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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

For the quarterly period ended September 30, 2004

or

Commission File Number: 0-21699

VIROPHARMA INCORPORATED

(Exact Name of Registrant as Specified in its Charter)

397 Eagleview Boulevard

Exton, Pennsylvania 19341

(Address of Principal Executive Offices and Zip Code)

610-458-7300

(Registrant’s Telephone Number, Including Area Code)

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

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

Number of shares outstanding of the issuer’s Common Stock, par value $.002 per share, as of November 1, 2004: 26,732,217 shares.

VIROPHARMA INCORPORATED

INDEX

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PART I. FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

ViroPharma Incorporated

(A Development Stage Company)

Consolidated Balance Sheets

(unaudited)

December 31, 2003 and September 30, 2004

See accompanying notes to unaudited consolidated financial statements.

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ViroPharma Incorporated

(A Development Stage Company)

Consolidated Statements of Operations

(unaudited)

Three months ended September 30, 2003 and 2004, nine months ended September 30, 2003 and 2004

and the period from December 5, 1994 (Inception) to September 30, 2004

See accompanying notes to unaudited consolidated financial statements.

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ViroPharma Incorporated

(A Development Stage Company)

Consolidated Statements of Cash Flows

(unaudited)

Nine months ended September 30, 2003 and 2004 and the

period from December 5, 1994 (Inception) to September 30, 2004

See accompanying notes to unaudited consolidated financial statements.

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ViroPharma Incorporated

(A Development Stage Company)

Notes to Consolidated Financial Statements

(1) Organization and Business Activities

ViroPharma Incorporated (a development stage company) commenced operations on December 5, 1994. ViroPharma Incorporated and its subsidiary (the “Company” or “ViroPharma”) is a development stage pharmaceutical company focused on the development and commercialization of products that address serious diseases treated by physician specialists and in hospital settings.

The Company is devoting substantial effort towards conducting drug development, conducting clinical trials, pursuing business development opportunities, pursuing regulatory approval for products under development, and raising capital. The Company has earned no significant revenue from product sales and has not achieved profitable operations or positive cash flow from operations. The Company’s deficit accumulated during the development stage aggregates $282.9 million through September 30, 2004. There is no assurance that profitable operations can ever be achieved, and even if achieved, could be sustained on a continuing basis.

The Company plans to continue to finance its operations with a combination of cash, cash equivalents, and short-term investments, revenues from sales of Vancocin^®, following the closing of the acquisition of Vancocin that was announced in October 2004 (see note 8), stock issuances and debt issuances, as available, license payments, payments from strategic research and development arrangements when and if agreed upon milestones are achieved and, in the longer term, revenues from other product sales or collaborations, if its planned products are commercialized or if it is successful in acquiring additional marketed products through its business development efforts. There are no assurances, however, that the Company will be successful in obtaining regulatory approval for any of its product candidates, in obtaining an adequate level of financing needed for the long-term development and commercialization of its product candidates or in acquiring additional marketed products through its business development efforts.

In October 2004, the Company signed an agreement to acquire all rights in the United States and its territories to manufacture, market and sell Vancocin Pulvules^® , the oral capsule formulation of Vancocin (vancomycin hydrochloride), as well as rights to certain related Vancocin products, from Eli Lilly and Company (“Lilly”). Oral Vancocin is a potent antibiotic approved by the U.S. Food and Drug Administration to treat antibiotic-associated pseudomembranous colitis caused by Clostridium difficile and enterocolitis caused by Staphylococcus aureus (including methicillin-resistant strains). Lilly will retain its rights to vancomycin outside of the United States and its territories. The acquisition is subject to customary closing conditions, including the expiration or early termination of the Hart-Scott-Rodino waiting period (see note 8 for additional information regarding the acquisition transaction and financing). ViroPharma received notice of early termination of the Hart-Scott-Rodino waiting period. Should this acquisition successfully close, the Company expects that it will no longer be a development stage company. The Company expects this transaction to close by mid-November 2004.

Basis of Presentation

The consolidated financial information at September 30, 2004, and for the three months and nine months ended September 30, 2003 and 2004 and for the period from December 5, 1994 (inception) to September 30, 2004, is unaudited but includes all adjustments (consisting only of normal recurring adjustments) which, in the opinion of management, are necessary to state fairly the consolidated financial information set forth therein in accordance with accounting principles generally accepted in the United States of America. The interim results are not necessarily indicative of results to be expected for the full fiscal year. These consolidated financial statements should be read in conjunction with the audited consolidated financial statements for the year ended December 31, 2003 included in the Company’s Annual Report on Form 10-K filed with the Securities and Exchange Commission.

During the second quarter of 2003, the Company discovered that it had been accounting for the discounts and premiums associated with its short-term investments incorrectly. The amortization of these discounts and premiums should have been recorded ratably over the holding period for each investment to interest income. In financial statements prior to the second quarter of 2003, the Company reported these amounts as a change in accumulated other comprehensive income (loss), a component of stockholders’ equity, in the consolidated balance sheet. Due to the lack of materiality, the cumulative net effect of the activity of approximately $2.1 million has been relieved from accumulated other comprehensive income (loss) and charged directly to deficit accumulated during the development stage in the consolidated balance sheet in 2003. The effects of this charge on loss from continuing operations for each of the years ended December 31, 2000, 2001, 2002 and 2003 and on the deficit accumulated during the development stage as of each period end is immaterial.

Reclassification

Certain prior year amounts have been reclassified to conform to the current year presentation.

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ViroPharma Incorporated

(A Development Stage Company)

Notes to Consolidated Financial Statements

(2) Comprehensive Loss

In the Company’s annual consolidated financial statements, comprehensive loss is presented as a separate financial statement. For interim consolidated financial statements, the Company is permitted to disclose the information in the footnotes to the consolidated financial statements. The disclosures are required for comparative purposes. The only comprehensive loss item the Company has is unrealized gains and losses on available for sale securities. The following reconciles net loss to comprehensive loss for the three and nine months ended September 30, 2003 and 2004:

During the nine months ended September 30, 2003, the Company recognized a $2.8 million gain, after the write-off of $0.1 million of deferred financing costs, related to the purchase of $5.0 million of principal amount of its outstanding 6% Convertible Subordinated Notes due March 2007 (the “Subordinated Convertible Notes”). The gain is classified as gain on repurchase of debt, net, and there were no comparable reductions in the Company’s outstanding Subordinated Convertible Notes during 2004. Through September 30, 2004, the Company has reduced its outstanding Subordinated Convertible Notes by $52.1 million of principal amount. In September 2004, the Company’s Board authorized the Notes Repurchase Committee of the Board to approve the issuance of up to 5,000,000 shares of its common stock in exchange for the surrender of Subordinated Convertible Notes from time to time. The Company’s ability to issue these shares in exchange for Subordinated Convertible Notes is subject to certain limitations. There can be no assurance that it will purchase or otherwise acquire any of the Subordinated Convertible Notes at prices favorable to the Company or at all.

