ESSENTIAL THERAPEUTICS INC - 10-Q Quarterly Report

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE

SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED

JUNE 30, 2002

TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE

SECURITIES EXCHANGE ACT OF 1934

Commission file number: 0-28006

ESSENTIAL THERAPEUTICS, INC.

(Exact name of registrant as specified in its charter)

Delaware		94-3186021
(State or other jurisdiction of incorporation of organization)		(I.R.S. Employer Identification Number)

1365 Main Street, Waltham, Massachusetts		02451
(Address of principal executive offices)		(ZIP Code)

Registrant’s telephone number, including area code: 781-647-5554

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 ¨

Number of shares of Common Stock, $0.001 par value per share, outstanding as of July 31, 2002: 18,849,447

ESSENTIAL THERAPEUTICS, INC.

INDEX FOR FORM 10-Q

For the Quarter Ended June 30, 2002

		Page Number

PART I FINANCIAL INFORMATION

Item 1.	Condensed Consolidated Financial Statements

	Condensed Consolidated Balance Sheets as of June 30, 2002 and December 31, 2001	3

	Condensed Consolidated Statements of Operations for the three and six months ended June 30, 2002 and June 30, 2001	4

	Condensed Consolidated Statements of Cash Flows for the six months ended June 30, 2002 and June 30, 2001	5

	Notes to Condensed Consolidated Financial Statements	6

Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	10

	Risk Factors That May Affect Results	14

Item 3.	Quantitative and Qualitative Disclosures about Market Risk	21

PART II OTHER INFORMATION

Item 4.	Submission of Matters to a Vote of Security Holders	22

Item 6.	Exhibits and Reports on Form 8-K	22

Signatures		23

PART I. FINANCIAL INFORMATION

Item 1. Condensed Consolidated Financial Statements

ESSENTIAL THERAPEUTICS, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

	June 30, 2002			December 31, 2001
	(in thousands, except share amounts)
	(unaudited)
ASSETS
Current assets:
Cash and cash equivalents	$	17,002		$	57,469
Marketable securities		26,310			2,065
Trade and other receivables		966			5,403
Prepaid expenses and other current assets		1,049			518
Assets held for sale		669			—

Total current assets		45,996			65,455
Restricted cash		472			—
Property and equipment, net		4,485			5,538
Goodwill		1,526			6,276
Other assets		1,244			775

Total assets	$	53,723		$	78,044

LIABILITIES AND STOCKHOLDERS’ EQUITY (DEFICIT)
Current liabilities:
Accounts payable	$	518		$	1,284
Accrued compensation		991			2,210
Current portion of notes payable		434			668
Accrued merger and financing costs		131			700
Deferred revenue		663			3,579
Accrued restructuring		2,515			—
Other accrued liabilities		1,052			1,196

Total current liabilities		6,304			9,637
Long-term portion of notes payable		280			456
Long-term portion of accrued restructuring		787			—
Accrued rent		354			395
Series B convertible redeemable preferred stock, par value $0.001; 60,000 shares authorized; 60,000 shares issued and outstanding at June 30, 2002 and December 31, 2001 (net of deemed dividend and issuance costs)		52,626			51,775
Commitments and contingencies		—			—
Stockholders’ equity (deficit):
Preferred stock, par value $0.001; 5,000,000 shares authorized; 60,000 Series B shares issued and outstanding at June 30, 2002 and December 31, 2001		—			—
Common stock, par value $0.001; 50,000,000 shares authorized; 18,838,821 and 16,752,723 shares issued and outstanding at June 30, 2002 and December 31, 2001, respectively		19			17
Additional paid-in capital		105,467			99,800
Deferred compensation		(1,756	)		(2,692	)
Notes receivable from officers		(217	)		(231	)
Accumulated deficit		(110,307	)		(81,113	)
Accumulated other comprehensive income		166			—

Total stockholders’ equity (deficit)		(6,628	)		15,781

Total liabilities and stockholders’ equity (deficit)	$	53,723		$	78,044

See Notes to Condensed Consolidated Financial Statements.

ESSENTIAL THERAPEUTICS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(unaudited)

(in thousands, except per share amounts)

	Three Months Ended June 30,						Six Months Ended June 30,
	2002			2001			2002			2001
Revenues:
Research revenue	$	1,826		$	961		$	3,864		$	2,731
Milestone, licensing and other revenue		449			892			1,516			1,784

Total revenues		2,275			1,853			5,380			4,515
Operating expenses:
Research and development		6,399			4,406			11,959			8,477
General and administrative		2,525			1,340			4,708			2,463
Purchased in-process research and development		—			—			7,702			—
Restructuring charges		10,720			—			10,720			—

Total operating expenses		19,644			5,746			35,089			10,940

Loss from operations		(17,369	)		(3,893	)		(29,709	)		(6,425	)
Interest and other income, net		261			166			515			337

Net loss		(17,108	)		(3,727	)		(29,194	)		(6,088	)
Accretion of deemed dividend to Series B preferred stockholders		(425	)		—			(850	)		—

Net loss allocable to common stockholders	$	(17,533	)	$	(3,727	)	$	(30,044	)	$	(6,088	)

Basic and diluted net loss per common share	$	(0.95	)	$	(0.32	)	$	(1.72	)	$	(0.53	)

Weighted-average shares used in computing basic and diluted net loss per common share		18,408			11,509			17,491			11,486

See Notes to Condensed Consolidated Financial Statements.

ESSENTIAL THERAPEUTICS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

	Six Months Ended June 30,
	2002			2001
	(in thousands)
Cash flows from operating activities:
Net loss	$	(29,194	)	$	(6,088	)
Adjustments to reconcile net loss to net cash provided by (used in) operating activities:
Depreciation and amortization		1,112			1,118
Stock compensation expense		485			15
Notes receivable from officers		14			—
Purchased in-process research and development		7,702			—
Accrued rent		(15	)		59
Loss on fixed assets disposal		15			44
Goodwill impairment		6,276			—
Charges for impairment of assets		1,037			—
Changes in assets and liabilities:
Trade and other receivables		4,137			7,245
Prepaid expenses and other current assets		(531	)		(197	)
Other assets		(469	)		(10	)
Accounts payable		(1,988	)		(54	)
Accrued compensation		(1,395	)		159
Accrued restructuring		2,540			—
Other accrued liabilities		(170	)		330
Deferred revenue		(2,916	)		(3,285	)

Net cash used in operating activities		(13,360	)		(664	)

Cash flows from investing activities:
Short-term loan to Maret prior to acquisition		(275	)		—
Direct costs of Althexis acquisition		(700	)		—
Direct costs of Maret acquisition		(366	)		—
Purchase of short-term investments		(24,079	)		(3,918	)
Sales and maturities of short-term investments		—			9,750
Change in restricted cash		(472	)		—
Capital expenditures		(997	)		(61	)

Net cash provided by (used in) investing activities		(26,889	)		5,771

Cash flows from financing activities:
Principal payments on notes payable		(410	)		(778	)
Net proceeds from issuance of common stock		192			269

Net cash used in financing activities		(218	)		(509	)

Net increase (decrease) in cash and cash equivalents		(40,467	)		4,598
Cash and cash equivalents at beginning of period		57,469			3,744

Cash and cash equivalents at end of period	$	17,002		$	8,342

Supplemental disclosure of cash flow information:
Interest paid	$	49		$	72

Supplemental disclosure of Maret acquisition:
Tangible assets acquired	$	82
Liabilities assumed		2,033
Goodwill acquired		1,526
Acquisition costs incurred		497
Purchased in-process research and development		7,702
Common stock issued		6,780

See Notes to Condensed Consolidated Financial Statements.

ESSENTIAL THERAPEUTICS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

1. Basis of Presentation

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete consolidated financial statements. In the opinion of management, all adjustments, which consist of normal recurring accruals, considered necessary for a fair presentation have been included. The results of operations for the interim periods shown herein are not necessarily indicative of operating results for the entire year.

This unaudited financial data should be read in conjunction with the consolidated financial statements and footnotes contained in our annual report on Form 10-K for the year ended December 31, 2001, which was filed with the Securities and Exchange Commission on March 29, 2002.

