. dollars. As a result, our gross profit was adversely affected by the decline in the U.S. dollar against the pound. Part of this effect was offset through foreign currency forward contracts whose gains were recorded in "Other Income".

Our foreign exchange risk is presently limited to currencies that historically have exhibited only minor fluctuations although during 2003, these currencies have shown more significant variation. Assets outside the United States are primarily located in England. Our investments in foreign subsidiaries with a functional currency other than the U.S. dollar are not hedged. The net assets in foreign subsidiaries translated into U.S. dollars using the year-end exchange rates were approximately $17.7 million and $10.4 million at December 31, 2003 and 2002, respectively. The potential reduction in fair value resulting from a hypothetical 10% adverse change in foreign currency exchange rates would be approximately $1.8 million and $1.0 million at December 31, 2003 and 2002, respectively. Any loss in fair value of permanently invested funds would be reflected in Other Comprehensive Income and would not impact our net income.

Our interest rate risk is attributable to borrowings under the line-of-credit and mortgage loan. During 2002 and early 2003, we had fixed a portion of our floating rate interest risk on the mortgage loan through the purchase of swap instruments. The interest rate swap agreements expired in April 2003 and were not replaced. Unrealized loss on our interest rate swap at December 31, 2002 was not significant. We will continue to monitor our exposure to floating interest rate risk on line-of-credit borrowings along with the outstanding balance on the mortgage loan and will endeavor to mitigate this risk through the use of appropriate hedging instruments.

Inventory amounts shown in the Consolidated Balance Sheet are net of an obsolescence reserve. In calculating the reserve, the age and sales trends of each category in the inventory are taken into account to determine the net realizable value. Any shortfall between the carrying cost of the inventory and the net realizable value is provided for in the reserve.

Accounting Estimates.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, liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements as well as the reported amounts of revenue and expenses during the reporting period. Actual results could differ from those estimates.

Property and Equipment are stated at cost. Depreciation is computed by applying an accelerated method over the estimated useful lives of the assets, which range from five to ten years for equipment and furniture, twenty-five to thirty-nine years for buildings, the shorter of the useful life of the improvement or the life of the related lease for leasehold improvements, and three years for purchased software. We make every attempt to closely match the book useful life of our assets to their expected productive lives. Assets deemed to be impaired or no longer productive, are written down to their net realizable value.

Development Costs primarily consist of software development costs related to new products that are capitalized after the establishment of technological feasibility (working model) in accordance with Statement of Financial Accounting Standards ("SFAS") No. 86. During 2003 and 2002 capitalized costs were $1,272 and $1,340, respectively related to development work on a laboratory research and inventory support system to be marketed to external customers. Amortization of capitalized software development costs is provided on a product-by-product basis as the greater of (a) the ratio of current gross revenues for a product to the total current and anticipated future gross revenues or (b) the straight-line method over the remaining estimated economic life of the product. Currently, we use an estimated economic life of three to five years for all capitalized software development costs. We assess the recoverability of capitalized softwa re development costs by comparing the remaining unamortized balance to the net realizable value of the related product. Any excess is written off. For 2003 and 2002, amortization of software developed for sale was $258 and $233 respectively.

Goodwill represents the excess of the cost of the net assets acquired of Tripos Receptor Research Ltd. over its fair value. Goodwill was amortized on a straight-line basis over 15 years. Beginning in 2002, we have adopted Statement of Accounting Standard No. 142, "Goodwill and Other Intangible Assets" ("FAS 142"), that suspends amortization of goodwill in favor of periodic evaluations of impairment by comparing the fair value of the business to which the goodwill relates to its carrying value. The Company performed formal impairment tests of goodwill in 2003 and 2002 and will continue to do so on an annual basis and between annual tests if an event occurs or circumstances change that would more likely than not reduce the fair value of Tripos Receptor Research Ltd. below its carrying value. The impact of no longer amortizing goodwill did not result in a material difference in either 2002 or 2003 results as compared to prior years.

Foreign Currency Translation. The local foreign currency is the functional currency for each of our foreign operations. Assets and liabilities of foreign operations are translated to U.S. dollars at the current exchange rates as of the applicable balance sheet date. Revenues and expenses are translated at the average exchange rates prevailing during the period. Adjustments resulting from translation are reported as a separate component of shareholders' equity. Net gains and losses from foreign currency transactions were not significant during any of the years presented and are presented in other income (expense).

Derivative Instruments. The Financial Accounting Standards Board issued Statement No. 133, "Accounting for Derivative Instruments and Hedging Activities" ("FAS 133"), which requires us to recognize all derivatives on the balance sheet at fair value. We enter into derivative contracts, principally currency hedges, to limit the risk of fluctuations in foreign currency exchange rates on the value of certain sales transactions. Additionally, we have previously entered interest rate swap contracts to effectively convert portions of our floating rate debt to a fixed rate. We do not attempt to speculate on the direction of currency rates nor interest rates. We take this conservative approach to protect against the risk of loss only. See Note 19 for a further discussion of Financial Instruments.

Warranty. We are a reseller of hardware and pass through to our customers the standard warranties provided by the hardware supplier. We warrant our application software products to perform in accordance with written user documentation and the agreements negotiated with our customers. Since we do not customize our applications software, software warranty costs are insignificant and expensed as incurred.

Income Taxes are computed using the liability method. The primary difference between financial statement income and taxable income results from the use of different methods of computing depreciation, capitalized development costs, certain revenue recognition activities, other timing differences and the valuation of net operating loss carryforwards.

 The Company recognizes revenues in accordance with the American Institute of Certified Public Accountants (AICPA) Statement of Position (SOP) 97-2, "Software Revenue Recognition," as amended. Revenues from software license agreements are recognized when all of the following criteria are met as set forth in paragraph 8 of SOP 97-2: (1) persuasive evidence of an arrangement exists, (2) delivery has occurred, (3) the fee is fixed or determinable, and (4) collectibility is probable.

Comprehensive Income. Financial Accounting Standards Board SFAS 130, "Reporting Comprehensive Income" establishes standards for reporting and display of comprehensive income and its components (revenue, gains and losses) in a full set of general purpose financial statements. SFAS 130 requires that all components of comprehensive income, including net income, be reported in a financial statement that is displayed with the same prominence as other financial statements. Comprehensive income is defined as the change in equity during a period from transactions and other events and circumstances from non-owner sources. Net income and other comprehensive income, including foreign currency translation adjustments, and unrealized gains and losses on investments, shall be reported, net of their related tax effect, to arrive at comprehensive income. Unrealized loss on our interest rate swap at December 31, 2002 was not significant.

Earnings Per Common and Dilutive Share. Basic earnings per common share is computed using the weighted average number of common shares outstanding during the year. Diluted earnings per common share is computed using the weighted average number of common shares and potential dilutive common shares that were outstanding during the period. Potential dilutive common shares may consist of outstanding stock options and the assumed conversion of the Series B Preferred shares (for periods in which the Series B shares were outstanding). See Note 13 for additional information regarding earnings per share.

Reclassifications. Certain reclassifications have been made to prior years' balances to conform with the current year presentation.

Stock-Based Compensation. At December 31, 2003, Tripos had the stock-based employee compensation plans described in Note 23. We account for stock option plans under the intrinsic value method as permitted under Accounting Principles Board Opinion No. 25 ("APB 25"), "Accounting for Stock Issued to Employees", and related Interpretations. Under APB 25, generally no compensation expense is recognized because the exercise price of the options equal the fair value of the stock at the grant date.