CURAGEN CORP - 10-Q Quarterly Report

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

x	QUARTERLY REPORT PURSUANT TO SECTION 13 or 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2004

¨	TRANSITION REPORT PURSUANT TO SECTION 13 or 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from to

Commission File Number 0-23223

CURAGEN CORPORATION

(Exact name of registrant as specified in its charter)


Delaware		06-1331400
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification No.)

555 Long Wharf Drive, 11th Floor, New Haven, Connecticut		06511
(Address of principal executive office)		(Zip Code)

Registrant’s telephone number, including area code: (203) 401-3330

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 x No ¨

The number of shares outstanding of the Registrant’s common stock as of October 29, 2004 was 50,124,088.

CURAGEN CORPORATION AND SUBSIDIARY

FORM 10-Q

INDEX


			Page
PART I. Financial Information

	Item 1.	Financial Statements

		Consolidated Balance Sheets, September 30, 2004 (unaudited) and December 31, 2003	3

		Consolidated Statements of Operations, for the Three and Nine Months Ended September 30, 2004 and 2003 (unaudited)	4

		Consolidated Statements of Cash Flows, for the Nine Months Ended September 30, 2004 and 2003 (unaudited)	5

		Notes to Consolidated Financial Statements (unaudited)	6 - 8

	Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	9 -32

	Item 3.	Quantitative and Qualitative Disclosures About Market Risk	32

	Item 4.	Controls and Procedures	32

PART II. Other Information

	Item 6.	Exhibits	34

Signatures			35

Exhibit Index			36

CURAGEN CORPORATION AND SUBSIDIARY

CONSOLIDATED BALANCE SHEETS

(in thousands, except par value and share data)


	September 30, 2004			December 31, 2003
	(unaudited)
ASSETS
Current assets:
Cash and cash equivalents	$	29,825		$	42,843
Short-term investments		100,237			72,402
Marketable securities		221,817			228,396

Cash and investments		351,879			343,641
Income taxes receivable		725			429
Other current assets		386			26
Prepaid expenses		1,370			1,757

Total current assets		354,360			345,853

Property and equipment, net		21,150			23,540
Intangible and other assets, net		14,825			7,564

Total assets	$	390,335		$	376,957

LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable	$	2,485		$	4,661
Accrued expenses		5,004			3,671
Accrued payroll and related items		2,334			1,864
Interest payable		1,850			3,750
Deferred revenue		2,169			3,010
Current portion of obligations under capital leases		—			204
Accrued restructuring and related charges		694			1,223
Other current liabilities		1,160			1,160

Total current liabilities		15,696			19,543

Long-term liabilities:
Convertible subordinated debt		240,000			150,000
Accrued long-term liabilities		1,000			1,500

Total long-term liabilities		241,000			151,500

Commitments and contingencies

Minority interest in subsidiary		4,105			8,233

Stockholders’ equity:
Common stock; $.01 par value, issued and outstanding 50,117,866 shares at September 30, 2004, and 49,896,622 shares at December 31, 2003		501			499
Additional paid-in capital		486,577			485,531
Accumulated other comprehensive (loss) income		(214	)		1,524
Accumulated deficit		(357,201	)		(289,492	)
Unamortized stock-based compensation		(129	)		(381	)

Total stockholders’ equity		129,534			197,681

Total liabilities and stockholders’ equity	$	390,335		$	376,957

See accompanying notes to consolidated financial statements

CURAGEN CORPORATION AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except per share data)

(unaudited)


	Three Months Ended September 30,						Nine Months Ended September 30,
	2004			2003			2004			2003
Revenue:
Grant revenue	$	395		$	—		$	753		$	—
Collaboration revenue		2,003			787			4,534			4,426

Total revenue		2,398			787			5,287			4,426

Operating expenses:
Grant research		302			—			402			—
Research and development		17,341			15,148			57,073			47,996
Asset impairment		1,909			—			1,909			—
General and administrative		4,533			4,771			14,336			14,544
Restructuring and related charges		—			—			—			2,888

Total operating expenses		24,085			19,919			73,720			65,428

Loss from operations		(21,687	)		(19,132	)		(68,433	)		(61,002	)
Interest income		2,125			2,302			6,177			6,713
Interest expense		(3,360	)		(2,456	)		(9,582	)		(7,395	)
Loss on extinguishment of debt		—			—			(294	)		—

Loss before income taxes and minority interest in subsidiary loss		(22,922	)		(19,286	)		(72,132	)		(61,684	)
Income tax benefit		111			329			295			329
Minority interest in subsidiary loss		1,333			1,480			4,128			4,309

Net loss	$	(21,478	)	$	(17,477	)	$	(67,709	)	$	(57,046	)

Basic and diluted net loss per share	$	(0.43	)	$	(0.35	)	$	(1.36	)	$	(1.16	)

Weighted average number of shares used in computing basic and diluted net loss per share		49,994			49,359			49,891			49,252

See accompanying notes to consolidated financial statements

CURAGEN CORPORATION AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

(unaudited)


	Nine Months Ended September 30,
	2004			2003
Cash flows from operating activities:
Net loss	$	(67,709	)	$	(57,046	)
Adjustments to reconcile net loss to net cash used in operating activities:
Asset impairment		1,909			—
Depreciation and amortization		7,212			6,306
Non-monetary compensation		312			769
Stock-based 401(k) employer plan match		588			571
Loss on extinguishment of debt		294			—
Minority interest		(4,128	)		(4,309	)
Changes in assets and liabilities:
Income taxes receivable		(296	)		527
Other current assets		(360	)		(150	)
Prepaid expenses		387			1,529
Intangible and other assets, net		(102	)		25
Accounts payable		(2,176	)		1,481
Accrued expenses		1,333			595
Accrued payroll and related items		470			(32	)
Interest payable		(1,900	)		(2,250	)
Deferred revenue		(841	)		115
Accrued restructuring and related charges		(529	)		1,065
Other current liabilities		—			128

Net cash used in operating activities		(65,536	)		(50,676	)

Cash flows from investing activities:
Acquisitions of property and equipment		(4,815	)		(5,202	)
Payments for intangible assets		—			(2,538	)
Acquisitions of non-perpetual licenses		(1,063	)		—
Loans to employees, net of repayments		(38	)		19
Convertible loan to collaborator		(5,000	)		—
Net (outflows) inflows from purchases and maturities of short-term investments		(27,835	)		89,541
Net inflows (outflows) from purchases and maturities of marketable securities		4,841			(50,847	)

Net cash (used in) provided by investing activities		(33,910	)		30,973

Cash flows from financing activities:
Payments on capital lease obligations		(204	)		(1,394	)
Proceeds from exercise of stock options		401			410
Proceeds from issuance of convertible debt		110,000			—
Payment for extinguishment of debt		(20,000	)		—
Payments of financing costs		(3,769	)		(13	)
Proceeds from issuance of preferred stock to minority interest		—			3,988
Payments of stock issuance costs on issuance of preferred stock		—			(520	)

Net cash provided by financing activities		86,428			2,471

Net decrease in cash and cash equivalents		(13,018	)		(17,232	)
Cash and cash equivalents, beginning of period		42,843			68,401

Cash and cash equivalents, end of period	$	29,825		$	51,169

Supplemental cash flow information:
Interest paid	$	10,679		$	9,082

Income tax benefit payments received	$	—		$	862

See accompanying notes to consolidated financial statements

CURAGEN CORPORATION AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

1.	Basis of Presentation

The accompanying unaudited consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States of America for complete financial statements. In the opinion of our management, the accompanying unaudited consolidated financial statements include all adjustments, consisting of only normal recurring accruals, necessary to present fairly our consolidated financial position, results of operations and cash flows. Interim results are not necessarily indicative of the results that may be expected for the entire year. The consolidated financial statements of CuraGen Corporation and subsidiary (the “Company”) include CuraGen Corporation (“CuraGen”) and its majority-owned subsidiary, 454 Life Sciences Corporation (“454”), and accordingly, all material intercompany balances and transactions have been eliminated.

The September 30, 2003 and December 31, 2003 consolidated financial statements have been reclassified to conform to the classifications used in 2004. All dollar amounts in tabular presentations are shown in thousands, except par value and per share data.

The accompanying consolidated financial statements should be read in conjunction with the audited consolidated financial statements and notes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2003.

2.	Comprehensive Loss

Statement of Financial Accounting Standards No. 130, “Reporting Comprehensive Income” (“SFAS 130”), requires reporting and displaying of comprehensive income and its components. In accordance with SFAS 130, the accumulated balance of other comprehensive loss is disclosed as a separate component of stockholders’ equity and is comprised of unrealized gains and losses on marketable securities.

A summary of total comprehensive loss is as follows:


	Three Months Ended September 30,						Nine Months Ended September 30,
	2004			2003			2004			2003
Net loss	$	(21,478	)	$	(17,477	)	$	(67,709	)	$	(57,046	)

Other comprehensive loss:
Unrealized (losses) gains on securities:
Unrealized holding (losses) gains arising during period		1,043			(981	)		(1,738	)		(643	)
Reclassification adjustment for losses (gains) included in net loss		25			(398	)		(11	)		(325	)

Net unrealized (losses) gains on securities		1,068			(1,379	)		(1,749	)		(968	)

Total comprehensive loss	$	(20,410	)	$	(18,856	)	$	(69,458	)	$	(58,014	)

3.	Stock-Based Compensation

In October 1995, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation” (“SFAS 123”), which was effective beginning January 1, 1996. SFAS 123 requires expanded disclosures of stock-based compensation arrangements with employees and non-employees and encourages (but does not require) compensation cost to be measured based on the fair value of the equity instruments awarded to employees. Companies are permitted to continue to apply Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”), which recognizes compensation cost based on the intrinsic value of the equity instruments awarded. The Company will continue to apply APB 25 to its stock-based compensation awards to employees.

Had compensation cost for the Company’s stock option plans been determined in accordance with SFAS 123, net loss and net loss per share would have approximated the pro forma amounts shown below for each of the three and nine month periods ended September 30, 2004 and 2003.


	Three Months Ended September 30,						Nine Months Ended September 30,
	2004			2003			2004			2003
Net loss, as reported	$	(21,478	)	$	(17,477	)	$	(67,709	)	$	(57,046	)
Stock-based employee compensation expense included in net loss		58			147			252			609
Total stock-based employee compensation expense determined under Black-Scholes option pricing model		(1,751	)		(3,021	)		(5,696	)		(9,232	)

Pro forma net loss	$	(23,171	)	$	(20,351	)	$	(73,153	)	$	(65,669	)

Basic and diluted net loss per share:
As reported	$	(0.43	)	$	(0.35	)	$	(1.36	)	$	(1.16	)
Pro forma	$	(0.46	)	$	(0.41	)	$	(1.47	)	$	(1.33	)

4.	Restructuring and Related Charges

In June 2003, the Company announced a restructuring plan intended to focus resources on continuing to advance its broad pipeline of protein, antibody, and small molecule therapeutics into preclinical and clinical development. In connection with this restructuring plan, a charge of approximately $2.9 million was recorded in the second quarter of 2003, including $1.8 million related to employee separation costs, $1.0 million of operating lease obligations and $0.1 million of asset impairment costs. The cash requirements under the June 2003 restructuring plan were $2.7 million, of which $2.0 million was paid prior to September 30, 2004. The remaining cash requirements of $0.7 million will be paid through the end of 2008. (See also Note 7).