2. Summary of Significant Accounting Policies

Goodwill—Goodwill is the excess of any purchase price over the estimated fair market value of net tangible assets acquired not allocated to specific intangible assets. In July 2001, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 142, “Goodwill and Other Intangible Assets.” Under SFAS No. 142, goodwill and indefinite-lived intangible assets are no longer amortized but are reviewed annually for impairment or more frequently if impairment indicators arise. Separable intangible assets that are not deemed to have an indefinite life will continue to be amortized over their useful lives.

Revenue Recognition—As part of our strategy to enhance our research and development capabilities and to fund, in part, our capital requirements, we have entered into collaboration agreements with several major pharmaceutical companies. Pursuant to our collaboration agreements, we received license fees, milestone payments and research support payments, and may potentially receive additional research support payments, milestone payments and royalty payments in the future. License payments are typically non-refundable up-front payments for licenses to develop, manufacture and market any products that are developed as a result of collaboration. Research support payments are typically contractually obligated payments to fund research and development over the term of collaboration. Milestone payments are contingent payments that are made only upon the achievement of specified milestones, such as selection of candidates for drug development, the commencement of clinical trials or receipt of regulatory approvals. If drugs are successfully developed and commercialized as a result of our collaboration agreements, we will receive royalty payments based upon the net sales of those drugs developed in accordance with the terms of the collaboration agreements. In addition, we have derived other revenues principally through the sale of molecular diversity to other pharmaceutical and biotechnology companies for use in their research programs, and through short-term contract research.

Segment Information—SFAS No. 131, “Disclosures about Segments of an Enterprise and Related Information,” establishes standards for the way that public business enterprises report information about operating segments in annual financial statements and requires that those enterprises report selected information about operating segments in interim financial reports. SFAS No. 131 also establishes standards for related disclosures about products and services, geographic areas and major customers. We operate in one business segment, which primarily focuses on the discovery, development and commercialization of pharmaceutical products.

Net Loss per Share—Our basic and diluted net loss per common share amounts are computed using the weighted-average number of shares of common stock outstanding less the weighted-average shares outstanding which are subject to our right of repurchase. Because we are in a net loss position, diluted earnings per share is calculated using the weighted-average number of shares of common stock outstanding less the weighted-average shares outstanding which are subject to our right of repurchase and excludes the effects of options, which are antidilutive.

Comprehensive Income (Loss)—Comprehensive income (loss) is comprised of net loss and other comprehensive income (loss). Other comprehensive income (loss) includes some changes in equity that are excluded from net loss. Specifically, unrealized holding gains and losses on our available-for-sale securities, which were reported separately in stockholders’ equity, are included in accumulated other comprehensive income (loss).

ESSENTIAL THERAPEUTICS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

	Three Months Ended
	June 30, 2002			June 30, 2001
	(in thousands)
Net loss	$	(17,108	)	$	(3,727	)
Change in unrealized gain (loss) on available-for-sale securities		342			(48	)

Comprehensive loss	$	(16,766	)	$	(3,775	)

	Six Months Ended
	June 30, 2002			June 30, 2001
	(in thousands)
Net loss	$	(29,194	)	$	(6,088	)
Change in unrealized gain (loss) on available-for-sale securities		166			(29	)

Comprehensive loss	$	(29,028	)	$	(6,117	)

3. Restructuring Costs

In June 2002, the Company refocused its resources on advancing the development of several promising antibiotic and antifungal compounds that have emerged from its research pipeline. As a result, the Company eliminated several early discovery programs that employed approximately 80 people to shift discovery funding to these lead compounds and clinical development candidates. In connection with the restructuring the Company recorded a restructuring charge of $10.7 million in the quarter ended June 30, 2002.

The restructuring expenses consist of non-cash charges of $7.5 million and cash charges of $3.2 million. The non-cash charges consist primarily of a $6.3 million impairment charge of the goodwill associated with the acquisition of The Althexis Company (“Althexis”) in October 2001 and an $0.8 million non-cash impairment charge on the carrying value of certain equipment that is held for sale. The cash charges consist primarily of $1.4 million in severance costs as well as $1.4 million in costs associated with exiting certain lease and other facility exit costs incurred as a direct result of these plans, which will not have future benefits.

Of the total restructuring charges unpaid as of June 30, 2002, $0.8 million has been classified as a long term liability in the accompanying condensed consolidated balance sheets, as these are lease commitments that extend past a year. The remaining restructuring charges of $2.5 million are classified in the condensed consolidated balance sheets as a current liability as these costs will be paid within the year.

4. Long-Lived Assets Held for Sale

The restructuring plan detailed in Note 3 resulted in a commitment by the Company to sell certain scientific equipment with a carrying value of $1.4 million. The Company believes that the equipment will be sold no later than the end of the year. On June 30, 2002, the Company determined that the plan of sale criteria in FASB Statement No. 144 “Accounting for the Impairment or Disposal of Long-Lived Assets” had been met. Accordingly, the carrying value of the scientific equipment was adjusted to its fair value less costs to sell, amounting to $0.7 million, which was determined based on quoted market prices of similar assets. The resulting $0.8 million non-recurring impairment loss has been recorded as part of the restructuring charge in the second quarter 2002 condensed consolidated statements of operations. The carrying value of the scientific equipment that is held for sale is separately presented in the “Assets Held for Sale” caption in the condensed consolidated balance sheets.

5. Goodwill Impairment

In management’s opinion, the restructuring detailed in Note 3 represented an indication of impairment of recorded goodwill. In accordance with SFAS No. 142, an interim test of goodwill impairment was performed as of June 30, 2002. In assessing the recoverability of the goodwill associated with the acquisition of Althexis, we made assumptions regarding estimated future cash flows associated with the technologies that were under development by Althexis and other factors to determine the fair value of the intangible assets acquired. The results of the impairment test indicated that no goodwill was present due to the decision not to

ESSENTIAL THERAPEUTICS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

pursue the research activities at Althexis and accordingly, we recognized a one-time goodwill impairment charge of $6.3 million in the second quarter of 2002, which was included in the restructuring charge.

The remaining goodwill as of June 30, 2002 of $1.5 million is the goodwill associated with the acquisition of Maret Pharmaceuticals, Inc. (“Maret”). As of June 30, 2002, the value of the goodwill has not been proven to be impaired. This goodwill will continue to be reviewed annually for impairment or more frequently if impairment indicators arise and will be adjusted as necessary.

6. Acquisition of Maret Pharmaceuticals, Inc.

In March 2002, we completed our acquisition of Maret for an aggregate purchase price of $7.3 million. The acquisition of Maret was structured as a tax-free share exchange and was accounted for under the purchase method of accounting. In connection with the acquisition, we issued a total of 2.0 million shares of our common stock, valued at $3.39 per share, or approximately $6.8 million. This per share fair value represents the average closing price of our common stock on and about the date of the merger agreement. In addition, we assumed $2.0 million in net financial liabilities, consisting mainly of accounts payable and accrued liabilities as well as cash advances to Maret by Essential made prior to the acquisition, and incurred $0.5 million of acquisition-related liabilities. The condensed consolidated financial statements herein include Maret’s operating results from the date of acquisition.

The cost to acquire Maret was allocated to the tangible and intangible assets acquired and liabilities assumed according to their respective fair values, with the excess purchase price allocated to goodwill. The following table summarizes the fair values of the assets acquired and liabilities assumed at the date of acquisition:

	(in thousands)
Current assets	$	61
Property and equipment		21
Research and development assets		7,702
Goodwill		1,526

Total assets acquired		9,310
Liabilities assumed		(2,033	)

Net assets acquired	$	7,277

We recorded a one-time, non-cash charge to operations in the quarter ended March 31, 2002 of $7.7 million for purchased in-process research and development. The valuation of acquired in-process research and development represents the estimated fair value of incomplete projects that, at the time of the acquisition, had no alternative future use and for which technological feasibility had not been established. The fair value was determined by discounting, to present value, the cash flows expected to result from each in-process research and development project once it has reached commercial feasibility. The income approach was utilized to value Maret’s in-process research and development. The income approach focuses on the income producing capability of the acquired technologies, and best represents the present value of the future economic benefits expected to be derived from them. The discount rates used to discount projected cash flows ranged from 60% to 70%, depending on the risk related with each program and its estimated stage of completion at the time of the acquisition.

