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SECURITIES AND EXCHANGE COMMISSION

Form 10-K

Commission File Number 0-19871

StemCells, Inc.

Registrant’s telephone number, including area code:

Securities registered pursuant to Section 12(b) of the Act:

Securities registered pursuant to Section 12(g) of the Act:

          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 þ          No o

          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 this Form 10-K or any amendment to this Form 10-K.     þ

          Indicate by check mark whether the registrant is an accelerated filer as defined in Exchange Act Rule 126(2).     Yes o          No þ

          Aggregate market value of Common Stock held by non-affiliates at June 30, 2003: $54,596,198. Inclusion of shares held beneficially by any person should not be construed to indicate that such person possesses the power, direct or indirect, to direct or cause the direction of management policies of the registrant, or that such person is controlled by or under common control with the Registrant.

          Common stock outstanding at March 17, 2004: 41,004,834 shares.

DOCUMENTS INCORPORATED BY REFERENCE

          Portions of the registrant’s definitive Proxy Statement relating to the registrant’s 2004 Annual Meeting of Stockholders to be filed with the Commission pursuant to Regulation 14A are incorporated by reference in Part III of this report.

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FORWARD LOOKING STATEMENTS

      THIS REPORT CONTAINS FORWARD-LOOKING STATEMENTS AS DEFINED UNDER THE FEDERAL SECURITIES LAWS. ACTUAL RESULTS COULD VARY MATERIALLY. FACTORS THAT COULD CAUSE ACTUAL RESULTS TO VARY MATERIALLY ARE DESCRIBED HEREIN AND IN OTHER DOCUMENTS FILED WITH THE SECURITIES AND EXCHANGE COMMISSION. READERS SHOULD PAY PARTICULAR ATTENTION TO THE CONSIDERATIONS DESCRIBED IN THE SECTION OF THIS REPORT ENTITLED “MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS” AS WELL AS EXHIBIT 99 TO THIS REPORT, ENTITLED “CAUTIONARY FACTORS RELEVANT TO FORWARD-LOOKING INFORMATION.” READERS SHOULD ALSO CAREFULLY REVIEW ANY RISK FACTORS DESCRIBED IN OTHER DOCUMENTS WE FILE FROM TIME TO TIME WITH THE SECURITIES AND EXCHANGE COMMISSION.

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Overview

      We are engaged in research aimed at the development of therapies that would use stem and progenitor cells to treat, and possibly cure, human diseases and injuries such as neurodegenerative diseases (for instance, Batten’s, Parkinson’s, and Alzheimer’s diseases, and other metabolic genetic disorders), demyelinating disorders (for instance, Multiple Sclerosis), spinal cord injuries, stroke, hepatitis, chronic liver failure, and diabetes. We believe that our stem cell technologies, if successfully developed, may provide the basis for effective therapies for these and other conditions. Our aim is to return patients to productive lives and significantly reduce the substantial health care costs often associated with these diseases and disorders. The body uses certain key cells known as stem cells to produce all the functional mature cell types found in normal organs of healthy individuals. Progenitor cells are cells that have already developed from the stem cells, but can still produce one or more types of mature cells within an organ. We use cells derived from fetal or adult tissue sources, and are not developing embryonic stem cells for therapeutic use. Neither are we involved in any activity directed toward human cloning; our programs are all directed toward the use of tissue-derived cells for treating or curing diseases and injuries.

      Many diseases, such as Alzheimer’s, Parkinson’s, and other degenerative diseases of the brain or nervous system, involve the failure of organs that cannot be transplanted. Other diseases, such as hepatitis and diabetes, involve organs such as the liver or pancreas that can be transplanted, but there is a very limited supply of those organs available for transplant. We estimate that these neural, liver and pancreatic conditions affect more than 49 million people in the United States and account for more than $300 billion annually in health care costs.(1)

      Our stem cell discovery engine relies upon our state of the art cell sorting capabilities and our library of proprietary monoclonal antibodies to human proteins. Using this library of monoclonal antibodies, we have successfully identified, purified, and characterized the human central nervous system stem cell. We have also used our proprietary monoclonal antibodies to make significant advances in our search for stem or progenitor cells of the liver and the pancreas. We have established an intellectual property position in all three areas of our stem cell research — the nervous system, the liver and the pancreas — by patenting our discoveries and entering into exclusive in-licensing arrangements. We believe that, if successfully developed, our platform of stem cell technologies may create the basis for therapies that would address a number of conditions with significant unmet medical needs. We are concentrating our in-house efforts on our neural and liver programs and, for the present, pursuing research on the pancreas primarily through an external collaborator.

Cell Therapy Background

      Cells maintain normal physiological function in healthy individuals by secreting or metabolizing substances, such as sugars, amino acids, neurotransmitters and hormones, which are essential to life. When cells are damaged or destroyed, they no longer produce, metabolize or accurately regulate those substances. Impaired cellular function is associated with the progressive decline common to many degenerative diseases of the nervous system, such as Parkinson’s disease and Alzheimer’s disease. Recent advances in medical science have identified cell loss or impaired cellular function as leading causes of degenerative diseases. Biotechnology advances have led to the identification of some of the specific substances or proteins that are deficient in some diseases, such as dopamine which is deficient in the brains of individuals with Parkinson’s disease as a result of

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      We believe that, if successfully developed, stem cell-based therapy — the use of stem or progenitor cells to treat diseases — has the potential to provide a broad therapeutic approach comparable in importance to traditional pharmaceuticals and genetically engineered biologics.

      Stem cells are rare and only available in limited supply, whether from the patients themselves or from donors. Cells obtained from the same person who will receive them may be abnormal if the patient is ill or the tissue is contaminated with disease-causing cells. Also, the cells can often be obtained only through significant surgical procedures. The challenge, therefore, has been three-fold:

	1) to identify the stem or progenitor cells of a particular organ;
	2) to create techniques and processes that can be used to expand these rare cells in sufficient quantities for effective transplants; and
	3) to establish a bank of normal human stem or progenitor cells that can be used for transplantation into individuals whose own cells are not suitable because of disease or other reasons.

      We have discovered and patented the use of monoclonal antibodies to markers on the cell surface that identify the human central nervous system, or CNS, stem cells. This methodology allows us to purify the stem cell population and eliminate other unwanted cell types. We have also developed a process, based on a proprietary in vitro culture system in chemically defined media, that reproducibly grows normal human CNS, stem and progenitor cells. We believe this is the first reproducible process for growing normal human CNS stem cells. Together, these discoveries enable us to select normal human CNS stem cells and to expand them in culture to produce a large number of pure stem cells. This process facilitates the banking of large quantities of individual vials of these cells, which could then be used for distribution to transplant centers worldwide for administration to patients.

      Because these cells have not been genetically modified, they may be especially suitable for transplantation and may provide a safer and more effective alternative to therapies that are based on cells derived from cancer cells, from cells modified by a cancer gene to make them grow, from an unpurified mixture of many different cell types, or from animal derived cells. We believe our proprietary stem cell technologies may be used to restore function by replacing specific cells that have been damaged or destroyed. In our research, we have shown that when human stem cells of the central nervous system are transplanted into animals, they are accepted, migrate, and successfully specialize to produce mature neurons and glial cells.

      More generally, because the tissue-derived stem cell is the pivotal cell that produces all the functional mature cell types in an organ, we believe these cells, if successfully identified and developed for transplantation, may serve as platforms for five major areas of regenerative medicine and biotechnology:

	•	tissue repair and replacement,
	•	correction of genetic disorders,
	•	drug discovery and screening,

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	•	gene discovery and use, and
	•	diagnostics.

      We intend to research, develop, and commercialize the therapeutic uses of our stem and progenitor cells alone or in partnership with third parties. We also intend to monetize non-core uses of our stem cell technology, such as diagnostics, gene discovery and use, drug discovery and screening, by engaging in a number of non-exclusive agreements.

Our Stem Cell Technology Programs

      Stem cells have two defining characteristics:

	•	some of the cells developed from stem cells produce all the kinds of mature cells making up the particular organ; and
	•	they self renew — that is, other cells developed from stem cells are themselves new stem cells, thus permitting the process to continue again and again.

      Stem cells are known to or thought to exist for many systems of the human body, including the blood and immune system, the central and peripheral nervous systems (including the brain), and the liver, pancreas endocrine, and the skin systems. These cells are responsible for organ regeneration during normal cell replacement and, to greater or lesser extent, after injury. We believe that further research and development will allow stem cells to be cultivated and administered in ways that enhance their natural function, so as to form the basis of therapies that will replace specific subsets of cells that have been damaged or lost through disease, injury or genetic defect.

      We also believe that the person or entity that first identifies and isolates a stem cell and defines methods to culture any of the finite number of different types of human stem cells will be able to obtain patent protection for the methods and the composition, making the commercial development of stem cell treatment and possible cure of currently intractable diseases financially feasible.

      Our strategy is to be the first to identify, isolate and patent multiple types of human stem and progenitor cells, derived from human tissue, with commercial importance. Our portfolio of issued patents includes a method of culturing normal human central nervous system stem and progenitor cells in our proprietary chemically defined media, and our published studies show that these cultured and expanded cells give rise to all three major cell types of the central nervous system. In rodents, we have shown that these cells exhibit the unique properties of stem cells: They migrate and colonize throughout the organ from which they were derived and mature into the specialized cells, such as neurons and glial cells, that are normally found in that region of the organ. We also have patent applications pending in connection with our search for liver and pancreas stem and progenitor cells.

      We have published the results of a study showing that human central nervous system stem cells can be successfully isolated by markers present on the surface of freshly obtained brain cells. We believe this is the first reproducible process for isolating highly purified populations of well-characterized normal human central nervous system stem cells. We own or have exclusive licenses to U.S. patents on this process, as well as issued patents and pending patent applications for compositions of matter. Because the cells are highly purified and have not been genetically modified, they may be especially suitable for transplantation and may provide a safer and more effective alternative than therapies that are based on cells derived from cancer cells, or from cells modified by a cancer gene to make them grow, or from an unpurified mixture of many different cell types or cells derived from animals. We are the exclusive licensee of a U.S. patent issued in December, 2002, covering the transplantation of central nervous system stem cells (U.S. Patent No. 6,497,872, “Neural transplantation using proliferated multipotent neural stem cells and their progeny”). We have also filed patent applications covering the growth and expansion of these purified normal human central nervous system cells.