5.	Segment Reporting

The Company currently operates in two business segments: CuraGen and 454. CuraGen is a genomics-based pharmaceutical development company dedicated to improving the lives of patients by developing novel protein, antibody and small molecule therapeutics in the areas of oncology, inflammatory diseases, obesity and diabetes. 454, the Company’s majority-owned subsidiary, is developing novel nanoscale instrumentation and technologies for rapidly and comprehensively determining the nucleotide sequence - “whole genome sequencing” - of entire genomes. The operations of 454 are run by a separate management team and governed by a separate Board of Directors made up of members of CuraGen’s management team and Board of Directors. The Company currently exceeds the quantitative thresholds governing segment reporting, and as a result, the financial information disclosed herein represents all of the material financial information related to the Company’s reportable business segments. All of the Company’s revenues are generated in the United States and all assets are located in the United States.


	September 30, 2004			December 31, 2003
*Cash and investments:*
CuraGen	$	340,456		$	319,444
454		11,423			24,197

Total	$	351,879		$	343,641

*Total assets:*
CuraGen	$	384,273		$	365,906
454		20,349			33,260
Intercompany eliminations		(14,287	)		(22,209	)

Total	$	390,335		$	376,957


	Three Months Ended September 30,						Nine Months Ended September 30,
	2004			2003			2004			2003
*Revenues:*
CuraGen	$	1,719		$	787		$	4,155		$	4,426
454		707			—			1,333			—
Intercompany eliminations		(28	)		—			(201	)		—

Total	$	2,398		$	787		$	5,287		$	4,426

*Operating expenses:*
CuraGen	$	19,460		$	15,980		$	60,336		$	54,292
454		4,653			3,939			13,585			11,136
Intercompany eliminations		(28	)		—			(201	)		—

Total	$	24,085		$	19,919		$	73,720		$	65,428

*Net loss:*
CuraGen	$	18,922		$	15,058		$	59,792		$	50,384
454		3,889			3,899			12,046			10,971
Minority interest in subsidiary loss		(1,333	)		(1,480	)		(4,129	)		(4,309	)

Total	$	21,478		$	17,477		$	67,709		$	57,046

*Capital expenditures:*
CuraGen	$	2,497		$	1,354		$	4,038		$	3,873
454		219			618			792			1,459
Intercompany eliminations		—			—			(15	)		(130	)

Total	$	2,716		$	1,972		$	4,815		$	5,202

*Depreciation and amortization:*
CuraGen	$	1,725		$	1,733		$	5,415		$	5,168
454		601			447			1,797			1,138

Total	$	2,326		$	2,180		$	7,212		$	6,306

6.	Asset Impairment

During the third quarter of 2004, the Company had an independent market value appraisal performed on the land it owns in Branford, Connecticut. This property is being held for the possible future construction of a corporate headquarters and protein production facility, although plans have been deferred, pending improvements in the external financing environment which would afford the Company the ability to finance the future construction costs. At September 30, 2004, the appraised market value of the property was below the Company’s holding value. Therefore, an asset impairment expense of $1.9 million was recorded in the third quarter of 2004 in order to properly reflect the estimate of the fair value of the property in accordance with Statement of Financial Accounting Standards No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets”.

7.	Subsequent Event

Restructuring and Related Charges

On October 19, 2004, the Company announced a corporate restructuring to focus on advancing its therapeutic pipeline through clinical development. As part of this restructuring, the Company reprioritized its development programs and reduced its employee base by approximately 110 people, resulting in a staff of 240 employees remaining at CuraGen and its subsidiary. In connection with the October 2004 restructuring plan, a charge of approximately $4.0 million will be recorded in the fourth quarter of 2004 including $3.0 million related to employee separation costs, and $1.0 million of asset impairment costs. The employee separation costs will be recorded under Statement of Financial Accounting Standards No. 146, “Accounting for Costs Associated with Exit or Disposal Activities”, and include amounts to be paid for severance and related benefits. The cash requirements under the October 2004 restructuring plan are expected to be approximately $2.7 million. The Company expects to pay the majority of the cash requirements related to the October 2004 restructuring plan during the fourth quarter of 2004.

CURAGEN CORPORATION AND SUBSIDIARY

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

This Management’s Discussion and Analysis of Financial Condition and Results of Operations as of September 30, 2004 and for the three and nine month periods ended September 30, 2004 and 2003 should be read in conjunction with the sections of our audited consolidated financial statements and notes thereto as well as our “Management’s Discussion and Analysis of Financial Condition and Results of Operations” that are included in our Annual Report on Form 10-K for the year ended December 31, 2003, as amended.

Overview

We are a genomics-based pharmaceutical development company dedicated to improving the lives of patients by developing novel protein, antibody and small molecule therapeutics in the areas of oncology, inflammatory diseases, obesity and diabetes. Our pipeline of therapeutics is based on targets from the human genome that we believe play a role in important mechanisms underlying disease.

We have taken a systematic approach to identifying and validating the most promising therapeutic targets from the human genome that are both applicable and amenable to drug development. We use internal resources to develop our potential protein therapeutics and have established development alliances with Abgenix, Inc. (“Abgenix”) to support our antibody projects, Bayer AG (“Bayer”) to support small molecule projects for obesity and diabetes, TopoTarget A/S (“TopoTarget”) to support small molecule histone deacetylase (“HDAC”) inhibitor projects for oncology and inflammatory diseases, and Seattle Genetics, Inc. (“Seattle Genetics”) to support antibody-drug conjugate projects.

As our pipeline has matured over the past few years, we have decreased our early-stage target discovery efforts and focused our resources on the advancement of our pipeline of potential protein, antibody and small molecule therapeutics into clinical development. On October 19, 2004, we announced a corporate restructuring to focus on advancing our therapeutic pipeline through clinical development. As part of this restructuring, we reprioritized our development programs and reduced our employee base by approximately 110 people. Going forward, we plan to conserve resources and utilize our cash position to finance the development of products that have the highest potential.

In 2003, we initiated a Phase I trial on CG53135, which is being investigated as a potential protein therapeutic for the prevention of oral mucositis (“OM”) in cancer patients that are undergoing chemotherapy and radiotherapy. During 2004, we continued to make progress on the development of CG53135 for OM, including the initiation of an additional Phase I trial in cancer patients undergoing bone marrow transplantation. In February 2004, we received orphan drug designation from the FDA for CG53135 in OM, which we believe will help to strengthen the program by offering important clinical development and commercialization benefits. In June 2004, we presented animal model data at the 16th Annual International Symposium on Supportive Care in Cancer held by the Multinational Association of Supportive Care in Cancer that highlighted the potential of this molecule and differentiated it from competing products. The data demonstrates that a single-dose of CG53135 administered to animals exposed to chemotherapy, but before the development of active OM, reduces the severity and duration of subsequent OM; and that administration of CG53135 to animals with active OM resulted in a significant reduction in the number of days and severity of OM. This preclinical data supports the Company’s strategy to investigate CG53135 as a single dose agent for the prevention of OM and as a treatment for active OM. The potency of CG53135 is believed to be due to the molecule’s activity on two critical layers of cells (epithelial and mesenchymal) present in the mucosa lining of the mouth and the remainder of a patient’s gastrointestinal tract. In November 2004, abstracts containing the results from both Phase I trials will be published in the proceedings of the 46^th Annual Meeting of the American Society of Hematology (“ASH”). Data from the Phase I trial on CG53135 for cancer patients undergoing bone marrow transplantation will be presented in a poster presentation during the ASH conference in December 2004.

In October 2004, we announced the initiation of a Phase II trial on CG53135 that will begin enrolling patients in a randomized, placebo-controlled, multi-center study to determine the safety and efficacy of a single-dose of CG53135 to prevent the development of clinically significant OM. Approximately 200 patients will be randomized to receive a single administration of either placebo or one of three dosages of CG53135 immediately after bone marrow transplantation.

In June 2004, we added PXD101, a novel HDAC inhibitor, to our pipeline through a license and collaboration agreement with TopoTarget. PXD101 is one of the most advanced HDAC inhibitors in development and will be investigated as a potential treatment of both solid and hematologic cancers either alone, or in combination with other cancer drugs. The collaboration with TopoTarget also provides us with access to their extensive library of HDAC inhibitor candidates. HDAC inhibitors represent a new mechanistic class of anti-cancer therapeutics that target HDAC

enzymes, and have been shown to: arrest growth of cancer cells; induce apoptosis, or programmed cell death; promote differentiation; inhibit angiogenesis; and sensitize cancer cells to overcome drug resistance. A Phase I clinical trial evaluating PXD101 in patients with solid tumors was initiated in October 2003. A second Phase I clinical trial was initiated in June 2004 to evaluate the safety and potential efficacy of PXD101 in patients with hematologic cancers, and we anticipate that PXD101 will transition to Phase II in the first half of 2005. In August 2004, we signed a clinical trials agreement with the National Cancer Institute (“NCI”) that provides us with access to the expertise at the NCI for the design, implementation, and monitoring of clinical trials with PXD101. Under the agreement, the NCI will sponsor several clinical trials evaluating the activity of PXD101, either alone or in combination with other anti-cancer therapies, for the treatment of solid and hematologic malignancies. NCI-sponsored clinical trials will occur in parallel to those sponsored by CuraGen with all data generated available for use in future product registration.

In October 2004, we announced that CR002, our most advanced fully-human monoclonal antibody stemming from our collaboration with Abgenix, has received clearance from the FDA to be investigated as a potential treatment for IgA nephropathy. A Phase I trial on CR002 will begin in November 2004 to determine the maximum tolerated dose in healthy male volunteers. CR002 is a novel fully-human monoclonal antibody with the potential to treat forms of kidney inflammation, such as IgA nephropathy, that, if left untreated, could progress to kidney failure.

In October 2004, we announced the advancement of CR011, a fully-human monoclonal antibody-drug conjugate, which we are investigating as a potential treatment for metastatic melanoma. CR011 is the second fully-human monoclonal antibody stemming from our collaboration with Abgenix, and applies antibody-drug conjugate technology that we licensed from Seattle Genetics. We anticipate that this therapeutic will enter clinical trials during the first half of 2006.

In October 2004, we also announced the advancement of CT052, an investigational small molecule drug for the potential management of adult-onset (Type 2) diabetes, which will be co-developed with Bayer. This compound represents the first drug candidate to enter preclinical development from our ongoing collaboration with Bayer that was established to identify and develop promising drugs for the treatment of diabetes and obesity based upon targets we discovered.

In addition to CG53135, PXD101, CR002, CR011, and CT052 we have several potential protein, antibody and small molecule therapeutics currently being evaluated in animal studies or being prepared for animal studies. These programs may lead to the filing of investigational new drug applications (“INDs”) in the future.

