UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

Commission File Number: 0-497

7068 Koll Center Parkway, Suite 401, Pleasanton, California 94566
(Address of principal executive offices) (Zip Code)

(925) 249-4000
(Registrant’s telephone number, including area code)

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

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

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

LIPID SCIENCES, INC.

FORM 10-Q

For the Period Ended June 30, 2004

Table of Contents

PART I – FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

See accompanying notes to Condensed Consolidated Financial Statements

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See accompanying notes to Condensed Consolidated Financial Statements

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See accompanying notes to Condensed Consolidated Financial Statements

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Lipid Sciences, Inc.
Notes to Condensed Consolidated Financial Statements
(Unaudited)

NOTE 1: ORGANIZATION AND BASIS OF PRESENTATION

     On November 29, 2001, Lipid Sciences, Inc., a privately-held corporation, merged with and into NZ Corporation. NZ Corporation survived the merger and changed its name to Lipid Sciences, Inc. In this report, unless the context otherwise requires, the current company, Lipid Sciences, Inc., is referred to as “we,” “the Company” or “Lipid Sciences” with respect to periods of time from the effective date of the merger to the date of this report; the merged company, Lipid Sciences, Inc., a privately-held corporation, is referred to as “we” or “Pre-Merger Lipid” with respect to periods prior to the effective date of the merger; and NZ Corporation is referred to as “NZ,” with respect to periods prior to the effective date of the merger.

     The Company is engaged in the research and development of products and processes intended to treat major medical conditions in which lipids, or fat components, play a key role. Our primary activities since incorporation have been conducting research and development, performing business, strategic and financial planning and raising capital, including, from the date of the merger with NZ, disposing of Company real estate assets. Accordingly, the Company is considered to be in the development stage.

     Historically, NZ engaged in various real estate and commercial real estate lending activities. On March 22, 2002, we formalized a plan to discontinue the operations of our real estate and real estate lending business, including commercial real estate loans, to fund the ongoing operations of Lipid Sciences’ biotechnology business. As a result, we have reclassified the results of operations and the assets and liabilities of the discontinued operations for all periods presented.

     In the course of our research and development activities, we have incurred significant operating losses and we expect these losses to continue for the foreseeable future as we continue to invest in research and development and begin to allocate significant and increasing resources to clinical testing and other activities related to seeking approval to market our products. As of June 30, 2004, we had cash and cash equivalents and short-term investments equal to approximately $21 million. We anticipate that these assets will provide sufficient working capital for our operations at least through the early part of 2006. We expect additional capital will be required in the future to fund our operations. We intend to seek capital needed to fund our operations through new collaborations, such as licensing or other arrangements, through pursuit of research and development grants or through public or private equity or debt financings.

     The Condensed Consolidated Financial Statements include the accounts of the Company and its wholly-owned subsidiaries. Intercompany accounts and transactions have been eliminated. Certain prior period amounts have been reclassified to conform to the current period’s presentation. Such reclassifications had no material effect on the Company’s previously reported consolidated financial position, results of operations or cash flows.

     The Condensed Consolidated Financial Statements presented are unaudited and in the opinion of management reflect all adjustments necessary (consisting only of normal recurring adjustments) for a fair presentation of the financial condition and results of operations as of, and for, the interim periods presented. The results for interim periods are not necessarily indicative of the results to be expected for the full year. The December 31, 2003 balance sheet, as presented, was derived from the audited Consolidated Financial Statements as of December 31, 2003. These Condensed Consolidated Financial Statements should be read in conjunction with the Company’s audited Consolidated Financial Statements and notes thereto included in the Company’s Annual Report on Form 10-K filed with the Securities and Exchange Commission on March 15, 2004.

     The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual amounts could differ from those estimates and assumptions.

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NOTE 2: ACQUISITION

     On November 29, 2001, we completed our merger with Pre-Merger Lipid. As a result of the merger, the Company was renamed Lipid Sciences, Inc. Pre-Merger Lipid ceased to exist as a separate corporation, and the stockholders of Pre-Merger Lipid became stockholders of the Company. In connection with the merger, Pre-Merger Lipid stockholders received 1.55902 shares of the Company’s common stock for each share of Pre-Merger Lipid common stock they held at the time the merger was completed. After the transaction, the Pre-Merger Lipid stockholders owned approximately 75% of the then outstanding stock of the Company and the NZ stockholders owned the remaining shares of the Company’s common stock.

     The merger was accounted for under the purchase method of accounting and was treated as a reverse acquisition because the stockholders of Pre-Merger Lipid owned the majority of the Company’s common stock after the merger. Pre-Merger Lipid was considered the acquiror for accounting and financial reporting purposes. The results of operations from NZ have been included only from November 29, 2001, the date of acquisition. The historical financial statements prior to November 29, 2001 are those of Pre-Merger Lipid.

     Pre-Merger Lipid acquired NZ for the aggregate purchase price of $60,952,000. The following table summarizes the fair values of the assets acquired and the liabilities assumed at the date of acquisition:

     In connection with the merger, the Company was obligated to issue additional shares of common stock to those individuals and entities who were stockholders of NZ on the day prior to the completion of the merger and who perfected their rights. Each perfected right entitled the holder to receive one additional share of the Company’s common stock. NZ stockholders had until April 30, 2002 to become the registered owner of the Company’s common stock and were required to continue to hold their shares in direct registered form through November 29, 2003 to perfect each right and receive an additional share of the Company’s common stock. Transfer of shares of the Company’s common stock before November 29, 2003 would disqualify the right attached to the transferred shares. We have issued a total of approximately 3.1 million shares of the Company’s common stock in the three months ended December 2003 and 352,358 shares in the six months ended June 30, 2004 to those individuals and entities who were stockholders of NZ on the day prior to the completion of the merger and who perfected their rights to receive additional shares of the Company’s common stock. We may issue additional shares of our common stock in the future with respect to the rights determination, which we do not expect to be material in number, if any.

NOTE 3: NET LOSS PER SHARE

     The Company computes its net loss per share under the provisions of Statement of Financial Accounting Standards (“SFAS”) No. 128, “Earnings Per Share.” Basic net loss per share is calculated by dividing net loss by the weighted average number of shares of common stock outstanding during the period. Diluted earnings per share reflects the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock. The Company had securities outstanding, which could potentially dilute basic earnings per share, but because the Company incurred a net loss for all periods presented, such securities were excluded from the computation of diluted net loss per share as their effect would have been antidilutive. The securities excluded from diluted loss per share consist of the following:

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NOTE 4: STOCK COMPENSATION

     The Company accounts for stock-based awards to employees using the intrinsic value method in accordance with Accounting Principles Board (“APB”) No. 25, Accounting for Stock Issued to Employees, as interpreted by Financial Accounting Standards Board (“FASB”) Interpretation No. 44, “Accounting for Transactions Involving Stock Compensation — an Interpretation of APB Opinion No. 25.” The Company accounts for stock-based awards to non-employees in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 123, Accounting for Stock-Based Compensation and Emerging Issues Task Force (“EITF”) Issue No. 96-18, Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services.