The following unaudited pro forma summary presents the condensed consolidated results of operations for Essential as if the acquisition had taken place on January 1, 2001, and excludes the write-off of in-process research and development of $7.7 million. The unaudited pro forma summary for the six months ended June 30, 2001 also includes the results of Essential as if its October 24, 2001 acquisition of The Althexis Company, Inc., previously disclosed in our annual report on Form 10-K for the year ended December 31, 2001, had taken place on January 1, 2001.

	June 30, 2002			June 30, 2001
	(in thousands, except per share data)
Revenues	$	5,388		$	7,748
Net loss allocable to common stockholders	$	(11,332	)	$	(7,278	)
Pro forma basic and diluted net loss per common share	$	(0.62	)	$	(0.39	)

ESSENTIAL THERAPEUTICS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

The pro forma net loss and net loss per share amounts for each period above exclude the acquired in-process research and development charge. The pro forma consolidated results do not purport to be indicative of results that would have occurred had the acquisition been in effect for the periods presented, nor do they purport to be indicative of the results that will be achieved in the future.

7. Recently Issued Accounting Standards

In July 2001, the FASB issued SFAS No. 141 “Business Combinations” and SFAS No. 142 “Goodwill and Other Intangible Assets.” SFAS No. 141 eliminates the pooling-of-interests method of accounting for business combinations except for qualifying business combinations that were initiated prior to July 1, 2001. SFAS No. 141 further clarifies the criteria to be met in order to recognize intangible assets separately from goodwill. The requirements of SFAS No. 141 are effective for any business combination accounted for by the purchase method that is completed after June 30, 2001. Under SFAS No. 142, goodwill and indefinite-lived intangible assets are no longer amortized but are reviewed annually for impairment or more frequently if impairment indicators arise. Separable intangible assets that are not deemed to have an indefinite life will continue to be amortized over their useful lives. The goodwill resulting from the acquisition of Maret is not being amortized.

In August 2001, the FASB issued SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” which addresses financial accounting and reporting for the impairment or disposal of long-lived assets and supercedes SFAS No. 121, “Accounting for Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of” and the accounting and reporting provisions of APB Opinion No. 30, “Reporting the Results of Operations,” for a disposal of a segment of a business. SFAS No. 144 is effective for fiscal years beginning after December 15, 2001, with transition provisions for assets “held for sale” that were initially recorded under previous models (APB No. 30 or SFAS No. 121) and do not meet the new “held for sale” criteria. We adopted SFAS No. 144 in the first quarter of 2002, and the adoption did not have any impact on our financial position or results of operations at that time.

8. Subsequent Events

In June 2002, the Company negotiated a $1.5 million lease line to finance the cost of capital purchases. As of June 30, 2002, the Company had not drawn down on this lease line but expects to draw down the remainder over the next six months. All amounts drawn on the lease line are required to be repaid in 48 equal monthly installments commencing in January 2003 at an interest rate of 9.94%.

In August 2002, the Company entered into an agreement with Fleet National Bank for a $2.5 million term loan to be used to finance leasehold improvements and equipment purchases at the Company’s new headquarters. The line would be drawn down through December 31, 2002 and would be payable in 16 equal quarterly installments beginning in March 2003 with an interest rate of LIBOR plus 100 basis points. Cash and marketable securities will collateralize the loan.

In August 2002, the Company entered into a collaborative research and development agreement with Fujisawa Pharmaceutical Co., Ltd. (“Fujisawa”). Essential will develop assay systems for the discovery of antibacterial antibiotics and will perform high-throughput screening of the compounds in Fujisawa’s library through a subcontractor. Fujisawa will conduct lead generation and optimization and will exclusively develop, manufacture and market the resulting products worldwide. The agreement provides for reimbursement revenue, payments upon the achievement of specified milestones and royalties based on worldwide sales of products.

I tem 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

Overview

Essential Therapeutics, Inc. is a biopharmaceutical company committed to the development of breakthrough products for treatment of life-threatening diseases in the areas of hematology, oncology and infectious diseases. Essential is dedicated to commercializing novel small molecule products addressing important unmet therapeutic needs. Our lead product, ETRX 101, is a small molecule angiotensin derivative for treatment and prophylaxis of the suppression of blood cells, known as myelosuppression, and other serious clinical diseases. Essential also has broad-based antibiotic and antifungal discovery and development programs with a significant product pipeline.

Acquisitions

On March 11, 2002, we completed the acquisition of Maret Pharmaceuticals, Inc., as a result of which Maret became a wholly owned subsidiary of Essential.

On October 24, 2001, we completed the acquisition of The Althexis Company, Inc., as a result of which Althexis became a wholly owned subsidiary of Essential.

The acquisitions were accounted for under the purchase method of accounting. The condensed consolidated financial statements discussed herein reflect the inclusion of the results of Maret and Althexis from the date of acquisition. All material intercompany accounts and transactions have been eliminated in consolidation.

Collaboration Agreements

We have entered into collaboration agreements with major pharmaceutical and biotechnology companies relating to a range of therapeutic products and services. These agreements provide us with the opportunity to receive license fees and funding research, and may provide certain additional payments contingent upon our achievement of research and regulatory milestones and royalties and/or share profits if our collaborations are successful in developing and commercializing products. The collaborations which we consider material to our business are:

•

a collaboration agreement with Johnson & Johnson Pharmaceutical Research & Development, L.L.C., or as we refer to them, J&JPRD to discover and develop novel beta-lactam antibiotics, antibiotic potentiators and inhibitors of bacterial signal transduction targeted at problematic gram-positive bacteria, including staphylococci and enterococci as well as a backup candidate.

•

another collaboration with J&JPRD with a focus on the discovery of products from our natural product extracts. We have provided J&JPRD with access to our natural products library for the purpose of screening for activity in various biological and therapeutic applications.

•

a collaboration agreement with Daiichi Pharmaceutical Co., Ltd. to discover and develop bacterial efflux pump inhibitors to be used in combination with Daiichi’s quinolone antibiotics to target gram-negative bacteria, including pseudomonas.

•

a collaboration agreement with NAEJA Pharmaceutical, Inc. to discover, develop and commercialize drugs based upon NAEJA’s proprietary azole antifungals and our proprietary fungal efflux pump inhibitor leads.

•

a collaboration agreement with Pfizer Inc. to implement our bacterial in vitro essential gene and multi-channel screening system to discover novel classes of antibiotics.

•

a collaboration agreement with Schering-Plough Animal Health Corporation, or as we refer to them, SPAH, to discover and develop compounds to be used in the treatment of veterinary bacterial infections based upon application of our efflux pump technology to existing SPAH antibacterials.

•

a collaboration with Iconix Pharmaceuticals, Inc., a biotechnology company to which we licensed or assigned genetics technology. Currently, we hold approximately a 17% ownership interest in Iconix, on a fully diluted basis. Iconix has applied the genetics technology to a number of viral disease targets in a search for novel antiviral agents in collaborative research funded by Essential.

Critical Accounting Policies

In December 2001, the SEC requested that all registrants discuss their most “critical accounting policies” in management’s discussion and analysis of financial condition and results of operations. The guidance defines a critical accounting policy as one that is both important to the portrayal of the company’s financial condition and results and one that requires management’s most subjective judgment, as most often it requires the need to make estimates about the effect of matters that are highly uncertain. On an on-going basis, we evaluate our estimates, including those related to accruals and revenue recognition. We base our estimates on historical experience and facts and circumstances that exist at each balance sheet date. While our significant accounting policies are described in Note 2 of these financial statements, we believe the following accounting policy to be critical:

Results of Operations

Three Months Ended June 30, 2002 and June 30, 2001

Revenues. Total revenues for the second quarter of 2002 were $2.3 million compared to $1.9 million in the second quarter of 2001 and were derived primarily from the major collaboration agreements. The increase during the period was due primarily to increased research funding from SPAH.

Research and Development Expenses. Research and development expenses for the second quarter increased from $4.4 million in 2001 to $6.4 million in 2002, due primarily to the inclusion of the operations of Althexis and Maret, which we acquired in October 2001 and March 2002, respectively. Additionally, research and development expenses slightly increased due to higher expenses for payroll and rent and the termination of the facilities and support contract with Iconix in February 2002. The increase in expenses was partially offset by lower expenses for recruiting and outside services.

