[X]  Annual Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934. For the fiscal year ended December 31, 2004.

or

[  ]  Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934. For the transition period from _____________ to _______________.

(Exact name of registrant as specified in its charter)

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

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

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

The aggregate market value of the voting stock held by non-affiliates of the Registrant as of June 30, 2004 was $20,246,815 (based upon the June 30, 2004 closing price for shares of the Registrant's Common Stock as reported by the NASDAQ National Market). Shares of Common Stock held by each officer, director and holder of 5% or more of the outstanding Common Stock have been excluded in that such persons may be deemed to be affiliates. This determination of affiliate status is not necessarily a conclusive determination for other purposes.

On March 15, 2005, there were 10,088,024 shares of the Registrant's Common Stock outstanding with a par value of $0.01.

Portions of the Registrant's Proxy Statement for the Annual Meeting of Shareholders to be held May 11, 2005 are incorporated by reference into Part I and III.

We have formed commercial relationships with most major pharmaceutical companies and with many emerging biotechnology companies based on their use of some or all of our products and services. In addition, we have established strategic collaborations with several of the companies based on our specific unique capabilities. Representative pharmaceutical clients include: Sanofi-Aventis, Bayer, Bristol-Myers Squibb, Pfizer, and Schering AG. Representative biotechnology clients include: Biovitrum, Chronogen, and Critical Therapeutics.

Tripos was formed in 1979 to commercialize software for molecular visualization, analysis and design. In building our discovery informatics services, we have focused on developing an integrated suite of offerings to stay at the leading edge of scientific research. In addition to creating discovery informatics product and service offerings, our chemistry research activities have created an opportunity for us to participate in therapeutic collaborations with certain of our customers, giving us the potential for milestones and/or royalty interests in early-stage new drug candidates.

Our business model is based primarily on deriving recurring revenues from our discovery informatics and discovery research businesses and secondarily on achieving contributions from therapeutic collaborations if and when new therapeutics are developed. The following is a description of each area of our business:

Tripos was founded 26 years ago by Professor Garland Marshall of the Washington University School of Medicine for the purpose of commercializing discovery research software tools. Tripos was purchased from its founder in 1987 by Evans & Sutherland Computer Corporation ("E&S"). In 1994, Tripos was spun-off in a tax-free distribution to E&S shareholders. We acquired our chemistry research capabilities, based in Bude, Cornwall, England, in late 1997 and also began offering discovery informatics consulting services in 1997.

The demand for our products and services is driven by fundamental change in the business of the largest pharmaceutical companies. These companies face significant pressures to develop new drugs that can generate substantial return on development costs while also contributing to improved health and life expectancy for the general populace. According to the Tufts Center for the Study of Drug Development, the average cost to bring a new medicine successfully to market can reach $800 million. The pressures on pharmaceutical companies are twofold: to reduce the time (and therefore the cost) of developing new drugs, and to discover and develop a greater number of new drugs or, to see a greater number of their drug candidates emerge from their R&D pipeline as approved and successful therapeutic products. Many large pharmaceutical companies are not meeting growth objectives. To maintain current levels of profitability, executives at large pharmaceutical companies project a ne ed for a minimum of five new chemical entities (blockbuster drugs) each year, yet the industry average is less than three per year. As a result of these pressures, the methods by which large pharmaceutical companies are conducting their research and development activities are changing rapidly.

Outsourcing. For the past two decades, pharmaceutical companies have consistently increased their research and development activities in an effort to increase their product pipelines. As the pressures mount to continue product development while rationalizing research and development expenditures, pharmaceutical companies have turned to outsourcing. In the past, pharmaceutical companies have outsourced tasks such as management of clinical trials or certain parts of the manufacturing process. Beginning in the 1990s, research outsourcing by major pharmaceutical companies has dramatically increased due to pressures to decrease time-to-market, reduce costs, and improve the yield on internal research and development activities. According to an ING Barings market study, approximately 10% of early stage discovery activities are currently outsourced. In a recent market study, the market size for discovery research outsourcing was estimated at $1.8 to $2.3 billion globally, with approximately 30% of that amount related to chemistry services and collaborations. These figures were expected to grow by 10-12% over a five-year period. The future influx of targets from genomics alone may result in a 20% to 25% growth rate in new drug targets, and is expected to further impact outsourcing.

The Information Revolution. Rapid changes in industry, academic and government research in recent years have resulted in the generation of vast amounts of biomolecular, chemical and other scientific data. Included is information related to the gene sequence, variation, expression, and function, along with protein structure and function. When coupled with the attendant volumes of structure-activity data generated by high-throughput chemistry and high-throughput screening technologies, the quantity of data/information is overwhelming. In addition to a need for tools that enable analysis and decision-making on an unprecedented scale, there is increasing awareness that clarifying the relationship between biological targets and the particular chemical compounds with which they interact could significantly streamline the success of drug discovery. Until recently, traditional drug discovery research within pharmaceutical companies has not effectively incorporated these methods. In order to realize the full potential of the relationships that link the various disciplines in discovery, we believe new information technology tools will be required.

Importance of small molecule drug discovery. Despite recent gains in biotechnology, small molecule drugs, which are invented and designed by chemists, remain the drugs of choice by healthcare professionals and their patients. Small molecule drugs have inherent advantages over protein-based therapeutics, including a greater universe of treatable diseases, lower cost with greater ease of manufacturing, and the ease of administration of pills versus injections.

Through our discovery informatics and discovery research products and services we offer comprehensive, customized solutions to address many of the discovery research needs of our customers. We apply computational design and analysis skills in our laboratories, where we employ all of our software technologies, to develop new chemical entities for our customers. Applying this scientific discipline, we have developed and applied informatics solutions that incorporate the full array of biological, chemical, screening and other scientific data along with comprehensive data mining and analysis, to meet the need of the discovery scientist, whether on our staff or our customer's staff. By being an integrated provider, we are also able to apply the Tripos solution to work with smaller companies in therapeutic collaborations using our tools and services where we may participate in the success of a particular therapeutic product through joint ownership in compounds or in the collaborator or both.

The key elements to Tripos' unique offerings are the integration of the science, software and information technology into a complete solution for use in customers' research and discovery process. To achieve this solution, we:

1. Offer software tools with leading-edge capabilities in a variety of applications, including 3-D molecular simulation and prediction of molecular structure and activity, data storage and analysis and in silico (computational research methods as opposed to laboratory methods) screening for biological activity;
2. Leverage our knowledge of life sciences and pharmaceutical discovery processes to develop informatics solutions that improve research knowledge management to facilitate data access and data analysis;
3. Operate state-of-the-art chemistry research facilities and processes to deliver high-quality compounds that can rapidly lead to new chemical entities; and
4. Work with customers using our knowledge-driven chemistry approach to perform strategic chemistry research tailored to their specific requirements.

We are a leading integrated provider of products and services for the drug discovery needs of pharmaceutical and biotechnology companies around the world. Key elements of our growth strategy are as follows:

Maintain Leading-Edge Discovery Informatics Innovation. Relying on 26 years of leadership in this field, we will continue to invest in new releases of our products, to develop new applications, and to create new technologies to meet the changing demands of researchers. We will also pursue software research and development collaborations with our customers to rapidly advance the state-of-the-art in computation while developing new products that we may market in the future. We will endeavor to deliver innovative informatics products that our customers can use to resolve their strategic informatics problems. We have experience in developing operational informatics systems and apply the pharmaceutical industry domain expertise of our scientists to develop innovative solutions that improve research operations through effective knowledge management. Technologies such as the Tripos Electronic Notebook, LITHIUM, Benchware, SARNavigator and other solutions aid in knowledge capture, sharing a nd utilization in the laboratory. .

Drive Chemistry Research Efforts. We have fully integrated chemistry research and design capabilities that are driven by our in-depth knowledge of chemistry, informatics and computer-aided drug discovery resulting in the highest quality research. We will continue to invest in our chemistry research facilities and in our scientific expertise due to our belief that these capabilities are an essential component in helping our customers meet their research and development needs.

Seek Therapeutic Collaborations on an Opportunistic Basis. We will continue to leverage our integrated solution to develop collaborative arrangements with pharmaceutical and biotechnology companies in which we invest to obtain an ownership interest. We screen the scientific and management capabilities of potential partner companies. For those companies that pass our evaluation process, if we believe that our solutions can help these companies develop promising products, we will seek to enter into collaborative arrangements in which we will benefit from the success of a product or of the collaborator itself. In addition, we are using our ChemSpace^® and other informatics technology to actively search our chemistry knowledge base for possible therapeutically interesting compounds that we may choose to investigate ourselves and offer in a research program to customers or collaborators. Once identified, we may initiate a program to further develop these compounds through t argeted screening and synthesis activities, the objective of which is to produce interesting libraries of compounds enhanced for a particular therapeutic area. We believe such products form attractive starting points for collaborative research programs with pharmaceutical and biotechnology companies.

In late December 2004, we announced the acquisition of Optive Research, Inc. that was subsequently completed in January 2005. Through this acquisition, we gained access to fifteen (15) software products developed by Optive that are complementary to Tripos' existing products. Some of these products will be utilized to expand our desktop product strategy. We are also excited about adding the talented scientists and executives from Optive to our team.