To enable us to focus on our drug pipeline, we announced the formation of 454 Life Sciences Corporation (“454”) in June 2000. This majority-owned subsidiary is developing novel nanoscale instrumentation and technologies for rapidly and comprehensively determining the nucleotide sequence — “whole genome sequencing” — of entire genomes. 454’s proprietary technology is expected to have widespread applications in industrial processes, agriculture, animal health, biodefense, human health care, including drug discovery and development, and disease diagnosis. Currently, 454 is focusing on the analysis of viruses, bacteria and regions of the human genome, and, with the support of a $2.4 million grant over 2 years and a $5.0 million grant over 3 years from the National Human Genome Research Institute, will continue scaling its technology to further analyze fungi, larger model organisms, human genomes, and other sequencing applications. 454 plans to sell both sequencing services and complete genomic analysis systems, including instrumentation and reagents to end-users.

We expect to generate value for our shareholders by developing genomics-based therapeutics. We expect to become profitable by commercializing a subset of therapeutics stemming from our development pipeline, and establishing partnerships with pharmaceutical and biotechnology companies for the co-development and co-commercialization of other therapeutics from our development pipeline. Our failure to successfully develop pharmaceutical products that we can commercialize would materially adversely affect our business, financial condition and results of operations. Royalties or other revenue generated from commercial sales of products developed through the application of our technologies and expertise are not expected for several years, if at all. We expect that our revenue or income sources for at least the next several years may be limited to: interest income; payments under various collaboration agreements to the extent milestones are met; and 454 grant, service and product revenue.

We expect to continue to incur substantial expenses relating to our research and development efforts, as we focus on: preclinical studies and clinical trials required for the development of therapeutic protein, antibody and small molecule product candidates; external programs identified by our platform as being promising and synergistic with our products and expertise; and 454, as it continues work on the development and commercialization of its technology for whole genome analysis. Conducting clinical trials is a lengthy, time-consuming and expensive process. We will incur substantial expenses for, and devote a significant amount of time to, these studies. As a result, we expect to incur continued and increasing losses over the next several years, unless we are able to realize additional revenues under

existing or new collaboration agreements or through 454’s sales of genomic analysis services and/or complete genomic analysis systems. The timing and amounts of such revenues, if any, cannot be predicted with certainty and may fluctuate. Results of operations for any period may be unrelated to the results of operations for any other period. In addition, historical results should not be viewed as indicative of future operating results.

The 2003 consolidated financial statements have been reclassified to conform to the classifications used in 2004. All dollar amounts in tabular presentations are shown in millions, unless otherwise noted.

Critical Accounting Policies and Use of Estimates

The discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these consolidated financial statements requires us to make estimates and judgments that affect the reported amount of assets and liabilities, and revenues and expenses, and as such, actual results may differ from our estimates under different assumptions or conditions. Our significant accounting policies are fully described in Note 1 to our consolidated financial statements included in our Annual Report on Form 10-K for the year ended December 31, 2003.

Results of Operations


	Three months ended September 30,
	2004		2003		$ Change			% Change
Grant revenue	$	0.4	$	—	$	0.4		100	%
Collaboration revenue		2.0		0.8		1.2		150	%
Grant research expenses		0.3		—		0.3		100	%
Research and development expenses		17.3		15.1		2.2		15	%
Asset impairment expense		1.9		—		1.9		100	%
General and administrative expenses		4.5		4.8		(0.3	)	(6	)%
Interest income		2.1		2.3		(0.2	)	(9	)%
Interest expense		3.4		2.5		0.9		36	%
Income tax benefit		0.1		0.3		(0.2	)	(67	)%
Minority interest in subsidiary loss		1.3		1.5		(0.2	)	(13	)%

Net loss	$	21.5	$	17.5


	Nine months ended September 30,
	2004		2003		$ Change			% Change
Grant revenue	$	0.8	$	—	$	0.8		100	%
Collaboration revenue		4.5		4.5		—		—
Grant research expenses		0.4		—		0.4		100	%
Research and development expenses		57.1		48.0		9.1		19	%
Asset impairment expense		1.9		—		1.9		100	%
General and administrative expenses		14.3		14.5		(0.2	)	(1	)%
Restructuring and related charges		—		2.9		(2.9	)	(100	)%
Interest income		6.2		6.7		(0.5	)	(7	)%
Interest expense		9.6		7.4		2.2		30	%
Loss on extinguishment of debt		0.3		—		0.3		100	%
Income tax benefit		0.3		0.3		—		—
Minority interest in subsidiary loss		4.1		4.3		(0.2	)	(5	)%

Net loss	$	67.7	$	57.0

The following tables set forth a comparison of revenue by segment, for the three and nine month periods ended September 30, 2004 and 2003:


	Three months ended September 30,
	2004		2003		$ Change		% Change
Grant revenue:
454	$	0.4	$	—	$	0.4	100	%

Total	$	0.4	$	—

Collaboration revenue:
CuraGen	$	1.7	$	0.8	$	0.9	113	%
454		0.3		—		0.3	100	%

Total	$	2.0	$	0.8


	Nine months ended September 30,
	2004		2003		$ Change			% Change
Grant revenue:
454	$	0.8	$	—	$	0.8		100	%

Total	$	0.8	$	—

Collaboration revenue:
CuraGen	$	4.1	$	4.5	$	(0.4	)	(9	)%
454		0.4		—		0.4		100	%

Total	$	4.5	$	4.5

Grant revenue. The increase in grant revenue for the three and nine months ended September 30, 2004 was primarily a result of two federal grants awarded to 454 in May 2004 and September 2004 from the National Human Genome Research Institute, one of the National Institutes of Health (“NIH”). These grants will partially fund the scale up of 454’s technology toward sequencing larger genomes. Each of these grants allowed 454 to recover all expenses that were directly related to the research outlined in the grant award for 90 days prior to the grant award date. We expect that grant revenue for the fourth quarter of 2004 will remain consistent with the third quarter of 2004.

Collaboration revenue. The increases in CuraGen’s collaboration revenue for the three and nine months ended September 30, 2004 were primarily related to the Bayer alliance and the Philip Morris collaboration. We expect that our fourth quarter 2004 collaboration revenue will decrease slightly as compared to the third quarter of 2004 due to a fluctuation in the volume of projects.

The increases in 454’s collaboration revenue for the three and nine months ended September 30, 2004 were related to the sales of genomic analysis services as 454 began to commercialize their sequencing platform. We anticipate that 454’s fourth quarter 2004 collaboration revenue will be consistent with the third quarter of 2004.

Grant research expenses. The increase in grant research expenses for the three and nine months ended September 30, 2004 was a result of two federal grants awarded to 454 in May 2004 and September 2004 from the NIH, which will partially fund the scale up of 454’s technology toward sequencing larger genomes. Grant research expenses for the first grant were recorded beginning in mid-May 2004 and for the second grant beginning at the end of September 2004. The expenses included personnel costs and lab supplies that were directly related to the research outlined in the grant award. We expect that grant research expenses for the fourth quarter of 2004 will remain consistent with the third quarter of 2004.

Research and development expenses.

The following tables set forth a comparison of research and development expenses by segment, for the three and nine month periods ended September 30, 2004 and 2003:


	Three months ended September 30,
	2004		2003		$ Change		% Change
Research and development expenses:
CuraGen	$	14.1	$	12.1	$	2.0	17	%
454		3.2		3.0		0.2	7	%

Total	$	17.3	$	15.1


	Nine months ended September 30,
	2004		2003		$ Change		% Change
Research and development expenses:
CuraGen	$	47.3	$	39.3	$	8.0	20	%
454		9.8		8.7		1.1	13	%

Total	$	57.1	$	48.0

Research and development expenses consist primarily of: salary and benefits; supplies and reagents; contractual and manufacturing costs; perpetual license fees; depreciation and amortization; and overhead. Our research and development efforts are concentrated on four major project areas: collaborations; preclinical drug candidates; clinical trials; and our majority-owned subsidiary, 454. With the exception of 454, we budget and monitor our research and development costs by expense category, rather than by project, because these costs often benefit multiple projects and/or our technology platform. However, once we receive FDA clearance to conduct a Phase I clinical trial for a potential therapeutic, we begin to track the direct research and development costs associated with that clinical candidate. As of September 30, 2004, we had incurred approximately $16.0 million of direct research and development expenses related to our initial clinical candidate, CG53135, for which we initiated a Phase I clinical trial for oral mucositis in the first quarter of 2003 and initiated an additional Phase I trial in cancer patients undergoing bone marrow transplantation during the second quarter of 2004. As of September 30, 2004, we had incurred approximately $0.7 million of direct research and development expenses related to our clinical candidate, PXD101, for which a Phase I clinical trial was initiated in patients with solid tumors in the fourth quarter of 2003, and an additional Phase I clinical trial was initiated in patients with hematologic cancer in the second quarter of 2004.

Below is a summary that reconciles our total research and development expenses for the three and nine month periods ended September 30, 2004 and 2003 by the major categories mentioned above:


	Three months ended September 30,
	2004		2003		$ Change			% Change
Salary and benefits	$	6.0	$	7.0	$	(1.0	)	(14	)%
Supplies and reagents		3.2		2.4		0.8		33	%
Contractual and manufacturing costs		4.3		3.1		1.2		39	%
Depreciation and amortization		1.3		1.4		(0.1	)	(7	)%
Overhead		2.5		1.2		1.3		108	%

Total research and development expenses	$	17.3	$	15.1


	Nine months ended September 30,
	2004		2003		$ Change			% Change
Salary and benefits	$	17.9	$	21.1	$	(3.2	)	(15	)%
Supplies and reagents		9.5		9.9		(0.4	)	(4	)%
Contractual and manufacturing costs		11.7		7.9		3.8		48	%
Perpetual license fees		7.2		—		7.2		100	%
Depreciation and amortization		4.1		4.1		—		—
Overhead		6.7		5.0		1.7		34	%

Total research and development expenses	$	57.1	$	48.0

The increases in research and development expenses for CuraGen for the three and nine months ended September 30, 2004 were primarily due to an increase in contractual and manufacturing costs related to our preclinical studies and clinical trials, and perpetual license fee payments during the second quarter of 2004 of approximately $7.0 million primarily related to the recent addition of the TopoTarget and Seattle Genetics collaborations, offset by a reduction in the first quarter of 2004 of prior year accruals related to payments subsequently determined to be no longer owed due to amended contract terms for the Abgenix collaboration. In addition, decreases in salary and benefits, and supplies and reagents, in connection with the June 2003 restructuring plan offset the overall increases in research and development expenses. We anticipate that research and development expenses, excluding perpetual license fees and potential milestone payments, will remain consistent for the remainder of 2004.

The increases in research and development expenses for 454 for the three and nine months ended September 30, 2004 were primarily due to increased personnel costs, lab supplies and reagents, consulting fees and depreciation expense associated with developing a measurement service center and manufacturing capabilities in connection with the preparation for commercialization of 454’s technology. We anticipate that 454’s research and development expenses will continue to increase in the fourth quarter of 2004 in connection with further improvements of its technology.

Currently, our potential pharmaceutical products require significant research and development efforts and preclinical testing, and will require extensive clinical trials prior to submitting an application to regulatory agencies for their commercial use. Although we are conducting human studies with respect to CG53135 and PXD101, we may not be successful in developing or commercializing CG53135, PXD101 or other products. Our product candidates are subject to the risks of failure inherent in the development and commercialization of pharmaceutical products and we cannot currently reliably estimate when, if ever, our product candidates will generate revenue and cash flows.

Completion of research and development, preclinical testing and clinical trials may take many years. Estimates of completion periods for any of our major research and development projects are highly speculative and variable, depending on the nature of the disease indication, how common it is among the general populace, and the results of the research. For example, preclinical testing and clinical trials can often go on for an indeterminate period of time since the results of tests are continually monitored, with each test considered “complete” only when sufficient data has been accumulated to assess whether the next phases are warranted or whether the effort should be abandoned. Typically, Phase I clinical trials are expected to last between 12 and 24 months, Phase II clinical trials are expected to last between 24 and 36 months and Phase III clinical trials are expected to last between 24 and 60 months. The most significant time and costs associated with clinical development are the Phase III trials as they tend to be the longest and most comprehensive studies conducted during the drug development process.

In addition, many factors may delay the commencement and speed of completion of preclinical testing and clinical trials, including the number of patients participating in the trial, the duration of patient follow-up required, the number of clinical sites at which the trials are conducted, and the length of time required to locate and enroll suitable patient subjects. The successful completion of our development programs and the successful development of our product candidates are highly uncertain and are subject to numerous challenges and risks. Therefore, we cannot presently estimate anticipated completion dates for any of our projects. See also “Risks Related to Our Business.”

Due to the variability in the length of time necessary to develop a product candidate, the uncertainties related to the cost of projects and our ability to obtain governmental approval for commercialization, accurate and meaningful estimates of the ultimate costs to bring our product candidates to market are not available. If our major research and development projects are delayed, then we can expect to incur additional costs in conducting our preclinical testing and clinical trials and a longer period of time before we become profitable from our operating activities, as described more fully in the Risk Factors section under the headings “We have a history of operating losses and expect to incur losses in the future” and “We may need to raise additional funding, which may not be available on favorable terms, if at all.” Accordingly, the timing of the potential market approvals for our existing product candidates, CG53135, PXD101, and future product development candidates, may have a significant impact on our capital requirements.

Asset impairment. During the third quarter of 2004, we had an independent market value appraisal performed on the land we own in Branford, Connecticut. This property is being held for the possible future construction of a corporate headquarters and protein production facility, although plans have been deferred, pending improvements in the external financing environment which would afford us the ability to finance the future construction costs. At September 30, 2004, the appraised market value of the property was below the holding value. Therefore, an asset impairment expense of $1.9 million was recorded in the third quarter of 2004 in order to properly reflect the estimate of the fair value of the property in accordance with Statement of Financial Accounting Standards No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets” (“SFAS 144”).

General and administrative expenses. General and administrative expenses for the three and nine months ended September 30, 2004 decreased slightly, as compared to the same periods in 2003 as a result of careful control over expenses. General and administrative expenses are expected to increase slightly during the fourth quarter of 2004 as a result of legal patent costs.

Interest income. Interest income for the three and nine months ended September 30, 2004 decreased primarily due to lower yields in our investment portfolio and decreases in the cash and investment balances. We earned an average yield of 2.2% in the third quarter of 2004 as compared to 2.6% in the third quarter of 2003, and earned an average yield of 2.1% in the first nine months of 2004 as compared to 2.4% during the same period in 2003. During the fourth quarter of 2004, we expect the yields in our investment portfolio to be slightly higher than the third quarter of 2004. However, we anticipate that interest income for 2004 will decrease by approximately $1.0 million as compared to 2003, as a result of the utilization of cash and investment balances in the normal course of operations and the repurchase of $20.0 million of our 6% convertible subordinated debentures due in 2007, offset by the receipt of net proceeds of approximately $106.2 million from our 4% convertible subordinated notes due in 2011.

Interest expense. We expect interest expense to be approximately $13.0 million during 2004, attributable to the interest paid semi-annually to the holders of our $130.0 million 6% convertible subordinated debentures due in 2007, and our $110.0 million 4% convertible subordinated notes due in 2011.

Loss on extinguishment of debt. In February 2004, we repurchased $20.0 million of our 6% convertible subordinated debentures due in 2007, for total consideration of $20.0 million, plus accrued interest of $0.05 million to the date of repurchase. As a result of the transaction, and in accordance with Statement of Financial Accounting Standards No. 145, “Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections”, we recorded a loss of approximately $0.3 million in “Loss on extinguishment of debt”, which includes the write-off of the ratable portion of unamortized deferred financing costs relating to the repurchased debt.

Income tax benefit. We recorded an income tax benefit during the three and nine months ended September 30, 2004 as a result of Connecticut legislation, which allows companies to obtain cash refunds from the State of Connecticut at a rate of 65% of their annual research and development expense credit, in exchange for forgoing carryforward of the research and development credit. During the fourth quarter of 2004, we anticipate an increase in the income tax benefit of approximately $0.8 million, due to the expiration of the State of Connecticut statute, as it relates to the 2000 income tax benefit.

Minority interest in subsidiary loss. Minority interest in subsidiary loss for the three and nine months ended September 30, 2004 (which is the portion of 454’s loss attributable to shareholders of 454 other than us) remained relatively consistent with the same periods in 2003. During the fourth quarter of 2004, losses attributed to the minority ownership in 454 are expected to remain fairly constant as compared to the third quarter of 2004, as 454 continues to make progress towards commercializing and developing new technologies.

Liquidity and Capital Resources

Since our inception, we have financed our operations and met our capital expenditure requirements primarily through public equity offerings, private placements of equity securities, convertible subordinated debt offerings, revenues received under our collaborative research agreements and government grants and exercises of stock options. On February 17, 2004, we completed an offering of $100.0 million of 4% convertible subordinated notes due February 15, 2011, and received net proceeds of approximately $96.5 million. In addition, on March 16, 2004, the initial purchasers exercised their option to purchase an additional $10.0 million of 4% convertible subordinated notes due February 15, 2011, providing us with additional net proceeds of approximately $9.7 million. On February 17, 2004, we repurchased $20.0 million of our 6% convertible subordinated debentures due in 2007, for total consideration of

$20.0 million, plus accrued interest of $0.05 million to the date of repurchase. As of September 30, 2004, we had recognized $111.3 million of cumulative sponsored research revenues from collaborative research agreements and government grants. At September 30, 2004, our gross investment in lab and office equipment, computers, land and leasehold improvements was $48.2 million. Since inception, we have not had any off-balance sheet arrangements. To date, inflation has not had a material effect on our business.

Cash and investments. The following table depicts the components of our operating, investing and financing activities for the nine months ended September 30, 2004, using the direct cash flow method:


Cash received from collaborators	$	3.7
Cash received from grantor		0.5
Cash paid to suppliers and employees		(64.6	)
Restructuring and related charges paid		(0.5	)
Interest income received		6.1
Interest expense paid		(10.7	)

Net cash and investments used in operating activities		(65.5	)

Cash paid to acquire property and equipment, net of sales proceeds		(4.8	)
Cash paid to acquire non-perpetual licenses		(1.1	)
Convertible loan to collaborator		(5.0	)

Net cash and investments used in investing activities		(10.9	)

Cash paid for principal portion of capital leases		(0.2	)
Cash received from employee stock option exercises		0.4
Cash received from issuance of convertible debt, net of financing costs		106.2
Cash paid for extinguishment of debt		(20.0	)

Net cash and investments provided by financing activities		86.4

Unrealized loss on marketable securities		(1.7	)

Net increase in cash and investments		8.3
Cash and investments, beginning of period		343.6

Cash and investments, end of period	$	351.9

In accordance with our investment policy, we are utilizing the following investment objectives for cash and investments: (1) investment decisions are made with the expectation of minimum risk of principal loss, even with a modest penalty in yield; (2) appropriate cash balances and related short-term funds are maintained for immediate liquidity needs, and appropriate liquidity is available for medium-term cash needs; and (3) maximum after-tax yield is achieved.

Future Liquidity

Sources of Liquidity. During the next twelve months, we expect to continue to fund our operations through a combination of the following sources: cash and investment balances; interest income; collaboration revenue; grant revenue; and potential public securities offerings and/or private strategic-driven common stock offerings.

Uses of Liquidity. Throughout the next twelve months, we plan to continue making substantial investments to advance our preclinical and clinical drug pipeline, as well as to advance 454’s genomic analysis technology. In that regard, we foresee the following as significant uses of liquidity: personnel costs; supplies and reagents; contract research organization (“CRO”) expenses and related costs for contractual services related to clinical trials and manufacturing; legal expenses in support of the continued protection of our intellectual property portfolio; costs related to 454, as they continue to make progress towards commercializing and developing new technologies for whole genome analysis; external programs identified by our platform as being promising and synergistic with our products and expertise; cost-sharing of expenses with Bayer related to CT052 preclinical development, in which both parties will jointly fund the relevant preclinical research, development and commercialization activities; and capital expenditures during the remainder of 2004 and the first quarter of 2005, primarily for the expansion of our existing protein production laboratory facilities. In addition, we expect the payments of interest to the holders of our convertible subordinated debt due in 2007 and in 2011 to be a continued significant use of liquidity.

Depending on market and other conditions, from time to time, we may repurchase a portion of the remainder of our existing notes due in 2007 in open market purchases, in privately negotiated transactions, or otherwise. In

addition, we will use cash and investments for working capital, general corporate purposes and potentially for future acquisitions of complementary businesses or technologies. The amounts and timing of our actual expenditures will depend upon numerous factors, including the amount and extent of our acquisitions, our product development activities, our investments in technology and the amount of cash generated by our operations. Actual expenditures may vary substantially from our estimates. Our failure to use such funds effectively could have a material adverse effect on our business, results of operations and financial condition.

We believe that our existing cash and investment balances and other sources of liquidity will be sufficient to meet our requirements for the next twenty-four months. Our operating and capital expenditures are considered to be crucial to our future success, and by continuing to make strategic investments in our preclinical and clinical drug pipeline, we believe that we are building substantial value for our shareholders. The adequacy of our available funds to meet our future operating and capital requirements, including the repayment of our remaining $130.0 million of 6% convertible subordinated debentures due February 2, 2007 and our $110.0 million of 4% convertible subordinated notes due February 15, 2011, will depend on many factors. These factors include: the number, breadth and progress of our research, product development and clinical programs; the costs and timing of obtaining regulatory approvals for any of our products; in-licensing of pharmaceutical products; costs incurred in enforcing and defending our patent claims and other intellectual property rights; and potential future acquisitions of complementary businesses or technologies.

While we will continue to explore alternative sources for financing our business activities, including the possibility of public securities offerings and/or private strategic-driven common stock offerings, we cannot be certain that in the future these sources of liquidity will be available when needed or that our actual cash requirements will not be greater than anticipated. In appropriate strategic situations, we may seek financial assistance from other sources, including contributions by others to joint ventures and other collaborative or licensing arrangements for the development and testing of products under development. However, should we be unable to obtain future financing either through the methods described above or through other means, we may be unable to meet the critical objective of our long-term business plan, and may be unable to continue operations. This result could cause the Company’s shareholders to lose all or a substantial portion of their investment.

Contractual Obligations

The following table represents our consolidated contractual obligations as of September 30, 2004 (in millions):


	Payments Due Year Ended December 31,
	Total		2004		2005		2006		2007		2008		Thereafter
Long-term debt obligations	$	240.0		—		—		—	$	130.0		—	$	110.0
Interest on convertible subordinated debt		48.1		—	$	12.2	$	12.2		8.3	$	4.4		11.0
Operating leases		6.9	$	0.7		2.8		1.9		1.2		0.3		—
Purchase commitments (1)		9.1		4.1		2.0		2.0		1.0				—
Other long-term liabilities		1.0		—		—		0.5		0.5		—		—

Total	$	305.1	$	4.8	$	17.0	$	16.6	$	141.0	$	4.7	$	121.0

(1)	Includes commitments for capital expenditures and contractual services, but excludes amounts included on our balance sheet as liabilities and certain purchase obligations as discussed below.

The expected timing of payment of the obligations discussed above is based on our current information. Timing of payments and actual amounts paid may be different depending on the time of receipt of goods or services or changes to agreed-upon amounts for some obligations.

Purchase obligations for supplies and reagents are not included in the table above, because our purchase orders typically represent authorizations to purchase rather than binding agreements. For the purposes of this table, contractual obligations for the purchase of goods or services are defined as agreements that are enforceable and legally binding on us and that specify all significant terms, including: fixed or minimum quantities to be purchased; fixed, minimum or variable price provisions; and the approximate timing of the transaction. Our purchase orders are based on our current operating needs and are fulfilled by our vendors within short time periods. We do not have significant agreements for the purchase of supplies and reagents specifying minimum quantities or set prices. However, we have entered into agreements for contractual services primarily relating to the manufacturing costs of our protein therapeutic CG53135, our fully-human monoclonal antibody CR002, and a license and collaboration agreement with TopoTarget under which we have agreed to fund the preclinical development and clinical testing costs of various HDAC inhibitors, and have included these amounts in our purchase commitments above.

Minority Interest in Subsidiary

As of September 30, 2004, minority interest in subsidiary was $4.1 million. Minority interest in subsidiary is related to 454 and reflects the minority shareholders’ capitalization, less a gain recognition of $3.9 million as a result of our contribution of technology to 454 in 2000, and less the minority shareholders’ portion of losses incurred to date. The loss attributed to the minority ownership in 454 is expected to remain fairly constant during 2004, as 454 continues to make progress towards commercializing and developing new technologies.

Certain Factors That May Affect Results of Operations

This report contains certain forward-looking statements. Generally, these statements can be identified by the use of terms such as “estimate,” “project,” “plan,” “intend,” “expect,” “believe,” “anticipate,” “should,” “may,” “will,” and similar expressions. Forward-looking statements may include statements about: (i) our ability to pay the remaining cash requirements of $0.7 million through the end of 2008 as part of our June 2003 restructuring plan, (ii) our ability to pay the majority of the cash requirements related to our October 2004 restructuring plan during the fourth quarter of 2004, (iii) our expectation to initiate a Phase II trial on CG53135 by enrolling patients in a randomized, placebo-controlled, multi-center study to determine the safety and efficacy of a single-dose, (iv) our expectation that PXD101 will transition to Phase II in the first half of 2005, (v) our expectation of initiating a Phase I trial of CR002 in November 2004, (vi) our expectation that CR011 will enter clinical trials during the first half of 2006; (vii) our expectation that many of the INDs that we plan to file in the future will be identified from our animal studies, (viii) the expectation that 454’s proprietary technology will have widespread applications in industrial processes, agriculture, animal health, biodefense, human health care, including drug discovery and development, and disease diagnosis, (ix) the ability of 454 to scale its technology to further analyze fungi, larger model organisms, human genomes, and other sequencing applications, (x) the ability of 454 to sell both sequencing services and complete genomic analysis systems, including instrumentation and reagents to end-users, (xi) our expectation to become profitable by commercializing a subset of therapeutics stemming from our development pipeline, and establishing partnerships with pharmaceutical and biotechnology companies for the co-development and co-commercialization of therapeutics from our development pipeline, (xii) our expectation that grant revenue for the fourth quarter of 2004 will remain consistent with the third quarter of 2004, (xiii) our expectation that our fourth quarter 2004 collaboration revenue will decrease slightly as compared to the third quarter of 2004, due to a fluctuation in the volume of projects, (xiv) our expectation that 454’s fourth quarter 2004 collaboration revenue will be consistent with the third quarter of 2004 (xv) our expectation that grant research expenses for the fourth quarter of 2004 will remain consistent with the third quarter of 2004, (xvi) our expectation that research and development expenses, excluding perpetual license fees and potential milestone payments, will remain consistent for the remainder of 2004, (xvii) our expectation that general and administrative expenses are expected to increase slightly during the fourth quarter of 2004 as a result of legal patent costs, (xviii) our expectation that during the fourth quarter of 2004, we expect the yields in our investment portfolio to be slightly higher than the third quarter of 2004, (xix) our expectation that interest income for 2004 will decrease by approximately $1.0 million overall as compared to 2003, (xx) our expectation that interest expense will be approximately $13.0 million during 2004, (xxi) our expectation of an increase in the income tax benefit of approximately $0.8 million, due to the expiration of the State of Connecticut statute, as it relates to the 2000 income tax benefit, (xxii) our expectation that during the fourth quarter of 2004, losses attributed to the minority ownership in 454 will remain fairly constant as compared to the third quarter of 2004, (xxiii) our plan to continue making substantial investments in our emerging preclinical and clinical drug pipeline as well as to advance 454’s genomic analysis technology, throughout the next twelve months, (xxiv) our expectation that the payments of interest to the holders of our convertible subordinated debt due in 2007 and 2011 to be a significant use of liquidity, (xxv) our expectation that we will incur significant capital expenditures during the remainder of 2004 and the first quarter of 2005, primarily for the expansion of our existing protein production laboratory facilities, and (xxvi) our belief that our existing cash and investment balances and other sources of liquidity will be sufficient to meet our requirements for the next twenty-four months.

These forward-looking statements involve a number of risks and uncertainties that could cause actual results to differ materially from those suggested by the forward-looking statements. Forward-looking statements, therefore, should be considered in light of all of the information included or referred to in this report, including the cautionary information set forth under the heading Risk Factors below. We disclaim any intention or obligation to update or revise any forward-looking statements, whether as a result of new information, future events, or otherwise, unless required by law.

Risk Factors

Risks Related to Our Business

Because our business strategy is still largely untested, we do not know whether we will be able to commercialize any of our products or to what extent we will generate revenue or become profitable.

We do not know whether we can implement our business strategy successfully because we are in the early stages of development. Initially, we set out to find as many genes and their related functions as possible and are now using that information to develop therapeutic products. This strategy is largely untested. Other companies first target particular diseases and try to find cures for them, have a limited number of genes and proteins of potential therapeutic interest, or rely on other more proven strategies. If our strategy does not result in the development of products that we can commercialize, we will be unable to generate revenue. We have not completed development of any product based on our genomics research. Although our first potential product has entered clinical trials, we cannot be certain that this or any future products will receive marketing approval. If we are unable to commercialize products, we may not be able to recover our investment in our product development efforts.

Because clinical trials for our products will be expensive and protracted and their outcome is uncertain, we must invest substantial amounts of time and money that may not yield viable products.

Conducting clinical trials is a lengthy, time-consuming and expensive process. Before obtaining regulatory approvals for the commercial sale of any product, we must demonstrate through laboratory, animal and human studies that such product is both effective and safe for use in humans. Preclinical drug candidate testing and clinical drug trials can often go on for an undetermined period of time in the sense that testing and trials are continually monitored, with each test or trial considered “complete” only when sufficient data has been accumulated to assess whether the next phases are warranted or whether the effort should be abandoned. Many factors may delay the commencement and speed of completion of preclinical drug candidate testing and clinical drug trials, including the size and number of patients participating in the trial, the duration of patient follow-up required, the number of clinical sites at which the trials are conducted, and the length of time required to locate and enroll suitable patient subjects. We will incur substantial expense for, and devote a significant amount of time to, these studies.

Completion of clinical trials may take many years. The length of time required varies substantially according to the type, complexity, novelty and intended use of the product candidate. The FDA monitors the progress of each phase of testing, and may require the modification, suspension, or termination of a trial if it is determined to present excessive risks to patients. Our rate of commencement and completion of clinical trials may be delayed by many factors, including:

•

our inability to manufacture sufficient quantities of materials for use in clinical trials;

•

variability in the number and types of patients available for each study, as well as the difficulty in enrolling patients in each study;

•

difficulty in maintaining contact with patients after treatment, resulting in incomplete data;

•

unforeseen safety issues or side effects;

•

poor or unanticipated effectiveness of products during the clinical trials;

•

institutional review board delays at institutions assisting us with our clinical trials; and

•

government or regulatory delays.

Studies that we conduct, or studies which third parties conduct on our behalf, may not demonstrate sufficient effectiveness and safety to obtain the requisite regulatory approvals for these or any other potential products. Regulatory authorities may not permit us to undertake any additional clinical trials. The clinical trial process may be accompanied by substantial delay and expense and there can be no assurance that the data generated in these studies ultimately will be sufficient for marketing approval by the FDA.

We have two products in clinical development and our other products are in preclinical development. None of these products may demonstrate sufficient effectiveness or safety to obtain the requisite regulatory approvals required for initiation or continuation of clinical studies or obtaining marketing approval.

Because we have limited experience in developing, commercializing and marketing products, we may be unsuccessful in our efforts to do so.

Currently, we are developing several potential pharmaceutical products, and such products will require significant research and development and preclinical testing, and will require extensive clinical testing prior to our submitting any regulatory application for their commercial use. Although we are conducting human studies with respect to two products, we have limited experience with these activities and may not be successful in developing or commercializing these or other products. These activities, if undertaken without the collaboration of others, will require the expenditure of significant funds. Such potential pharmaceutical products will be subject to the risks of failure inherent in the development of pharmaceutical products based on new technologies. Before we can commercialize a product, we must rigorously test the product in the laboratory and complete extensive human studies. Even if we complete such studies, our ability to develop and commercialize products will depend on our ability to:

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complete laboratory testing and human studies;

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obtain and maintain necessary intellectual property rights to our products;

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obtain and maintain necessary regulatory approvals related to the efficacy and safety of our products;

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enter into arrangements with third parties to manufacture our products on our behalf; and

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deploy sales and marketing resources effectively or enter into arrangements with third parties to provide these functions.

As a result of these possibilities, we may not be able to develop through our research and development activities any commercially viable products. We cannot be certain that expenses for testing and study will yield profitable products or even products approved for marketing by the FDA. If we are not successful in identifying products that we can develop commercially, we may be unable to recover the large investment we have made in research, development and manufacturing. In addition, should we choose to develop pharmaceutical products internally, we will have to make significant investments in pharmaceutical product development, marketing, sales and regulatory compliance resources, and we will have to establish or contract for the manufacture of products under the current good manufacturing practices (“cGMPs”) of the FDA. Any potential products developed by our licensees will be subject to the same risks.

We do not have any marketed products. If we develop products that can be marketed, we intend to market the products either independently or together with collaborators or strategic partners. If we decide to market any products independently, we will incur significant additional expenditures and commit significant additional management resources to establish a sales force. For any products that we market together with partners, we will rely, in whole or in part, on the marketing capabilities of those parties. We may also contract with third parties to market certain of our products. Ultimately, we and our partners may not be successful in marketing our products.

We depend on a limited number of suppliers and depend on them to manufacture and supply critical components of our development and clinical programs.

Currently, we contract with third-party manufacturers or develop products with partners and use the partners’ manufacturing capabilities. As we use others to manufacture our products, we depend on those parties to comply with cGMPs, and other regulatory requirements and to deliver materials on a timely basis. These parties may not perform adequately. Any failures by these third parties may delay our development of products or the submission of these products for regulatory approval.

We depend on third-party research organizations to design and conduct our laboratory testing and human studies. If we are unable to obtain any necessary testing services on acceptable terms, we may not complete our product development efforts in a timely manner. As we rely on third parties for laboratory testing and human studies, we may lose some control over these activities and become too dependent upon these parties. These third parties may not complete testing activities on schedule or when we request.

Because neither we nor any of our collaborative partners have received marketing approval for any product resulting from our research and development efforts, and may never be able to obtain any such approval, we may not be able to generate any product revenue.

All the products being developed by our collaborative partners also will require additional research and development, extensive preclinical studies and clinical trials and regulatory approval prior to any commercial sales. In some cases, the length of time that it takes for our collaborative partners to achieve various regulatory approval milestones may affect the payments that we are eligible to receive under our collaboration agreements. We and our collaborative partners may need to address a number of technical challenges successfully in order to complete development of our products. Moreover, these products may not be effective in treating any disease or may prove to have undesirable or unintended side effects, toxicities or other characteristics that may preclude our obtaining regulatory approval or prevent or limit commercial use.

We may be unable to manufacture or obtain sufficient quantities of our products and ensure their proper performance and quality.

Biopharmaceuticals must be produced under the cGMPs of the FDA. We do not have facilities capable of manufacturing drug products under cGMPs and must outsource any such production. We are devoting resources to establishing our own manufacturing capabilities to support development and preclinical activities and are contracting with third-party vendors for the manufacture of materials for use in humans. We may be unable to contract successfully for cGMPs manufacture of any products and may be unable to obtain required quantities of our products economically. We may not be able to obtain capacity to produce a sufficient amount of commercial product to meet our commercial and clinical development needs. Failure to meet the demand for product may adversely affect our ability to continue to market the product.

Compliance with government regulation is critical to our business and failure to satisfy regulatory requirements could impair our business.

Prior to the marketing of any new drug developed by us, or by our collaborators, that new drug must undergo an extensive regulatory review process in the United States and other countries. This regulatory process, which includes preclinical and clinical studies, as well as post-marketing surveillance to establish a compound’s safety and efficacy, can take many years and require the expenditure of substantial resources. Data obtained from such studies are susceptible to varying interpretations that could delay, limit or prevent regulatory approval. Even if the FDA approves our products, we will still need to obtain institutional review board approval, which may involve additional delays. The rate of completion of clinical trials depends upon, among other factors, the enrollment of patients. Patient enrollment is a function of many factors, including:

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timing and restriction of institutional review board approval;

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the size of the patient population;

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proximity of patients to clinical sites;

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eligibility criteria for the study;

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time commitment of a patient to the study; and

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existence of competitive clinical trials.

We have not had any of our product candidates receive approval for commercialization in the United States or elsewhere. Neither we nor our collaborators may be able to conduct clinical testing or obtain the necessary approvals from the FDA or other regulatory authorities for any products. Failure by us or our collaborators to obtain required governmental approvals will delay or preclude our collaborators or us from marketing drugs developed with us or limit the commercial use of such products and could have a material adverse effect on our business, financial condition and results of operations. Even where a product is exempted from FDA clearance or approval, the FDA may impose restrictions as to the types of customers to which we can market and sell our products. Such restrictions may materially and adversely affect our business, financial condition and results of operations.

In addition, the FDA may condition marketing approval on the conduct of specific post-marketing studies to further evaluate safety and efficacy. Rigorous and extensive FDA regulation of pharmaceutical products continues after approval, particularly with respect to compliance with cGMPs reporting of adverse effects, advertising, promotion and marketing. Discovery of previously unknown problems or failure to comply with the applicable regulatory requirements may result in restrictions on the marketing of a product or withdrawal of the product from the market as well as possible civil or criminal sanctions, any of which could materially adversely affect our business.

We must obtain regulatory approval by governmental agencies in other countries prior to commercialization of our products in those countries. Foreign regulatory systems may be just as rigorous, costly and uncertain as in the United States.

We rely significantly on our collaborative partners, and our business could be harmed if we are unable to maintain strategic alliances.

As part of our business strategy, we have strategic research and development alliances with companies to gain access to specific technologies. These alliances with other pharmaceutical and biotechnology companies may provide us with access to unique technologies, access to capital, near-term revenues, milestone and/or royalty payments, and potential profit sharing arrangements. In return, we provide access to unique technologies, expertise in genomics, and information on the molecular basis of disease, drug targets, and drug candidates. To date, we have entered into significant strategic alliances with Abgenix, Bayer, TopoTarget, and Seattle Genetics in addition to numerous smaller agreements to facilitate these efforts. In these strategic alliances, either party can terminate the agreement at any time the alliance permits them to or if either party materially breaches the contract. We may not be able to maintain or expand existing alliances or establish any additional alliances. If any of our existing collaborators were to breach, terminate or not renew their agreements with us or otherwise fail to conduct activities successfully and in a timely manner, the preclinical or clinical development or commercialization of product candidates or research programs may be delayed or terminated.

We depend on attracting and retaining key employees.

We are highly dependent on the principal members of our management and scientific staff, including Jonathan M. Rothberg, Ph.D., our Chief Executive Officer, President and Chairman of the Board; David M. Wurzer, Executive Vice President, Treasurer and Chief Financial Officer; Christopher K. McLeod, Executive Vice President; Timothy M. Shannon, M.D., Executive Vice President and Chief Medical Officer; and Richard F. Begley, Ph.D., President and Chief Executive Officer of 454. The loss of services of any of these personnel could materially adversely affect our business, financial condition and results of operations. We have entered into employment agreements with all of the principal members of our management and scientific staff. We maintain key person life insurance on the life of Dr. Rothberg in the amount of $2.0 million. Our future success also will depend in part on the continued services of our key scientific and management personnel and our ability to attract, hire and retain additional personnel. There is intense competition for such qualified personnel and there can be no assurance that we will be able to continue to attract and retain such personnel. Failure to attract and retain key personnel could materially, adversely affect our business, financial condition and results of operations.

We depend on academic collaborators, consultants and scientific advisors.

We have relationships with collaborators and consultants at academic and other institutions who conduct research at our request. These collaborators and consultants are not our employees. Substantially all of our collaborators and consultants are employed by employers other than us and may have commitments to, or consulting or advisory contracts with, other entities that may limit their availability to us. As a result, we have limited control over their activities and, except as otherwise required by our collaboration and consulting agreements, can expect only limited amounts of their time to be dedicated to our activities. Our ability to discover genes and biological pathways involved in human disease and commercialize products based on those discoveries may depend in part on continued collaborations with researchers at academic and other institutions. We may not be able to negotiate additional acceptable collaborations with collaborators or consultants at academic and other institutions.

Our academic collaborators, consultants and scientific advisors may have relationships with other commercial entities, some of which could compete with us. Our academic collaborators, consultants and scientific advisors sign agreements which provide for confidentiality of our proprietary information and of the results of studies. We may not be able to maintain the confidentiality of our technology and other confidential information in connection with every academic collaboration or advisory arrangement, and any unauthorized dissemination of our confidential information could materially adversely affect our business, financial condition and results of operations. Further, any such collaborator, consultant or advisor may enter into an employment agreement or consulting arrangement with one of our competitors.

Competition in our field is intense and likely to increase.

We face, and will continue to face, intense competition from one or more of the following entities:

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biotechnology companies;

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pharmaceutical companies;

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academic and research institutions; and

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government agencies.

We also are subject to significant competition from organizations that are pursuing approaches, technologies and products that are the same as, or similar to, our technology and products. Many of the organizations competing with us have greater capital resources, research and development staffs and facilities and marketing capabilities. In addition, research in the field of genomics, protein therapeutics, and fully-human antibodies generally is highly competitive. Our competitors include:

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Human Genome Sciences, Inc.;

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Genentech, Inc.;

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ZymoGenetics, Inc.;

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Amgen, Inc.;

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Incyte Pharmaceuticals, Inc.;

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major biotechnology and pharmaceutical companies; and

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universities and other non-profit research organizations.

A number of organizations are attempting to rapidly identify and patent genes and gene fragments sequenced at random, typically without specific knowledge of the function of such genes or gene fragments. If our competitors discover or characterize important genes or gene fragments before we do, it could adversely affect our ability to commercialize our products. We expect that competition in genomics research, protein therapeutics, and therapeutic antibodies will intensify as technical advances are made and become more widely known. In addition, a number of competitors are producing proteins from genes and claiming both the proteins as potential therapeutics as well as claiming antibodies against these proteins. In many cases generic antibody claims are being issued by the United States Patent and Trademark Office (“USPTO”) even though competitors have not actually made antibodies against the protein of interest, or do not have cellular, animal, or human data to support the use of these antibodies as therapeutics. These claims on proteins as therapeutics and these claims covering all antibodies against the proteins and methods of use in broad human indications are being filed at a rapid rate, and some number of these claims have issued and may continue to issue. In addition, purified proteins, therapeutic data, and antibodies, including polyclonal antibodies, mouse monoclonal antibodies and, in some cases, fully-human monoclonal antibodies, are being generated against a large number of targets within the human genome. All of these activities may make it difficult to commercialize products, or, if licenses are made available, may make the royalty burden on these products so high as to prevent commercial success.

We may engage in acquisitions that are unsuccessful.

In the future, we may engage in acquisitions in order to exploit technology or market opportunities. We are not experienced in acquiring and integrating new businesses. If we acquire another company, we may not be able to integrate the acquired business successfully into our existing business in a timely and non-disruptive manner or at all. Furthermore, an acquisition may not produce the revenues, earnings or business synergies that we anticipate. If we fail to integrate the acquired business effectively or if key employees of that business leave, the anticipated benefits of the acquisition would be jeopardized. The time, capital management and other resources spent on an acquisition that fails to meet our expectations could cause our business and financial condition to be materially and adversely affected. In addition, acquisitions can involve material non-recurring charges and amortization of significant amounts of non-cash acquisition costs that could adversely affect our results of operations.

If our patent applications do not result in issued patents, then our competitors may obtain rights to commercialize our discoveries.

Our business and competitive position depends on our ability to protect our products, processes and technologies. We file patent applications covering novel genes and gene transcripts, as well as our development products, processes and technologies with the USPTO and major foreign patent authorities. As of the date of this report, we had been issued approximately 72 patents with respect to aspects of our gene portfolio, products, processes and technologies.

Our commercial success also depends in part on obtaining patent protection on genes and proteins for which we or our collaborators discover utility and on products, methods and services based on such discoveries. We have applied for patent protection on novel genes and proteins, novel mutants of known genes and their uses, partial sequences of novel proteins and their gene sequences and uses, and novel uses for previously identified genes discovered by third parties. We have applied for patents on antibodies against the proteins we have discovered, as well as seek or have our partners seek patent protection on the antibodies we produce against these proteins. We have sought and intend to continue to seek patent protection for novel uses for genes and proteins and therapeutic antibodies that may have been patented by third parties. In such cases, we would need a license from the holder of the patent with respect to such gene or protein in order to make, use or sell such gene or protein for such use. We may not be able to acquire such licenses on commercially reasonable terms, if at all. Our patent application filings that result from the identification of genes associated with the cause or effect of a particular disease generally seek to protect the genes and the proteins encoded by such genes as well as antibodies raised against these gene products. We also seek patent protection for our therapeutic, diagnostic and drug screening methods and products.

In 2001, the USPTO issued new guidelines for patent applications reflecting the USPTO’s current policy regarding statutory written description and utility requirements for patentability. The implementation of these new guidelines may cause the USPTO initially to reject some of our pending new gene and protein patent applications. There is no guarantee that the USPTO will approve them. We strive especially to gain issued patents for our commercially important genes and proteins.

The patent positions of pharmaceutical, biopharmaceutical and biotechnology companies, including us, are generally uncertain and involve complex legal and factual questions. Our patent applications may not protect our products, processes and technologies because of the following reasons:

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there is no guarantee that any of our pending patent applications will result in additional issued patents;

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we may develop additional proprietary technologies that are not patentable;

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there is no guarantee that any patents issued to us or our collaborative customers will provide a basis for commercially viable products;

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there is no guarantee that any patents issued to us or our collaborative customers will provide us with any competitive advantages;

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there is no guarantee that any patents issued to us or our collaborative customers will not be challenged or circumvented or invalidated by third parties; and

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there is no guarantee that any patents issued to others will not have an adverse effect on our ability to do business.

In addition, patent law relating to the scope of claims in the technology fields in which we operate is still evolving. The degree of future protection for our proprietary rights is uncertain. Furthermore, there can be no assurance that others will not independently develop similar or alternative technologies, duplicate any of our technologies, or, if patents are issued to us, design around the patented technologies developed by us. In addition, we could incur substantial costs in litigation if we are required to defend ourselves in patent suits brought by third parties or if we initiate such suits.

The issuance of patents may not provide us with sufficient protection.

We may not be able to obtain further patents for our products, processes and technologies, or, if we are able to obtain further patents, these patents may not provide us with substantial protection or be commercially beneficial. The issuance of a patent is not conclusive as to its validity or enforceability, nor does it provide the patent holder with freedom to operate without infringing the patent rights of others. A patent could be challenged by litigation and, if the outcome of such litigation were adverse to the patent holder, competitors could be free to use the subject matter covered by the patent, or the patent holder may license the technology to others in settlement of such litigation. The invalidation of key patents owned by or licensed to us or non-approval of pending patent applications could increase competition, and materially adversely affect our business, financial condition and results of operations. In addition, any application or exploitation of our technology could infringe patents or proprietary rights of others and any licenses that we might need as a result of such infringement might not be available to us on commercially reasonable terms, if at all. Third parties have indicated to us that they believe we may be required to obtain a license in order to perform certain processes that we use in the conduct of our business or in order to market potential drugs we have in development.

We cannot predict whether our or our competitors’ pending patent applications will result in the issuance of valid patents. Litigation, which could result in substantial cost to us, also may be necessary to enforce our patent and proprietary rights and/or to determine the scope and validity of others’ proprietary rights. We may participate in interference proceedings that may in the future be declared by the USPTO to determine priority of invention, which could result in substantial cost to us. The outcome of any such litigation or interference proceeding might not be favorable to us, and we might not be able to obtain licenses to technology that we require or that, if obtainable, we could license such technology at a reasonable cost.

The public availability of genomic sequence information or other sequence information prior to the time we apply for patent protection on a corresponding full-length or partial gene could adversely affect our ability to obtain patent protection with respect to such gene or gene sequences. In addition, certain other groups are attempting to rapidly identify and characterize genes through the use of gene expression analysis and other technologies. To the extent any patents issue to other parties on such partial or full-length genes or uses for such genes, the risk increases that the sale of potential products, including therapeutics, or processes developed by us or our collaborators may give rise to claims of patent infringement. Others may have filed and in the future are likely to file patent applications covering genes or gene products or antibodies against the gene products that are similar or identical to our products. Any such patent application may have priority over our patent applications. Any legal action against us or our collaborators claiming damages and seeking to enjoin commercial activities relating to the affected products and processes could, in addition to subjecting us to potential liability for damages, require us or our collaborators to obtain a license in order to continue to manufacture or market the affected products and processes or could enjoin us from continuing to manufacture or market the affected products and processes. There can be no assurance that we or our collaborators would prevail in any such action or that any license required under any such patent would be made available on commercially acceptable terms, if at all. We believe that there may be significant litigation in the industry regarding patent and other intellectual property rights. If we become involved in such litigation, it could consume a substantial portion of our managerial and financial resources.

There is substantial uncertainty concerning the extent to which supportive data will be required for issuance of patents for human therapeutics. If data additional to that available to us is required, our ability to obtain patent protection could be delayed or otherwise adversely affected. Although the USPTO issued new utility guidelines in July 1995 that address the requirements for demonstrating utility for biotechnology inventions, particularly for inventions relating to human therapeutics, there can be no assurance that the USPTO examiners will follow such guidelines or that the USPTO’s position will not change with respect to what is required to establish utility for gene sequences and products and methods based on such sequences.

We cannot be certain that our security measures will protect our proprietary technologies.

We also rely upon trade secret protection for some of our confidential and proprietary information that is not subject matter for which patent protection is being sought. We have developed a database of proprietary gene expression patterns and biological pathways which we update on an ongoing basis and which can be accessed over the Internet. We have taken security measures to protect our proprietary technologies, processes, information systems and data and continue to explore ways to enhance such security. Such measures, however, may not provide adequate protection for our trade secrets or other proprietary information. While we require employees, academic collaborators and consultants to enter into confidentiality and/or non-disclosure agreements where appropriate, any of the following could still occur:

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proprietary information could be disclosed;

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others may independently develop substantially equivalent proprietary information and techniques or otherwise gain access to our trade secrets or disclose such technology; or

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we may not be able to meaningfully protect our trade secrets.

We depend upon our ability to license technologies.

We may have to acquire or license certain components of our technologies or products from third parties. We may not be able to acquire from third parties or develop new technologies, either alone or with others. Failure to license or otherwise acquire necessary technologies could materially adversely affect our business, financial condition and results of operations.

The 454 Life Sciences technology platform is in development and the early stages of commercialization.

The technology platform of 454, our majority-owned subsidiary, is still in development and 454 has not had significant sales of its services or products. 454 may not be able to continue to successfully develop or commercialize the 454 technology platform. The success of commercialization of the 454 technology platform depends on many factors, including:

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the acceptance of 454’s technology in the market place;

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technical performance of 454’s platform in relation to existing technologies; and

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454’s ability to obtain key components for the manufacture of the 454 instrument and reagents from suppliers.

454 is subject to competition from organizations that have developed or are developing technologies and products to service 454’s potential customers.

Many of the organizations competing with 454 potentially have greater capital resources, research and development staffs and facilities and marketing capabilities. 454’s potential competitors include:

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Applied Biosystems;

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GE Healthcare (formerly Amersham Biosciences);

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Affymetrix;

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Lynx Therapeutics;

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Perlegen; and

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other companies recently formed or soon to be funded to develop whole genome sequencing technologies.

We believe that the future success of 454 will depend in large part on our ability to maintain a competitive position in instruments for the high throughput nucleic acid sequencing field. Before we recover development expenses for our products or technologies, such products or technologies may become obsolete as a result of technological developments by us or others. Our products could also be made obsolete by new technologies which are less expensive or more effective. We may not be able to make the enhancements to our technology necessary to compete successfully with newly emerging technologies. A market for the high throughput nucleic acid sequencing field may not be sufficient to generate revenues significant enough for 454 to achieve profitability.

We could be liable for any failure to comply with hazardous product regulations.

Our research and development activities involve the controlled use of hazardous materials and chemicals. We are subject to federal, state and local laws and regulations governing the use, storage, handling and disposal of such materials and certain waste products. Although we believe that our safety procedures for handling and disposing of such materials comply with the standards prescribed by federal, state and local laws and regulations, the risk of accidental contamination or injury from these materials cannot be completely eliminated. In the event of such an accident, we could be held liable for any damages that result and any liability could exceed our resources.

Risks Related to Our Financial Results

We have a history of operating losses and expect to incur losses in the future.

We have incurred losses since inception, principally as a result of research and development and general and administrative expenses in support of our operations. We anticipate incurring additional losses over the next several years as we focus our resources on prioritizing, selecting and advancing our most promising drug candidates. We may never be profitable or achieve significant revenues. For example, we experienced net losses of $74.5 million in 2003, $90.4 million in 2002 and $42.9 million in 2001, and as of September 30, 2004 had an accumulated deficit of $357.2 million.

Our quarterly operating results have fluctuated greatly and may continue to do so.

Our operating results have fluctuated on a quarterly basis. We expect that losses will continue to fluctuate from quarter to quarter and that these fluctuations may be substantial. Our results of operations are difficult to predict and may fluctuate significantly from period to period, which may cause our stock price to decline and result in losses to investors. Some of the factors that could cause our operating results to fluctuate include:

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changes in the demand for our services;

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the nature, pricing and timing of products and services provided to our collaborators;

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our ability to compete effectively in our therapeutic discovery and development efforts against competitors that have greater financial or other resources or drug candidates that are in further stages of development;

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acquisition, licensing and other costs related to the expansion of our operations;

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losses and expenses related to our investments;

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regulatory developments or changes in public perceptions relating to the use of genetic information and the diagnosis and treatment of disease based on genetic information;

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regulatory actions and changes related to the development of drugs;

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changes in intellectual property laws that affect our patent rights;

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payments of milestones, license fees or research payments under the terms of our external alliances and collaborations and our ability to monitor and enforce such payments; and

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the timing of intellectual property licenses that we may enter into.

We believe that quarterly comparisons of our financial results are not necessarily meaningful and should not be relied upon as an indication of future performance. In addition, fluctuations in quarterly results could affect the market price of our common stock in a manner unrelated to our long-term operating performance.

The market price of our common stock is highly volatile.

The market price of our common stock has fluctuated widely and may continue to do so. For example, during the third quarter of 2004, the closing sale price of our stock ranged from a high of $6.15 per share to a low of $4.41 per share. Many factors could cause the market price of our common stock to rise and fall. These factors include:

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variations in our quarterly operating results;

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announcements of technological innovations, clinical results, or new products by us or our competitors;

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introduction of new products or new pricing policies by us or our competitors;

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acquisitions or strategic alliances by us or others in our industry;

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announcement by the government or other agencies regarding the economic health of the United States and the rest of the world;

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the hiring or departure of key personnel;

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changes in market valuations of companies within the biotechnology industry; and

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changes in estimates of our performance or recommendations by financial analysts.

We have a large amount of debt and our debt service obligations may prevent us from taking actions that we would otherwise consider to be in our best interests.