The Company accounts for its stock option plans in accordance with the provisions of Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (APB 25), and related interpretations. As such, compensation cost for employees and directors is measured on the date of grant for fixed options as the excess of the current market price of the underlying stock over the exercise price. Such compensation amounts are amortized over the respective vesting periods of the option grant. Any charge to operations for variable options with performance criteria is affected each reporting period by changes in the fair value of the Company’s common stock. The Company adopted the disclosure provisions of Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation,” (SFAS 123) which permits entities to provide pro forma net income (loss) and pro forma earnings (loss) per share disclosures for employee stock option grants as if the fair-value based method defined in SFAS 123 had been applied. In addition, the Company adopted the revised disclosure requirements under Statement of Financial Accounting Standards No. 148, “Accounting for Stock-Based Compensation—Transition and Disclosure, an amendment of SFAS 123.”

Compensation expense for options granted to non-employees is determined in accordance with SFAS No. 123, and related interpretations, as the fair value of the consideration received or the fair value of the equity instruments issued, whichever is more reliably measured. Compensation expense for options granted to non-employees is remeasured each period as the underlying options vest.

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ViroPharma Incorporated

(A Development Stage Company)

Notes to Consolidated Financial Statements

The Company applies APB Opinion No. 25 in accounting for its stock options granted to employees and directors. Had the Company determined compensation cost for options granted to employees and directors based on the fair value at the grant date under SFAS 123, the Company’s net loss and net loss per share would have been increased to the pro forma amounts under SFAS 123 indicated below:

(5) Restructuring

In January 2004, the Company announced that it had restructured its organization to focus its resources on the advancement and development of later stage products. As a result of this restructuring, the Company has reduced its workforce by 70% from December 2003 levels. This reduction is the result of the Company discontinuing its early stage activities, including discovery research and most internal preclinical activities, and reductions in clinical development and general and administrative personnel. During the first nine months of 2004, the Company included approximately $9.2 million of severance and asset impairment costs related to this restructuring in its loss from continuing operations. The following table reflects the charges recorded, payments made, and liability remaining at September 30, 2004 (in thousands):

As of September 30, 2004, the restructuring accrual consists of severance related payments. The balance of these obligations was substantially paid by the end of the third quarter of 2004. In the second quarter of 2004, the Company recorded an additional charge of $0.4 million for the acceleration of options upon the separation of two executives as well as other charges for employee separations. In addition, the Company adjusted its restructuring charge as a result of receiving $0.4 million in additional proceeds from the sale of unused fixed assets.

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ViroPharma Incorporated

(A Development Stage Company)

Notes to Consolidated Financial Statements

(6) Lease Costs

The Company leases an aggregate of 119,000 square feet in two facilities for its corporate and development activities under operating leases expiring in 2008 and 2017, respectively. During the third quarter of 2003, the Company determined that it would not utilize 30,000 square feet of leased space in the facility leased through 2017 and it recognized a non-cash charge of approximately $1.7 million in its general and administrative expenses relating to this space. This charge was an estimate of the present value of the loss the Company might incur over the remaining 13 years of the related lease and was net of assumed sublease income.

As a result of the Company’s restructuring in January 2004, it further reduced its space requirements and may record a non-cash charge in future periods as it periodically reviews its provision for non-utilized space consistent with Statement of Financial Accounting Standards No. 146, “Accounting for Costs Associated with Exit or Disposal Activities” (SFAS 146). During July 2004, the Company moved all of its operations to the facility leased through 2017 and is currently seeking to sublease all planned unused space in both facilities to third parties. Consequently, in the third quarter of 2004, the Company reversed the remaining accrual from the third quarter of 2003 and established a new provision based upon the new lease requirements. There was no net charge recorded in the consolidated statement of operations. The Company cannot be certain that it will be able to sublease its planned unused space on favorable terms or that the Company will be able to sublease any or all of its unused space by the period it anticipates or at all. As of September 30, 2004, the Company had a $0.9 million liability related to this issue remaining on the consolidated balance sheet.

(7) Litigation

In March and May 2002, the Company and certain of its directors were named as defendants in purported class actions filed in the United States District Court for the Eastern District of Pennsylvania. In July 2002, these actions were consolidated into a single complaint that also named certain of its officers as defendants. The plaintiffs in these actions have alleged that certain statements by the Company about Picovir^® were misleading. A judgment against the Company could materially exceed the coverage which may be available under the Company’s directors’ and officers’ liability insurance. The Company filed a motion to dismiss this action in August 2002. In April 2003, the court granted in part and denied in part the Company’s motion to dismiss the consolidated complaint.

In March 2004, the Company entered into an agreement in principle with plaintiffs’ counsel to settle this litigation. The parties subject to the litigation then entered into a stipulation and agreement of the settlement dated June 29, 2004. Under the terms of the settlement, the Company’s insurance carriers assumed the obligation to pay the settlement amount of $9.0 million from the Company’s insurance coverage. The settlement will therefore not result in the payment of any funds by the Company. On July 12, 2004, the Court issued an order granting preliminary approval of the settlement. However, the proposed settlement is still subject to final approval of the court. A hearing on the proposed settlement was held in November 2004. If the proposed settlement does not receive final approval by the Court, then the range of possible resolutions of these proceedings could include judgments against the Company or its directors or officers or settlements that could require substantial payments by the Company, which could have a material adverse impact on its financial position, results of operations and cash flows. To date no liability related to this matter has been reflected in the Company’s consolidated balance sheet as the proposed settlement is within the limits of the Company’s insurance coverage and will be paid directly by the Company’s insurers. These proceedings might require substantial attention of the Company’s management team and therefore divert time and attention from the Company’s business and operations.

(8) Subsequent Event – Vancocin Acquisition

In October 2004, the Company signed an agreement to acquire all rights in the United States and its territories to manufacture, market and sell Vancocin Pulvules, the oral capsule formulation of Vancocin, as well as rights to certain related Vancocin products, from Lilly. Oral Vancocin is a potent antibiotic approved by the U.S. Food and Drug Administration to treat antibiotic-associated pseudomembranous colitis caused by Clostridium difficile and enterocolitis caused by Staphylococcus aureus (including methicillin-resistant strains). Lilly will retain its rights to vancomycin outside of the United States and its territories.

Through this acquisition, ViroPharma will acquire certain know-how related to manufacturing of the product, the Vancocin trademark, starting material inventory, the active NDA for Vancocin Pulvules, as well as additional rights relating to the injectable and oral solution formulations of vancomycin. In addition, ViroPharma will receive certain related intellectual property and other information and materials required to continue marketing the brand in the United States and its territories.