Research and development expenses consist of salary and related fringe benefit expenses as well as laboratory supplies and chemicals, outside contract services and facility costs. Members of our research and development team typically work on a number of development projects concurrently. We have not historically tracked separately the costs associated with our various projects so as to enable accurate disclosure of the actual costs incurred to date on a project-by-project basis. Due to the risks inherent in the drug development process we are unable to estimate with any certainty the costs we will incur in advancing our projects toward commercialization. We do expect our research and development costs to increase as we continue to advance our existing projects through pre-clinical and clinical phases and as we incorporate the new projects assumed in the acquisition of Maret into our business.

General and Administrative Expenses. General and administrative expenses for the second quarter increased from $1.3 million in 2001 to $2.5 million in 2002, due primarily to the inclusion of the operations of Althexis and Maret, which we acquired in October 2001 and March 2002, respectively, as well as higher rent expense and the termination of the facilities and support contract with Iconix in February 2002.

Restructuring Expenses. In connection with the elimination of several of our early stage discovery programs, we recorded total restructuring charges of $10.7 million in the second quarter of 2002. The restructuring expenses consist of non-cash charges of $7.5 million and cash charges of $3.2 million. The $7.5 million in non-cash charges consist primarily of a $6.3 million write-off of goodwill associated with the acquisition of Althexis in the prior year and $0.8 million of reductions in the carrying value of certain research equipment now held for sale. The cash charges consist primarily of $1.4 million in severance and related costs and $1.4 million in lease costs for excess facilities.

Interest Income, net. Interest income for the second quarter increased from $0.2 million in 2001 to $0.3 million in 2002, due primarily to an increase in average invested cash balances, partially offset by lower interest rates. Interest expense for the second

quarter decreased from $31,000 in 2001 to $23,000 in 2002, due primarily to the declining balance on an equipment-financing loan.

Six Months Ended June 30, 2002 and June 30, 2001

Revenues. Total revenues for the first half of 2002 were $5.4 million, an increase of $0.9 million from $4.5 million for the first half of 2001. The increase in revenues during the period was due primarily to increased research funding and a milestone payment from SPAH. The increase in revenues was partially offset by the conclusion of funded research with Pfizer and Daiichi at the end of the first quarter of 2001.

Research and Development Expenses. Research and development expenses for the first half of 2002 increased from $8.5 million in 2001 to $12.0 million in 2002, due primarily to the inclusion of the operations of Althexis and Maret, which we acquired in October 2001 and March 2002, respectively. Additionally, research and development expenses also slightly increased due to higher expenses for payroll, rent expense and the termination of the facilities and support contract with Iconix in February 2002. The increase in expenses was partially offset by lower expenses for recruiting and outside services.

General and Administrative Expenses. General and administrative expenses for the first half of 2002 increased from $2.5 million in 2001 to $4.7 million in 2002, due primarily to the inclusion of the operations of Althexis and Maret, which we acquired in October 2001 and March 2002, respectively. Additionally, general and administrative expenses slightly increased due to higher rent expense and the termination of the facilities and support contract with Iconix in February 2002.

In-Process Research and Development Expenses. In connection with the acquisition of Maret, we recorded a non-recurring non-cash charge of $7.7 million for purchased in-process research and development in the first quarter of 2002. The purchased in-process research and development, which represents the fair value attributable to the technology acquired, was expensed on the acquisition date since the technology had not yet reached technological and commercial feasibility and had no future alternative uses. The income approach was utilized in valuing the in-process research and development. The fair value assigned to the in-process research and development was determined by discounting, to present value, the cash flows expected to result from each in-process research and development project once it has reached commercial feasibility. The discount rates used to discount projected cash flows ranged from 60% to 70%, depending on the risk related with each program and its estimated stage of completion at the time of the merger. The major risk associated with the timely completion and commercialization of products resulting from the purchased in-process research and development is the ability to confirm the safety and efficacy of the technology based on the data of both pre-clinical testing and long-term clinical trials. If these projects are not successfully developed, our future results of operations may be adversely affected.

Restructuring Expenses. Restructuring charges totaling $10.7 million were recorded in the second quarter of 2002, in connection with the elimination of several of our early stage discovery programs. The restructuring expenses consist of non-cash charges of $7.5 million and cash charges of $3.2 million. The $7.5 million in non-cash charges consist primarily of a $6.3 million write-off of goodwill associated with the acquisition of Althexis in the prior year and $0.8 million of reductions in the carrying value of certain research equipment now held for sale. The cash charges consist primarily of $1.4 million in severance and related costs and $1.4 million in lease costs for excess facilities.

Interest Income, net. Interest income for the first half of 2002 increased from $0.5 million in 2001 to $0.6 million in 2002, due primarily to an increase in average invested cash balances, partially offset by lower interest rates. Interest expense for the first half of 2002 decreased from $72,000 in 2001 to $49,000 in 2002, due primarily to the declining balance on an equipment-financing loan.

Liquidity and Capital Resources

We have financed our operations since inception primarily through the sale of equity securities, through funds provided under collaboration agreements, through other revenues principally consisting of sales of molecular diversity and through equipment financing arrangements. As of June 30, 2002, we had received $126.7 million from the sale of common and preferred stock and $69.3 million from license fees, research support and milestone payments under collaboration agreements.

Cash Flows

Cash, cash equivalents and investments at June 30, 2002 were $43.3 million compared to $59.5 million at December 31, 2001. Trade and other receivables at June 30, 2002 were $1.0 million compared to $5.4 million at December 31, 2001. The decrease in cash during the first six months of 2002 was due primarily to cash used by operations of $13.4 million, $1.3 million in acquisition related costs, $997,000 in capital expenditures, $472,000 in restricted cash and $410,000 in principal payments under our debt obligations. This decrease was partially offset by $192,000 in net proceeds from the issuance of common stock from the exercise of employee stock options.

We invested $997,000 in capital expenditures in the first six months of 2002 compared to $61,000 in the first six months of 2001. We expect to spend up to $2.5 million in 2002 for building improvements related to our Waltham, Massachusetts building lease entered into in January 2002. We expect to finance these improvement expenditures with a bank term loan. We made principal payments under our debt obligations of $410,000 in the first six months of 2002 compared to $778,000 in the first six months of 2001. At June 30, 2002, the remaining balance on our debt obligations was $714,000.

In March 2002, we acquired Maret, a development stage pharmaceutical company with clinical and pre-clinical programs focused in hematology, oncology and the prevention of serious infectious diseases. We expect that this acquisition will increase our research and development and general and administrative spending in the future.

In June 2002, we announced that we shifted our resources from early stage platform discovery efforts to focus on advancing pre-clinical and clinical development of several promising antibiotic and antifungal compounds that emerged from the research pipeline. In connection with the elimination of several of our early stage discovery programs, we recorded total restructuring charges of $10.7 million, which includes cash charges of $3.2 million. The cash charges consist primarily of $1.4 million in severance and related costs and $1.4 million in lease costs for excess facilities. While the restructuring will result in lower salaries and payroll related expenses, we expect to funnel these savings into the advancement of the clinical programs.

Contractual Obligations

In February 2002, we pledged $0.4 million for a standby letter of credit of the same amount, related to our Waltham, Massachusetts building lease entered into in January 2002. The term of the standby letter of credit expires in 2009. Additionally, we have pledged $0.1 million for a credit card line to finance operating expenses.

In June 2002, we negotiated a $1.5 million lease line to finance the cost of capital purchases. As of June 30, 2002, we had not drawn down on this lease line but we expect to draw down the remainder over the next six months. All amounts drawn on the lease line are required to be repaid in 48 equal monthly installments commencing in January 2003 at an interest rate of 9.94%.

In October 2001, we completed an equity financing by way of a private placement of an aggregate of 60,000 shares of our Series B convertible redeemable preferred stock for a total purchase price of $60.0 million that by its terms is required to be redeemed in October 2006, or, upon the occurrence of specified adverse events, may be required to be redeemed sooner. Under the terms of our Series B convertible redeemable preferred stock agreements, we would be required to obtain the approval of the preferred stockholders prior to incurring indebtedness above specified amounts.