As of September 30, 2004, we had total consolidated debt of $241.0 million; and for the year ended December 31, 2003, we had a deficiency of earnings available to cover fixed charges of $80.6 million. A variety of uncertainties and contingencies will affect our future performance, many of which are beyond our control. We may not generate sufficient cash flow in the future to enable us to meet our anticipated fixed charges, including our debt service requirements with respect to our notes due in 2007 and in 2011. At September 30, 2004, $240.0 million of those notes remained outstanding.

The following table shows, as of September 30, 2004, the remaining aggregate amount of our interest payments due in each of the years listed (in millions):


Year	Aggregate Interest
2005	$	12.2
2006		12.2
2007		8.3
2008		4.4
2009		4.4
Thereafter		6.6

Our substantial leverage could have significant negative consequences for our future operations, including:

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increasing our vulnerability to general adverse economic and industry conditions;

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limiting our ability to obtain additional financing;

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requiring the dedication of a substantial portion of our expected cash flow to service our indebtedness, thereby reducing the amount of our expected cash flow available for other purposes, including working capital and capital expenditures;

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limiting our flexibility in planning for, or reacting to, changes in our business and the industry in which we compete; or

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placing us at a possible competitive disadvantage compared to less leveraged competitors and competitors that have better access to capital resources.

Our debt investments are impacted by the financial viability of the underlying companies.

We have a diversified portfolio of investments of which $184.4 million at September 30, 2004 were invested in U.S. Treasuries and debt investments that are sponsored by the U.S. Government. Our corporate fixed-rate debt investments comply with our policy of investing in only investment-grade debt instruments. The ability for the debt to be repaid upon maturity or to have a viable resale market is dependent, in part, on the financial success of the underlying company. Should the underlying company suffer significant financial difficulty, the debt instrument could either be downgraded or, in the worst case, our investment could be worthless. This would result in our losing the cash value of the investment and incurring a charge to our statement of operations.

We may need to raise additional funding, which may not be available on favorable terms, if at all.

We believe that we have sufficient capital to satisfy our capital needs for at least the next twenty-four months. However, our future funding requirements will depend on many factors and we anticipate that, at some future point, we will need to raise additional capital to fund our business plan and research and development efforts on a going-forward basis. To the extent that we need to obtain additional funding, the amount of additional capital we would need to raise would depend on many factors, including:

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the number, breadth and progress of our research, product development and clinical programs;

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our ability to establish and maintain additional collaborations;

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the progress of our collaborators;

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our costs incurred in enforcing and defending our patent claims and other intellectual property rights; and

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the costs and timing of obtaining regulatory approvals for any of our products.

We expect that we would raise any additional capital we require through public or private equity offerings, debt financings or additional collaborations and licensing arrangements. We cannot be certain that in the future these sources of liquidity will be available when needed or that our actual cash requirements will not be greater than anticipated. In appropriate strategic situations, we may seek financial assistance from other sources, including contributions by others to joint ventures and other collaborative or licensing arrangements for the development and testing of products under development. If we raise additional capital by issuing equity securities, the issuance of such securities would result in ownership dilution to our shareholders. If we raise additional funds through collaborations and licensing arrangements, we may be required to relinquish rights to certain of our technologies or product candidates, or to grant licenses on unfavorable terms. The relinquishing of rights or granting of licenses on unfavorable terms could materially adversely affect our business, financial condition and results of operations. If adequate funds are not available, our business, financial condition and results of operations would be materially adversely affected. However, should we be unable to obtain future financing either through the methods described above or through other means, we may be unable to meet the critical objective of our long-term business plan, which is to successfully develop and market pharmaceutical products. If we require additional capital at a time when investment in biotechnology companies such as ours, or in the marketplace in general, is limited due to the then prevailing market or other conditions, we may not be able to raise such funds at the time that we desire or any time thereafter.

Risks Related to Our Convertible Debt and Our Common Stock into which Our Debt is Convertible

We have significant leverage as a result of the issuances of our debt in 2000 and 2004.

In February 2000, in connection with the sale of our 6% convertible subordinated debentures due in 2007, we incurred $150.0 million of indebtedness. In February 2004, we repurchased $20.0 million of these debentures, for total consideration of $20.0 million, plus accrued interest of $0.05 million to the date of repurchase. As a result of the remaining indebtedness of $130.0 million, our interest payment obligations amount to $7.8 million per year.

In February 2004, in connection with the sale of our 4% convertible subordinated notes due in 2011, we incurred an additional $100.0 million of indebtedness. In addition, in March 2004, the initial purchasers exercised their option to purchase an additional $10.0 million of 4% convertible subordinated notes due in 2011, providing us with additional net proceeds of approximately $9.7 million. As a result of this indebtedness of $110.0 million, our interest payment obligations amount to $4.4 million per year. The degree to which we are leveraged could adversely affect our ability to obtain further financing for working capital, acquisitions or other purposes and could make us more vulnerable to industry downturns and competitive pressures. Our ability to meet our debt service obligations will depend upon our future performance, which may be subject to the financial, business and other factors affecting our operations, many of which are beyond our control.

These notes, due in 2007 and in 2011, are effectively subordinated to all of our secured indebtedness and all indebtedness of our subsidiaries. These notes are our general unsecured obligations and are not guaranteed by any of our subsidiaries. Accordingly, these notes are effectively subordinated to all of our current and future secured indebtedness to the extent of the assets securing the indebtedness. Furthermore, our right to receive any distribution of assets of any subsidiary upon that subsidiary’s liquidation, reorganization or otherwise, is subject to the prior claims of creditors of that subsidiary, except to the extent we also are recognized as a creditor of that subsidiary. As a result, these notes are effectively subordinated to the claims of such creditors.

There are no restrictive covenants in our indentures relating to our ability to incur future indebtedness.

The indentures governing our notes due in 2007 and in 2011 do not contain any financial or operating covenants or restrictions on the payment of dividends, the incurrence of indebtedness, transactions with affiliates, incurrence of liens or the issuance or repurchase of securities by us or any of our subsidiaries. We may therefore incur additional debt, including secured indebtedness senior to these notes. As part of our growth strategy, we potentially may use proceeds from the 2004 offering to finance future acquisitions of complementary businesses or technologies, which may cause us or our subsidiaries to incur significant indebtedness to which these notes would be subordinate.

These notes, due in 2007 and in 2011, are obligations exclusively of CuraGen Corporation. Our subsidiaries are separate and distinct legal entities. Our subsidiaries have no obligation to pay any amounts due on these notes or to provide us with funds for our payment obligations, whether by dividends, distributions, loans or other payments. In addition, any payment of dividends, distributions, loans or advances by our subsidiaries to us could be subject to statutory or contractual restrictions. Payments to us by our subsidiaries will also be contingent upon our subsidiaries’ earnings and business considerations.

Our debt service obligations may adversely affect our cash flow.

A higher level of indebtedness increases the risk that we may default on our debt obligations. We cannot be certain that we will be able to generate sufficient cash flow to pay the interest on our debt or that future working capital, borrowings or equity financing will be available to pay or refinance such debt. If we are unable to generate sufficient cash flow to pay the interest on our debt, we may have to delay or curtail our research and development programs.

The level of our indebtedness among other things, could:

•

make it difficult for us to make payments on our notes;

•

make it difficult for us to obtain any necessary financing in the future for working capital, capital expenditures, debt service requirements or other purposes;

•

limit our flexibility in planning for, or reacting to, changes in our business and the industry in which we compete; and

•

make us more vulnerable in the event of a downturn in our business.

Our ability to repurchase notes, if required, with cash upon a change in control or fundamental change may be limited.

In certain circumstances involving a change in control, we may be required to repurchase some or all of the notes due in 2007. In certain circumstances involving a fundamental change, we may be required to repurchase some or all of the notes due in 2011. We cannot be certain that we will have sufficient financial resources at such time or would be able to arrange financing to pay the repurchase price of the notes. Our ability to repurchase the notes in such event may be limited by law, by the indenture and by such indebtedness and agreements as may be entered into, replaced, supplemented or amended from time to time.

Securities we issue to fund our operations could cause dilution to our shareholders’ ownership.

The conversion of our notes into shares of common stock will dilute the ownership interest of our current shareholders. We may decide to raise additional funds through a public or private debt or equity financing to fund our operations. If we raise funds by issuing equity securities, the percentage ownership of current shareholders, including the ownership that holders of the notes would have upon conversion, will be reduced, and the new equity securities may have rights prior to those of the common stock issuance upon conversion of the notes. We may not obtain sufficient financing on terms that are favorable to existing shareholders and us.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

Our outstanding long-term liabilities as of September 30, 2004 consisted of $130.0 million of our 6% convertible subordinated debentures due February 2, 2007, $110.0 million of our 4% convertible subordinated notes due February 15, 2011, and an accrued long-term liability of $1.0 million for the remaining future minimum payments under a license agreement (see Note 11 to our consolidated financial statements included in our Annual Report on Form 10-K for the year ended December 31, 2003). As the debentures and notes bear interest at a fixed rate, our results of operations would not be affected by interest rate changes. As of September 30, 2004, the market value of our $130.0 million 6% convertible subordinated debentures due 2007, based on quoted market prices, was estimated at $126.0 million, and the market value of our $110.0 million 4% convertible subordinated notes due 2011, based on quoted market prices, was estimated at $95.4 million. Although future borrowings may bear interest at a floating rate, and our result of operations would therefore be affected by interest rate changes, at this point we do not anticipate any significant future borrowings, and therefore do not believe that a change of 100 basis points in interest rates would have a material effect on our financial condition.

There have been no other significant changes in our market risk compared to the disclosures in Item 7a of our Annual Report on Form 10-K for the year ended December 31, 2003.

Item 4. Controls and Procedures

(a)

Evaluation of Disclosure Controls and Procedures

As of the end of the period covered by this Quarterly Report on Form 10-Q, an evaluation was performed under the supervision and with the participation of our management, including the Chief Executive Officer (“CEO”) and Chief Financial Officer (“CFO”), of the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)). Based on that evaluation, the CEO and CFO have concluded that our disclosure controls and procedures were adequate and effective to ensure that material information relating to us, including our consolidated subsidiary, was made known to them by others within those entities, particularly during the period in which this Quarterly Report on Form 10-Q was being prepared.

(b)

Changes in Internal Controls

There have been no changes in our internal controls over financial reporting, identified in connection with the above-mentioned evaluation of such internal controls that occurred during our last fiscal quarter that have materially affected, or are reasonably likely to materially affect, our internal controls over financial reporting.

Part II - Other Information

Item 6. Exhibits


Exhibit 31.1		Certification of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

Exhibit 31.2		Certification of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

Exhibit 32		Certification Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (Subsections (a) and (b) of Section 1350, Chapter 63 of Title 18, United States Code).

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.


Dated: November 8, 2004	CuraGen Corporation

	By:	/s/ Jonathan M. Rothberg, Ph.D.
		Jonathan M. Rothberg, Ph.D.
		Chief Executive Officer, President and
		Chairman of the Board

	By:	/s/ David M. Wurzer
		David M. Wurzer
		Executive Vice-President, Chief Financial Officer and Treasurer (principal financial and accounting officer of the registrant)

CURAGEN CORPORATION

EXHIBIT INDEX


No.
Exhibit 31.1		Certification of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

Exhibit 31.2		Certification of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

Exhibit 32		Certification Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (Subsections (a) and (b) of Section 1350, Chapter 63 of Title 18, United States Code).

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