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ViroPharma Incorporated

(A Development Stage Company)

Notes to Consolidated Financial Statements

At closing, ViroPharma and Lilly will enter into a supply agreement and a transition services agreement. The process of qualifying a third party supply chain will be ongoing during the term of the supply agreement. Following the transition period, ViroPharma will assume responsibility for product inventory, sales, marketing and distribution of the Vancocin Pulvules brand. The transaction is subject to customary closing conditions, including the expiration or early termination of the Hart-Scott-Rodino waiting period. ViroPharma received notice of early termination of the Hart-Scott-Rodino waiting period. ViroPharma expects the transaction to close by mid-November 2004.

Under the terms of the agreement, at closing ViroPharma will pay an upfront cash payment of $116.0 million, comprised of $53.5 million from ViroPharma’s existing cash reserves and $62.5 million gross proceeds from the issuance of $62.5 million aggregate principal amount of Senior Secured Bridge Notes due 2005 (the “Senior Notes”) and warrants to purchase 5 million shares of the Company’s common stock at $0.01 per share (the “Warrants”). The Senior Notes and the Warrants will be automatically exchanged for 6% Convertible Senior Secured Notes due October 2009 (the “Senior Convertible Notes”) following stockholder approval of the issuance of the Senior Convertible Notes. In addition, ViroPharma will pay Lilly royalties on annual net sales of Vancocin within certain defined levels of sales occurring between 2005 and 2011. The Company expects to spend $1.9 million in fees related to this transaction.

To partially finance the acquisition of the product, ViroPharma issued the Senior Notes and the Warrants. The offering, which was made to selected qualified institutional investors in a private placement under Regulation D of the Securities Act of 1933, closed into an escrow account and the proceeds will be released at the closing of the Vancocin acquisition. Following the closing of the acquisition, the Senior Notes will be secured by a first lien on our vancomycin assets which are primarily related to the manufacture, production, preparation, packaging or shipment of vancomycin products and all proceeds of such assets, including accounts receivable generated from the sale of such vancomycin products. The Senior Notes and the Warrants are automatically exchanged into the Senior Convertible Notes upon stockholder approval of the issuance of such Senior Convertible Notes. The Senior Notes and the Warrants would no longer be outstanding after the exchange occurs. Interest on the Senior Notes is payable monthly at an annual rate of 10% until February 2005 and will increase by 2% each month thereafter until the maturity date of October 2005, unless the Senior Notes have been exchanged for the Senior Convertible Notes. One full year of interest payable on the Senior Notes was also placed into escrow and will be released as interest payments become due. Upon stockholder approval of the issuance of the Senior Convertible Notes, the outstanding Senior Notes and the Warrants will be automatically exchanged for an aggregate principal amount of the Senior Convertible Notes which is equal to the aggregate principal amount of Senior Notes then outstanding. Interest on the Senior Convertible Notes will be payable semi-annually at an annual rate of 6% and the Senior Convertible Notes will have a maturity date of October 2009.

The Company will record this transaction as an asset purchase with the purchase price and related transaction costs allocated to specific tangible and intangible assets. The assets will be amortized over the related useful life, if not indefinitely.

(9) Subsequent Event – Schering-Plough License Agreement

In November 2004, ViroPharma announced that Schering-Plough Corporation (“Schering-Plough”) and ViroPharma entered into a license agreement under which Schering-Plough has assumed responsibility for all future development and commercialization of pleconaril. Other than transitioning the technology to Schering-Plough, ViroPharma will have no further continuing operational involvement with the development and commercialization of the intranasal formulation of pleconaril for the treatment of the common cold. Upon the effective date of the agreement, Schering-Plough will pay ViroPharma an initial license fee of $10 million and thereafter will purchase ViroPharma’s existing inventory of bulk drug substance for up to an additional $6 million. ViroPharma will also be eligible to receive up to an additional $65 million in milestone payments upon achievement of certain targeted regulatory and commercial events, as well as royalties on Schering-Plough’s sales of intranasal pleconaril in the licensed territories. The agreement will become effective after the expiration or early termination of the Hart-Scott-Rodino waiting period.

(10) Sale of Biodefense Assets

During the third quarter of 2004, ViroPharma sold certain of its early stage biodefense assets, including compounds, assays and other intellectual property related to the development of antiviral drugs targeting the smallpox virus and viral hemorrhagic fever viruses, to SIGA Technologies, Inc. (“SIGA”), a company that focuses on the development of products for the prevention and treatment of infectious diseases, with an emphasis on products for biological warfare defense. As consideration for such assets, SIGA paid ViroPharma $1.0 million in cash and issued ViroPharma 1.0 million shares of SIGA common stock. The shares received were accounted for as available-for-sale securities and marked to market as of September 30, 2004 in accordance with SFAS 115, “Accounting for Certain Debt and Equity Securities”. The total net gain recognized by the Company was $1.7 million on the date of the transactions, which was net of broker fees.

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IMPORTANT INFORMATION ABOUT FORWARD-LOOKING STATEMENTS

Our disclosure and analysis in this report contains some forward-looking statements. Forward-looking statements give our current expectations or forecasts of future events. You can identify these statements by the fact that they do not relate strictly to historical or current facts. They use words such as “anticipate”, “estimate”, “expect”, “project”, “intend”, “plan”, “believe” and other words and terms of similar meaning in connection with any discussion of future operating or financial performance. These forward-looking statements include the statements in this report on Form 10-Q about:

Our actual results could differ materially from those results expressed in, or implied by, these forward-looking statements. We may not have sufficient resources to execute our plans, and our actual revenues and expenses over the period described in this report may vary depending on a variety of factors, including: the cost of retiring or refinancing the Senior Notes if our stockholders do not approve the issuance of the new Senior Convertible Notes in exchange for the Senior Notes and the Warrants issued to fund a portion of the purchase price for the Vancocin acquisition; sales of Vancocin may fall materially below the historical sales generated by the product; the cost of acquiring additional new product opportunities as a result of business development efforts; the actual cost of conducting clinical trials; the outcome of clinical trials in our CMV and HCV programs, and our resulting right to receive or obligation to pay milestone payments under collaborations relating to those programs; and the costs associated with ongoing litigation. Also, we will face intense competition in acquiring additional products to expand further our product portfolio. Many of the companies and institutions that we will compete with in acquiring additional products to expand further our product portfolio have substantially greater capital resources, research and development staffs and facilities than we have, and substantially greater experience in conducting business development activities.

The commercial sale of approved pharmaceutical products, and conducting clinical trials for investigational pharmaceutical products, are subject to risks and uncertainties. There can be no assurance that future Vancocin sales will meet or exceed the historical rate of sales for the product, planned clinical trials can be initiated, or that planned or ongoing clinical trials can be successfully concluded or concluded in accordance with our anticipated schedule. We may need additional financing in order to acquire new products in connection with our plans as described in this report.

