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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

(MARK ONE)

FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2003

FOR THE TRANSITION PERIOD FROM ____________ TO ____________ .

COMMISSION FILE NUMBER: 000-30369

VIROLOGIC, INC.

345 OYSTER POINT BLVD
SOUTH SAN FRANCISCO, CA 94080
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES)

TELEPHONE NUMBER (650) 635-1100
(REGISTRANT’S TELEPHONE NUMBER, INCLUDING AREA CODE)

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

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

     As of November 10, 2003 there were 44,364,172 shares of the registrant’s common stock outstanding.

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VIROLOGIC, INC.

INDEX

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VIROLOGIC, INC.
CONDENSED BALANCE SHEETS
(In thousands)

See accompanying notes to Condensed Financial Statements.

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VIROLOGIC, INC.
CONDENSED STATEMENTS OF OPERATIONS
(In thousands, except per share amounts)
(Unaudited)

See accompanying notes to Condensed Financial Statements.

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VIROLOGIC, INC.
CONDENSED STATEMENTS OF CASH FLOWS
(In thousands)
(Unaudited)

See accompanying notes to Condensed Financial Statements.

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VIROLOGIC, INC.
NOTES TO CONDENSED FINANCIAL STATEMENTS
September 30, 2003
(Unaudited)

1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

     The accompanying unaudited condensed financial statements have been prepared in accordance with accounting principles generally accepted in the United States for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States for complete financial statements. In the opinion of management, all adjustments (consisting of adjustments of a normal recurring nature) considered necessary for a fair presentation have been included. Operating results for the nine-month period ended September 30, 2003 are not necessarily indicative of the results that may be expected for the year ending December 31, 2003 or any other future periods. The condensed balance sheet as of December 31, 2002 has been derived from the audited financial statements as of that date but does not include all of the information and footnotes required by accounting principles generally accepted in the United States for complete financial statements. For further information, refer to the audited financial statements and notes thereto included in our Annual Report to Stockholders on Form 10-K for the year ended December 31, 2002.

Use of Estimates

     The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates.

Revenue Recognition

     Product revenue is recognized upon completion of tests made on samples provided by customers and the shipment of test results to those customers. Services are provided to certain patients covered by various third-party payor programs, including Medicare. Billings for services under third-party payor programs are included in revenues net of an allowance for contractual discounts and an allowance for differences between the amounts billed and estimated payment amounts. The Company estimates these allowances based on historical payment information and current sales data. If the government and other third-party payors significantly change their reimbursement policies or the relative mix of third-party payors changes, an adjustment to the allowance may be necessary. Revenue generated from the Company’s database of resistance test results is recognized when earned under the terms of the related agreements, generally at the shipment of the requested reports. Contract revenue consists of revenue generated from National Institutes of Health (“NIH”) grants and commercial assay development, and other non-product revenue. NIH grant revenue is recorded on a reimbursement basis as grant costs are incurred. The costs associated with contract revenue are included in research and development expenses. Deferred revenue relates to cash received in advance of meeting the revenue recognition criteria described above.

Inventory

     Inventory is stated at the lower of standard cost, which approximates actual cost, or market. Inventory consists of the following (in thousands):

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Stock-Based Compensation

     The Company has elected to continue to follow Accounting Principles Board Opinion No. 25 “Accounting for Stock-Based Compensation” (“APB 25”) to account for employee stock options. Under APB 25, no compensation expense is recognized when the exercise price of the Company’s employee stock options equals the market price of the underlying stock on the date of grant. Deferred compensation, if recorded, is amortized using the graded vesting method. Statement of Financial Accounting Standards Board Statement No. 123, “Accounting for Stock-Based Compensation” (“SFAS 123”) as amended by Statement of Financial Accounting Standards Board Statement No. 148, “Accounting for Stock-Based Compensation — Transition and Disclosure — an amendment of FASB Statement No. 123” (“SFAS 148”) requires the disclosure of pro forma information regarding net loss and net loss per share as if the Company had accounted for its stock options under the fair value method.

     The information regarding net loss applicable to common stockholders and net loss per share prepared in accordance with SFAS 123 has been determined as if the Company had accounted for its employee stock option and employee stock purchase plans using the fair value method prescribed by SFAS 123. The resulting effect on net loss applicable to common stockholders and net loss per share pursuant to SFAS 123 as amended by SFAS 148 is not likely to be representative of the effects in future years, due to subsequent years including additional grants and years of vesting.

     The Company has two stock-based employee compensation plans: the 2000 Equity Incentive Plan and the 2000 Employee Stock Purchase Plan. The Company estimates the fair value of these stock options and stock purchase rights at the date of grant using the Black-Scholes option valuation model with the following weighted-average assumptions for the three and nine months ended September 30, 2003 and 2002: risk-free interest rate of 2.9%; a weighted-average expected life of stock options from grant date of four years; a weighted-average expected stock purchase right of six months; volatility factor of the expected market price of the Company’s common stock of 100%; and a dividend yield of zero.

     For purposes of disclosures pursuant to SFAS 123 as amended by SFAS 148, the estimated fair value of the stock options and stock purchase rights are amortized to expense over the vesting period. The Company’s pro forma information is as follows:

     The Company accounts for stock option grants to non-employees in accordance with the Emerging Issues Task Force Consensus No. 96-18, “Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services,” which requires the options subject to vesting to be periodically re-valued and expensed over their vesting periods, which approximates the period over which services are rendered or goods are received.

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Reclassification

     Reclassifications have been made to certain 2002 amounts to conform to the 2003 presentation.

Recent Accounting Pronouncements

     In May 2003, the FASB issued Statement of Financial Accounting Standards No. 150 “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity” (“SFAS 150”). SFAS 150 established standards for classifying and measuring as liabilities certain financial instruments that embody obligations of the issuer and have characteristics of both liabilities and equity. SFAS 150 must be applied immediately to instruments entered into or modified after May 31, 2003. The adoption of SFAS 150 did not have a material effect on the Company’s results of operations or financial position.

     In April 2003, the FASB issued Statement of Financial Accounting Standards No. 149 “Amendment of Statement 133 on Derivative Instruments and Hedging Activities” (“SFAS 149”). SFAS 149 amends SFAS 133 to provide clarification on the financial accounting and reporting of derivative instruments and hedging activities and requires contracts with similar characteristics to be accounted for on a comparable basis. The provisions of SFAS 149 are effective for contracts entered into or modified after June 30, 2003. The adoption of SFAS 149 did not have a material effect on the Company’s results of operations or financial position.

     In November 2002, the FASB issued Emerging Issues Task Force Issue No. 00-21, “Revenue Arrangements with Multiple Deliverables” (“EITF 00-21”). EITF 00-21 addresses certain aspects of the accounting by a company for arrangements under which it will perform multiple revenue-generating activities. EITF 00-21 addresses when and how an arrangement involving multiple deliverables should be divided into separate units of accounting. EITF 00-21 provides guidance with respect to the effect of certain customer rights due to company nonperformance on the recognition of revenue allocated to delivered units of accounting. EITF 00-21 also addresses the impact on the measurement and/or allocation of arrangement consideration of customer cancellation provisions and consideration that varies as a result of future actions of the customer or the company. Finally, EITF 00-21 provides guidance with respect to the recognition of the cost of certain deliverables that are excluded from the revenue accounting arrangement. The provisions of EITF 00-21 will apply to revenue arrangements entered into in fiscal periods beginning after June 15, 2003. The adoption of EITF 00-21 did not have a material effect on the Company’s results of operations or financial position.

     In November 2002, the FASB issued Interpretation 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others” (“FIN 45”). FIN 45 requires a guarantor to recognize, at the inception of a guarantee, a liability for the fair value of the obligation undertaken in issuing the guarantee. FIN 45 also expands the disclosures required to be made by a guarantor about its obligations under certain guarantees that it has issued. Initial recognition and measurement provisions of FIN 45 are applicable on a prospective basis to guarantees issued or modified. The disclosure requirements are effective immediately. The adoption of the recognition and measurement provisions of FIN 45 did not have a material effect on the Company’s results of operations or financial position.