Tripos' business proposition is based on our ability to deliver an integrated offering of technologies for in silico discovery for the expert user and the non-computational chemist, information-rich chemical libraries, and collaborative chemistry research projects. The following summarizes some of the key components of our products and services.

Discovery informatics products offer customers the ability to accelerate the identification and optimization of new compounds that have the potential to become drug products. Tripos' design tools improve the efficiency of the research process by identifying physical and structural properties of molecules that are likely to make them suitable as drugs, and then use this information to design novel molecules that possess these properties. These calculations are based on complex pattern analysis and 3D simulation of chemical structures and behaviors, and often involve many thousands of molecules. By viewing and analyzing the results of calculations done with Tripos' software products, scientists can make decisions about which compounds to move forward in their research. Tripos discovery software enables scientists to avoid costly synthesis and testing expenses for chemical compounds that are not likely to be effective and to quickly design the experiments most likely to advance a proj ect. Our proprietary software is used by scientists at major research facilities around the world to manage, analyze and share biological and chemical information.

We believe Tripos' is well positioned to meet the growing demand in the life sciences industries for integrated, managed, accessible information that spans all aspects of an organization's research efforts. The highly specialized research environments of these industries require an experienced understanding of the discovery process. We draw upon over 26 years of experience developing scientific software applications for the pharmaceutical and biotechnology industries.

Tripos has developed and deployed operational informatics technologies designed to enhance everyday laboratory activities -- such as experiment management, workflow and logistics. We have experience in research and development of novel strategic informatics technologies that focus on scientific data analysis, predictive science and decision support for large pharmaceutical organizations. These strategic systems capitalize on experimental work by maximizing the utility of generated data.

In mid-2004, we began using our research capabilities to investigate several specific known biological target areas of interest to a large number of pharmaceutical and biotechnology firms. In this process, we identified compounds from our collections and had these compounds screened externally for biological activity and selectivity. Based on the outcome of these results, we designed and synthesized new libraries of compounds and iterated this process to further develop the intellectual property associated with these libraries. We plan to offer these LeadDiscovery packages to our customers both as products and as initiators in new collaborative research programs beginning in 2005.

Our discovery research capabilities were acquired in late 1997 along with an initial staff of 8 and were expanded over subsequent years to meet customer demand. The laboratories are based in Bude, Cornwall, England and now have a staff that numbers nearly 170. In 1999 we built a 25,000 square foot state-of-the-art research center. Our recent expansion added 48,000 square feet to our capacity in early 2004, bringing the total facility to 73,000 square feet.

We also sell computer systems to our customers upon request as a convenience, however, we do not maintain an inventory of systems on-hand. As such, we do not expect nor realize high margins on these products.

Our growth strategy is based on expanding relationships with large pharmaceutical and biotechnology companies to offer multiple Tripos products and services to enhance their drug discovery operations. Below are some of our major collaborations:

Bristol-Myers Squibb. In December 2000, we initiated the first phase of a program with Bristol-Myers Squibb (BMS) to design and implement an integrated research informatics system. Working with BMS and Accenture LLP, we developed an enterprise-wide program to provide a new decision support capability to accelerate drug discovery. The system, titled SMART-IDEA, incorporates our MetaLayer™ software and was deployed by BMS to their research staff numbering more than 1,500 scientists, during 2002. In September 2003, we entered into an extension to our then current agreement with BMS to integrate our FormsBUILDER™ technology, a forms-based querying tool for retrieval and browsing of research data, into the SMART-IDEA application. This form-based searching technology enables scientists to easily customize their own forms and combine queries requesting chemical structures with associated data from experiments in many areas. The FormsBUILDER™ technology was deploye d at BMS in 2004. We continue to deploy staff on-site at BMS for the purposes of support and enhancement of these technologies.

Pfizer, Inc. In January, 2002, we entered into a strategic collaboration with Pfizer for up to four years and originally up to $100 million to design, synthesize and purify high-quality, drug-like compounds to expand Pfizer's chemistry compound collection. 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-stage hit follow-up work between Tripos and Pfizer. The amendment also reflected a further minimum commitment for 2004 and expected overall 4-year revenue of $90 million, with the potential to recognize up to $22 million in 2005.

In a separate transaction in October 2004, Pfizer renewed and increased their multi-million dollar, multi-year agreement to license the Tripos suite of discovery software technologies, including the SYBYL and UNITY software products, to Pfizer research locations worldwide.

Schering AG. In August, 2002, Tripos began a collaboration with Schering AG to develop an integrated chemical information management system that would allow Schering scientists to manage information, plan syntheses, order reagents and track all their chemical assets globally. This system is known as the Enterprise Chemical Information Management System (ECIMS). In March 2004, we announced the completion of a significant milestone in this collaboration with Schering AG. Schering accepted Tripos' AUSPYX^® data cartridge for Oracle^® as the foundation of ECIMS. ECIMS is based on our ChemCore™ technologies in use at our chemistry research facilities in Cornwall, England, and our Tripos Electronic Notebook™ (TEN) systems. Tripos and Schering amended their agreement in mid-2004 to adjust the timing, scope and payment schedule for the remainder of the project. Tripos achieved other key milestones during the latter stages of 2004 and remains on track to complete the project according a revised schedule.

Critical Therapeutics, Inc. In October 2003, we entered into an agreement with Critical Therapeutics (CTI) to identify and optimize small-molecule agonists for CTI's development program targeting a nicotinic acetylcholine receptor. The project has progressed through 2004 and we continue to use our chemistry and discovery research processes, including our LeadQuest^® chemical compound libraries and ChemSpace^®-enabled LeadFocus^SM and LeadHopping^SM programs, to select and synthesize compounds for CTI's target. We will receive research payments and additional payments for successful achievement of agreed milestones.

Chronogen Inc. In January 2004, we entered into a three-year collaboration with Chronogen to discover and optimize small-molecule therapeutics for cardiovascular disorders. Under the agreement, we are employing our knowledge-driven chemistry process to provide complete drug discovery chemistry services for Chronogen. Drawing upon our chemical libraries, expertise in data analysis, design tools and rapid synthetic follow-up capabilities, we are supporting Chronogen's biological expertise in metabolic pathways related to aging. Chronogen has been applying its in vitro screening technologies to rapidly select effective molecules, and we are optimizing those molecules for specific cardiovascular indications. Tripos is paid on a fee for service basis with the potential for success based milestones.

Divergence, Inc. In June 2004 we entered into a collaboration with Divergence, Inc., a leader in genomics-based discovery of solutions for the prevention and treatment of parasitic infections in plants, animals, and people. We are employing our chemistry knowledge base and knowledge-driven chemistry process to expand structure-activity-relationship (SAR) models and optimize appropriate candidates for parasite control. We will receive research payments during the collaboration.

European Molecular Biology Laboratory (EMBL). In July 2004 we entered into a multi-year relationship with EMBL and the German Cancer Research Centre (DKFZ), to assist in rapid identification of potential molecular leads. We employ our chemistry knowledge base and associated knowledge-driven chemistry process to facilitate rapid hit finding, hit follow-up and chemical optimization of candidate molecules for a wide range of projects. We will receive research funding during the relationship.

Strida Pharma Inc. In August 2004 we entered into a multi-year joint collaboration with Strida Pharma Inc. and NovaScreen Biosciences Corporation to support Strida's cancer therapeutics development program. We are working to identify, design and synthesize suitable compounds for biological activity assessment in a high-throughput screening assay developed by NovaScreen. Tripos is paid on a fee for service basis.

Sanofi-Synthelabo Recherche. In September 2004 we entered into a strategic collaboration with Sanofi-Synthelabo Recherche, an affiliate of Sanofi-Aventis. Working with proprietary therapeutically relevant chemistry motifs identified by Sanofi-Synthelabo Recherche, we continue to employ our knowledge-driven chemistry approach to design and synthesize compounds that expand these areas of therapeutic interest. We will receive research payments during the collaboration.

Bayer AG. In October 2004, we successfully completed work on a three-party arrangement with Bayer and LION Bioscience to provide Bayer with an integrated cheminformatics technology to speed Bayer's identification of lead candidates for its drug programs.

Biovitrum Our collaboration with Biovitrum in the discovery informatics area enhanced the GASP™ software tool, which applies a genetic algorithm to a set of compounds active against a common target. Molecules that match the models created in GASP™ are more likely to be active, making this an important tool to identify other active structural series in large corporate databases. Tripos expects to release the new software technology to the market during 2005.

NOVASCREEN Biosciences Corp. We participate in a mutual service and distribution agreement with NOVASCREEN Biosciences (NovaScreen) that allows each company's sales force to offer the other's products and services to their biotechnology and pharmaceutical clients. NovaScreen is able to use our LeadScreen™ compound plates as a source of compounds for high throughput screening (HTS) services, as well as our LeadQuest^® libraries for secondary screening and in vitro ADME/Tox (Absorption, Distribution, Metabolism, Excretion and Toxicity) follow-up. In turn, we are offering our customers assay development, HTS reagents, HTS services, secondary screening and in vitro ADME/Tox screening through NovaScreen. The goal is to provide customers access to a comprehensive range of both companies' products and services, from assay development to identification and production of optimized lead compounds, all under one agreement thus enabling either company to perform comp lete discovery and optimization projects for clients.