Our outstanding indebtedness may make it more difficult for us to raise additional financing and we may not be able to service our debt obligations. In addition, in the future we may not be able to maintain our listing on the Nasdaq Stock Market.

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These and other risks and uncertainties that could affect our actual results are discussed in greater detail in this report and in our other filings with the Securities and Exchange Commission. Although we believe that the expectations reflected in the forward-looking statements are reasonable, we cannot guarantee future results, events, levels of activity, performance, or achievements. We do not assume responsibility for the accuracy and completeness of the forward-looking statements other than as required by applicable law. We do not undertake any duty to update after the date of this report any of the forward-looking statements in this report to conform them to actual results.

You should read this report on Form 10-Q, including the risk factors detailed in this report, in combination with the Management’s Discussion and Analysis of Financial Condition and Results of Operations and the description of our business included in our Annual Report on Form 10-K for the year ended December 31, 2003.

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

Background

We are a development stage pharmaceutical company focused on the development and commercialization of products that address serious diseases treated by physician specialists and in hospital settings. Since commencing operations in December 1994 and through September 30, 2004, we have devoted substantially all of our resources to our product development programs, debt service, business development, sales and marketing activities and our former early stage research activities. We have generated no revenues from sales of our own products and have been dependent upon funding primarily from equity and debt financing. We have not been profitable from product sales since inception and have incurred a cumulative net loss of $282.9 million through September 30, 2004. Losses have resulted principally from costs incurred in research and development activities, write-off of acquired technology rights, general and administrative expenses, debt service and sales and marketing expenses. We expect to incur additional net losses over the next several years.

Business Developments

Strategic Direction

In January 2004, we redefined our strategic direction to focus on development of later stage opportunities, to build specific franchises relating to our current development programs and to expand our product portfolio through the acquisition of complementary late stage or commercial product opportunities as a means to accelerate our path toward becoming a profitable pharmaceutical company.

We intend to build franchises within narrowly focused prescribing groups. Initially we will focus on the transplant and gastroenterology areas, using our two core clinical programs in cytomegalovirus (CMV) infections related to hematopoietic stem cell (bone marrow) transplantation, and hepatitis C (HCV) infection, as foundations for that effort. To expand further our product portfolio, we plan to seek additional products for diseases treated by physician specialists and in hospital settings to complement the markets that we hope our CMV and HCV programs will serve. To build these franchises we intend to:

Acquisition of Vancocin Pulvules^®

Our first significant step toward becoming a company focused on product development and commercialization by establishing franchises within narrowly focused prescribing groups was our entry into an agreement regarding the acquisition of Vancocin. In October 2004, we signed an agreement to acquire all rights in the United States and its territories, to manufacture, market and sell Vancocin Pulvules, the oral capsule formulation of Vancocin (vancomycin hydrochloride), as well as rights to certain related Vancocin products, from Eli Lilly and Company (“Lilly”). Oral Vancocin is a potent antibiotic approved by the U.S. Food and Drug Administration to treat antibiotic-associated pseudomembranous colitis caused by Clostridium difficile and enterocolitis caused by Staphylococcus aureus (including methicillin-resistant strains). Lilly will retain its rights to vancomycin outside of the United States and its territories.

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Through this acquisition, we will acquire certain know-how related to manufacturing of the product, the Vancocin trademark, starting material inventory, the active NDA for Vancocin Pulvules, as well as additional rights relating to the injectable and oral solution formulations of vancomycin. In addition, we will receive certain related intellectual property and other information and materials required to continue marketing the brand in the United States and its territories. At closing, we and Lilly will enter into a supply agreement and a transition services agreement. The process of qualifying a third party supply chain will be ongoing during the term of the supply agreement. Following the transition period, we will assume responsibility for product inventory, sales, marketing and distribution of the Vancocin Pulvules brand. The transaction is subject to customary closing conditions, including the expiration or early termination of the Hart-Scott-Rodino waiting period. We received notice of early termination of the Hart-Scott-Rodino waiting period. We expect the transaction to close by mid-November 2004.

Under the terms of the agreement, at closing we will pay Lilly an upfront cash payment of $116.0 million. In addition, we will pay Lilly royalties on annual net sales of Vancocin as set forth below:

No royalties are due to Lilly on sales below or above the sales levels reflected in the above table.

In the event we develop any line extensions, revive discontinued vancomycin product lines (injectable or oral solutions), make improvements of existing products, or expand the label to cover new indications, Lilly would receive an additional royalty on net sales on these additional products for a predetermined time period.

Vancocin Pulvules is currently the only approved oral antibiotic used to treat antibiotic-associated pseudomembranous colitis, caused by an overgrowth of C. difficile in the colon (more generally, C. difficile -associated disease) and staphylococcal enterocolitis, an inflammation of the mucus membrane of the intestine caused by S. aureus. There are estimated to be 3 million cases of infectious diarrhea per year, of which, according to the Centers for Disease Control and Prevention (CDC), 15% to 25% are C. difficile- associated.

Acquisition – Liquidity impact

We expect to fund the $116.0 million purchase price for the Vancocin acquisition through the use of approximately $53.5 million from our existing cash reserves and $62.5 million gross proceeds from the issuance of $62.5 million aggregate principal amount of the Senior Notes and the Warrants. The Senior Notes and the Warrants will be automatically exchanged for the Senior Convertible Notes following stockholder approval of the issuance of the Senior Convertible Notes. In addition, we expect to incur $1.9 million in fees related to this acquisition.

We anticipate that revenues from this product will generate significant cash flows, and should allow us, over the next several years, to fund substantially all of our ongoing development and operating costs.

Acquisition – Critical Accounting policies

We anticipate that we will have several new policies and estimates that will be critical in understanding the more complex judgments that are involved in preparing our consolidated financial statements and that could impact our results of operations, financial position, and cash flows.

Development programs

We have two core clinical development programs: (1) CMV, with an initial focus on CMV infections in recipients of hematopoietic stem cell (e.g., bone marrow) transplants, and (2) HCV. These programs are within the transplant and gastroenterology areas and are at the center of our strategic focus. The following chart generally describes our core clinical development programs:

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CMV program – In the first quarter of 2004, we initiated two phase 1 clinical trials with maribavir to evaluate the potential for drug interactions and to evaluate the pharmacokinetics of maribavir in subjects with renal impairment, respectively. We initiated a dose-ranging phase 2 clinical trial with maribavir for the prevention of CMV infections in allogeneic stem cell transplant patients in July 2004. We expect to have the results of our phase 2 clinical trial in mid- 2005. If these data are supportive, we plan to initiate phase 3 clinical trials in late 2005.

HCV program – In the first quarter of 2004, we and Wyeth initiated a phase 1 clinical trial with HCV-086 in healthy subjects. In June 2004, we initiated a phase 1b proof of concept dose ranging clinical trial with HCV-086 in hepatitis C infected patients with the objectives of collecting safety and antiviral activity data. We expect to have the results of the phase 1b proof of concept trial in the fourth quarter of 2004 or the first quarter of 2005. If the data from these studies are supportive, we plan to begin phase 2 clinical trials with HCV-086 in mid-2005. In addition, we expect to submit an investigational new drug application to the Food and Drug Administration for HCV-796 in the fourth quarter of 2004.

We also have non-core research and development programs that we have either discontinued or are attempting to outlicense. The following chart sets forth our non-core research and development programs that contributed to our financial results set forth in this report, and their status:

Common Cold program – In November 2004, we announced that we entered into a license agreement with Schering-Plough Corporation under which Schering-Plough has assumed responsibility for all future development and commercialization of pleconaril. Upon the effective date of the agreement, Schering-Plough will pay us an initial license fee of $10 million and thereafter will purchase some or all of our existing inventory of bulk drug substance for up to an additional $6 million. We will also be eligible to receive up to an additional $65 million in milestone payments upon achievement of certain targeted regulatory and commercial events, as well as royalties on Schering-Plough’s sales of intranasal pleconaril in the licensed territories. The agreement will become effective after the expiration or early termination of the Hart-Scott-Rodino waiting period. Other than transitioning the technology to Schering-Plough, we will have no further continuing operational involvement with the development and commercialization of the intranasal formulation of pleconaril for the treatment of the common cold. In November 2003, we entered into an agreement granting Schering-Plough an option to license our intranasal formulation of pleconaril for the treatment of the common cold in the United States and Canada. Schering-Plough paid us an upfront option fee of $3 million, and following its assessment of the product’s performance in the characterization studies, in August 2004 Schering-Plough exercised its option to enter into a full license agreement with us. Sanofi-Synthelabo has exclusive rights to market and sell pleconaril in countries other than the United States and Canada.

Other agreements

In November 2003, we amended our pleconaril license agreement with Sanofi-Synthelabo in connection with our entry into the option agreement with Schering-Plough in respect of intranasal pleconaril. The amendment, among other things, reduces the royalty rate applicable to future product sales, if any, used to calculate royalties payable to Sanofi-Synthelabo.

In August 2003, we announced the acquisition of worldwide rights (excluding Japan) from GlaxoSmithKline (GSK) to an antiviral compound (maribavir, or VP 41263) that is an inhibitor of cytomegalovirus (CMV). Maribavir is a benzimidazole compound that was originally intended as a treatment for CMV retinitis, and phase 1 data from studies previously conducted by GSK demonstrated antiviral effect and a favorable safety profile. Under the terms of the agreement, we have exclusive worldwide rights (excluding Japan) to develop and commercialize maribavir for the prevention and treatment of cytomegalovirus infections related

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to transplant (including solid organ and hematopoietic stem cell transplantation), congenital transmission, and in patients with HIV infection. We plan to focus initially on patients who have undergone allogeneic stem cell (e.g., bone marrow) transplantation. We paid GSK a $3.5 million licensing fee upon entering into the agreement and may pay additional milestones based upon the successful outcome of certain clinical development and regulatory events. We also may pay royalties to GSK and its licensor on product sales, if any, in the United States and the rest of the world (excluding Japan). We initiated a phase 2 clinical trial in July 2004. The $3.5 million up-front licensing fee was recorded as an acquisition of technology rights expense during 2003, as the underlying technology has not reached technological feasibility and has no alternative uses.

In June 2003, we amended our HCV collaboration agreement with Wyeth to, among other things, focus the parties’ screening activity on one target, to allocate more of the collaboration’s pre-development efforts to us (subject to our cost sharing arrangement with Wyeth for this work), and to clarify certain of the reconciliation and reimbursement provisions of the collaboration agreement. In addition, under the amended agreement both companies are permitted to work outside the collaboration on screening against targets other than the target being addressed together under the collaboration. In connection with our restructuring in January 2004, we and Wyeth agreed to cease screening compounds against HCV under our collaboration.

Restructuring

In January 2004, we announced that we began to implement our strategic decision to focus on later stage opportunities. As part of this process, we substantially discontinued our early stage activities, including discovery research and most internal preclinical development activities. We also made reductions in clinical development and general and administrative personnel. As a result of this restructuring, we reduced our workforce by approximately 70% overall from December 31, 2003 levels. Included in the operating expenses for the nine months ended September 30, 2004 are approximately $9.2 million of costs related to this restructuring, including employee severance and asset impairment costs.

Liquidity

We expect that our near term source of revenue will arise from Vancocin product sales, milestone and license fee payments that we may receive from Wyeth and Schering-Plough if we achieve agreed upon events under our agreements with each of these companies, as well as from the sale of various non-core assets and programs. However, there are no assurances that sales of Vancocin will meet or exceed the historical rate of sales for the product, that we can achieve the events that require payments to us under the Wyeth and Schering-Plough arrangements, or that we can sell any additional non-core assets and programs.

Overall Cash Flows

Through September 30, 2004, we used approximately $270.5 million of cash in operating activities. We invest our cash in short-term investments. Through September 30, 2004, we have used approximately $97.6 million in investing activities, including $82.4 million in short-term investments and $15.2 million in equipment purchases, asset sales and new construction. Through September 30, 2004, we have financed our operations primarily through private and public offerings of common stock, a convertible subordinated notes offering, private placements of redeemable preferred stock, two bank loans and equipment lease lines totaling approximately $381.6 million, net of approximately $18.5 million used to repurchase $50.1 million in principal amount of our Subordinated Convertible Notes, and 473,054 shares of our common stock issued in exchange for the surrender of $2.0 million in principal amount of such notes. In addition, in October 2004 we raised $62.5 million through the issuance of Senior Notes to partially fund the $116.0 million upfront cash purchase price in the acquisition of Vancocin from Lilly.

During the nine months ended September 30, 2004, we used approximately $27.3 million of cash in operating activities. We invest our cash in short-term investments. For the nine months ended September 30, 2004, cash provided by investing activities was approximately $27.5 million, primarily from short-term investments, net of asset sales of $2.1 million. For the nine months ended September 30, 2004, we have received approximately $0.3 million of cash from financing activities, all of which relates to cash received from employees exercising stock options. At September 30, 2004 we had cash, cash equivalents and short-term investments of approximately $96.6 million. Also, at September 30, 2004 the annualized weighted average nominal interest rate on our short-term investments was approximately 1.3%.

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Operating Cash Outflows

The cash flows we have used in operations historically have been applied to research and development activities, marketing and business development efforts, general and administrative expenses, and servicing our debt. Bringing drugs from the preclinical research and development stage through phase 1, phase 2, and phase 3 clinical trials and FDA approval is a time consuming and expensive process. Because our product candidates are currently in the preclinical and clinical stages of development, there are a variety of events that could occur during the development process that will dictate the course we must take with our drug development efforts and the cost of these efforts. As a result, we cannot reasonably estimate the costs that we will incur through the commercialization of any product candidate. Nonetheless, we expect that the most significant uses of our near-term operating development cash outflows are as described below.

For each of our research and development programs, we incur both direct and indirect expenses. Direct expenses include third party costs related to these programs such as contract research, consulting, cost sharing payments or receipts, and preclinical and clinical development costs. Indirect expenses include personnel, facility, and other overhead costs.

Direct expenses—Core Development Programs

CMV program – From the date we in-licensed maribavir through September 30, 2004, we have incurred $5.5 million of direct costs in connection with this program, including the acquisition fee of $3.5 million paid to GSK for the rights to maribavir.

During 2004, we expect to spend up to $6.0 million in direct expenses for research and development activities for the development of maribavir, of which $2.0 million was spent during the nine month period ended September 30, 2004. These activities include phase 1 studies with maribavir, initiated in January 2004, and a phase 2 study that we initiated during July 2004. The results of these studies will significantly impact the timing and the amount of expenses, including potential milestone payments to GSK, that we will incur related to this program in future periods. In addition, discussions with the FDA regarding these future studies may impact the timing, nature and cost of future planned studies. We are solely responsible for the cost of developing our CMV product candidate.

Should we achieve certain product development events, we are obligated to make certain milestone payments to GSK, the licensor of maribavir.

HCV program – From the date that we commenced predevelopment activities for compounds in this program that are currently active through September 30, 2004, we have incurred $0.8 million in direct expenses for the predevelopment and development activities relating to such compounds. These costs are net of contractual cost sharing arrangements between Wyeth and us. Wyeth pays a substantial portion of the collaboration’s predevelopment and development expenses.

During 2004, we expect to spend up to $2.5 million in direct expenses for predevelopment and development activities, of which $0.7 million was spent during the nine month period ended September 30, 2004. The planned activities include a phase 1 clinical trial for our lead product candidate, initiated in February 2004, a phase 1b proof of concept clinical trial, initiated in June 2004, and other predevelopment activities. The results of the planned studies, along with other predevelopment activities performed during the year, will significantly impact the timing and amount of expenses we will incur related to this program in future periods. In addition, discussions with the FDA regarding these future studies may impact the timing, nature and cost of future planned studies.

Should we achieve certain product development events, Wyeth is required to pay us certain cash milestones and to purchase, in cash, our common stock pursuant to terms of our collaboration agreement. Based on the activities planned by Wyeth and us, there is the potential to achieve one of these milestones in 2004 or 2005. However, there can be no assurances that we will be successful in achieving this milestone during this timeframe, or at all.

Direct Expenses—Non-Core Development Programs (Active)

Common Cold – From the date that we commenced predevelopment activities for the intranasal formulation of pleconaril through September 30, 2004, we have incurred $1.9 million in direct expenses. We do not expect to incur any additional direct

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expenses in connection with predevelopment activities of this program. In the fourth quarter of 2003, we received $3.0 million under our option agreement with Schering-Plough, which we are using to fund these activities. In addition, we have billed Schering-Plough for specific activities approved by them under the agreement.

In November 2004, we announced that we entered into a license agreement with Schering-Plough Corporation under which Schering-Plough has assumed responsibility for all future development and commercialization of pleconaril. Upon the effective date of the agreement, Schering-Plough will pay us an initial license fee of $10 million and thereafter will purchase our existing inventory of bulk drug substance for up to an additional $6 million. We will also be eligible to receive up to an additional $65 million in milestone payments upon achievement of certain targeted regulatory and commercial events, as well as royalties on Schering-Plough’s sales of intranasal pleconaril in the licensed territories. The agreement will become effective after the expiration or early termination of the Hart-Scott-Rodino waiting period.

Indirect development expenses

During the first nine months of 2004, we incurred restructuring costs of approximately $3.6 million that are related to our development and former discovery operations. In addition, we spent $1.9 million on our former discovery operations during the first nine months of 2004. We do not expect to incur additional material costs related to our former discovery operations in 2004.

During 2004, we expect to spend up to $8.5 million in indirect expenses in connection with our predevelopment and development programs, of which $7.0 million was spent in the nine month period ended September 30, 2004.

Business development activities

Through September 30, 2004, we have not incurred material costs in connection with the business development activities related to our current business other than the acquisition fee of $3.5 million paid to GSK in 2003 for the rights to maribavir (VP 41263).

We anticipate that we will incur approximately $1.9 million of fees and expenses in connection with the Vancocin acquisition transaction. In addition, the costs associated with acquiring any additional product or product candidate can vary substantially based upon market size of the product, the commercial effort required for the product, the product’s current stage of development, and actual and potential generic and non-generic competition for the product, among other factors. Due to the variability of the cost of acquiring a product candidate, it is not feasible to predict what our actual acquisition costs would be, however, the costs could be substantial.

General and administrative activities

During the nine months ended September 30, 2004, we have incurred restructuring costs of approximately $5.7 million that are related to our general and administrative activities, of which $5.0 million relates to non-cash transactions.

We expect to spend up to $9.3 million in cash on general and administrative activities in 2004 on activities not related to the restructuring of the company, of which $7.4 million was spent as of September 30, 2004. This includes costs related to unused office and research and development space that we are actively seeking to sub-lease.

Restructuring and transition activities

All restructuring and transition costs are properly reflected in either research and development or general and administrative expense in our consolidated statements of operations. During the first nine months of 2004, we incurred approximately $9.2 million in costs related to our January 2004 restructuring, of which $5.0 million relates to non-cash transactions. Of these costs, $4.5 million relates to severance payments and stock option modification costs that have been or will be paid in 2004 and $4.7 million relates to asset impairments. In addition, we expect to have transition related costs of $2.5 million during 2004, most of which is compensation related expenses and were incurred and paid as of September 30, 2004.

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Operating Cash Inflows

We expect to begin to receive cash inflows from the sale of Vancocin immediately following the closing of the acquisition transaction. We expect the transaction to close by mid-November 2004. However, we cannot reasonably estimate the period in which we will begin to receive material net cash inflows from our product candidates currently under development. Cash inflows from development-stage products are dependent on several factors, including the achievement of milestones and regulatory approvals. We may not receive milestone payments from any existing or future collaborations if a development-stage product fails to meet technical or performance targets or fails to obtain the required regulatory approvals. Further, our revenues from collaborations will be affected by efforts of our collaborative partners. Even if we achieve technical success in developing drug candidates, our collaborative partners may not devote the resources necessary to complete development and commence marketing of these products, when and if approved, or they may not successfully market these products.

Debt service requirements

Annual interest payments on our outstanding $127.9 million Subordinated Convertible Notes total $7.7 million. Interest on the Senior Notes is payable monthly at an annual rate of 10% until February 2005 and will increase by 2% each month thereafter until the maturity date of October 2005, unless the Senior Notes have been exchanged for the Senior Convertible Notes. In October 2004, one full year of interest payable on the Senior Notes was also placed into escrow and will be released as interest payments become due. These notes are fully described below under the heading “Debt Financing”.

Contractual Obligations

Future contractual obligations and commercial commitments at September 30, 2004, are as follows:

Subsequent to September 30, 2004, we signed an agreement with Lilly to acquire Vancocin Pulvules. Under the terms of the agreement, at closing we will pay Lilly an upfront cash payment of $116.0 million, as well as royalties within certain defined levels of sales occurring between 2005 and 2011. The transaction is subject to customary closing conditions, including the expiration or early termination of the Hart-Scott-Rodino waiting period. We received notice of early termination of the Hart-Scott-Rodino waiting period. We expect the transaction to close by mid-November 2004. In connection with this transaction, we issued $62.5 million aggregate principal amount of Senior Notes to partially finance the acquisition of Vancocin. Our debt financing activities are described in more detail below.

We lease an aggregate of 119,000 square feet in two facilities for our corporate and development activities under operating leases expiring in 2008 and 2017, respectively. During the third quarter of 2003, we determined that we would not utilize 30,000 square feet of leased space in the facility leased through 2017 and we recognized a non-cash charge of approximately $1.7 million in our general and administrative expenses relating to this space. This charge was an estimate of the present value of the loss we might incur over the remaining 13 years of the related lease and was net of assumed sublease income.

As a result of our restructuring in January 2004, we further reduced our space requirements and may record a non-cash charge in future periods as we periodically review our provision for non-utilized space consistent with Statement of Financial Accounting Standards No. 146, “Accounting for Costs Associated with Exit or Disposal Activities” (SFAS 146). During July 2004, we moved to our facility

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leased through 2017 and are currently seeking to sublease all planned unused space in both facilities to third parties. Consequently, in the third quarter of 2004, we reversed the remaining accrual from the third quarter of 2003 and established a new provision based upon the new lease requirements. There is no net charge recorded in the consolidated statements of operations. We cannot be certain that we will be able to sublease our planned unused space on favorable terms or that we will be able to sublease any or all of the unused space by the period we anticipate or at all. As of September 30, 2004, we had a $0.8 million liability related to these leases remaining on our consolidated balance sheet.

Capital Resources

As a result of our restructuring in January 2004, particularly the discontinuation of our early stage activities, we expect our recurring monthly expenses and operating losses in 2004 to be lower than we experienced during 2003. We also expect the cash, cash equivalents and short-term investments available following the closing of our acquisition of Vancocin, together with our expected cash flows from Vancocin sales and the proceeds from the Senior Notes closed in October 2004 to fund a portion of the purchase price of the Vancocin acquisition, will be sufficient to fund our current business operations and debt service requirements until at least the end of 2006. We expect that we will need to raise substantial additional funds to continue our business activities and fund our debt service and other obligations beyond 2006. To obtain this financing, we intend to access the public or private equity or debt markets or enter into additional arrangements with corporate collaborators to whom we may issue equity or debt securities. Our outstanding indebtedness may make it more difficult for us to raise additional financing. In addition, if we are unable to maintain our listing on the Nasdaq Stock Market, it will be difficult for us to raise additional financing.

Equity financing

We have an effective Form S-3 universal shelf registration statement filed with the Securities and Exchange Commission for the potential additional issuance of up to approximately $212.0 million of our securities. The registration statement provides us with the flexibility to determine the type of security we choose to sell, including common stock, preferred stock, warrants and debt securities, as well as the ability to time such sales when market conditions are favorable.

If we raise additional capital by issuing equity securities, the terms and prices for these financings may be much more favorable to the new investors than the terms obtained by our existing stockholders. These financings also may significantly dilute the ownership of existing stockholders.

Additional equity financing, however, may not be available on acceptable terms from any source as a result of, among other factors, our outstanding indebtedness, our inability to achieve regulatory approval of any of our product candidates, our inability to generate revenue through our existing collaborative agreements, the existence of pending litigation involving allegations of securities fraud, and our inability to file, prosecute, defend and enforce any patent claim and or other intellectual property rights. If sufficient additional financing is not available, we may need to delay, reduce or eliminate current development programs, or reduce or eliminate other aspects of our business.

Additionally, Wyeth is required to purchase our common stock at the time of successful completion of certain product development events pursuant to the terms of our collaboration agreement. However, in the event we are not able to successfully achieve the product development events, this additional financing would not be available to us.

Debt Financing

Senior Notes

In October 2004, to partially finance the acquisition of Vancocin, we issued $62.5 million aggregate principal amount of Senior Notes and the Warrants. We anticipate that our expenses related to this financing will equal approximately $3.5 million. The offering, which was made to selected qualified institutional investors in a private placement under Regulation D of the Securities Act of 1933, closed into an escrow account and will be released at the closing of the Vancocin acquisition. We intend to seek approval from our

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stockholders to issue the Senior Convertible Notes described below in exchange for the Senior Notes and the Warrants. The Senior Notes and the Warrants are automatically exchanged into the Senior Convertible Notes upon stockholder approval of the issuance of such Senior Convertible Notes. The Senior Notes and the Warrants would no longer be outstanding after the exchange occurs. Interest on the Senior Notes is payable monthly at an annual rate of 10% until February 2005 and will increase by 2% each month thereafter for as long as such notes are outstanding. We also placed one full year of interest payable on the Senior Notes into escrow which will be released as interest payments become due.

Following the closing of the acquisition, the Senior Notes will be secured by a first lien on our vancomycin assets which are primarily related to the manufacture, production, preparation, packaging or shipment of vancomycin products and all proceeds of such assets, including accounts receivable generated from the sale of such vancomycin products. If we and/or Lilly terminate the Vancocin transaction prior to its closing, the Senior Notes and the Warrants will be redeemed at par, plus any accrued and unpaid interest.

In the event our stockholders vote to not approve the issuance of the Senior Convertible Notes, the Senior Notes will remain outstanding and will come due in October 2005. Commencing in February 2005, the interest rate on the Senior Notes will increase from 10% by 2% each month thereafter for as long as such notes are outstanding. Additionally, each of the Warrants will become exercisable for one share of common stock at an initial exercise price of $0.01 per share and will remain exercisable until the Warrants expire in October 2005. We will also undertake to file a registration statement related to the resale of the shares of common stock issuable upon exercise of the Warrants. There can be no assurance that we will have adequate financial resources to pay in full all outstanding obligations on the Senior Notes if they remain outstanding and become due in October 2005. We believe that we would likely be able to restructure or refinance the Senior Notes prior to their maturity date, however, if we are unable to restructure or otherwise obtain the funds necessary to pay the Senior Notes in full when they become due, we would be in default under the Senior Notes. In the event of a default, the investors could enforce their security interest and cause the sale of the Vancocin related assets. As a result, our operations would be significantly curtailed or we may not be able to continue as a going concern.

Senior Convertible Notes

Upon stockholder approval of the issuance of the Senior Convertible Notes, all of the outstanding Senior Notes and the Warrants will be automatically exchanged for an aggregate principal amount of the Senior Convertible Notes which is equal to the aggregate principal amount of the Senior Notes then outstanding. Interest on the Senior Convertible Notes will be payable semi-annually at an annual rate of 6% and the Senior Convertible Notes will have a maturity date of October 18, 2009. The Senior Convertible Notes will rank senior in right of payment to our existing and future subordinated indebtedness and will be secured by a first lien on the vancomycin assets. The investors will also have an option to purchase an additional $12.5 million of the Senior Convertible Notes on identical terms within thirty days after the date of stockholder approval of the issuance of the Senior Convertible Notes.

Subject to certain limitations, the Senior Convertible Notes will be convertible into shares of common stock at the option of the holder at any time prior to maturity at a conversion rate of $2.50 per share, subject to adjustment upon certain events. At any time following the effectiveness of a registration statement related to the resale of the shares of common stock issuable upon the conversion of the Senior Convertible Notes, we may elect to automatically convert in any calendar quarter up to twenty-five percent of the principal amount of the Senior Convertible Notes into shares of its common stock if the daily volume weighted average price of our stock exceeds $3.75, subject to adjustment upon certain events, for 20 trading days during any 30 trading day period, ending within 5 days of the notice of automatic conversion. If the investors voluntarily convert the Senior Convertible Notes or if we effect an auto-conversion of the Senior Convertible Notes prior to October 18, 2007, then we will make an additional payment on the principal amount converted equal to three full years of interest, less any interest actually paid or provided for prior to the conversion date.

We have also agreed that until six months following the registration for resale of the Senior Convertible Notes and shares of common stock underlying the Senior Convertible Notes, we will not issue, sell, or contract to sell or issue more than 10 million shares of common stock plus an additional number of shares equal to the number of shares of common stock into which the Senior Convertible Notes are actually converted, or securities convertible into common stock, without the consent of holders of a majority of the Senior Notes (or the Senior Convertible Notes if a stockholder vote approving the issuance of the Senior Convertible Notes has occurred). We also agreed that we would not issue any common stock, or securities convertible into common stock, at a price below $2.75 per share during such period. The forgoing restrictions may expire sooner under certain circumstances, and are subject to certain exclusions as set forth in the indentures and, in any event, the restrictions will terminate in the event that our stockholders vote to not approve the issuance of the Senior Convertible Notes.

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Subordinated Convertible Notes

Through September 30, 2004 we have reduced the principal amount of our existing Subordinated Convertible Notes by $52.1 million and the outstanding balance of our Subordinated Convertible Notes at September 30, 2004 is $127.9 million. We have purchased an aggregate of $50.1 million in principal amount of our Subordinated Convertible Notes for approximately $18.5 million in cash through September 30, 2004. In October and November 2003, we entered into agreements with a third party under which we issued a total of 473,054 shares of our common stock in exchange for the surrender of $2.0 million of face amount of our Subordinated Convertible Notes held by such third party. We are currently exploring alternatives to either reduce the outstanding principal amount or to restructure our Subordinated Convertible Notes. Even if we are successful in such efforts, our outstanding indebtedness may make it more difficult for us to raise additional financing. In September 2004, our Board authorized the Notes Repurchase Committee of the Board to approve the issuance of up to 5,000,000 shares of our common stock in exchange for the surrender of the Subordinated Convertible Notes from time to time. Our ability to issue these shares in exchange for the Subordinate Convertible Notes is subject to the limitations described above under the heading “Senior Convertible Notes”. There can be no assurance that we will purchase or otherwise acquire any of the Subordinated Convertible Notes at prices favorable to us or at all.

Critical Accounting Policies

Our consolidated financial statements and accompanying notes are prepared in accordance with accounting principles generally accepted in the United States of America. Preparing consolidated financial statements requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses and contingent assets and liabilities. These estimates and assumptions are affected by the application of our accounting policies. Critical policies and practices are both most important to the portrayal of a company’s financial condition and results of operations, and require management’s most difficult, subjective or complex judgments, often as a result of the need to make estimates about the effects of matters that are inherently uncertain.

Our summary of significant accounting policies is described in Note 2 to our consolidated financial statements included in Item 8 of our most recent Annual Report on Form 10-K. Due to the nature of our business and our stage of development, we do not currently face the many complex or subjective judgments that face companies that are further along in their life cycle that may be necessary in applying accounting policies. However, we consider the following policies and estimates to be the most critical in understanding the more complex judgments that are involved in preparing our consolidated financial statements and that could impact our results of operations, financial position, and cash flows:

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As we progress in our development and move closer to product approval and commercial operations, we may face additional issues that will require increased levels of management estimation and complex judgments.

Results of Operations

Quarters ended September 30, 2004 and 2003

Overview

For the quarter ended September 30, 2004, we reported a net loss of $3.3 million compared to a net loss of $15.8 million for the same period in 2003. Net loss per share for the quarter ended September 30, 2004 was $0.13 per share, basic and diluted, compared to net loss of $0.61 per share, basic and diluted, for the same period in 2003. The decrease in net loss of $12.5 million from the third quarter of 2003 to the same period in 2004 was due primarily to reduction in headcount and operational costs resulting from our restructuring during January 2004, a one-time $1.7 million gain on sale of biodefense assets in the third quarter of 2004 and a $3.5 million one-time write-off of acquired technology rights in the third quarter of 2003.

Revenues

Revenues were approximately $0.4 million for the quarter ended September 30, 2004, compared to approximately $0.2 million during the same period in 2003. During the quarter ended September 30, 2004, we recognized revenue of approximately $0.2 million from advance payments received under our option agreement with Schering-Plough. In both periods we recognized similar amounts of revenue related to advance payments from Wyeth under our collaboration agreement.

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Research and Development Expenses

Research and development expenses decreased approximately $5.0 million to $2.0 million in the third quarter of 2004 from $7.0 million in the third quarter of 2003. Our research and development expenses were divided between our research and development programs in the following manner (in thousands):