AVIGEN INC \DE - 10-Q Quarterly Report

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-Q

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

For the quarterly period ended September 30, 2004

or

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

For the transition period from ____________ to ____________

Commission File Number: 0-28272

AVIGEN, INC.
(Exact name of registrant as specified in its charter)

Delaware		13-3647113
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification No.)

1301 Harbor Bay Parkway
Alameda, California 94502
(Address of principal executive offices and zip code)

(510) 748-7150
(Registrant’s telephone number,
including area code)

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

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

As of November 3, 2004, the number of outstanding shares of the registrant’s Common Stock, $.001 par value, was 20,380,688.

AVIGEN, INC.
FORM 10-Q
Quarter Ended September 30, 2004

INDEX

		PAGE

	PART I. FINANCIAL INFORMATION

Item 1.	Financial Statements	3

	Condensed Balance Sheets at September 30, 2004 and December 31, 2003	3
	Condensed Statements of Operations -	4
	For three and nine months ended September 30, 2004 and 2003 and the period from October 22, 1992 (inception) through September 30, 2004
	Condensed Statements of Cash Flows -	5
	For nine months ended September 30, 2004 and 2003 and the period from October 22, 1992 (inception) through September 30, 2004

	Notes to Condensed Financial Statements	6
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	13
Item 3.	Quantitative and Qualitative Disclosures About Market Risk	32
Item 4.	Controls and Procedures	32

	PART II. OTHER INFORMATION

Item 1.	Legal Proceedings	32
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	32
Item 3.	Defaults upon Senior Securities	32
Item 4.	Submission of Matters to a Vote of Security Holders	33
Item 5.	Other Information	33
Item 6.	Exhibits	34

SIGNATURES		35

PART I. FINANCIAL INFORMATION
Item 1. Financial Statements

AVIGEN, INC.
(a development stage company)

CONDENSED BALANCE SHEETS
(in thousands, except share and per share information)

	September 30, 2004			December 31, 2003

	(Unaudited)			Note 1
ASSETS
Current Assets:
Cash and cash equivalents.	$	2,497		$	2,384
Available-for-sale securities		66,739			84,566
Accrued interest		747			774
Prepaid expenses and other current assets		412			444

Total current assets		70,395			88,168
Restricted investments		11,928			11,928
Property and equipment, net		13,383			15,641
Deposits and other assets		695			858

Total assets	$	96,401		$	116,595

LIABILITIES AND STOCKHOLDERS’ EQUITY
Current Liabilities:
Accounts payable and other accrued liabilities	$	620		$	1,140
Accrued compensation and related expenses		981			477
Deferred revenue – current		—			500

Total current liabilities		1,601			2,117
Long-term loan payable		8,000			8,000
Deferred rent		1,048			967
Deferred revenue		—			1,625
Stockholders’ equity:
Preferred Stock, $0.001 par value, 5,000,000 shares authorized, none issued and outstanding		—			—
Common Stock, $0.001 par value, 50,000,000 shares authorized, 20,374,688 and 20,276,394 shares issued and outstanding at September 30, 2004 and December 31, 2003, respectively		20			20
Additional paid-in capital		236,939			236,120
Accumulated other comprehensive income		(287	)		402
Deficit accumulated during development stage		(150,920	)		(132,656	)

Total stockholders’ equity		85,752			103,886

Total liabilities and stockholders’ equity	$	96,401		$	116,595

See accompanying notes.

AVIGEN, INC.
(a development stage company)

CONDENSED STATEMENTS OF OPERATIONS
(in thousands, except for share and per share information)
(unaudited)

													Period from October 22, 1992 (inception) through September 30, 2004


	Three months ended September 30,						Nine months ended September 30,

	2004			2003			2004			2003

Revenue	$	8		$	140		$	2,160		$	298		$	3,410
Operating Expenses:
Research and development		4,968			5,594			15,030			15,985			123,191
General and administrative		1,902			2,084			6,673			5,635			50,496
In-license fees		—			—			—			—			5,034

Total operating expenses		6,870			7,678			21,703			21,620			178,721

Loss from operations		(6,862	)		(7,538	)		(19,543	)		(21,322	)		(175,311	)
Interest expense		(42	)		(54	)		(149	)		(173	)		(2,320	)
Interest income		449			699			1,496			2,602			26,901
Other expense, net		(15	)		(16	)		(68	)		(51	)		(190	)

Net loss	$	(6,470	)	$	(6,909	)	$	(18,264	)	$	(18,944	)	$	(150,920	)

Basic and diluted net loss per common share	$	(0.32	)	$	(0.34	)	$	(0.90	)	$	(0.94	)

Shares used in basic and diluted net loss per common share calculation		20,372,396			20,143,101			20,356,167			20,129,479

See accompanying notes.

AVIGEN, INC.
(a development stage company)

CONDENSED STATEMENTS OF CASH FLOWS
(in thousands)
(unaudited)

							Period from October 22, 1992 (inception) Through September 30, 2004


	Nine Months Ended September 30,

	2004			2003

Operating Activities
Net cash used in operating activities	$	(17,073	)	$	(12,985	)	$	(127,945	)
Investing Activities
Purchases of property and equipment		(446	)		(309	)		(28,157	)
Increase in restricted investments		—			(428	)		(11,928	)
Purchases of available-for-sale securities		(67,523	)		(58,072	)		(692,938	)
Maturities of available-for-sale securities		84,662			69,993			625,915

Net cash provided by (used in) investing activities		16,693			11,184			(107,108	)
Financing Activities
Proceeds from long-term obligations		—			—			10,133
Proceeds from warrants and options exercised		493			168			14,044
Proceeds from issuance of common stock, net of issuance costs and repurchases		—			—			205,619
Other financing activities		—			—			7,754

Net cash provided by financing activities		493			168			237,550
Net increase (decrease) in cash and cash equivalents		113			(1,633	)		2,497
Cash and cash equivalents, beginning of period		2,384			7,879			—

Cash and cash equivalents, end of period	$	2,497		$	6,246		$	2,497

See accompanying notes.

AVIGEN, INC.
(a development stage company)

NOTES TO CONDENSED FINANCIAL STATEMENTS

1. Interim Financial Statements

Our accompanying unaudited condensed financial statements have been prepared in accordance with accounting principles generally accepted in the United States for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States for complete financial statements. In the opinion of management, all adjustments, consisting only of normal recurring adjustments and accruals, considered necessary for a fair presentation of the results for the interim periods presented have been included. Operating results reported for the three and nine months ended September 30, 2004 are not necessarily indicative of the results that may be expected for any other interim period or for the entire year ending December 31, 2004. These unaudited interim financial statements should be read in conjunction with our audited financial statements and the notes thereto included in our Annual Report on Form 10-K for the period ended December 31, 2003, filed with the Securities and Exchange Commission on March 15, 2004.

The balance sheet at December 31, 2003 has been derived from the audited financial statements at that date, but does not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements.

2. Stock-Based Compensation

The information regarding net loss and loss per common share as required by FAS 123 “Accounting for Stock-Based Compensation” has been determined as if we had accounted for our employee stock options under the fair value method prescribed by FAS 123. The resulting effect on net loss and loss per common share pursuant to FAS 123 is not likely to be representative of the effects on net loss and loss per common share pursuant to FAS 123 in future years, since future years are likely to include additional grants and the variable impact of future years’ vesting.

The following table illustrates the effect on our net loss and loss per common share if we had applied the fair value recognition provisions of FAS 123 to our stock-based employee compensation (in thousands, except for per share data):

	Three Months Ended September 30,						Nine Months Ended September 30,

	2004			2003			2004			2003

Net Loss - as reported	$	(6,471	)	$	(6,909	)	$	(18,264	)	$	(18,944	)
Add: Stock-based employee compensation		—			—			220			28
Less: Total stock-based employee compensation expense determined under the fair-value based method for all awards		(895	)		(2,336	)		(5,772	)		(7,770	)

Net loss - pro forma	$	(7,366	)	$	(9,245	)	$	(23,816	)	$	(26,686	)

Net loss per common share basic & diluted - as reported	$	(0.32	)	$	(0.34	)	$	(0.90	)	$	(0.94	)

Net loss per common share basic & diluted - pro forma	$	(0.36	)	$	(0.46	)	$	(1.17	)	$	(1.33	)

During the preparation of our Notes to the Financial Statements for the year ended December 31, 2003, we determined that the calculation of total stock-based employee compensation expense determined under the fair-value-based method for the three- and nine-month periods ended September 30, 2003, as reported in that period, inadvertently included data that overstated the expected volatility used in the calculation. Accordingly, the amount of the total stock-based employee compensation expense determined under the fair-value-based method reported under FAS 123 for the three- and nine-month periods ended September 30, 2003 presented in the table above, and the respective volatility for the period presented in the table below, have been revised, resulting in decreases in the previously reported amounts of $554,000 and $1.8 million, respectively. This revision had no effect on our previously reported results of operations or financial condition.