ChanTest, Inc. We collaborate with ChanTest to develop models that predict which drug compounds are likely to produce cardiac liability due to blockage of the hERG ion channel as well as those chemical features that may be corrected in drugs already having a cardiac liability. We are providing compounds for testing by ChanTest and, based on test results, developing the predictive model and employing it to examine clients' data. Our chemistry research facilities are optimizing clients' leads to remove any cardiac ion channel liability that becomes visible in lead candidates. This collaborative process aims to deliver an effective compound free of cardiac liability more rapidly than client's internal resources, thus saving time and expense. This model is the first of its kind and works to assist customers in meeting potential FDA clinical trial mandates for hERG channel ion testing.

United Devices, Inc. We also work with United Devices to enable our virtual screening applications to operate on United Devices' parallel grid computing platform. We are collaborating to port FlexX™, FlexX-Pharm™ and FlexE™, programs that allow virtual screening of compound databases by rapidly docking flexible ligands at active sites, and Unity® 3D software that provides fast, flexible 3-D searching of chemical databases to United Devices' Grid MP™ platform. It will be offered as a product to other customers upon completion. United Devices' Grid MP™ Enterprise platform is currently being used by a number of pharmaceutical companies as well as by university researchers.

We market our products and services directly in the U.S., Canada and Europe. We market our products through an exclusive distributor arrangement in Japan and Australia, and through non-exclusive agency relationships in Brazil, Korea, China, Singapore, and India. On December 31, 2004, our sales force consisted of 46 management, technical, sales and administrative employees: 21 for the United States and Canada and 25 in Europe. Our domestic sales and support center is located at our headquarters in St. Louis, Missouri. Sales representatives are located in or near key research areas around the U.S. We also maintain sales offices near London, Paris and Munich.

The sales staff includes employees with Ph.D. degrees in chemistry, various advanced degrees in the sciences and work experience with various hardware and software suppliers as well as with the pharmaceutical and biotechnology industries we serve. Our sales representatives are compensated through a combination of base salary, commissions and bonuses based on quarterly and annual sales performance. In addition, our pre-sales scientists, all of whom have Ph.D. degrees in chemistry or a closely related field, receive total compensation determined in part by their success in supporting and generating sales in a particular territory.

Teams, which include scientists working in collaboration with our sales employees, have developed a consultative sales approach through which we have created relationships with our key customers. We believe these relationships enable us to understand and better serve the needs of our customers. Because our customers frequently have both domestic and international operations, our sales staff and scientists in foreign locations work closely with their counterparts in the United States to ensure that our customers' international needs are met in a coordinated and consistent fashion.

We market our workstation-based software products in a variety of ways, one of which is term licenses on the basis of a fixed number of simultaneous users per software module. Network-based licensing is available, based on a count of the number of simultaneous users. We also have time-based (one, two or three years) license options that offer customers the ability to tailor their product selections to their specific research needs and that are renewable at the end of the selected terms. Our customer base has taken advantage of the flexibility of time-based licensing to access more of our software products. These arrangements provide a more predictable recurring revenue stream from the periodic renewals. Software packages consisting of modules typically purchased by customers in particular industry segments have been defined and have been specially priced to facilitate customer purchase of an optimal module set for their needs.

Discovery informatics and software development arrangements are sold on a collaborative basis by focused business developers and scientists directly to research management and information technology departments. Each contract is negotiated based on the particular software needs of the customer. The term of the contract is highly variable and may range from two weeks up to a number of years. Tripos provides programming and scientific expertise. Discovery informatics contracts may include specification, gap and risk assessment, and/or full biological and chemical data integration. Our proprietary technologies such as LITHIUM, FormsBUILDER, Tripos Electronic Notebook, AUSPYX and ChemCoreRIO, may be installed at a client site to solve many research information problems. These technologies have annual license fees.

Sales of the compound libraries are made through our sales teams and distributors. The LeadQuest® library includes approximately 80,000 compounds available for purchase. The compounds are sold on a nonexclusive basis to all purchasers and we generally retain no trailing rights to the compounds once purchased by a customer. LeadQuest® high-throughput screening libraries are novel, diverse, high-quality, drug-like compounds that serve as a pathway to more extensive discovery research.

Discovery research collaborations are offered through a team comprised of business developers, scientists and members of senior management. This approach is best suited for the long cycle required in developing meaningful partnerships with key customers for outsourcing or collaborating on discovery research projects.

We exhibit our products and services at various scientific conferences and trade exhibitions, including national and regional conferences of the American Chemical Society, at the InfoTech Pharma Conference, a variety of IBC Drug Discovery Conferences, Society for Biomolecular Screening Conference and CHI High-throughput Screening for Drug Discovery Conference and others. Our scientists frequently publish and present results of original research at these and other conferences throughout the world.

We offer customer training in the use of our products through a dedicated training staff knowledgeable in both chemistry and computer science. We send technical newsletters, bulletins, and advance notification about future software releases to our customers to keep them informed and to help them with resource allocation and scheduling. We also sponsor seminars throughout the world for our customers, involving presentations both by our personnel and guest lecturers. These seminars are designed to enhance customer understanding of our products and their potential use as an aid to customer research requirements. We provide our customers with advice on computer system configuration management and frequently provide customers with consulting advice in addressing particular research questions as part of the normal pre- and post-sales process.

In 2004, 2003 and 2002, we obtained 54%, 52% and 33%, respectively, of our total revenues from Pfizer, Inc. No other individual customer accounted for over 10% of total revenue in these years.

We sell software licenses, compound products and research services through our wholly owned subsidiaries in Canada and Europe and through a network of distributors and agents in the Pacific Rim, South America and India. Net sales from our activities outside of North America represented approximately 80%, 74% and 64% of total net sales in 2004, 2003 and 2002, respectively, with Europe accounting for 75%, 67% and 57%, and the respective balances coming from customers in the Pacific Rim. We believe that revenues from foreign activities will continue to account for a significant percentage of our total net sales. See Note 12 to the consolidated financial statements, Segment Information, later in this Annual Report.

Software license and compound product sales through distributors or agents to our Pacific Rim customers accounted for 4%, 4%, and 4% of 2004, 2003, and 2002 total sales, respectively. Software products and access keys are sent either directly to the customer or through the local representative firm. For Pacific Rim transactions in all countries except Japan and Taiwan, the end-user customers enter software license agreements with Tripos. Japanese and Taiwanese customers enter sub-license agreements with the local distributor. All access keys are created by Tripos upon receipt of proof of agreement (purchase requests from the Japanese and Taiwanese distributor or license agreements from end-user customers). Revenue is recognized for all countries except Japan and Taiwan upon shipment of product to the customer and when access is granted. Revenue is recognized for Japanese and Taiwanese transactions upon shipment of product to the distributor. The Japanese and Taiwanese distributors a re contractually obligated on a non-recourse basis for all software license transactions in their territories.

We believe our position as a leader in discovery informatics products and services will depend in large part on our ability to enhance our current product line, develop new products, maintain technological competitiveness, integrate complimentary third-party products and meet a rapidly evolving range of customer requirements. We intend to continue to make substantial investments in product and technology development to meet our customers' demands.

The complexity of developing new and enhanced scientific information management software in a client/server environment is significant. Delays or unexpected difficulties in any segment of a development project can result in late or undeliverable product. In view of this complexity, there can be no certainty that we will be able to introduce our products on a timely basis in the future, or that our new products and product enhancements will adequately meet the requirements of the marketplace or achieve market acceptance.

Our research and development activities are undertaken by our discovery software group and our discovery research group. The discovery software group, composed of chemists and other scientists, works closely with customers to identify market needs for new products. Upon identification of a market need for a new product, the discovery software group collaborates with our software engineers to develop requirements and specifications, implement code and perform regression tests for the new product. Separate quality assurance, environment management and systems groups manage the final release, documentation and porting of the new product to all supported platforms. In addition, we fund research at certain academic institutions. We believe that this funding allows us to gain access to significant technology not otherwise available. Also, we enter into software development arrangements with major pharmaceutical customers to develop software tools crucial to high throughput research environments and for other emerging issues in the life sciences industry.

In September 1998, we opened our first laboratory facility (6,600 sq. ft.) suitable for complete chemical synthesis operations. We began production of newly designed screening libraries, started pilot projects for contract research and generated focused libraries. In May 1999 we opened our second and larger laboratory facility (18,400 sq. ft.), providing us with the capacity to accommodate large library synthesis and contract research operations simultaneously. Our compound library inventory, LeadQuest®, has subsequently increased to around 80,000 highly pure compounds available for sale. In addition to LeadQuest® library synthesis, we have the facilities and staff to perform several contract research projects concurrently. The latest expansion of our chemistry facilities was completed early in 2004 and added 48,000 sq. ft. of laboratory space to accommodate production under the Pfizer compound enrichment contract and other incremental business opportunities. The Company now has 73 ,000 square feet of laboratory space at its discovery research center in Cornwall, England.

