Back to GetFilings.com

Table of Contents

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

For the quarterly period ended March 31, 2003

OR

For the transition period from              to             

Commission File Number 000-31147

DELTAGEN, INC.

(Exact name of Registrant as specified in its charter)

(650) 569-5100

(Registrant’s telephone number, including area code)

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

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

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

Table of Contents

DELTAGEN, INC.

FORM 10-Q

QUARTERLY REPORT

TABLE OF CONTENTS

2

Table of Contents

PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

DELTAGEN, INC.

CONSOLIDATED BALANCE SHEETS

(unaudited)

(in thousands, except share data)

The accompanying notes are an integral part of these consolidated financial statements.

3

Table of Contents

DELTAGEN, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

(unaudited)

(in thousands, except per share data)

The accompanying notes are an integral part of these consolidated financial statements.

4

Table of Contents

DELTAGEN, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(unaudited)

(in thousands)

The accompanying notes are an integral part of these consolidated financial statements.

5

Table of Contents

DELTAGEN, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

March 31, 2003

1. Business of the Company

Deltagen, founded in 1997 and headquartered in Redwood City, California, uses in vivo mammalian gene function information to define the function and disease relevance of mammalian genes for the purpose of discovering and validating novel drug targets. The Company’s proprietary information platform serves the Company’s customers in their efforts to discover potential new drug therapies.

2. Basis of Presentation

The accompanying interim consolidated financial statements as of March 31, 2003 of Deltagen, Inc. (the “Company”) are unaudited and have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information, the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not contain all of the information and footnotes required by accounting principles generally accepted in the United States of America for complete financial statements. The unaudited interim consolidated financial statements have been prepared on the same basis as the annual consolidated financial statements and, in the opinion of management, reflect all adjustments, which include only normal recurring adjustments, necessary to present fairly the Company’s financial position and its results of operations and its cash flows for the periods presented. Operating results for the interim periods presented are not necessarily indicative of the results that may be expected for the fiscal year or any future interim period. Certain costs and expenses in the three months ended March 31, 2002 have been reclassified to conform to the presentation in the three months ended March 31, 2003. Certain balances at December 31, 2002 have been reclassified to conform to the presentation at March 31, 2003.

These interim financial statements should be read in conjunction with the annual audited consolidated financial statements included in the Company’s Annual Report on Form 10-K/A (File No. 000-31147) filed with the Securities and Exchange Commission (the “SEC”) on April 30, 2003.

The Company’s commercial operations commenced during 2000 at which time it emerged from the development stage. The Company has incurred net losses since inception of $224,279,000 and may incur net losses and negative cash flow from operations for at least the next several years. These matters raise substantial doubt about the Company’s ability to continue as a going concern. Management’s plans include increasing sales by refocusing on providing drug discovery services to the biopharmaceutical industry and reducing cash spending during the current fiscal year resulting from the continued down sizing of the Company and elimination of the Company’s internal small molecule drug discovery programs. These reduction efforts began in the third quarter of fiscal year 2002 and have continued into 2003 and are expected to reduce the current cash outflows. Management also recognizes the need for an infusion of cash during the year ended December 31, 2003. In April 2003, the Company received a minimum commitment for $10,000,000 in equity capital from existing institutional investors subject to shareholder approval and satisfaction of closing conditions. The Company will finance its operations primarily through its cash and cash equivalents and future revenues. The Company requires additional funding and will attempt to sell additional shares of its common or preferred stock through private placements or further public offerings, or it may seek additional credit facilities. The sale of additional equity or debt securities would likely result in additional dilution to existing stockholders. If additional funds are raised through the issuance of equity or debt securities, these securities could have rights that are senior to existing stockholders and could contain covenants that would restrict operations. Any additional financing may not be available in amounts or on terms acceptable to the Company, if at all.

While the Company is aggressively pursuing the actions discussed above, there can be no assurance that the Company will be successful in its efforts to achieve future profitable operations, generate sufficient cash from operations or obtain additional funding sources. The financial statements do not contain any adjustments that might result from the outcome of this uncertainty.

6

Table of Contents

3. Recent Accounting Pronouncements

In November 2002, the Emerging Issues Task Force (“EITF”) reached a consensus on Issue No. 00-21 (“EITF 00-21”), “Revenue Arrangements with Multiple Deliverables.” EITF 00-21 provides guidance on how to account for arrangements that involve the delivery or performance of multiple products, services and/or rights to use assets. The provisions of EITF 00-21 will apply to revenue arrangements entered into in fiscal periods beginning after June 15, 2003. The Company believes that the adoption of EITF 00-21 will not have a material impact on the financial position or results of operations of the Company.

In January 2003, the FASB issued FASB Interpretation No. 46 (“FIN 46”), “Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51.” FIN 46 requires certain variable interest entities to be consolidated by the primary beneficiary of the entity if the equity investors in the entity do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. FIN 46 is effective immediately for all new variable interest entities created or acquired after January 31, 2003. For variable interest entities created or acquired prior to February 1, 2003, the provisions of FIN 46 must be applied for the first interim or annual period beginning after June 15, 2003. The Company is currently evaluating the impact, if any, that the adoption of FIN 46 will have on the financial position or results of operations of the Company.

4. Net Loss Per Share

Basic earnings per share is calculated based on the weighted average number of common shares outstanding during the period. Diluted earnings per share would give effect to the dilutive effect of potentially dilutive securities consisting of restricted stock, stock options and warrants. Potentially dilutive securities have been excluded from the diluted earnings per share calculations as they have an antidilutive effect due to the Company’s net losses.

A reconciliation of the numerator and denominator used in the net loss per share calculations is as follows:

The following unvested common stock subject to repurchase, outstanding options and warrants (prior to the application of the treasury stock method) were excluded from the computation of diluted net loss per share as they had an antidilutive effect:

7

Table of Contents

5. Accounting for Stock Based Compensation

The Company accounts for stock-based employee compensation arrangements in accordance with provisions of Accounting Principles Board Opinion No. 25 (“APB 25”), “Accounting for Stock Issued to Employees,” and related interpretations and complies with the disclosure provisions of Statement of Financial Accounting Standards No. 123 (“SFAS 123”), “Accounting for Stock-Based Compensation.”

Under APB 25, compensation expense is based on the difference, if any, on the date of the grant, between the fair value of the Company’s stock and the exercise price. SFAS 123 defines a “fair value” based method of accounting for an employee stock option or similar equity investment.

The Company accounts for equity instruments issued to non-employees in accordance with the provisions of SFAS 123 and Emerging Issues Task Force Issue No. 96-18 (“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 Financial Accounting Standards Board Interpretation No. 28 (“FIN 28”), “Accounting for Stock Appreciation Rights and Other Variable Stock Option or Award Plans.”

The following table provides pro forma disclosures as if the Company had recorded compensation costs based on the estimated grant date fair value, as defined by SFAS No. 123, for awards granted under its stock option and stock purchase plans.