      In 2001, we also announced the results of a new study (published in 2002) in which we used novel human specific monoclonal antibodies to demonstrate the extent of engraftment, migration and site-specific formation of the human neural stem cells into mature neurons. These neuronal cells integrate in a 3-dimensional array

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      In 2003, we announced results of three preclinical studies showing proof of principle of the human CNS-SC for a neurodegenerative disease using the mouse model for Infantile Batten Disease (a rare lysosomal storage disease), for spinal cord injury using a spinal cord crush mouse model and for myelination in the shiverer mouse model.

      Neurological disorders such as Parkinson’s disease, Alzheimer’s disease, the side effects of stroke, and the mental retardation that accompanies genetic disorders such as Gaucher’s Disease, Tay-Sachs Disease, and Batten’s Disease affect a significant portion of the U.S. population and there currently are no effective long-term therapies for them. We believe that therapies based on our process for identifying, isolating and culturing neural stem and progenitor cells may be useful in treating such diseases. We are continuing our research into, and have initiated the development of, human central nervous system stem and progenitor cell-based therapies for some of these diseases.

      We have demonstrated in a mouse model for the Batten disease mouse model that the Company’s human CNS-SC engraft, migrate throughout the brain and produce the enzyme that is missing in this transgenic mouse. The transplanted human cells are able to neuroprotect specific neurons, in the transgenic mouse, from death and quantitatively reduce the insoluble storage material in the brain, a characteristic hallmark of this disease. The Company has submitted these results to the FDA and held formal discussions with the FDA pertaining to the filing of an IND for Batten Disease.

      The Company has also obtained and presented preclinical results in spinal cord injury. A preclinical study in mice by Drs. Aileen Anderson and Brian Cummings of the Reeve-Irvine Center at the University of California showed promising results using the Company’s proprietary human neural stem cell technology as a potential means to regenerate damaged nerves and nerve fibers in patients with spinal cord injuries. In quantitative tests designed to measure functional recovery from complete hind limb paralysis to normal walking, the Company’s researchers reported that injured mice transplanted with the Company’s human neural stem cells (hCNS-SC) showed improved motor function compared to control animals. Inspection of the spinal cords from these mice showed significant levels of human neural cells derived from the transplanted stem cells. Previously, injured rats have been given stem cells from other rats or mice, but not stem cells from humans. The performance of the human cells in this rodent injury model suggests the possibility that similar results may be obtainable in humans. We believe that the significance of this study is that there is now hope in treating two aspects of spinal cord injury: nerve damage and loss of motor function.

      In November 2003, the Company presented data at the 33rd Annual Society for Neuroscience Meeting showing production of myelin, the insulator for nerve cells. In the mutant shiverer mouse, which is deficient in myelin production, transplantation of hCNS-SC into the brain resulted in widespread engraftment of human cells that matured into oligodendrocytes, the myelin producing cells. Analysis of the brain tissue of these mice shows the human cells juxtaposed to the mouse nerves where the myelin produced by the human cells now ensheath the mouse nerve, providing the proper layers of insulation. Further studies are in progress to demonstrate proper function of the newly produced myelin. Loss of myelin characterizes conditions such as spinal cord injury, multiple sclerosis and certain genetic disorders (for example, Krabbe’s disease, metachormatic leukodystrophy, Tay Sachs disease).

      We continue to advance our research programs to discover the liver and pancreas stem and/or progenitor cells. Liver stem cells may be useful in the treatment of diseases such as hepatitis, liver failure, blood-clotting disorder, cirrhosis of the liver and liver cancer. Islet cells are the pancreas cells that produce insulin, so pancreatic stem cells may be useful in the treatment of Type 1 diabetes and those cases of Type 2 diabetes where insulin secretion is defective.

      An important element of our stem cell discovery program is the further development of intellectual property positions with respect to stem and progenitor cells. We have also obtained rights to certain inventions relating to stem cells from, and are conducting stem cell related research at, several academic institutions. We

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Expected Advantages of Our Stem Cell Technology

      To our knowledge, no one has developed an FDA-approved method for replacing lost or damaged tissues from the human nervous system. Replacement of tissues in other areas of the human body is mainly limited to those few sites, such as bone marrow or peripheral blood cell transplants, where transplantation of the patient’s own cells is now feasible. In a few additional areas, including the liver, transplantation of donor organs is now used, but is limited by the scarcity of organs available through donation. We believe that our stem cell technologies have the potential to reestablish function in at least some of the patients who have suffered the losses referred to above.

      Because stem cells can duplicate themselves, or self-renew, and specialize into the multiple kinds of cells that are commonly lost in various diseases, transplanted stem cells may be able to migrate limited distances to the proper location within the body, to expand and specialize and to replace damaged or defective cells, facilitating the return to proper function. We believe that such replacement of damaged or defective cells by functional cells is unlikely to be achieved with any other treatment.

      Most approved therapies for the diseases being targeted by the Company are palliative in nature, primarily treating the symptoms of the disease. Stem cell therapy, by contrast, has the potential to arrest or slow down the progression of the disease or even cure the patient.

Research and Development Programs

      We have devoted substantial resources to our research programs to isolate and develop a series of stem and progenitor cells that we believe can serve as a basis for replacing diseased or injured cells. Our efforts to date have been directed at methods to identify, isolate and culture large varieties of stem and progenitor cells of the human nervous system, liver and pancreas and to develop therapies utilizing these stem and progenitor cells.

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      The following Table lists the potential therapeutic indications for, and current status of, our primary research and product development programs and projects. The table is qualified in its entirety by reference to the more detailed descriptions of such programs and projects appearing elsewhere in this report. We continually evaluate our research and product development efforts and reallocate resources among existing programs or to new programs in light of experimental results, commercial potential, availability of third party funding, likelihood of near-term efficacy, collaboration success or significant technology enhancement, as well as other factors. Our research and product development programs are at relatively early stages of development and will require substantial resources to commercialize.

Research and Product Development Programs

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(1)	“Research” refers to early stage research and product development activities in vitro, including the selection and characterization of product candidates for preclinical testing. “Preclinical” refers to further testing of a defined product candidate in vitro and in animals prior to clinical studies.

      Our portfolio of stem cell technology results from our exclusive licensing of central nervous system, stem and progenitor cell technology, animal models for the identification and/or testing of stem and progenitor cells and our own research and development efforts to date. We believe that therapies using stem cells represent a fundamentally new approach to the treatment of diseases caused by lost or damaged tissue. We have assembled an experienced team of scientists and scientific advisors to consult with and advise our scientists on their continuing research and development of stem and progenitor cells. This team includes founding scientists Irving L. Weissman, M.D., of Stanford University, Fred H. Gage, Ph.D., of The Salk Institute, and David Anderson, Ph.D., of the California Institute of Technology, as well as other occasional consultants including William C. Mobley, M.D., Ph.D., Ben Barres, Ph.D., and Seung Kim, M.D., Ph.D., all of Stanford University.

      We began our work with central nervous system stem and progenitor cell cultures in collaboration with NeuroSpheres, Ltd., in 1992. We believe that NeuroSpheres was the first to invent these cultures. We are the exclusive, worldwide licensee from NeuroSpheres to such inventions and associated patents and patent applications for all uses, including transplantation in the human body, as embodied in these patents. See “NeuroSpheres Ltd.” under “License Agreements” below.

      In 1997, our scientists invented a reproducible method for growing human CNS stem and progenitor cells in culture. In preclinical in vivo and early in vivo studies, we demonstrated that these cells specialize into all three of the cell types of the central nervous system. Because of these results, we believe that these cells may form the basis for replacement of cells lost in certain degenerative diseases. We are continuing research into, and have initiated the development of, our human CNS stem and progenitor cell cultures. We have initiated the cultures and demonstrated that these cultures can be expanded for a number of generations in vivo in chemically defined media. In collaboration with Dr. Anders Bjorklund of Lund University, Sweden, that cells from these cultures can be successfully transplanted and accepted into the brains of rodents where they subsequently migrated and specialized into the appropriate cell types for the site of the brain into which they were placed.

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      StemCells Inc holds a substantial portfolio of issued and allowed patents in the neural field. See “Patents, Proprietary Rights And Licenses.”

      In 2000, using our proprietary markers on the surface of the cell, our researchers succeeded in identifying, isolating and purifying human CNS stem cells from brain tissue. We believe that this was the first study to show a reproducible process for isolating highly purified populations of well-characterized normal human CNS stem cells. Because the cells are normal human CNS stem cells and have not been genetically modified, they may be especially suitable for transplantation and may provide a safer and more effective alternative to therapies that are based on cells derived from cancer cells or from an unpurified mix of many different cell types, or from animal derived cells. Even more importantly, in our view, our researchers have been able to take these purified and expanded stem cells and transplant them into the normal brains of immunodeficient mouse hosts, where they take hold and grow into neurons and glial cells.

      During the course of this long-term study, the transplanted human CNS stem cells survived for as long as one year and migrated to specific functional domains of the host brain, with no sign of tumor formation or adverse effects on the animal recipients; moreover, the cells were still dividing. These findings show that when CNS stem cells isolated and cultured with our proprietary processes are transplanted, they adopt the characteristics of the host brain and act like normal stem cells. In other words, the study suggests the possibility of a continual replenishment of normal human brain cells.

      The company has established a number of research collaborations in the neural field to assess the effects of transplanting the human CNS stem cells into preclinical animal models, including the spinal cord injury collaboration with Drs. Aileen Anderson and Brian Cummings of the Reeve-Irvine Center at the University of California and a collaboration with Dr. Gary Steinberg, Chairman of the Department of Neurosurgery of Stanford University School of Medicine and Co-director of the Stanford Stroke Center, pertaining to the evaluation of our human neural stem cells in animal models of stroke.