Research and development expenses include all non-capitalizable costs of software development from Discovery Informatics and any non-capitalizable research associated with the validation of compound libraries or discovery research projects from our Discovery Research area. R&D expenses for 2004, 2003 and 2002 were $9.3 million, $12.9 million and $10.1 million, respectively. In accordance with Statement of Financial Accounting Standards No. 86 and AICPA Statement Of Position 98-1, Tripos capitalizes software development costs for both external and internal use. Net capitalized software development costs were $2.2 million at December 31, 2004 and $2.4 million at December 31, 2003. The capitalized software costs are related to work in creating a commercial version of our ChemCoreRIO (Registration, Inventory and Ordering) technology that is already in place at our own chemistry laboratory in the U.K. along with multiple new "benchtop" software technologies for laboratory chemists.

A portion of our chemistry R&D efforts are attributable to development of our LeadDiscovery packages that include chemical compounds and associated intellectual property derived from biological screening activity. We have captured the costs for promising leads in inventory as we assemble the package offering. We anticipate bringing a few of these packages to market in 2005.

Our discovery informatics software production operations consist of assembling, packaging, shipping of software and database products along with documentation needed to fulfill orders. Outside vendors provide printing of documentation and manufacturing of packaging materials. We typically ship our software products promptly after the acceptance of a customer purchase order and the execution of a software license agreement.

Discovery informatics service contracts, or enterprise software consulting, may be structured under a variety of terms including billing for hours worked, successful delivery of milestones or fixed-price contracts. Staff assigned to these contracts is principally located in the U.S. These contracts may contain provisions for license fees on the core technologies delivered at the inception of the project or for the system software activated upon completion of the contract. Quarterly revenues and costs from software consulting will vary due to the mix of contracts being serviced in any particular quarter.

Discovery research activities, LeadDiscovery and LeadQuest® chemical compound production are performed and carried out at Tripos Discovery Research in Bude, Cornwall, England. With respect to discovery research projects, they vary in size, scope and length of time to complete. Discovery research agreements may include technology access fees, full-time equivalent billing rates, and trailing rights in the form of milestone payments or royalties. Certain projects include management of biology screening processes performed by third parties. The unpredictability of chemistry reactions may impact the rate of progress on research contracts and lead to fluctuations in revenue recognition.

We produce our LeadQuest® chemical compounds in the same laboratories as our discovery research activity using the same state-of-the-art equipment and processes. The LeadQuest compounds are created from chemistry templates that do not overlap with customer-specific projects or the LeadDiscovery sets. All of our chemistry research and production activities rely on our proprietary ChemSpace technology to generate "drug-like" ideas from the trillions of potential candidates.

We do not manufacture computer hardware, but simply act as a reseller for one vendor.

We rely upon a combination of patent, copyright, trademark and trade secret laws to protect our intellectual property. License and non-disclosure agreements are used to establish and protect the proprietary rights in our products. We hold four key patents in the area of analysis of the relationship of chemical structure to activity; one issued in the early 1990's on our SYBYL CoMFA product, another issued in 1998 on our Hologram QSAR, and two on our ChemSpace technology issued in 2001. The source code for our products is protected both as trade secrets and as unpublished, copyrighted work. In addition, our core software products are developed and manufactured only at our facilities. We do not disclose the source code for our products to any of our distributors. We supply our source code under special, restrictive license provisions to a very limited number of customers only on special request, none of which has been received in the last five years. Also, upon request, Tripos has placed source code in escrow for the benefit of a minimal number of designated customers for limited support purposes on a contingency basis. All major software products are shipped from our St. Louis facility under a technical license management system that governs access. Despite these precautions, it may be possible for a third party to gain use of our products or technology without prior authorization, or to develop similar technology independently. Effective copyright and trade secret protection may be unavailable or limited in certain foreign countries where we do business. The markets in which we compete are characterized by rapid technological change. While we believe that legal protection of our technology is an important competitive factor, we are aware that such factors as the technological and creative skills of our personnel, new product development, frequent product enhancements, name recognition and reliable product support are important in maintaining a sustained technology leadership position.

We license our workstation software through the execution of license agreements. We license our personal computer software products by use of a "shrinkwrap" license. A "shrinkwrap" license agreement is a printed license agreement included within packaged software that sets forth the terms and conditions under which the purchaser can use the product and is intended to bind the purchaser, by the purchaser's acceptance of the software, to such terms and conditions.

We have a number of contracts with academic institutions and individuals providing us the right to license, market and use technology developed outside the company. These products enhance our ability to offer an enriched product line and represent a material percentage of our annual revenue.

Our general screening and targeted compound libraries, which are manufactured and shipped by Tripos Discovery Research from their Bude, England facilities, and the related synthesis methods and approaches, are protected as trade secrets by non-disclosure agreements and other means. Compound, consulting, discovery research and collaborative agreements we enter require specific documentation regarding defined proprietary rights, responsibilities of the parties, and/or allowed use of any related compounds or libraries of compounds.

We operate in a highly competitive industry characterized by rapidly changing technology, frequent new product introductions and enhancements, and evolving industry standards. We compete with other vendors of software products designed for applications in analytical chemistry, computational chemistry, chemical information management, and combinatorial chemistry; the four principal areas in the chemical and pharmaceutical research market. Our discovery research group competes with other vendors for the sale of contract chemistry research, focused compound libraries and diverse compound screening libraries. The competition in our industry is fragmented and populated with a wide spectrum of organizations ranging from small start-up companies to large multi-national firms along with academic research institutions.

Competition is likely to intensify as current competitors expand their product offerings and as new companies enter the market. The competition we experience in our existing and targeted markets could result in price reductions, reduced margins and loss of market share, all of which could have a material adverse effect on us. A number of our existing competitors have significantly greater financial, technical and marketing resources than we do. We believe that the principal factors affecting competition in our markets are product quality, performance, reliability, scientific and technological innovation, ease of use, technical service, support, and price. We expect that these factors will remain major competitive issues in the future, but additional factors will become increasingly important, including contribution to the overall efficiency of the research effort through enhanced integration, communication and analysis. Although we believe that we currently compete favorably with respect t o these factors, there can be no assurance that we will be able to compete successfully against current and future competitors or that the competitive pressures we face will not have a material effect on our business, operating results or financial condition.

As of December 31, 2004, we had a total of 332 employees, of whom 148 were based in the United States and 184 were based internationally. Of the total, 61 were engaged in marketing, sales and related customer-support services, 76 in software product development and consulting services, 136 in chemistry laboratory activities and 59 in operations, administration, MIS and finance. Our future success is significantly dependent on the continued service of our key technical and senior management personnel and our continuing ability to attract and retain highly qualified technical and managerial personnel. None of our employees are represented by a labor union nor covered by a collective bargaining agreement. We have not experienced any work stoppages and consider our relations with employees to be good.

The Company's annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and all amendments to those reports are available free of charge on the Company's website at www.tripos.com as soon as reasonably practicable after such material is electronically filed with or furnished to the Securities and Exchange Commission. Printed copies of the Company's annual report will be made available, free of charge, upon written request.

Our principal administrative, sales, marketing and software product development facility is located in St. Louis, Missouri. We own this facility, which is financed by a mortgage note. Tripos also owns laboratory facilities (73,000 square feet) in which chemical product development and discovery research service contracts are executed located in Bude, Cornwall, England. Our European subsidiaries lease sales and service offices in the United Kingdom, France and Germany. In addition, on January 5, 2005 we assumed a lease for office space in Austin, Texas for Optive Research, Inc. We believe that our existing facilities are adequate for our current needs and that additional space will be available as needed.

On or about July 24, 2003, the Company and two of its executive officers, Dr. John P. McAlister and Mr. B. James Rubin, were sued in federal district court in St. Louis, Missouri on behalf of purchasers of the Company's common stock during the first half of 2002. The consolidated class action complaint alleged that statements made by the Company in press releases and other public disclosures contained materially false and misleading information in violation of the federal securities laws.

On or about May 5, 2004, plaintiffs filed a second amended complaint on behalf of a purported class of purchasers of the Company's common stock between February 9, 2000 and July 1, 2002 (the "Class Period"). The second amended complaint generally alleges that, during the Class Period, defendants made false or misleading statements of material fact about the Company's prospects and failed to follow generally accepted accounting principles in violation of the federal securities laws. The second amended complaint also names Ernst & Young LLP as a co-defendant. In August 2004, the Company and the individual defendants and Ernst & Young filed motions to dismiss the second amended complaint. The amount of damages being sought is unspecified at this time. Although the Company believes that it has meritorious defenses to the claims alleged against it in this action, it is too early in the litigation to provide an accurate assessment of the likelihood or the extent of any liability arising from this matter.

No matters were submitted to a vote of Tripos' shareholders during the fourth quarter of its fiscal year ended December 31, 2004.