The above pro forma disclosures are not likely to be representative of the effects on net income (loss) and basic and diluted net income (loss) per share in future years because options vest over several years and additional grants are made each year.

6. Notes Receivable

Notes Receivable from Related Parties

In January 2003, an amount equal to $41,000, including accrued interest, of the outstanding balance of a promissory note for $50,000 from an officer was forgiven. The remaining balance of the note and the remaining accrued interest was settled in exchange for the repurchase of 64,383 shares of common stock.

In January 2003, an amount equal to $43,000, including accrued interest, of the outstanding balance of a promissory note for $50,000 from an officer was forgiven. The remaining balance of the note and the remaining accrued interest was settled in exchange for the repurchase of 64,657 shares of common stock.

Notes Receivable from Stockholders

In January 2003, a promissory note from an officer in the amount of $537,000 and accrued interest of $102,000 was settled in exchange for $190,000 in cash payments related to his separation agreement, the repurchase of 573,014 vested shares of common stock at $0.49 per share and 107,146 unvested shares of common stock at $1.57 per share.

In February 2003, a promissory note from an officer in the amount of $268,000 and accrued interest of $53,000 was settled in exchange for the repurchase of 792,601 vested shares of common stock at $0.30 per share and 53,573 unvested shares of common stock at $1.57 per share.

8

Table of Contents

7. Loans Payable

In March 2003, the Company repaid in full, without penalty, the outstanding balance of $10,000,000 under its term loan facility. As a result of this payment, the Company is no longer required to maintain restricted cash balances of $10,500,000 as security for the loan facility.

Future principal payments of loans payable at March 31, 2003 are as follows (in thousands):

8. Research and Development Collaborations and License Agreements

On February 8, 2002, the Company entered into its third DeltaBase subscription agreement with Merck & Co., Inc. Under the DeltaBase agreement, Merck has the right to access DeltaBase information on gene function based upon knockout mouse studies. The DeltaBase agreement also grants Merck non-exclusive, worldwide licenses to knockout mice, materials and intellectual property rights under DeltaBase. The Company will receive an aggregate of $15,250,000 in subscription licensing and access fees during the term of the agreement. Merck will have non-exclusive access to information related to 750 genes and access to certain of the corresponding DeltaBase intellectual property rights. Revenues recognized related to this agreement were $1,531,000 in the three months ended March 31, 2003. Deferred revenues related to this agreement were $4,674,000 and $8,990,000 at March 31, 2003 and 2002, respectively. No revenue was recognized related to this agreement during the three months ended March 31, 2002.

In February 2003, the Company granted a royalty-free, fully paid, worldwide, non-exclusive, non-transferable, non-sublicenseable, internal license to Bristol-Meyers Squibb Company for certain patent rights in exchange for 1,800,000 shares of Deltagen, Inc. common stock. No revenue was recognized related to this agreement during the three months ended March 31, 2003.

9

Table of Contents

9. Acquisitions

Acquisition of BMSPRL, L.L.C.

On February 16, 2002, the Company completed the acquisition of BMSPRL, L.L.C. (“BMSPRL”), formerly known as CombiChem, Inc., from Bristol-Myers Squibb Company for 2,647,481 unregistered shares of the Company’s common stock valued at approximately $23,510,000 and incurred acquisition related costs of approximately $465,000. The subsidiary, located in San Diego, California, was renamed Deltagen Research Laboratories, or DRL. The addition of DRL was intended to enable the Company to advance its targets by identifying lead candidate compounds for drug development.

Accordingly, the results of operations of BMSPRL and estimated fair value of assets acquired and liabilities assumed were included in the Company’s consolidated financial statements starting on February 16, 2002.

The total purchase price was allocated to the estimated fair value of assets acquired and liabilities assumed based on independent appraisals and management estimates as follows (in thousands):

10

Table of Contents

BMSPRL had no in-process research and development projects underway at the time of the acquisition.

The amount allocated to completed technology was being amortized over the estimated useful life of three to ten years using the straight-line method. All of this completed technology was written-off as part of the charge for intangible asset impairment during 2002.

The amount of the purchase price in excess of the net assets acquired was recorded as goodwill. This goodwill was written-off as part of the charge for goodwill impairment during 2002.

On October 2, 2002, the Company announced a cost savings and business restructuring plan to reduce cash burn rate. The plan included the closing of the San Diego facility that housed the DRL operations. As a result of the restructuring plan, substantially all DRL activities and chemistry capabilities have ceased or been eliminated.

Acquisition of XenoPharm, Inc.

On March 14, 2002, the Company acquired XenoPharm, Inc. (“XenoPharm”), a San Diego, California-based private company for 498,236 unregistered shares of the Company’s common stock valued at approximately $3,622,000 and incurred acquisition related cost of approximately $536,000. Additionally, the Company may be required to issue up to an additional 1,449,262 shares of common stock upon the satisfaction of certain milestones. XenoPharm provides a proprietary technology platform to pharmaceutical, biotechnology, chemical and agricultural companies to better understand and predict reactions of foreign substances, termed “xenobiotics,” in human systems. XenoPharm’s XenoSensor Mice, implanted with human SXR and CAR, coupled with XenoPharm’s CleanScreen high-throughput screening assays provide a proprietary technology platform to improve the predictive value of cell- and animal-based biomedical research.

The results of operations of XenoPharm and estimated fair value of assets acquired and liabilities assumed were included in the Company’s consolidated financial statements starting on March 14, 2002.

The total purchase price was allocated to the estimated fair value of assets acquired and liabilities assumed based on independent appraisals and management estimates as follows (in thousands):

In connection with the purchase of XenoPharm, the Company recorded a $110,000 charge to in-process research and development in the March 31, 2002 quarter. The amount was determined by identifying research projects for which technological feasibility had not been established and no alternative future uses existed. The value of the projects identified to be in progress was determined by estimating the future cash flows from the projects once commercially feasible, discounting the net cash flows back to their present value and then applying a percentage of completion to the calculated value. The net cash flows from the identified projects were expected to commence at various times in 2002, and were based on estimates of revenues, cost of revenues, research and development costs, selling, general and administrative costs and applicable income taxes for the projects. The discount rates used in the present value calculations were typically derived from a weighted-average cost of capital analysis based upon comparable public companies, adjusted upward to reflect additional risks inherent in the development life cycle. Such discount rates ranged between 45% and 55% for all projects. Development of the technologies remains a substantial risk to the Company due to factors including the remaining effort to achieve technological feasibility, rapidly changing customer markets and competitive threats from other companies.

        The completed technology consisted of transgenic animal models. The value of the completed technology was determined by estimating the future cash flows from the technology, discounting the net cash flows back to their present value. The net cash flows from the identified technologies were expected to commence at various times in 2002, and were based on estimates of revenues, cost of revenues, selling, general and administrative costs and applicable income taxes. The discount rates used in the present value calculations were typically derived from a weighted-average cost of capital analysis based upon comparable public companies, adjusted upward to reflect additional inherent risks. Such discount rates ranged between 45% and 50% for all projects. The Company has generated no revenue to date from this technology as of March 31, 2003. The future generation of revenues from the technologies remains a substantial risk to the Company due to factors including rapidly changing customer markets and competitive threats from other companies.