For purposes of disclosure pursuant to FAS 123, as amended by FAS 148, the estimated fair value of our employee stock options is amortized to expense over the vesting period of the options. We use the Black-Scholes option valuation model to estimate the fair value of our options on the date of

grant. Options that were granted during the three and nine months ended September 30, 2004 and 2003 were valued with the following weighted average assumptions:

	Three Months Ended September 30,						Nine Months Ended September 30,

	2004			2003			2004			2003

Expected volatility		0.8163			0.8759			0.8215			0.8924
Risk free interest rate		3.51	%		3.14	%		3.41	%		2.87	%
Expected life of options in years		5			5			5			5
Expected dividend yield		—			—			—			—

The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options and warrants that have no vesting restrictions and are fully transferable. In addition, option valuation models, including Black-Scholes, require the input of highly subjective assumptions, including the expected stock price volatility. Because our stock options and warrants are not traded, they have characteristics significantly different from those of traded options and warrants, and because changes in the subjective input assumptions can materially affect the fair value estimate, in our opinion, the existing option valuation models, including Black-Scholes, do not necessarily provide a reliable single measure of the fair value of our stock options and warrants.

For equity awards to non-employees, including lenders, lessors and consultants, we also apply the Black-Scholes method to determine the fair value of such investments in accordance with FAS 123 and Emerging Issues Task Force Issue No. 96-18, “Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring or in Conjunction with Selling, Goods, or Services.” The options and warrants granted to non-employees are re-measured as they vest and the resulting value is recognized as an expense against our net loss over the period during which the services are received or the term of the related financing.

In March 2004, the FASB issued an exposure draft of a proposed standard that, if adopted, will significantly change the accounting for employee stock options and other equity-based compensation. In October 2004, the FASB voted to delay the initially proposed effective date for six months rather than making it effective on January 2, 2005, as originally proposed. The proposed standard would require companies to expense the fair value of stock options on the grant date and, if adopted, we would be required to implement the proposed standard no later than the quarter that begins July 1, 2005. We will evaluate the requirements of the final standard, which is expected to be issued during 2005, to determine the impact on the results of our operations.

3. Cash and Cash Equivalents, Available-For-Sale Securities, and Restricted Investments

Cash and Cash Equivalents

We consider all highly liquid investments with a maturity of three months or less when purchased to be cash equivalents. These amounts are recorded at cost, which approximates fair market value.

Available-for-sale Securities

We invest our excess cash balances in marketable securities, primarily corporate debt securities,

federal agency obligations, asset-backed securities, and municipal bonds, with the primary investment objectives of preservation of principal, a high degree of liquidity, and maximum total return. In accordance with Statement of Financial Accounting Standards No. 115, “Accounting for Certain Investments in Debt and Equity Securities,” we have classified our investments in marketable securities as available-for-sale. Available-for-sale securities are reported at market value and unrealized holding gains and losses, net of the related tax effect, if any, are excluded from earnings and are reported in other comprehensive income and as a separate component of stockholders’ equity until realized. A decline in the market value of a security below its cost that is deemed other than temporary is charged to earnings, and would result in the establishment of a new cost basis for the security.

Our available-for-sale securities consist principally of obligations with a minimum short-term rating of A1/P1 and a minimum long-term rating of A- and with effective maturities of less than three years. The cost of securities sold is based on the specific identification method. Interest on securities classified as available-for-sale is included in interest income.

Restricted Investments

At September 30, 2004 and December 31, 2003, $11.9 million was classified as restricted investments in long-term assets, representing the combined aggregate portion of our portfolio of available-for-sale securities that were pledged in connection with a financing arrangement, equipment operating leases, and two letters of credit serving as deposits in connection with a building lease.

The following is a summary of cash, restricted investments, and available-for-sale securities as of September 30, 2004 (in thousands):

	Cost		Gross Unrealized Gains		Gross Unrealized Losses			Fair Value

Cash	$	2,498	$	—	$	—		$	2,498
Corporate debt securities		35,792		19		(123	)		35,688
Federal agency obligations		27,495		1		(150	)		27,346
Asset-backed and other securities		6,628		8		(30	)		6,606
Short-term municipals		3,150		—		—			3,150
Treasury obligations		5,888		3		(15	)		5,876

Total	$	81,451	$	31	$	(318	)	$	81,164

Amounts reported as:
Cash and cash equivalents		2,497		—		—			2,497
Restricted investments		11,928		—		—			11,928
Available-for-sale securities		67,026		31		(318	)		66,739

Total	$	81,451	$	31	$	(318	)	$	81,164

The weighted average maturity of our investment portfolio at September 30, 2004 was 387 days, with $42.7 million carrying an effective maturity of less than twelve months, and $38.4 million carrying an effective maturity between one and three years.

The following is a summary of cash, restricted investments, and available-for-sale securities as of December 31, 2003 (in thousands):

	Cost		Gross Unrealized Gains		Gross Unrealized Losses			Fair Value

Cash	$	2,384	$	—	$	—		$	2,384
Corporate debt securities		45,474		232		(25	)		45,681
Federal agency obligations		24,813		81		(21	)		24,873
Asset-backed and other securities		17,048		134		(3	)		17,179
Short-term municipals		2,000		—		—			2,000
Treasury obligations		6,757		9		(5	)		6,761

Total	$	98,476	$	456	$	(54	)	$	98,878

Amounts reported as:
Cash and cash equivalents		2,384		—		—			2,384
Restricted Investments		11,928		—		—			11,928
Available-for-sale securities		84,164		456		(54	)		84,566

Total	$	98,476	$	456	$	(54	)	$	98,878

The weighted average maturity of our investment portfolio at December 31, 2003 was 405 days, with $46.3 million carrying an effective maturity of less than twelve months, and $52.6 million carrying an effective maturity between one and three years.

4. Deferred Revenue

In March 2003, we received a $2.5 million payment from Bayer Corporation under the terms of our collaboration agreement for the development of Coagulin-B, our product candidate that we were developing for the treatment of hemophilia B, involving administration to the liver. This amount was recorded as deferred revenue and was being recognized as revenue ratably over the estimated development period for this product, which was determined to be five years, or approximately $125,000 per quarter.

In May 2004, we announced the suspension of patient enrollment in our phase I clinical trial involving the administration of Coagulin-B to the liver. This resulted in the termination of the development of the liver-targeted product candidate associated with the March 2003 Bayer payment. As a result, we accelerated the recognition of the remaining $2.0 million of deferred revenue in our statements of operations during the quarter ended June 30, 2004.

5. Restructuring Plan and Staff Reduction Expenses

In July 2004, we implemented a plan to restructure the company and reduce staff levels in order to reduce our expenses for ongoing operations and extend the anticipated life of our existing financial resources. This plan was implemented in connection with the decision to suspend patient enrollment in our phase I clinical trial involving the administration of Coagulin-B to the liver for hemophilia B in May 2004 and our expectations that the FDA will require longer than previously anticipated clinical timelines for gene therapy clinical trials, including AV201, our product for Parkinson’s disease.

We reduced our workforce by 37 positions, primarily in research and development areas. We incurred approximately $800,000 in severance payments and other termination-related benefits.

Approximately $690,000 of the costs associated with the workforce reduction are included in research and development expenses and approximately $110,000 in general and administrative expenses for the three months ended September 30, 2004. All expenses were paid as of September 30, 2004 and we do not expect to incur any additional costs associated with the restructuring plan.

6. Comprehensive Loss

Comprehensive loss is comprised of net loss and unrealized holding gains and losses on available-for-sale securities, in accordance with Statement of Financial Accounting Standards No. 130, “Reporting Comprehensive Income.”

	Three Months Ended September 30,						Nine Months Ended September 30,

(Amounts in thousands)	2004			2003			2004			2003

Net loss	$	(6,471	)	$	(6,909	)	$	(18,264	)	$	(18,944	)
Net unrealized gain or (loss) on available-for-sale securities		197			(388	)		(689	)		(825	)

Comprehensive loss	$	(6,274	)	$	(7,297	)	$	(18,953	)	$	(19,769	)

7. Basic and Diluted Net Loss Per Common Share

Basic net loss per common share is computed by dividing net loss by the weighted-average number of common shares outstanding during the period. The computation of basic net loss per common share for all periods presented is derived from the information on the face of the statement of operations, and there are no reconciling items in either the numerator or denominator.

Diluted net loss per common share is computed as though all potential common shares that are dilutive were outstanding during the period using the treasury stock method, for purposes of calculating the weighted-average number of dilutive common shares outstanding during the period. Potential dilutive common shares consist of shares issuable upon exercise of stock options and warrants. Securities that potentially could have diluted basic earnings per common share, but were excluded from the diluted net loss per common share computation because their inclusion would have been anti-dilutive, were as follows:

	Three Months Ended September 30,				Nine Months Ended September 30,

	2004		2003		2004		2003

Potential dilutive stock options outstanding		479,778		535,632		547,463		523,391
Outstanding securities excluded from the potential dilutive common shares calculation (1)		4,729,319		4,932,208		4,386,571		4,694,786

(1) For purpose of computing the potential dilutive common shares, we excluded outstanding stock options and warrants to purchase common stock whose exercise prices exceed the average of the closing sale prices of our common stock as reported on the NASDAQ National Market for the period.