      As noted above, human CNS stem and progenitor cells harvested and purified and expanded using our proprietary processes may be useful for creating therapies for the treatment of degenerative brain diseases such as Batten Disease and other genetic disorders affecting the brain, Parkinson’s and Alzheimer’s diseases. These conditions affect about 5 million people in the United States and there are no effective long-term therapies currently available. We believe the ability to purify human brain stem cells directly from fresh tissue is important because:

	•	it provides an enriched source of normal stem cells, not contaminated by other unwanted or diseased cell types, that can be expanded in culture without fear of also expanding some unwanted cell types;
	•	it opens the way to a better understanding of the properties of these cells and how they might be manipulated to treat specific diseases. For example, in certain genetic diseases such as Tay Sachs and Batten’s, a key metabolic enzyme required for normal development and function of the brain is absent. Brain-derived stem cells might produce enough enzyme after transplantation to degrade the toxic product build-up, or, if not enough enzyme is made naturally, the cells might be genetically modified to produce those proteins. The native or modified brain stem cells could be transplanted into patients with these genetic diseases;
	•	the efficient acceptance of these non-transformed normal human stem cells into host brains means that the cell product can be tested in animal models for its ability to correct deficiencies caused by various human neurological diseases. This technology could also provide a unique animal model for the testing of drugs that act on human brain cells either for effectiveness of the drug against the disease or its toxicity to human nerve cells.

      We initiated our discovery work for the liver stem and progenitor cell through a sponsored research agreement with Markus Grompe, Ph.D., of Oregon Health Sciences University. Dr. Grompe’s work focuses on the discovery and development of a suitable method for identifying and assessing liver stem and progenitor cells for use in transplantation. We have also obtained rights to a novel mouse model of liver failure for

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      Approximately 1 in 10 Americans suffers from diseases and disorders of the liver for many of which there are currently no effective, long-term treatments. Our researchers continue to advance methods for establishing enriched cell populations suitable for transplantation in preclinical animal models. We are focused on discovering and utilizing proprietary methods to identify and isolate liver stem and progenitor cells and to evaluate these cells in culture and in preclinical animal models.

      The Company focuses on discovering and utilizing proprietary methods to identify and isolate liver stem and progenitor cells and to evaluate these cells in culture and in preclinical animal models. The Company intends to use these advanced methods, as they become available, to establish enriched cell populations suitable for transplantation.

      StemCells has devised a culture assay that it uses in its efforts to identify liver stem and progenitor cells. In addition, the culture assay can support the growth of an early human liver bipotent progenitor cell — a cell that can develop into two kinds of mature liver cells: bile duct cells and hepatocytes. Further, since cells in this culture can be infected with human hepatitis virus, it provides a valuable system for study of the virus. This technology also could provide a unique in vitro model for the testing of drugs that act on, or are metabolized by, human liver cells.

      The Company’s scientists have identified proprietary monoclonal antibodies that enrich for distinct subsets of human liver cells, including a candidate human liver stem-like cell that the Company refers to as a human liver engrafting cell (hLEC). When tested in the Company’s in vitro culture assay, these antibody-enriched cells produce human serum albumin, a measure of hepatocyte generation. Studies to date show that these hLECs can produce of human serum albumin in mouse serum following transplantation into immunodeficient mice, suggesting that the human liver-engrafting cell, once transplanted, becomes a functional cell. The program will focus on demonstrating the robust engraftment and function of these hLECs in a preclinical animal model of liver degeneration for proof of principle of a therapeutic cell for liver disease. A source of defined human cells capable of engraftment and substantial liver regeneration could provide a cell-based therapeutic product available to a wider patient base than liver transplants. An in vitro culture system that can reproducibly grow human liver progenitor cells might also provide cells for genetic modification to correct inborn errors of metabolism.

      The Company’s scientists have again used StemCells’ monoclonal antibody-based search engine to identify a rare subset of human pancreatic cells that may be candidate pancreatic stem/progenitor cells. The Company has filed a patent application on these critical monoclonal antibodies. For the present, the Company is not pursuing its pancreas program in-house. In 2002, the Company established a collaboration with Dr. Seung Kim of Stanford University to pursue other avenues to identify an insulin-producing cell. Dr. Kim’s laboratory is studying the developmental biology and controlling events of generating insulin-producing cells. We believe this may lead to the development of cell-based treatments for Type 1 diabetes and that portion of Type 2 diabetes characterized by defective secretion of insulin.

      The Company has an exclusive, worldwide license from The Scripps Research Institute (Scripps), to novel technology developed by Dr. Nora Sarvetnick, Ph.D., which may facilitate the identification and isolation of those cells by using a mouse model that continuously regenerates the pancreas. U.S. Patent Number 6,242,666 was issued on the animal model on June 5, 2001. We believe that stem cells produce the regeneration, in which case this animal model may be useful for identifying specific markers on the cell surface unique to the pancreas stem cells. We also obtained licenses from Scripps to novel markers on the cell surface identified by Dr. Sarvetnick and her research team as being unique to the pancreas islet stem cell; a U.S. patent has issued on certain of the markers, and another US patent applications has been allowed. The issued patent covers a unique gene that is expressed on regenerating mouse pancreas cells. Antibodies to the

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Subsidiary

      On September 26, 1997, we acquired by merger StemCells California, Inc., a California corporation, in exchange for 1,320,691 shares of our common stock and options and warrants for the purchase of 259,296 common shares. StemCells California remains our wholly-owned subsidiary, and the owner or licensee of most of our intellectual property. The members of its Board of Directors are Irving L. Weissman, M.D., David J. Anderson, Ph.D., and Fred H. Gage, Ph.D., who were the founders of StemCells California, as well as John J. Schwartz, Ph.D. and Martin McGlynn. Drs. Weissman and Schwartz and Mr. McGlynn are also members of the Board of the parent company; Mr. McGlynn is President of StemCells California as well as President and CEO of StemCells, Inc. References in this annual report to “the Company,” “we,” “us,” and similar words include this subsidiary.

License Agreements

      We have entered into a number of research-plus-license agreements with academic organizations including The Scripps Research Institute (Scripps), the California Institute of Technology (Cal Tech), and the Oregon Health Sciences University (OHSU), the University of Texas Medical Branch (UTMB), and the University of California — Irvine (UC-I). The research components of the UTMB and UC-I agreements are in progress, but those with the other institutions mentioned have been concluded and have resulted in a number of license agreements for resultant technology. Under the license agreements, we are typically subject to obligations of due diligence and the requirement to pay royalties on products that use patented technology licensed under such agreements. The license agreements with these institutions relate largely to stem or progenitor cells and or to processes and methods for the isolation, identification, expansion or culturing of stem or progenitor cells. Generally speaking, these license agreements will terminate upon expiration, revocation or invalidation of the patents licensed to us, unless governmental regulations require a shorter term. They also will terminate earlier if we breach our obligations under the agreement and do not cure the breach, or if we declare bankruptcy, and we can terminate the license agreements at any time upon notice.

      In the case of Scripps, we must pay $50,000 upon the initiation of the Phase II trial for our first product using Scripps licensed technology, and upon completion of that Phase II trial we must pay Scripps an additional $125,000. Upon approval of the first product for sale in the market, we must pay Scripps $250,000.

      Pursuant to the terms of our license agreement with Cal Tech and our acquisition of our wholly owned subsidiary, StemCells California, we issued 14,513 shares of our common stock to Cal Tech. We issued an additional 12,800 shares of common stock to Cal Tech with a market value of approximately $40,000 in May 2000, upon execution of an amendment adding four families of patent applications to the license agreement. We must pay an additional $10,000 upon the issuance of the patent licensed to us under the relevant agreement and $5,000 on the first anniversary of the issuance of the patent licensed to us under the relevant agreement. These amounts are creditable against royalties we must pay under the license agreements. The maximum royalties that we will have to pay to the California Institute of Technology will be $2 million per year, with an overall maximum of $15 million. Once we pay the $15 million maximum royalty, the licenses will become fully paid and irrevocable. In August 2002 we acquired an additional license from Cal Tech to different technology, pursuant to which we issued 27,535 shares of our common stock with a market value of approximately $35,000.

      Pursuant to the terms of the license agreement with OHSU and our acquisition of StemCells California, we issued 4,838 shares of our common stock and an option to purchase up to 62,888 additional shares to OHSU with an exercise price of $.01 per share. The option has vested as to 9,675 shares for which shares were issued on March 31, 2002; the remaining option was terminated and we issued 4,000 shares of our common stock, with a market value of approximately $3,900, to OHSU in January 2003, pursuant to an amendment to the license agreement.

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      In 2002, we issued a license to BioWhittaker, Inc., for the exclusive right to make, sell and distribute one of our proprietary cells for the research market only. In 2003, we issued a non-exclusive license to StemCell Technologies, Inc., a Canadian corporation, to make, use and sell certain proprietary mouse and rat neural stem cells and culture media for all mammalian neural stem cells, also for the research market. These licenses are not expected to generate material revenues.

      In December 1997, we entered into two license agreements with Signal Pharmaceuticals (Signal), Inc. under which each party licensed to the other certain patent rights and biological materials for use in defined fields. Signal has now been acquired by Celgene. Each agreement with Signal will terminate at the expiration of all patents licensed under it, but the licensing party can terminate earlier if the other party breaches its obligations under the agreement or declares bankruptcy. Also, the party receiving the license can terminate the agreement at any time upon notice to the other party. Under these agreements, we must reimburse Signal for payments it must make to the University of California based on products we develop and for 50% of certain other payments Signal must make.

      In March 1994, we entered into a Contract Research and License Agreement with NeuroSpheres, Ltd., which was clarified in a License Agreement dated as of April 1, 1997. Under the agreement as clarified, we obtained an exclusive patent license from NeuroSpheres in the field of transplantation, subject to a limited right of NeuroSpheres to purchase a nonexclusive license from us, which right was not exercised and has expired. We have developed additional intellectual property relating to the subject matter of the license. We entered into an additional license agreement with NeuroSpheres as of October 30, 2000, under which we obtained an exclusive license in the field of non-transplant uses, such as drug discovery and drug testing. Together, our rights under the licenses are exclusive for all uses of the technology. We made up-front payments to NeuroSpheres of 65,000 shares of our common stock in October 2000 and $50,000 in January 2001, and we will make additional cash payments when milestones are achieved in the non-transplant field, or in any products employing NeuroSpheres patents for generating cells of the blood and immune system from neural stem cells. In addition, in October 2000 we reimbursed Neurospheres for patent costs amounting to $341,000. Milestone payments, payable at various stages in the development of potential products, would total $500,000 for each product that is approved for market. The first milestone for a potential product is $50,000, due when the product candidate enters pre-clinical development in a non-rodent model. We expect to reach this milestone in 2004 with respect to a potential treatment for Batten’s disease. In addition, we will make annual payments of $50,000 a year to NeuroSpheres beginning in 2004; the annual payments are due by the last day of the year and are fully creditable against royalties due to NeuroSpheres. Our agreements with NeuroSpheres will terminate at the expiration of all patents licensed to us, but can terminate earlier if we breach our obligations under the agreement and do not cure the breach, or if we declare bankruptcy. We have a security interest in the licensed technology.

Manufacturing

      We believe that our facility in Palo Alto has the capacity to be used for manufacture of cells under FDA-determined clinical Good Manufacturing Practices conditions in quantities sufficient for clinical trials, and we have developed a robust and replicable process for producing and processing the cells. We are at the pre-clinical stage of our stem and progenitor cell programs, and are keeping all options open about the means by which potential future cell products will be manufactured.

Marketing

      Because of the early stage of our stem and progenitor cell programs, we have not yet addressed questions of channels of distribution and marketing of potential future products.

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Patents, Proprietary Rights And Licenses

      We believe that proprietary protection of our inventions will be critical to our future business. We vigorously seek out intellectual property that we believe might be useful in connection with our products, and have an aggressive program of protecting our intellectual property. We believe that our know-how will also provide a significant competitive advantage, and we intend to continue to develop and protect our proprietary know-how. We may also from time to time seek to acquire licenses to important externally developed technologies.

      We have exclusive or non-exclusive rights to a portfolio of patents and patent applications related to various stem and progenitor cells and methods of deriving and using them. These patents and patent applications relate to compositions of matter, methods of obtaining such cells, and methods for preparing, transplanting and utilizing such cells. Currently, our U.S. patent portfolio includes thirty-nine issued U.S. patents, four of which issued in 2003. Approximately forty additional patent applications are pending, two of which have been allowed. In addition, we have foreign counterparts to many of the U.S. applications and patents; the counterparts to eleven of our U.S. patents or applications have issued in various countries, making a total of ninety-five individual non-U.S. patents from those eleven cases. One party has recently opposed two of our issued European patent cases. While we are confident that we will overcome the opposition, there is no guarantee that we will prevail. If we are unsuccessful in our defense of the opposed patents, all claimed rights in the opposed patents will be lost in Europe. U.S. counterparts to these patents are part of our issued patent portfolio; they are not subject to opposition, since that procedure does not exist under U.S. patent law, although other types of proceedings may be available to third parties to contest our U.S. patents.

      In December 1998, the US Patent and Trademark Office granted Patent No. 5,851,832, covering our methods for the human CNS cell cultures containing central nervous system stem cells, for compositions of human CNS cells expanded by these methods, and for use of these cultures in human transplantation. These human CNS stem and progenitor cells expanded in culture may be useful for repairing or replacing damaged central nervous system tissue, including the brain and the spinal cord. U.S. Patent No. 5,968,829, entitled “Human CNS Neural Stem Cells,” which covers our composition of matter for human CNS stem cells, was granted in 1999, and U.S. Patent No. 6,103,530, covering our media for culturing human CNS stem cells, was granted in 2000.

      In 2002, the U.S. Patent Office issued a key strategic patent to us: U.S. Patent Number 6,468,794, entitled “Enriched central nervous system stem cell and progenitor cell populations, and methods for identifying, isolating and enriching for such populations.” The patent issued on October 22, 2002 and covers the identification and purification of the human CNS stem cell. In 2001, we were granted U.S. Patent No. 6,238,922 (“Use of collagenase in the preparation of neural stem cell cultures”) which described methods to advance the in vivo culture and passage of human CNS stem cells that result in a 100-fold increase in CNS stem and progenitor cell production after 6 passages. We believe the methodologies of these two patents together will augment our leadership position in the stem cell field by providing a reproducible proprietary method for obtaining and expanding stem cells for therapeutic uses.

      Another significant patent in the neural field, of which we are the exclusive licensees, was also issued in 2002, and, we believe, may prove even more important: We believe that U.S. Patent Number 6,497,872, entitled “Neural transplantation using proliferated multipotent neural stem cells and their progeny,” covers transplanting any neural stem cells or their differentiated progeny, whether the cells have been cultured in suspension or as adherent cells, for the treatment of any disease. The patent gives us the right to exclude others from practicing the claimed invention.

      In 2003, two neurogenin-related patents were issued (U.S. Patents Numbers 6,555,337 and 6,566,496) as well as U.S. Patent Number 6,638,501, covering the use of multipotent neural stem cell progeny to augment non-neural tissues and U.S. Patent Number 6,541,251, covering a novel pancreatic progenitor gene and its uses.

      These new patents, together with U.S. Patent Number 6,294,346 (“Use of multipotent neural stem cells and their progeny for the screening of drugs and other biological agents”), which issued September 25, 2001,

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      The following table lists our issued U.S. patents and published international patent applications:

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      We also rely upon trade-secret protection for our confidential and proprietary information and take active measures to control access to that information.

      Our policy is to require our employees, consultants and significant scientific collaborators and sponsored researchers to execute confidentiality agreements upon the commencement of an employment or consulting relationship with us. These agreements generally provide that all confidential information developed or made known to the individual by us during the course of the individual’s relationship with us is to be kept confidential and not disclosed to third parties except in specific circumstances. In the case of employees and consultants, the agreements generally provide that all inventions conceived by the individual in the course of rendering services to us shall be our exclusive property.

      We have obtained rights from universities and research institutions to technologies, processes and compounds that we believe may be important to the development of our products. These agreements typically require us to pay license fees, meet certain diligence obligations and, upon commercial introduction of certain products, pay royalties. These include exclusive license agreements with NeuroSpheres, The Scripps Institute, the California Institute of Technology and the Oregon Health Sciences University, to certain patents and

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      The patent positions of pharmaceutical and biotechnology companies, including ours, are uncertain and involve complex and evolving legal and factual questions The coverage sought in a patent application can be denied or significantly reduced before or after the patent is issued. Consequently, we do not know whether any of our pending applications will result in the issuance of patents, or if any existing or future patents will provide significant protection or commercial advantage or will be circumvented by others. Since patent applications are secret until the applications are published (usually eighteen months after the earliest effective filing date), and since publication of discoveries in the scientific or patent literature often lags behind actual discoveries, we cannot be certain that we were the first to make the inventions covered by each of our pending patent applications or that we were the first to file patent applications for such inventions. There can be no assurance that patents will issue from our pending or future patent applications or, if issued, that such patents will be of commercial benefit to us, afford us adequate protection from competing products, or not be challenged or declared invalid.

      In the event that a third party has also filed a patent application relating to inventions claimed in our patent applications, we may have to participate in interference proceedings declared by the United States Patent and Trademark Office to determine priority of invention, which could result in substantial uncertainties and cost for us, even if the eventual outcome is favorable to us. There can be no assurance that our patents, if issued, would be held valid by a court of competent jurisdiction.

      One party has recently opposed two of our issued European patents. While we are confident that we will overcome the opposition, there is no guarantee that we will prevail. If we are unsuccessful in our defense of the opposed patents, all claimed rights in the opposed patents will be lost in Europe. U.S. counterparts to these patents are part of our issued patent portfolio; they are not subject to opposition, since that procedure does not exist under U.S. patent law, although other types of proceedings may be available to third parties to contest our U.S. patents.

      A number of pharmaceutical, biotechnology and other companies, universities and research institutions have filed patent applications or have been issued patents relating to cell therapy, stem cells and other technologies potentially relevant to or required by our expected products. We cannot predict which, if any, of such applications will issue as patents or the claims that might be allowed. We are aware that a number of companies have filed applications relating to stem cells. We are also aware of a number of patent applications and patents claiming use of genetically modified cells to treat disease, disorder or injury. We are aware of two patents issued to a competitor claiming certain methods for treating defective, diseased or damaged cells in the mammalian CNS by grafting genetically modified donor cells from the same mammalian species.

      If third party patents or patent applications contain claims infringed by our technology and such claims or claims in issued patents are ultimately determined to be valid, there can be no assurance that we would be able to obtain licenses to these patents at a reasonable cost, if at all, or be able to develop or obtain alternative technology. If we are unable to obtain such licenses at a reasonable cost, we may not be able to develop certain products commercially. There can be no assurance that we will not be obliged to defend ourselves in court against allegations of infringement of third party patents. Patent litigation is very expensive and could consume substantial resources and create significant uncertainties. An adverse outcome in such a suit could subject us to significant liabilities to third parties, require disputed rights to be licensed from third parties, or require us to cease using such technology.

Competition

      The targeted disease states for our initial products in some instances currently have no effective long-term therapies. However, we do expect that our initial products will have to compete with a variety of therapeutic products and procedures. Major pharmaceutical companies currently offer a number of pharmaceutical

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      Competition for any stem and progenitor cell products that we may develop may be in the form of existing and new drugs, other forms of cell transplantation, ablative and simulative procedures, and gene therapy. We believe that some of our competitors are also trying to develop stem and progenitor cell-based technologies. We expect that all of these products will compete with our potential stem and progenitor cell products based on efficacy, safety, cost and intellectual property positions.

      We may also face competition from companies that have filed patent applications relating to the use of genetically modified cells to treat disease, disorder or injury. In the event our therapies should require the use of such genetically modified cells, we may be required to seek licenses from these competitors in order to commercialize certain of our proposed products, and such licenses may not be granted.

      If we develop products that receive regulatory approval, they would then have to compete for market acceptance and market share. For certain of our potential products, an important success factor will be the timing of market introduction of competitive products. This is a function of the relative speed with which we and our competitors can develop products, complete the clinical testing and approval processes, and supply commercial quantities of a product to market. These competitive products may also impact the timing of clinical testing and approval processes by limiting the number of clinical investigators and patients available to test our potential products.

      While we believe that the primary competitive factors will be product efficacy, safety, and the timing and scope of regulatory approvals, other factors include, in certain instances, obtaining marketing exclusivity under the Orphan Drug Act, availability of supply, marketing and sales capability, reimbursement coverage, price, and patent and technology position.

Government Regulation

      Our research and development activities and the future manufacturing and marketing of our potential products are, and will continue to be, subject to regulation for safety and efficacy by numerous governmental authorities in the United States and other countries.

      In the United States, pharmaceuticals, biologicals and medical devices are subject to rigorous Food and Drug Administration, or FDA, regulation. The Federal Food, Drug and Cosmetic Act, as amended, and the Public Health Service Act, as amended, the regulations promulgated thereunder, and other Federal and state statutes and regulations govern, among other things, the testing, manufacture, safety, efficacy, labeling, storage, export, record keeping, approval, marketing, advertising and promotion of our potential products. Product development and approval within this regulatory framework takes a number of years and involves significant uncertainty combined with the expenditure of substantial resources. In addition, the federal, state, and other jurisdictions have restrictions on the use of fetal tissue.

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      The steps required before our potential products may be marketed in the United States include:

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      After FDA approval for the product, the manufacturing and the initial indications, further clinical trials may be required to gain approval for the use of the product for additional indications. The FDA may also require unusual or restrictive post-marketing testing and surveillance to monitor for adverse effects, which could involve significant expense, or may elect to grant only conditional approvals.

      Among the conditions for product licensure is the requirement that the prospective manufacturer’s quality control and manufacturing procedures conform to the FDA’s current good manufacturing practice (cGMP) requirement. Even after product licensure approval, the manufacturer must comply with cGMP on a continuing basis, and what constitutes cGMP may change as the state of the art of manufacturing changes. Domestic manufacturing facilities are subject to regular FDA inspections for cGMP compliance, which are normally held at least every two years. Foreign manufacturing facilities are subject to periodic FDA inspections or inspections by the foreign regulatory authorities with reciprocal inspection agreements with the FDA. Domestic manufacturing facilities may also be subject to inspection by foreign authorities.

      The Orphan Drug Act provides incentives to drug manufacturers to develop and manufacture drugs for the treatment of diseases or conditions that affect fewer than 200,000 individuals in the United States. Orphan drug status can also be sought for treatments for diseases or conditions that affect more than 200,000 individuals in the United States if the sponsor does not realistically anticipate its product becoming profitable

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      Our research and development is based on the use of human stem and progenitor cells. The FDA has published a “Proposed Approach to Regulation of Cellular and Tissue-Based Products” which relates to the use of human cells. As part of this approach, the FDA has published final rules for registration of establishments that engage in the recovery, screening, testing, processing, storage or distribution of human cells, tissues, and cellular and tissue-based products, and for the listing of such products. These products specifically include hematopoietic stem cells (stem cells that are progenitors of blood cells); however, the FDA makes no explicit statement regarding the inclusion of other types of stem cells. In addition, the FDA has published proposed rules for making suitability determinations for donors of cells and tissue and for current good tissue practice for manufacturers using them. We cannot now determine the full effects of this regulatory initiative, including precisely how it may affect the clarity of regulatory obligations and the extent of regulatory burdens associated with pluripotent stem cell research (for stem cells that give rise to various tissue types, including blood), and the manufacture and marketing of stem cell products.

      In addition to safety regulations enforced by the FDA, we are also subject to regulations under the Occupational Safety and Health Act, the Environmental Protection Act, the Toxic Substances Control Act and other present and potential future foreign, Federal, state and local regulations.

      Outside the United States, we will be subject to regulations that govern the import of drug products from the United States or other manufacturing sites and foreign regulatory requirements governing human clinical trials and marketing approval for our products. The requirements governing the conduct of clinical trials, product licensing, pricing and reimbursements vary widely from country to country. In particular, the European Union, or EU, is revising its regulatory approach to high tech products, and representatives from the United States, Japan and the EU are in the process of harmonizing and making more uniform the regulations for the registration of pharmaceutical products in these three markets.

Reimbursement and Health Care Cost Control

      Reimbursement for the costs of treatments and products such as ours from government health administration authorities, private health insurers and others both in the United States and abroad is a key element in the success of new health care products. Significant uncertainty often exists as to the reimbursement status of newly approved health care products.

      The revenues and profitability of some health care-related companies have been affected by the continuing efforts of governmental and third party payers to contain or reduce the cost of health care through various means. Payers are increasingly attempting to limit both coverage and the level of reimbursement for new therapeutic products approved for marketing by the FDA, and are refusing, in some cases, to provide any coverage for uses of approved products for disease indications for which the FDA has not granted marketing approval. For example, in certain foreign markets, pricing or profitability of prescription pharmaceuticals is subject to government control. In the United States, there have been a number of Federal and state proposals to implement government control over health care costs.

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Employees

      As of December 31, 2003, we had twenty-seven full-time employees, of whom nine have Ph.D. degrees. Twenty-one full-time employees work in research and development and laboratory support services. No employees are covered by collective bargaining agreements.

Scientific Advisory Board

      Members of our Scientific Advisory Board provide us with strategic guidance in regard to our research and product development programs, as well as assistance in recruiting employees and collaborators. Each Scientific Advisory Board member has entered into a consulting agreement with us. These consulting agreements specify the compensation to be paid to the consultant and require that all information about our products and technology be kept confidential. All of the Scientific Advisory Board members are employed by employers other than us and may have commitments to or consulting or advising agreements with other entities that limit their availability to us. The Scientific Advisory Board members have generally agreed, however, for so long as they serve as consultants to us, not to provide any services to any other entities that would conflict with the services the member provides to us. We are entitled to terminate the arrangement if we determine that there is such a conflict. Members of the Scientific Advisory Board offer consultation on specific issues encountered by us as well as general advice on the directions of appropriate scientific inquiry for us. In addition, Scientific Advisory Board members assist us in assessing the appropriateness of moving our projects to more advanced stages. The following persons are members of our Scientific Advisory Board:

	— Irving L. Weissman, M.D., is the Karel and Avice Beekhuis Professor of Cancer Biology, Professor of Pathology and Professor of Developmental Biology at Stanford University, Stanford California, and Director of the Stanford University Institute for Cancer/Stem Cell Biology and Medicine. Dr. Weissman’s lab was responsible for the discovery of the first ever mammalian stem cell, the hematopoietic (blood-forming) stem cell. Dr. Weissman was responsible for the formation of three stem cell companies, SyStemix, Inc., StemCells, Inc., and Cellerant, Inc. He is a member of the Board of Directors and Chairman of the Scientific Advisory Boards of StemCells and Cellerant. Dr. Weissman co-discovered the mammalian and human hematopoietic stem cells and the human neural stem cell. Past achievements of Dr. Weissman’s laboratory include identification of the states of development between stem cells and mature blood cells and identification of the states of thymic lymphocyte development. More recently, his laboratory at Stanford has developed accurate mouse models of human leukemias, and has shown the central role of inhibition of programmed cell death in that process. Dr. Weissman has been elected to the National Academy of Science. He has received the Kaiser Award for Excellence in Preclinical Teaching, the Pasarow Foundation Award, and the Outstanding Investigator Award from the National Institutes of Health.
	— David J. Anderson, Ph.D., is Professor of Biology, California Institute of Technology, Pasadena, California and Investigator, Howard Hughes Medical Institute. His laboratory was the first to isolate a multipotent, self-renewing, stem cell for the peripheral nervous system, the first to identify instructive signals that promote the differentiation of these stem cells along various lineages, and the first to accomplish a direct purification of peripheral neural stem cells from uncultured tissue. Dr. Anderson’s laboratory also was the first to isolate transcription factors that act as master regulators of neuronal fate. More recently, he has identified signals that tell a neural stem cell to differentiate to a glial cell rather than a neuron. Dr. Anderson is a co-founder of StemCells and a member of its SAB. Dr. Anderson also serves on the SAB of Allen Institute for Brain Science. He has held a presidential Young Investigator Award from the National Science Foundation, a Sloan foundation Fellowship in Neuroscience, and has been Donald D. Matson lecturer at Harvard Medical School. He has received the Charles Judson Herrick Award from the American Association of Anatomy, and the 1999 W. Alden Spencer Award in Neurobiology from Columbia University.
	— Fred H. Gage, Ph.D., is Professor, Laboratory of Genetics, The Salk Institute for Biological Studies, La Jolla, California and Adjunct Professor, Department of Neurosciences, University of California, San Diego, California. Dr. Gage’s lab was the first to discover the mammalian central nervous

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system stem cell. His research focus is on the development of strategies to induce recovery of function following central nervous system (CNS) damage. Dr. Gage is a co-founder of StemCells and a member of its SAB. Dr. Gage also serves on the Scientific Advisory Board of Ceregene, Inc. Dr. Gage has been the recipient of numerous awards, including the 1993 Charles A. Dana Award for Pioneering Achievements in Health and Education, the Christopher Reeves Medal, the Decade of the Brain Medal, the Max-Planck research Prize, and the Pasarow Foundation Award. In 2003, Professor Gage was elected to the National Academy of Science.

      Consultants to our SAB include William C. Mobley, M.D., Ph.D., Ben Barres, Ph.D., and Seung Kim, M.D., Ph.D., all of Stanford University.

Available Information

      Our principal executive offices are located at 3155 Porter Drive, Palo Alto, CA 94304, and our main telephone number is (650) 475-3100. Investors can obtain access to this annual report on Form 10-K, our quarterly reports on Form 10-Q, our current reports on Form 8-K and all amendments to these reports, free of charge, on our website at http://www.stemcellsinc.com as soon as reasonably practicable after such filings are electronically filed with the SEC. The public may read and copy any material we file with the SEC at the SEC’s Public Reference Room at 450 Fifth Street, N.W., Washington D.C., 20549. The public may obtain information on the operations of the Public Reference Room by calling the SEC at 1-800-SEC-0330. The SEC maintains an Internet site, http://www.sec.gov, which contains reports, proxy and information statements and other information regarding issuers that file electronically with the SEC.

      We entered into a 5-year lease, as of February 1, 2001, for a 40,000 square foot facility, located in the Stanford Research Park in Palo Alto, California. This facility includes space for animals as well as laboratories, offices, and a Good Manufacturing Practices suite, signifying that the facility can be used to manufacture materials for clinical trials. The facility will better enable us to achieve our goal of utilizing genetically unmodified human stem cells for the treatment of disorders of the nervous system, liver, and pancreas. We have space-sharing agreements for part of the animal facility not needed for our own use, including one with Stanford University.

      We continue to lease the following facilities in Lincoln, Rhode Island obtained in connection with our former encapsulated cell technology: our former research laboratory and corporate headquarters building which contains 62,500 square feet of wet labs, specialty research areas and administrative offices held on a lease agreement that goes through June 2013, as well as a 21,000 square-foot pilot manufacturing facility and a 3,000 square-foot cell processing facility financed by bonds issued by the Rhode Island Industrial Facilities Corporation. We have subleased the 21,000 square-foot facility. We have also subleased approximately one-fourth of the 62,500 square foot facility. We are actively seeking to sublease, assign or sell our remaining interests in these properties.

      None.

      None.

PART II

      The common stock of StemCells is traded on the SmallCap Market System of NASDAQ under the Symbol STEM. Prior to December 23, 2002 our common stock was traded on the NASDAQ National

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      No cash dividends have been declared on the Company common stock since the Company’s inception.

      As of March 17, 2004, there were approximately 451 holders of record of the common stock.

      By agreement with one of the Company’s outside providers of legal services, a part of the fees incurred were paid in authorized, unregistered stock of the Company, issued pursuant to the exemption from registration provided by Section 4(2) of the Securities Act of 1933, as amended. In 2003 we issued 80,940 shares with a fair market value of $125,499 under that agreement. The agreement has been changed to provide that the payments be made in registered stock.

Equity Compensation Plan Information

      The following table provides certain information with respect to all of the Company’s equity compensation plans in effect as of the end of December 31, 2003.

(1)	Consists of Incentive Stock Options issued to employees and options issued as compensation to consultants for consultation services. These options were issued under the Company’s 1992 Equity Incentive Plan, its Directors’ Stock Option Plan, its StemCells, Inc. Stock Option Plan, or its 2001 Equity Incentive Plan.
(2)	Consists of warrants outstanding that are fully vested to purchase:

	—	50,500 shares of our common stock for $5.04 per share, issued in August 2000, and exercisable, in whole or in part, for five years from the date of issuance.
	—	146,199 shares of our common stock that was issued in December 2001 fully vested with an exercise price of $3.42 per share and exercisable, in whole or in part, for four years from the date of issuance.

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	—	200,000 shares of our common stock that was issued in January 2003 fully vested with an exercise price of $1.20 per share and exercisable, in whole or in part, for five years from the date of issuance.

      These warrants, which constitute the equity compensation arrangements not approved by security holders, were all issued in exchange for placement agent or advisory services by non-employees.

      The following selected historical information has been derived from the audited financial statements of the Company. The financial information as of December 2003 and 2002 and for each of the three years in the period ended December 31, 2003 are derived from audited financial statements included elsewhere in this Form 10-K.

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(1)	See footnote 9 in the consolidated financial statements
(2)	See footnote 11 in the consolidated financial statements
(3)	See footnote 1 in the consolidated financial statements

      The following discussion of our financial condition and results of operations should be read in conjunction with the accompanying financial statements and the related footnotes thereto.

      This report contains forward looking statements within the meaning of Section 27A of the Securities Act and Section 21E of the Securities Exchange Act that involve substantial risks and uncertainties. Such statements include, without limitation, all statements as to expectation or belief and statements as to our future results of operations, the progress of our research, product development and clinical programs, the need for, and timing of, additional capital and capital expenditures, partnering prospects, costs of manufacture of products, the protection of and the need for additional intellectual property rights, effects of regulations, the need for additional facilities and potential market opportunities. Our actual results may vary materially from those contained in such forward-looking statements because of risks to which we are subject, such as failure to obtain a corporate partner or partners to support the development of our stem cell programs, our ability to sell, assign or sublease our interest in our facilities related to our encapsulated cell technology program, risks of delays in, or adverse results from, our research, development and clinical testing programs, obsolescence of our technology, lack of available funding, competition from third parties, intellectual property rights of third parties, failure of our collaborators to perform, regulatory constraints, litigation and other risks to which we are subject. See “Cautionary Factors Relevant to Forward-Looking-Information” filed herewith as Exhibit 99 and incorporated herein by reference.

Overview

      Since our inception in 1988, we have been primarily engaged in research and development of human therapeutic products. Since the second half of 1999, our sole focus has been on our stem cell technology.

      We have not derived any revenues from the sale of any products apart from license revenue for the research use of our human neural stem cells and other patented cells and media, and we do not expect to receive revenues from product sales for at least several years. We have not commercialized any product and in order to do so we must, among other things, substantially increase our research and development expenditures as research and product development efforts accelerate and clinical trials are initiated. We anticipate filing our first IND, to evaluate the safety and efficacy of our human neural stem cells as a treatment for Batten’s disease, in the first quarter of 2005. This will require substantial expenditures for toxicology and other studies in preparation for submitting the IND to the FDA. We have incurred annual operating losses since inception and expect to incur substantial operating losses in the future. As a result, we are dependent upon external financing from equity and debt offerings and revenues from collaborative research arrangements with corporate sponsors to finance our operations. There are no such collaborative research arrangements at this time and there can be no assurance that such financing or partnering revenues will be available when needed or on terms acceptable to us.

      In 2001, we entered into two significant financing arrangements: In May, we entered into an equity line enabling us to draw up to $30,000,000 subject to various restrictions, and we did draw down $4,000,000 in July of 2001, $118,000 in December of 2002, $66,000 in January of 2003 and $375,000 in May of 2003. This agreement expired in January 2004. In December of 2001, we issued 3% convertible preferred stock to Riverview Group, L.L.C., (Riverview) a wholly-owned subsidiary of Millennium Partners, for $5,000,000 gross. The preferred stock was convertible into shares of the Company’s stock and a mandatory feature required the Company to redeem unconverted preferred stock on December 4, 2003. By November 11, 2003, all of the 3% convertible preferred stock was converted into the Company’s common stock. (See “Liquidity and Capital Resources” below for further detail on each of these transactions.)

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      In September 2002, in order to conserve cash and to concentrate all our resources on our primary goal of evaluating the potential of using our stem and progenitor cells to treat or even cure some of the world’s most debilitating diseases, we announced that we had initiated a cost reduction program that curtailed expenditures on our discovery research activities in favor of channeling resources into accelerating preclinical development of our proprietary cells for the treatment of neural and liver disease. The initiative, which was implemented during the third quarter of 2002, reduced our workforce and annualized expenses by approximately 25% relative to 2001.

      In May and again in December of 2003, the Company entered significant financing agreements with Riverview. In May, we entered into a stock purchase agreement with Riverview under which Riverview agreed to purchase 4 million shares of the Company’s common stock for $6.5 million, or $1.625 per share. On the date of the agreement, the price was above the trading price of the Company’s common stock, which closed at $1.43 per share on that date. The Company also agreed to issue a 2-year warrant to Riverview to purchase 1,898,000 shares of common stock at $1.50 per share. Riverview exercised its right to purchase 1,098,000 of those shares in November of 2003. In December, the Company completed a $9.5 million financing transaction with Riverview through the sale of 5 million shares of common stock at a price of $1.90 per share. (See “Liquidity and Capital Resources” below for further detail on these transactions.)

      In September of 2003 the Company was awarded a one year, $342,000, Small Business Innovation Research grant from the National Institute of Neurological Disease and Stroke (NINDS), to further its work in the treatment of spinal cord injuries. The grant is to fund a continuing collaborative endeavor between the Company and Drs. Aileen J. Anderson and Brian J. Cummings of the Reeve-Irvine Center at the University of California-Irvine, who earlier this year reported preclinical results using the Company’s human neural stem cell (hCNS-SC). In the same month, the Company also entered a long-term license agreement with StemCell Technologies, Inc., a Canadian corporation, authorizing it to manufacture, use and sell certain proprietary mouse and rat neural stem cells, as well as culture media for all mammalian neural stem cells, for educational and research purposes worldwide.

      Our results of operations have varied significantly from year to year and quarter to quarter and may vary significantly in the future due to the occurrence of material recurring and nonrecurring events, including without limitation the receipt and payment of recurring and nonrecurring licensing payments, the initiation or termination of research collaborations, the on-going expenses to lease and maintain our facilities in Rhode Island and the increasing costs associated with our facility in California. To expand and provide high quality systems and support to our Research and Development programs, we will need to hire more personnel, which will lead to higher operating expenses. We have already hired a Vice President of Development and contracted with an Acting Chief Medical Officer in preparation for our first clinical trial.

      Our program in neural stem and progenitor cells ranges from the preclinical stage, as we focus increasingly on testing human neural stem cells in small animal models of human diseases, both in-house and through external academic collaborators, through the development phase with respect to the planned clinical trial in Batten’s disease mentioned above. In our liver stem cell program, we are engaged in evaluating our proprietary liver engrafting cell in various in vivo assays. Our pancreas program research is being carried on for the present primarily through a collaborator. It is our intention to pursue the discovery and development of cell therapies useful in the treatment of Diabetes once we have secured a corporate partner.

Critical Accounting Policies

      The Company believes the following critical accounting policies affect its more significant judgments and estimates used in the preparation of its consolidated financial statements:

Use of Estimates

      The preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States of America that requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements. Actual results could differ from these

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Stock-Based Compensation

      As permitted by the provisions of Statement of Financial Accounting Standards (“FAS”) No. 148, “Accounting for Stock-Based Compensation — Transition and Disclosure,” and Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation,” the Company’s employee stock option plan is accounted for under Accounting Principles Board Opinion No. 25 (“APB 25”), “Accounting for Stock Issued to Employees.” The Company grants qualified stock options for a fixed number of shares to employees with an exercise price equal to the fair market value of the shares at the date of grant. In accordance with APB 25, the Company recognizes no compensation expense for qualified stock option grants. The Company also issues non-qualified stock options for a fixed number of shares to employees with an exercise price less than the fair market value of the shares at the date of grant. When such options vest, the Company recognizes the difference between the exercise price and fair market value as compensation expense in accordance with APB 25. Note 11 of the Notes to the Consolidated Financial Statements describes our equity compensation plans, and Note 1 of the Notes to the Consolidated Financial Statements contains a summary of the pro forma effects to reported net (loss) and (loss) per share for 2003, 2002, and 2001 as if we had elected to recognize compensation cost based on the fair value of the options granted at grant date, as prescribed by FAS No. 123.

      For certain stock options granted to non-employees, the Company accounts for these grants in accordance with FAS No. 123 and Emerging Issues Task Force (“EITF”) 96-18 — accounting for equity instruments that are issued to other than employees for acquiring, or in conjunction with selling, goods or services, and accordingly, recognizes as expense the estimated fair value of such options as calculated using the Black-Scholes valuation model, and is remeasured during the service period. Fair value is determined using methodologies allowable by FAS No. 123. The cost is amortized over the vesting period of each option or the recipient’s contractual arrangement, if shorter.

Long-Lived Assets

      The Company adopted FAS No. 144, “Accounting for the Impairment or Disposal of Long-lived Assets,” at the beginning of 2002. As permitted by the transition rules of FAS No. 144, long-lived assets classified as held for sale as a result of activities that were initiated prior to this Statement’s initial application shall continue to be accounted for in accordance with FAS No. 121. If however, the criteria for classifying long-lived assets held for sale under FAS No. 144 are not met by the end of the fiscal year in which this Statement is initially applied, the related long-lived assets shall be reclassified as held and used. At December 31, 2002, the criteria under FAS No. 144 for classifying the Company’s long-lived assets held for sale were not met and accordingly, such assets were reclassified as held and used on the balance sheet.

      The Company routinely evaluates the carrying value of its long-lived assets. The Company records impairment losses on long-lived assets used in operations when events and circumstances indicate that assets may be impaired and the undiscounted cash flows estimated to be generated by the assets are less than the carrying amount of those assets. If an impairment exists, the charge to operations is measured as the excess of the carrying amount over the fair value of the assets.

Research and Development Costs

      The Company expenses all research and development costs as incurred. Research and Development costs include costs of personnel, external services, supplies, facilities and miscellaneous other costs.

Wind-down and Exit Costs

      In connection with the Company’s wind-down of its ECT operations, its research and manufacturing operations in Lincoln, Rhode Island, and the relocation of its remaining research and development activities and corporate headquarters, to California, in October 1999, the Company has provided a reserve for its

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      Effective with the adoption in 2003 of FAS NO. 146, “Accounting for Costs Associated with Exit or Disposal Activities,” issued in June 2002, the Company will account for future restructuring and exit costs in accordance with FAS No. 146.

Results of Operations

      Revenues totaled $273,000, $415,000, and $805,000 for the years ending December 31, 2003, 2002 and 2001, respectively. Revenues for 2003 include $143,000, which is part of the $342,000 Small Business Innovation Research Grant from the National Institute of Neurological Disease and Stroke, and $112,000 from the grant awarded by the National Institute of Diabetes & Digestive & Kidney Disorders (NIDDKD) of the National Institutes of Health. The Company does not intend to draw further funds from the NIDDKD grant since it will no longer pursue the particular research that the grant covered. addition, revenues for 2003 include $18,000 in licensing revenue. 2002 include $150,000 that is a part of the grant awarded by the National Institutes of Health’s Small Business Innovation Research (SBIR) office, $225,000 from the NIDDKD grant, and $40,000 in licensing revenue. Revenues for Revenues for In 2001 include $505,000 for grants received from the National Institute of Health’s Small Business Innovation Research (SBIR) office for research relating to our Neural & Liver stem cell programs, and $300,000 from the assignment to Modex Therapeutics, Ltd., of our retained rights to a portion of certain possible future revenues arising out of our sale of our former Encapsulated Cell Technology (ECT) to Neurotech, S.A. The decrease in revenue from 2001 to 2002 was primarily due to the one time receipt of $300,000 from the assignment of rights to Modex Therapeutics, Ltd., and a decrease in grant revenue from $505,000 in 2001 to $375,000 in 2002. The decrease in revenue from 2002 to 2003 was primarily due to the completion of the $150,000 SBIR grant in 2002, and to the only partial draw down in 2003 from the $225,000 NIDDKD grant.

      Research and development expenses totaled $6,144,000 in 2003, as compared to $7,382,000 in 2002 and $8,603,000 in 2001. The decrease of 17% or $1,238,000 in 2003, was primarily attributable to the cost reduction program initiated in the last quarter of 2002 which resulted in a reduction in personnel and related expenses, reduction in expenditure on supplies and outside services, and a reduction in rent expense as a result of an amendment to the lease on our current facilities in California. This decrease in expenses in 2003 relative to 2002 was offset by the effect of a lower valuation in 2002 of stock options granted as compensation to non-employees as compared to the valuation in 2003. The valuation — computed by the Black Scholes Method — is dependant on variable factors at the time of valuation such as stock price, stock price volatility, interest rate and remaining life of the option. The decrease of $1,221,000, or 14%, from 2001 to 2002 was primarily attributable to the effect of the lower valuation of stock options on non-employee compensation in 2002 as compared to 2001.

      General and administrative expenses were $3,391,000 in 2003, compared with $3,359,000 in 2002 and $3,788,000 in 2001. The increase of $32,000 or 1%, from 2002 to 2003 was primarily attributable to the depreciation expense of our Rhode Island facility (Pilot plant building related to our former ECT research). No depreciation expense was recorded in 2002, as the assets were classified as held for sale. At December 31, 2002, the criteria under FAS No. 144 for classifying the Company’s long-lived assets held for sale were not met and accordingly, such assets with a fair value of $3,203,491 at December 31, 2002 were reclassified as held and used on the balance sheet for all periods presented and are included in building and improvements. We resumed depreciating these assets effective January 2003. This increase in expense relative to 2002 was offset by a decrease in other expenses such as external services, facilities, information technology related expenses, all of which resulted from a cost reduction program initiated in the last quarter of 2002. The

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      In 1999 in connection with exiting our former corporate headquarters and ECT facilities we created a reserve for the estimated lease payments and operating expenses of the Rhode Island facilities through June 30, 2000, when we expected to fully sublease, assign or sell our remaining interests in the property. We did not fully sublet the Rhode Island facilities as expected and therefore made a change in estimate in June 2000 to accrue additional expenses of $3,327,000 to cover operating lease payments, utilities, taxes, insurance, maintenance, interest and other non-employee expenses through 2001. At December 31, 2001 the $3,327,000 reserve was exhausted and we recorded an additional reserve of $575,000. This reserve was based on information provided by our broker/realtor that estimated, based on assumptions relevant to the real estate market conditions as of the end of 2001, the time it would be likely to take until the facility would be fully sub-leased. In 2002, we incurred $964,000 in lease payments and operating expenses, net of subtenant income for this facility, of which $575,000 was booked against the reserve created at the end of 2001 and the remainder recorded as wind-down expenses. At the end of December 2002, based on an analysis of the real estate market conditions at that time, we revised the reserve to $775,000. In 2003 we incurred $984,000 in lease payments and operating expenses, net of subtenant income for this facility of which $775,000 was recorded against the reserve and the remainder recorded as wind-down expenses. After considering various factors such as the Company’s experience in subleasing the facility since exiting the facility in 1999, our lease payments through to the end of the lease, facility operating expenses, the current real estate market in Rhode Island, and estimated subtenant income based on occupancy both actual and projected occupancy the Company revised the reserve at December 31, 2003 to $2,676,000. Even though it is the intent of the Company to sublease, assign or sell our interests in the facility at the earliest possible time, we cannot determine with certainty a fixed date by which such events will occur. In light of this uncertainty, based on estimates, we will periodically re-evaluate and adjust the reserve, as necessary.

      Interest income for the years ended December 31, 2003, 2002 and 2001 totaled $39,000, $109,000 and $201,000, respectively. The decrease in interest income from 2001 to 2003 was attributable to the lower interest rate on overnight and money market funds and a lower average bank balance.

      In 2003, interest expense was $207,000, compared to $227,000 in 2002 and $246,000 in 2001. Interest expense for year 2001 was charged against the wind-down reserve, as the expense was part of the bond payments related to the Rhode Island facilities. The decrease from 2001 to 2003 was attributable to lower outstanding debt and capital lease balances.

      Gain on sale of short-term investments in 2001 relates to the sale of Modex Therapeutics Ltd. (“Modex”) shares. On January 9, 2001, we sold 22,616 Modex shares for a net price of 182.00 Swiss francs per share, which converted to $112.76 per share, for total proceeds and a realized gain of $2,550,000. On April 30, 2001, we sold our remaining shares in Modex for a net price of 87.30 Swiss Francs per share, which converted to approximately $50.51, for total proceeds and a realized gain of $5,232,000, net of commissions and fees. After the April 2001 sale, we no longer hold any shares of Modex.

Deemed Dividends Related to Convertible Preferred Stock

      We recorded deemed dividends of $2,066,000, $1,280,000 and $1,546,000 for 2003, 2002 and 2001 respectively. The dividends are related to the 3% Cumulative Convertible Preferred Stock (see note 11 to the consolidated financial statements) which includes the accretion of common stock warrants, the accretion of the beneficial conversion feature and the accretion of related issuance costs. The aggregate accretion value associated with the warrants, beneficial conversion feature and issuance costs were included in the calculation of net loss applicable to common stockholders.

      In 2000 we recorded an initial deemed dividend aggregating $481,000 related to the 6% Cumulative Convertible Preferred Stock (see note 11 to the consolidated financial statements). The dividend reflects the value of warrants issued and the beneficial conversion feature.

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      In 2001, we recorded an additional deemed dividend of $802,000 for the beneficial conversion feature of the 6% Cumulative Convertible Preferred Stock which resulted from the subsequent change to the effective conversion price of those shares due to the issuance in 2001 of adjustable warrants in connection with the common stock financing transaction with Millennium Partners, LP. (See Note 11 to the consolidated financial statements).

      There is no longer any preferred stock outstanding as of December 31, 2003 as all of the Company’s previously outstanding 3% and 6% cumulative convertible preferred stock was converted to the Company’s common stock prior to the end of 2003.

Liquidity and Capital Resources

      Since our inception, we have financed our operations through the sale of common and preferred stock, the issuance of long-term debt and capitalized lease obligations, revenues from collaborative agreements, research grants and interest income.

      We had cash and cash equivalents totaling $13,082,000 at December 31, 2003. Cash equivalents are invested in US Treasuries with maturities of less than 90 days. We used $8.6 million, $10.1 million, and $10.5 million of cash, in 2003, 2002 and 2001 respectively, in our operating activities. The decrease in cash used in operating activities from 2001 to 2003 was primarily due to a cost reduction program initiated in the last quarter of 2002 which included a reduction in head count and other operating expenses. In addition, we negotiated an amendment in our rent obligations under the lease on our current facilities in California which reduced our average annual rent over the remaining term of the lease from approximately $3.7 million to $2.0 million.

      Our liquidity and capital resources were, in the past, significantly affected by our relationships with corporate partners, which were related to our former ECT. These relationships are now terminated, and we have not yet established corporate partnerships with respect to our stem cell technology. Our liquidity and capital resources have, in the past, also been affected by our holdings of Modex, all of which holdings have now been sold, resulting in proceeds to us of $7,782,000 in 2001.

      On December 10, 2003 the Company completed a $9.5 million financing transaction with Riverview Group L.L.C. (Riverview), through the sale of 5 million shares of common stock at a price of $1.90 per share. The closing price of the Company’s common stock on that date was $2.00 per share.

      On May 7, 2003, the Company entered into a stock purchase agreement with Riverview under which it agreed to purchase 4 million shares of the Company’s common stock for $6.5 million, or $1.625 per share. On the date of the agreement, the sale price was above the trading price of the Company’s common stock, which closed at $1.43 per share on that date. The Company also agreed to issue a 2-year warrant to Riverview to purchase 1,898,000 shares of common stock at $1.50 per share. The exercise price is subject to adjustment for stock splits, dividends, distributions, reclassifications and similar events. In the event that certain conditions are met, including the closing sale price of the Common Stock remaining at or above $2.50 per share for 10 consecutive trading days, the Company may require Riverview to exercise the warrant for any remaining shares or to relinquish any unexercised portion. On November 11, 2003, Riverview exercised part of the warrant acquiring 1,098,000 shares at $1.50 per share. The proceeds to the Company from this warrant exercise totaled $1,647,000. The warrant is exercisable for the remaining 800,000 shares until April 8, 2005, subject to our right to require exercise or forfeiture as described above.

      On August 23, 2002, we entered into an agreement with Triton West Group, Inc. (Triton) pursuant to which we sold 1,028,038 shares of common stock to Triton for aggregate proceeds of $1,100,000, or approximately $1.07 per share.

      On December 4, 2001, we issued 5,000 shares of 3% cumulative convertible preferred stock to Riverview. We received total proceeds of $4,728,000 net of the fee to Cantor Fitzgerald and other associated costs. This preferred stock is convertible into shares of our common stock at a current conversion price of $2.00 per share of common stock. There was a mandatory redemption provision in the preferred stock under which any preferred stock remaining on December 4, 2003, was to be redeemed on that date. In connection with the

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      On May 10, 2001, we entered into a common stock purchase agreement with Sativum Investments Limited for the potential future issuance and sale of up to $30,000,000 of our common stock, subject to restrictions and other obligations. The agreement expired in January 2004. We had the right to draw down on this facility, sometimes termed an equity line, from time to time, and Sativum was obligated to purchase shares of our common stock at a 6% discount to a volume weighted average market price over the 20 trading days following the draw-down notice. We were limited with respect to how often we could exercise a draw down and the amount of each draw down. The Company did draw down $4,000,000 by issuance of 707,947 shares in July of 2001, $118,000 by issuance of 107,812 shares in December of 2002, $66,000 by issuance of 58,516 shares in January of 2003, and $375,000 by issuance of 245,472 shares in May of 2003, before applicable fees. In connection with our execution of the common stock purchase agreement with Sativum, we issued three-year warrants to purchase an aggregate of 350,000 shares of our common stock at $2.38 per share to Sativum (250,000 shares) and our placement agents (Pacific Crest Securities Inc., 75,000 shares and Granite Financial Group, Inc., 25,000 shares). Our placement agents exercised their warrants in full in July 2001, and we received payment of $238,050 for the shares issued to them.

      On August 3, 2000, we completed a $4 million common stock financing transaction with Millennium Partners, LP at $4.33 per share. In the purchase agreement, we granted Millennium an option to purchase up to an additional $3 million of our common stock. Millennium exercised its option to purchase $1 million of our common stock on August 23, 2000 at $5.53 per share. On June 8, 2001, Millennium exercised its remaining option to purchase $2 million of our common stock at $4.3692 per share. As a result of the financing agreement, Millennium received five year warrants to purchase 101,587 shares of common stock at $4.725 per share, 19,900 shares of common stock at $6.03 per share, and 50,352 shares at $4.7664 per share. We may call the warrants at any time at $7.875, $10.05 and $7.944 per underlying share respectively. In addition to the afore-mentioned warrants, Millennium was issued adjustable warrants in connection with the original $4 million purchase, each of which entitled Millennium to receive additional shares on eight dates beginning six months from the respective closing dates and every three months thereafter. The exercisable price per share under the adjustable warrant was $0.01. Millennium exercised the first of the adjustable warrants to purchase 463,369 shares on March 30, 2001, 622,469 shares on July 26, 2001 and 25,804 shares on August 15, 2001, at $0.01 per share. On December 4, 2001, simultaneously with the issuance of 3% cumulative convertible preferred stock to Riverview, we entered into an agreement with Millennium under which we issued 176,101 shares of our common stock as a final cashless exercise of all outstanding adjustable warrants that Millennium was entitled to or would be entitled to. Immediately following delivery of these shares, any further right to acquire common stock under these adjustable warrants were cancelled by the agreement. Riverview is an affiliate of Millennium.

      We continue to have outstanding obligations in regard to our former facilities in Lincoln, Rhode Island. In 1997, we had entered into a fifteen-year lease for a scientific and administrative facility (the “SAF”) in a sale and leaseback arrangement. The lease includes escalating rent payments. For the year 2004, we expect to pay $938,000 as an operating lease payment and in addition, based on our 2003 expenses, approximately

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      The following table summarizes our future contractual cash obligations (including both Rhode Island and California leases, but excluding interest income and sub-lease income with respect to the Rhode Island properties):

      We have incurred significant operating losses and negative cash flows since inception. We have not achieved profitability and may not be able to realize sufficient revenues to achieve or sustain profitability in the future. Although we have taken actions to reduce our expense rates over the last six quarters, we do not expect to be profitable in the next several years, but rather expect to incur additional operating losses. We have limited liquidity and capital resources and must obtain significant additional capital resources in order to sustain our product development efforts, for acquisition of technologies and intellectual property rights, for preclinical and clinical testing of our anticipated products, pursuit of regulatory approvals, acquisition of capital equipment, laboratory and office facilities, establishment of production capabilities, for general and administrative expenses and other working capital requirements. We rely on cash balances and proceeds from equity and debt offerings, proceeds from the transfer or sale of our intellectual property rights, equipment, facilities or investments, and government grants and funding from collaborative arrangements, if obtainable, to fund our operations. If we exhaust our cash balances and are unable to realize adequate financing, we may be unable to meet operating obligations and be required to initiate bankruptcy proceedings.

      We intend to pursue opportunities to obtain additional financing in the future through equity and debt financings, grants and collaborative research arrangements. The source, timing and availability of any future financing will depend principally upon market conditions, interest rates and, more specifically, on our progress in our exploratory, preclinical and future clinical development programs. Funding may not be available when needed at all; or on terms acceptable to us. Our existing capital resources are sufficient to fund our operations through the end of 2004. Lack of necessary funds may require us to delay, scale back or eliminate some or all of our research and product development programs and/or our capital expenditures or to license our potential products or technologies to third parties.

      With the exception of operating leases for facilities, we have not entered into any off balance sheet financial arrangements and have not established any special purpose entities. We have not guaranteed any debts or commitments of other entities or entered into any options on non-financial assets. During 2001, we were party to a space-sharing agreement entered into between us and Celtrans, LLC. (now Cellerant, Inc.).

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Recent Accounting Pronouncements

      In June 2002, the FASB issued SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities. SFAS No. 146 provides guidance related to accounting for costs associated with disposal activities covered by SFAS No. 144 and with one-time termination benefits and other exit or restructuring activities previously covered by Emerging Issues Task Force (“EITF”) 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 No. 146 supersedes EITF Issue No. 94-3 in its entirety. Under SFAS No. 146, the following conditions must be met for an action to qualify as an exit or disposal plan: management having the authority to approve the action commits to a plan of termination; the plan identifies the number of employees to be terminated, their job classifications or functions and their locations, and the expected completion date; the plan establishes the terms of the benefit arrangement including the benefits that employees will receive upon termination (including but not limited to cash payments) in sufficient detail to enable employees to determine the type and amount of benefits they will receive if they are involuntarily terminated; and actions required to complete the plan indicate that it is unlikely that significant changes to the plan will be made or that the plan will be withdrawn. SFAS No. 146 was effective in 2003 and will be applied prospectively to qualifying exit or disposal activities initiated after December 31, 2002.

      The Company has no financial instruments that are sensitive to market risk.

STEMCELLS, INC.

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

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REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS

To the Stockholders and Board of Directors of Stemcells, Inc.:

We have audited the accompanying consolidated balance sheet of Stemcells, Inc. as of December 31, 2003, and the related consolidated statements of operations, changes in redeemable preferred stock and stockholder’s equity and cash flows for the year then ended. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audit.

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

In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Stemcells Inc. at December 31, 2003, and the consolidated results of their operations and their cash flows for the year then ended, in conformity with accounting principles generally accepted in the United States of America.

The accompanying financial statements have been prepared assuming Stemcells, Inc. will continue as a going concern. As discussed in Note 1, the Company has incurred significant operating losses and negative cash flows since inception and expects to continue to incur significant operating losses for the foreseeable future. These factors, among others, as discussed in Note 1 to the financial statements, raise substantial doubt about the Company’s ability to continue as a going concern. Management’s plans in regard to these matters are also described in Note 1. The financial statements do not include any adjustments that might result from the outcome of this uncertainty.

/s/ Grant Thornton LLP

San Jose, California

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REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS

Stockholders and Board of Directors

      We have audited the accompanying consolidated balance sheets of StemCells, Inc. as of December 31, 2002 and 2001, and the related consolidated statements of operations, changes in redeemable preferred stock and stockholders’ equity, and cash flows for each of the two years in the period ended December 31, 2002. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.

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

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

      The accompanying financial statements have been prepared assuming that StemCells, Inc. will continue as a going concern. As more fully described in Note 1, the Company has incurred significant operating losses and negative cash flows since inception and expects to continue to incur significant operating losses for the foreseeable future. These conditions raise substantial doubt about the Company’s ability to continue as a going concern. Management’s plans in regard to these matters are also described in Note 1. The financial statements do not include any adjustments to reflect the possible future effects on the recoverability and classification of assets or the amounts and classification of liabilities that may result from the outcome of this uncertainty.

      As discussed in Note 1 to the accompanying consolidated financial statements, the Company has restated its financial statements as of and for the two years in the period ended December 31, 2002.

	/s/ ERNST & YOUNG LLP

Palo Alto, California

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STEMCELLS, INC.

CONSOLIDATED BALANCE SHEETS

See accompanying notes to consolidated financial statements.

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STEMCELLS, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

See accompanying notes to consolidated financial statements.

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STEMCELLS, INC.

CONSOLIDATED STATEMENTS OF CHANGES IN REDEEMABLE CONVERTIBLE PREFERRED STOCK