The amount allocated to completed technology is being amortized over the estimated useful life of three years using the straight-line method due to rapidly changing customer markets and competitive threats from other companies.

The amount of the net assets in excess of the purchase price was recorded as a deferred credit since the Company may be required to issue additional shares of common stock upon the satisfaction of certain milestones. The amount of additional consideration paid will reduce the deferred credit and be included as additional purchase price. If the milestones are not met or the value of the common stock issued is less than the deferred credit, the excess will primarily reduce the value of the completed technology.

11

Table of Contents

Proforma Results

The following unaudited pro forma summary is provided for illustrative purposes only and is not necessarily indicative of the consolidated results of operations for future periods or that actually would have been realized had the Company, BMSPRL and XenoPharm been a consolidated entity during the periods presented. The summary combines the results of operations as if BMSPRL and XenoPharm had been acquired as of the beginning of the periods presented.

10. Intangible Assets

Intangible assets consist of the following (in thousands):

At March 31, 2003 amortization expense was expected to be as follows (in thousands):

Amortization expense was $585,000 and $619,000 in the three months ended March 31, 2003 and 2002, respectively.

11. Business Restructuring

On January 6, 2003, the Company announced a business restructuring and cost reduction plan. The Company’s business strategy will focus on providing drug discovery tools and services to the biopharmaceutical industry utilizing the Company’s

12

Table of Contents

proprietary in vivo mammalian transgenic technologies. The Company has decided to terminate its internal small molecule drug discovery and development programs.

As part of this restructuring, the Company reduced its staff to approximately 200 employees. The plan included the closing of its Strasbourg, France operations and its Salt Lake City operations acquired in the acquisition of Arcaris, Inc. and the planned consolidation of core activities into the Company’s Redwood City, California facility.

Facility Leases

In March 2003, the Company entered into an agreement with the landlord of its Menlo Park, California facilities to terminate its remaining lease obligations. The agreement required the Company to make a termination payment of $500,000 and pay decommissioning costs of $12,000 in March 2003, forfeit restricted cash underlying letters of credit totaling $431,000 in April 2004 and issue warrants to purchase 250,000 shares of the Company’s Common or Series A Convertible Preferred Stock at the landlord’s option. The value of the warrants at March 31, 2003 was approximately $50,000. The value of the warrant was calculated using the Black-Scholes pricing model. The assumptions used in the Black-Scholes model are as follows: dividend yield of 0%, term of ten years, volatility of 115.64% and risk-free interest rate of 3.90%. The Company had ceased using these facilities in January 2003. The expenses associated with this agreement were recorded during the three months ended March 31, 2003 and are included in restructuring charges on the consolidated statement of operations.

In March 2003, the Company entered into an agreement with the landlord of its Alameda, California facility to terminate its remaining sub-lease obligation. The agreement requires the Company to forfeit restricted cash underlying letters of credit totaling approximately $211,000 and make a termination payment of $590,000 on or before August 31, 2003 or the date of the closing of the Company’s sale of not less than $10,000,000 of its equity securities. The Company had ceased using this facility in February 2003. The expenses associated with this agreement were recorded during the three months ended March 31, 2003 and are included in restructuring charges on the consolidated statement of operations.

In March 2003, the Company entered into an option agreement with the landlord of one of its Redwood City, California facilities to terminate its remaining lease obligation. The agreement requires the Company to forfeit restricted cash underlying letters of credit totaling approximately $1,701,000, make termination payments of $1,200,000 on or before August 31, 2003 and $200,000 on or before January 15, 2005 and to issue warrants to purchase 900,000 shares of the Company’s Common or Series A Preferred Stock at the landlord’s option plus additional warrants equal to 0.05 warrants per dollar for each dollar of Series A preferred stock issued in excess of $10,000,000. The value of the warrants at March 31, 2003 was approximately $278,000. The value of the warrant was calculated using the Black-Scholes pricing model. The assumptions used in the Black-Scholes model are as follows: warrants to purchase 1,400,000 shares of the Company’s Common or Series A Convertible Preferred Stock, dividend yield of 0%, term of ten years, volatility of 115.64% and risk-free interest rate of 3.90%. The Company had ceased using this facility in February 2003. The expenses associated with this agreement were recorded during the three months ended March 31, 2003 and are included in restructuring charges on the consolidated statement of operations.

In March 2003, the Company entered into an assignment agreement related to its remaining lease obligation on its San Diego, California facility. The agreement requires the Company to forfeit lease deposits totaling approximately $191,000 and other costs of $275,000. The Company had ceased using this facility in January 2003. The expenses associated with this agreement were recorded during the three months ended March 31, 2003 and are included in restructuring charges on the consolidated statement of operations.

Business Restructuring Charges

The Company recorded a restructuring charge of $9,262,000 in the first quarter of 2003 for severance and other employee related costs, costs associated with lease obligations and settlements and other costs associated with the consolidation of the Company’s facilities. These costs relate to the Company’s operations in the San Francisco Bay Area, Strasbourg, France, Salt Lake City, Utah (Arcaris acquisition in 2001) and excess facilities in Alameda, Menlo Park and Redwood City, California.

13

Table of Contents

On October 2, 2002, the Company announced a business restructuring and plan to reduce expenses. The Company’s business strategy will focus on tools, services and targets for the discovery and development of small molecule drugs. These products and services will be marketed to the biopharmaceutical industry and will serve to complement the Company’s production and licensing of its DeltaBase product. The Company also expects to continue to pursue its development in secreted proteins through its current and potential future collaborations.

As part of this restructuring, the Company reduced its staff by approximately 130 employees. The plan included the closing of its San Diego operations acquired in the acquisition of BMSPRL, L.L.C., as discussed in Note 9, the planned exit from its operations in Europe and the planned consolidation of core activities into the Company’s Redwood City, CA and Salt Lake City, UT facilities.

As a result of these actions, the Company recorded a charge in 2002 of $7,100,000 for the impairment of intangible assets related to activities that will no longer be pursued or that will be scaled back, $7,500,000 for the impairment of property and equipment and $4,900,000 for the impairment of leasehold improvements. The Company also recorded a charge in 2002 for severance and other employee related costs, costs associated with lease obligations and other costs. These costs relate primarily to the Company’s operations in San Diego, California (BMSPRL, L.L.C. acquisition), Salt Lake City, Utah (Arcaris, Inc. acquisition in 2001) and Europe.

The following table sets forth certain details associated with the business restructuring charges in 2003 and the obligations recorded in 2002 for cost reductions programs enacted in 2002 (in thousands of dollars):

It is anticipated that a majority of the remaining accrual will be paid during fiscal year 2003.