8. Stockholder’s Equity

We received $108,900 in cash proceeds related to exercise of warrants for 18,000 shares of common stock in March 2004.

In March 2004, the exercise period for stock options for 427,500 shares of common stock were extended and as a result we recorded a non-cash compensation expense of $220,000.

9. Long Term Loan Payable

In June 2004, we amended the terms of our $10 million revolving line of credit to extend the expiration date of the borrowing from June 1, 2005 to June 1, 2007. Accordingly, the loan continues to be classified as long term.

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

The following discussion may be understood more fully by reference to the financial statements, notes to the financial statements, and management’s discussion and analysis of financial conditions and results of operations contained in our Annual Report on Form 10-K for the year ended December 31, 2003, filed with the Securities and Exchange Commission on March 15, 2004.

This Quarterly Report on Form 10-Q contains forward-looking statements, which include, but are not limited to, statements of our expectations regarding our future financial results, and statements about future events and results regarding our drug development programs, clinical trials, sources of revenue, receipt of regulatory approvals, expense savings and cash burn rate resulting from the implementation of our strategic plan, capital needs, intellectual property, and other events. In some cases, you can identify forward-looking statements by such terms as “may,” “will,” “should,” “could,” “expect,” “plan,” “anticipate,” “believe,” “estimate,” “project,” “intend,” “predict,” “potential,” and similar expressions which imply that the statements relate to future events and are based on assumptions and subject to risks and uncertainties. Given these uncertainties, you should not place undue reliance on these forward-looking statements. We discuss the risks we believe are most important in greater detail under the heading “Risk Factors” below and elsewhere in this report. Also, these forward-looking statements represent our estimates and assumptions only as of the date of this Form 10-Q. Avigenundertakes no obligation to update any of the forward- looking statements contained in this report to reflect any future events or developments.

Overview

We are focused on developing innovative therapeutics to treat serious disorders, primarily for neurological conditions. We have developed proprietary DNA-based drug delivery technologies, including our proprietary gene-delivery platform based on adeno-associated virus (AAV) vectors. We are using our DNA-based drug delivery technologies to develop products designed to treat diseases that are difficult to treat using conventional pharmaceutical drugs. We are also actively pursuing the acquisition or in-licensing of non-gene therapy drug candidates, primarily with prior human clinical trial experience.

Third Quarter and Other Recent Highlights

In August 2004, we announced that the FDA had authorized the initiation of a phase I clinical trial of AV201, our drug candidate for the treatment of Parkinson’s disease. This trial is based on promising findings in animal models of the disease and will treat subjects with mid-to-late stage Parkinson’s disease. AV201 is designed to restore the therapeutic effectiveness of levadopa (L-Dopa). L-Dopa is an effective medication for treating Parkinson’s disease symptoms in early stages of the disease, but becomes less effective over time. AV201 delivers a human gene into the striatum of the brain that enables more efficient utilization of the drug. In October, we received approval from the institutional review board of UCSF to proceed with the trial and have initiated the enrollment of participants with the expectation that we may begin treatment in the fourth-quarter of 2004.

In July 2004, we announced a 38% reduction in staff levels, reducing the number of our employees to approximately 65. We took this action to reduce our ongoing operating expenses and extend the life of our current financial resources. This reduction was consistent with the announcement to suspend patient enrollment in our phase I hemophilia B trial in May 2004 and the current requirement from the FDA for a longer than previously anticipated clinical timeline for our planned phase I clinical trial for AV201. Despite the reduction in our staff levels, we believe we have retained in full our core research and

development competencies, including those associated with our manufacture and use of AAV for gene delivery.

The regulatory environment for gene therapy remains challenging. We see this heightened level of scrutiny and review of gene therapy trials continuing for the foreseeable future, and are expecting longer than previously anticipated clinical development timelines for our gene therapy product candidates. However, we are working with regulatory agencies to address their concerns and improve the overall pace of all our clinical development programs, including AV201, our product candidate for Parkinson’s disease. We also continue to focus our new product evaluation process toward development candidates that target life-threatening chronic diseases with risk-benefit profiles that we believe favor more accelerated subject enrollment and faster clinical development timelines. In addition, we are increasing efforts to evaluate in-licensing opportunities with non-gene therapy drug candidates that are consistent with our focus on neurological conditions, but that would not be subject to the same regulatory challenges as our existing gene therapy programs.

We continue to work with our collaboration partners at Bayer HealthCare to evaluate options for taking forward our Coagulin-B program for treating hemophilia B. In May 2004, we suspended patient enrollment in our phase I clinical trial for this drug candidate. However, we feel there is considerable value in our years of clinical experience and manufacturing, and intellectual property development within the program, and we hope that these efforts could lead to additional hemophilia trials in the future.

We are a development stage company and have primarily supported the financial needs of our research and development activities since our inception through public offerings and private placements of our equity securities. We have not received any revenue from the sale of our products in development, and we do not anticipate generating revenue from the sale of products in the foreseeable future. As a result, we expect that we will need to obtain additional funding to support the anticipated future needs of our research and development activities. We expect our source of revenue, if any, for the next several years to consist of payments under collaborative arrangements with third parties, government grants, and license fees. We have incurred losses since our inception and expect to incur substantial losses over the next several years due to lack of any substantial revenue and the continuation of our ongoing and planned research and development efforts, including preclinical studies and clinical trials. There can be no assurance that we will successfully develop, commercialize, manufacture, or market our product candidates or ever achieve or sustain product revenue for profitability. At September 30, 2004 we had an accumulated deficit of $150.9 million and cash, cash equivalents, available-for-sale securities, and restricted investments of approximately $81.2 million. We believe that our capital resources at September 30, 2004 will be adequate to fund our current operating needs for the next four years.

Critical Accounting Policies

Our management’s discussion and analysis of our financial condition and results of operations are based on our financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States for interim financial information. The preparation of these financial statements requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements as well as the reported revenues and expenses during the reporting periods. On an ongoing basis, we evaluate our estimates and judgments related to revenue recognition, valuation of investments in financial instruments, impairment of property and equipment, and allocation of research and development expenses. We base our estimates on historical experience and on various other factors that

we believe are reasonable under the circumstances, the results of which form the basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

We believe the following accounting policies are critical to the process of making significant judgments and estimates in the preparation of our financial statements.

Revenue recognition

We recognize revenue associated with up-front license, technology access and research and development funding payments under collaborative agreements ratably over the relevant periods specified in the agreements, generally the development phase. This development phase can be defined as a specified period of time; however, in certain cases, the collaborative agreement specifies a development phase that culminates with milestone objectives but does not have a fixed date and requires us to estimate the time period over which to recognize this revenue. Our estimated time periods are based on management’s estimate of the time required to achieve a particular development milestone considering the projected level of effort and current stage of development. If our estimate of the development-phase time period changes, the amount of revenue we recognize related to up-front payments for a given period will accelerate or decrease accordingly. For example, in March 2003, we received a $2.5 million payment under the terms of a collaboration agreement for Coagulin-B administered to the liver. The revenue associated with the payment was being recognized ratably over the development phase, which was initially estimated to be five years. In May 2004, we suspended patient enrollment in the phase I clinical trial for this product and, as a result, ended the development-phase for this product and accelerated the recognition of the remainder of the revenue associated with the Bayer payment during the quarter ended June 30, 2004.

We recognize non-refundable product license fees, including fees associated with research license agreements, for which we have no further performance obligations, and no continuing involvement requirements, on the earlier of the dates on when the payments are received or when collection is assured.

Valuation of investments in financial instruments

We carry investments in financial instruments at fair value with unrealized gains and losses included in accumulated other comprehensive income or loss in stockholders’ equity. Our investment portfolio does not include equity securities or derivative financial instruments that could subject us to material market risk; however, we do invest in corporate obligations that subject us to varying levels of credit risk. Management assesses whether declines in the fair value of investment securities are other-than-temporary. If a decline in fair value of a financial instrument is judged to be other-than-temporary, the cost basis of the individual security is written down to fair value and the amount of the write down is included in earnings. In determining whether a decline is other-than-temporary, management considers:

	•	The length of time and the extent to which the market value of the security has been less than cost;

	•	The financial condition and near-term prospects of the issuer; and

	•	Our intention and ability to retain our investment in the issuer for a period of time sufficient to allow for any anticipated recovery in market value, which could be until maturity.

The determination of whether a decline in fair value is other-than-temporary requires significant judgment, and could have a material impact on our balance sheet and results of operations. We have not had any write-downs for other-than-temporary declines in the fair value of our financial instruments since our inception.

Impairment of property and equipment

We have invested significant amounts on construction for improvements to our research and development facilities, with the largest portion of our spending made to modify manufacturing facilities that are intended to comply with requirements of government mandated manufacturing rules for pharmaceutical production. Management assesses whether there has been any impairment in the value of these facilities. If the value of our construction for improvements is judged to be impaired, the cost basis of the property and equipment is written down to fair value and the amount of the write down is included in earnings. In determining whether the value of our property and equipment is impaired, management considers:

	•	failure of manufacturing facilities and equipment to comply with government mandated policies and procedures;

	•	failure of the products for which the manufacturing facilities have been constructed to receive regulatory approval; and

	•	the extent that facilities could be idled due to the adoption of operating efficiencies for an other-than-temporary period, resulting in excess capacity.

The determination of whether the value of our property and equipment is impaired requires significant judgment, and could have a material impact on our balance sheet and results of operations. We have not had any write-downs for impairment in the value of our construction for improvements since our inception.

Research and development expenses

Our research and development expenses include certain expenses that are incurred over multiple reporting periods, such as fees for contractors and consultants, fees to collaborators for preclinical research studies, patient treatment costs related to clinical trials and related clinical manufacturing costs, and license fees for use of third-party intellectual property rights. Management assesses how much of these multi-period costs should be charged to research and development expense in each reporting period. In determining whether clinical trial activities and preclinical animal studies performed by third parties should be recognized in a specific reporting period, management considers:

	•	estimates of the percentage of work completed over the life of the individual study in accordance with agreements established with the third-party service providers; and

	•	estimates of the percentage of work completed over the life of the individual study in accordance with discussions with internal clinical and preclinical personnel and outside service providers as to the progress or stage of completion of trials or services and the agreed upon fee to be paid for such services.

The determination of the percentage of work completed that determines the amount of research and development expense that should be recognized in a given period requires significant judgment, and could have a material impact on our balance sheet and results of operations. These estimates may or may not match the actual services performed by the service providers as determined by patient

enrollment levels, preclinical animal study schedules, and related activities. We monitor service provider activities to the extent possible; however, if we underestimated activity levels associated with various studies at a given point in time, we could record significant research and development expenses in future periods.

Results of Operations

Three and nine months ended September 30, 2004 compared to the three and nine months ended September 30, 2003

Revenue

	Three Months Ended September 30,				Nine Months Ended September 30,

(Dollars in thousands)	2004		2003		2004		2003

Revenue	$	8	$	140	$	2,160	$	298

During the three months ended September 30, 2004, revenue primarily consisted of research license fees of $7,000 and royalty revenue of $1,000. Research license agreements allow the licensee to make or use products using our patented AAV technologies for research purposes only, and do not allow for the use of our technologies in products for commercial sale. These licenses usually include initiation fees and annual maintenance fees based on the initial date of the agreement, and therefore do not occur ratably throughout the year. All of our royalty revenue was attributed to a single royalty license that was entered into in July 2000, which allows for the development, manufacture, use and commercial sale of products using our patented AAV technologies. Revenue for the three months ended September 30, 2003 primarily consisted of research license fees of $13,000, royalty revenue of $2,000, and the recognition of $125,000 of deferred revenue from the $2.5 million payment received from Bayer in March 2003 in connection with our collaboration on the development of Coagulin-B for the treatment of hemophilia B to the liver. The payment was being recognized ratably over the estimated development period of the hemophilia B product candidate, which was estimated at five years from the date of the payment.

During the nine months ended September 30, 2004 and 2003, revenue primarily consisted of the recognition of $2.1 million and $250,000, respectively, of deferred revenue from the $2.5 million payment received from Bayer in 2003. As discussed above, the payment was being recognized ratably at $125,000 per quarter since June 2003. In May 2004, we suspended patient enrollment in the trial, which resulted in the termination of the development period of the liver-targeted product candidate associated with the Bayer payment, and the recognition of the remaining $2.0 million deferred revenue in the second quarter of 2004. During the nine-month periods ended September 30, 2004 and 2003, research license fees totaled $31,000 and $41,000, respectively, and royalty revenue totaled $4,200 and $7,000, respectively.

As a result of the recognition of the remaining amount of the Bayer payment in the second quarter of 2004, we expect that our revenues for the foreseeable future will consist solely of research license fees and royalty revenue, which we expect to be immaterial.

Research and Development Expenses

Our research and development expenses can be divided into two primary functions, costs to support research and preclinical development and costs to support preparation for and implementation of human clinical trials. Research and preclinical development costs include activities associated with general research and exploration, animal studies, production of vector for use by external collaborators in general research and exploration, and development of processes to translate research achievements into commercial scale capabilities. Clinical development costs include activities associated with preparing for regulatory approvals, maintaining regulated and controlled processes, manufacturing vector for use in human clinical trials, and supporting patient enrollment and patient administration within clinical trials.

During the three and nine months ended September 30, 2004 and 2003, our research and preclinical development expenses included activities for our development programs for hemophilia, Parkinson’s disease, neuropathic pain, and other neurological targets, and our clinical development expenses included activities to support our development programs for Coagulin-B and our product candidate AV201 for the treatment of Parkinson’s disease.

We estimate that the costs associated with these two categories approximate the following (in thousands):

	Three Months Ended September 30,				Percentage decrease over prior year			Nine Months Ended September 30,				Percentage decrease over prior year
	Three Months Ended September 30,							Nine Months Ended September 30,

	2004		2003					2004		2003

Research and preclinical development	$	3,326	$	3,765		(12	)%	$	9,943	$	10,317		(4	)%
Clinical development		1,642		1,829		(10	)%		5,087		5,668		(10	)%

Total research and development expenses	$	4,968	$	5,594		(11	)%	$	15,030	$	15,985		(6	)%

Because a significant percentage of our research and development resources are dedicated to activities that focus on fundamental platform technologies that may be used in many different product applications, including production and administration techniques, the majority of our costs are not directly attributed to individual development programs. Decisions regarding our project management and resource allocation are primarily based on interpretations of scientific data, rather than cost allocations. Our estimates of costs between research and preclinical development and clinical development are primarily based on staffing roles within our research and development departments. As such, costs allocated to specific projects may not necessarily reflect the actual costs of those efforts and, therefore, we do not generally evaluate actual costs-incurred information on a project-by-project basis. In addition, we are unable to estimate the future costs to completion for any specific projects.

Three Months Ended September 30, 2004 and 2003

The decrease of $439,000 in our research and preclinical development expenses in the third quarter of 2004, compared to the third quarter of 2003, was primarily due to changes in costs for the following:

		•	lower expenditures for services from third-party collaborators associated with our preclinical animal studies of $671,000, primarily related to the completion of a significant portion of our work with Parkinson’s disease in 2003,

		•	lower personnel-related expenses of $148,000, related to the staff reduction in July 2004 of approximately 18 employees, partially offset by higher average salaries in 2004, and

		•	lower materials expenses of $118,000, reflecting the benefits of operating efficiencies we have implemented over the last year in the production of our AAV vectors and the general decline in the amounts of AAV vectors needed to be produced to support our on-going research,

	partially offset by:

		•	severance expenses of $410,000 paid to employees affected by the staff reduction in July 2004, and

		•	bonus expenses of $102,000, reflecting the accrual and payment of bonuses in 2004 compared to no bonuses accrued at September 30, 2003.

The decrease of $187,000 in our clinical development expenses for the third quarter of 2004, compared to the third quarter of 2003, was primarily due to changes in costs for the following:

		•	lower personnel-related expenses of $178,000, related to the staff reduction in July 2004 of approximately 15 employees, partially offset by higher average salaries in 2004,

		•	lower materials expenses of $85,000, reflecting lower levels of materials consumed in 2004 for the production of clinical grade AAV vectors due to the delayed needs of our development programs at the clinical development stage,

		•	lower facilities expenses of $82,000 due to the decrease in the allocation of space held for clinical development activities to other research and warehousing functions in 2004,

		•	lower consulting services of $67,000, primarily related to validation services for new facilities and other process improvements developed in 2003, and

		•	lower expenditures to third-party collaborators associated with treating and monitoring subjects in our clinical trial of $56,000, reflecting the delayed progress in 2004 of our subject treatment timelines,

	partially offset by:

		•	severance expenses of $280,000 paid to employees affected by the staff reduction in July 2004.

Nine Months Ended September 30, 2004 and 2003

The decrease of $374,000 in our research and preclinical development expenses for the nine months ended September 30, 2004, compared to 2003, was primarily due to changes in costs for the following:

		•	lower materials expenses of $387,000, reflecting the benefits of operating efficiencies we have implemented over the last year in the production of our AAV vectors and the general decline in the amounts of AAV vectors needed to be produced to support our on-going research,

		•	lower expenditures for services from third-party collaborators associated with our preclinical animal studies of $368,000, primarily related to the completion of a significant portion of our work with Parkinson’s disease in 2003,

		•	lower use tax expenses of $261,000, related to payments in the first nine months of 2003 for materials that had not been properly assessed in previous years, and

		•	lower recruiting and relocation expenses of $194,000, reflecting the decline in hiring and the payment of relocation incentives in 2004 compared to 2003,

	partially offset by:

		•	higher severance expenses of $299,000, representing $410,000 paid to employees affected by the staff reduction in July 2004, compared to $111,000 paid to an executive in February 2003,

		•	higher facilities-related expenses of $225,000, related to the rise in costs under the new building lease that went into effect in June 2003,

		•	higher bonus expenses of $167,000, reflecting the accrual and payment of bonuses in 2004, compared to the reversal of accrued bonuses of $35,000 during the first nine months of 2003, and

		•	higher personnel-related expenses of $141,000, related to higher staff levels during the first six months of 2004 compared to 2003 and higher average salaries paid in 2004, partially offset by the impact of the staff reduction in July 2004.

The decrease of $581,000 in our clinical development expenses for the nine months ended September 30, 2004, compared to 2003, was primarily due to changes in costs for the following:

		•	lower materials expenses of $412,000, reflecting lower levels of materials consumed in 2004 for the production of clinical grade AAV vectors due to the delayed needs of our development programs at the clinical development stage,

		•	lower personnel-related expenses of $175,000, related to the staff reduction in July 2004 of approximately 15 employees, partially offset by higher average salaries in 2004,

		•	lower facilities expenses of $162,000 due to the decrease in the allocation of space to clinical development activities in 2004, and

		•	lower consulting services of $75,000, primarily related to validation services for new facilities and other process improvements developed in 2003,

	partially offset by,

		•	higher severance expenses of $145,000, representing $280,000 paid to employees affected by the staff reduction in July 2004, compared to $135,000 paid to an executive in February 2003, and

		•	higher bonus expenses of $67,000, reflecting the accrual and payment of bonuses in 2004 compared to the reversal of accrued bonuses of $14,000 during the first nine months of 2003.

Total research and development expenses for the three and nine months ended September 30, 2004 were within management’s expectations, taking into account the impact of the July 2004 staff reduction, the suspension of patient enrollment in the phase I clinical trial of Coagulin-B in May 2004, and the delay in the anticipated initiation of a clinical trial for AV201. We believe delays in regulatory approvals and patient scheduling and coordination will continue to be factors that contribute to slower progress in our future clinical trials. In addition, we expect our total research and development spending

for the fiscal year ending December 31, 2004 will decrease below our fiscal-year 2003 level and continue to decline into 2005 as a result of the impact of our lower staff levels and the pace of patient enrollment in clinical trials.

General and Administrative Expenses

	Three Months Ended September 30,				Percentage decrease over prior year			Nine Months Ended September 30,				Percentage increase over prior year

(Dollars in thousands)	2004		2003					2004		2003

General and administrative expenses	$	1,902	$	2,084		(9	)%	$	6,673	$	5,635		18	%

The decrease of $182,000 in our general and administrative expenses for the third quarter of 2004, compared to 2003, was primarily due to changes in costs for the following:

		•	lower personnel-related expenses of $123,000, reflecting the impact of a general decline in general and administrative staff levels during the last year, including the resignation of our former CEO in March 2004,

		•	lower professional service expenses of $94,000, primarily for legal support and corporate communications activities,

		•	lower travel and other corporate expenses of $135,000, primarily for insurance, and

		•	lower recruiting expenses of $65,000, reflecting the decline in hiring in 2004 compared to 2003,

	partially offset by,

		•	higher severance expenses of $110,000, paid to employees affected by the staff reduction in July 2004, and

		•	higher bonus expenses of $105,000, reflecting the accrual and payment of bonuses in 2004 compared to no bonuses accrued at September 30, 2003.

The increase of $1.0 million in our general and administrative expenses for the nine months ended September 30, 2004, compared to 2003, was primarily due to changes in costs for the following:

		•	higher severance expenses of $1.0 million, approximately $900,000 of which was accrued in connection with the resignation of our former CEO in March 2004 and approximately $110,000 paid to employees affected by the staff reduction in July 2004,

		•	higher bonus expenses of $311,000, reflecting the accrual and payment of bonuses in 2004 compared to the reversal of $101,000 of accrued bonuses during the nine months ended September 30, 2003, and

		•	higher facilities-related expenses of $270,000, related to the rise in costs under the new building lease that went into effect in June 2003,

	partially offset by,

		•	lower personnel-related expenses of $142,000, reflecting the impact of a general decline in general and administrative staff levels during the last year, including the resignation of our former CEO in March 2004,

		•	lower travel and other corporate expenses of $141,000, primarily for insurance,

		•	lower depreciation expenses of $120,000, as many of our office equipment and furniture assets reach the end of their depreciable lives,

		•	lower recruiting expenses of $83,000, reflecting the decline in hiring in 2004 compared to 2003, and

		•	lower professional service expenses of $82,000, primarily for legal support, business consulting, and corporate communications activities.

We expect our general and administrative expenses for the fiscal year ending December 31, 2004 to approximate the levels reported for the fiscal-year ended December 31, 2003, as higher severance costs for the year are offset by lower operating costs, and to decline slightly in 2005.

Interest Income

	Three Months Ended September 30,					Nine Months Ended September 30,

(Dollars in thousands)	2004			2003		2004			2003

Interest Income	$	449		$	699	$	1,496		$	2,602
Percentage decrease over prior period		(36	)%				(43	)%

Almost all of our interest income is generated from our investments in high-grade marketable securities of government and corporate debt. The decline in interest income for the three- and nine- month periods ended September 30, 2004 as compared to the same periods in 2003 was primarily due to the decrease in outstanding interest-bearing cash and securities balances due to resources having been used to fund our on-going operations during the last year.

Liquidity and Capital Resources

Since our inception in 1992, cash expenditures have significantly exceeded our revenue. We have funded our operations primarily through public offerings and private placements of our equity securities. After our initial public offering in May 1996, we raised $189 million from private placements and public offerings of our common stock and warrants to purchase our common stock, and we received $2.5 million in research support from Bayer Corporation in March 2003.

In addition to funding our operations through sales of our common stock, we have attempted to contain costs and reduce cash flow requirements by renting scientific equipment and facilities, contracting with third parties to conduct research and development and using consultants, where appropriate. We expect to incur additional future expenses, resulting in significant additional cash expenditures, as we continue our research and development activities and undertake additional preclinical studies and clinical trials of our product candidates. We also expect to incur substantial additional expenses relating to the filing, prosecution, maintenance, defense and enforcement of patent and other intellectual property claims.

At September 30, 2004, we had cash, cash equivalents, available-for-sale securities, and

restricted investments of approximately $81.2 million, compared to approximately $98.9 million at December 31, 2003. At September 30, 2004 and December 31, 2003, $11.9 million was pledged to secure certain long-term liabilities which included $10.0 million for our line of credit, $1.5 million for equipment operating leases, and approximately $428,000 for letters of credit which serve as security deposits on our building lease. Our restricted investments are reported as a long-term asset and would not be considered a current source of additional liquidity.

In July 2004, we eliminated 37 staff positions, thereby reducing our staff level to approximately 65 employees in order to reduce our ongoing operating expenses and extend the life of our current financial resources. The eliminated positions were primarily in research and development areas. During the three-months ended September 30, 2004, we incurred approximately $800,000 in severance payments and other termination-related benefits, of which $110,000 was included in general and administrative expenses and $690,000 was included in research and development expenses. All severance-related costs were paid as of September 30, 2004. We believe that the future annual savings in personnel costs, including salaries, benefits, and temporary staffing, will approximate $3.1 million.

In June 2004, we amended the terms of a $10.0 million revolving line of credit which had been put in place with Wells Fargo Bank in June 2000, and amended in June 2002, to provide support for construction related activities. Under the terms of the current amendment, the expiration date of the borrowing was extended from June 1, 2005 to June 1, 2007, thereby deferring the timetable to repay principal borrowed for two years.

Our commitments under leases and other obligations as of September 30, 2004 were not materially different from that as of December 31, 2003. As of December 31, 2003, we had commitments under leases and other obligations totaling $24.1 million, payable in varying amounts over more than five years, as more fully described in Item 7 of our Annual Report on Form 10-K filed with the SEC on March 15, 2004.

During the nine months ended September 30, 2004, net cash used in operating activities was $17.1 million, primarily due to the net loss of $18.3 million for the period. The cash used in operating activities was primarily used to support our internal research and development activities, as well as preclinical studies and clinical trials performed by third parties. The level of cash used for operating activities during the nine months ended September 30, 2004 was slightly lower than management’s expectations at the beginning of the year due to general delays in the progress of our clinical trials.

During the nine months ended September 30, 2004, $16.7 million and $493,000 was provided by investing and financing activities, respectively. The cash provided by investing activities consisted primarily of maturities, net of purchases, of available-for-sale securities, offset to a small degree by purchases of property and equipment of $446,000. The cash provided by financing activities consisted of proceeds from the exercise of stock options and warrants during the period.

We have announced that we are actively seeking to broaden our portfolio of drug development candidates through an in-licensing program, and that this effort has identified several validated compounds that are being investigated, some of which have experience in human clinical trials. If we are successful in in-licensing or otherwise acquiring compounds, and we pay for such programs in cash, our capital resources will be reduced. Further, any in-license of compounds in greater amounts than we currently project could cause our expenses to increase beyond our current expectations.

We believe that we will continue to require substantial additional funding in order to complete the research and development activities currently contemplated and to commercialize our proposed products. We believe that with the implementation of the staff reduction in July 2004 and our projected

lower levels of spending to support ongoing operations, our capital resources at September 30, 2004 will be adequate to fund our current operating needs for approximately four years. However, this forward-looking statement is based upon our current plans and assumptions regarding our future operating and capital requirements, which may change. Our future operating and capital requirements will also depend on many other factors, including:

	•	how successful, if at all, we are at in-licensing compounds, and the nature of the consideration we pay for in-licensing compounds;

	•	continued scientific progress in research and development programs;

	•	the scope and results of preclinical studies and clinical trials;

	•	the time and costs involved in obtaining regulatory approvals;

	•	the costs involved in filing, prosecuting and enforcing patent claims and other intellectual property rights;

	•	competing technological developments;

	•	the cost of manufacturing scale-up;

	•	the cost of commercialization activities; and

	•	other factors which may not be within our control.

We intend to continue to seek additional funding through public or private equity or debt financing, when market conditions allow, or through additional collaborative arrangements with corporate partners. If we raise additional funds by issuing equity securities, there may be further dilution to existing stockholders. We cannot assure our investors that we will be able to enter into such financing arrangements on acceptable terms or at all. Without such additional funding, we may be required to delay, reduce the scope of, or eliminate one or more of our research or development programs.

RISK FACTORS

This section briefly discusses certain risks that should be considered by stockholders and prospective investors in Avigen. Some of these risks are discussed in other contexts in other sections of this report.

We expect to continue to operate at a loss and we may never achieve profitability

Since our inception in 1992, we have not been profitable, and we cannot be certain that we will ever achieve or sustain profitability. To date, we have been engaged in research and development activities and have not generated any revenues from product sales. As of September 30, 2004, we had an accumulated deficit of $150.9 million. We currently have one product candidates in clinical trials, AV201 for Parkinson’s disease. However we only recently received authorization from the FDA and other authorities to begin the trial, and have not yet treated a subject or incurred costs associated with screening, treating, and monitoring participants in this trial. Developing our products will require significant additional research and development, preclinical testing and clinical trials, as well as regulatory approval. We expect these activities, together with our general and administrative expenses,

to result in operating losses for the foreseeable future. Our ability to achieve profitability will depend, in part, on our ability to successfully complete development of our proposed products, obtain required regulatory approvals and manufacture and market our products directly or through business partners.

The success of our technology in animal models does not guarantee that the same results will be replicated in humans

Even though our product candidates have shown successful results in mouse, dog, and non-human primate models, animals are different than humans and results in animal models may not be replicated in our clinical trials with humans. For example, while the results of our gene therapy treatment for hemophilia B were favorable and demonstrated sustained long-term expression in both dogs and mice for multiple years, the one human subject who demonstrated therapeutic levels of circulating factor IX when given a comparable dose size to that used in the successful animal studies was not able to sustain steady factor IX expression beyond five weeks. In addition, this human subject experienced a mild, temporary elevation of two liver enzymes, which was not seen in any of the animal models. Further, we have observed an immune system response in subjects treated with Coagulin-B that was not observed in the animal models, which we have not yet been able to, and may not be able to, adequately address. In May 2004, we suspended patient enrollment in our phase I clinical trial of Coagulin-B. Consequently, you should not rely on the results in any of our animal models as being predictive of the results that we will see in our clinical trials with humans.

Adverse events in the field of gene therapy may negatively impact regulatory approval or public perception of our potential products

The commercial success of our potential products will depend in part on public acceptance of the use of gene therapy for the prevention or treatment of human diseases. Public attitudes may be influenced by claims that gene therapy is unsafe, and consequently our products may not gain the acceptance of the public or the medical community. Negative public reaction to gene therapy in general could result in greater government regulation and stricter labeling requirements of gene therapy products, including any of our products, and could cause a decrease in the demand for any products we may develop.

Our stock price is also influenced by public perception. For example, in January 2003, a report of serious adverse events in a retroviral trial for infants with severe combined immune deficiency (SCID) in France and subsequent FDA actions putting related trials on hold in the United States had a significant impact on the public perception and stock price of all companies involved in gene therapy. Avigen’s stock declined despite the fact that we do not work with retroviruses or with infants with SCID and our clinical trial was not affected by the FDA’s actions in this case.

Other potential adverse events in the field of gene therapy may occur in the future that could result in greater governmental regulation of our potential products and potential regulatory delays relating to the testing or approval of our potential products.

AAV technology is new and developing rapidly; there is limited clinical data and new information may arise which may cause delays in designing our protocols, submitting applications that satisfy all necessary regulatory review requirements, and ultimately completing the clinical trials of our products

Clinical trials are governed by regulations enforced by the FDA. Our technology is fairly new, and we have limited historical data from preclinical studies or clinical trials that are often necessary to satisfy the FDA’s regulatory review process. In addition, as new information about the technology

becomes available, it may change perceptions of previously accepted data, which could require additional periods of time to review and interpret these data. For example, while animals in preclinical studies do not appear to develop antibodies to the AAV vector or the expressed protein, further clinical testing is required to confirm to what extent our product candidates might cause human patients to develop antibodies to these potential products or the proteins produced by these potential products. Such antibodies could make our product ineffective or lead to unwanted side effects. In addition, prior to suspending patient enrollment in our clinical trial for Coagulin-B, we observed the mild, temporary elevation of two liver enzymes, which were not seen in any of the animal models and the inability to sustain steady factor IX expression beyond five weeks. Consequently, we may encounter deficiencies in the design or application stages while developing our clinical trial studies, or in the subsequent implementation stages of such studies, which could cause us or the FDA to delay, suspend or terminate our trials at any time.

Because our product candidates are in an early state of development, there is a high risk that they may never be commercialized

All of our product candidates are in early stages of development. We do not have any product candidates that have received regulatory approval for commercial sale, and we face the risk that none of our product candidates will ever receive regulatory approval. We have received authorization from the FDA to initiate a phase I clinical trial for AV201, our product candidate for the treatment of Parkinson’s disease. We are not aware of any other gene therapy products of other companies that have received regulatory approval for commercial sale in the United States, and do not expect any of our prospective products, including AV201, to be commercially available for at least several years, if at all. As results of future stages of clinical trials become available and are evaluated, we may decide at any time to discontinue any further development of one or more of our product candidates.

The testing of our potential products relies heavily on the voluntary participation of patients in our clinical trials, which is not within our control, and could substantially delay or prevent us from completing development of such products

The development of our potential products is dependent upon collecting sufficient data from human clinical trials to demonstrate safe and effective results. We experienced delays in enrolling patients in our former clinical trials for Coagulin-B. We may experience similar difficulties in any future clinical trials. Any delay or failure to recruit sufficient numbers of patients to satisfy the level of data required to be collected under clinical trial protocols could prevent us from developing any products we may target.

Our potential products must undergo rigorous clinical testing and regulatory approvals, which could substantially delay or prevent us from marketing any products

Prior to marketing in the United States, any product developed by us must undergo rigorous preclinical testing and clinical trials as well as an extensive regulatory approval process implemented by the FDA. This process is lengthy, complex and expensive, and approval is never certain. Positive results from preclinical studies and early clinical trials do not ensure positive results will be demonstrated in clinical trials designed to permit application for regulatory approval.

Potential problems we may encounter in the implementation stages of our studies include the chance that we may not be able to conduct clinical trials at preferred sites, obtain sufficient test subjects or begin or successfully complete clinical trials in a timely fashion, if at all. Furthermore, the FDA may temporarily suspend clinical trials at any time if it believes the subjects participating in trials are being exposed to unacceptable health risks, if it finds deficiencies in the clinical trial process or conduct of the

investigation, or to better analyze data surrounding any unexpected developments. For example, prior to its discontinuation, progress in our Coagulin-B clinical trial had been interrupted twice to better analyze data from unexpected observations. These included the identification of vector fragments in the seminal fluid of two early patients beyond an expected timeframe and the development reported in December 2002 of a temporary elevation in the levels of two liver enzymes in one patient treated with a higher dose.

Because of the risks and uncertainties in biopharmaceutical development, our gene therapy products could take a significantly longer time to gain regulatory approval than we expect or may never gain FDA approval. If we do not receive these necessary approvals from the FDA, we will not be able to market our products in the United States or generate substantial revenues, and will not become profitable.

We may not be successful in obtaining required foreign regulatory approvals, which would prevent us from marketing our products internationally

We cannot be certain that we will obtain any regulatory approvals in other countries. In order to market our products outside of the United States, we must comply with numerous and varying foreign regulatory requirements implemented by foreign regulatory authorities. The approval procedure varies among countries and can involve additional testing. The time required to obtain approval may differ from that required to obtain FDA approval. The foreign regulatory approval process includes all of the risks associated with obtaining FDA approval set forth above, and approval by the FDA does not ensure approval by the regulatory authorities of any other country.

Our success is dependent upon our ability to effectively protect our patents and proprietary rights, which we may not be able to do

Our success will depend to a significant degree on our ability to obtain patents and licenses to patent rights, preserve trade secrets, and to operate without infringing on the proprietary rights of others. If we are not successful in these endeavors, our business will be substantially impaired.

To date, we have filed a number of patent applications in the United States relating to technologies we have developed or co-developed. In addition, we have acquired exclusive and non-exclusive licenses to certain issued patents and pending patent applications. We cannot guarantee that patents will issue from these applications or that any patent will issue on technology arising from additional research or, if patents do issue, that claims allowed will be sufficient to protect our technologies.

The patent application process takes several years and entails considerable expense. The failure to obtain patent protection on the technologies underlying our proposed products may have a material adverse effect on our competitive position and business prospects. Important legal issues remain to be resolved as to the scope of patent protection for biotechnology products, and we expect that administrative proceedings, litigation or both may be necessary to determine the validity and scope of our and others’ biotechnology patents. These proceedings or litigation may require a significant commitment of our resources in the future.

If patents can be obtained, we cannot assure you that any of these patents will provide us with any competitive advantage. For example, others may independently develop similar technologies or duplicate any technology developed by us, and patents may be invalidated in litigation.

In addition, several of our patents and patent applications are co-owned with co-inventors or institutions. To date, we have negotiated exclusive licenses for many of our co-invented technologies.

However, if we cannot negotiate exclusive rights to other co-owned technology, each co-inventor may have rights to independently make, use, offer to sell, or sell the patented technology. Commercialization, assignment, or licensing of the technology by a co-inventor could harm our business.

We also rely on a combination of trade secret and copyright laws, employee and third-party nondisclosure agreements and other protective measures to protect intellectual property rights pertaining to our products and technologies. We cannot be certain that these measures will provide meaningful protection of our trade secrets, know-how, or other proprietary information. In addition, the laws of certain foreign countries do not protect our intellectual property rights to the same extent as do the laws of the United States. We cannot assure you that we will be able to protect our intellectual property successfully.

Other persons may assert rights to our proprietary technology, which could be costly to contest or settle

Third parties may assert patent or other intellectual property infringement claims against us with respect to our products, technologies, or other matters. Any claims against us, with or without merit, as well as claims initiated by us against third parties, can be time-consuming and expensive to defend or prosecute and resolve. There may be third-party patents and other intellectual property relevant to our products and technology which are not known to us. We have not been accused of infringing any third party’s patent rights or other intellectual property, but we cannot assure you that litigation asserting claims will not be initiated, that we would prevail in any litigation, or that we would be able to obtain any necessary licenses on reasonable terms, if at all. If our competitors prepare and file patent applications in the United States that claim technology also claimed by us, we may have to participate in interference proceedings declared by the Patent and Trademark Office to determine priority of invention, which could result in substantial cost to us, even if the outcome is favorable to us. In addition, to the extent outside collaborators apply technological information developed independently by them or by others to our product development programs or apply our technologies to other projects, disputes may arise as to the ownership of proprietary rights to these technologies.

We may be required to obtain rights to proprietary genes and other technologies to further develop our business, which may not be available or may be costly

We currently investigate and use certain gene sequences or proteins encoded by those sequences, including the factor VIII and IL-10 genes, and manufacturing processes that are or may become patented by others. As a result, we may be required to obtain licenses to these gene sequences, proteins, manufacturing processes, or other technology in order to test, use or market products. We may not be able to obtain these licenses on terms favorable to us, if at all. In connection with our efforts to obtain rights to these gene sequences, proteins, manufacturing processes, or other technology, we may find it necessary to convey rights to our technology to others. Some of our gene therapy products may require the use of multiple proprietary technologies. Consequently, we may be required to make cumulative royalty payments to several third parties. These cumulative royalties could become commercially prohibitive. We may not be able to successfully negotiate these royalty adjustments to a cost effective level, if at all.

If we do not achieve certain milestones, we may not be able to retain certain licenses to our intellectual property

We have entered into license agreements with third parties for technologies related to our gene therapy product development programs. Some of these license agreements provide for the achievement of development milestones. If we fail to achieve these milestones or to obtain extensions, the licensor

may terminate these license agreements with relatively short notice to us. Termination of any of our license agreements could harm our business.

If we are able to bring our potential products to market, we continue to face a number of risks including our inexperience in marketing or selling our potential products, the acceptance of gene therapy products by physicians and insurers, our ability to price our products effectively and to obtain adequate reimbursement for sales of our products.

Even if we are able to develop our potential products and obtain necessary regulatory approvals, we have no experience in marketing or selling any of our proposed products. We intend to enter into distribution and marketing agreements with other companies for our potential products and do not anticipate establishing our own sales and marketing capabilities for any of our potential products in the foreseeable future. However, if we are unable to do so, we would need to market our potential products ourselves, and we may not be able to establish adequate marketing capabilities for our potential products, either on our own or through other third parties.

Our success is dependent on acceptance of our products. We cannot assure you that our products will achieve significant market acceptance among patients, physicians or third-party payors, even if we obtain necessary regulatory and reimbursement approvals. Failure to achieve significant market acceptance will harm our business. In addition, we cannot assure you that these products will be considered cost-effective and that reimbursement to the consumer will be available or will be sufficient to allow us to sell our products on a profitable basis. In both the United States and elsewhere, sales of medical products and treatments are dependent, in part, on the availability of reimbursement to the consumer from third-party payors, such as government and private insurance plans. Third-party payors are increasingly challenging the prices charged for medical products and services. We cannot predict whether any legislative or regulatory proposals will be adopted or the effect of such potential proposals or managed care efforts may have on our business.

We expect that we will face intense competition, which may limit our ability to become profitable

Our competitors may develop more effective or more affordable products, or commercialize products earlier than we do, which would limit the prices that we could charge for the products that we are able to market, and prevent us from becoming profitable. We expect increased competition from fully integrated pharmaceutical companies and more established biotechnology companies. Most of these companies have significantly greater financial resources and expertise than we do in research and development, preclinical studies, clinical trials, obtaining regulatory approvals, manufacturing, and marketing and distribution.

Smaller companies may also prove to be significant competitors, particularly through collaborative arrangements with large pharmaceutical companies. Academic institutions, government agencies and other public and private research organizations also conduct research, seek patent protection and establish collaborative arrangements for product development and marketing. In addition, these companies and institutions compete with us in recruiting and retaining highly qualified scientific and management personnel.

We are aware that other companies are conducting preclinical studies and clinical trials for viral and non-viral gene therapy products that could compete with products we are developing.

We have limited experience in manufacturing our potential products at a commercial scale, which raises uncertainty about our ability to manufacture our potential products cost-effectively

Even if we are able to develop our potential products and obtain necessary regulatory approvals, we have limited experience in manufacturing any of our proposed products on a commercial basis. If we are unable to manufacture our products in a cost-effective manner, we are not likely to become profitable. We have not yet received a license from the FDA for our manufacturing facilities, and cannot apply for one until we submit our product for commercial approval. Even if we do receive a manufacturing license, we may fail to maintain adequate compliance with the FDA’s regulations concerning current good manufacturing practices (GMP), in which case the license, and our authorization to manufacture product, could be revoked.

We may lose access to critical materials from single source suppliers, which is not within our control and could delay us from manufacturing vector needed to support our clinical trials or future commercialization

We obtain materials used in the manufacture of our clinical vector products from a number of suppliers, some of whom are our sole qualified source of these materials. We qualify the suppliers of our clinical materials according to GMP regulations. If we were to lose access to critical materials from any of these sole-source suppliers, we would be required to obtain a new source of the materials. It could take us several months to qualify new suppliers before we could use their materials in the manufacture of our clinical vector products.

We may be unable to attract and retain the qualified employees, consultants and advisors we need to be successful

We are highly dependent on key members of our senior management and scientific staff. The loss of any of these persons could substantially impair our research and development efforts and impede our ability to develop and commercialize any of our products. Recruiting and retaining qualified scientific, technical and managerial personnel will also be critical to our success. Biotechnology personnel with these skills are in high demand. As a result, competition for and retention of personnel, particularly for employees with technical expertise, is intense and the turnover rate for these people can be high.

In addition, we rely on consultants and advisors to assist us in formulating our research and development strategy. A majority of our scientific advisors are engaged by us on a consulting basis and are employed on a full-time basis by others. We have limited control over the activities of these scientific collaborators which often limit their availability to us. Failure of any of these persons to devote sufficient time and resources to our programs could delay our progress and harm our business. In addition, some of these collaborators may have consulting or other advisory arrangements with other entities that may conflict or compete with their obligations to us.

We face the risk of liability claims which may exceed the scope or amount of our insurance coverage

The manufacture and sale of medical products entail significant risk of liability claims. We currently carry liability insurance; however, we cannot assure you that this coverage will remain in place or that this coverage will be adequate to protect us from all liabilities which we might incur in connection with the use of our products in clinical trials or the future use or sale of our products upon commercialization. In addition, we may require increased liability coverage as additional products are used in clinical trials and commercialized. This insurance is expensive and may not be available on acceptable terms in the future, if at all. A successful liability claim or series of claims brought against us in excess of our insurance coverage could harm our business. We must indemnify certain of our

licensors against any liability claims brought against them arising out of products developed by us under these licenses.

Our use of hazardous materials exposes us to the risk of environmental liabilities, and we may incur substantial additional costs to comply with environmental laws in connection with the operation of our research and manufacturing facilities

We use radioactive materials and other hazardous substances in our research and development and manufacturing operations. As a result, we are potentially subject to substantial liabilities related to personal injuries or property damages they may cause. In addition, clean up costs associated with radioactivity or other hazardous substances, and related damages or liabilities could be significant and could harm our business. We are required to comply with increasingly stringent laws and regulations governing environmental protection and workplace safety which could impose substantial fines and criminal sanctions for violations. Maintaining compliance with these laws and regulations could require substantial additional capital.

Risks Related to Our Stock

Anti-takeover effects of certain charter provisions and Delaware law may negatively affect the ability of a potential buyer to purchase some or all of our stock at an otherwise advantageous price, which may limit the price investors are willing to pay for our common stock

Certain provisions of our charter and Delaware law may negatively affect the ability of a potential buyer to attempt an acquisition of takeover of Avigen, which may have a negative effect on the price investors are willing to pay for our common stock. For example, our board of directors has the authority to issue up to 5,000,000 shares of preferred stock and to determine the price, rights, preferences, and privileges of those shares without any further vote or action by the stockholders. This would enable our board of directors to establish a stockholder rights plan, commonly referred to as a “poison pill,” which would have the effect of making it more difficult for a third party to acquire a majority of the outstanding voting stock of Avigen. In addition, our board of directors is divided into three classes, and each year on a rotating basis the directors of one class are elected for a three-year term. This provision could have the effect of making it less likely that a third party would attempt to obtain control of Avigen through Board representation. Furthermore, certain other provisions of our charter may have the effect of delaying or preventing changes in control or management, which could adversely affect the market price of our common stock. In addition, we are subject to the provisions of Section 203 of the Delaware General Corporation Law, an anti-takeover law.

Our stock price is volatile, and as a result investing in our common stock is very risky

From September 30, 2002 to October 31, 2004, our stock price has fluctuated between a range of $10.33 and $2.69 per share. In addition, in recent years, the stock market in general, and the shares of biotechnology and health care companies in particular, have experienced extreme price fluctuations. We believe that in addition to broad market and industry fluctuations that may cause the market price of our common stock to decline dramatically, various other factors may cause the market price of our common stock to continue to fluctuate, perhaps substantially, including announcements of:

	•	technological innovations or regulatory approvals;

	•	results of clinical trials;

	•	new products by us or our competitors;

	•	developments or disputes concerning patents or proprietary rights;

	•	achieving or failing to achieve certain developmental milestones;

	•	public concern as to the safety of gene therapy, recombinant biotech or traditional pharmaceutical products;

	•	health care or reimbursement policy changes by governments or insurance companies;

	•	developments in relationships with corporate partners; or

	•	a change in financial estimates or securities analysts’ recommendations.

Item 3. Quantitative and Qualitative Disclosure About Market Risk

Our market risk disclosures set forth in Item 7A of our Annual Report on Form 10-K for the year ended December 31, 2003, have not changed significantly. We have evaluated the risk associated with our portfolios of investments in marketable securities and have deemed this risk to be immaterial. If market interest rates were to increase by 100 basis points, or 1%, from their September 30, 2004 levels, we estimate that the fair value of our securities portfolio would decline by approximately $848,000 compared to our estimated exposure of $1.1 million at December 31, 2003, primarily due to the reduction in size of our overall portfolio.

Item 4. Controls and Procedures

Evaluation of disclosure controls and procedures. Our management, with the participation of our chief executive officer and chief financial officer, has evaluated our disclosure controls and procedures (as defined in Securities Exchange Act Rules 13a-15(e) and 15d-15(e)) as of September 30, 2004 and concluded that they were effective to provide a reasonable assurance that the information required to be disclosed by us in this Quarterly Report on Form 10-Q was recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and Form 10-Q.

Changes in internal control over financial reporting. There were no changes in our internal control over financial reporting during the three months ended September 30, 2004 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

PART II. OTHER INFORMATION

Item 1. Legal Proceedings

As of October 31, 2004, we were not involved in any material legal proceedings.

Item 2. Unregistered Sales of Securities and Use of Proceeds

None.

Item 3. Defaults Upon Senior Securities

None.

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

None.

Item 5. Other Information

Consistent with Section 10A(i)(2) of the Securities Exchange Act of 1934, as added by Section 202 of the Sarbanes-Oxley Act of 2002, we are responsible for listing the non-audit services approved by our Audit Committee to be performed by Ernst & Young LLP, our external auditor. Non-audit services are defined as services other than those provided in connection with an audit or a review of our financial statements. The Audit Committee has approved our recurring engagements of Ernst & Young LLP for the following non-audit services: (1) preparation of tax returns, and tax advice in preparing for and in connection with such filings; (2) all work required to be performed by Ernst & Young LLP in connection with preparing and giving consents required to be given in connection with our filings with the Securities and Exchange Commission; (3) all work required to be performed by Ernst & Young LLP in connection with preparing and giving consents required to be given in connection with our filing on June 22, 2004 with the Securities and Exchange Commission of a Form S-8 to register 250,000 shares of the Company’s common stock pursuant to the amendment to the Company’s 1996 Non-Employee Director’s Stock Option Plan that was approved at the Company’s annual meeting of stockholders in May 2004; and (4) advice in preparing for the internal control documentation requirements of Section 404 of the Sarbanes-Oxley Act of 2002.

Item 6. Exhibits

The following exhibits are included herein:

Exhibit No.		Description

3.1*		Amended and Restated Certificate of Incorporation
3.1.1**		Certificate of Amendment to Certificate of Incorporation
3.2*		Restated Bylaws of the Registrant
4.1*		Specimen Common Stock Certificate
4.2		Reference is made to Exhibits 3.1, 3.1.1 and 3.2
10.55		Arrangement Regarding Non-Employee Director Compensation
31.1		Certification of Principal Executive Officer required by Rule 13a-14(a) or Rule 15d-14(a)
31.2		Certification of Principal Financial Officer required by Rule 13a-14(a) or Rule 15d-14(a)
32.1		Certification required by Rule 13a-14(b) or Rule 15d-14(b) and Section 1350 of Chapter 63 of Title 18 of the United States Code (18 U.S.C. §1350)


*	Filed as an exhibit to Avigen’s Registration Statement on Form S-1 (No. 333-3220) and incorporated herein by reference.
**	Incorporated by reference from such document filed with the SEC as an exhibit to Avigen’s Quarterly Report on Form 10-Q for the quarter ended December 31, 2000 (Commission file number 0-28272), as filed with the SEC on February 13, 2001.

SIGNATURES

Pursuant to the requirements of the Securities and Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

	AVIGEN, INC.

Date: November 5, 2004	By:	/s/ KENNETH G. CHAHINE

		Kenneth G. Chahine Chief Executive Officer and President

Date: November 5, 2004	By:	/s/ THOMAS J. PAULSON

		Thomas J. Paulson Vice President Finance, Chief Financial and Accounting Officer, and Secretary

EXHIBIT INDEX

Exhibit No.		Description

3.1*		Amended and Restated Certificate of Incorporation
3.1.1**		Certificate of Amendment to Certificate of Incorporation
3.2*		Restated Bylaws of the Registrant
4.1*		Specimen Common Stock Certificate
4.2		Reference is made to Exhibits 3.1, 3.1.1 and 3.2
10.55		Arrangement Regarding Non-Employee Director Compensation
31.1		Certification of Principal Executive Officer required by Rule 13a-14(a) or Rule 15d-14(a)
31.2		Certification of Principal Financial Officer required by Rule 13a-14(a) or Rule 15d-14(a)
32.1		Certification required by Rule 13a-14(b) or Rule 15d-14(b) and Section 1350 of Chapter 63 of Title 18 of the United States Code (18 U.S.C. §1350)


*	Filed as an exhibit to Avigen’s Registration Statement on Form S-1 (No. 333-3220) and incorporated herein by reference.
**	Incorporated by reference from such document filed with the SEC as an exhibit to Avigen’s Quarterly Report on Form 10-Q for the quarter ended December 31, 2000 (Commission file number 0-28272), as filed with the SEC on February 13, 2001.