Tripos' common stock trades on The NASDAQ National Market System under the symbol "TRPS". The following table sets forth the range of the high and low sales prices per share of the common stock for the fiscal quarters indicated, as reported by NASDAQ. Quotations represent actual transactions in NASDAQ's quotation system but do not include retail markup, markdown, or commission.

We had approximately 800 shareholders of record and 2,800 beneficial holders as of December 31, 2004. We have not declared or paid any dividends on our common stock. We currently intend to retain earnings for use in our business, therefore, we do not anticipate paying cash dividends to common shareholders in the foreseeable future. In addition, our credit facilities with LaSalle Bank N.A. restrict the payment of dividends to shareholders.

The following discussion should be read in conjunction with the audited consolidated financial statements and notes thereto.

Except for the historical information and statements contained in Management's Discussion and Analysis of Financial Condition and Results of Operations ("MD&A"), the matters and items contained in this document, including MD&A, contain certain forward-looking statements that involve uncertainties and risks, some of which are discussed below, including, under the caption "Cautionary Statements-Additional Important Factors to be Considered." We are under no obligation to update any forward-looking statements in this section. Words such as "expects", "anticipates", "projects", "estimates", "intends", "plans", "believes", variations of such words and similar expressions are intended to identify such forward-looking statements.

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 83% of all new contracts sold during 2004. 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. 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 terms of one to three years. This business is generally predictable, as we have experienced high renewal rates in the past 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 our 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 focused process 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, we have focused on profitability and cashflow. That said, we have not always been profitable, but have achieved profitability in certain years. Major investments, such as the recent expansion of our chemistry research laboratories in England, have been funded by successful investments (e.g. Arena Pharmaceuticals), cash from operations, temporary use of debt capacity, and grant funding from the British government.

We generate revenues from a diversified offering of products and services. We derived 38% of our 2004 and 44% of our 2003 revenues from discovery informatics products and support, 6% of 2004 and 6% of 2003 revenues from discovery informatics services, and 56% of 2004 and 48% of 2003 revenues from discovery research products and services. The remainder is from hardware sales.

We license our discovery informatics 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 discovery informatics services (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, ChemCoreRIO 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 informatics 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 only order hardware products on an "as needed" basis, and thus do not maintain any inventory. 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. This is due to sales compensation, bonuses, 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. From 2002 to 2004, 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, as well as 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, our partners and that of 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 Consoli dated Financial 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.

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

The following information should be read in conjunction with the information contained in the Consolidated Financial Statements and Notes thereto appearing elsewhere in this Annual Report on Form 10-K.

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

Net Sales. Total net sales increased 20% to $64.8 million in 2004 from $54.1 million in 2003, which was up 10% over the $49.1 million recorded in 2002. These increases were the result of higher revenues in discovery software products and support (4% in 2004 and 7% in 2003) along with the continued growth in discovery research (37% in 2004 and 46% in 2003) principally due to the four-year contract with Pfizer, Inc. to design and synthesize chemical compounds. Under the Pfizer compound design and synthesis contract (file enrichment), we have the potential to realize up to $90 million of revenue over the planned four-year period. In the first three years of the contract to-date, we have recognized $68 million. Therefore, we have the potential to recognize up to $22 million in 2005. Our discovery informatics service revenues grew in 2004 by 24% after declining 59% in 2003. The rebound in discovery informatics service revenues is primarily due to the successful delivery of milestones on exi sting contracts, including our contract with Schering AG. Discovery informatics service is discussed in more detail below. We generate a substantial portion of our revenues from the pharmaceutical industry. New sales to this industry accounted for approximately 83%, 76% and 67%, of total new sales in 2004, 2003, and 2002, respectively.

Net sales from our activities outside of North America represented approximately 80%, 74% and 64% of total net sales in 2004, 2003 and 2002, respectively, with Europe accounting for 75%, 67% and 57%, and the respective balances coming from customers in the Pacific Rim. We believe that revenues from foreign activities will continue to account for a significant percentage of our total net sales. Software license sales in Japan for 2004 were adversely impacted by an injunction issued by a Japanese court that prevents Tripos' local distributor from selling a certain third-party software product within a Tripos offering.

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, we expect that price increases for our more established products will remain moderate for the foreseeable future.

Increasing net sales from period to period is dependent, in part, on our ability to introduce new products and services, which are accepted by the market, and on our ability to penetrate new and existing markets. Sales to existing customers have represented over 90% of total contracts sold during each of the last three years.

Total discovery informatics product and support sales increased 4% to $24.6 million from $23.7 million in 2003 which was up 7% from 2002's $22.2 million. 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 sold in 2004, 2003 and 2002 was over $11million, $12 million and $11 million, respectively. 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 2005-2008 is projected to be over $24 million. The table presented in "Note 13. Time-based Software License Arrangements" presents the total amounts of deferred revenues from non-cancelable time-based software licens e 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. We noticed that fewer custom informatics projects were being initiated by major pharmaceutical firms. Of late, the industry started to show signs of recovery in its outsource spending activity in terms of new projects being put out for bid, however, the size of projects are reduced in time and scope. Discovery informatics service revenues grew in 2004 by 24% after declining by 59% to $3.2 million in 2003. This turnaround is principally due to progress on our revised contract with Schering AG. At the end of 2003, Tripos and Schering were in talks regarding the specifications and financial arrangements necessary to complete the development and deployment of the production version of the agreed technology scheduled for mid-2004. Changes in the scope and funding required a change to the existing contract. Because these discussion s were not finalized as of December 31, 2003, we made an adjustment of $802,000 to reduce the revenue recognized up to that point from our contract with Schering. In calculating the amount of the adjustment to be recorded in 2003, Tripos assumed that the project would not continue past delivery and rollout of the 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 that mid-2004 delivery date. Tripos was required to make this adjustment to revenues so that its 2003 financial statements fairly reflected the project status and contractual terms as of December 31, 2003. In mid-2004, Tripos and Schering agreed on an amendment to the contract that would provide funding to cover functionality and time that were not anticipated in the original contract for full implementation of this project. During 2004, Tripos achieved the agreed milestones for 2004 and realized the incremental revenues. In addition to the revenue adjustment for the Schering contract, revenues in 2003 declined from 2002 levels due to the lack of new contracts.

We derive discovery research revenues from our compound library product, LeadQuest®, and discovery research activities. Discovery research sales increased 37% to $36.0 million in 2004 from $26.2 million in 2003, which was 46% higher than the $18.0 million recognized in 2002. The primary reason for the increases was growth in production levels on our four-year $90 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 contract total value was amended down to $90 million from $100 million in early 2004 to reflect a reduction in compound collection production that was partially offset by a move into next-stage hit follow-up work between Tripos and Pfizer.

Hardware revenues declined 86% in 2004 to $131,000 from just over $900,000 in 2003 and 2002. The high-end server and workstation equipment that we historically sold to our customers continues to face growing competition from lower cost alternatives. As a result of the shift in demand, we do not aggressively promote hardware due to its low-margin, but merely provide access to hardware products as a convenience to customers.

Cost of Sales. Total cost of sales increased to $32.8 million in 2004, up 25% from 2003's $26.2 million, which in turn was up 27% from $20.6 million in 2002. These costs represent 51%, 48% and 42% of total net sales, respectively.

Costs of discovery informatics products and support represented 21%, 17% and 16% of software license and support sales in 2004, 2003 and 2002, respectively. Costs of software products and support consist of amortization of capitalized software, product 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. Included in the 2004 cost of sales was a write-down in the carrying cost of our ChemCoreRIO software asset of $890,000. We analyzed the net realizable value of the asset based on our assessment of the market for the product and determined that a reduction in the amount capitalized was appropriate. Cost of sales as a percent to software sales has increased over the past few years d ue to a change in the mix of internal versus third-party products sold, thus resulting in higher royalty payments. The effective rate of royalties may continue to fluctuate in future periods.

Costs of discovery research products and services represented 68%, 68% and 53% of discovery research sales in 2004, 2003 and 2002, 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 higher levels of cost of sales of discovery research activities in 2004 and 2003 are attributable to increased production under the Pfizer compound design and synthesis contract. A significant component of cost of sales from 2002 to early 2004 was outsourcing required to successfully deliver against the contract, combined with the financial impact of the decline of the US dollar against the Great B ritain Pound Sterling where the operation is based. See the discussion of discovery research revenues above for additional information on this contract. Although our reliance on outsourcing was essentially eliminated by the end of 2004 thus allowing for better control over costs and efficiency, we continue to experience the effects of the further decline in the value of the US dollar that adversely impacts margins.

Costs of hardware represented 81%, 86%, and 88% of hardware sales in 2004, 2003 and 2002, 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 $32.0 million in 2004, $27.9 million in 2003 and $28.5 million in 2002, which represents gross profits of 49%, 52% and 58%, respectively. The decreases in gross margin are attributable to the increase in the effective rate of royalties on discovery informatics products and the ramp-up on the Pfizer compound file enrichment project. In addition, 2004 gross margin was impacted by the write-down of $890,000 for the ChemCoreRIO capitalized software asset while 2003 reflects the charges taken for the Schering discovery informatics services contract. The rate of decrease in gross profit is expected to slow in future periods but is dependent on the mix of discovery research versus discovery informatics business, the 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.