     Because the Company follows APB 25 and grants stock option awards to employees at market value, there is no compensation expense recorded. Had compensation expense for the Company’s employee stock option awards been determined based on the Black-Scholes fair value at the grant dates for awards under those plans consistent with the fair value method of SFAS No. 123, the Company would have recorded additional compensation expense and its net loss and loss per share (“EPS”) would have been reduced to the pro forma amounts presented in the following table:

     Stock compensation expense related to options granted to non-employees as consideration for services was $1,040,000 and $40,000 for the three-months ended June 30, 2004 and 2003, respectively, and $1,448,000 and $48,000 for the six-months ended June 30, 2004 and 2003, respectively. The increase in stock compensation expense recognized during the three-months ended June 30, 2004 was primarily due to the modification of certain existing non-employee stock options to extend their expiration dates.

NOTE 5: RECENTLY ISSUED ACCOUNTING STANDARDS

     In April 2003, the FASB issued SFAS No. 149, “Amendment of Statement 133 on Derivative Instruments and Hedging Activities.” This statement amends and clarifies financial accounting and reporting for derivative instruments, including certain derivative instruments embedded in other contracts (collectively referred to as derivatives) and for hedging activities under FASB Statement No. 133, “Accounting for Derivative Instruments and Hedging Activities.” This statement is effective for contracts entered into or modified after June 30, 2003, and for hedging relationships designated after June 30, 2003. The adoption of this statement did not have an impact on Lipid’s financial position, results of operations or cash flows.

     In May 2003, the FASB issued SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity.” This statement establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. This statement is effective for financial instruments entered into or modified after May 31, 2003. The adoption of this statement did not have an impact on Lipid’s financial position, results of operations or cash flows.

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     In December 2003, the FASB revised SFAS No. 132, “Employers’ Disclosures about Pensions and Other Postretirement Benefits — an amendment of FASB Statements No. 87, 88, and 106.” This statement requires additional disclosures to those in the original Statement 132 about the assets, obligations, cash flows, and net periodic benefit cost of defined benefit pension plans and other defined benefit postretirement plans. This statement is effective for financial statements with fiscal years ending after December 15, 2003. The adoption of this statement did not have an impact on Lipid’s financial position, results of operations or cash flows.

NOTE 6: PROPERTY AND EQUIPMENT

     Property and equipment are carried at cost less accumulated depreciation and amortization. Property and equipment are depreciated using the straight-line method over the estimated useful lives, generally three to five years. Leasehold improvements are amortized using the straight-line method over the shorter of the estimated useful life of the asset or the remaining term of the lease. Property and equipment consist of the following (in thousands):

NOTE 7: DEVELOPMENT AGREEMENT

     In October 2000, we entered into a Development Agreement with SRI International, a California nonprofit public benefit corporation, pursuant to which SRI provides us with various consulting and development services (defined in the Development Agreement as “Phase I” and “Phase “II”). Phase I was completed on March 28, 2001 for total fees of $1,517,000. Phase II was initiated upon the completion of Phase I for fees not to exceed $9,500,000. In connection with the Development Agreement, we issued SRI a warrant to purchase 779,510 shares of our common stock at an exercise price of $3.21 per share. The warrant vested with respect to 233,853 shares upon completion of Phase I. The remaining 545,657 shares vest upon completion of two, Phase II development milestones. If either development milestone is discontinued at the option of the Company, all 545,657 remaining warrant shares will vest at the completion of the remaining milestone. Neither milestone related to Phase II has been completed. On April 14, 2004, SRI exercised 40,000 of their 233,853 warrant shares in exchange for 40,000 shares of our common stock. Consistent with our restructuring initiatives, we have refocused our development efforts internally, resulting in a significant reduction in spending related to the Development Agreement. Approximately $325,000 and $846,000 for the three and six month periods ended June 30, 2003, respectively, were charged to operations for fees related to the Development Agreement. No significant amounts of funds related to the Development Agreement were spent during the three or six month periods ended June 30, 2004.

NOTE 8: RELATED PARTY TRANSACTIONS

     In December 1999, we entered into an Intellectual Property License Agreement to obtain the exclusive worldwide rights to certain patents, trademarks, and technology with Aruba International Pty. Ltd., an Australian company, controlled by Bill E. Cham, Ph.D., a founding stockholder of Pre-Merger Lipid and a former Director. Under this agreement, we are obligated to pay Aruba a continuing royalty on revenue in future years, subject to a minimum annual royalty amount of $500,000, 10% of any External Research Funding received by us to further this technology, as defined in the agreement, and $250,000 upon commencement of our initial human clinical trial utilizing the technology under the patents. For the three month periods ended June 30, 2004 and June 30, 2003 we have expensed $125,000 and $125,000, respectively, and for the six month periods ended June 30, 2004 and June 30, 2003 we have expensed $250,000 and $250,000, respectively, related to this agreement. Amounts for 2004 and 2003 were charged to research and development expense.

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     Additionally, in the normal course of business, we have consulted with Dr. Cham, and companies with which he is affiliated, regarding various matters relating to research and development. In November 2001, we entered into a Service Agreement with Karuba International Pty. Ltd., a company controlled by Dr. Cham, in order to consolidate such consulting services. We were required to pay approximately $191,000 a year for Karuba’s consulting services, as well as out-of-pocket expenses incurred in the performance of such services. Under the terms of the agreement, the annual obligation to Karuba increased to approximately $198,000 per year in May 2002. This agreement, the initial term of which expired on November 27, 2002, automatically renewed every year, however, either party could terminate the agreement, without cause, upon thirty days written notice. Having given 30 days written notice of termination to Karuba on July 30, 2003, the agreement was terminated effective August 31, 2003. As a result of such termination, we were required to pay Karuba a termination amount equal to one third of the annual fee, payable in equal monthly installments through December 2003. No expense was incurred in 2004. Approximately $72,000 and $143,000 for the three and six month periods ended June 30, 2003, respectively, were expensed to research and development under this agreement.

     In June 2001, Pre-Merger Lipid engaged MDB Capital Group, LLC as its financial advisor in the merger between NZ and Pre-Merger Lipid. The engagement letter committed the Company to pay MDB Capital Group an advisory fee. In December 2001, we paid MDB Capital Group approximately $446,000, which represented a portion of the advisory fee and was based on 5% of the cash and cash equivalents of the Company immediately after the merger, as compared to Pre-Merger Lipid’s cash and cash equivalents immediately prior to the merger. The remainder of the advisory fee was based on 5% of the gross sales of the Company’s pre-merger assets during the two-year period after the closing of the merger, the Company’s assets on the two-year anniversary of the merger and the net operating income of the Company derived from the Company’s pre-merger assets during the two-year period after the closing of the merger. The estimated total advisory fee of approximately $2,446,000 was included in the purchase price of NZ on the date of the acquisition. Approximately $430,000 and $1,400,000 of the advisory fee was paid during the twelve months ended December 31, 2003 and 2002, respectively. On the two-year anniversary of the merger, the Company determined the remainder of the advisory fee to be $288,000, which was paid to MDB Capital Group, LLC in January 2004.

     On September 18, 2003 we entered into a service agreement with H. Bryan Brewer, Jr., M.D., a Director of the Company. Pursuant to such agreement, Dr. Brewer is obligated to provide to the Company certain consulting services for the period commencing on the effective date of the agreement until September 17, 2004. Either party may terminate the agreement, at any time during the term of the service relationship with or without cause. In consideration for Dr. Brewer’s services, we will pay Dr. Brewer $125,000 annually, payable monthly together with a non-qualified stock option award of 150,000 shares of our common stock to vest equally over a forty-eight month period. Approximately $31,000 and $63,000 for the three and six month periods ended June 30, 2004, respectively, were charged to operations for fees related to the service agreement. Approximately $91,000 and $273,000 for the three and six month periods ended June 30, 2004, respectively, were recorded as non-cash compensation charges related to the stock option awarded to Dr. Brewer under the service agreement.