12. Subsequent Events

Business Restructuring

In April 2003, the Company announced a further 50 employee reduction in staff to approximately 150 employees. The Company expects to record a charge of approximately $780,000 in the second quarter of 2003 for final facilities closures, employee severance and other related costs.

Facility Leases

In April 2003, the Company entered into a forbearance agreement related to the lease of its principal operating and administrative facility in Redwood City, CA. This agreement provides for lease rent and certain facility operating expense to be paid from the Company’s $1,500,000 cash security deposit or $500,000 restricted cash related to letters of credit in 2003. Lease rent is also reduced by approximately 25% during the forbearance period. The agreement has certain default criteria that if breeched would cause the lease rent to revert to prior levels retroactively.

Events that would cause a default include:

Bridge Loan and Commitment for Equity Financing

        In April 2003, the Company obtained a minimum commitment for $10,000,000 in equity capital from existing institutional investors to purchase Series A Convertible Preferred Stock in a transaction referred to here in as a private placement. The private placement is subject to shareholder approval and the satisfaction of closing conditions. In addition to the terms of the private placement, the Company’s stockholders will be asked to approve a number of other matters including a reverse stock split.

Under the terms of the private placement, the investors have agreed to purchase $10,000,000 of Series A Convertible Preferred Stock. The preferred stock is convertible into common stock on a 1:1 basis. The preferred stock will be issued at a 25% discount to the five-day average closing common stock price for the period ending three days prior to closing. The preferred stock bears no

14

Table of Contents

dividend, has a liquidation preference right equal to the amount invested in the preferred stock and standard anti-dilution protections. The terms of the preferred stock agreement include the right to appoint designees to a total of three seats on the Company’s Board of Directors. The Company expects to record a charge related to the beneficial conversion feature in connection with the issuance of the Series A Convertible Preferred Stock.

The Company also obtained a secured bridge loan commitment from the same investors of $5,000,000. This facility can be increased to $6,000,000 upon the occurrence of certain events and milestones and is collateralized by all of the Company’s assets not pledged to the equipment loans. The loan bears interest at 10% per annum. The principal and interest on the bridge loan will be repaid upon the earlier of the closing of the private placement with a portion of the proceeds thereof or August 31, 2003. There are financial covenants to the bridge loan associated with cash and earnings before interest, taxes, depreciation and amortization (“EBITDA”) performance versus forecast which if not met could lead to loan default and acceleration of the loan.

In connection with the private placement, the Company has agreed to use reasonable best efforts, as soon as reasonably practicable after the closing of the private placement, to offer stockholders of record as of the last business day prior to the closing of the private placement (other than the investors in such financing) non-transferable rights to purchase newly issued preferred stock at the same purchase price paid by the investors. The amount of preferred shares so offered to each stockholder would be sufficient to allow each such stockholder to maintain the percentage ownership interest in the Company held by each such stockholder as of the last business day prior to the closing of the private placement.

Loans Payable

In April 2003, the Company reached an agreement with a General Electric Capital Corporation to restructure its existing loan agreements. The existing loan agreements had outstanding balances at March 31, 2003 of $4,998,000 and were payable in monthly installments at interest rates ranging from 8.87% to 12.75% with maturities to July 2005. Under the terms of the restructuring, the Company forfeited letters of credit totaling $2,316,000 to the lender in partial payment of the loans and entered into a new loan for the remaining balance of $2,732,000. The new loan will bear an interest rate of 10.50% and is required to be repaid in 18 monthly installments, beginning in April 2003. The loan is collateralized by a first position security interest in certain fixed assets and a second position security interest in substantially all of the Company’s other assets.

Future principal payments of loans payable after April 1, 2003 are as follows (in thousands):

Legal Matters

On April 28, 2003, the Company received from Lexicon a letter which Lexicon claims serves as notice of termination of the sublicense agreement under which the Company obtained a commercial license to the ‘215 patent and the Capecchi patents. In this letter, Lexicon specified two grounds that allegedly entitles Lexicon to terminate the sublicense agreement: (1) the Company’s purported material breach of the DeltaBase agreement, under which Lexicon obtained a commercial license to our DeltaBase product; and (2) the Company’s purported insolvency. On April 29, 2003, the Company received from Lexicon a letter which Lexicon claims serves as notice under the DeltaBase agreement of: (1) Lexicon’s alleged entitlement to damages in the amount of $25,000,000, plus attorneys’ fees and costs, for the Company’s purported material breach of the DeltaBase agreement; and (2) alleged noncompliance with the content criteria in the DeltaBase agreement. The Company believes that Lexicon’s claims and allegations are without merit, and intends to promptly address these claims according to the dispute resolution procedures provided by the settlement and other agreements between Lexicon and Deltagen. The possible loss or the range of the possible loss cannot be estimated at this time.

15

Table of Contents

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

INFORMATION REGARDING FORWARD-LOOKING STATEMENTS

This report contains forward-looking statements. The forward-looking statements are contained principally in the sections entitled “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and “Business.” These statements involve known and unknown risks, uncertainties and other factors which may cause our actual results, performance or achievements to be materially different from any future results, performances or achievements expressed or implied by the forward-looking statements. Forward-looking statements include, but are not limited to, statements about:

This report contains information regarding the biotechnology and pharmaceutical industries that we obtained from private and public industry publications. These publications generally indicate that they have obtained their information from sources believed to be reliable, but do not guarantee the accuracy and completeness of their information. Although we believe that the publications are reliable, we have not independently verified their data.

In some cases, you can identify forward-looking statements by terms such as “may,” “will,” “should,” “could,” “would,” “expects,” “plans,” “anticipates,” “believes,” “estimates,” “projects,” “predicts,” “potential” and similar expressions intended to identify forward-looking statements. These statements reflect our current views with respect to future events and are based on assumptions and subject to risks and uncertainties. Given these uncertainties, you should not place undue reliance on these forward-looking statements. We discuss many of these risks in this prospectus in greater detail under the heading “Risk Factors.” Also, these forward-looking statements represent our estimates and assumptions only as of the date of this report.

You should read this report and the documents that we reference in this report completely and with the understanding that our actual future results may be materially different from what we expect. We qualify all of our forward-looking statements by these cautionary statements.

16

Table of Contents

YOU SHOULD READ THE FOLLOWING DISCUSSION AND ANALYSIS IN CONJUNCTION WITH OUR FINANCIAL STATEMENTS AND THE ACCOMPANYING NOTES TO THE FINANCIAL STATEMENTS.

Overview

Deltagen, founded in 1997, is a leader in using in vivo derived mammalian gene function information to define the function and disease relevance of mammalian genes for the purposes of discovering and validating novel drug targets. Our proprietary information platform serves our pharmaceutical partners and customers in their efforts to discover potential new drug therapies.

Our products, based on our platform technology, provide databases of in vivo mammalian gene function information on target genes of interest to drug researchers. We delete, or “knock out,” these genes in mice and then utilize an extensive, integrated analysis program to assess the function and potential pharmaceutical relevance of these genes and the proteins these genes encode. We also focus our efforts to determine the function of secreted proteins. We are undertaking the discovery and development of biotechnology drug candidates in collaboration with other parties.

Our current customers and partners include many of the world’s largest pharmaceutical companies, Eli Lilly and Company, GlaxoSmithKline plc, Merck & Co., Inc., Pfizer Inc., and Schering-Plough Research Institute, as well as significant biotechnology and biopharmaceutical companies including Lexicon Genetics Incorporated, Millennium Pharmaceuticals, Nuvelo, Inc. and Tanox, Inc.

We also have the capability to conduct further target discovery and validation efforts through our Target Research and Development, or TRD, program. Our TRD program adds comprehensive in-depth analysis to further characterize and identify potential key targets for the treatment of disease. The program currently focuses on the identification and validation of targets in metabolism and inflammatory diseases.

A principal goal of Deltagen is to validate and characterize potential drug targets through our phenotypic analysis and TRD programs in an effort to further identify and validate potential drug candidates for our biopharmaceutical customers.

We are implementing a strategy to identify, validate and commercialize potential drug targets through our:

Our recent acquisition of XenoPharm, Inc. (“XenoPharm,”) further complements our target validation and characterization technologies. XenoPharm provides a proprietary technology platform to evaluate the metabolism of drug candidates, to improve the predictive value of cell - and animal-based biomedical research and predict the reaction of a drug candidate in a human system, thereby screening candidates for improved chances of clinical success.

We believe that our ability to determine gene function, to develop products and to identify and validate potential drug targets is a result of our leveraging of our technology platforms. Our genomics technologies, processes and information systems are integrated with one another and generate information on the function and relationships between genes and the proteins these genes encode and the usefulness of genes as new drug targets and proteins as new drug candidates. We have used these systems to establish and develop our products and programs that include our:

17

Table of Contents

DeltaBase is our proprietary database that provides information, based on knockout mouse studies, on gene function for drug discovery. We created DeltaBase to be marketed to the pharmaceutical and biotechnology industries to help define the role that genes play in biological processes and disease. We select genes for DeltaBase based upon what we believe to be their potential to become useful drug targets. We generate information on these genes by comprehensively analyzing knockout mice generated through our proprietary gene knockout methods. Each knockout mouse undergoes a standardized, detailed and extensive analysis in order to determine the function and role that a particular gene plays in the mouse. Additionally, DeltaBase subscribers will have access to the knockout mice used to generate this data.

The DeltaSelect program was our initial program. Customers received phenotypic target validation information for selected genes on a fee-for-service basis. This program was provided to validate our proprietary technology and promote interest in the DeltaBase product that became available in 2000. We believe that the DeltaSelect program has provided validation of our proprietary platform technology and promoted interest in DeltaBase, however, the revenues generated from the DeltaSelect program have to date not been significant and have with time become relatively less significant. We anticipate that revenues from DeltaSelect will continue to become less significant and that DeltaSelect will be utilized only under very limited circumstances to develop new technologies, product offerings and programs in collaboration with pharmaceutical companies.

We recently launched a product line known as DeltaOne that offers access to our extensive portfolio of knockout mice and/or accompanying phenotypic data, as well as any corresponding intellectual property, on a gene-by-gene basis. Our current customers include Aventis Pharmaceuticals, Inc., Euroscreen, S.A. and Millennium Pharmaceuticals.

We have DeltaBase agreements with GlaxoSmithKline, Pfizer and Merck. Each of these agreements provides for payments aggregating approximately $15 million in exchange for three years’ worth of DeltaBase targets. In addition, we may receive additional fees for access to certain corresponding intellectual property. We began recognizing revenue from the GlaxoSmithKline agreement in the fourth quarter of 2000. Revenue from the Pfizer agreement began to be recognized in the first quarter of 2001. We began to recognize revenue from the Merck agreement in the second quarter of 2002. We anticipate that a significant portion of our revenues for at least the next six months will be derived from fees under agreements with DeltaBase subscribers and access to information and tools related to the DeltaBase product offering. Our current DeltaBase agreements with GlaxoSmithKline and Pfizer are coterminous, each terminating upon our delivery of DeltaBase in June 2003, and, although renewable beyond such date, may not be renewed. The Merck agreement provides for payments on 600 genes (through our delivery of DeltaBase in December 2002) with payments for the remaining 150 genes to be paid upon delivery of initial gene data that may be delivered to Merck subsequent to June 2003.

We also have secreted protein agreements with Eli Lilly and Nuvelo.

Secreted Protein Agreements and Collaborations

In August 2001, we entered into a secreted protein agreement with Eli Lilly (“Lilly”) to evaluate, and potentially develop and commercialize, therapeutic secreted proteins. Under the terms of the agreement, Lilly has provided potential targets from its secreted protein pipeline for which we will further evaluate the therapeutic potential in mammalian models. Among those secreted proteins with potential therapeutic value, each company may select proteins for commercial development, with each company receiving royalties based on sales of therapeutic products. The agreement provides Lilly with certain acquisition, co-promotion, co-marketing and profit-sharing options with respect to therapeutic products developed and commercialized by us. The agreement also provides us with certain co-promotion, co-development and profit-sharing opportunities.

In October 2001, we entered into a collaboration agreement with Nuvelo to research, develop and commercialize biopharmaceutical products based on secreted proteins. Under the terms of the agreement, Nuvelo has provided us with gene sequences encoding secreted proteins and we will utilize our proprietary in vivo mammalian gene knockout technology to discover and validate potential commercially relevant biopharmaceutical drug targets. We and Nuvelo will each have certain joint development and commercialization rights around potential biopharmaceutical drug targets discovered through the collaboration. We and Nuvelo will share the collaboration’s costs; Nuvelo will provide us with approximately $8 million in research and development payments over two years. In addition, we received $10 million in equity proceeds from the sale of shares of our common stock to George B. Rathmann, Ph.D., chairman of the Board of Directors of Nuvelo.

18

Table of Contents

Revenue for the three months ended March 31, 2003 and 2002 is as follows (in thousands):

Under our revenue recognition policy, revenues are recognized when persuasive evidence of an arrangement exists, delivery has occurred or services have been rendered and meet all customer-specified criteria, the price is fixed and determinable and collectibility is reasonably assured. Revenue derived from DeltaBase agreements is recognized on a straight-line basis over the term in which services are to be provided. Research and development collaboration agreements specify milestones to be met and the payments associated with meeting each milestone. Revenue derived from these contracts is recognized upon completion of the milestone. The amount of revenue recognized upon completion of each milestone is such that the earned revenue, as a percentage of total anticipated revenue, approximates the costs incurred in achieving the related milestone, as a percentage of the total anticipated costs. Any payments received in advance of the completion of a milestone or services performed are recorded as deferred revenue.