Sales and Marketing Expenses decreased 5% to $12.6 million in 2004 from $13.2 million in 2003, which was a decrease of 15% from $15.5 million in 2002. Sales and marketing expenses represented 19%, 25% and 31% of 2004, 2003, and 2002 total net sales, respectively. During 2004, we realized expense savings in the Sales and Marketing organization due to open or eliminated positions, estimated at $600,000. In addition, we converted our representation in Australia from direct sales to the use of a distributor generating a savings of $200,000. 2003 sales and marketing costs were less than 2002 due to lower commissions (of approximately $1 million), open Senior Vice President position for the entire year (estimated at $300,000) along with an overall reduction in spending on selling and marketing activities.

Research and Development Expenses decreased 28% in 2004 to $9.3 million from the $12.9 million in 2003, which was up 28% from $10.1 million in 2002. R&D costs represented 14%, 24%, and 21% of net sales in 2004, 2003 and 2002, respectively. The reduced level of R&D expense in 2004 reflects: 1) more scientific costs charged to cost of sales for the Pfizer and other discovery research contracts; 2) redeployment of our discovery informatics personnel to work on software product development resulting in the capitalization of software development costs ($630,000) for our new "benchware" discovery informatics products; 3) inventoried costs of our new Lead Discovery chemistry packages ($1.2 million); and 4) reduced headcount in our discovery informatics group. The Benchware and LeadDiscovery products are expected to be released to the market in 2005. The increased spending for R&D in 2003 reflects additional chemistry research staff at Tripos Receptor Research and software devel opment work that was not directly related to customer contracts or was for product development that had not yet qualified for capitalization under FAS 86.

Research and development expenses, including the amount of capitalized costs were $11.2 million in 2004, $14.2 million in 2003, and $13.8 million in 2002. 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® and LeadDiscovery libraries. Costs associated with investigating 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 7% to $7.8 million in 2004 over the $7.2 million in 2003 which was up 5% from the $6.9 million in 2002. G&A expenses represented 12%, 13% and 14% of net sales for 2004, 2003 and 2002, respectively. Increased G&A expenses for 2004 are primarily the result of legal fees to defend against the class action lawsuit ($300,000) and costs to document and test internal controls for compliance with the Sarbanes-Oxley Act of 2002 ($237,000). The increase in 2003 was attributable to legal fees for the class action lawsuit ($97,000) and higher corporate insurance premiums ($137,000). We expect general and administrative expenses to remain relatively stable, but will fluctuate as a percentage of sales.

Interest Income was $127,000 in 2004, $208,000 in 2003 and $216,000 in 2002 reflecting a decreasing average amount of cash on hand due to the reduction of outstanding debt in 2004 and investment in the UK laboratory expansion in the prior years.

Interest Expense of $1.1 million in 2004, $516,000 in 2003 and $376,000 in 2002 was from interest due on the long-term note payable for the corporate building, interest due on our line-of-credit, and interest costs associated with our capital leases. Interest expense has varied commensurate with the change in average outstanding debt balances to finance the expansion of the UK chemistry lab. The Company's mortgage loan had a fixed interest rate in 2002 of 7.4%. The floating rate incurred by the Company averaged 4.3% in 2003 and 3.8% in 2004. The interest rate incurred on our line of credit was below 4.3% in 2003 and 2004. Interest rates on our capital leases range from 3% to 8%.

Other Income was $829,000 in 2004, $9.4 million in 2003 and $3.6 million in 2002. Early in 2004 we sold the last of our holdings of Arena Pharmaceuticals, Inc. common stock and realized a gain of $144,000. The remainder of the 2004 income was from foreign currency gains realized by our European subsidiaries. 2003 other income included a $6.7 million pre-tax gain on the sale of just under 1.3 million shares of Arena. In addition, the Company benefited from a $900,000 gain on the mark-to-market of a series of foreign exchange hedges that fixed the rate of U.S. dollars to British pounds. Also, due to the weakness of the U.S. dollar, our European subsidiaries recorded currency exchange gains of approximately $2.0 million. In 2002, other income included $3.6 million from the sale of 619,000 shares of Arena common stock.

Income Tax Expense (Benefit). Our tax expense (benefit) was $2.0 million in 2004, $1.6 million in 2003 and $(0.6) million in 2002. The effective tax rates were 89.6%, 42.8% and 105.8% for 2004, 2003 and 2002, respectively. The effective tax rates for 2004, 2003 and 2002 reflect management's current estimate of the distribution of earnings among the statutory jurisdictions in which we operate and the valuation of certain tax credits and net operating losses in the U.S. and U.K. for those tax years (each ending December 31). The high tax rate in 2004 results from taxes accrued in certain jurisdictions that are not mitigated by the benefit of losses in other jurisdictions. This is due to a valuation allowance being established against the deferred tax assets created by cumulative net operating losses incurred in the U.S. The establishment of the valuation allowance for the deferred tax assets does not impair our ability to use the deferred tax assets upon achieving profitability in the re lated jurisdictions. Upon the recognition of income in future periods in the jurisdictions where the deferred tax assets were created, release of the corresponding valuation allowances may result in a lower effective tax rate.

Operating Activities. Net cash provided from 2004 operating activities was $13.2 million. Cash was generated by net income of $0.2 million, net collections of accounts receivable of $2.1 million, reductions of inventory of $1.8 million, reductions of prepaid expenses and changes in deferred taxes of $0.5 million each, increases in deferred revenues of $3.1 million, delivery on currency hedges outstanding at the end of the prior year in the amount of $0.9 million plus the add-back of non-cash depreciation and amortization expenses of a combined $4.6 million. Inventory was reduced in 2004 due to sale of more quantities of chemical products and reduced production time on the Pfizer contract. 2004's lower level of accounts receivable reflects a change in the invoice timing of a significant informatics contract compared to 2003. Depreciation commenced early in 2004 upon the completion and fit-out of our U.K. laboratory leading to the higher levels compared to prior years. Amortizatio n for 2004 included $0.9 million for the write-down of the carrying value of our ChemCoreRIO software asset to its expected net realizable value. Operating funds in 2004 were used to reduce accounts payable and accrued expenses by $0.5 million.

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 excluded 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 Tripos Discovery Research laboratories. Inventory levels pe aked in 2003 related to 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 excluded from the net loss to show the effect of operations on our cash position. The growth in deferred revenue is principally attributable to the prepayments received in our Discovery Research contrac ts.

Investing Activities. During 2004 we invested $0.5 million in the completion of our U.K. chemistry facility along with computer equipment for our discovery informatics area. Also in 2004 we invested an additional $0.2 million in the A.M. Pappas Life Science II fund plus $0.6 million in new informatics product development. We realized proceeds of $0.4 million from the sales of marketable securities and equipment.

Investing activities in 2003 consumed a net of $2.0 million. We spent $5.3 million on our U.K. laboratory facility building and equipment along with $1.3 million for the development of our ChemCoreRIO software technology. 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 had 31,000 shares (market value of $192,000) 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 16 and 17 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. During 2004 we obtained access to cash by drawing a total of $8.4 million from our line of credit and by issuing shares from our stock plans for $0.9 million. We made payments totaling $18.9 million on debt and capital leases resulting in a net cash used from financing activities of $9.6 million for 2004.

Financing activities yielded a net $4.2 million of cash in 2003. Our outstanding borrowings on bank lines of credit increased by a 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.

We financed equipment and fixtures acquisitions at our chemistry laboratory through capital leases of $3.7 million and $5.4 million in 2004 and 2003, respectively.

In 2004, we completed construction on our laboratory expansion project at our U.K. research facility. We estimate that we will expend approximately $2.2 million for the balance of payments on the building and equipment in 2005. Additionally, over the next 12 to 18 months, we will fund the remainder of our investment commitment ($0.8 million) to the A.M. Pappas Life Science II Fund.

We expect to fund prospective operating needs and capital expenditures through cash from operations. 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 (assuming comparable renewal of credit facilities), 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 11 of the Notes to Consolidated Financial Statements for a discussion of the credit facilities available to us.

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.

In November 2004, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards ("SFAS") No. 151 "Inventory Costs-an amendment of ARB No. 43, Chapter 4" ("FAS 151"). FAS 151 clarifies the accounting for abnormal amounts of idle facility expense, freight, handling costs, and wasted material (spoilage) to require that these items be included as current-period charges and not included in overhead. In addition, FAS 151 requires that allocation of fixed production overheads to the costs of conversion be based on the normal capacity of the production facilities. The provisions in FAS 151 are effective for inventory costs incurred during fiscal years beginning after June 15, 2005. We are in the process of evaluating the requirements of FAS 151 but do not expect the adoption of FAS 151 to have a significant effect on our financial statements.

In December 2004, the FASB issued SFAS No. 123 (revised 2004), "Share--Based Payment" ("FAS 123R"), which revises and replaces SFAS No. 123, "Accounting for Stock-Based Payment" and supercedes APB Opinion No. 25, "Accounting for Stock Issued to Employees." FAS 123R requires the measurement of all share-based payments to employees, including grants of employee stock options, using a fair-value based method and the recording of such expense in our consolidated statements of operations. The pro-forma disclosures previously permitted under SFAS No. 123 will no longer be an alternative to financial statement recognition. The provisions of FAS 123R are effective for reporting periods beginning after June 15, 2005. We are currently evaluating the requirements of FAS 123R, but because we are accounting for employee stock option grants in a footnote disclosure as permitted by SFAS No. 123, the adoption of FAS 123R will have an impact on our results of operations. See Note 1, Stock-Based Compensatio n for an illustration of the historical effects of expensing stock options.

In December 2004, the FASB issued Staff Position no. FAS 109-2, "Accounting and Disclosure Guidance for the Foreign Earnings Repatriation Provision within the American Jobs Creation Act of 2004" ("FAS 109-2"). The American Jobs Creation Act of 2004 allows for a special one-time dividends received deduction on the repatriation of certain foreign earnings to a U.S. taxpayer if certain criteria are met. The provisions of FAS 109-2 were effective immediately upon issuance. We do not expect that the adoption of FAS 109-2 will have a significant impact on our consolidated financial statements.

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, positive or negative. For example, under the terms of our contract with Pfizer to perform discovery research services, part of our payments are received in US Dollars while related costs are in Great Britain Pounds Sterling. This negatively impacted our gross margins from this business in 2003 and 2004. 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 continues to review the steps that need to be taken to assure compliance with the Act and remain current with related requirements of the SEC and NASDAQ.

Section 401 of the Act requires companies to disclose all material off-balance sheet transactions, arrangements, obligations and other relationships. For the periods ending December 31, 2004 and 2003, Tripos had no off-balance

sheet transactions or arrangements other than ordinary operating leases that are further discussed in Note 7 of Tripos' consolidated financial statements contained in this Form 10-K

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 $600,000 of the revolving credit facility is outstanding throughout 2005 and that would generate an interest payable of $32,000 at a constant rate of 5.25%. For the mortgage loan we have assumed an interest rate of 4.8% 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. Tripos was unable to collect on a loan made to a former senior executive that existed prior to the effective date of Section 402 and took a charge of $137,000 in the first quarter of 2003 to write off the remaining amount.

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 or market 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.

Our current and potential customers consist primarily of pharmaceutical and biotechnology companies, which face risks that could affect our ability to sell our products. We have benefited to date from the increasing trend among pharmaceutical and biotechnology companies to outsource chemical research and development projects. However, a reversal or slowing of this trend or a general economic downturn in these industries, such as experienced in 2002, could have a material adverse effect on our business, financial condition and results of operations. Thus, our ability to generate revenue is subject to risks and uncertainties that could cause reductions and delays in research and development expenditures within our industry. These risks and uncertainties are not within our control. In addition, further consolidation in the pharmaceutical and biotechnology industries will reduce the number of our potential customers, and may adversely affect our futu re revenues. If one of the parties to a consolidation uses the products or services of one of our competitors, we may lose existing customers as a result of such consolidation.

We derive a significant portion of our revenues from a limited number of large customers. We seek to enter into large, multi-year contracts with large pharmaceutical companies and biotechnology companies. It is difficult for us to predict when contracts of this nature will be awarded or the terms of these contracts. In addition, the terms of these contracts may permit the customer to terminate the contracts or reduce their requirements. We may not always be in a position to adjust utilization of our resources to the needs of one or more of these large-contract customers.

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, because 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 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 overall 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 informatics 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 affected 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 and 2004, 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 for much of the work. 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 and 2004, 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 $15.5 million and $17.7 million at December 31, 2004 and 2003, respectively. The potential reduction in fair value resulting from a hypothetical 10% adverse change in foreign currency exchange rates would be approximately $1.6 million and $1.8 million at December 31, 2004 and 2003, 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. We monitor our exposure to floating interest rate risk on line-of-credit borrowings along with the outstanding balance on the mortgage loan and endeavor to mitigate this risk through the use of appropriate hedging instruments.

Basis of Consolidation. The accompanying consolidated financial statements include the accounts of Tripos and its wholly owned subsidiaries. All significant intercompany accounts and transactions are eliminated in consolidation. Investments in affiliates, owned more than 20%, but not in excess of 50%, are recorded on the equity method. Investments in unconsolidated affiliates less than 20% owned are accounted for under the cost method, except for those investments classified as marketable securities.

Cash and Cash Equivalents are highly liquid investments with maturities of three months or less from the date purchased.

Marketable Securities consist of investments in equity securities of unconsolidated affiliates that are held as available-for-sale and foreign currency exchange contracts that do not qualify for hedge accounting. We account for securities that can be sold within the next 12 months as marketable securities. Amounts presented are the fair values of the investments on the balance sheet date determined using then current market quotes. Unrealized gains and losses are recorded as increases or decreases in the assets' value (pre-tax basis) with corresponding entries reflected in Other Comprehensive Income and Deferred Taxes until the assets are sold. See Note 18 "Financial Instruments" for a further discussion of foreign currency exchange instruments. Marketable Securities at December 31, 2004 consisted of 33 shares of NuVasive, Inc. which had a market value of $341. At December 31, 2003, Marketable Securities on the Balance Sheet was comprised of 31 shares of Arena Pharmaceuticals, Inc. which had a market value of $192. Other Comprehensive Income at December 31, 2004 and 2003 included an accumulated unrealized after-tax gain of $96 and $83, respectively, as calculated on an average cost per share basis.

Investments Recorded at Cost consist of investments in common stock and limited partnerships that are accounted for under the cost method as permitted under Accounting Principles Board Opinion No. 18.

Accounts Receivable includes current outstanding invoices billed to customers. Invoices are typically issued with Net 30-day terms upon shipment of product or upon achievement of billable events for service-based contracts. Our bad debt experience from uncollectible accounts has been historically immaterial. As a result, we provide a reserve for bad debts on a specific account basis if and when customer payment problems arise.

Capitalization and Valuation of Chemical Compound Costs. Initial costs to develop our LeadQuest compounds (chemical compounds for sale for use in drug discovery) are categorized as research and development expense until such time as it is probable that a salable library can be successfully produced. Therefore, costs for design, research, and analytical procedures for every library of compounds are expensed as incurred. Our research chemists review the results of analytical procedures to determine if the chemical reactions completed are as expected and the product purity and product yields are within acceptable tolerances. This "validation" process determines whether the chemistry is successful and if a saleable product will result. We capitalize costs to inventory once the validation process is completed and successful production is reasonably assured. If the core reaction is unsuccessful, the library template is abandoned and no further development takes place.

Similarly, we capitalize the costs of LeadDiscovery packages once we are reasonably assured of the success of the underlying chemistry. After this point we capture the costs of labor, chemicals and screening activity into work in process inventory. Should a LeadDiscovery library not reach its full potential as a standalone offering, we can utilize the products within discovery research contracts for customers or in our LeadQuest compound library.

Inventory amounts shown in the Consolidated Balance Sheet are net of an obsolescence reserve. In calculating the reserve for inventory held for sale, 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. A portion of the LeadQuest inventory is used in discovery research projects. This portion of the inventory asset is depreciated over its 10-year expected useful life.

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 term 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.

Capitalized interest. The interest cost associated with major development and construction projects is capitalized and included in the cost of the project or asset. Capitalization of interest ceases when the project is substantially complete. Capitalized interest for 2004, 2003 and 2002 was $39, $257 and $30, respectively.

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 2004, 2003 and 2002 capitalized costs were $639, $1,272 and $1,416, respectively related to development work on a laboratory research and inventory support system along with other desktop technologies 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 capi talized software development costs by comparing the remaining unamortized balance to the net realizable value of the related product. Any excess is written off. During the fourth quarter of 2004 we wrote down one of our capitalized products, ChemCoreRIO, by $890 to properly reflect the current net realizable value of the product based upon the change in target market customer base. For 2004, 2003 and 2002, amortization of software developed for sale was $6, $258 and $309, respectively. At times, we capitalize development costs attributable to internal use software in accordance with AICPA Statement Of Position 98-1 "Accounting for the Costs of Computer Software Developed or Obtained for Internal Use". Amortization of internal use software is over the estimated useful life or three years, which ever is less. During 2004 we wrote off the cost and accumulated amortization for fully amortized capitalized software assets for internal use in the amount of $544.

Goodwill represents the excess of the cost of the net assets acquired of Tripos Discovery Research Ltd. over its fair value. The recorded goodwill is a component of our Discovery Research segment, which is geographically part of our European region. There were no additions or write-offs of goodwill during the periods presented. 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 annual evaluations of impairment by comparing the fair value of the business to which the goodwill relates to its carrying value. If it is determined that the carrying value exceeds the fair value, we would be required to recognize an impairment loss in earnings at that time. Prior to January 1, 2002, goodwill was amortized on a straight-line basis over 15 years. We performed formal impairment tests of goodwill in 2004, 2003 and 2002 by using a disco unted cash flow approach to estimate fair value. Based on our evaluations, we determined there was no impairment of the remaining goodwill. We 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 Discovery Research Ltd. below its carrying value.

Other Intangible Assets. The Company from time to time will apply for and obtain a patent to protect the interests in our proprietary software and chemistry research properties. As of December 31, 2004 and 2003, $183 and $185, respectively was recorded in Other Assets related to patents. Patent costs are amortized over a 20-year period. Accumulated amortization related to patents was $93 and $82 as December 31, 2004 and 2003, respectively. For the year-ended December 31, 2004, the aggregate amortization expense recorded was $11. The estimated amortization expense for each of the five succeeding years is $11 in 2005, 2006, and 2007, $9 in 2008 and $8 in 2009.

Long-Lived Assets. In accordance with Statement of Financial Accounting Standards No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets", the Company reviews identified intangible and other long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying value of the asset may not be recoverable. If such events or changes in circumstances are present, an impairment loss would be recognized if the sum of the expected future net cash flows was less than the carrying amount of the asset.

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 significant during 2004 and 2003 due to fluctuations in the exchange rate for the U.S. dollar and Great Britain pound. We hedged a portion of our exposure and recorded the gains and losses from this activity in other income (expense). Net gains and losses from foreign currency transactions were not significant in the other years presented.

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 We account for income taxes in accordance with Statement of Financial Accounting Standards No. 109 ("FAS109"),Accounting for Income Taxes, which prescribes the use of the asset and liability method whereby deferred tax assets or liabilities are calculated at the balance sheet date using current tax laws and rates in effect. Valuation allowances are established when necessary to reduce deferred tax assets when it is more likely than not that a portion or all of the deferred tax assets will not be realized. In accordance with FAS No. 109, income tax expense includes 1) deferred tax expense, which generally represents the net change in the deferred tax asset or liability balance during the year plus any change in valuation allowances, and 2) current tax expense, which represents the amount of tax currently payable to or receivable from a taxing authority. The primary difference between financial statement income and taxable income results from the use of diff erent methods of computing depreciation, capitalized development costs, certain revenue recognition activities, other timing differences and the valuation of net operating loss carryforwards. Deferred taxes do not reflect temporary differences relating to our investment in foreign subsidiaries as these amounts have been deemed to be permanently invested. Estimating the deferred tax position on these amounts is not practical.

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.

The Company allocates revenues on perpetual software arrangements involving multiple elements to each element based on the relative fair values of each element. The Company's determination of fair value of each element in multiple element arrangements is based on vendor-specific objective evidence (VSOE). The Company limits its assessment of VSOE for each element to the price charged when the same element is sold separately by the Company. The Company has analyzed all of the elements included in its multiple-element arrangements and determined that it has sufficient VSOE to allocate revenues to maintenance and support services, and training. The Company sells training

separately and has established VSOE on this basis. VSOE for maintenance and support is determined based upon the renewal rates in contracts, which is based on a fixed percentage of license revenue. Accordingly, assuming all other revenue recognition criteria are met, revenues from perpetual licenses are recognized upon delivery of the software using the residual method in accordance with SOP 98-9, "Modification of SOP 97-2, Software Revenue Recognition, with Respect to Certain Transactions."

Software maintenance agreements provide technical support and the right to unspecified enhancements and upgrades on a "when-and-if-available" basis. Post-contract customer support revenues on perpetual agreements are recognized ratably over the term of the support period (generally one year), and training and other service revenues are recognized as the related services are provided. Any unrecognized portion of amounts paid in advance for licenses and services is recorded as deferred revenue.

Term licenses represent time-based license arrangements for one or multiple software products that are sold with maintenance and support for the term of the license arrangement. The Company does not have VSOE to determine fair value of the maintenance and support in term arrangements. The Company recognizes revenues from these bundled term licenses ratably over the license term, which is typically 1 to 3 years.

Included in discovery informatics services are contracts for software consulting as well as software development.

Discovery Informatics Services (DIS) represent contracts for the development and delivery of enterprise-wide customized software (such as laboratory information systems or database integration projects). Technological feasibility exists on these software arrangements and they typically include installation at the customer's site. We account for these arrangements in accordance with SOP 81-1, as required by SOP 97-2 since the contract to deliver software and installation requires significant production, modification or customization of software.

In applying the provisions of SOP 81-1 the percentage of completion is utilized. For contracts where customer approval of contractually required tasks must occur at each distinct milestone, and where amounts billable are indicative of progress-to-completion, we record revenues when a milestone has been met and accepted by the customer. For contracts without distinct milestones, we measure progress using the cost-to-cost method, which approximates progress towards completion.

Software Development ("SD") projects are contractual arrangements with customers for use of Tripos software developers in an effort to develop a scientific software tool for use in drug discovery. The contractual arrangements are on a "best efforts" basis, and the customer is subject to billings on a time and materials basis. Accordingly, we record the related revenue when the time and costs are incurred at the stated contractual rates.

Discovery research sales include sales of chemical compounds from (1) inventory, (2) long-term contracts to design and produce chemical compounds to customer specifications, or (3) contracts to perform discovery research activities.

Sales of chemical compounds from inventory are recorded upon delivery.

In accordance with SOP 81-1, sales derived from long-term contracts to design and produce chemical compounds to customer specifications are recorded using the percentage of completion method as the compounds are delivered (under the units of delivery method). The contract costs related to delivered compounds are recorded to cost of sales as the compounds are delivered and revenue is recognized.

Discovery research activities involve lead compound optimization projects, custom synthesis, and compound design. These contracts are generally on a "best efforts" basis and call for non-refundable contractual fees tied to time and materials. Accordingly, revenues under contracts of this type are recorded on a time and material basis. When contracts to perform discovery research activities require a specific deliverable, the direct and incremental contract costs are deferred. Revenue and the contract costs are then recorded upon delivery and acceptance.

Comprehensive Income. Financial Accounting Standards Board SFAS No. 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 No. 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.

The components of accumulated other comprehensive income, net of related tax, at December 31, 2004 and December 31, 2003 are as follows:

Stock-Based Compensation. At December 31, 2004, Tripos had the stock-based employee compensation plans described in Note 21. 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.

The following table illustrates the effect on net income and earnings per share if the Company had applied the fair value recognition provisions of SFAS No. 123, "Accounting for Stock-Based Compensation", to stock-based employee compensation. Our stock option plans have fixed stock option awards (grants) that vest over a period of four years (pro-rata). The impact shown below reflects the accelerated expense method of applying SFAS No. 123.

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 14 for additional information regarding earnings per share.

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

New Accounting Pronouncements. In November 2004, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards ("SFAS") No. 151 "Inventory Costs-an amendment of ARB No. 43, Chapter 4" ("FAS 151"). FAS 151 clarifies the accounting for abnormal amounts of idle facility expense, freight, handling costs, and wasted material (spoilage) to require that these items be included as current-period charges and not included in overhead. In addition, FAS 151 requires that allocation of fixed production overheads to the costs of conversion be based on the normal capacity of the production facilities. The provisions in FAS 151 are effective for inventory costs incurred during fiscal years beginning after June 15, 2005. We are in the process of evaluating the requirements of FAS 151 but do not expect the adoption of FAS 151 to have a significant effect on our financial statements.

In December 2004, the FASB issued SFAS No. 123 (revised 2004), "Share--Based Payment" ("FAS 123R"), which revises and replaces SFAS No. 123, "Accounting for Stock-Based Payment" and supercedes APB Opinion No. 25, "Accounting for Stock Issued to Employees." FAS 123R requires the measurement of all share-based payments to employees, including grants of employee stock options, using a fair-value based method and the recording of such expense in our consolidated statements of operations. The pro-forma disclosures previously permitted under SFAS No. 123 will no longer be an alternative to financial statement recognition. The provisions of FAS 123R are effective for reporting periods beginning after June 15, 2005. We are currently evaluating the requirements of FAS 123R, but because we are accounting for employee stock option grants in a footnote disclosure as permitted by SFAS No. 123, the adoption of FAS 123R will have an impact on our results of operations. See Note 1 Stock-Based Compensation for an illustration of the historical effects of expensing stock options.

In December 2004, the FASB issued Staff Position FAS No. 109-2, "Accounting and Disclosure Guidance for the Foreign Earnings Repatriation Provision within the American Jobs Creation Act of 2004" ("FAS 109-2"). The American Jobs Creation Act of 2004 allows for a special one-time dividends received deduction on the repatriation of certain foreign earnings to a U.S. taxpayer if certain criteria are met. The provisions of FAS 109-2 were effective immediately upon issuance. We do not expect that the adoption of FAS 109-2 will have a significant impact on our consolidated financial statements.

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In 1994, we established a defined contribution 401(k) Plan covering all U.S. employees who are at least 21 years of age. Employees may contribute to the plan up to 50% of their compensation, which is further limited by law. We match employee contributions for an amount up to 50% of the employee's deferral limited to the first 6% of each employee's compensation. Contributions made by the Company were $351 in 2004, $378 in 2003, and $409 in 2002.

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Accrued expenses consist of the following at the end of each year:

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6. Property and Equipment

Property and equipment at the end of each year are summarized below: