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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

For the quarterly period ended: September 30, 2004.

OR

For the transition period from              to             

Commission File Number:

0-30365

Icoria, Inc.

(Exact name of registrant as specified in its charter)

108 T.W. Alexander Drive, Research Triangle Park, North Carolina 27709

(Address of principal executive offices and zip code)

Registrant’s telephone number, including area code: (919) 425-3000

Former name, former address, and former year, if changed since last report: Paradigm Genetics, Inc.

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

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

Indicate the number of shares outstanding of each of the Issuer’s classes of Common Stock, as of the latest practicable date.

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ICORIA, INC.

INDEX

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PART I. FINANCIAL INFORMATION

Item 1. Financial Statements.

ICORIA, INC.

CONDENSED BALANCE SHEETS

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

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ICORIA, INC.

CONDENSED STATEMENTS OF OPERATIONS

(Unaudited)

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

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ICORIA, INC.

CONDENSED STATEMENTS OF CASH FLOWS

(Unaudited)

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

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Icoria, Inc.

Notes to Condensed Financial Statements

(Unaudited)

Note 1. Organization and Summary of Significant Accounting Policies

Icoria, Inc. was founded on September 9, 1997, as Paradigm Genetics, Inc., and is an integrated systems biology company applying its proprietary platform to the discovery and development of safer, more effective drugs and agrichemicals. The Company is growing the business by partnering with life sciences companies in both healthcare and agriculture, while building its own portfolio of products. Additionally, the Company is leveraging its existing infrastructure to provide services that generate near-term revenue. On August 17, 2004, the Company changed its corporate identity to Icoria, Inc.

The accompanying financial statements have been prepared on a basis which assumes that the Company will continue as a going concern and which contemplates the realization of assets and the satisfaction of liabilities and commitments in the normal course of business. The Company had an accumulated deficit of approximately $94,902,000 as of September 30, 2004, incurred a net loss of approximately $10,343,000 for the nine months then ended and expects to incur additional losses for the remainder of 2004.

The Company has historically financed its operations through the sale of equity, debt and capital lease financing, payments received from services, commercial partnerships and government grants. As of September 30, 2004, the Company had total cash and investments of approximately $7,087,000, which is comprised of cash and cash equivalents of approximately $4,085,000 and short-term investments of approximately $3,002,000. As further described in Note 3, on October 19, 2004, the Company received $5,000,000 gross proceeds through the sale of a three-year convertible term note.

The Company expects to continue expanding its operations through internal growth and, possibly, through strategic acquisitions. The Company expects these activities will be funded from existing cash, cash flow from operations, issuances of stock and borrowings under credit facilities. Management believes that these sources of liquidity will be sufficient to fund its operations at least into the second half of 2005. From time to time, the Company evaluates potential acquisitions and other growth opportunities, which might require additional external financing, and the Company may seek funds from public or private issuances of equity or debt securities.

Basis of Presentation

The accompanying unaudited condensed financial statements have been prepared by the Company in accordance with accounting principles generally accepted in the United States of America for interim financial information and pursuant to the instructions to Form 10-Q and Article 10 of Regulation S-X of the Securities and Exchange Commission. 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 management, all adjustments (consisting of normal recurring adjustments) considered necessary for a fair presentation have been included. Operating results for the three and nine month periods ended September 30, 2004 are not necessarily indicative of the results that may be expected for the year ending December 31, 2004 or for any future period. These financial statements and notes should be read in conjunction with the financial statements and notes thereto for the year ended December 31, 2003 included in the Company’s Form 10-K filed with the Securities and Exchange Commission on March 30, 2004.

Use of Estimates

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

Reclassifications

Certain amounts in the 2003 financial statements have been reclassified to conform to the 2004 presentations, with no effect on previously reported net loss, stockholders’ equity, or net loss per share.

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Icoria, Inc.

Notes to Condensed Financial Statements

(Unaudited)

Cash and Cash Equivalents

The Company considers all highly liquid investments with a maturity of three months or less at the date of purchase to be cash equivalents.

Restricted Cash

Restricted cash comprises cash held in escrow for security deposits on the Company’s facilities.

Property and Equipment

Property and equipment comprises buildings, laboratory equipment, computer equipment, furniture, and leasehold improvements, which are recorded at cost and depreciated using the straight-line method over their estimated useful lives. Expenditures for maintenance and repairs are charged to operations as incurred; major expenditures for renewals and betterments are capitalized and depreciated. Property and equipment acquired under capital leases are being depreciated over their estimated useful lives or the respective lease term, if shorter.

Other Assets

Other assets include intangible assets, resulting from the Company’s acquisition of TissueInformatics.Inc (See Note 2), deposits for building leases and other deferred costs.

Capitalized Software Costs

The Company accounts for the costs of development of software applications to be sold to or used by third parties in accordance with Statement of Financial Accounting Standards No. 86 “Accounting for the Costs of Computer Software to Be Sold, Leased or Otherwise Marketed.” Software development costs are required to be capitalized beginning when a product’s technological feasibility has been established and ending when a product is available for general release. To date, the establishment of technological feasibility has substantially coincided with the release of any software products developed. Accordingly, no costs have been capitalized.

Impairment of Long-Lived Assets

The Company evaluates the recoverability of its property and equipment and intangible assets in accordance with Statement of Financial Accounting Standards No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets” (“SFAS No. 144”). SFAS No. 144 requires long-lived assets to be reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. An impairment is recognized in the event that the net book value of an asset exceeds the future undiscounted cash flows attributable to such asset or the business to which such asset relates and the net book value exceeds fair value. The impairment amount is measured as the amount by which the carrying amount of a long-lived asset (or asset group) exceeds its fair value. No impairment loss was required to be recognized during the three and nine months ended September 30, 2004 and 2003.

Income Taxes

The Company accounts for income taxes using the liability method which requires the recognition of deferred tax assets or liabilities for the temporary differences between financial reporting and tax bases of the Company’s assets and liabilities and for tax carryforwards at enacted statutory rates in effect for the years in which the differences are expected to reverse. The effect on deferred taxes of a change in tax rates is recognized in income in the period that includes the enactment date. In addition, valuation allowances are established where necessary to reduce deferred tax assets to the amounts expected to be realized.

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Icoria, Inc.

Notes to Condensed Financial Statements

(Unaudited)

Revenue Recognition

Revenues are derived from commercial partnerships and government contracts and grants. Payments from our commercial contracts are generally related to refundable or nonrefundable fees, milestone achievements, genomic expression data deliveries or assay deliveries. Payments for refundable and nonrefundable fees and milestone achievements are recognized as revenues on a progress to completion basis over the term of the respective commercial partnership, except with respect to refundable fees for which revenue recognition does not commence until the refund right expires. Payments related to genomic expression data or assay deliveries are recognized as revenues when the deliveries are accepted by the customer. Payments received under the Company’s commercial partnerships and government contracts and grants are generally non-refundable regardless of the outcome of the future research and development activities to be performed by the Company. Payments from government contracts and grants are recognized as revenues as related expenses are incurred over the term of each contract or grant.

Progress to completion under commercial partnerships is calculated based on applicable output measures such as a comparison of the number of genes analyzed to the total number of genes to be analyzed, assessed on a contract-by-contract basis. To the extent payments received exceed revenue recognized for each contract or grant, the excess portion of such payments are recorded as deferred revenues. To the extent revenues recognized exceed payments received for each contract or grant, the excess revenues are recorded as accounts receivable. The Company recognizes revenue in accordance with Staff Accounting Bulletin No. 104 (“SAB 104”) issued by the Securities and Exchange Commission.

Research and Development

Research and development costs include personnel costs, costs of supplies, facility costs, license fees, consulting fees, the recording of deferred compensation and depreciation of laboratory equipment. These costs were incurred by the Company to develop its proprietary GeneFunction Factory®, biochemical profiling, metabolomics, TissueAnalytics® and data coherence platforms, perform required services under commercial partnerships and government grants and perform research and development on internal projects. Research and development costs are expensed as incurred.

Stock-Based Compensation

The Company accounts for stock-based compensation based on the provisions of Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB No. 25”) which states that no compensation expense is recorded for stock options or other stock-based awards to employees that are granted with an exercise price equal to or above the estimated fair value of the Company’s common stock on the grant date. In the event that stock options are granted with an exercise price below the estimated fair value of the Company’s common stock at the grant date, the difference between the fair value of the Company’s common stock and the exercise price is recorded as deferred compensation. The Company reversed $1,226 and $6,853 of deferred compensation related to the cancellation of unvested options during the three and nine months ended September 30, 2003, respectively. Deferred compensation is amortized to compensation expense over the vesting period of the related stock option. The Company recognized $92,670 in non-cash compensation expense related to amortization of deferred compensation during the three months ended September 30, 2003. The Company recognized $1,806 and $314,926 in non-cash compensation expense related to amortization of deferred compensation during the nine months ended September 30, 2004 and 2003, respectively.

At December 31, 2002, the Company had accrued $147,750 in stock-based compensation related to grants that were made for 492,500 shares of common stock as part of 2002 bonuses, subject to shareholder approval. During the three and nine months ended September 30, 2003, the Company had accrued $0 and $497,425, respectively, as additional stock-based compensation expense. Following receipt of shareholder approval to increase the shares in the company’s stock option plan, the shares of common stock were issued on June 27, 2003 at a fair market value of $1.31 per share. In connection with the issuance of the common stock, the Company recorded an addition to common stock and additional paid in capital in the amount of $4,925 and $640,250, respectively, and eliminated the accrued liability.

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Icoria, Inc.

Notes to Condensed Financial Statements

(Unaudited)

The Company has adopted the disclosure requirements of Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation,” (“SFAS No. 123”) as amended by SFAS No. 148, which requires compensation expense to be disclosed based on the fair value of the options granted at the date of grant. Stock options or warrants granted to consultants for services are accounted for in accordance with SFAS No. 123, which requires that these options and warrants be valued using the Black-Scholes model and the resulting charge is then recorded as the related services are performed. The Company did not issue stock options to consultants or accelerate the vesting of stock options during the three months ended September 30, 2004 and 2003.

Had compensation costs for the two plans been determined based on the fair value at the grant date for awards under the plans, consistent with the methods of Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation,” (SFAS No. 123), as amended, the Company’s net loss and net loss per share (basic and diluted) for the three months and nine months ended September 30, 2004 and 2003, would have been increased to the pro forma amounts indicated below:

The per share weighted average fair value of stock options granted during the three and nine months ended September 30, 2004 and 2003 was estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted average assumptions for 2004 and 2003: expected dividend yield of 0%; risk free interest rates of approximately 3% in 2004 and 4% in 2003; expected option lives of approximately seven years in 2004 and four years in 2003; and volatility factors of 103% in 2004 and 112% in 2003.

Concentration of Credit Risk

Financial instruments, which potentially subject the Company to a concentration of credit risk, consist principally of cash, investments, and accounts receivable. The Company primarily places its cash, short-term and long-term investments with high-credit quality financial institutions which invest primarily in U.S. Government securities, commercial paper of prime quality and certificates of deposit guaranteed by banks which are members of the FDIC. Cash deposits are all in financial institutions in the United States. The Company performs ongoing credit evaluations to reduce credit risk and requires no collateral from its customers. Management estimates the allowance for uncollectible accounts based on their historical experience and credit evaluation.

The Company has three commercial partnerships, a contract with the United States federal government, and a grant, which accounted for 43%, 10%, 8%, 27% and 7%, respectively, of the Company’s total revenue for the nine months ended September 30, 2004. As of September 30, 2004 and December 31, 2003, receivables from one of the commercial partnerships comprised 34% and 84%, respectively, of the total accounts receivable balance. As of September 30, 2004 and December 31, 2003 receivables from a contract with the United States federal government comprised 40% and 11%, respectively, of the total accounts receivable balance.

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Icoria, Inc.

Notes to Condensed Financial Statements

(Unaudited)

Comprehensive Loss

SFAS No. 130, “Reporting Comprehensive Income” established standards for reporting and display of comprehensive income and its components in the financial statements. Comprehensive income, as defined, includes all changes in equity during a period from non-owner sources. The Company’s total comprehensive loss for the three month periods ended September 30, 2004 and 2003 was $3,029,410 and $2,275,587, respectively. The Company’s comprehensive gain consisted of unrealized gains on investments of $24,330 for the three months ended September 30, 2004 and unrealized losses on investments of $32,711 for the three months ended September 30, 2003. The Company had no other items of other comprehensive gains or losses during the three months ended September 30, 2004 or 2003.

The Company’s total comprehensive losses for the nine month periods ended September 30, 2004 and 2003 were $10,255,075 and $9,797,340, respectively. The Company’s other comprehensive income consisted of unrealized gains on investments of $87,939 and $148,995 for the nine months ended September 30, 2004 and 2003, respectively. The Company had no other items of other comprehensive gains or losses during the nine months ended September 30, 2004 or 2003.

Net Loss Per Common Share

The Company computes net loss per common share in accordance with Statement of Financial Accounting Standards No. 128, “Earnings Per Share,” (“SFAS No. 128”). Under the provisions of SFAS No. 128, basic net loss per common share (“Basic EPS”) is computed by dividing net loss attributable to common stockholders by the weighted average number of common shares outstanding. Diluted net loss per common share (“Diluted EPS”) is computed by dividing net loss attributable to common stockholders by the weighted average number of common shares and dilutive potential common share equivalents then outstanding. Potential common shares consist of shares issuable upon the exercise of stock options and warrants.

The following table sets forth potential shares of common stock that are not included in the diluted net loss per share because to do so would be antidilutive for the periods indicated:

Segment Reporting

Statement of Financial Accounting Standards No. 131, “Disclosures About Segments of an Enterprise and Related Information,” (“SFAS No. 131”) requires companies to report information about operating segments in interim and annual financial statements. It also requires segment disclosures about products and services, geographic areas and major customers. The Company has determined that it operated in only one segment.

Internal Use Software

Statement of Position No. 98-1, “Accounting for the Costs of Computer Software Developed or Obtained for Internal Use,” (“SOP No. 98-1”) provides guidance regarding when software developed or obtained for internal use should be capitalized. The predominant portion of the software applications used by the Company were purchased or licensed from third parties. The Company expenses the cost of accumulating and preparing data for use in its database applications as such costs are incurred.

Discontinued Operations

During 2002, the Company decided to close the operations of ParaGen, its plant genotyping business. At December 31, 2002, all of the goodwill and associated assets were written down to their fair value less cost to sell and reported in the loss from discontinued operations. As a result, the Company recognized an impairment loss of $1,484,786 in 2002. In February 2003,

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Icoria, Inc.

Notes to Condensed Financial Statements

(Unaudited)

the ParaGen business assets were sold to DNA Landmarks for $300,000 and potential future royalties between 10% and 15%, over the next three years, of revenues from certain identified customers. The Company is reporting the operating results from ParaGen in discontinued operations.

Notes Payable

During September of 2004, the Company was permitted to prepay, without penalty, $0.3 million of the amount due to General Electric Capital Corporation (“GECC”), leaving approximately $0.3 million outstanding as of September 30, 2004. Subsequent to September 30, 2004, the Company repaid, without penalty, the remaining amounts due to GECC.

Note 2. Acquisition

On March 11, 2004, the Company purchased all of the outstanding common and preferred stock of TissueInformatics.Inc (“TissueInformatics”), in exchange for the issuance of approximately 3,403,000 shares of the Company’s common stock. These shares were estimated to have a total fair value of approximately $4,614,000, based on the average closing price of the common stock of $1.36 for the day of the closing and two-day period immediately preceding and following the date of the announcement of the acquisition. In addition, subject to the achievement of performance milestones by December 31, 2004, the Company could be obligated to issue another 2.4 million shares and options. As of October 31, 2004, approximately 524,000 of the shares and options potentially issuable had lapsed because the related performance milestones were not met.

The Company assumed approximately $214,000 in net liabilities and incurred costs of approximately $547,000 related to this acquisition. The Company also assumed TissueInformatics’s obligations under its employee stock option plan. At closing, approximately 214,000 shares were reserved to satisfy obligations underlying outstanding options. Under the terms of the agreement, approximately 171,000 additional shares were issuable pursuant to outstanding options upon the achievement of performance milestones by December 31, 2004. The TissueInformatics stock option plan was assumed by the Company in the acquisition. The acquisition has been accounted for using the purchase method of accounting and, accordingly, the initial purchase price of approximately $6,713,000 was allocated to the assets acquired and liabilities assumed based on estimated fair values. This purchase price includes $1,108,000 for the contingent purchase consideration that may be payable if certain performance milestones are achieved. The fair value assigned to intangible assets acquired was based on a third party valuation report.

Of the total purchase price, $3,455,000 was allocated to the tangible assets, which were comprised of cash, property and equipment and prepaid and other assets, $3,559,000 has been allocated to intangible assets and $301,000 has been allocated to liabilities. The intangible assets include $3,350,000 and $209,000 related to developed software technologies and a customer base, respectively. These intangible assets are being amortized over a period of five years.

Upon the resolution of all contingencies related to the additional 2.4 million shares issuable based on performance milestones, the purchase price and related allocation will be reassessed. In the event that the fair value of the contingent shares issued differs from the $1,108,000 contingent purchase consideration recognized as of September 30, 2004, the intangible assets recorded for the acquisition will be adjusted.

The Company’s results of operations for the nine-month period ended September 30, 2004 include the results of TissueInformatics operations from the day after the closing date of the acquisition, March 12, 2004, to September 30, 2004. The Company’s results of operations for the three-month period ending September 30, 2004 include TissueInformatics’ operations for the full period.

The following unaudited pro forma financial information reflects the results of operations of the Company for the three months ended September 30, 2003 and the nine-month periods ended September 30, 2004 and 2003 as if the acquisition of TissueInformatics had occurred on July 1, 2003 and January 1, 2004 and 2003, respectively. These pro forma results are not necessarily indicative of what the Company’s operating results would have been had the acquisition actually taken place on July 1, 2003 and January 1, 2004 or 2003, and may not be indicative of future operating results.

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Icoria, Inc.

Notes to Condensed Financial Statements

(Unaudited)

Note 3. Subsequent Event

On October 19, 2004, the Company entered into a series of agreements with Laurus Master Fund, Ltd. (“Laurus”) whereby the Company received $5,000,000 gross proceeds through the sale of a three-year convertible term note. In accordance with the terms of the note, the note is payable in cash or convertible into common stock of the Company at a fixed conversion price of $0.53 per share subject to certain conditions relating to increases in the price of the Company’s common stock above $0.59 per share and the actual trading volume of the Company’s common stock. Laurus may also elect to have interest paid in stock at a fixed conversion price of $0.53 per share. The note is collateralized by essentially all of the Company’s otherwise unencumbered fixed assets. In connection with the financing, the Company paid approximately $0.2 million of costs and expenses of Laurus and has issued warrants for the purchase of 1,650,943 shares of Common Stock at a weighted average price of $0.79. One half of the warrants expire two years after issuance and the other half of the warrants expire five years after issuance. In addition, the Company also paid a placement agent approximately $0.4 million and issued a five-year warrant to purchase an aggregate of 843,396 of shares of Common Stock exercisable at $0.53 per share. The placement agent also previously received consideration consisting of a warrant for 100,000 shares of common stock exercisable at $0.72 per share in connection with entering into the placement agency agreement dated July 14, 2004. These warrants also expire five years after issuance.

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

The following Management’s Discussion and Analysis of Financial Condition and Results of Operations contains forward-looking statements that are based upon current expectations. Our actual results and the timing of events could differ materially from those anticipated in our forward-looking statements as a result of many factors, including those set forth under “Risk Factors”, “Forward-Looking Statements” and elsewhere in this report.

You should read the following discussion and analysis in conjunction with “Selected Financial Data” and the financial statements and related notes included elsewhere in this report. Unless the context otherwise requires, the terms “we,” “our,” “Company,” and “Icoria” are all used herein to refer to Icoria, Inc.

Overview

Icoria, Inc., formerly Paradigm Genetics, Inc., is an integrated systems biology company applying its proprietary platform to the discovery and development of safer, more effective drugs and agrichemicals. The Company is growing its business by partnering with pharmaceutical, biotech and agricultural companies and entities, while building its own portfolio of products. Additionally, the Company is leveraging its existing infrastructure to provide services that generate near-term revenue.

In March 2004, the Company acquired TissueInformatics.Inc, a privately held company, which develops and applies automated pathology software for the quantitative analysis of tissue changes in drug discovery, disease assessment, toxicology, and tissue engineering. Management believes this acquisition provides the Company with a competitive advantage as the first company to combine gene expression profiling, biochemical profiling and quantitative tissue analysis in a systems biology approach to life sciences discovery. It is through this combination and analysis of different biological data streams that the Company can identify novel biomarkers and targets that were previously inaccessible due to biological “noise.”

The Company’s business model targets near-term and mid-term revenues and cash flow from its current commercial partnerships, government contracts and grants, new commercial partnerships and our service businesses — Paradigm Array Labs^™ and TissueInformatics^® automated pathology software. In the long-term, the Company is targeting revenues and cash flow through the development of our proprietary product portfolio. The Company’s current proprietary product development efforts are focused on diagnostics for liver disease and injury, biomarkers and drugs for diabetes and obesity and novel agricultural compounds as well as the development and application of automated pathology software.

Commercial Partnership Revenue

Currently, the Company has several revenue generating partnerships and contracts. The table below presents these revenue sources:

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The Company currently has commercial partnerships with Bayer CropScience, a subsidiary of Bayer AG, (“Bayer”) in the area of crop protection and The Monsanto Company (“Monsanto”) and Pioneer Hi-Bred International, Inc. (“Pioneer”), a subsidiary of E.I. du Pont de Nemours and Company, in the area of crop trait discovery. The Company’s partnership with Bayer was signed in September 1998 and was extended in November 2003. Under the terms of the agreement, the companies intended to collaborate on herbicide discovery through September 2006. Management currently believes that Bayer will exercise its right to terminate the contract prior to the end of its term. The partnership with Monsanto was signed in November 1999 and began contributing revenues in the second quarter of 2000. As amended, the agreement commits Monsanto to a total partnership term of six years with committed funding through January 2006. The three-year partnership with Pioneer was signed in December 2003 and began contributing to the Company’s revenues in the first quarter of fiscal year 2004.

The Company also has a $23.8 million five-year contract with the National Institute of Environmental Health Sciences (“NIEHS”) that was signed in September 2002 and began contributing to the Company’s revenue in the fourth quarter of 2002. In April 2003, the Company announced that NIEHS exercised an $8.4 million option under this contract bringing the total contact value to $32.2 million through 2007. Under the terms of the contract, the Company will use its technologies to determine how toxicants work and cause damage at the cellular level.

The Company’s acquisition of TissueInformatics.Inc brings revenue-generating contracts, of which the most significant is the contract with L’Oréal, a subsidiary of L’Oréal S.A. (“L’Oréal”), for the development and license of TissueInformatics^® software for the automated pathology slide screening of tissue-engineered skin. This contract was signed in November 2003 and includes a three-year maintenance agreement. The Company anticipates that the L’Oréal contract should begin contributing to revenue in late 2004.

The Company’s Advanced Technology Program (“ATP”) grant from National Institute of Standards and Technology (“NIST”) was awarded in June 2002 for $11.7 million over five years to develop innovative tools for target discovery through the analysis of complex coherent data sets. This grant, the largest bioinformatics grant ever awarded in NIST’s Advanced Technologies Program history, supports the development of methods and tools for the creation, evaluation and analysis of coherent data sets. The grant will be shared between the Company and a joint venture partner based on the research work plan. The Company’s current joint venture partner is Agilent Technologies. Another grant with the National Science Foundation (“NSF”) for the development of a high throughput gene discovery system in Arabidopsis using geminivirus ended in June 2003.

During June 2004, the Company was awarded two Small Business Innovative Research (“SBIR”) contracts. The first contract was a SBIR Phase I/II contract from the NIEHS for biomarkers that predict the early onset of drug-indicated liver injury. This contract is worth up to $742,000, with $99,000 funded for the six-month Phase I part of the study and an additional $643,000 over two years for Phase II, upon the successful completion of Phase I. The Company was awarded a second SBIR Phase I/II contract from the National Institutes of Health for biomarker research in alcohol induced liver and brain injury. This contract is worth up to approximately $850,000, with $100,000 funded for the six-month Phase I part of the study and up to $750,000 over two years for Phase II, upon the successful completion of Phase I.

Liquidity and Capital Resources

The Company has historically financed its operations through the sale of equity, debt and capital lease financing, payments received from commercial partnerships and government contracts and grants. From inception through September 30, 2004, the Company has raised an aggregate of approximately $95.5 million through the sale of equity and approximately $25.6 million in proceeds from secured debt financing.

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At September 30, 2004, the Company had cash, cash equivalents and short-term investments totaling approximately $7.1 million. The Company’s management believes there are currently several factors which could negatively impact the Company’s cash position:

If the Company was required to pay off the loan with Silicon Valley Bank, the Company believes its remaining cash would be sufficient to support its operations at least into the second half of 2005.

During September of 2004, the Company repaid $0.3 million of its remaining debt to GECC without penalty. As of September 30, 2004, the Company owed GECC approximately $0.3 million. During October of 2004, the Company repaid the remainder of its debt to GECC without penalty.

On October 19, 2004, the Company entered into a series of agreements with Laurus Master Fund, Ltd. (“Laurus”) whereby the Company received $5,000,000 gross proceeds through the sale of a three-year convertible term note. In accordance with the terms of the note, the note is payable in cash or convertible into common stock of the Company at a fixed conversion price of $0.53 per share subject to certain conditions relating to increases in the price of the Company’s common stock above $0.59 per share and the actual trading volume of the Company’s common stock. Laurus may also elect to have interest paid in stock at a fixed conversion price of $0.53 per share. The note is collateralized by essentially all of the Company’s otherwise unencumbered fixed assets. In connection with the financing, the Company paid approximately $0.2 million of costs and expenses of Laurus and has issued warrants for the purchase of 1,650,943 shares of Common Stock at a weighted average price of $0.79. One half of the warrants expire two years after issuance and the other half of the warrants expire five years after issuance. In addition, the Company also paid a placement agent approximately $0.4 million and issued a five year warrant to purchase an aggregate of 843,396 of shares of Common Stock immediately exercisable at $0.53 per share. The placement agent also previously received consideration consisting of a warrant for 100,000 shares of common stock exercisable at $0.72 per share in connection with entering into the placement agency agreement dated July 14, 2004. These warrants also expire five years after issuance.

In order to best understand the Company’s cash flow, management believes that the cash flow measure presented below, which includes Short- and Long-Term Investments, is an appropriate measure for evaluating the Company’s liquidity, because this reflects all liquid resources available for strategic opportunities including, among others, investment in the business and continuing operating activities. However, this measure should be considered in addition to, and not as a substitute for, or superior to, cash flows prepared in accordance with generally accepted accounting principles in the U.S.

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Cash used in operating activities:

Management expects the Company’s cash used in operating activities in 2004 will be higher than 2003, as the Company is expecting new revenues in 2004 to contribute to its cash flow from operations to be more than offset by higher research and development costs from the Company’s expanding research programs. No assurance can be given that the Company will earn the new revenues anticipated in 2004.

Cash provided by (used in) investing activities:

The Company expects cash used in investing activities will increase in 2004 compared to 2003 as the Company continues to purchase equipment to support our operations.

Cash used in financing activities:

For the remainder of 2004, our obligation for financing activities amounts to approximately $0.7 million, including prepayment of the remainder of the amounts due to GECC.

Based on the above discussion, management believes that the Company has sufficient cash to fund its operations at least into the second half of 2005. The Company may attempt to raise additional funds to support our expanding research and development programs, general working capital needs, and debt obligations through the public or private offering of our equity securities, additional debt financing or both. No assurance can be given that such additional financings will be available or, if available, can be obtained on terms acceptable to the Company.

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Under GAAP, cash flows from investing activities above would improve by net maturities of investment securities; also under GAAP, cash and cash equivalents at the beginning and end of the period would be less, as they would exclude short and long-term investments. The following table presents these differences:

Results of Operations

Three Months Ended September 30, 2004 and September 30, 2003.

Revenues

The table below presents our revenue sources for the three months ended September 30, 2004 compared to the three months ended September 30, 2003.

Notes:

1. The Company recognizes revenues relating to its partnership with Bayer in two components, gene discovery and assay development. For the gene discovery component, from which the majority of the revenue is generated, the Company recognizes revenue by comparing the number of genes analyzed during the period to the total number of genes to be analyzed over the term of the contract. During the three months ended June 30, 2004, the Company successfully completed the gene analysis portion of the contract. Therefore, there was no revenue associated with the gene discovery component during the three month period ended September 30, 2004. For the assay component, the Company recognizes revenue when Bayer accepts assays. There was no significant difference in revenues related to assays in the third quarter of 2004 compared to the same period in 2003. Overall, as the contract nears completion, the Company expects to recognize less revenue in 2004 when compared to 2003 for this commercial partnership. Management currently believes that Bayer will exercise its right to terminate the contract prior to the end of its term; however, the Company does not currently expect this action to significantly affect 2004 revenue.

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2. The Company recognizes revenues relating to its partnership with Monsanto by comparing the number of genes analyzed during the period to the total number of genes to be analyzed over the term of the contract. The Company expects that revenues related to this commercial partnership will decline in 2004 when compared to 2003 as the project enters later phases in which there is a lower number of genes to be analyzed.

3. The Company recognizes revenues relating to its partnership with Pioneer by comparing the number of plant lines analyzed during the period to the total number of plant lines to be analyzed over the term of the three-year contract. This commercial partnership was signed in December 2003.

4. The Company recognizes revenues relating to its partnership with NIEHS on a cost plus fixed fee basis, generally as samples are processed. In the third quarter of 2004, revenues increased primarily as a result of a higher number of samples processed as well as short-term opportunities which occurred primarily during the third quarter of 2004. The Company expects this increase to continue in 2004 and, as a result, the Company expects revenues will increase in 2004 when compared to 2003.

5. The Company recognizes revenues relating to its service business, Paradigm Array Labs^™, as the Company completes work for its various customers. The Company expects that revenues related to this service will increase in 2004 when compared to 2003 as the Company has signed contracts that the Company expects to generate significant revenue in the fourth quarter of 2004.

6. The Company recognizes revenues under its grants as the related expenses are incurred. Grant revenues for the three months ended September 30, 2004 were generated from the ATP grant. Grant revenues for the three months ended September 30, 2003 were generated from our ATP grant and included revenue from a realignment of the ATP contract which resulted in increased revenue during this quarter. The Company is expecting that grant revenues will be slightly lower in 2004 when compared to 2003, due to revenues from our ATP grant decreasing in 2004, as well as decreasing grant revenues from the National Science Foundation, which ended in June 2003.

Research and Development and Selling, General and Administrative Expenses

The table below presents our operating expenses for the third quarter of 2004 compared to the same period in 2003.

Notes:

1. The Company’s costs increased during the third quarter of 2004 when compared to the same period in 2003. The increase was primarily related to increased headcount, laboratory supplies, consulting, subcontractor and other costs, which increased approximately $1.4 million as the Company incurred costs related to certain short-term opportunities on the NIEHS contract work and ramped up its PAL services as well as the

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TissueInformatics operations. The Company is expecting its payroll, lab supply and other expenses to increase in 2004 when compared to 2003 due to the addition of the TissueInformatics operations and as the Company continues to expand its services under its contract with NIEHS, expand its PAL and other healthcare businesses and deliver on its new contract with Pioneer Hi-Bred.

2. Total depreciation and amortization expense during the third quarter of 2004 was comparable to the same period in 2003 due to additional amortization of the intangible assets and depreciation of the equipment acquired with the TissueInformatics acquisition offset by some older assets being fully depreciated. The Company is expecting depreciation and amortization expenses to increase in 2004 compared to 2003 as it increases its capital expenditures and amortizes intangible assets associated with the TissueInformatics acquisition.

3. At March 31, 2004, the Company completed the amortization of the remaining balance of deferred compensation expense. Therefore, deferred compensation expense will be lower in 2004 when compared to 2003.

4. Costs increased during the third quarter of 2004 when compared to the same period in 2003. This increase was primarily related to payroll and related costs which increased approximately $0.5 million, primarily due to higher headcount associated with the expansion of the sales and marketing function including the TissueInformatics operations. Other expenses, which consist primarily of professional expenses, such as legal and accounting fees, facilities costs, patent fees and conference costs also increased slightly. The Company is expecting payroll and other expenses to increase in 2004 when compared to 2003 as the Company expands operations, delivers on new revenue generating contracts and increases business development activities.

Interest Income (Expense), Net

Interest income (expense), net represents interest earned on our cash, cash equivalents and short-term and long-term investments, offset by interest expense on long-term debt and capital leases. Interest income (expense), net decreased to an expense of approximately $46,000 for the quarter ended September 30, 2004 compared to an expense of approximately $227,000 for the quarter ended September 30, 2003. This decrease was primarily attributable to a decrease in interest expense. Interest expense declined as a result of the Silicon Valley Bank financing that the Company closed in July of 2003. The financing replaced some of the Company’s existing debt, which carried higher interest rates. The Company expects that net interest expense will increase primarily as a result of the new $5,000,000 Laurus note, net of a reduction in interest expense costs due to the repayment of the GECC debt.

Divestiture

The Company is reporting a small gain from discontinued operations in 2004. In 2002, the Company discontinued the operations of a plant genotyping business, ParaGen, and in February 2003, sold ParaGen to DNA Landmarks. The Company is expecting a minimal income contribution from discontinued operations as the Company recognizes royalties from the sale during 2004.

Net Loss

Net loss increased 36% to approximately $3,054,000 for the quarter ended September 30, 2004, compared to approximately $2,243,000 for the quarter ended September 30, 2003. The increase in the net loss was primarily due to increased revenues between the two periods offset by higher research and development and selling, general and administrative costs.

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Nine Months Ended September 30, 2004 and 2003.

Revenues

The table below presents our revenue sources for the nine months ended September 30, 2004 compared to the nine months ended September 30, 2003.