     In December 2003, the Company issued to Mr. Pope, directly or indirectly as custodian for his children, and to Sun NZ and Sterling Pacific Assets, Inc., two entities controlled by Mr. Pope, an aggregate of 1,511,724 shares of our common stock pursuant to rights granted to them in connection with the merger of NZ and Pre-Merger Lipid. The Company issued shares of common stock to those individuals and entities who were stockholders of NZ on the day prior to the completion of the merger and who perfected their rights pursuant to the merger agreement and joint proxy statement/prospectus for such merger (see Note 2 of the Condensed Consolidated Financial Statements).

NOTE 9: RESTRUCTURING

     In December 31, 2001, we recorded restructuring charges of approximately $885,000, which were charged to general and administrative expense. Our restructuring initiatives involved strategic decisions to exit the real estate market through the orderly disposition of substantially all of NZ’s assets. As part of this restructuring, we terminated nine employees. The restructuring was completed in April 2003, with all accrued amounts paid within twelve months of the restructuring completion. As of June 30, 2004, all amounts accrued for real estate restructuring purposes have been paid.

     On January 28, 2003, we announced a new strategic direction for the Company and the application and development of our novel technology of plasma delipidation. In connection with this new strategic direction, we discontinued our Phase 1 human clinical trial in Australia, which was paused in the three months ended September 30, 2002, and ceased all operations in Australia. In the twelve month period ended December 31, 2003, we recorded restructuring charges of approximately $1,104,000 related to this new

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strategic direction. As part of this restructuring, we terminated eleven employees. The restructuring related to our new strategic direction was completed in the three months ended March 31, 2003 with all accrued amounts paid by March 31, 2004.

     In connection with these restructuring initiatives, we have recorded the following:

NOTE 10: DISCONTINUED OPERATIONS

     As a result of the merger between Pre-Merger Lipid and NZ on November 29, 2001, certain real estate assets, including commercial real estate loans, were acquired. As part of the merger, we announced our intent to conduct an orderly disposition of those assets to fund the ongoing operations of Lipid Sciences’ biotechnology business. On March 22, 2002, we formalized a plan to discontinue the operations of our real estate business, including commercial real estate loans. All of those assets were included in the Real Estate segment. The plan identified the major assets to be disposed of, the method of disposal, and the period required for completion of the disposal. As a result, we have reclassified the results of operations and the assets and liabilities of the discontinued operations for all periods presented. The carrying amounts of the major classes of assets and liabilities included as part of the disposal group as of June 30, 2004 and December 31, 2003, are as follows:

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     During the three months ended March 31, 2003, the Company reclassified the remaining assets of a component of the real estate business from discontinued operations to assets held for use. These assets consisted of certain notes receivable secured by real estate, which the Company obtained as a result of providing seller-financing of prior real estate sales. As a result, notes receivable with a carrying value of $6,569,000 at December 31, 2002 were reclassified from current assets of discontinued operations to notes receivable. The results of operations of this component, previously reported in discontinued operations through December 31, 2002, were also reclassified and are included in interest and other income for all periods presented. Income of $747,000 for the period from Inception (May 21, 1999) to December 31, 2002 was reclassified to interest and other income. All related income tax expenses/benefits and accrued interest were reclassified accordingly. Of the notes receivable reclassified to assets held for use, one note was prepaid in its entirety in June 2003 and the remaining two notes were prepaid at a discount in May 2004. These payoffs reduced the carrying value of the reclassified assets by $6,569,000, resulting in no carrying value at June 30, 2004.

NOTE 11: INCOME TAXES

     The Company’s effective tax rate was zero for the three month periods ended June 30, 2004 and 2003. The effective tax rate was calculated using an estimate of our expected annual pretax income for 2004. The effective tax rate for 2004 differed from the statutory federal income tax rate primarily due to additional valuation allowance provided.

     A valuation allowance is provided when it is more likely than not that some portion of the deferred tax asset will not be realized. The company has established a valuation allowance against its net operating loss carryforward and credits due to the uncertainty of realizing these benefits in the future.

NOTE 12: SEGMENTS

     As a result of the merger between Pre-Merger Lipid and NZ, the Company was previously organized into two segments, Biotechnology and Real Estate. The Biotechnology segment is primarily engaged in the research and development of products and processes focused on treating major medical indications in which lipids, or fat components, play a key role. As part of the merger we announced our intent to conduct an orderly disposition of the real estate assets, including commercial real estate loans, acquired to fund the ongoing operations of Lipid Sciences. On March 22, 2002, we approved a plan to dispose of the Real Estate segment and intend to focus on Biotechnology in the future. Substantially all of the assets and liabilities of the Real Estate segment are included in the discontinued operations plan formalized by the Company on March 22, 2002 (see Note 10 of the Condensed Consolidated Financial Statements).

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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

     This Form 10-Q contains forward-looking statements concerning plans, objectives, goals, strategies, future events or performance as well as all other statements which are not statements of historical fact. These statements contain words such as, but not limited to, “believes,” “anticipates,” “expects,” “estimates,” “projects,” “will,” “may” and “might.” The forward-looking statements contained in this Form 10-Q reflect our current beliefs and expectations on the date of this Form 10-Q. Actual results, performance or outcomes may differ materially from what is expressed in the forward-looking statements. We have discussed the important factors, which we believe could cause actual results, performance or outcomes to differ materially from what is expressed in the forward-looking statements, under the caption “Factors That May Affect Future Results and Financial Condition.” We are not obligated to publicly announce any revisions to these forward-looking statements to reflect a change in facts or circumstances.

     You should read the discussion below in conjunction with Part I, Item 1, “Financial Statements,” of this Form 10-Q and Part II, Items 7, 7A and 8, “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” “Quantitative and Qualitative Disclosures About Market Risk” and “Financial Statements and Supplementary Data,” respectively, of our Annual Report on Form 10-K for the year ended December 31, 2003.

Overview

     We are a development-stage biotechnology company engaged in research and development of products and processes intended to treat major medical indications such as cardiovascular disease, HIV and other viral infections in which lipids, or fat components, play a key role. Our primary activities since incorporation have been conducting research and development, performing business, strategic and financial planning, and raising capital, including, from the date of the merger with NZ, disposing of Company real estate assets. Accordingly, the Company is considered to be in the development stage.

     On November 29, 2001, we completed our merger with NZ. The merger with NZ was accounted for under the purchase method of accounting and was treated as a reverse acquisition because the stockholders of Pre-Merger Lipid owned the majority of our common stock immediately after the merger. Pre-Merger Lipid was considered the acquiror for accounting and financial reporting purposes. Accordingly, all financial information prior to November 29, 2001 included in this report reflects Pre-Merger Lipid results. As a result of the merger, certain real estate assets were acquired, and thus our business was organized into two segments: Biotechnology and Real Estate. On March 22, 2002, we formalized a plan to discontinue the operations of our Real Estate segment, and as of June 30, 2004, we have substantially completed the disposition of these real estate assets.

     In the course of our research and development activities, we have incurred significant operating losses and we expect these losses to continue for the foreseeable future as we continue to invest in research and development and begin to allocate significant and increasing resources to clinical testing and other activities related to seeking approval to market our HDL Therapy and Viral Immunotherapy platforms.

     In January 2003, we announced a new strategic direction for the Company and the application and development of our novel technology of plasma delipidation. In connection with the adoption of this strategic direction, we also restructured our business operations. This change in strategy was recommended by the management team and approved by the Board of Directors. We believe that this new strategic direction and restructuring has strengthened our organizational capability and our management and Board of Directors continue to look for ways to capitalize on our technologies.

     As of June 30, 2004, we had cash, cash equivalents and short-term investments equal to approximately $21,039,000. We anticipate that these assets will provide sufficient working capital for our operations at least through the early part of 2006. Our Board of Directors continues to consider various strategic initiatives, including evaluating recent third-party inquiries, public or private equity or debt financings, the formation of strategic development or licensing partnerships, and strategic business combinations to determine the best way for the Company to capitalize on the major market opportunities represented by our HDL Therapy and Viral Immunotherapy platforms.

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Results of Continuing Operations — Three Months Ended June 30, 2004 and 2003

     Revenue. We have had no revenues from continuing operations since Inception (May 21, 1999). Future revenues will depend on our ability to develop and commercialize our two primary platforms for the treatment of cardiovascular disease (HDL Therapy) and viral infections (Viral Immunotherapy).

     Research and Development Expenses. Research and development expenses include applied and scientific research, regulatory, and business development expenses. Research and development expenses increased approximately $1,066,000, or 67%, to $2,655,000 in the three months ended June 30, 2004 from $1,589,000 for the same period in 2003. The increase was due primarily to a $910,000 increase in stock compensation expense, $855,000 of which was due to the expiration date extension of our Scientific Advisory Board members’ option agreements, and an increase in outside research expenses in preparation for our animal studies. Stock compensation expenses expensed to research and development for the three-month periods ended June 30, 2004 and June 30, 2003, were approximately $950,000 and $40,000, respectively. These increases were partially offset by reduced external development services and the absence of consulting fees related to the Karuba agreement which was terminated in August 2003. Additionally, we have refocused our development efforts internally, resulting in a significant reduction in spending related to the Development Agreement with SRI.

     While we allocate and track resources when required pursuant to the terms of development arrangements, our research team typically works on different platforms concurrently, and our equipment and intellectual property resources often are deployed over a range of platforms with a view to maximize the benefit of our investment. Accordingly, we have not separately tracked, and do not intend to separately track the costs for each of our research projects on a platform-by-platform basis. For the three months ended June 30, 2004, however, we estimate that the majority of our research and development expense was associated with our two primary platforms, HDL Therapy and Viral Immunotherapy.

     Selling, General and Administrative Expenses. General and administrative expenses decreased approximately $191,000, or 18%, to $854,000 in the three months ended June 30, 2004 from $1,045,000 for the same period in 2003. The decrease was due primarily to the absence of advisory fees related to the merger between NZ and Pre-Merger Lipid (see Note 8 of the Condensed Consolidated Financial Statements) and a reduction in employee related expenses. These decreases were partially offset by a $90,000 stock compensation expense incurred during the three-month period ended June 30, 2004, a non-cash charge related to issuance of options to purchase our common stock to consultants. No stock compensation expenses were incurred during the three month period ended June 30, 2003.

     Interest and Other Income. Interest and other income for the three months ended June 30, 2004 decreased approximately $341,000, or 94%, to $23,000 from $364,000 for the same period in 2003. The decrease was due primarily to the absence of a gain recognized from the payoff of a note receivable in the three months ended June 30, 2003, coupled with a discount recognized on the early payoff of two notes receivable in the three months ended June 30, 2004. All three of these notes receivable were reclassified from discontinued operations to assets held for use in the three months ended March 31, 2003 (see Note 10 of the Condensed Consolidated Financial Statements).

Results of Continuing Operations — Six Months Ended June 30, 2004 and 2003

     Revenue. We have had no revenues from continuing operations since Inception (May 21, 1999). Future revenues will depend on our ability to develop and commercialize our two primary platforms for the treatment of cardiovascular disease (HDL Therapy) and viral infections (Viral Immunotherapy).

     Research and Development Expenses. Research and development expenses include applied and scientific research, regulatory, and business development expenses. Research and development expenses increased approximately $462,000, or 11%, to $4,482,000 for the six month period ended June 30, 2004 from $4,020,000 for the same period in 2003. The increase was due primarily to a $1,130,000 increase in stock compensation expense, $855,000 of which was due to the expiration date extension of our Scientific Advisory Board members’ option agreements, and increases in outside research expenses related to the preparation of our animal studies. For the six-month periods ended June 30, 2004 and June 30, 2003, we charged approximately $1,175,000 and $48,000, respectively, in stock compensation expense to research and development. These increases were partially offset by the absence of restructuring charges recorded in the three months ended March 31, 2003, reduced external development services and the absence of consulting fees related to the Karuba agreement which was terminated in August 2003. Additionally, we have refocused our development efforts internally, resulting in a significant reduction in spending related to the Development Agreement with SRI.

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Research and development expenses accounted for approximately 70% of total operating expenses for the six months ended June 30, 2004.

     On March 31, 2004 we received a Small Business Technology Transfer (“STTR”) grant awarded by the National Institutes of Health (“NIH”) for a Virion Solvent Treatment for Severe Acute Respiratory Syndrome (“SARS”). The STTR grant is for a term of one year, beginning April 1, 2004. We expect to receive $100,000 in payments under the terms of this agreement. The overall goal of this STTR grant is for us to use our proprietary delipidation technology to provide proof of principle of viral particle modification to prepare a preventive vaccine against the SARS Coronavirus, a lipid-enveloped virus. No significant costs related to the grant were incurred during the six month period ended June 30, 2004, and consequently, no payments have been requested or received from the NIH.

     Selling, General and Administrative Expenses. Selling, general and administrative expenses decreased approximately $558,000, or 23%, to $1,921,000 for the six month period ended June 30, 2004 from $2,479,000 for the same period in 2003. The decrease was due primarily to the absence of restructuring charges recorded in the three months ended March 31, 2003, the absence of advisory fees related to the merger between NZ and Pre-Merger Lipid (see Note 8 of the Condensed Consolidated Financial Statements), and a reduction in employee related expenses. These decreases were partially offset by an increase in legal and administrative fees associated with the issuance of common stock related to the merger with NZ, and an increase in stock compensation expense, a non-cash charge related to the issuance of options to purchase our common stock to consultants. For the six-month period ended June 30, 2004, we charged approximately $273,000 in stock compensation expense to selling, general and administrative expense. No stock compensation expenses were incurred during the six month period ended June 30, 2003. General and administrative expenses accounted for approximately 30% of total operating expenses for the six months ended June 30, 2004.

     Interest and Other Income. Interest and other income for the six month period ended June 30, 2004 decreased approximately $372,000, or 64%, to $211,000 from $583,000 for the same period in 2003. The decrease was due primarily to the absence of a gain recognized from the payoff of a note receivable in the three months ended June 30, 2003, coupled with a discount recognized on the early payoff of two notes receivable in the three months ended June 30, 2004. All three of these notes receivable were reclassified from discontinued operations to assets held for use during the three months ended March 31, 2003 (see Note 10 of the Condensed Consolidated Financial Statements).

Results of Discontinued Operations — Three and Six Months Ended June 30, 2004

     During the six months ended June 30, 2004, we disposed of our last residential lot in New Mexico and all of our residential lots in San Diego County, California, for an aggregate sales price of approximately $5,700,000. From these transactions, we received cash of approximately $5,600,000, net of commissions, title fees, closing costs and pro-rations of property taxes. Additionally, we collected approximately $1,300,000 in principal payments from our last remaining commercial real estate loan.

     During the three months ended June 30, 2004, there were no sales of assets from discontinued operations. As of June 30, 2004, the remaining assets in the disposal group were one other note receivable and mineral rights.

     During the three months ended March 31, 2003, the Company reclassified the remaining assets of a component of the real estate business from discontinued operations to assets held for use. These assets consisted of certain notes receivable secured by real estate, which the Company obtained as a result of providing seller-financing of prior real estate sales. As a result, notes receivable with a carrying value of $6,569,000 at December 31, 2002 were reclassified from current assets of discontinued operations to notes receivable. The results of operations of this component, previously reported in discontinued operations through December 31, 2002, were also reclassified and are included in interest and other income for all periods presented. Income of $747,000 for the period from Inception (May 21, 1999) to December 31, 2002 was reclassified to interest and other income. All related income tax expenses/benefits and accrued interest were reclassified accordingly. Of the notes receivable reclassified to assets held for use, one note was prepaid in its entirety in June 2003 and the remaining two notes were prepaid at a discount in May 2004. These payoffs reduced the carrying value of the reclassified assets by $6,569,000, resulting in no carrying value at June 30, 2004.

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Liquidity and Capital Resources

     Pre-Merger Lipid financed its operations principally through two private placements of equity securities, which yielded net proceeds of approximately $16,900,000, and the sale of common stock to one of its founders. The merger with NZ resulted in the acquisition of net assets of approximately $45,000,000, net of repurchase of stock and acquisition costs, through June 30, 2004.

     The net cash provided by operating activities was approximately $588,000 for the six months ended June 30, 2004, resulting primarily from the early payoff of two notes receivable, offset by operating losses incurred and adjusted for non-cash stock compensation charges. The net cash used in operating activities was $5,309,000 and $34,502,000 for the six months ended June 30, 2003 and the period from Inception (May 21, 1999) to June 30, 2004, respectively, resulting primarily from operating losses incurred and the early payoff of two notes receivable, as adjusted for non-cash stock compensation charges. The net cash provided by investing activities was approximately $28,000 for the six months ended June 30, 2004, primarily attributable to the purchase, maturity and sale of short-term investments. The net cash used in investing activities was approximately $3,657,000 and $10,310,000 for the six months ended June 30, 2003 and the period from Inception (May 21, 1999) to June 30, 2004, respectively, primarily attributable to the purchase, maturity and sale of short-term investments and the purchase of capital equipment. Net cash provided by financing activities for the six months ended June 30, 2004 and for the period from Inception (May 21, 1999) to June 30, 2004, was approximately $184,000 and $23,989,000, respectively, primarily attributable to the proceeds collected from the exercise of options and warrants of our common stock, the acquisition of NZ Corporation and the sale of equity securities in private placement transactions. No cash was provided by, or used in, financing activities for the six months ended June 30, 2003. Net cash provided by discontinued operations of approximately $6,395,000, $2,158,000, and $32,923,000 for the six months ended June 30, 2004 and June 30, 2003, and the period from Inception (May 21, 1999) to June 30, 2004, respectively, was primarily due to the sale of real estate assets and collection of principal payments on commercial real estate loans and other notes receivable.

     In December 1999, we entered into an Intellectual Property License Agreement to obtain the exclusive worldwide rights to certain patents, trademarks, and technology with Aruba International Pty. Ltd., an Australian company, controlled by Bill E. Cham, Ph.D., a founding stockholder of Pre-Merger Lipid and a former Director. Under this agreement, we are obligated to pay Aruba a continuing royalty on revenue in future years, subject to a minimum annual royalty amount of $500,000, 10% of any External Research Funding received by us to further this technology, as defined in the agreement, and $250,000 upon commencement of our initial human clinical trial utilizing the technology under the patents. For the three month periods ended June 30, 2004 and June 30, 2003, we have expensed $125,000 and $125,000, respectively, related to this agreement. For the six month periods ended June 30, 2004 and June 30, 2003 we have expensed $250,000 and $250,000, respectively, related to this agreement. Amounts for 2004 and 2003 were charged to research and development expense.

     Additionally, in the normal course of business, we have consulted with Dr. Cham, and companies with which he is associated, regarding various matters relating to research and development. In November 2001, we entered into a Service Agreement with Karuba International Pty. Ltd., a company controlled by Dr. Cham, in order to consolidate such consulting services. We were required to pay approximately $191,000 a year for Karuba’s consulting services, as well as out-of-pocket expenses incurred in the performance of such services. Under the terms of the agreement, the annual obligation to Karuba increased to approximately $198,000 per year in May 2002. This agreement, the initial term of which expired on November 27, 2002, automatically renewed every year, however, either party could terminate the agreement, without cause, upon thirty days written notice. Having given 30 days written notice of termination to Karuba on July 30, 2003, the agreement was terminated effective August 31, 2003. As a result of such termination, we were required to pay Karuba a termination amount equal to one third of the annual fee, payable in equal monthly installments through December 2003.

     In May 2000, we sold a total of 4,925,300 shares of our common stock at $2.25 per share in a private placement to accredited investors. Net cash proceeds, after expenses of the placement, were approximately $11,000,000.

     In October 2000, we entered into a Development Agreement with SRI International, a California nonprofit public benefit corporation, pursuant to which SRI provides us with various consulting and development services (defined in the Development Agreement as “Phase I” and “Phase “II”). Phase I was completed on March 28, 2001 for total fees of $1,517,000. Phase II was initiated upon the completion of Phase I for fees not to exceed $9,500,000. In connection with the Development Agreement, we issued SRI a warrant to purchase 779,510 shares of our common stock at an exercise price of $3.21 per share. The warrant vested with respect to 233,853 shares upon completion of Phase I. The remaining 545,657 shares vest upon completion of two, Phase II development milestones. If either development milestone is discontinued at the option of the Company, all 545,657 remaining warrant shares will vest at the completion of the remaining milestone. Neither milestone related to Phase II has been completed. On April 14,

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2004, SRI exercised 40,000 of their 233,853 warrant shares in exchange for 40,000 shares of our common stock. Consistent with our restructuring initiatives, we have refocused our development efforts internally, resulting in a significant reduction in spending related to the Development Agreement.

     In March 2001, we closed a private placement of 1,375,282 shares of common stock at $4.49 per share for gross proceeds of $6,175,000. In connection with the private placement, we paid a commission to MDB Capital Group, LLC of approximately 7% of the gross proceeds, payable in shares of common stock, for services rendered in the private placement. Accordingly, 95,491 shares of common stock at $4.49 per share were issued as commission for the transaction.

     In June 2001, Pre-Merger Lipid engaged MDB Capital Group, LLC as its financial advisor in the merger between NZ and Pre-Merger Lipid. The engagement letter committed the Company to pay MDB Capital Group an advisory fee. In December 2001, we paid MDB Capital Group approximately $446,000, which represented a portion of the advisory fee and was based on 5% of the cash and cash equivalents of the Company immediately after the merger, as compared to Pre-Merger Lipid’s cash and cash equivalents immediately prior to the merger. The remainder of the advisory fee was based on 5% of the gross sales of the Company’s pre-merger assets during the two-year period after the closing of the merger, the Company’s assets on the two-year anniversary of the merger and the net operating income of the Company derived from the Company’s pre-merger assets during the two-year period after the closing of the merger. Approximately $1,400,000 and $430,000 of the advisory fee was paid during the year ended December 31, 2002 and 2003, respectively. On the two-year anniversary of the merger, the Company determined the remainder of the advisory fee to be $288,000, which was paid to MDB Capital Group, LLC in January 2004.

     In connection with the merger, the Company was obligated to issue additional shares of common stock to those individuals and entities who were stockholders of NZ on the day prior to the completion of the merger and who perfected their rights. Each perfected right entitled the holder to receive one additional share of the Company’s common stock. NZ stockholders had until April 30, 2002 to become the registered owner of the Company’s common stock and were required to continue to hold their shares in direct registered form through November 29, 2003 to perfect each right and receive an additional share of the Company’s common stock. Transfer of shares of the Company’s common stock before November 29, 2003 would disqualify the right attached to the transferred shares. We have issued a total of approximately 3.1 million shares of the Company’s common stock in the three months ended December 2003 and 352,358 shares in the six months ended June 30, 2004 to those individuals and entities who were stockholders of NZ on the day prior to the completion of the merger and who perfected their rights to receive additional shares of the Company’s common stock. We may issue additional shares of our common stock in the future with respect to the rights determination, which we do not expect to be material in number, if any.

     Our principal uses of funds are expected to be the payment of operating expenses and continued research and development funding to support our HDL Therapy and Viral Immunotherapy platforms. Our principal sources of funds are expected to be cash on hand. We have undertaken a number of programs to efficiently manage our cash and working capital. During the three month period ended June 30, 2004, we disposed of real estate notes receivable totaling $5.4 million. This transaction represented the substantial completion of our two-year long real estate asset liquidation program. As of June 30, 2004, we had cash and cash equivalents and short-term investments equal to approximately $21,039,000. Based on our belief that the implementation of our January 2003 strategic plan has proven effective, we anticipate that these assets will provide sufficient working capital for our operations at least through the early part of 2006. We expect additional capital will be required in the future. Our Board of Directors continues to consider various strategic initiatives, including third-party inquiries, public or private equity or debt financings, the formation of strategic development or licensing partnerships, and strategic business combinations. However, there can be no assurance that funds secured from any of these efforts, if obtained, will be sufficient to meet the Company’s future cash requirements.

Critical Accounting Policies

     In December 2001, the Securities and Exchange Commission (“SEC”), required that all registrants disclose and describe their “critical accounting policies” in MD&A. The SEC indicated that a “critical accounting policy” is one which is both important to the portrayal of the Company’s financial condition and results of operations and requires management’s most difficult, subjective or complex judgments, often as a result of the need to make estimates about the effect of matters that are inherently uncertain. In applying those policies, our management uses its judgment to determine the appropriate assumptions to be used in the determination of certain estimates. Those estimates are based on our historical experience, terms of existing contracts, our observance of trends in the industry and information available from other outside sources, as appropriate. We believe that our following accounting policies fit this definition:

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Stock Compensation

     The Company accounts for stock options granted to employees using the intrinsic value method in accordance with the provisions of Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees,” and, thus, recognizes no compensation expense for those options granted with exercise prices equal to the fair market value of the Company’s common stock on the date of grant. As permitted, the Company has elected to adopt the disclosure provisions only of SFAS No. 123, “Accounting for Stock-Based Compensation". The Company accounts for stock-based awards to non-employees in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 123, Accounting for Stock-Based Compensation and Emerging Issues Task Force (“EITF”) Issue No. 96-18, Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services. Significant judgment is required on the part of management in determining the proper factors to use in the computation of the amounts to be disclosed or recorded pursuant to the provisions of SFAS No. 123.

Income Taxes

     The Company follows SFAS No.109, “Accounting for Income Taxes.” Under the asset and liability method of SFAS No.109, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating loss and tax credit carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date.

     In assessing the realizability of deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. Management considers the scheduled reversal of deferred tax liabilities, projected future taxable income, and tax planning strategies in making this assessment.

     The above listing is not intended to be a comprehensive list of all of our accounting policies. In many cases, the accounting treatment of a particular transaction is specifically dictated by generally accepted accounting principles, with no need for management’s judgment in their application. There are also areas in which management’s judgment in selecting any available alternative would not produce a materially different result. Our significant accounting policies are more fully described in our audited Consolidated Financial Statements and notes thereto for the year ended December 31, 2003, which appear in the Company’s Annual Report on Form 10-K filed with the SEC on March 15, 2004.

Factors That May Affect Future Results and Financial Condition

If we are unable to obtain adequate funds, we may not be able to develop and pursue the commercial application of our HDL Therapy and Viral Immunotherapy platforms.

     For the six months ended June 30, 2004, we incurred a net loss of approximately $6,206,000 and since Inception through June 30, 2004, we have incurred an accumulated deficit of approximately $48,697,000. We expect to continue to incur losses for the foreseeable future as we continue funding for clinical testing and other activities related to seeking approval for the commercial application of our HDL Therapy and Viral Immunotherapy platforms. Conducting clinical trials necessary to apply for regulatory approval for the commercial application of our HDL Therapy and Viral Immunotherapy platforms will take a number of years and will require significant amounts of capital.

     As of June 30, 2004, we had cash, cash equivalents and short-term investments equal to approximately $21,039,000. We anticipate that these assets will provide sufficient working capital for our operations at least through the early part of 2006. In the near future, we will require additional capital in amounts that cannot be quantified, but are expected to be significant. We intend to seek capital needed to fund our operations through new collaborations, through pursuit of research and development grants, or through public or private equity or debt financings. Additional financing may not be available on terms favorable to us, or at all. If we are unable to obtain financing on acceptable terms, our ability to continue our business as planned will be significantly impaired.

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Our technology is only in the pre-clinical development stage, may not prove to be safe or effective, and may never receive regulatory approval or achieve widespread use, which would significantly harm our business prospects.

     Before obtaining required regulatory approvals for the commercial sale of any of our potential products, we must demonstrate, through pre-clinical studies and clinical trials, that our technology is safe and effective for use in at least one medical indication. These studies and clinical trials are expected to take a number of years and may fail to show that our technology is sufficiently safe and effective, in which case our technology will not receive regulatory approval, and we will not be able to develop and pursue the commercial application of our HDL Therapy and Viral Immunotherapy platforms. In connection with our restructuring plan, we discontinued our Phase 1 human clinical trial and ceased all operations in Australia in January 2003.

     Our technology, and hence, our business, at present is limited to addressing two medical applications: cardiovascular disease, using our HDL Therapy platform, and viral infections, using our Viral Immunotherapy platform. HDL Therapy is aimed at developing treatments for the reversal of atherosclerosis, while the Viral Immunotherapy platform is focused on treatments for people suffering from conditions associated with lipid-enveloped viruses such as HIV, Hepatitis B and C, SARS, and West Nile. If our technology does not prove to be safe or effective, if we otherwise fail to receive regulatory approval for our potential product indications, or if we fail to successfully commercialize any product that may receive regulatory approval, our business prospects would be significantly harmed and we may even be forced to cease operations.

Our future clinical studies may be delayed or unsuccessful.

     Our future success depends in large part upon the results of clinical trials designed to assess the safety and efficacy of our potential product indications. The ultimate results of clinical studies cannot be predicted with accuracy and can be impacted by many variables. We cannot be sure whether planned clinical trials will begin on time or will be completed on schedule or at all. Delay or failure to complete clinical studies may delay or prevent us from bringing products to market, which would materially harm our business. For example, any of our future clinical studies might be delayed in their initiation or performance, or even halted after initiation because:

	•		extensive pre-clinical animal studies are required by the regulatory authorities to demonstrate the safety of the process technology;
	•		the data generated by the pre-clinical animal studies does not indicate to the regulatory authorities that there is a sufficient margin of safety;
	•		the potential clinical benefit from the delipidation process cannot be effectively demonstrated through the pre-clinical animal studies;
	•		the relevant regulatory requirements for initiating and maintaining an application for a clinical study cannot be met;
	•		the product or process is not effective, or physicians perceive that the product is not effective;
	•		patients experience severe side effects during treatment or possibly even death as a result of the treatment;
	•		patients die during a clinical study because their disease is too advanced or because they experience medical problems that are not related to the product being studied;
	•		patients do not enroll in the studies at the rate we expect; or
	•		the discovery by the sponsor, during the course of the study, of deficiencies in the way the study is being conducted by the study investigators that raise questions as to whether the study is being conducted in conformity with the relevant regulatory authorities’ regulations or Good Clinical Practice.

We depend on our license agreement with Aruba International Pty. Ltd. that may, if terminated, significantly harm our business.

     We have entered into an agreement for an exclusive license to patents, know-how and other intellectual property relating to our foundation technology for removal of lipids from proteins and our continued operations at present are dependent upon such intellectual property. The licensor is Aruba International Pty. Ltd., a company controlled by Dr. Bill E. Cham, a founding stockholder of Pre-Merger Lipid and a former Director of the Company. Dr. Cham also controls KAI International, LLC, our largest stockholder. The technology licensed from Aruba currently represents an important part of the technology owned or licensed by us. Aruba may

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terminate the license agreement if we fail to perform and fail to remedy following written notice of default with respect to our material obligations under the agreement, including our obligations to make royalty payments, or if we cease, without intention to resume, all efforts to commercialize the subject matter of the licensed intellectual property. If our license with Aruba terminates, our business would be significantly harmed and it may cause us to cease operations.

We intend to rely on collaborations in order to further develop our products and processes. If these collaborations are unsuccessful, the development of our products could be adversely affected and we may incur significant unexpected costs.

     We intend to enter into collaborations with strategic partners, licensors, licensees and others. We may be unable to maintain or expand our existing collaborations on favorable terms, or at all, or establish additional collaborations or licensing arrangements necessary to develop our technology on favorable terms, or at all. We may not be able to enter into any collaborations or licensing arrangements with strategic partners in the future, and any existing or future collaborations or licensing arrangements may not be successful. In addition, parties we collaborate with may develop products or processes that compete with ours, and we cannot be certain that they will perform their contractual obligations or that any revenues will be derived from such arrangements. If one or more of these parties fails to achieve product development objectives, this failure could harm our ability to fund related programs and develop or commercialize products.

Our industry is intensely competitive.

     The biotechnology industry is intensely competitive and we may not be able to develop, perfect or acquire rights to new products with commercial potential. We compete with biotechnology and pharmaceutical companies that have been established longer than we have, have a greater number of products on the market, have greater financial and other resources and have other technological or competitive advantages. We also compete in the development of technologies and processes and in acquiring personnel and technology from academic institutions, governmental agencies, and other private and public research organizations. We cannot be certain that one or more of our competitors will not receive patent protection that dominates, blocks or adversely affects our clinical studies, product development or business; will benefit from significantly greater sales and marketing capabilities; or will not develop products that are accepted more widely than ours.

If we fail to secure and then enforce patents and other intellectual property rights underlying our technologies, or if the use of our technology is determined to infringe on the intellectual property rights of others, our business could be harmed.

     Our future success will depend in part on our ability to obtain patent protection, enforce patents once obtained, maintain trade secrets and operate without infringing upon the patents and proprietary rights of others, and if needed, obtain appropriate licenses to patents or proprietary rights held by third parties with respect to their technology, both in the United States and in foreign countries. We currently have an exclusive license from Aruba International Pty. Ltd. with respect to three issued U.S. patents (and three issued Australian counterpart patents) and counterpart applications as well as independent pending patent applications. The issued patents will expire in January 2008, January 2016 and June 2017. There are additional pending applications assigned to us and we are constantly strengthening our IP portfolio in accordance with our technological advancements. Each of the patents and pending applications relates to different aspects of our technology platforms. However, these patent applications may not be approved and, even if approved, our patent rights may not be upheld in a court of law or may be narrowed if challenged. The patent positions of pharmaceutical and biotechnology companies can be highly uncertain and involve complex legal and factual questions. Our patent rights may not provide competitive advantages for our products and may be challenged, infringed upon or circumvented by our competitors.

     In addition to patents, we rely on trade secrets, know-how, continuing technological innovations, and licensing opportunities to develop and maintain our competitive position. It is our policy to require our employees, certain contractors, consultants, members of our scientific and viral advisory boards and parties to collaborative agreements to execute confidentiality agreements upon the commencement of a business relationship with us. We cannot assure you that these agreements will not be breached, that they will provide meaningful protection of our trade secrets or know-how or adequate remedies if there is unauthorized use or disclosure of this information or that our trade secrets or know-how will not otherwise become known or be independently discovered by our competitors.

     If it were ultimately determined that our intellectual property rights are unenforceable, or that our use of our technology infringes on the intellectual property rights of others, we may be required or may desire to obtain licenses to patents and other intellectual property held by third parties to develop, manufacture and market products using our technology. We may not be able to

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obtain these licenses on commercially reasonable terms, if at all, and any licensed patents or intellectual property that we may obtain may not be valid or enforceable. In addition, the scope of intellectual property protection is subject to scrutiny and challenge by courts and other governmental bodies. Litigation and other proceedings concerning patents and proprietary technologies can be protracted, expensive and distracting to management and companies may sue competitors as a way of delaying the introduction of competitors’ products. Any litigation, including any interference proceedings to determine priority of inventions, oppositions to patents in foreign countries or litigation against our partners, may be costly and time-consuming and could significantly harm our business.

     Because of the large number of patent filings in the biopharmaceutical field, our competitors may have filed applications or been issued patents and may obtain additional patents and proprietary intellectual property rights relating to products or processes competitive with or similar to ours. We cannot be certain that U.S. or foreign patents do not exist or will not be issued that would harm our ability to commercialize our products and product candidates.

If we use biological and hazardous materials in a manner that causes injury, we may be liable for damages.

     Our research and development activities involve the controlled use of potentially harmful biological materials, such as blood products, organic solvents and other hazardous materials. We cannot completely eliminate the risk of accidental contamination or injury from the use, storage, handling or disposal of these materials. In the event of contamination or injury, we could be held liable for damages that result, and any liability could be significant. We are subject to federal, state and local laws and regulations governing the use, storage, handling and disposal of these materials and specified waste products. The cost of compliance with these laws and regulations could be significant.

Our business exposes us to product liability claims.

     Our design, testing, development, manufacturing and marketing of products involve an inherent risk of exposure to product liability claims and related adverse publicity. Insurance coverage is expensive and difficult to obtain, and we may be unable to obtain coverage in the future on acceptable terms, if at all. Although we currently maintain product liability insurance for our products in the amounts we believe to be commercially reasonable, we cannot be certain that the coverage limits of our insurance policies or those of our strategic partners will be adequate. If we are unable to obtain sufficient insurance at an acceptable cost or if a successful product liability claim is made against us, whether fully covered by insurance or not, our business could be harmed.

We depend on key personnel and will need to hire additional key personnel in the future.

     Our ability to operate successfully depends in significant part upon the experience, abilities and continued service of certain key scientific, technical and managerial personnel. If we lose the services of any of these personnel and we are unable to hire qualified replacements, our business could be harmed. Our future success also depends upon our ability to attract and retain additional highly qualified personnel in these areas and our ability to develop and maintain relationships with qualified clinical researchers. There can be no assurance that we can retain such personnel or that we can attract or retain other highly qualified scientific, technical and managerial personnel or develop and maintain relationships with clinical researchers in the future.

Our stock price may be volatile and there may not be an active trading market for our common stock.

     There can be no assurance that there will be an active trading market for our common stock or that the market price of the common stock will not decline below its present market price. The market prices for securities of biotechnology companies have been, and are likely to continue to be, highly volatile. Factors that have had, and are expected to continue to have, a significant impact on the market price of our common stock include:

	•		material public announcements;
	•		actual or potential clinical results with respect to our products under development or those of our competitors;
	•		the announcement and timing of any new product introductions by us or others;
	•		technical innovations or product development by us or our competitors;
	•		regulatory approvals or regulatory issues;
	•		developments relating to patents and proprietary rights;

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	•		political developments or proposed legislation in the medical device or healthcare industry;
	•		economic and other external factors, disaster or crisis;
	•		changes to our management;
	•		period-to-period fluctuations in our financial results or results which do not meet or exceed analyst expectations; and
	•		market trends relating to or affecting stock prices throughout our industry, whether or not related to results or news regarding us or our competitors.

     In the past, securities class action litigation has often been brought against a company following periods of volatility in the market price of its securities. We may, in the future, be the target of similar litigation. Regardless of its outcome, securities litigation may result in substantial costs and divert management’s attention and resources, which could harm our business and results of operations.

Existing stockholders may experience future dilution.

     In connection with the merger of Pre-Merger Lipid with and into NZ, we have issued approximately 3.1 million shares of the Company’s common stock in the three months ended December 31, 2003 and 352,358 shares in the six months ended June 30, 2004 to qualifying stockholders of NZ who perfected their rights pursuant to the merger agreement related thereto. This common stock issuance diluted ownership of stockholders not holding rights by approximately 14%, based on 21,141,455 shares outstanding as of November 29, 2003. It is possible that additional shares of common stock will be issued pursuant to this rights determination. We do not expect the number of such additional shares, if any, to be material, and therefore we do not expect any potential future issuance pursuant to the merger rights will have a material dilutive effect. In addition, as of June 30, 2004, 6,307,436 stock options and 1,036,314 warrants to purchase our common stock were outstanding, which if exercised, would result in the issuance of our common stock. Moreover, in the near future, we anticipate the need for additional capital to fund our operations. Such capital could be obtained by selling additional common stock or other equity instruments. Any future issuance of our common stock will have the effect of diluting ownership of existing stockholders.

We have adopted several anti-takeover measures.

     We have taken a number of actions that could discourage a takeover attempt that might be beneficial to stockholders who wish to receive a premium for their shares from a potential bidder. For example:

	•		our Board of Directors has the authority to issue, without vote or action of stockholders, up to 10,000,000 shares of preferred stock and to fix the price, rights, preferences and privileges of those shares. Any series of preferred stock could contain dividend rights, conversion rights, voting rights, terms of redemption, redemption prices, liquidation preferences or other rights superior to the rights of holders of common stock;
	•		our Directors are elected to staggered terms, which prevents the entire Board from being replaced in any single year;
	•		our Certificate of Incorporation and Bylaws require the affirmative vote of the holders of sixty-six and two-thirds percent (66 2/3%) of the voting power of all of the then outstanding shares entitled to vote generally in the election of Directors, voting together as a single class, to make, alter, amend or repeal our Bylaws;
	•		our Certificate of Incorporation does not permit stockholders to take an action by written consent;
	•		our Certificate of Incorporation and the Bylaws provide that special meetings of the stockholders may be called only by the Chairman of the Board, the President, or the Board of Directors by a resolution approved by a majority of the total number of Directors we would have if there were no vacancies; and
	•		under our Bylaws, notice regarding stockholder proposals and Director nominations must have been delivered not less than 45 days nor more than 75 days prior to the first anniversary of the date on which we first mailed our proxy materials for the preceding year’s annual meeting.

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ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

     Our exposure to market risk associated with changes in interest rates relates to our investment portfolio. We maintain a non-trading investment portfolio consisting of government issued securities. These investments are classified as held-to-maturity and are accounted for at their amortized cost, as per FASB Statement No. 115. Due to the short-term nature of our investment portfolio, we do not believe that fluctuations in interest rates would materially affect the value of our securities.

ITEM 4. CONTROLS AND PROCEDURES

	(a)		Evaluation of Disclosure Controls and Procedures. Our President and Chief Executive Officer and our Chief Accounting Officer, who is our principal financial officer, have evaluated the procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)) as of the end of the period covered by this Quarterly Report on Form 10-Q (the “Evaluation Date”). Based on such evaluation, such officers have concluded that, as of the Evaluation Date, our disclosure controls and procedures are effective in alerting them, on a timely basis, to material information relating to the Company (including its consolidated subsidiaries) required to be included in our periodic filings under the Exchange Act.
	(b)		Changes in Internal Controls. There have not been any significant changes in our internal controls or in other factors that could significantly affect such controls subsequent to the Evaluation Date.

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PART II — OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

     We are from time to time a party to legal proceedings. All of the legal proceedings we are currently involved in are ordinary and routine. The outcomes of the legal proceedings are uncertain until they are completed. We believe that the results of the current proceedings will not have a material adverse effect on our business or financial condition or results of operations.

ITEM 2. CHANGES IN SECURITIES, USE OF PROCEEDS AND ISSUER PURCHASES OF EQUITY SECURITIES

     None.

ITEM 3. DEFAULTS UPON SENIOR SECURITIES

     None.

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

     On June 17, 2004, the Company held its annual meeting of stockholders. As of April 19, 2004, the record date for the annual meeting, there were 24,633,178 shares of common stock of the Company issued and outstanding and entitled to vote at the annual meeting. The following item was submitted to a vote of the stockholders:

     To elect three Class II members currently serving on the Board of Directors to three-year terms.

     As a result, Dr. Brewer and Messrs. Djordjevic, and Placenti were elected as Directors of the Company. The following incumbent members continue to serve on the Board of Directors: Richard G. Babbitt, S. Lewis Meyer, Ph.D., William A. Pope, and Gary S. Roubin, M.D., Ph.D.

ITEM 5. OTHER INFORMATION

     None.

ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K

	(a)		Exhibits — See Exhibit Index.
	(b)		Reports on Form 8-K. During the quarter for which this report is filed, the Company filed the following reports on Form 8-K:

(i)

Report on Form 8-K filed June 3, 2004 under “Item 5. Other Events and Regulation FD Disclosure” and “Item 7. Financial Statements and Exhibits” containing Lipid Sciences, Inc.’s news release dated June 3, 2004 with respect to the announcement of the sale of real estate assets totaling $5.4 million.

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SIGNATURES

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

Explanatory Note: Currently, the Company’s principal financial officer is the Chief Accounting Officer.

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EXHIBIT INDEX

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