We expect that our existing capital resources, including the funds from the October 2001 preferred stock financing, interest income and future payments due under our collaboration agreements will enable us to maintain current and planned operations at least through 2003. We expect to seek additional funds to continue our business activities beyond that time and will seek to raise additional funding, as opportunities arise, from other collaboration arrangements or public or private financings, including sales of equity or debt securities. Any collaboration or licensing arrangements could result in limitations on our ability to control the commercialization of resulting drugs, if any, and could limit profits, if any, therefrom. Any equity financing could result in dilution to our then-existing stockholders.

On February 9, 2001, we filed a registration statement on Form S-3 for a “shelf” registration, which was amended on March 21, 2001. Pursuant to the registration statement, we may offer up to $35.0 million of newly issued common stock. The registration statement became effective in March 2001. While we have no current plans to do so, we may in the future offer additional shares of common stock under our “shelf” registration statement in order to finance our operations. If we do, we cannot assure you that additional funds will be available on favorable terms, or at all, or that any funds, if raised, would be sufficient to permit us to continue to conduct our operations. If adequate funds are not available, we may be required to curtail significantly or eliminate one or more of our research programs.

Risk Factors That May Affect Results

IF OUR RESEARCH AND DEVELOPMENT EFFORTS DO NOT RESULT IN POTENTIAL DRUG CANDIDATES AND/OR WE CANNOT ADVANCE POTENTIAL PRODUCTS THROUGH CLINICAL TRIALS, WE MAY FAIL TO DEVELOP PHARMACEUTICAL PRODUCTS.

In July 2002, J&JPR&D initiated Phase I clinical trials with RWJ-442831, an Essential-developed prodrug form of the collaboration’s lead parenteral cephalosporin product, known as RWJ-54428. The Phase I clinical trials for this cephalosporin compound may not be completed. We have two other cephalosporin compounds in the J&JPR&D collaboration: another parenteral compound that is in pre-clinical development and a cephalosporin intended for oral administration, in the research stage. ETRX 101, our small molecule angiotensin derivative, has completed Phase I clinical testing. The Phase II clinical trials for this compound may not be completed. Our other potential products are in the pre-clinical or research stage. All of our potential products will require significant additional research and development efforts before we can sell them. These efforts include extensive pre-clinical and clinical testing prior to submission to the Food and Drug Administration, or FDA, or other regulatory authority. Pre-clinical and clinical testing will likely take several years. After submission, these potential products will be subject to lengthy regulatory review. We cannot predict with accuracy the time required to commercialize new pharmaceutical products.

The development of new pharmaceutical products is highly uncertain and subject to a number of significant risks. We do not expect any of our potential products to be commercially available for a number of years, if at all. Pharmaceutical products that appear to be promising at early stages of development may not reach the market for a number of reasons including the following:

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we or our partners may not successfully complete research and development efforts;

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any pharmaceutical products we or our partners develop may be found to be ineffective or to cause harmful side effects during pre-clinical testing or clinical trials;

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we may fail to obtain required regulatory approvals for any products that we develop;

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we may be unable to manufacture enough of any potential products at an acceptable cost and with appropriate quality;

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our products may not be competitive with other existing or future products; and

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proprietary rights of third parties may prevent us from commercializing our products.

IF WE ARE UNABLE TO MAINTAIN OUR CURRENT COLLABORATIONS WITH OUR PARTNERS, ENTER INTO NEW COLLABORATIONS OR EXTEND CONCLUDED COLLABORATIONS, DEVELOPMENT OF OUR POTENTIAL PRODUCTS COULD BE DELAYED.

Our strategy for enhancing our research and development capability and funding, in part, our capital requirements involves entering into collaboration agreements with major pharmaceutical companies, which we refer to as our partners. We have entered into collaboration agreements with J&JPR&D, Daiichi, Pfizer, Schering-Plough Animal Health and Fujisawa. Under these agreements, our partners are responsible for:

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selecting which compounds discovered in the appropriate collaboration will proceed into subsequent development, if any;

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conducting pre-clinical testing, clinical trials and obtaining required approvals for potential products; and

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manufacturing and commercializing any approved products.

We cannot control the timing of these actions or the amount of resources devoted to these activities by our partners. In addition, these agreements are subject to cancellation or the election not to extend by our partners. As a result, our receipt of revenue, whether in the form of continued research funding, product development milestone payments, or royalties on sales, depends upon the decisions made and the actions taken by our partners. Our partners may view compounds that we may discover as competitive with their own products or potential products, and, therefore, any partner may elect not to proceed with the development of our potential products. Our partners are free to pursue their own existing or alternative technologies to develop products in preference to our potential products. We cannot be certain that our interests will continue to coincide with those of our partners, or that disagreements concerning our rights, technology, or other proprietary interests will not arise with our partners.

Substantially all of our revenues to date have resulted from our collaborations. We intend to continue to rely on our collaborations to fund a substantial portion of our research and development activities over the next several years. If our existing

partners do not extend our collaborations or if we are unable to enter into new collaborations, the development and commercialization of our potential products may be delayed. In addition, we may be forced to seek alternative sources of financing for product development and commercialization activities.

WE HAVE INCURRED SUBSTANTIAL LOSSES IN THE PAST, EXPECT TO CONTINUE TO INCUR LOSSES FOR THE NEXT SEVERAL YEARS AND MAY NEVER ACHIEVE PROFITABILITY.

We have incurred substantial net losses in every year since our inception in December 1992. We had net losses allocable to common stockholders of $10.7 million in 1999, $13.9 million in 2000 and $28.2 million in 2001. We had an accumulated deficit of $110.3 million through June 30, 2002. We expect to continue to incur operating losses over the next several years.

Substantially all of our revenues to date have resulted from license fees, research support and milestone payments under our collaboration agreements. We will not receive revenues or royalties from drug sales until we or our partners successfully complete clinical trials with regard to a drug candidate, obtain regulatory approval for this drug candidate, and successfully commercialize the drug. We do not expect to receive revenues or royalties from sales of drugs for a number of years, if at all. If we fail to achieve sufficient revenues to become profitable or sustain profitability, we may be unable to continue operations.

IF WE FAIL TO SATISFY SAFETY AND EFFICACY REQUIREMENTS OR MEET REGULATORY REQUIREMENTS IN OUR CLINICAL TRIALS, WE WILL NOT BE ABLE TO COMMERCIALIZE OUR DRUG CANDIDATES.

Either we or our collaborators must show through pre-clinical studies and clinical trials that each of our pharmaceutical products is safe and effective in humans for each indication before obtaining regulatory clearance from the FDA for the commercial sale of that pharmaceutical product. If we fail to adequately show the safety and effectiveness of a pharmaceutical product, regulatory approval could be delayed or denied. The results from pre-clinical studies and early clinical trials are often different than the results that are obtained in large-scale testing. We cannot be certain that we will show sufficient safety and effectiveness in our clinical trials that would allow us to obtain regulatory approval. A number of companies in the pharmaceutical industry, including biotechnology companies, have suffered significant setbacks in advanced clinical trials, even after promising results in earlier trials.

Any drug is likely to produce some level of toxicity or undesirable side effects in animals and in humans when administered at sufficiently high doses and/or for a long period of time. Unacceptable toxicities or side effects may occur in the course of toxicity studies or clinical trials. If we observe unacceptable toxicities or other side effects, we, our partner or regulatory authorities may interrupt, limit, delay or halt the development of the drug. In addition, unacceptable toxicities or side effects could prevent approval by the FDA or foreign regulatory authorities for any or all indications.

We must obtain regulatory approval before marketing or selling our future drug products. In the United States, we must obtain FDA approval for each drug that we intend to commercialize. The FDA approval process is lengthy and expensive, and approval is never certain. Products distributed abroad are also subject to foreign government regulation. The process of obtaining FDA and other required regulatory approvals can vary a great deal based upon the type, complexity and novelty of the products involved. Delays or rejections may be caused by additional government regulation from future legislation or administrative action or changes in FDA policy during the period of clinical trials and FDA regulatory review. Similar delays also may be experienced in foreign countries.

None of our drug candidates has received regulatory approval. If we fail to obtain this approval, we will be unable to manufacture and sell our drug products commercially. Even if we obtain regulatory approval and begin selling a pharmaceutical product, we may be required to continue clinical studies. In addition, identification of side effects after a drug is on the market or the occurrence of manufacturing problems could cause subsequent withdrawal of approval, reformulation of the drug, additional pre-clinical testing or clinical trials and changes in labeling of the product. This could delay or prevent us from generating revenues from the sale of that drug or cause our revenues to decline.

If we obtain regulatory approval, we will also be subject to existing and future FDA regulations and guidelines and continued regulatory review. In particular, we, our collaborators, or any third party that we use to manufacture the drug, will be required to adhere to regulations setting forth current good manufacturing practices. The regulations require that we manufacture our products and maintain our records in a particular way with respect to manufacturing, testing and quality control activities. Furthermore, we, our collaborators, or our third-party manufacturers, must pass a pre-approval inspection of manufacturing facilities by the FDA before obtaining marketing approval.

Failure to comply with the FDA or other relevant regulatory requirements may subject us to administrative or legally imposed restrictions. These restrictions may include warning letters, civil penalties, injunctions, product seizure or detention, product recalls, total or partial suspension of production and FDA refusal to approve pending New Drug Applications, or NDAs, or supplements to approved NDAs.

OUR COMMON STOCK MAY BE DELISTED.

Our common stock is presently listed on the Nasdaq National Market System under the symbol “ETRX.” All companies listed on Nasdaq are required to comply with certain continued listing standards, including maintaining stockholders’ equity of at least $10,000,000 or a minimum bid price of at least $1.00. We are not in compliance with this stockholders’ equity standard as of June 30, 2002. We intend to explore various alternatives and take steps to address any Nasdaq listing standard noncompliance. We cannot assure you that any appeal of any Nasdaq delisting determination will prove successful. If we are unable to work out any listing standard noncompliance with Nasdaq, or otherwise regain compliance, we cannot assure you that our common stock will continue to remain eligible for listing on Nasdaq. In the event that Essential’s common stock is delisted from Nasdaq, its market value and liquidity would be materially adversely affected. Moreover, any delisting of our common stock from the Nasdaq National Market would constitute a holder optional repurchase event under the terms of our outstanding Series B preferred stock, giving our Series B preferred stockholders the right to cause Essential to redeem the shares of preferred stock. For a description of the holder optional repurchase event and the rights of the Series B preferred stockholders associated therewith, please see Note 7 to our financial statements filed with our Form 10-K for the year ended December 31, 2001.

IF WE ARE UNABLE TO PROTECT OUR INTELLECTUAL PROPERTY, WE MAY LOSE THE COMPETITIVE ADVANTAGE INHERENT IN OUR PROPRIETARY TECHNOLOGIES.

Our success depends in part on our ability to establish, protect and enforce our proprietary rights relating to our lead compounds, gene discoveries, screening technology and other proprietary technology. We have numerous patent applications in the United States, in addition to applications filed in other countries, in order to protect clinical and lead compounds, gene discoveries and screening technology, and more than 55 United States patents have been issued to date on these applications. We cannot be certain that patents will be granted with respect to any of our patent applications currently pending in the United States or in other countries, or with respect to applications filed in the future. For example, although in 2000 a patent was granted in the United States covering our cephalosporin compounds now in development, prosecution has not yet begun on more recently filed patent applications related to prodrugs of our earlier inventions, as well as on our new compounds having potential for oral administration. Our failure to obtain patents pursuant to our current or future applications could have a material adverse effect on our business. Furthermore, we cannot be certain that any patents issued to us will not be infringed, challenged, invalidated or circumvented by others, or that the rights granted there under will provide competitive advantages to us. In particular, it is difficult to enforce patents covering methods of use of screening and other similar technologies. Litigation to establish the validity of patents, to defend against copatent infringement claims and to assert infringement claims against others can be expensive and time-consuming, even if the outcome is favorable to us. If the outcome of patent prosecution or litigation is not favorable to us, our business could be materially adversely affected.

Our commercial success also depends on our ability to operate without infringing patents and proprietary rights of third parties. We cannot assure you that our products will not infringe on the patents or proprietary rights of others. For example, many companies are active in the field of genomics, and some have filed patents on essential genes in bacteria. While we are not currently aware of any patents encumbering our ability to practice the technologies we have discovered, it is possible that a patent of this nature may issue in the future. We may be required to obtain licenses to patents or other proprietary rights of others. Any licenses may not be available on terms acceptable to us, if at all. The failure to obtain these licenses could delay or prevent our partners’ activities, including the development, manufacture or sale of drugs requiring such licenses.

In addition to patent protection, we rely on trade secrets, proprietary know-how and technological advances that we seek to protect, in part, by confidentiality agreements with our partners, employees and consultants. We cannot assure you that these agreements will not be breached, that we would have adequate remedies for any breach that might occur, or that our trade secrets, proprietary know-how and technological advances will not otherwise become known or be independently discovered by others.

IF OTHER COMPANIES DEVELOP BETTER PRODUCTS THAN OURS OR MARKET SIMILAR PRODUCTS SOONER, OUR PRODUCTS MAY BE RENDERED OBSOLETE OR NONCOMPETITIVE.

We operate in a field in which new developments are occurring at an increasing pace. Competition from biotechnology and pharmaceutical companies, joint ventures, academic and other research institutions and others is intense and is expected to increase. Many of our competitors have substantially greater financial, technical and personnel resources than we have. Although we believe that we have identified new and distinct approaches to drug discovery, there are other companies with drug discovery programs, at least some of the objectives of which are the same as or similar to ours. For example, there are other companies that have recently described cephalosporins in early stages of development that are designed for treatment of resistant gram-positive infections in hospitals, the same objective as our lead cephalosporin compound. Similarly, several other companies are seeking to capitalize on the expanding body of knowledge of efflux pumps in microorganisms.

Competing technologies may be developed that would render our technologies obsolete or noncompetitive. We are aware of many pharmaceutical and biotechnology companies that are engaged in efforts to treat myelosuppression and each of the infectious diseases for which we are seeking to develop therapeutic products. We cannot assure you that our competitors will not develop competing drugs that are more effective than those developed by us and our partners or obtain regulatory approvals of their drugs more rapidly than we and our partners, thereby rendering our and our partners’ drugs obsolete or noncompetitive. Moreover, we cannot assure you that our competitors will not obtain patent protection or other intellectual property rights that would limit our and our partners’ ability to use our technology or commercialize our or their drugs.

OUR POTENTIAL PRODUCTS MAY NOT BE ACCEPTABLE IN THE MARKET OR ELIGIBLE FOR THIRD PARTY REIMBURSEMENT, RESULTING IN A NEGATIVE IMPACT ON OUR FUTURE FINANCIAL RESULTS.

Any products successfully developed by us or our partners may not achieve market acceptance. The hematology/oncology and antibiotic products that we are attempting to develop will compete with a number of well-established traditional drugs manufactured and marketed by major pharmaceutical companies. The degree of market acceptance of any of our products will depend on a number of factors, including:

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the establishment and demonstration in the medical community of the clinical efficacy and safety of our products;

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the potential advantage of our products over existing treatment methods; and

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reimbursement policies of government and third-party payors.

Physicians, patients or the medical community in general may not accept or use any products that may be developed by us or our partners. Our ability to receive revenues and income with respect to drugs, if any, developed through the use of our technology will depend, in part, upon the extent to which reimbursement for the cost of these drugs will be available from third-party payors, such as government health administration authorities, private health care insurers, health maintenance organizations, pharmacy benefits management companies and other organizations. Third-party payors are increasingly challenging the prices charged for pharmaceutical products. If third-party reimbursement is not available or sufficient to allow profitable price levels to be maintained for drugs developed by us or our partners, it could adversely affect our business.

WE HAVE NO MANUFACTURING, MARKETING OR SALES EXPERIENCE, AND IF WE ARE UNABLE TO ENTER INTO MANUFACTURING AGREEMENTS OR MAINTAIN COLLABORATIONS WITH MARKETING PARTNERS OR IF WE ARE UNABLE TO DEVELOP OUR OWN MANUFACTURING, SALES AND MARKETING CAPABILITY, WE MAY NOT BE SUCCESSFUL IN COMMERCIALIZING OUR PRODUCTS.

We do not have any experience in the manufacture of commercial quantities of drugs, and our current facilities and staff are inadequate for the commercial production or distribution of drugs. We intend to rely on our partners for the manufacturing, marketing and sales of any products that result from these collaborations. The current third-party manufacturer of our potential cephalosporin product has in the past encountered difficulties with the manufacture of related compounds in sufficient quantities for clinical trial purposes. Manufacturers often encounter difficulties in scaling up to manufacture commercial quantities of pharmaceutical products. We cannot be certain that our current or any other manufacturer will not encounter similar delays in the scale-up to manufacture this or any other compound in commercial quantities in the future.

We will be required to contract with third parties for the manufacture of our products or to acquire or build production facilities before we can manufacture any of our products. We cannot assure you that we will be able to enter into contractual manufacturing arrangements with third parties on acceptable terms, if at all, or acquire or build production facilities ourselves.

To date we have no experience with sales, marketing or distribution. In order to market any of our products, we will be required to develop marketing and sales capabilities, either on our own or in conjunction with others. We cannot assure you that we will be able to develop any of these capabilities.

HEALTH CARE REFORM MEASURES OR COST CONTROL INITIATIVES MAY NEGATIVELY IMPACT PHARMACEUTICAL PRICING, THEREBY HARMING OUR ABILITY TO COMMERCIALIZE OUR POTENTIAL PRODUCTS.

The levels of revenue and profitability of pharmaceutical companies may be affected by continuing governmental efforts to contain or reduce the costs of health care through various means. For example, in some foreign markets pricing or profitability of prescription pharmaceuticals is already subject to governmental control. In the United States, there have been, and we expect that there will continue to be, a number of federal and state proposals to implement similar governmental control. Cost control initiatives could decrease the price that we or our partners receive for any products that we or they may develop in the future which would adversely affect our business. Further, to the extent that these types of proposals or initiatives have a material adverse effect on our partners or potential partners, our ability to commercialize our potential products may be materially adversely affected.

IF OUR PRODUCTS HARM PEOPLE, WE MAY EXPERIENCE PRODUCT LIABILITY CLAIMS THAT MAY NOT BE COVERED BY INSURANCE.

We face an inherent business risk of exposure to potential product liability claims in the event that drugs, if any, developed through the use of our technology are alleged to have caused adverse effects on patients. This risk exists for products being tested in human clinical trials, as well as products that receive regulatory approval for commercial sale. We will, if appropriate, seek to obtain product liability insurance with respect to drugs developed by us and our partners. We may not, however, be able to obtain insurance. Even if insurance is obtainable, it may not be available at a reasonable cost or in a sufficient amount to protect us against liability. Any successful product liability claims may exceed our financial resources. Further, costs of defending against product liability claims, even if we were to prevail ultimately, may have a material adverse effect on our business and results of operations.

IF WE CANNOT ATTRACT AND RETAIN MANAGEMENT AND SCIENTIFIC STAFF, WE MAY NOT BE ABLE TO PROCEED WITH OUR DRUG DISCOVERY AND DEVELOPMENT PROGRAMS.

We are highly dependent on management and scientific staff, including Mark Skaletsky, our President and Chief Executive Officer, George H. Miller, Ph.D., our Executive Vice President—Research and Development, Paul Mellett, our Senior Vice President and Chief Financial Officer and on our other officers. Considering the time necessary to recruit replacements, if we lose the services of any of the named individuals or other senior management and key scientific staff, we may incur delays in our product development and commercialization efforts or experience difficulties in raising additional funds. We may also lose a significant amount of revenues without the senior staff necessary to adequately maintain existing corporate collaborations or to enter into new collaborations. We do not carry key-man life insurance on any of our executives. We believe that our future success will depend, in part, on our ability to attract and retain highly talented managerial and scientific personnel and consultants. In recent years, because of great demand for qualified personnel and the numerous opportunities available to them in the biotechnology and pharmaceutical industries, we have experienced intense competition attracting and retaining employees from the limited number of qualified personnel available. Many of the other biotechnology and pharmaceutical companies with whom we compete for qualified personnel have qualities such as greater financial and other resources, different risk profiles and a longer history in the industry, or provide different opportunities, such as greater career advancement, that may be more appealing to, and helpful in attracting and retaining, qualified personnel. We cannot assure you that we will be able to attract and retain the personnel we require on acceptable terms, or at all. In the event we are unable to do so, the rate at which we can develop and commercialize drugs will be limited.

OUR OPERATIONS INVOLVE HAZARDOUS MATERIALS, WHICH COULD SUBJECT US TO SIGNIFICANT LIABILITY.

As with many biotechnology and pharmaceutical companies, our activities involve the use of radioactive compounds and hazardous materials. As a consequence, we are subject to numerous environmental and safety laws and regulations. We are subject to periodic inspections for possible violations of any environmental or safety law or regulation. Any violation of, and the cost of compliance with, these regulations could materially adversely affect our operations.

ANTI-TAKEOVER PROVISIONS IN OUR CHARTER AND BY-LAWS AND DELAWARE LAW, TOGETHER WITH OUR STOCKHOLDER RIGHTS PLAN, COULD MAKE THE ACQUISITION OF OUR COMPANY BY ANOTHER COMPANY MORE DIFFICULT.

Some provisions of our certificate of incorporation and by-laws may have the effect of making it more difficult for a third party to acquire, or discouraging a third party from attempting to acquire, control of Essential. These provisions could limit the price that investors might be willing to pay in the future for shares of our common stock. These provisions allow us to issue preferred stock without a vote or further action by our stockholders, provide for staggered elections of our Board of Directors and specify procedures for director nominations by stockholders and submission of other proposals for consideration at stockholder meetings. None of these provisions provides for cumulative voting in the election of directors. Some provisions of Delaware law applicable to us could also delay or make more difficult a merger, tender offer or proxy contest involving us, including Section 203 of the Delaware General Corporation Law, which prohibits a Delaware corporation from engaging in any business combination with any stockholder owning 15% or more of our outstanding voting stock for a period of three years from the date the person became a 15% stockholder unless specified conditions are met.

We adopted a stockholder rights plan, dated as of February 2, 1999, pursuant to which our Board of Directors declared a dividend of one right for each share of the common stock outstanding, which right entitles the holder to purchase for $30.00 a fraction of a share of our Series A preferred stock with economic terms similar to that of one share of the common stock. In the event that an acquiror obtains 20% or more of our outstanding common stock, each right, other than rights owned by the acquiror or its affiliates, will thereafter entitle the holder thereof to purchase, for the exercise price, a number of shares of the common stock having a then current market value equal to twice the exercise price. If, after an acquiring person obtains 20% or more of our outstanding common stock, we merge into another entity, an acquiring entity merges into our company, or we sell more than 50% of our assets or earning power, then each right, other than rights owned by the acquiring person or its affiliates, will entitle the holder thereof to purchase for the exercise price, a number of shares of common stock of the person engaging in the transaction having a then current market value equal to twice the exercise price.

The possible issuance of Series A preferred stock, the procedures required for director nominations and stockholder proposals and Delaware law could have the effect of delaying, deferring or preventing a change in control of Essential, including without limitation, discouraging a proxy contest or making more difficult the acquisition of a substantial block of our common stock. These provisions could also limit the price that investors might be willing to pay in the future for shares of our common stock.

IF WE CANNOT OBTAIN ADDITIONAL FUNDING FOR FUTURE OPERATIONS, WE MAY NOT BE ABLE TO PROCEED WITH OUR DRUG DISCOVERY AND DEVELOPMENT PROGRAMS.

The development of our potential pharmaceutical products will require substantially more money than we currently have. We intend to seek to raise such additional funding from sources including other partners and through public or private financings involving the sale of equity or debt securities. We cannot assure you that any financings will be available when needed, or if

available will be on acceptable terms. Funding from partners could limit our ability to control the research, development and commercialization of potential products, and could limit our revenues and profits from such products, if any. Collaboration agreements may also require us to give up rights to products or technologies that we would otherwise seek to develop or commercialize ourselves. Any additional equity financing will result in dilution to our current stockholders. If we fail to secure sufficient additional funding we will have to delay or terminate some or all of our drug discovery and development programs.

MARKET CONDITIONS AND CHANGES IN OPERATING RESULTS MAY CONTINUE TO CAUSE VOLATILITY IN THE MARKET PRICE OF OUR STOCK, MAKING FUTURE EQUITY FINANCINGS MORE DIFFICULT.

The market price of the common stock, like that of the securities of many other biopharmaceutical companies, has been and is likely to continue to be highly volatile. The stock market has experienced significant price and volume fluctuations that are often unrelated to the operating performance of particular companies. Factors contributing to volatility in the market price of our common stock include:

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results of pre-clinical studies and clinical trials by us or our competitors;

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announcements of new collaborations;

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announcements of our technological innovations or new therapeutic products or that of our competitors;

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developments in our patent or other proprietary rights or that of our competitors, including litigation;

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governmental regulation; and

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healthcare legislation.

Fluctuations in our operating results and market conditions for biotechnology stocks in general could have a significant impact on the volatility of the market price for our common stock and on the future price of our common stock.

WE EXPECT TO RETAIN ALL FUTURE EARNINGS AND HAVE NO INTENTION TO PAY DIVIDENDS.

We have never paid any cash dividends on our common stock. We currently intend to retain all future earnings, if any, for use in our business and do not expect to pay any dividends in the foreseeable future.

WE MAY NOT REALIZE ANY OF THE ANTICIPATED BENEFITS FROM OUR ACQUISITIONS.

On October 24, 2001, we concluded our acquisition of Althexis and on March 11, 2002, we concluded our acquisition of Maret. We consummated these transactions with the expectation that they will result in mutual benefits including benefits relating to expanded and complementary product offerings, increased market opportunity, new technology and the addition of research and development personnel. Achieving the benefits of these acquisitions will depend in part on the integration of our technology, operations and personnel in a timely and efficient manner so as to minimize the risk that the acquisitions will result in the loss of market opportunity or key employees or the diversion of the attention of management. We cannot assure you that, following these transactions, our businesses will achieve revenues, specific net income or loss levels, efficiencies or synergies that justify the acquisitions or that the acquisitions will result in increased earnings, or reduced losses, for the combined company in any future period.

WE MAY NOT BE ABLE TO EFFECTIVELY AND EFFICIENTLY INTEGRATE THE OPERATIONS OF ESSENTIAL THERAPEUTICS WITH ALTHEXIS AND MARET.

Integrating the operations and management of Essential with Althexis and Maret will be a complex process, and we cannot assure you that this integration will be completed rapidly or will achieve all of the anticipated synergies and other benefits expected from the acquisitions. The integration of the three companies will require significant management attention, which may temporarily distract management from its usual focus on the daily operations of the combined company. Moreover, as a result of the change of our corporate headquarters from California to Massachusetts and the operation of offices on both coasts, management will face new challenges. Management’s inability to successfully integrate the operations of Essential with Althexis and Maret, or any significant delay in achieving this integration, could cause our business to suffer.

WE MAY NOT REALIZE ANY OF THE ANTICIPATED BENEFITS FROM OUR RESTRUCTURING.

In June 2002, we announced and initiated a strategic restructuring of our business. We initiated this transaction with the expectation that it will result in a refocused company that will concentrate its resources on advancing the development of several promising antibiotic and antifungal compounds that have emerged from our research pipeline. Achieving the benefit of this restructuring will depend in part on the focusing of our technology, operations and personnel in a timely and efficient manner so

as to minimize the risk that the restructuring will result in the loss of market opportunity or key employees or the diversion of the attention of management. We cannot assure you that, following this transaction, our businesses will achieve revenues, specific net income or loss levels, efficiencies or synergies that justify the restructuring or that the restructuring will result in increased earnings, or reduced losses, for the company in any future period.

Forward-Looking Statements

This document contains “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. In some cases, these statements can be identified by the use of forward-looking terminology such as “may,” “will,” “could,” “should,” “would,” “expect,” “anticipate,” “continue” or other similar words. These statements discuss future expectations, contain projections of results of operations or of financial condition or state trends and known uncertainties or other forward-looking information. Furthermore, these statements are based on current expectations that involve a number of uncertainties including those set forth in the risk factors above. When considering forward-looking statements, you should keep in mind that the risk factors noted above and other factors noted throughout this document or incorporated by reference could cause our actual results to differ significantly from those contained in any forward-looking statement.

Forward-looking statements include information concerning possible or assumed future results of our operations, including statements regarding:

•

our ability to use our discovery and technology platforms to identify potential product candidates;

•

our expectations regarding the anticipated date of selection of clinical development candidates;

•

our expectations regarding dates for commencement of clinical trials and development time lines;

•

the timing and likelihood of regulatory approvals;

•

the continuation of our collaborations with our partners;

•

our future capital requirements and the expected time period during which our existing financial resources will meet these capital requirements; and

•

our expectations regarding business conditions generally and growth in the biopharmaceutical industry and overall economy.

Many factors could affect our actual financial results, and could cause these actual results to differ materially from those in these forward-looking statements. These factors include the following:

•

costs or difficulties related to the integration of the businesses of Althexis and Maret being greater than expected;

•

demands placed on management by the change in the size of Essential;

•

unanticipated increases occurring in financing and other costs;

•

general economic or business conditions being less favorable than expected; and

•

legislative or regulatory changes adversely affecting Essential or the biopharmaceutical industry generally.

I tem 3. Quantitative and Qualitative Disclosures About Market Risk

Interest Rate Sensitivity

We maintain an investment portfolio in accordance with our Investment Policy. The primary objectives of our Investment Policy are to preserve principal, maintain proper liquidity to meet operating needs and maximize yields. Although our investments are subject to credit risk, our Investment Policy specifies credit quality standards for our investments and limits the amount of credit exposure from any single issue, issuer or type of investment. Our investments are also subject to interest rate risk and will decrease in value if market interest rates increase. However, due to the conservative nature of our investments and relatively short duration, interest rate risk is mitigated. We do not own derivative financial instruments in our investment portfolio. Accordingly, we do not believe that there is any material market risk exposure with respect to derivative or other financial instruments which would require disclosure under this item.

The interest rates on our capital lease obligations are fixed and therefore not subject to interest rate risk.

As of June 30, 2002 we did not have any off-balance sheet financings.

Foreign Currency Exchange Risk

At this time, we do not participate in any foreign currency exchange activities; therefore, we are not subject to risk of gains or losses for changes in foreign exchange rates.

PART II. OTHER INFORMATION

I tem 4. Submission of Matters to a Vote of Security Holders

The Company’s 2002 Annual Meeting of Stockholders was held on May 23, 2002. The following is a description of the two matters submitted to a vote of the stockholders at such meeting and the results of the voting.

(a) At the meeting two directors were elected to serve on the Company’s Board of Directors.

Director Elected	Number of Shares Voted For	Number of Shares Voted Against Or Withheld	Number of Shares Abstained
Kate Bingham	12,058,920	—	—
James E. Rurka	30,220,753	45,236	—

The following directors’ terms of office as directors continued after the meeting: Richard H. Aldrich, Charles W. Newhall III, David Schnell, M.D., Mark Skaletsky and John P. Walker.

(b) To ratify the appointment of Ernst & Young LLP as independent auditors for the fiscal year ending December 31, 2002.

Number of Shares Voted For:		24,652,131
Number of Shares Voted Against or Withheld:		9,520
Number of Shares Abstained:		15,514

I tem 6. Exhibits and Reports on Form 8-K

(a) The following exhibits have been filed with this report:


10.1	†	Amendment No. 4 to the Research Agreement between Maret Corporation and the University of Southern California dated June 24, 2002.

99.1		Certification pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

99.2		Certification pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

(b) Reports on Form 8-K.

On June 10, 2002, Essential Therapeutics, Inc. filed a current report on Form 8-K with the Securities and Exchange Commission. The purpose of the filing was to announce the Company’s intention to advance clinical development programs and to restructure resources to focus on development goals.

†

Confidential treatment requested.

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.

ESSENTIAL THERAPEUTICS, INC. (Registrant)

By:		/s/ MARK SKALETSKY
		Mark Skaletsky President and Chief Executive Officer (principal executive officer)

By:		/s/ PAUL MELLETT
		Paul Mellett Senior Vice President and Chief Financial Officer (principal financial officer)

Dated: August 14, 2002

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