We had net losses of $18.0 million and $18.7 million for the three months ended March 31, 2003 and 2002, respectively. Our losses have resulted primarily from costs incurred in connection with research and development activities, from selling, general and administrative costs associated with our operations, asset impairment and restructuring charges and non-cash charges for amortization of unearned stock-based compensation costs and amortization of intangibles. Amortization totaled $585,000 and $619,000 for the three months ended March 31, 2003 and 2002, respectively. The quarter ended March 31, 2003 included a $9.3 million charge for restructuring charges. Research and development expenses consist primarily of salaries and related personnel costs, material costs, legal expenses resulting from intellectual property filings and other expenses related to our DeltaBase, DeltaSelect and secreted protein programs. We expense our research and development costs as they are incurred. Selling, general and administrative expenses consist primarily of salaries and related expenses for executive, finance and other administrative personnel, professional and other corporate expenses including business development, marketing, litigation costs and general legal activities. In connection with the development and expansion of our gene function database and our secreted protein program, we may incur research and development and selling, general and administrative costs that may exceed revenues. As a result, we may report net losses through the next several years.

We account for stock-based employee compensation arrangements in accordance with provisions of Accounting Principles Board Opinion No. 25 (“APB 25”), “Accounting for Stock Issued to Employees” and related interpretations and comply with the disclosure provisions of Statement of Financial Accounting Standards No. 123 (“SFAS 123”), “Accounting for Stock-Based Compensation.”

Under APB 25, compensation expense is based on the difference, if any, on the date of the grant, between the fair value of our stock and the exercise price. SFAS 123 defines a “fair value” based method of accounting for an employee stock option or similar equity investment.

We account for equity instruments issued to non-employees in accordance with the provisions of SFAS 123 and Emerging Issues Task Force Issue No. 96-18 (“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 Financial Accounting Standards Board Interpretation No. 28 (“FIN 28”), “Accounting for Stock Appreciation Rights and Other Variable Stock Option or Award Plans.”

During the three months ended March 31, 2003, we recorded unearned stock-based compensation of approximately $1.0 million. This amount is being amortized as charges to operations over the respective vesting period of the individual stock options, generally four years. During the three months ended March 31, 2002, we reversed approximately $138,000 of unearned stock-based compensation related to unvested stock options due to employee terminations and changes in the fair market value of our common stock.

We may incur additional stock-based compensation expense in the future as a result of both options or other securities granted at below fair market value and fluctuations in the market value of our stock that have a direct impact on the value of options and warrants held by non-employees.

19

Table of Contents

Major Developments since December 31, 2002

On January 6, 2003, we announced a cost savings and business restructuring plan to reduce our cash expenditures. As part of this restructuring plan, we closed the Salt Lake City facility that housed the Deltagen Proteomics, Inc. operations. As a result of the restructuring plan, substantially all Deltagen Proteomics, Inc. activities and capabilities have ceased or been eliminated.

The Company’s restructuring efforts are expected to reduce operating costs and decrease cash outflows from operations going forward. The restructuring efforts are not expected to impact potential revenues from the Company’s core business of providing derived mammalian gene function information to define the function and disease relevance of mammalian genes. Since internal drug development efforts will no longer be pursued, any potential revenues that the Company might have realized from such pursuits will not occur. There are no available estimates for the forgone revenue opportunities related to such efforts. The total expected annual cost savings from ongoing operations as well as the abandonment of drug development efforts is expected to be approximately $79 million. Total annual operating cash cost savings from ongoing operations are expected to be approximately $20 million in 2003 with such savings beginning in Q1 2003 ($13.4 million from R&D activities and $6.6 million from G&A activities which include approximately $9.9 million due to headcount reductions that began in October 2002) Total annual cash cost savings from the abandonment of drug development efforts are expected to be approximately $57.6 million. Depreciation expense is not expected to be materially impacted by the restructuring activities. Due to the write-off of certain intangible assets in 2002, the expense reduction for the amortization of intangible assets is expected to be $1.4 million in 2003. As a result of the renegotiation of existing and excess facilities, the Company reduced its aggregate future minimum lease commitments from 2003 forward by approximately $70 million. Additional restructuring charges of $780,000 are expected in the second quarter of 2003.

Restructuring Activities

With the acquisitions of Arcaris, Inc. and BMSPRL, L.L.C. and the expansion of our internal drug development efforts, the number of employees peaked at 450 by September 30, 2002 and we were leasing ten facilities. Given the significant net cash outflow from operations and the difficulty in accessing additional capital, we undertook a series of cost cutting measures beginning in October 2002. These included workforce reductions in October 2002, January 2003 and April 2003 and the closure of our operations outside of the San Francisco Bay Area, including the closure of Arcaris, BMSPRL and Europe operations. Remaining operations are being consolidated into our recently renovated 132,000 square foot facility in Redwood City, California. We discontinued our internal drug discovery efforts and refocused our strategies and operations on providing drug discovery tools and services to the biopharmaceutical industry utilizing the Company’s proprietary core mammalian in vivo transgenic technologies. In addition to the workforce reduction and cost cutting actions, we negotiated settlement of obligations with certain landlords, lenders and vendors.

Facility Leases

In March 2003, we entered into an agreement with the landlord of our Menlo Park, California facilities to terminate our remaining lease obligations. The agreement required us to make a termination payment of $500,000 and pay decommissioning costs of $12,000 in March 2003, forfeit restricted cash underlying letters of credit totaling $431,000 in April 2004 and issue warrants to purchase 250,000 shares of our Common or Series A Preferred Stock at the landlord’s option. The value of the warrants at March 31, 2003 was approximately $50,000. The value of the warrant was calculated using the Black-Scholes pricing model. The assumptions used in the Black-Scholes model are as follows: dividend yield of 0%, term of ten years, volatility of 115.64% and risk-free interest rate of 3.90%. We ceased using these facilities in January 2003. The expenses associated with this agreement were recorded during the three months ended March 31, 2003 and are included in restructuring charges on the consolidated statement of operations.

In March 2003, we entered into an agreement with the landlord of our Alameda, California facility to terminate our remaining sub-lease obligation. The agreement requires us to forfeit restricted cash underlying letters of credit totaling approximately $211,000 and make a termination payment of $590,000 on or before August 31, 2003 or the date of the closing of our sale of not less than $10,000,000 of our equity securities. We ceased using this facility in February 2003. The expenses associated with this agreement were recorded during the three months ended March 31, 2003 and are included in restructuring charges on the consolidated statement of operations.

In March 2003, we entered into an option agreement with the landlord of one of our Redwood City, California facilities to terminate our remaining lease obligation. The agreement requires us to forfeit restricted cash underlying letters of credit totaling approximately $1.7 million, make termination payments of $1.2 million on or before August 31, 2003 and $200,000 on or before January 15, 2005 and to issue warrants to purchase 900,000 shares of our Common or Series A Preferred Stock at the landlord’s option plus additional warrants equal to 0.05 warrants per dollar for each dollar of Series A preferred stock issued in excess of $10 million. The value of the warrants at March 31, 2003 was approximately $278,000. The value of the warrant was calculated using the Black-Scholes pricing model. The assumptions used in the Black-Scholes model are as follows: warrants to purchase 1,400,000 shares of the Company’s Common or Series A Preferred Stock, dividend yield of 0%, term of ten years, volatility of 115.64% and risk-free interest rate of 3.90%. We ceased using this facility in February 2003. The expenses associated with this agreement were recorded during the three months ended March 31, 2003 and are included in restructuring charges on the consolidated statement of operations.

In March 2003, we entered into an assignment agreement related to our remaining lease obligation on our San Diego, California facility. The agreement requires us to forfeit lease deposits totaling approximately $191,000 and incur other costs of $275,000. We ceased using this facility in January 2003. The expenses associated with this agreement were recorded during the three months ended March 31, 2003 and are included in restructuring charges on the consolidated statement of operations.

In April 2003 we entered into a forbearance agreement related to the lease of our principal operating and administrative facility in Redwood City, California. This agreement provides for lease rent and certain facility operating expense to be paid from our $1.5 million cash security deposit or $500,000 restricted cash related to letters of credit in 2003. Lease rent is also reduced by approximately 25% during the forbearance period. The agreement has certain default criteria that if breeched would cause the lease rent to revert to prior levels retroactively.

Events that would cause a default include:

Lending Arrangements

In March 2003, we repaid in full, without penalty, the outstanding balance of $10 million under a term loan facility. As a result of this payment, we are no longer required to maintain restricted cash balances of $10.5 million as security for the loan facility.

20

Table of Contents

In March 2003, we reached an agreement with General Electric Capital Corporation to restructure our existing loan agreements. The existing loan agreements had outstanding balances at March 31, 2003 of $5.0 million and were payable in monthly installments at interest rates ranging from 8.87% to 12.75% with maturities to July 2005. Under the terms of the restructuring, we forfeited letters of credit totaling $2.3 million to the lender in partial payment of the loans and entered into a new loan for the remaining balance of $2.7 million. The new loan will bear an interest rate of 10.50% and is required to be repaid in 18 monthly installments beginning in April 2003. The loan is collateralized by a first position security interest in certain fixed assets and a second position security interest in substantially all of our other assets.

Vendor Arrangements

In March 2003, we negotiated the settlement of a $1.2 million obligation with a vendor for $434,000 in current cash payments, $144,000 to be paid upon completion of the Series A Preferred Stock financing described below and $290,000 in Series A Preferred Stock to be issued upon closing of the private placement. The remaining $290,000 balance is to be forgiven upon the completion of the preferred financing.

Bridge Loan and Commitment for Equity Financing

In April 2003, we obtained a minimum commitment for $10 million in equity capital from existing institutional investors to purchase preferred stock in a transaction referred to here in as the private placement. The private placement is subject to shareholder approval and the satisfaction of closing conditions. In addition to the terms of the private placement, our stockholders will be asked to approve a number of other matters including a reverse stock split.

Under the terms of the private placement, the investors have agreed to purchase $10 million of preferred stock. The preferred stock is convertible into common stock on a 1:1 basis. The preferred stock will be issued at a 25% discount to the five-day average closing common stock price for the period ending three days prior to closing. The preferred stock bears no dividend, has a liquidation preference right equal to the amount invested in the preferred stock and standard anti-dilution protections. The terms of the preferred stock agreement include the right to appoint designees to a total of three seats on the Board of Directors.

We also obtained a secured bridge loan commitment of $5 million from the same investors. This facility can be increased to $6 million upon the occurrence of certain events and milestones and is secured by all of our assets not pledged to the equipment loans. The loan bears interest at 10% per annum. The principal and interest on the bridge loan will be repaid upon the earlier of the closing of the private placement with the proceeds thereof or August 31, 2003. There are financial covenants to the bridge loan associated with cash and earnings before interest, taxes, depreciation and amortization (“EBITDA”) performance versus forecast which if not met could lead to loan default and acceleration of the loan.

In connection with the private placement, we have agreed to use reasonable best efforts, as soon as reasonably practicable after the closing of the preferred stock financing, to offer stockholders of record as of the last business day prior to the closing of the private placement (other than the investors in such financing) non-transferable rights to purchase newly issued preferred stock at the same purchase price paid by the investors. The amount of preferred shares so offered to each stockholder would be sufficient to allow each such stockholder to maintain the percentage ownership interest in Deltagen held by each such stockholder as of the last business day prior to the closing of the private placement.

Legal Matters

On April 28, 2003, the Company received from Lexicon a letter which Lexicon claims serves as notice of termination of the sublicense agreement under which the Company obtained a commercial license to the ‘215 patent and the Capecchi patents. In this letter, Lexicon specified two grounds that allegedly entitles Lexicon to terminate the sublicense agreement: (1) the Company’s purported material breach of the DeltaBase agreement, under which Lexicon obtained a commercial license to our DeltaBase product; and (2) the Company’s purported insolvency. On April 29, 2003, the Company received from Lexicon a letter which Lexicon claims serves as notice under the DeltaBase agreement of: (1) Lexicon’s alleged entitlement to damages in the amount of $25 million, plus attorneys’ fees and costs, for the Company’s purported material breach of the DeltaBase agreement; and (2) alleged noncompliance with the content criteria in the DeltaBase agreement. The Company believes that Lexicon’s claims and allegations are without merit, and intends to promptly address these claims according to the dispute resolution procedures provided by the settlement and other agreements between Lexicon and Deltagen.

21

Table of Contents

RESULTS OF OPERATIONS

Revenue for the three months ended March 31, is as follows (in thousands):

Costs and expenses for the three months ended March 31, are as follows (in thousands):

Three Months Ended March 31, 2003 and 2002

Revenues

Contract revenue increased by $2.0 million to $4.6 million in three months ended March 31, 2003 from $2.6 million in the first quarter of 2002. The increase was due primarily to increased revenue from our DeltaBase gene function database product as a result of our collaboration with Merck signed in 2002. Revenue for the Merck agreement was first recognized in the second quarter of 2002. In 2003, our DeltaBase, DeltaOne and DeltaSelect revenue came principally from contracts with GlaxoSmithKline, Merck, Millennium Pharmaceuticals, Pfizer and Schering-Plough Research Institute.

Costs and Expenses

Costs and expenses for the three months ended March 31, 2003 were $22.4 million compared to $21.6 million in the first quarter of 2002. Costs and expenses for the quarter ended March 31, 2003 include charges of $9.3 million for restructuring. These charges are associated with our strategic business realignments announced in January 2003 and include severance costs of $2.5 million and lease settlement costs of $4.2 million. Further charges for severance and other employee related costs of approximately $780,000 will be recorded in the second quarter of 2003 related to a additional 50 employee reduction in staff announced on April 10, 2003 as well as final facilities closures.