     In June 2002, the FASB issued Statement of Financial Accounting Standards No. 146 “Accounting for Costs Associated with Exit or Disposal Activities” (“SFAS 146”). SFAS 146 addresses financial accounting and reporting for costs associated with exit or disposal activities and nullifies Emerging Issues Task Force Issue No. 94-3, “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring).” SFAS 146 requires that a liability for a cost associated with an exit or disposal activity be recognized and measured initially at fair value when the liability is incurred, rather than at the date of an entity’s commitment to an exit plan. The provisions of SFAS 146 are effective for exit or disposal activities that are initiated after December 31, 2002. The adoption of SFAS 146 did not have a material effect on the Company’s results of operations or financial position.

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2. COMPREHENSIVE INCOME (LOSS)

     Comprehensive income (loss) is comprised of net loss and other comprehensive income (loss). Other comprehensive income includes certain changes in equity that are excluded from net income (loss). Specifically, unrealized gains and losses on our available-for-sale securities, which are reported separately in stockholders’ equity, are included in accumulated other comprehensive income. Comprehensive income (loss) and its components are as follows (in thousands):

3. NET LOSS PER SHARE

     Basic earnings (loss) per share is calculated based on the weighted-average number of common shares outstanding during the periods presented. Diluted earnings per share would give effect to the dilutive effect of common stock equivalents consisting of convertible preferred stock and stock options and warrants, calculated using the treasury stock method. Potentially dilutive securities have been excluded from the diluted earnings per share computations as they have an anti-dilutive effect due to the Company’s net loss.

4. CONVERTIBLE PROMISSORY NOTES

     On February 4, 2003, the Company’s stockholders approved the conversion of certain convertible secured promissory notes (“Notes”) into an aggregate of 1,204.6 shares of the Company’s Series C Convertible Preferred Stock (“Series C Preferred Stock”). In addition, the Company’s stockholders approved the issuance of warrants to purchase approximately 5.0 million shares of the Company’s common stock at an exercise price of $1.11 per share in exchange for warrants originally issued in connection with the issuance of the Company’s Series B Redeemable Convertible Preferred Stock (“Series B Preferred Stock”). See the “Capital Stock” note below for further details.

5. CAPITAL STOCK

Preferred Stock

Series A Redeemable Convertible Preferred Stock

     During 2001, the Company issued and sold, in a private placement, an aggregate of 1,625 shares of the Company’s Series A Redeemable Convertible Preferred Stock (“Series A Preferred Stock”) and warrants to purchase an aggregate of 3.2 million shares of common stock, for an aggregate purchase price of $16.25 million.

     Of the 1,625 shares issued in the financing, 539 shares remain outstanding as of September 30, 2003, and the remainder were converted into an aggregate of approximately 5.0 million shares of the Company’s common stock. As a result of the Company’s sale of Series C Preferred Stock, which is described below, the conversion price of the Series A Preferred Stock and the exercise price of the warrants issued to the purchasers of the Series A Preferred Stock has each been reduced to $1.11. Accordingly, the 539 shares of Series A Preferred Stock outstanding are convertible into approximately 4.9 million shares of common stock, and the outstanding warrants are exercisable for approximately 6.1 million shares of common stock.

     The Series A Preferred Stock bears dividends payable in common stock semi-annually. The dividends were initially at an annual rate of 6% but increased to an 8% annual rate on the fourth such payment, which was made in 2003, and will increase by 2 percentage points every six months up to a maximum annual rate of 14%. This dividend is paid as a stock dividend semi-annually. Subject to the limitations described below, the holders of Series A

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Preferred Stock may elect to convert their shares into the Company’s common stock at any time, just as they may choose to exercise their warrants at any time. Also subject to the limitations described below, the Company may, at its option, convert the Series A Preferred Stock into common stock at any time after June 21, 2002 for Series A Preferred Stock issued at the first closing and after July 9, 2002 for Series A Preferred Stock issued at the second closing, but only if the Company’s stock price exceeds $5.10 for 20 consecutive trading days. The Company may also, at its option, convert the Series A Preferred Stock into common stock upon a sale of common stock in a firm commitment underwritten offering to the public if the public offering price exceeds $5.10, the aggregate gross proceeds exceed $40 million and the registration statements covering shares underlying the Series A Preferred Stock are effective.

     The holders are not subject to any limitations on the number of conversions of Series A Preferred Stock or subsequent sales of the corresponding common stock, that they can effect, other than a prohibition on any holder acquiring beneficial ownership of more than 4.99% of the outstanding shares of the Company’s common stock. This limitation also applies to the Company’s ability to convert Series A Preferred Stock.

     The holders of Series A Preferred Stock have the right to require the Company to redeem all of the Series A Preferred Stock for cash equal to the greater of (i) 115% of their original purchase price plus 115% of any accrued and unpaid dividend or (ii) the aggregate fair market value of the shares of common stock into which such shares of Series A Preferred Stock are then convertible. Series A Preferred Stock is redeemable by the holders in any of the following situations:

•

If the Company fails to remove a restrictive legend on any certificate representing any common stock that was issued to any holder of such series upon conversion of their preferred stock or exercise of their warrant and that may be sold pursuant to an effective registration statement or an exemption from the registration requirements of the federal securities laws

•

If the Company fails to have sufficient shares of common stock reserved to satisfy conversions of the series

•

If the Company fails to honor requests for conversion, or if the Company notifies any holder of such series of its intention not to honor future requests for conversion

•

If the Company institutes voluntary bankruptcy or similar proceedings

•

If the Company makes an assignment for the benefit of creditors, or applies for or consents to the appointment of a receiver or trustee for the Company or for a substantial part of the Company’s property or business, or such a receiver or trustee shall otherwise be appointed

•

If the Company sells all or substantially all of its assets

•

If the Company merges, consolidates or engages in any other business combination (with some exceptions), provided that such transaction is required to be reported pursuant to Item 1 of Form 8-K

•

If the Company commits a material breach under, or otherwise materially violates the terms of, the transaction documents entered into in connection with the issuance of such series

•

If the registration statements covering shares of common stock underlying the Series A Preferred Stock and related warrants cannot be used by the respective selling security holders for the resale of all the underlying shares of common stock for an aggregate of more than 30 days

•

If the Company’s common stock is not tradable on the NYSE, the AMEX, the Nasdaq National Market or the Nasdaq SmallCap market for an aggregate of twenty trading days in any nine month period. In order for the Company’s common stock to continue to be quoted on the National Market, the Company must continue to satisfy various listing maintenance standards established by Nasdaq, including, among other things, a requirement that the Company has stockholders’ equity of at least $10 million and that the Company’s stock price consistently trades at or above $1.00 per share

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•

If 35% or more of the Company’s voting power is held by any one person, entity or group

•

If the Company fails to pay any indebtedness in excess of $350,000 when due, or if there is any event of default under any agreement that is likely to have a material adverse effect on the Company

•

Upon the institution of involuntary bankruptcy proceedings

     Upon the occurrence of any of the redemption events described above, individual holders of the Series A Preferred Stock would have the option, while such event continues, to require the Company to purchase some or all of the then outstanding shares of Series A Preferred Stock held by such holder. If the Company receives any notice of redemption, the Company is required to immediately (no later than one business day following such receipt) deliver a written notice to all holders of the same series of preferred stock stating the date when the Company received the redemption notice and the amount of preferred stock covered by the notice. If holders of the Series A Preferred Stock were to exercise their rights to redeem a material number of their shares as a result of any of the events described above, such a redemption could have a material adverse effect on the Company.

     The Company may redeem the Series A Preferred Stock at any time after June 29, 2003, for Series A Preferred Stock issued at the first closing and after September 27, 2003 for Series A Preferred Stock issued at the second closing. Due to the nature of the redemption features of the Series A Preferred Stock, such stock has been excluded from permanent equity in the Company’s financial statements.

     The Company initially recorded the Series A Preferred Stock at its fair value on the date of issuance. In accordance with EITF Topic D-98: Classification and Measurement of Redeemable Securities (“EITF Topic D-98”), the Company has elected not to adjust the carrying value of the Series A Preferred Stock to the redemption value of such shares, since it is uncertain whether or when the redemption events described above will occur. Subsequent adjustments to increase the carrying value to the redemption value will be made when it becomes probable that such redemption will occur. As of September 30, 2003, the redemption value of the Series A Preferred Stock was $6.2 million.

Series B Redeemable Convertible Preferred Stock

     During 2002, the Company issued and sold, in a private placement, an aggregate of 1,005 shares of Series B Preferred Stock and warrants to purchase an aggregate of 2.2 million shares of common stock, for an aggregate purchase price of $10.05 million. In connection with this financing, the Company also granted warrants to purchase an aggregate of 637,261 shares of common stock to holders of Series A Preferred Stock, as a payment in order to secure their consent and waiver concerning the financing and the resulting impact on the Series A Preferred Stock.

     The Company recorded a deemed dividend of $2.9 million in the first quarter of 2002 relating to the beneficial conversion feature of the Series B Preferred Stock and the additional warrants issued to the holders of the Series A Preferred Stock in connection with the Series B Preferred Stock financing. The net proceeds of $2.6 million attributable to the fair value of warrants are included in additional paid-in capital.

     In connection with the sale of Series C Preferred Stock, described below, on November 19, 2002, the Company repurchased all of the outstanding Series B Preferred Stock in exchange for Notes. The aggregate principal amount of the Notes was $12.05 million. In addition, the Notes bore an interest rate of 8%, had a maturity date of March 19, 2003 and were secured by substantially all of the Company’s assets. On February 4, 2003, the Company’s stockholders approved the conversion of the Notes into an aggregate of 1,204.6 shares of Series C Preferred Stock. In addition, the Company’s stockholders approved the issuance of warrants to purchase approximately 5.0 million shares of the Company’s common stock at an exercise price of $1.11 per share in exchange for warrants originally issued in connection with Series B Preferred Stock.

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Series C Convertible Preferred Stock

     On November 14, 2002, the Company entered into a securities purchase agreement with several investors to issue and sell, in a private placement, an aggregate of 706 shares of Series C Preferred Stock and warrants to purchase an aggregate of 4.4 million shares of common stock, for an aggregate purchase price of $7.06 million. The transaction closed on November 19, 2002. On February 4, 2003, the Company issued an aggregate of 1,204.6 additional shares of Series C Preferred Stock upon conversion of the Notes. The rights, preferences and privileges of the Series C Preferred Stock are set forth in the Certificate of Designations, Preferences and Rights of Series C Preferred Stock (“Certificate”), as amended on February 4, 2003 to (a) provide that any dividend payments due thereunder may be paid in either cash or shares of common stock at the option of the Company, and (b) include anti-dilution provisions substantially identical to those applicable with respect to Series A Preferred Stock. The warrants are subject to the terms and conditions of the stock purchase warrants issued by the Company and evidencing the warrants.

     The Series C Preferred Stock bears an initial 8% annual dividend rate which increases to a 9% annual dividend rate on June 30, 2004, then increases by 1 percentage point every quarter thereafter up to a maximum annual rate of 14%, subject to an additional increase to an annual rate of 15% under certain circumstances. Subject to the limitations described below, the holders of Series C Preferred Stock may elect to convert their shares into common stock at any time. Upon conversion, each share of Series C Preferred Stock is convertible into approximately 8,264 shares of common stock. Subject to the limitations described below, the Company may, at its option, convert the Series C Preferred Stock into common stock (i) at any time after the first anniversary of the issuance of the Series C Preferred Stock, but only if the Company’s stock price exceeds $2.42 for 20 consecutive trading days or (ii) with the consent of a majority of the holders of the Series C Preferred Stock. The warrants are exercisable beginning May 20, 2003 and expire November 19, 2007. The exercise price of the warrants is $1.11 per share.

     The holders of Series C Preferred Stock are not subject to any limitations on the number of conversions of Series C Preferred Stock or subsequent sales of the corresponding common stock that they can effect, other than a prohibition on any holder acquiring, upon conversion, beneficial ownership of more than 4.99% of the outstanding shares of our common stock, or, in the case of Biotech Target NV and its affiliates, more than 19.99% of the outstanding shares of the Company’s common stock. This limitation also applies to the Company’s ability to convert Series C Preferred Stock to common stock.

     The Company recorded a deemed dividend of $7.7 million in the fourth quarter of 2002 relating to the issuance of the Series C Preferred Stock. The charge includes deemed dividends associated with an automatic adjustment of the conversion price of the Company’s Series A Preferred Stock, which was triggered as a result of the issuance of the Series C Preferred Stock. The charge also includes deemed dividends associated with the exchange of the Series B Preferred Stock for Notes and the sale of the Series C Preferred Stock together with the warrants described above. The Company recorded a deemed dividend of $2.2 million in the first quarter of 2003, relating to the warrant exchange. The deemed dividend increased the loss applicable to common stockholders in the calculation of basic and diluted net loss per common share and is included in stockholders’ equity as offsetting charges and credits to additional paid-in capital.

     The Series C Preferred Stock is non-voting, except with respect to certain extraordinary transactions as set forth in the Certificate. In addition, until November 19, 2004, in the event that the Company proposes to issue any equity securities or debt which is convertible into equity securities, each holder of Series C Preferred Stock will have the right to purchase a certain amount of such securities or debt based upon its holdings of Series C Preferred Stock.

     The investors of Series C Preferred Stock have the right to require the Company to redeem all of the Series C Preferred Stock for cash equal to the greater of (i) 120% of their original purchase price plus 120% of any accrued and unpaid dividend or (ii) the aggregate fair market value of the shares of common stock into which such shares of Series C Preferred Stock are then convertible. The Series C Preferred Stock is redeemable by the holders in any of the following situations:

•

If the Company fails to remove a restrictive legend on any certificate representing any common stock that was issued to any holder of such series upon conversion of their preferred stock or exercise of their warrant

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and that may be sold pursuant to an effective registration statement or an exemption from the registration requirements of the federal securities laws

•

If the Company fails to have sufficient shares of common stock reserved to satisfy conversions of the series

•

If the Company fails to honor requests for conversion, or if the Company notifies any holder of such series of its intention not to honor future requests for conversion

•

If the Company institutes voluntary bankruptcy or similar proceedings

•

If the Company makes an assignment for the benefit of creditors, or apply for or consent to the appointment of a receiver or trustee for the Company or for a substantial part of the Company’s property or business, or such a receiver or trustee shall otherwise be appointed

•

If the Company sells all or substantially all of its assets

•

If the Company merges, consolidates or engages in any other business combination (with some exceptions), provided that such transaction is required to be reported pursuant to Item 1 of Form 8-K

•

If the Company commits a material breach under, or otherwise materially violates the terms of, the transaction documents entered into in connection with the issuance of such series

     In addition, the Series C Preferred Stock is redeemable by its holders if, on or prior to November 19, 2004, the two year anniversary of the initial issuance of the Series C Preferred Stock, the Company issues equity, equity-linked securities, or debt which is convertible into equity, other than (i) upon the exercise of warrants, options or convertible securities issued and outstanding as of the issuance of the Series C Preferred Stock, (ii) upon the grant or exercise of stock options under any stock option plan, (iii) upon issuance or conversion of the Series C Preferred Stock or exercise of the warrants issued in connection with the Series C Preferred Stock, (iv) the issuance of securities in connection with strategic business partnerships, (v) pursuant to an equipment financing from a financial or lending institution and (vi) common stock issued as premium payments on Series A or Series C Preferred Stock.

     Upon the occurrence of any of the redemption events described above, individual holders of the Series C Preferred Stock would have the option, while such event continues, to require the Company to purchase some or all of the then outstanding shares of Series C Preferred Stock, held by such holder. If the Company receives any notice of redemption, the Company is required to immediately (no later than one business day following such receipt) deliver a written notice to all holders of the same series of preferred stock stating the date when the Company received the redemption notice and the amount of preferred stock covered by the notice.

     If holders of Series C Preferred Stock were to exercise their rights to have redeemed a material number of their shares as a result of any of the events described above, and such a redemption were to have a material adverse effect on the Company, all holders of the Company’s Series A Preferred Stock may be able to redeem their shares as well, further endangering the Company’s financial position.

     The redemption events described above are all within the control of the Company. Therefore, in accordance with EITF Topic D-98, the Company has classified the Series C Preferred Stock in permanent equity. In addition, the Company initially recorded the Series C Preferred Stock at its fair value on the date of issuance. It has elected not to adjust the carrying value of the Series C Preferred Stock to the redemption value of such shares, since it is uncertain whether or when the redemption events described above will occur. Subsequent adjustments to increase the carrying value to the redemption value will be made when it becomes probable that such redemption will occur. As of September 30, 2003, the redemption value of the Series C Preferred Stock was $13.8 million.

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Liquidation Preference

     In the event of any liquidation, dissolution or winding up of the Company, or the sale of substantially all of the Company’s assets, the holders of the Series C Preferred Stock are entitled to receive, prior to any distribution to the holders of any other capital stock of the Company, an amount equal to the greater of:

•

$10,000 per share plus all accrued and unpaid premiums thereon, and

•

an amount equal to the amount that such holder would have received had the holder converted such holder’s shares of Series C Preferred Stock into common stock immediately prior to the event.

     After payment of the liquidation preference of the Series C Preferred Stock set forth above, the holders of the Series A Preferred Stock are entitled to receive an amount equal to $10,000 per share of Series A Preferred Stock plus all accrued and unpaid premiums thereon. Any assets remaining for distribution following the payment of the preferences to the holders of the Series C Preferred Stock and Series A Preferred Stock set forth above shall be distributed to the holders of the common stock.

     In the event funds are not sufficient to make a complete distribution to either the holders of Series C Preferred Stock or Series A Preferred Stock as described above, the assets of the Company available for distribution will be distributed ratably among the holders of Series C Preferred Stock or Series A Preferred Stock, respectively. As of September 30, 2003, the liquidation value of the Series A and C Preferred Stock was $5.4 million and $11.5 million, respectively.

6. COMMITMENTS

     The Company leases two buildings and subleases one building, totaling approximately 80,000 square feet of laboratory and office space in South San Francisco, California. The leases expire in the years 2004 and 2010 and provide the Company with options to extend the terms for an additional seven and ten years, respectively. The sublease, which covers approximately 14,000 square feet, expires on June 30, 2004 and provides the Company with the option to extend for an additional six months. In addition, the Company is currently marketing one of the leased buildings totaling approximately 25,000 square feet for sublease.

     In June 2002, the Company assigned a lease of excess laboratory and office space and transferred ownership through the sale of related leasehold improvements and equipment to a third party. The Company received net proceeds from the lease assignment of $3.8 million, resulting in a net gain of $0.3 million was recognized as other income over the initial sublease term. In the event of default by the assignee, the Company would be contractually obligated for payments under the lease of: $0.2 million in 2003; $1.0 million in 2004; $1.4 million in 2005; and $8.5 million from 2006 through 2011.

     At September 30, 2003, contractual obligations for the next five years and thereafter, excluding the lease assignment guarantee discussed above, are as follows:

     In addition, the Company is obligated to pay dividends to the Series A and C preferred stockholders. See “Capital Stock” note for further discussion.

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results Of Operations

     The following discussion of the financial condition and results of operations should be read in conjunction with the financial statements and the notes thereto included in this Form 10-Q.

Forward-Looking Statements

     This Quarterly Report on Form 10-Q contains certain forward-looking statements within the meaning of the “safe harbor” provisions of the Private Securities Litigation Reform Act of 1995 including, without limitation, statements regarding our PhenoSense and GeneSeq testing products, the growth of our pharmaceutical business, research and development expenditures, adequacy of our capital resources, and other financial matters. These statements, which sometimes include words such as “expect,” “goal,” “may,” “anticipate,” “should,” “continue,” or “will,” reflect our expectations and assumptions as of the date of this Quarterly Report based on currently available operating, financial and competitive information. Actual results could differ materially from those in the forward-looking statements as a result of a number of factors, including our ability to raise additional capital, the market acceptance of our resistance testing products, the effectiveness of our competitors’ existing products and new products, the ability to effectively manage growth and the risks associated with our dependence on patents and proprietary rights. These factors and others are more fully described in “Risk Factors” and elsewhere in this Form 10-Q. We assume no obligation to update any forward-looking statements.

OVERVIEW

     We are a biotechnology company developing, marketing and selling innovative products to guide and improve treatment of viral diseases. We incorporated in the state of Delaware on November 14, 1995 and commenced commercial operations in 1999. We developed a practical way of directly measuring the impact of genetic mutations on drug resistance and using this information to guide therapy. We have proprietary technology, called PhenoSense, for testing drug resistance in viruses that cause serious viral diseases such as HIV/AIDS and hepatitis. Our products are used by physicians in selecting optimal treatments for their HIV patients and by industry, academia and government for clinical studies, drug screening and characterization, and basic research.

SUMMARY OF CRITICAL ACCOUNTING POLICIES

     The preparation of our financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the amounts reported in our financial statements and accompanying notes. Actual results could differ materially from those estimates. See Note 1 to the financial statements for further discussion. Items in our financial statements requiring significant estimates and judgments are as follows:

Revenue Recognition

     Product revenue is recognized upon completion of tests made on samples provided by customers and the shipment of test results to those customers. Services are provided to certain patients covered by various third-party payor programs, including Medicare. Billings for services under third-party payor programs are included in revenues net of an allowance for contractual discounts and an allowance for differences between the amounts billed and estimated payment amounts. We estimate these allowances based on historical payment information and current sales data. If the government and other third-party payors significantly change their reimbursement policies or the relative mix of third-party payors changes, an adjustment to the allowance may be necessary. Revenue generated from our database of resistance test results is recognized when earned under the terms of the related agreements, generally at the shipment of the requested reports. Contract revenue consists of revenue generated from National Institutes of Health (“NIH”) grants and commercial assay development, and other non-product revenue. NIH grant revenue is recorded on a reimbursement basis as grant costs are incurred. The costs associated with contract revenue are included in research and development expenses. Deferred revenue relates to cash received in advance of meeting the revenue recognition criteria described above.

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Deferred Tax Assets

     We recorded a valuation allowance to reduce our deferred tax assets to the amount that we believe is more likely than not to be realized. Due to our lack of earnings history, the net deferred tax assets have been fully offset by a valuation allowance.

Deemed Dividends

     We estimated a beneficial conversion feature for our convertible preferred stock in accordance with Emerging Issues Task Force Consensus No. 98-5, “Accounting for Convertible Securities with Beneficial Conversion Features” and No. 00-27, “Application of Issue No. 98-5 to Certain Convertible Instruments” based on the difference between the estimated conversion price and common stock fair market value at the date of issuance. We recorded the beneficial conversion feature as a deemed dividend on the Statement of Operations, resulting in an increase to the net loss applicable to common stockholders in the calculation of basic and diluted net loss per common share.

Stock-Based Compensation

     We have elected to continue to follow Accounting Principles Board Opinion No. 25 “Accounting for Stock-Based Compensation” (“APB 25”) to account for employee stock options. Under APB 25, no compensation expense is recognized because the exercise price of our employee stock options equals the market price of the underlying stock on the date of grant. Deferred compensation, if recorded, is amortized using the graded vesting method. Statement of Financial Accounting Standards Board Statement No. 123, “Accounting for Stock-Based Compensation” (“SFAS 123”) as amended by Statement of Financial Accounting Standards Board Statement No. 148, “Accounting for Stock-Based Compensation — Transition and Disclosure — an amendment of FASB Statement No. 123” (“SFAS 148”) requires the disclosure of pro forma information regarding net loss and net loss per share as if we had accounted for its stock options under the fair value method. See “Summary of Significant Accounting Policies” note to the financial statements for further discussion.

     We account for stock option grants to non-employees in accordance with the Emerging Issues Task Force Consensus No. 96-18, “Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services,” which requires the options subject to vesting to be periodically re-valued and expensed over their vesting periods.

RESULTS OF OPERATIONS

Three and Nine Months Ended September 30, 2003 and 2002

     Revenue. Revenue was $9.1 million and $24.0 million for the three and nine months ended September 30, 2003, compared to $5.9 million and $18.3 million for the corresponding periods in 2002. The increase was primarily attributable to greater sales of PhenoSense HIV, GeneSeq HIV and PhenoSense GT. Contract revenue consists of revenue from NIH research grants and commercial assay development, and other non-product revenue. During the third quarter 2003, we were awarded four Small Business Innovation Research (SBIR) grants from the National Institute of Allergy and Infectious Diseases (NIAID), a division of the U.S. National Institutes of Health, for more than $4 million over three years. The grants will support the development of analytical and database tools to

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facilitate the identification and characterization of drug resistant strains of HIV, and assays that will aid in the pre-clinical and clinical evaluation of the next generation of anti-viral therapeutics. We believe increased demand for existing and new products will be the primary factors contributing to an increased level of sales in 2003 as compared to 2002. We anticipate quarterly differences in the revenue growth rate due to timing of various clinical studies for pharmaceutical customers and the seasonal effects observed in patient testing, which has historically occurred in the first and third quarters.

     Cost of product revenue. Cost of product revenue was $4.4 million and $12.5 million for the three and nine months ended September 30, 2003, compared to $3.5 million and $10.6 million for the corresponding periods in 2002. The increase was primarily due to the higher volume of testing. Included in these costs are materials, supplies, labor and overhead related to product revenue. Gross margin on product revenue increased to 50% and 46% for the three and nine months ended September 20, 2003 compared to 39% for the corresponding periods in 2002. The increase is primarily due to improved operational efficiency and economies of scale, and the implementation of the business restructuring plan as discussed below. We anticipate that gross margin on our product revenue will continue to improve as revenue increases and further economies of scale are achieved.

     Research and development. Research and development expenses were $1.1 million and $3.5 million for the three and nine months ended September 30, 2003, compared to $2.5 million and $8.3 million for the corresponding periods in 2002. The decrease was primarily the result of reallocating certain clinical research and research and development resources to revenue generating activities and the implementation of the business restructuring plan as discussed below. Total research and development expenses included costs associated with contract revenue as follows:

     Because our resistance tests target viral diseases and our product lines overlap, most of our core research and development activities are advancing multiple potential product lines. Due to this substantial overlap, we do not track costs on a project by project basis, except for the costs reimbursed by the NIH as discussed above. We expect research and development spending in the future to trend with the level of NIH grants and/or other research and development cost reimbursement arrangements under contract.

     Below is a summary of products and products in development. The information in the column labeled “Estimated Completion” contains forward-looking statements regarding completion of products in development and is dependent on securing NIH grants and/or other research and development funding as well as demand for the products. The actual timing of completion of those products could differ materially from the estimates provided in the table.

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     The following summarizes our products and products in development:

     General and administrative. General and administrative expenses were $2.1 million and $7.0 million for the three and nine months ended September 30, 2003, compared to $2.3 million and $7.7 million for the corresponding periods in 2002. The decrease was primarily due to the implementation of the business restructuring plan as discussed below and a reduction in noncash compensation expenses related to granting stock and options prior to our initial public offering, and was partially offset by an increase in fees for professional services and costs associated with facilities currently marketed for sublease. We expect general and administrative expenses to decrease in 2003 as compared to 2002 primarily due to continued leveraging of existing infrastructure and the implementation of the business restructuring plan as discussed below.

     Sales and marketing. Sales and marketing expenses were $2.0 million and $6.3 million for the three and nine months ended September 30, 2003, compared to $3.3 million and $9.2 million for the corresponding periods in 2002. This decrease was primarily due to continued effective utilization of our sales and marketing capabilities and the implementation of the business restructuring plan as discussed below. In addition, in 2002, we incurred expenses for sales and marketing programs related to the commercialization of PhenoSense GT and Replication Capacity. We currently have 20 personnel in our direct sales force. We expect sales and marketing expenses to decrease in 2003 as

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compared to 2002 primarily due to continued effective utilization of our sales and marketing capabilities and the implementation of the business restructuring plan as discussed below.

     Interest income. Interest income was $22,000 and $85,000 for the three and nine months ended September 30, 2003, compared to $54,000 and $252,000 for the corresponding periods in 2002. This decrease was primarily due to lower average cash balances and lower interest rates.

     Interest expense. Interest expense was $32,000 and $120,000 for the three and nine months ended September 30, 2003, compared to $75,000 and $246,000 for the corresponding periods in 2002. This decrease was primarily due to the payoff of several equipment loans which expired.

     Other income. Other income was $52,000 and $156,000 for the three and nine months ended September 30, 2003, compared to $52,000 and $295,000 for the corresponding periods in 2002. Other income represents residual income from our lease assignment in 2002.

     Deemed dividend. On February 4, 2003, our stockholders approved the conversion of certain convertible secured promissory notes (“Notes”) issued to prior Series B preferred stockholders into Series C Preferred Stock and the issuance of warrants to purchase shares of our common stock in exchange for warrants originally issued in connection with Series B Preferred Stock. The warrant exchange resulted in a charge of $2.2 million which was recorded at the time of the exchange in the first quarter of 2003.

     In the first quarter of 2002, we sold 1,005 shares of Series B Preferred Stock with warrants to purchase an aggregate of 2.2 million shares of common stock, for an aggregate purchase price of $10.05 million. In connection with this financing, we also granted warrants to purchase an aggregate of 637,261 shares of common stock to holders of Series A Preferred Stock as a payment in order to secure their consent and waiver concerning the financing and the resulting impact on the Series A Preferred Stock. The issuance of the Series B Preferred Stock resulted in a beneficial conversion feature of $2.9 million.

     The beneficial conversion features were calculated in accordance with Emerging Issues Task Force Consensus No. 98-5, “Accounting for Convertible Securities with Beneficial Conversion Features” and Emerging Issues Task Force Consensus No. 00-27 “Application of Issue No. 98-5 to Certain Convertible Instruments.” The beneficial conversion features were reflected as deemed dividends in the Statement of Operations of $2.2 million and $2.9 million in the first quarter of 2003 and 2002, respectively, and are included in stockholders’ equity as offsetting charges and credits to additional paid-in capital.

     Preferred stock dividend. We recorded a preferred stock dividend of $0.4 million and $1.4 million for the three and nine months ended September 30, 2003, compared to $0.2 million and $0.7 million for the corresponding periods in 2002. The Series A Preferred Stock issued in 2001 bore an initial 6% annual dividend rate, payable twice a year in shares of common stock, which increased to an 8% annual rate on the fourth such payment, and then increases by 2 percentage points every six months thereafter up to a maximum annual rate of 14%. The Series C Preferred Stock bears an initial 8% annual dividend rate, payable quarterly, which increases to a 9% annual dividend rate on June 30, 2004, then increases by one percentage point every quarter thereafter up to a maximum annual rate of 14% and is payable in cash or shares of common stock at our option. In 2003, we paid the Series C dividend in shares of common stock.

     Business restructuring. In the fourth quarter of 2002, we implemented a business restructuring plan to reallocate certain resources to revenue maximizing activities and reduce cash consumption. The plan included a reduction in force of approximately 17% or 35 employees: 8 employees in laboratory operations; 6 employees in research and development; 8 employees in sales and marketing; and 13 employees in administration. In the fourth quarter of 2002, we recorded a charge for salaries, severance and other personnel related costs to the respective departments totaling $0.3 million. We did not incur any additional expenses relating to the business restructuring in 2003.

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LIQUIDITY AND CAPITAL RESOURCES

     We expect our available cash and cash equivalents, short-term investments and short-term restricted cash of $8.7 million at September 30, 2003, funds provided by the sale of our products, contract revenue, and borrowing under equipment financing arrangements will be adequate to fund our operations through December 2004, assuming revenues reach projected levels and cost containment measures continue to be effective. In addition, we plan to continue to evaluate various strategic opportunities, including among others, research and development collaborations, international alliances and marketing partnerships.

     We have funded our operations since inception primarily through public and private sales of common and preferred stock, equipment financing arrangements, product revenue and contract revenue. In particular, we have completed three private financings since our initial public offering in May 2000. Although we expect our operating and capital resources will be sufficient to meet future requirements through December 2004, we may have to raise additional funds to continue the development and commercialization of future technologies and our business operations in general. These funds may not be available on favorable terms, or at all. If adequate funds are not available on commercially reasonable terms, we may be required to curtail operations significantly or sell significant assets and may not be able to continue as a going concern. In addition, we may choose to raise additional capital due to market conditions or strategic considerations even if we believe that we have sufficient funds for current or future operating plans.

     Net cash used in operating activities was $3.5 million and $15.6 million for the nine months ended September 30, 2003 and 2002, respectively. The decrease in cash used in operating activities primarily relates to lower operating losses as discussed above.

     Net cash used in investing activities of $0.8 million for the nine months ended September 30, 2003 resulted primarily from capital expenditures and costs associated with acquiring other assets. Net cash provided by investing activities of $8.7 million for the nine months ended September 30, 2002 resulted primarily from the net proceeds from maturities and sales of short-term investments, a lease assignment of $3.2 million, and a tenant improvement reimbursement of $1.3 million, partially offset by capital expenditures of $1.2 million.

     Net cash provided by financing activities of $1.5 million for the nine months ended September 30, 2003 resulted primarily from warrant exercises for proceeds of $2.7 million, partially offset by payments on loans and capital lease obligations. Net cash provided by financing activities of $8.5 million for the nine months ended September 30, 2002 resulted primarily from the sale of Series B Preferred Stock in March 2002 for net proceeds of $9.8 million, partially offset by payments on loans and capital lease obligations.

     We lease two buildings and sublease one building, totaling approximately 80,000 square feet of laboratory and office space in South San Francisco, California. The leases expire in the years 2004 and 2010 and provide us with options to extend the terms for an additional seven and ten years, respectively. The sublease, which covers approximately 14,000 square feet expires on June 30, 2004 and provides us with the option to extend for an additional six months. In addition, we are currently marketing one of the leased buildings totaling approximately 25,000 square feet for sublease.

     In June 2002, we assigned a lease of excess laboratory and office space and transferred ownership through the sale of related leasehold improvements and equipment to a third party. We received net proceeds from the lease assignment of $3.8 million, resulting in a net gain of $0.3 million was recognized as other income over the initial sublease term. In the event of default by the assignee, we would be contractually obligated for payments under the lease of: $0.2 million in 2003; $1.0 million in 2004; $1.4 million in 2005; and $8.5 million from 2006 through 2011.

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     At September 30, 2003, our contractual obligations for the next five years and thereafter, excluding the lease assignment guarantee discussed above, are as follows:

     In addition, we are obligated to pay dividends to the Series A and C preferred stockholders. See “Capital Stock” note to the financial statements for further discussion.

     The contractual obligations discussed above are fixed costs. If we are unable to generate sufficient cash from operations to meet these contractual obligations, we may have to raise additional funds. These funds may not be available on favorable terms or at all.

RECENTLY ISSUED ACCOUNTING STANDARDS

     In May 2003, the FASB issued Statement of Financial Accounting Standards No. 150 “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity” (“SFAS 150”). SFAS 150 established standards for classifying and measuring as liabilities certain financial instruments that embody obligations of the issuer and have characteristics of both liabilities and equity. SFAS 150 must be applied immediately to instruments entered into or modified after May 31, 2003. The adoption of SFAS 150 did not have a material effect on our results of operations or financial position.

     In April 2003, the FASB issued Statement of Financial Accounting Standards No. 149 “Amendment of Statement 133 on Derivative Instruments and Hedging Activities” (“SFAS 149”). SFAS 149 amends SFAS 133 to provide clarification on the financial accounting and reporting of derivative instruments and hedging activities and requires contracts with similar characteristics to be accounted for on a comparable basis. The provisions of SFAS 149 are effective for contracts entered into or modified after June 30, 2003. The adoption of SFAS 149 did not have a material effect on our results of operations or financial position.

     In November 2002, the FASB issued Emerging Issues Task Force Issue No. 00-21, “Revenue Arrangements with Multiple Deliverables” (“EITF 00-21”). EITF 00-21 addresses certain aspects of the accounting by a company for arrangements under which it will perform multiple revenue-generating activities. EITF 00-21 addresses when and how an arrangement involving multiple deliverables should be divided into separate units of accounting. EITF 00-21 provides guidance with respect to the effect of certain customer rights due to company nonperformance on the recognition of revenue allocated to delivered units of accounting. EITF 00-21 also addresses the impact on the measurement and/or allocation of arrangement consideration of customer cancellation provisions and consideration that varies as a result of future actions of the customer or the company. Finally, EITF 00-21 provides guidance with respect to the recognition of the cost of certain deliverables that are excluded from the revenue accounting arrangement. The provisions of EITF 00-21 will apply to revenue arrangements entered into in fiscal periods beginning after June 15, 2003. The adoption of EITF 00-21 did not have a material effect on our results of operations or financial position.

     In November 2002, the FASB issued Interpretation 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others” (“FIN 45”). FIN 45 requires a guarantor to recognize, at the inception of a guarantee, a liability for the fair value of the obligation undertaken in issuing the guarantee. FIN 45 also expands the disclosures required to be made by a guarantor about its obligations under certain guarantees that it has issued. Initial recognition and measurement provisions of FIN 45 are applicable on a

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prospective basis to guarantees issued or modified. The disclosure requirements are effective immediately. The adoption of the recognition and measurement provisions of FIN 45 did not have a material effect on our results of operations or financial position.

     In June 2002, the FASB issued Statement of Financial Accounting Standards No. 146 “Accounting for Costs Associated with Exit or Disposal Activities” (“SFAS 146”). SFAS 146 addresses financial accounting and reporting for costs associated with exit or disposal activities and nullifies Emerging Issues Task Force Issue No. 94-3, “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring).” SFAS 146 requires that a liability for a cost associated with an exit or disposal activity be recognized and measured initially at fair value when the liability is incurred, rather than at the date of an entity’s commitment to an exit plan. The provisions of SFAS 146 are effective for exit or disposal activities that are initiated after December 31, 2002. The adoption of SFAS 146 did not have a material effect on our results of operations or financial position.

RISK FACTORS

     You should carefully consider the following factors and other information in this Form 10-Q when considering our company and its stock.

In the event that we need to raise additional capital, our stockholders could experience substantial additional dilution. If such financing is not available on commercially reasonable terms, we may have to significantly curtail our operations or sell significant assets and may be unable to continue as a going concern.

     As of September 30, 2003, we had available cash and cash equivalents, short-term investments and short-term restricted cash of $8.7 million. We anticipate that our existing capital resources together with funds from the sale of our products, contract revenue and borrowing under equipment financing arrangements will enable us to maintain currently planned operations through December 31, 2004. However, we may need additional funding sooner than that. To the extent operating and capital resources are insufficient to meet our obligations, including lease payments and future requirements, we will have to raise additional funds to continue the development, commercialization and expansion of our technologies. Our inability to raise capital would seriously harm our business and product development efforts. In addition, we may choose to raise additional capital due to market conditions or strategic considerations even if we believe we have sufficient funds for our current or future operating plans. However, we cannot guarantee that additional financing, in any form, will be available at all, or on terms acceptable to us. Our ability to raise additional capital also may be dependent upon our common stock being quoted on the Nasdaq Stock Market. We cannot guarantee that we will be able to satisfy the criteria for continued listing on the Nasdaq Stock Market or any other market. If we sell equity or convertible debt securities to raise additional funds, our existing stockholders may incur substantial dilution and any shares so issued will likely have rights, preferences and privileges superior to the rights, preferences and privileges of our outstanding common and preferred stock. In the event financing is not available in the time frame required, we will be forced to reduce our operating expenses, curtail sales and marketing activities, reschedule research and development projects or delay, scale back or eliminate some or all of our activities. Further, we might be required to sell certain of our assets or obtain funds through arrangements with third parties that require us to relinquish rights to certain of our technologies or products that we would seek to develop or commercialize ourselves. These actions, while necessary for the continuance of operations during a time of cash constraints and a shortage of working capital, could make it difficult or impossible to implement our long-term business plans or could affect our ability to continue as a going concern.

We may incur future losses and may not achieve profitability as soon as expected, which may cause our stock price to fall.

     We have experienced significant losses each year since our inception and may incur additional losses. We experienced net losses applicable to common stockholders of approximately $8.6 million in the nine month period ended September 30, 2003, $33.3 million in 2002 and $28.8 million in 2001. As of September 30, 2003, we had an accumulated deficit of approximately $105.9 million. We may continue to incur losses primarily as a result of spending related to:

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•

Expanding patient sample processing capabilities

•

Research and product development costs

•

Sales and marketing activities

•

Additional clinical laboratory and research space and other necessary facilities

•

General and administrative costs

     If our history of losses continues, our stock price may fall and you may lose part or all of your investment.

Our stockholders will experience substantial additional dilution if our shares of preferred stock or their related warrants are converted into or exercised for shares of common stock. As of September 30, 2003, our outstanding shares of preferred stock and related warrants are convertible into or exercisable for up to an aggregate of 28,941,166 shares of common stock, or approximately 74% of the number of shares of outstanding common stock.

     As of September 30, 2003, we had approximately 39,145,417 shares of common stock outstanding. However, as of September 30, 2003, we also had outstanding the following shares of preferred stock and related warrants:

•

539 shares of Series A Redeemable Convertible Preferred Stock (“Series A Preferred Stock”), convertible into 4,855,856 shares of common stock (not including the conversion of accrued but unpaid premiums)

•

1,148.98 shares of Series C Convertible Preferred Stock (“Series C Preferred Stock”), convertible into 9,495,702 shares of common stock

•

warrants issued to the purchasers of our preferred stock in connection with our preferred stock financings to purchase 14,589,608 shares of common stock

     Together, the common shares reserved for issuance upon conversion of the Series A Preferred Stock and Series C Preferred Stock, and upon exercise of the warrants referenced above, represent approximately 28,941,166 shares of common stock, or 74% of the outstanding shares of our common stock at September 30, 2003, all of which are issuable for an approximate weighted-average effective price of $1.17 per share.

     The number of shares of common stock that we may be required to issue upon conversion of the Series A Preferred Stock, and exercise of the warrants granted to purchasers of our Series A Preferred Stock in connection with the issuance thereof, can increase substantially upon the occurrence of several events, including if:

•

We issue shares of stock (with certain exceptions) for an effective price less than the conversion price of the Series A Preferred Stock or the related warrants (each $1.11 as of October 28, 2003). This could be likely given that this sort of adjustment has already occurred, our stock price has been below $1.11, the historical volatility of our stock price and the recent volatility of stocks of companies in our industry and of the stock market in general

•

We fail to have sufficient shares of common stock reserved to satisfy conversions, exercises and other issuances

•

We fail to honor requests for conversion, or notify any holder of Series A Preferred Stock of our intention not to honor requests for conversion

•

We fail to issue shares upon exercise of the warrants

•

We fail to redeem any shares of Series A Preferred Stock when required

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     We are also obligated to issue additional shares of common stock every six months to the holders of the Series A Preferred Stock as “premium payments.” As of October 28, 2003, these issuances equaled about 333 shares of common stock for every share of Series A Preferred Stock outstanding at the time the issuance is made. This number of shares will increase every six months, by about 66 shares of common stock for each share of Series A Preferred Stock, up to a maximum of about 467 shares of common stock for every share of Series A Preferred Stock. All of the previous share totals are based upon an assumed stock price of $1.50, which was the closing price of our stock on the Nasdaq National Market on October 28, 2003, but the actual number of shares will be based upon our stock price from time to time as of the payment dates. To date, we have issued 696,738 shares of common stock to holders of Series A Preferred Stock as premium payments on those shares. If the 539 shares of the Series A Preferred Stock outstanding as of September 30, 2003 remain outstanding for five years following such date, we will be required to issue as premium payments an additional 2,407,533 shares of common stock (again based on an assumed stock price of $1.50) to holders of the Series A Preferred Stock, which is 6.2% of the shares of common stock outstanding as of September 30, 2003. We do not receive payment or other consideration for these issuances.

     We amended the rights of the Series C Preferred Stock to (i) provide that any premium payments due thereunder may be paid in either cash or shares of common stock at our option, and (ii) include anti-dilution provisions substantially identical to those applicable with respect to our Series A Preferred Stock. As a result, the number of shares of common stock that we may be required to issue upon conversion of the Series C Preferred Stock will increase substantially in the event that we issue shares of stock for an effective price less than the then conversion price of the Series C Preferred Stock ($1.50 as of October 28, 2003). The premium payment due on each share of Series C Preferred Stock each quarter is currently equal to $200, but will increase beginning with the payment due on June 30, 2004 by $25 per share up to a maximum of $350 per share. To date, we have issued 723,517 shares of common stock to holders of Series C Preferred Stock as premium payments on those shares. If all 1,148.98 shares of Series C Preferred Stock outstanding as of September 30, 2003 remain outstanding for five years following such date, and we choose to pay all premium amounts due on those shares in common stock instead of cash, we will issue an additional 4,959,764 shares of common stock (again based on an assumed stock price of $1.50) to holders of the Series C Preferred Stock, which is 12.7% of the shares of common stock outstanding as of September 30, 2003. We do not receive payment or other consideration for these issuances.

     All of the foregoing issuances of common stock would be substantially dilutive to the outstanding shares of common stock, especially where, as described above, the shares of common stock are issued without additional consideration. We cannot predict whether or how many additional shares of our common stock will become issuable due to these provisions.

     Any dilution or potential dilution may cause our stockholders to sell their shares, which would contribute to a downward movement in the stock price of our common stock. This could prevent us from sustaining a per share price sufficient to enable us to maintain an active trading market on, or meet the continued listing requests of, the Nasdaq National Market. In addition, any downward pressure on the trading price of our common stock could encourage investors to engage in short sales, which could further contribute to a downward trend in the price of our common stock.

We may be obligated to redeem our Series A and Series C Preferred Stock at a premium to the purchase price.

     Holders of our Series A Preferred Stock and Series C Preferred Stock have the right, under certain circumstances, to require us to redeem for cash all of the preferred stock that they own. The redemption price for the Series A Preferred Stock is the greater of (i) 115% of the original purchase price plus 115% of any accrued premium payment thereon and (ii) the aggregate fair market value of the shares of common stock into which such shares of Series A Preferred Stock are then convertible. The redemption price for the Series C Preferred Stock is the greater of (i) 120% of the original purchase price plus 120% of any accrued premium payment thereon and (ii) the aggregate fair market value of the shares of common stock into which such shares of Series C Preferred Stock are then convertible. As of September 30, 2003, there were 539 shares of Series A Preferred Stock and 1,148.98 shares of Series C Preferred Stock outstanding, with an aggregate redemption price equal to approximately $6.2 million and $13.8 million, respectively.

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     The Series A Preferred Stock and Series C Preferred Stock are each redeemable by the holders of the respective series in any of the following situations:

•

If we fail to remove a restrictive legend on any certificate representing any common stock that was issued to any holder of such series upon conversion of their preferred stock or exercise of their warrants and that may be sold pursuant to an effective registration statement or an exemption from the registration requirements of the federal securities laws

•

If we fail to have sufficient shares of common stock reserved to satisfy conversions of the series

•

If we fail to honor requests for conversion, or if we notify any holder of such series of our intention not to honor future requests for conversion

•

If we institute voluntary bankruptcy or similar proceedings

•

If we make an assignment for the benefit of creditors, or apply for or consent to the appointment of a receiver or trustee for us or for a substantial part of our property or business, or such a receiver or trustee shall otherwise be appointed

•

If we sell all or substantially all of our assets

•

If we merge, consolidate or engage in any other business combination (with some exceptions), provided that such transaction is required to be reported pursuant to Item 1 of Form 8-K

•

If we commit a material breach under, or otherwise materially violate the terms of, the transaction documents entered into in connection with the issuance of such series

     In addition to the situations already mentioned, the Series A Preferred Stock is redeemable by its holders in either of the following circumstances:

•

If the registration statements covering shares of common stock underlying the Series A Preferred Stock and related warrants cannot be used by the respective selling security holders for the resale of all the underlying shares of common stock for an aggregate of more than 30 days.

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If our common stock is not tradable on the NYSE, the AMEX, the Nasdaq National Market or the Nasdaq SmallCap market for an aggregate of twenty trading days in any nine month period. In order for our common stock to continue to be quoted on the National Market, we must continue to satisfy various listing maintenance standards established by Nasdaq, including, among other things, a requirement that we have stockholders’ equity of at least $10 million and that our stock price consistently trades at or above $1.00 per share. We have had, and may continue to have, challenges meeting these requirements to maintain a listing on the Nasdaq National Market.

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If 35% or more of our voting power is held by any one person, entity or group

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If we fail to pay any indebtedness in excess of $350,000 when due, or if there is any event of default under any agreement that is likely to have a material adverse effect on us

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Upon the institution of involuntary bankruptcy proceedings

     In addition, the Series C Preferred Stock is redeemable by its holders if, on or prior to November 19, 2004, the two year anniversary of the initial issuance of the Series C Preferred Stock, we issue equity, equity-linked securities, or debt which is convertible into equity, other than (i) upon the exercise of warrants, options or convertible securities issued and outstanding as of the issuance of the Series C Preferred Stock, (ii) upon the grant or exercise of stock options under any stock option plan, (iii) upon issuance or conversion of the Series C Preferred Stock or exercise of the warrants issued in connection with the Series C Preferred Stock, (iv) the issuance of securities in connection with

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strategic business partnerships, (v) pursuant to an equipment financing from a financial or lending institution and (vi) common stock issued as premium payments on Series A Preferred Stock or Series C Preferred Stock.

     Upon the occurrence of any of the events described above, individual holders of the relevant series of preferred stock (or both series in those cases where the right of redemption is triggered for both the Series A Preferred Stock and the Series C Preferred Stock) would have the option, while such event continues, to require us to purchase some or all of the then outstanding shares of Series A Preferred Stock and/or Series C Preferred Stock, as applicable, held by such holder. If we receive any notice of redemption, we are required to immediately (no later than one business day following such receipt) deliver a written notice to all holders of the same series of preferred stock stating the date when we received the redemption notice and the amount of preferred stock covered by the notice.

     Redemption of the Series A Preferred Stock or Series C Preferred Stock in any event described above would require us to expend a significant amount of cash that would exceed our total available cash and cash equivalents and our ability to make such payments or raise additional capital. In addition, if holders of Series C Preferred Stock were to exercise their rights to have redeemed a material number of their shares as a result of any of the events described above, and such a redemption were to have a material adverse effect on the Company, all holders of our Series A Preferred Stock may be able to redeem their shares as well, further endangering our financial position. See the notes to the financial statement for further details.

Our testing products may not achieve market acceptance, which could limit our future revenue.

     Our ability to establish phenotypic resistance testing as the standard of care to guide and improve the treatment of viral diseases will depend on physicians’ and clinicians’ acceptance and use of phenotypic resistance testing. Phenotypic resistance testing is still relatively new. We cannot predict the extent to which physicians and clinicians will accept and use phenotypic resistance testing. They may prefer competing technologies and products. The commercial success of phenotypic resistance testing will require demonstrations of its advantages and potential economic value in relation to the current standard of care, as well as to competing products. We have introduced two products using our proprietary PhenoSense technology, PhenoSense HIV and PhenoSense GT, which we began actively marketing in November 1999 and November 2001, respectively. We are still in the early stages of development of new products applying our PhenoSense technology to other viral diseases. If PhenoSense HIV or PhenoSense GT is not accepted in the marketplace, our ability to sell other PhenoSense products would be undermined. Market acceptance will depend on:

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Our marketing efforts and continued ability to demonstrate the utility of PhenoSense in guiding anti-viral drug therapy, for example, through the results of retrospective and prospective clinical studies

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Our ability to demonstrate the advantages and potential economic value of our PhenoSense testing products over current treatment methods and other resistance tests

     If the market does not accept phenotypic resistance testing, or our PhenoSense products in particular, our ability to generate revenue will be limited.

Our revenues will be diminished if government and third-party payors limit the amounts that they will reimburse for our current products, or do not authorize reimbursement for our planned products.

     Government and third-party payors, which reimburse patients and healthcare providers for medical expenses, are attempting to contain or reduce the costs of healthcare and are challenging the prices charged for medical products and services. In addition, increasing emphasis on managed care in the United States will continue to put pressure on the pricing of healthcare products. This could in the future limit the price that we can charge for our products. This could also hurt our ability to generate revenues. Significant uncertainty exists as to the reimbursement status of new medical products like the products we are currently developing, particularly if these products fail to show demonstrable value in clinical studies. Currently, nearly all public and a majority of private payors have approved the reimbursement of our existing products. However, the majority of our payors are currently reimbursing our products at varying levels from 70% to 100% of our list prices. If government and other third-party payors do not

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continue to provide adequate coverage and reimbursement for our testing products or do not authorize reimbursement for our planned products, our revenues will be reduced.

Billing complexities associated with health care payors may result in increased bad debt expense, which could impair our cash flow and limit our ability to reach profitability.

     Billing for laboratory services is complex. Laboratories must bill various payors, such as patients, insurance companies, Medicare, Medicaid, doctors and employer groups, all of whom have different requirements. Billing difficulties often result in bad debt expense which impairs cash flow and ultimately reduces profitability. Most of the bad debt expense is the result of several noncredit related issues, primarily missing or incorrect billing information on requisitions. We perform the requested tests and report test results regardless of incorrect or missing billing information. We subsequently attempt to obtain any missing information and rectify incorrect billing information received from the healthcare provider. Missing or incorrect information on requisitions slows the billing process, creates backlogs of unbilled requisitions and generally increases the aging of accounts receivable. Among many other factors complicating billing are:

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Pricing differences between our fee schedules and those of the payors

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Disputes between payors as to which party is responsible for payment

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Disparity in coverage among various payors