Research and development expenses decreased by $6.7 million to $10.1 million for the three months ended March 31, 2003 from $16.8 million for the comparable period in 2002. The decrease in costs and expenses was due primarily to the benefits of the cost reduction actions taken in October 2002 and January 2003. These actions included reductions in our workforce and the discontinuance of our internal small molecule drug discovery efforts following the closedown of chemistry capabilities in October 2002 and our January 2003 workforce reductions including the close down of our Salt Lake City, Utah operations. The decrease includes $3.7 million related to decreased personnel, $1.5 million related to decreased laboratory supply costs to support development of our gene function database and secreted protein programs, $158,000 related to decreased professional fees, $2 million related to decreased facilities related expenses and $552,000 related to increased depreciation expenses.

        Selling, general and administrative expenses decreased by $1.8 million to $3.0 million for the three months ended March 31, 2003 from $4.8 million for the comparable period of 2002. This decrease included $1 million related to decreased personnel and support costs, $501,000 related to decreases in facilities and depreciation related expenses, $60,000 related to decreases in legal and professional fees and $51,000 related to decreases in marketing and advertising expenses.

22

Table of Contents

Net Interest Income

Net interest expense was $164,000 in the three months ended March 31, 2003 compared to net interest income of $263,000 in the three months ended March 31, 2002. This decrease resulted from reduced average cash and investment balances, lower interest rates on cash investments and increased borrowings during 2003 and as compared to 2002.

Business Restructuring

On January 6, 2003, we announced additions to our business restructuring and cost reduction plan. As part of this restructuring, we reduced our staff to approximately 200 employees. The plan included the closing of our Strasbourg, France operations and our Salt Lake City operations acquired in the acquisition of Arcaris, Inc. and the consolidation of core activities into our Redwood City, California facility. As a result, the Company recorded a charge in the first quarter of 2003 for severance and other employee related costs, costs associated with lease obligations and settlements and other costs. These costs relate to the Company’s operations in the San Francisco Bay Area, Strasbourg, France, Salt Lake City, Utah (Arcaris acquisition in 2001) and excess facilities in Alameda, Menlo Park and Redwood City, California.

The Company’s restructuring efforts are expected to reduce operating costs and decrease cash outflows from operations going forward. The restructuring efforts are not expected to impact potential revenues from the Company’s core business of providing derived mammalian gene function information to define the function and disease relevance of mammalian genes. Since internal drug development efforts will no longer be pursued, any potential revenues that the Company might have realized from such pursuits will not occur. There are no available estimates for the forgone revenue opportunities related to such efforts. The total expected annual cost savings from ongoing operations as well as the abandonment of drug development efforts is expected to be approximately $79 million. Total annual operating cash cost savings from ongoing operations are expected to be approximately $20 million in 2003 with such savings beginning in Q1 2003 ($13.4 million from R&D activities and $6.6 million from G&A activities which include approximately $9.9 million due to headcount reductions that began in October 2002). Total annual cash cost savings from the abandonment of drug development efforts are expected to be approximately $57.6 million. Depreciation expense is not expected to be materially impacted by the restructuring activities. Due to the write-off of certain intangible assets in 2002, the expense reduction for the amortization of intangible assets is expected to be $1.4 million in 2003. As a result of the renegotiation of existing and excess facilities, the Company reduced its aggregate future minimum lease commitments from 2003 forward by approximately $70 million.

The following table sets forth certain details associated with the business restructuring charges in 2003 and the obligations recorded in 2002 for cost reductions programs enacted in 2002 (in thousands of dollars):

It is anticipated that a majority of the remaining accrual will be paid during fiscal year 2003.

We will record a charge of approximately $780,000 in the second quarter of 2003 for final facilities closures, employee severance and other related costs associated with a further reduction in the workforce to approximately 150 employees announced on April 10, 2003.

23

Table of Contents

In March 2003, we entered into an agreement with the landlord of our Menlo Park, California facilities to terminate our remaining lease obligations. The agreement required us to make a termination payment of $500,000 and pay decommissioning costs of $12,000 in March 2003, forfeit restricted cash underlying letters of credit totaling $431,000 in April 2004 and issue warrants to purchase 250,000 shares of our Common or Series A Preferred Stock at the landlord’s option. The value of the warrants at March 31, 2003 was approximately $50,000. The value of the warrant was calculated using the Black-Scholes pricing model. The assumptions used in the Black-Scholes model are as follows: dividend yield of 0%, term of ten years, volatility of 115.64% and risk-free interest rate of 3.90%. We ceased using these facilities in January 2003. The expenses associated with this agreement were recorded during the three months ended March 31, 2003 and are included in restructuring charges on the consolidated statement of operations.

In March 2003, we entered into an agreement with the landlord of our Alameda, California facility to terminate our remaining sub-lease obligation. The agreement requires us to forfeit restricted cash underlying letters of credit totaling approximately $211,000 and make a termination payment of $590,000 on or before August 31, 2003 or the date of the closing of our sale of not less than $10,000,000 of our equity securities. We ceased using this facility in February 2003. The expenses associated with this agreement were recorded during the three months ended March 31, 2003 and are included in restructuring charges on the consolidated statement of operations.

In March 2003, we entered into an option agreement with the landlord of one of our Redwood City, California facilities to terminate our remaining lease obligation. The agreement requires us to forfeit restricted cash underlying letters of credit totaling approximately $1.7 million, make termination payments of $1.2 million on or before August 31, 2003 and $200,000 on or before January 15, 2005 and to issue warrants to purchase 900,000 shares of our Common or Series A Preferred Stock at the landlord’s option plus additional warrants equal to 0.05 warrants per dollar for each dollar of Series A preferred stock issued in excess of $10 million. The value of the warrants at March 31, 2003 was approximately $278,000. The value of the warrant was calculated using the Black-Scholes pricing model. The assumptions used in the Black-Scholes model are as follows: warrants to purchase 1,400,000 shares of the Company’s Common or Series A Preferred Stock, dividend yield of 0%, term of ten years, volatility of 115.64% and risk-free interest rate of 3.90%. We ceased using this facility in February 2003. The expenses associated with this agreement were recorded during the three months ended March 31, 2003 and are included in restructuring charges on the consolidated statement of operations.

In March 2003, we entered into an assignment agreement related to our remaining lease obligation on our San Diego, California facility. The agreement requires us to forfeit lease deposits totaling approximately $191,000 and incur other costs of $275,000. We ceased using this facility in January 2003. The expenses associated with this agreement were recorded during the three months ended March 31, 2003 and are included in restructuring charges on the consolidated statement of operations.

In April 2003 we entered into a forbearance agreement related to the lease of our principal operating and administrative facility in Redwood City, California. This agreement provides for lease rent and certain facility operating expense to be paid from our $1.5 million cash security deposit or $500,000 restricted cash related to letters of credit in 2003. Lease rent is also reduced by approximately 25%, approximately $8.8 million, during the forbearance period. The agreement has certain default criteria that if breeched would cause the lease rent to revert to prior levels retroactively.

Events that would cause a default include: