UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934



For the quarter ended: ~~September 30, 2005~~March 31, 2006	Commission File Number:	~~Commission File Number:~~0-19871

STEMCELLS, INC.

(Exact name of registrant as specified in its charter)


DELAWARE		94-3078125

(State or other jurisdiction of		(I.R.S. Employer
incorporation or organization)		identification No)

3155 PORTER DRIVE
PALO ALTO, CA 94304
(Address of principal executive offices including zip code)

(650) 475-3100
(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 twelve months (or for such shorter periods that the registrant was required to file such reports) and (2) has been subject to such filing requirements for the past 90 days.

Yesþ Noo

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, ~~as defined~~or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange ~~Act Rule 12b-2.~~Act. (Check One):

~~Yes~~þ No


Large accelerated filero		Accelerated filerþ		Non-accelerated filero

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the ~~Securities~~ Exchange ~~Act of 1934)~~

Act). Yeso Noþ

At ~~October~~April 26, ~~2005,~~2006, there were ~~64,705,670~~77,733,866 shares of Common Stock, $.01 par value, issued and outstanding.

PART I — ITEM 1 — FINANCIAL STATEMENTS

STEMCELLS, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS


	September 30, 2005			December 31, 2004			March 31, 2006			December 31, 2005
	(unaudited)						(unaudited)
Assets
Current assets:
Cash and cash equivalents	$	34,970,584		$	41,059,532		$	30,875,874		$	34,540,908
Receivables		151,661			180,963			350,027			201,919
Other current assets		446,914			209,074			560,107			386,966

Total current assets		35,569,159			41,449,569			31,786,008			35,129,793

Marketable securities		3,820,963			—			2,420,467			3,720,794
Property, plant and equipment, net		3,386,880			3,424,294			3,258,350			3,282,588
Other assets, net		2,679,166			2,753,419			2,679,177			2,705,513

Total assets	$	45,456,168		$	47,627,282		$	40,144,002		$	44,838,688


Liabilities and stockholders’ equity
Current liabilities:
Accounts payable	$	550,238		$	524,917		$	722,126		$	637,122
Accrued expenses		851,537			1,547,370			937,524			1,483.300
Accrued wind-down expenses, current portion		1,151,116			1,013,460			1,181,962			1,118,796
Capital lease obligations, current portion		54,676			52,843			54,676			54,676
Bonds payable, current portion		251,667			244,167			256,667			254,167

Total current liabilities		2,859,234			3,382,757			3,152,955			3,548,061

Capital lease obligations less current maturities		—			41,065
Bonds payable, less current maturities		1,416,250			1,605,417			1,286,250			1,351,250
Deposits & other long-term liabilities		514,953			610,126
Deposits and other long-term liabilities								522,866			522,866
Accrued wind-down expenses, non-current portion		5,569,038			4,514,569			6,002,680			6,186,930
Deferred rent		710,318			523,801			965,859			853,997

Total liabilities		11,069,793			10,677,735			11,930,610			12,463,104

Stockholders’ equity:
Common stock, $.01 par value; 125,000,000 shares authorized; 64,430,494 and 62,129,407 shares issued and outstanding at September 30, 2005 and December 31, 2004, respectively		644,304			621,293
Common stock, $.01 par value; 125,000,000 shares authorized; 65,983,046 and 65,396,022 shares issued and outstanding at March 31, 2006 and December 31, 2005, respectively								659,830			653,960
Additional paid in capital		215,512,017			211,419,300			219,244,727			217,919,336
Accumulated deficit		(181,616,026	)		(174,205,214	)		(190,136,691	)		(185,943,565	)
Accumulated other comprehensive loss		(153,920	)		—			(1,554,474	)		(254,147	)
Deferred compensation		—			(885,832	)

Total stockholders’ equity		34,386,375			36,949,547			28,213,392			32,375,584

Total liabilities and stockholders’ equity	$	45,456,168		$	47,627,282		$	40,144,002		$	44,838,688

PART I — ITEM 1 — FINANCIAL STATEMENTS

STEMCELLS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(unaudited)


	Three months ended						Nine months ended						Three months ended
	September 30,						September 30,						March 31,
	2005			2004			2005			2004			2006			2005
Revenue:
Revenue from grants and licensing agreements	$	91,255		$	4,541		$	163,345		$	103,470

Revenue from grants													$	37,550		$	26,092
Revenue from licensing agreements														4,000			9,229

Total revenue		91,255			4,541			163,345			103,470			41,550			35,321
Operating expenses:
Research and development		2,526,542			2,075,025			6,453,835			5,882,366			2,691,881			1,618,932
General and administrative		1,359,463			904,104			3,479,943			2,645,092			1,677,324			1,505,203
Wind-down expenses		297,184			1,345,564			2,015,384			1,943,707			156,117			520,974

Total operating expenses		4,183,189			4,324,693			11,949,162			10,471,165			4,525,322			3,645,109

Loss from operations		(4,091,934	)		(4,320,152	)		(11,785,817	)		(10,367,695	)		(4,483,772	)		(3,609,788	)

Other income (expense):
Interest income		301,255			82,531			790,407			158,942			339,814			227,763
Interest expense		(42,021	)		(46,093	)		(133,777	)		(145,025	)		(38,593	)		(46,411	)
License and settlement agreement, net		3,747,601			—			3,747,601			—
Other income (expense)		(8,594	)		(53,886	)		(29,226	)		(57,081	)		(10,575	)		(20,397	)

Total other income (expense)		3,998,241			(17,448	)		4,375,005			(43,164	)		290,646			160,955

Net loss applicable to common stockholders														(4,193,126	)		(3,448,833	)


Net loss applicable to common stockholders	($	93,693	)	($	4,337,600	)	($	7,410,812	)	($	10,410,859	)

Net loss per share applicable to common stockholders; basic and diluted	($	0.00	)	($	0.08	)	($	0.12	)	($	0.23	)		($0.06	)		($0.06	)

Weighted average shares used to compute net loss per share applicable to common stockholders; basic and diluted		64,179,563			54,232,231			63,226,214			46,132,704			65,443,062			62,406,725

PART I — ITEM 1 — FINANCIAL STATEMENTS

STEMCELLS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(unaudited)


	Nine months ended						Three months ended
	September 30,						March 31,
	2005			2004			2006			2005
Cash flows from operating activities:

Net loss		($7,410,812	)		($10,410,859	)	$	(4,193,126	)	$	(3,448,833	)
Adjustments to reconcile net loss to net cash used in operating activities:
Depreciation and amortization		834,135			769,402			262,106			273,155
Amortization of deferred compensation		354,624			8,482			—			(76,382	)
Stock-based compensation expense		550,649			174,650			459,197			36,011
Loss on disposal of fixed assets		1,377			50,045
Unrealized income from license and settlement agreement, net		(3,974,883	)		—
Changes in operating assets and liabilities:
Accrued interest receivable		(31,215	)		(20,566	)		4,295			(11,660	)
Receivables		60,517			93,545			(152,403	)		19,051
Other current assets		(237,840	)		(38,929	)		(173,141	)		(420,526	)
Other assets, net		52,947			—
Other assets								—			52,947
Accounts payable and accrued expenses		(670,512	)		736,415			(460,772	)		(618,672	)
Accrued wind-down expenses		1,192,125			1,090,165			(121,083	)		224,427
Deposits received (refunded)		(95,173	)		—
Deferred rent		186,517			(279,300	)		111,862			(120,094	)


Net cash used in operating activities		(9,187,544	)		(7,826,950	)		(4,263,065	)		(4,090,576	)


Cash flows from investing activities:
Purchase of property, plant and equipment		(696,793	)		(581,194	)		(211,531	)		(58,429	)
Acquisition of licenses		(80,000	)		(15,000	)

Acquisition of other assets								—			(50,000	)

Net cash used in investing activities		(776,793	)		(596,194	)		(211,531	)		(108,429	)


Cash flows from financing activities:

Proceeds from the exercise of stock options		343,165			—			91,126			269,432
Proceeds from the exercise of warrants		3,753,123			—			994,896			347,327
Proceeds from issuance of common stock, net		—			18,659,837
Repayment of capital lease obligations		(39,232	)		—
Expense from issuance of common stock								(213,960	)		—
Repayments of capital lease obligations								—			(12,812	)
Repayment of debt obligations		(181,667	)		(177,083	)		(62,500	)		(59,665	)

Net cash provided by financing activities		3,875,389			18,482,754			809,562			544,282


Increase (decrease) in cash and cash equivalents		(6,088,948	)		10,059,610
Decrease in cash and cash equivalents								(3,665,034	)		(3,654,723	)
Cash and cash equivalents, beginning of period		41,059,532			13,081,703			34,540,908			41,059,532


Cash and cash equivalents, end of period	$	34,970,584		$	23,141,313		$	30,875,874		$	37,404,809


Supplemental disclosure of cash flow information:

Interest paid	$	133,777		$	145,025		$	38,593		$	46,411

Stock issued for licensing agreements				$	15,000

PART I — ITEM 1. — FINANCIAL STATEMENTS

~~NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)~~ Notes to Condensed Consolidated Financial Statements
~~September 30, 2005~~(Unaudited) March 31, 2006 and ~~2004~~2005

NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Basis of Presentation

The terms ~~“StemCells,”~~“StemCells”, the ~~“Company,” “our,”~~“Company”, “our”, “we” and “us” as used in this report refer to StemCells Inc. The accompanying unaudited, condensed consolidated financial statements have been prepared by the Company in accordance with generally accepted accounting principles 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 generally accepted accounting principles for complete financial statements. In the opinion of management, the accompanying financial statements include all adjustments, consisting of normal recurring accruals, considered necessary for a fair presentation of the financial position, results of operations and cash flows for the periods presented. Results of operations for the ~~nine~~three months ended ~~September 30, 2005,~~March 31, 2006, are not necessarily indicative of the results that may be expected for the entire fiscal year ending December 31, ~~2005.~~2006.

The balance sheet at December 31, ~~2004~~2005 has been derived from the audited financial statements at that date but does not include all of the information and footnotes required for complete financial statements in accordance with accounting principles generally accepted in the United States of America. For the complete financial statements, refer to the audited financial statements and footnotes thereto as of December 31, ~~2004,~~2005, included on Form 10-K.

The Company has incurred significant operating losses and negative cash flows since inception. It has not achieved profitability and may not be able to realize sufficient revenues to achieve or sustain profitability in the future. The Company has limited capital resources and it will need to raise additional capital from time to time to sustain its product development efforts, acquisition of technologies and intellectual property rights, preclinical and clinical testing of anticipated products, pursuit of regulatory approvals, acquisition of capital equipment, laboratory and office facilities, establishment of production capabilities, general and administrative expenses and other working capital requirements. To fund its operations, the Company relies on cash balances, proceeds from equity and debt offerings, proceeds from the transfer or sale of intellectual property rights, equipment, facilities or investments, and on government grants and collaborative arrangements. The Company cannot be certain that such funding will be available when needed. The financial statements do not include any adjustments to reflect the possible future effects on the recoverability and classification of assets or the amounts and classification of liabilities that may result from the outcome of this uncertainty.

Use of Estimates

The preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements. Actual results could differ from these estimates. Significant estimates include the accrued wind-down ~~expenses.~~expenses and the grant date fair value of share based awards recognized as compensation expense in accordance with the provisions of Statement of Financial Accounting Standards No. 123 (Revised 2004)“Share-Based Payment”(SFAS 123R). See “Stock-Based Compensation” below.

Marketable securities

In accordance with Statement of Financial Accounting Standards No. 115“Accounting for Certain Investments in Debt and Equity Securities", the Company has classified the Company’s short-term investments as available-for-sale marketable securities in the accompanying consolidated financial statements. The marketable securities are stated at fair

market value, with unrealized gains and losses reported in other comprehensive income. Management reviews securities with unrealized losses for other than temporary impairment. A decline in the fair value of securities that is deemed other than temporary is charged to earnings when so deemed.

Reclassification

Certain reclassifications of prior year amounts have been made to conform to current year presentation. Patent related expenses of $205,998 for the three-month period ended March 31, 2005 have been reclassified from research and development expense to general and administrative expense on the consolidated statements of operations for that period to conform with current year presentation.

Net Loss Per Share

The Company has computed net loss per common share according to the Statement of Financial Accounting Standards ~~Board Statement (“SFAS”)~~(SFAS) No. 128 ~~“Earnings~~“Earnings Per Share,”which requires disclosure of basic and diluted earnings per share. Basic earnings per share excludes any dilutive effects of options, warrants and convertible securities, and is computed using the weighted average number of common shares outstanding during the period. Diluted earnings

per share includes the impact of potentially dilutive securities and is computed using the weighted average of common and diluted equivalent stock options, warrants and convertible securities outstanding during the period. Stock options, warrants and convertible securities that are anti-dilutive are excluded from the calculation of diluted loss per common share.

Three months ended Nine months ended
September 30, September 30,
2005 2004 2005 2004
Net loss applicable to common stockholders $ (93,693 ) $ (4,337,600 ) (7,410,812 ) $ (10,410,859 )
Weighted average shares used in computing net loss per share applicable to common stockholders, basic and diluted 64,179,563 54,232,231 63,226,214 46,132,704
Net loss per share applicable to common stockholders, basic and diluted $ (0.00 ) $ (0.08 ) $ (0.12 ) $ (0.23 )


	Three months ended
	March 31,
	2006			2005
Net loss applicable to common stockholders	$	(4,193,126	)	$	(3,448,833	)
Weighted average shares used in computing net loss per share applicable to common stockholders, basic and diluted.		65,443,062			62,406,725
Net loss per share applicable to common stockholders, basic and diluted.	$	(0.06	)	$	(0.06	)

The Company has excluded outstanding stock options ~~warrants~~ and ~~convertible securities~~warrants from the calculation of diluted loss per common share because all such securities are anti-dilutive for all applicable periods presented. These outstanding securities consist of the following potential common shares:


	Outstanding at September 30,				Outstanding at March 31,
	2005		2004		2006		2005
Outstanding options		6,641,401		6,222,389		6,828,323		6,728,787
Outstanding warrants		3,341,212		6,038,430		1,995,000		5,165,283

Total		9,982,613		12,260,819		8,823,323		11,894,070

outstanding options with respect to vesting periods or exercise prices prior to adopting SFAS 123R. In March 2005, the Securities and Exchange Commission (SEC) issued Staff Accounting Bulletin No. 107 (SAB 107), which provides guidance on the implementation of SFAS 123R. The Company applied the principles of SAB 107 in conjunction with its adoption of SFAS 123R.

The Company adopted SFAS 123R effective January 1, 2006, using the modified-prospective transition method. Under this transition method, compensation expense will be recognized based on the grant date fair value estimated in accordance with the provisions of SFAS 123R for all new grants effective January 1, 2006, and for options granted prior to but not vested as of December 31, 2005. Prior periods were not restated to reflect the impact of adopting the new standard and therefore do not include compensation expense related to qualified stock option grants for those periods. In accordance with SFAS 123R, the Company recognized stock option related compensation expense of approximately $388,000 for the three month period ended March 31, 2006. All options granted in the three-month period ended March 31, 2006 were qualified stock options and the related compensation expense was recognized on a straight line basis over the vesting period of each grant net of estimated forfeitures. The Company’s ~~stock-based employee~~estimated forfeiture rates are based on its historical experience within separate groups of employees. The estimated fair value of the options granted during 2006 and prior years was calculated using a Black Scholes Merton option pricing model (Black Scholes model). The following summarizes the assumptions used in the Black Scholes model as applied in the first quarter of 2006:


Risk —free interest rate⁽¹⁾	4.72	%
Volatility⁽²⁾	119.5	%
Dividend yield⁽³⁾	0	%
Expected term (years until exercise)⁽⁴⁾	6.25


(1)		The risk-free interest rate is based on US Treasury debt securities with maturities close to the expected term of the option.

(2)		Expected volatility is based on historical volatility of the Company’s stock factoring in daily share price observations. In computing expected volatility, the length of the historical period used is equal to the length of the expected term of the option.

(3)		No cash dividends have been declared on the Company’s common stock since the Company’s inception, and the Company currently does not anticipate paying cash dividends over the expected term of the option.

(4)		The expected term is equal to the average of the contractual life of the stock option and its vesting period.

At March 31, 2006, approximately $4,710,000 of unrecognized compensation expense related to stock options is expected to be recognized over a weighted average period of approximately 1.56 years. The resulting effect on net loss and net loss per share attributable to common stockholders is not likely to be representative of the effects in future periods, due to additional grants and subsequent periods of vesting.

Prior to January 1, 2006, the Company accounted for its stock-based compensation plans under Accounting Principles Board Opinion No. 25 ~~(“APB 25”)~~(APB 25),“Accounting for Stock Issued to ~~Employees.”~~Employees”.~~The Company grants qualified stock options for a fixed number of shares to employees with an exercise price equal to the fair market value of the shares at the date of grant.~~ In accordance with APB 25, the Company ~~recognizes~~recognized no compensation expense for qualified stock option grants. ~~The Company also issues non-qualified stock~~For options ~~for a fixed number of shares to employees~~issued with an exercise price less than the fair market value of the shares at the date of ~~grant. In accordance with APB 25, as such options vest,~~grant, the Company ~~recognizes~~recognized the difference between the exercise price and fair market value as compensation ~~expense.~~

~~For purposes of disclosures pursuant~~expense in accordance with APB 25. Prior to January 1, 2006, the Company provided pro forma disclosure amounts in accordance with Statement of Financial Accounting Standards No. 123“Accounting for Stock-Based Compensation,”(“SFAS ~~123”)~~123) as amended by

Statement of Financial Accounting Standards No. 148“Accounting for Stock-Based Compensation — Transition and Disclosure,”(“SFAS ~~148”), the estimated fair value of options is amortized~~148). As compensation expense was disclosed but not recognized in periods prior to ~~expense over the options’ vesting period. Although the Company’s stock-based employee compensation is accounted~~January 1, 2006, no cumulative adjustment for ~~under APB 25, the~~forfeitures was recorded in 2006. The following table illustrates the effect on net loss and net loss per share if the Company had applied the fair value recognition provisions of SFAS 123 to stock-based employee ~~compensation:~~compensation in the prior three-month period ended March 31, 2005:

Three months ended Nine months ended
September 30, September 30,
2005 2004 2005 2004
Net loss applicable to common stockholders – as reported $ (93,693 ) $ (4,337,600 ) $ (7,410,812 ) $ (10,410,859 )
Add: Stock-based employee/director compensation expense included in reported net loss — — — 33,868

Deduct: Total stock-based employee/director compensation expense under the fair value based method for all awards (507,833 ) (168,124 ) (746,525 ) (588,613 )

Three months ended Nine months ended
September 30, September 30,
2005 2004 2005 2004
Net loss applicable to common stockholders – pro forma $ (601,526 ) $ (4,505,724 ) $ (8,157,337 ) $ (10,965,604 )
Basic and diluted net loss per share applicable to common stockholders as reported $ (0.00 ) $ (0.08 ) $ (0.12 ) $ (0.23 )
Basic and diluted net loss per share applicable to common stockholders – pro forma $ (0.01 ) $ (0.08 ) $ (0.13 ) $ (0.24 )
Shares used in basic and diluted loss per share applicable to common stockholder amounts 64,179,563 54,232,231 63,226,214 46,132,704

The effects on pro forma net loss and net loss per share of expensing the estimated fair value of stock options are not necessarily representative of the effects on reporting the results of operations for future years. The Company has used the Black-Scholes model for option valuation, which method may not accurately value the options described.


	Three months ended
	March 31, 2005
Net loss applicable to common stockholders — as reported	$	(3,448,833	)
Add: Stock-based employee/director compensation expense included in reported net loss		—
Deduct: Total stock-based employee/director compensation expense under the fair value based method for all awards		(137,461	)
Net loss applicable to common stockholders — pro forma	$	(3,586,294	)
Basic and diluted net loss per share applicable to common stockholders as reported	$	(0.06	)
Basic and diluted net loss per share applicable to common stockholders — pro forma	$	(0.06	)
Shares used in basic and diluted loss per share applicable to common stockholder amounts		62,406,725

The Company accounts for stock options granted to non-employees in accordance with SFAS 123 and Emerging Issues Task Force (EITF) 96-18 —“Accounting For Equity Instruments That Are Issued To Other Than Employees For Acquiring, Or In Conjunction With Selling, Goods Or ~~Services”~~Services", and accordingly, recognizes as expense the estimated fair value of such options as calculated using the ~~Black-Scholes valuation~~Black Scholes model. The fair value is remeasured during the service period and is amortized over the vesting period of each option or the recipient’s contractual arrangement, if shorter.

~~In December 2004, FASB issued SFAS No. 123R (revised 2004~~~~),” Share-Based Payment”~~~~(“SFAS 123R”). This Statement is a revision of SFAS 123 and amends SFAS No. 95,~~~~“Statement of Cash Flows”~~ ~~and supersedes APB 25 and its related implementation guidance. SFAS 123R covers a wide range of share-based compensation arrangements including~~ No stock options restricted share plans, performance-based awards, share appreciation rights, and employee share purchase plans. The new standard is effective as of the beginning of the first interim or annual reporting period that begins after December 15, 2005 and pro forma disclosure of fair value recognition will no longer be an alternative. Based on the aforementioned effective date, the Company will begin expensing stockwere issued to non-employees other than options granted to its employees in its Statement of Operations using a fair-value based method effective the period beginning January 1, 2006. The Company intends to use the modified prospective method: Compensation cost is recognized beginning with the effective date of adoption (a) based on the requirements of SFAS 123R for all share-based payments granted after the effective date of adoption and (b) based on the requirements of SFAS 123 for all awards granted to employees prior to the effective date of adoption that remain unvested on the date of adoption. Adoptionnon-employee members of the ~~expensing requirements will increase the Company’s operating expenses.~~Board of Directors for service as Board members.

Revenue Recognition

Revenues from collaborative agreements and grants are recognized as earned upon either the incurring of reimbursable expenses directly related to the particular research ~~project~~plan or the completion of certain development milestones as defined within the terms of the collaborative agreement. Payments received in advance of research performed are designated as deferred revenue. Fees associated with substantive at risk, performance-based milestones are recognized as revenue upon their completion, as defined in the respective agreements. Incidental assignment of technology rights is recognized as revenue at the time of receipt.

Recent Accounting Pronouncements

Accounting for Changes and Error Corrections

In June 2005, the FASB issued Statement of Financial Accounting Standards No. 154 “Accounting Changes and Error Corrections ~~(“SFAS 154”)~~” “SFAS 154). SFAS 154 replaces APB Opinion No. 20“Accounting ~~Changes”~~Changes” and SFAS No. 3 ““Reporting Accounting Changes in Interim Financial ~~Statements”~~Statements”. SFAS 154 requires that a voluntary change in accounting principle be applied retrospectively with all prior period financial statements presented on the new accounting principle. SFAS 154 also requires that a change in method of depreciating or amortizing a long-lived ~~nonfinancial~~non-financial asset be accounted for prospectively as a change in estimate, and correction of errors in previously issued financial statements should be termed a restatement. SFAS 154 is effective for accounting changes

and correction of errors made in fiscal years beginning after December 15, 2005. The implementation of ~~FAS~~SFAS 154 is not expected to have a material impact on ~~the Company’s~~our consolidated ~~financial statements.~~

In March 2005, Staff Accounting Bulletin No. 107 (“SAB 107”) was issued which expressed views of the Securities and Exchange Commission (SEC) regarding the interaction between SFAS 123R, and certain SEC rules and regulations and provides the staff’s views regarding the valuation of share-based payment arrangements for public companies. FASB issued SFAS No. 123R in December 2004. This Statement is a revision of SFAS No. 123, Accounting for Stock-Based Compensation and amends SFAS No. 95,~~“Statement of Cash Flows”~~~~. This Statement supersedes APB Opinion No. 25,~~~~“Accounting for Stock Issued to Employees”~~, and its related implementation guidance. SFAS 123R covers a wide range of share-based compensation arrangements including stock options, restricted share plans, performance-based awards, share appreciation rights, and employee share purchase plans. The new standard is effective as of the beginning of the first interim or annual reporting period that begins after December 15, 2005. Based on the aforementioned effective date, the Company will begin expensing stock options granted to its employees in its Statement of Operations using a fair-value based method effective the period beginning January 1, 2006. Adoption of the expensing requirements will reduce the Company’s reported earnings. See “Stock-based Compensation” above in this Note 1 for disclosures regarding the effect on net earnings and earnings per share if we had applied the fair value recognition provisions of the exposure draft and SFAS 123. Depending on the model used to calculate stock-based compensation expense in the future, that disclosure may not prove indicative of the stock-based compensation expense to be recognized in future financial statements.

NOTE 2. RENEURON LICENSE AND SETTLEMENT AGREEMENT

In July 2005, the Company entered into ana license and settlement agreement with ReNeuron Limited, a wholly owned subsidiary of ReNeuron Group plc, a publicly listed UK corporation (collectively referred to as “ReNeuron”). As part of the agreement, the Company granted ReNeuron a license that allows ReNeuron to exploit their “c-mycER” conditionally immortalized adult human neural stem cell technology for therapy and other purposes. In return for the license, StemCells received a 7.5% fully-diluted equity interest in ReNeuron, subject to certain anti-dilution provisions, and a cross-license to the exclusive use of ReNeuron’s technology for certain diseases and conditions, including lysosomal storage diseases, spinal cord injury, cerebral palsy and multiple sclerosis. The agreement also provides for full settlement of any potential claims that either StemCells or ReNeuron might have had against the other in connection with any putative infringement of certain of each party’s patent rights prior to the effective date of the agreement. The agreement is Exhibit 10.71 to the Company’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2005. ~~On July 1, 2005 the Company was entitled~~An amendment to ~~3,774,493 shares of ReNeuron, representing 7.5% of its fully-diluted share capital. On August 12~~^th ~~2005 ReNeuron listed its shares on the London Stock Exchange’s Alternative Investment Market (“AIM”), a market for smaller, growing companies. As provided for under~~ the agreement ~~the placement and listing~~was entered on April 3, 2006, a copy of ~~additional shares by ReNeuron resulted in StemCells’ receiving~~which is attached as an ~~additional 5,165,000 shares.~~

The Company recorded approximately $3,748,000 as other income, which was the fair value of the ReNeuron shares as of August 12, 2005, net of legal fees and the value of an estimated 104,000 shares that will be transferredexhibit to NeuroSpheres Ltd., an Alberta corporation from which StemCells has licensed some of the patent rights that are the subject of the agreement with ReNeuron. The ReNeuron shares are classified as “marketable securities.”this Report on Form 10-Q. The fair market value of the securities ~~(8,835,629~~(8,835,766 shares) as of ~~September 30,~~December 31, 2005 and March 31, 2006 was approximately $3,721,000 and $2,420,000 respectively. Changes in market value as a result of changes in market price per share or the exchange rate between the US dollar and the British pound are accounted for under “other comprehensive loss” if deemed temporary, and are not recorded as “other income or loss” until the shares are disposed of and a gain or loss realized. The unrealized loss as of March 31, 2006, is ~~$3,820,963.~~approximately $1,554,000. A decline in the fair value of securities that is deemed other than temporary would be charged to earnings.

NOTE 3. LEASES

The Company ~~which was originally resident in Rhode Island,~~ had undertaken direct financing transactions with the State of Rhode Island and received proceeds from the issuance of industrial revenue bonds totaling $5,000,000 to finance the construction of a pilot manufacturing facility related to its former encapsulated cell technology. The related leases are structured such that lease payments will fully fund all semiannual interest payments and annual principal payments through maturity in August 2014. Interest rates vary with the respective

bonds’ maturities, ranging currently from 8.1% to 9.5%. The outstanding principal at ~~September 30, 2005~~March 31, 2006 was approximately ~~$1,668,000.~~$1,543,000. The bonds contain certain restrictive covenants, which limit among other things, the payment of cash dividends and the sale of the related assets.

The Company entered into a fifteen-year lease for a laboratory facility in connection with a sale and leaseback arrangement in 1997. The lease has escalating rent payments ~~which~~and accordingly, the Company is recognizing rent expense on a straight-line ~~basis as required by U.S. Generally Accepted Accounting Principles (“GAAP”).~~basis. At December 31, ~~2004~~2005 and ~~September 30, 2005,~~March 31, 2006, the Company had deferred rent liability for this facility of ~~$1,177,000~~approximately $1,208,000 and ~~$1,200,000~~$1,215,000 respectively; the deferred rent liability is presented as part of the wind-down accrual.

Although the Company previously discontinued activities relating to encapsulated cell technology, the Company remains obligated under the leases for the pilot manufacturing facility and the laboratory facility. The Company has succeeded in subleasing the pilot manufacturing facility and part of the laboratory facility. The aggregate income received by the Company is significantly less than the Company’s aggregate obligations under the leases, and the Company’s continued receipt of rental income is dependent on the financial ability of the occupants to comply with their obligations under the subleases. The Company continues to seek to sublet the vacant portions of the Rhode Island facilities, to assign or sell its interests in all of these properties, or to otherwise arrange for the termination of its obligations under the lease obligations on these facilities. There can be no assurance, however, that the Company will be able to dispose of these properties in a reasonable time, if at all, or to terminate its lease obligations without the payment of substantial ~~consideration.~~consideration

As of February 1, 2001, the Company entered into a 5-year lease for a 40,000 square feet of an approximately 68,000 square foot facility located in the Stanford Research Park in Palo Alto, CA. The facility includes space for animals, laboratories, offices, and a GMP (Good Manufacturing Practices) suite. GMP facilities can be used to manufacture materials for clinical trials. On December 19, 2002 the Company negotiated an amendment to the lease, which resulted in reducing the average annual rent over the remaining term of the lease from approximately $3.7 million to $2.0 million. As part of the amendment the Company issued a letter of credit on

January 2, 2003 for $503,079, which was an addition to the letter of credit in the amount of $275,000 issued at commencement of the lease, to serve as a deposit for the duration of the lease. The Company negotiated an amendment to the lease effective April 1, 2005, which extends the term of the lease through March 31, 2010, includes an immediate reduction in the rent per square foot, and provides for an expansion of the leased premises by approximately 28,000 additional square feet effective July 1, 2006. In addition, the Company has sublet some of the additional space for the period from April 1, 2005 through June 30, 2006. The average annual rent due from the Company under this lease for the period commencing April 1, 2005 to March 31, 2010 will be approximately $2 million before subtenant income. The lease has escalating rent payments, which the Company is recognizing on a straight-line ~~basis as required by GAAP.~~basis. At ~~December~~March 31, ~~2004 and September 30, 2005,~~2006, the Company had deferred rent liability for this facility of ~~$524,000 and $710,000 respectively.~~approximately $966,000. At ~~September 30, 2005~~March 31, 2006 the Company has space-sharing agreements covering in total approximately 13,000 square feet of ~~the 40,000 square foot~~this facility. The Company receives the amount of base rent plus the proportionate share of the operating expenses that it pays for such space over the term of these agreements.

NOTE 4. RELOCATION TO CALIFORNIA FROM RHODE ISLAND

In October 1999, the Company relocated to California from Rhode Island and established a wind down reserve for the estimated lease payments and operating costs of the Rhode Island facilities through an expected disposal date of June 30, 2000. The Company did not fully sublet the Rhode Island facilities in 2000. Even though the Company intends to dispose of the facility at the earliest possible time, the Company’s management cannot determine with certainty a fixed date by which such disposal will occur. In light of this uncertainty, the Company periodically re-evaluates and adjusts the reserve. The Company considers various factors such as the Company’s lease payments through to the end of the lease, operating expenses, the current real estate market in Rhode Island, and estimated subtenant income based on actual and projected occupancy. At December 31, ~~2004~~2005 the reserve was ~~$4,350,000.~~approximately $6,098,000. The Company incurred ~~$845,000~~approximately $284,000 in operating expenses for the ~~nine month~~three-month period ending ~~September 30, 2005,~~March 31, 2006, which was recorded against the reserve. After evaluating the afore-mentioned factors the Company re-valued the reserve to ~~$4,568,000, $5,482,000 and $5,520,000~~$5,970,000 at March 31, ~~2005, June 30, 2005 and September 2005 respectively,~~2006, by booking an additional ~~$521,000, $1,197,000 and $297,000 respectively~~$156,000 as wind-down expenses.

Wind-down reserve


							July 1 to			January 1 to
	January 1 to			April 1 to June 30,			September 30,			September 30,
	March 31, 2005			2005			2005			2005			January to March			January to December
													31, 2006			31, 2005
Accrued wind-down reserve at beginning of period	$	4,350,000		$	4,568,000		$	5,482,000		$	4,350,000		$	6,098,000		$	4,350,000
Less actual expenses recorded against estimated reserve during the period		(303,000	)		(283,000	)		(259,000	)		(845,000	)		(284,000	)		(1,079,000	)
Additional expense recorded to revise estimated reserve at period-end		521,000			1,197,000			297,000			2,015,000			156,000			2,827,000

Revised reserve at period-end		4,568,000			5,482,000			5,520,000			5,520,000			5,970,000			6,098,000
Add deferred rent at period end (Note 3)		1,185,000			1,192,000			1,200,000			1,200,000
Add deferred rent at period end (Note 3														1,215,000			1,208,000

Total accrued wind-down expenses at period-end (current and non current portion)	$	5,753,000		$	6,674,000		$	6,720,000		$	6,720,000		$	7,185,000		$	7,306,000

Accrued wind-down expenses
Current portion	$	1,034,000		$	1,095,000		$	1,151,000		$	1,151,000		$	1,182,000		$	1,119,000

Non current portion		4,719,000			5,579,000			5,569,000			5,569,000			6,003,000			6,187,000

Total accrued wind-down expenses	$	5,753,000		$	6,674,000		$	6,720,000		$	6,720,000
Total Accrued wind-down expenses													$	7,185,000		$	7,306,000

31, 2006. The studies ~~will be~~have been conducted by Dr. George A. Carlson of the McLaughlin Research Institute (MRI) in Great Falls, Montana, which will receive approximately $222,000 of the total award. The ~~balance will be~~remaining $242,000 has been recognized by the Company as grant revenue as and when resources ~~are~~were expended for this study. ~~The Company recognized $26,000 in~~For the ~~last quarter of 2004 and $150,000 for the nine~~three month period ended ~~September 30, 2005.~~March 31, 2006, the Company recognized approximately $38,000; the Company has now drawn down in full its share of the grant.

NOTE 6. STOCKHOLDERS’ EQUITY

~~During the nine-month period ended September 30, 2005, warrants~~In March 2006, a warrant issued as part of the June 16, 2004 financing arrangement ~~were~~was exercised to purchase an aggregate of ~~897,882~~526,400 shares of the Company’s common stock at ~~$1.90~~$1.89 per share. The Company issued ~~897,882~~526,400 shares of its common stock and received proceeds of approximately ~~$1,706,000. In May 2005, warrants issued as part of a Stock Purchase Agreement dated May 7, 2003, were exercised to purchase an aggregate of 800,000 shares of~~$995,000. For the Company’s common stock at $1.50 per share. The Company issued 800,000 shares of its common stock and received proceeds of $1,200,000. During the months July and August 2005, warrants issued as part of a common stock financing transaction to purchase an aggregate of 196,150 shares were exercised for which 26,559 shares were issued at $ 4.52 per share, 129,591 shares at $ 3.70 per share, and issuance of 5,846 shares in a cashless exercise to settle a warrant exercise to purchase 40,000 shares at $5.0375 per share, for proceeds aggregating approximately $600,000. Also in January 2005, 79,899 shares of unregistered stock (which the Company has no obligation to register) were issued upon the cashless exercise by the holder of a warrant acquired as partial compensation for services to the Company.

~~On April 13, 2000~~three month period ended March 31, 2006, the Company issued 1,500 shares of 6% cumulative convertible preferred stock plus adjustable warrants to two members of its Board of Directors. The preferred shares were converted into common shares in 2002. In March 2005, one of the members exercised his adjustable warrant in full for 72,252 shares at $3.42 per share. The Company issued 72,252 shares and received proceeds of $247,000. In May 2005 the other member through a cashless exercise, exercised in full, his adjustable warrant for 72,252 shares for which, the Company issued 10,784 shares.

~~For the nine month period ended September 30, 2005, the Company issued 278,273~~60,624 shares from activity related to its stock option plans. The following table presents the activity of the Company’s stock option plans for the ~~nine~~three month period ended ~~September 30, 2005~~March 31, 2006 and ~~2004.~~2005.


	2005					2004
				Weighted					Weighted		2006					2005
				Average Exercise					Average Exercise					Weighted					Weighted
	Options			Price		Options			Price					Average Exercise					Average Exercise
											Options			Price		Options			Price
Outstanding at January 1		6,682,201		$	2.67		5,025,374		$	2.91		6,608,109		$	3.02		6,682,201		$	2.91
Granted		963,057		$	4.84		1,388,559		$	1.43		459,715		$	3.69		329,838		$	4.33
Exercised		(278,273	)	$	1.26		(83,544	)	$	0.00		(60,624	)	$	2.20		(173,252	)	$	1.76
Canceled		(725,584	)	$	3.11		(108,000	)	$	3.79		(178,877	)	$	2.02		(110,000	)	$	1.95

Outstanding at September 30		6,641,401		$	3.00		6,222,389		$	2.61
Outstanding at March 31												6,828,323		$	3.10		6,728,787		$	2.79

Options exercisable at September 30		4,204,398		$	3.09		3,497,738		$	3.01
Options exercisable at March 31												4,448,369		$	3.02		3,623,637		$	3.00

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

The following discussion of our financial condition and the results of our operations for the three ~~and nine~~ month periods ended ~~September 30,~~March 31, 2006 and 2005 ~~and 2004~~ should be read in conjunction with the accompanying unaudited condensed consolidated financial statements and the related footnotes thereto.

This report contains forward looking statements within the meaning of Section 27A of the Securities Act and Section 21E of the Securities Exchange Act that involve substantial risks and uncertainties. Such statements include, without limitation, all statements as to ~~hope,~~ expectation or belief and statements as to our future results of operations, the progress of our research, product development and clinical programs, the need for, and timing of, additional capital and capital expenditures, partnering prospects, costs of manufacture of products, the protection of and the need for additional intellectual property rights, effects of regulations, the need for additional facilities and potential market opportunities, expectations concerning identification of a suitable site for our proposed clinical trial in Batten disease, obtaining the required Institutional Review Board approval, instituting the clinical study and the conduct of the study once instituted, expectations regarding ReNeuron’s technology, the Company’s ability to develop products using the ReNeuron technology, the likelihood of obtaining milestone or royalty payments from ReNeuron under the license agreement, the likelihood of any future collaborations with ReNeuron, and the value of the Company’s equity interest in ReNeuron.opportunities. Our actual results may vary materially from those contained in such forward-looking statements because of risks to which we are subject, including uncertainty as to whether the U.S. Food and Drug Administration (FDA) will permit us to proceed to clinical testing of proposed products despite the novel and unproven nature of our technology; the risk that, even if approved, our initial clinical trial could be substantially delayed beyond its expected dates or cause us to incur substantial unanticipated costs; uncertainties ~~regardingour~~regarding our ability to obtain the capital resources needed to continue our current research and development operations and to conduct the research, preclinical development and clinical trials necessary for regulatory approvals; ~~the risk of~~ failure to obtain a corporate partner or partners to support the development of our stem cell ~~programs,~~programs; the uncertainty regarding the outcome of the Phase I clinical trial and any other trials ~~the Company~~we may conduct in the future; the uncertainty regarding the validity and enforceability of issued patents; the uncertainty whether any products that may be generated in ~~the Company’s~~our stem cell programs will prove clinically effective and not cause tumors or other side effects; the uncertainty whether ~~the Company~~we will achieve revenues from product sales or become profitable; uncertainties regarding ~~the Company’s~~our obligations in regard to ~~its~~our former encapsulated cell therapy facilities in Rhode Island; obsolescence of our technology; competition from third parties; intellectual property rights of third parties; litigation and other risks to which we are subject. Before you invest in our common stock, you should be aware that the occurrence of the events described in the “Cautionary Factors Relevant to Forward Looking Information” and “Business” sections included in our Form 10-K report as of December 31, 2004 could harm our business, operating results and financial condition. All forward-looking statements attributable to us or to persons acting on our behalf are expressly qualified in their entirety by the cautionary statements and risk factors contained or referred to herein.

~~OVERVIEW~~Overview

Since our inception in 1988, we have been primarily engaged in research and development of human therapeutic products. Since the second half of 1999, our sole focus has been on our stem cell technology. In ~~the last quarter of 2004~~October 2005, we ~~filed the first in a planned series of INDs (Investigational New Drug Applications) for CNS (Central Nervous System) diseases or conditions with~~received clearance from the FDA ~~(U.S. Food and Drug Administration). This IND, which is for~~to initiate a Phase I clinical trial of our human neural stem cells to treat Batten disease, was on clinical hold pending the resolution of questions and issues raised by the FDA. In October 2005, the FDA removed the hold, permitting the Company to proceed with the clinical trial. The Company must identifyas a ~~suitable clinical site~~treatment for the ~~trial~~infantile and ~~obtain the~~late infantile forms of neuronal ceroid lipofuscinosis (NCL), a rare, fatal neurodegenerative disease often referred to as Batten disease. In March 2006, we received approval offrom the Institutional Review Board ~~for that site before it can initiate~~of Oregon Health & Science University (OHSU) to conduct the trial. Batten disease is included among the neuronal ceroid lipofuscinoses (NCLs), a set of several closely related genetic lysosomal storage disorders caused by a deficiency of specific enzymes required for normal cell metabolism. The deficiency resultsPhase I trial at Doernbecher Children’s Hospital at OHSU in ~~storage of toxic waste materials~~Portland, Oregon, and the ~~death of certain neurons. The NCLs primarily affect infants~~investigators have begun screening potential patients for eligibility. Both FDA and ~~young children, and are always fatal.~~IRB approval were required before this trial could be initiated.

We have not derived any revenues from the sale of any products apart from license revenue for the research use of our human neural stem cells and other patented cells and media, and we do not expect to receive revenues from product sales for at least several years. We have not commercialized any product and in order to do so we

must, among other things, substantially increase our research and development expenditures as research and product development efforts accelerate and clinical trials are initiated. We had expenditures for toxicology and other studies in preparation for submitting the Batten disease IND to the FDA and getting it cleared by the FDA, and will incur more such expenditures for any future INDs. We have incurred annual operating losses since inception and expect to incur substantial operating losses in the future. As a result, we are dependent upon external financing from equity and debt offerings and revenues from collaborative research arrangements with corporate sponsors to finance our operations. There are no such collaborative research arrangements at this time and there can be no assurance that such financing or partnering revenues will be available when needed or on terms acceptable to us.

In July 2005, we entered into an agreement with ReNeuron Limited, a wholly owned subsidiary of ReNeuron Group plc, a listed UK corporation (collectively referred to as “ReNeuron”). As part of the agreement, we granted ReNeuron a license that allows ReNeuron to exploit its “c-mycER” conditionally immortalized adult human neural stem cell technology for therapy and other purposes. In return for the license, we received a 7.5% fully-diluted equity interest in ReNeuron, subject to certain anti-dilution provisions, and a cross-license to the exclusive use of ReNeuron’s technology for certain diseases and conditions, including lysosomal storage diseases, spinal cord injury, cerebral palsy and multiple sclerosis. ReNeuron will supply cells for StemCells’ use under the cross-license. The agreement also provides for royalties and milestone payments by each party on the achievement of various goals under the license and cross-license.

In September 2005 the Nasdaq Stock Market approved our application to move the listing of our common stock from the Nasdaq Capital Market (previously known as the Nasdaq SmallCap Market) to the Nasdaq National Market. The stock began trading on the Nasdaq National Market on September 30, 2005 under the same symbol, STEM.

Since 2001, we have entered into a number of financing arrangements including an equity line (which has now expired) from which we drew $4.6 million; sale of 1 million shares of common stock for $1.1 million; sale of 4 million shares of common stock for $6.5 million; issuance of convertible preferred stock for $5 million (all of which has now been converted); sale of 5 million shares of common stock for a total of $9.5 million, and in 2004, two financing arrangements for gross proceeds of $20 million and $22.5 million in June and October respectively. (See “Liquidity and Capital Resources” below for further detail on each of these transactions.

Our results of operations have varied significantly from year to year and quarter to quarter and may vary significantly in the future due to the occurrence of material recurring and nonrecurring events, including without limitation the receipt and payment of recurring and nonrecurring licensing payments, the initiation or termination of

research collaborations, the ~~changes in the sublease income and rental and other~~on-going expenses to lease and maintain our facilities in Rhode Island and ~~changes in~~ the increasing costs associated with our ~~move to a larger~~ facility in California. To expand and provide high quality systems and support to our ~~research~~Research and ~~development~~Development programs, as well as to enhance our internal controls over financial reporting, we ~~would~~will need to hire more personnel, which ~~would~~will lead to higher operating expenses.

Our program in neural stem and progenitor cells ranges from the preclinical stage, in which we test human neural stem cells in small animal models of human diseases, both in-house and through external academic collaborators, through the development phase, in which we evaluate improvements to expansion methods and the toxicology of the cells, through the clinical development phase, with respect to the planned clinical trial in Batten disease mentioned above. In our liver stem cell program, we are engaged in evaluating our proprietary liver engrafting cell in various in vivo assays, and are planning to advance our liver stem cell program into product development as rapidly as we can. Our pancreas program is still in the discovery stage and further evaluation of the therapeutic potential of the candidate human pancreatic stem/progenitor cell will be required.

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

We believe the following critical accounting policies affect our more significant judgments and estimates used in the preparation of our consolidated financial statements:

Use of Estimates

The preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements. Actual results could differ from these estimates. The significant estimates include the accrued wind-down expenses related to our Rhode Island ~~facilities.~~facilities and the grant date fair value of share based awards recognized as compensation expense in accordance with the provisions of SFAS 123R.

Stock-Based Compensation

~~As permitted by the provisions of Statement of Financial Accounting Standards (“SFAS”) No. 148,~~~~“Accounting for Stock-Based Compensation — Transition and Disclosure,”~~~~and Statement of Financial Accounting Standards No. 123,~~~~“Accounting for Stock-Based Compensation,”~~~~our stock-based employee compensation is~~

~~accounted for under Accounting Principles Board Opinion No. 25 (“APB 25”),~~~~“Accounting for Stock Issued to Employees.”~~We grant qualified stock options for a fixed number of shares to employees with an exercise price equal to the fair market value of the shares at the date of grant. In accordance with APB 25, we recognize no compensation expense for qualified stock option grants. We also issue non-qualified stock options for a fixed number of shares to employees with an exercise price less than the fair market value of the shares at the date of grant. In accordance with APB 25, we recognize the difference between the exercise price and fair market value as compensation expense as such options vest. Note 9 of the Notes to the Consolidated Financial Statements, included in our 2004 Annual Report on Form 10-K, describes our equity compensation plans. Note 1 of the Notes to the Condensed Consolidated Financial Statements elsewhere in this report contains a summary of the pro forma effects to reported net loss and loss per share for the three and nine months ended September 30, 2005 and 2004 as if we had elected to recognize compensation cost based on the fair value of the options granted at grant date, as prescribed by SFAS 123. We account for certain stock options granted to non-employees in accordance with SFAS No. 123 and Emerging Issues Task Force (“EITF”) 96-18 — accounting for equity instruments that are issued to other than employees for acquiring, or in conjunction with selling, goods or services, and accordingly, we recognize as expense the estimated fair value of such options as calculated using the Black-Scholes valuation model, and as re-measured during the service period. Fair value is determined using methodologies allowable by SFAS No. 123. The cost is amortized over the vesting period of each option or the recipient’s contractual arrangement, if shorter.

In December 2004, FASB issued SFAS 123R ~~(revised 2004~~),” Share-Based Payment”.. This Statement is a revision of SFAS 123 “Accounting for Stock-Based Compensation”and amends SFAS No. 95“Statement of Cash ~~Flows”~~Flows"~~and~~. SFAS 123R supersedes APB Opinion No. 25“Accounting for Stock Issued to Employees", and its related implementation guidance. SFAS 123R covers a wide range of share-based compensation arrangements including stock options, restricted share plans, performance-based awards, share appreciation rights, and employee share purchase plans. The new standard is effective as of the beginning of the first interim or annual reporting period that begins after December 15, 2005. ~~Based on the afore mentioned~~The Company has adopted SFAS 123R effective ~~date, we will begin expensing stock options granted to our employees in our Statement of Operations using a fair-value based method effective the period beginning~~ January 1, 2006. Adoption of the expensing requirements will reduce the Company’s reported earnings. See “Stock Based Compensation” under Note 1 for its current and potential impact on net loss and net loss per share attributable to common shareholders.

Research and Development Costs

We expense all research and development costs as incurred. Research and Development costs include costs of personnel, external services, supplies, facilities and miscellaneous other costs.

Wind-down and Exit Costs

In connection with the wind-down of our former encapsulated cell technology operations, our research and manufacturing operations in Lincoln, Rhode Island, and the relocation of our remaining research and development activities and corporate headquarters to California in October 1999, we provided a reserve for our estimate of the exit cost obligation in accordance with EITF 94-3 ~~“Other~~“Other Cost to Exit an Activity.” The reserve reflects estimates of the ongoing costs of our former research and administrative facility in Lincoln, which we hold on a lease that terminates on June 30, 2013. We are seeking to sublease, assign, sell or otherwise divest ourselves of our interest in the facility at the earliest possible time, but we cannot determine with certainty a fixed date by which such events will occur, if at all.

In determining the facility exit cost reserve amount, we are required to consider the Company’s lease payments through to the end of the lease term and estimate other relevant factors such as facility operating expenses, real estate market conditions in Rhode Island for similar facilities, occupancy rates and sublease rental rates projected over the course of the leasehold. We re-evaluate the estimate each quarter, taking account of changes, if any, in each underlying factor. The process is inherently subjective because it involves projections over time –— from the date of the estimate through the end of the lease –— and it is not possible to determine any of the factors except the lease payments with certainty over that period.

Management forms its best estimate on a quarterly basis, after considering actual sublease activity, reports from our broker/realtor about current and predicted real estate market conditions in Rhode Island, the likelihood of new subleases in the foreseeable future for the specific facility and significant changes in the actual or projected operating expenses of the property. ~~The Company discounts~~We discount the projected net outflow over the term of the leasehold to arrive at the present value, and ~~adjusts~~adjust the reserve to that figure. The estimated vacancy rate for the facility is an important assumption in determining the reserve because changes in this assumption have the greatest effect on

estimated sublease income. In addition, the vacancy rate estimate is the variable most subject to change, while at the same time it involves the greatest judgment and uncertainty due to the absence of highly predictive information concerning the future of the local economy and future demand for specialized laboratory and office space in that area. The average vacancy rate of the facility for years 2001 through 2005 was approximately 64%, varying from 49% to 80%. ~~The actual rate so far in 2005 is 62%.~~ As of ~~September 30, 2005,~~March 31, 2006, based on current information available to management, the vacancy rate is projected to be ~~80%~~83% for 2006, ~~76%~~84% for 2007, and approximately 70% from 2008 through the end of the lease. These estimates are based on actual occupancy in ~~2005,~~2006, expiration of subleases in 2006 and 2008, predicted lead time for acquiring new subtenants, historical vacancy rates for the area and assessments by our broker/realtor of future real estate market conditions. If the assumed vacancy rate for 2008 to the end of the Lease had been five percentage points higher at ~~September 30, 2005,~~March 31, 2006,, then the reserve would have been increased by approximately ~~$200,000;~~$226,000; conversely, if the assumed vacancy rate for that period were five percentage points lower, then the reserve would have been decreased by approximately ~~$200,000.~~$226,000. Similarly, a 5% increase or decrease in the operating expenses for the facility from 2006 would have increased or decreased the reserve by approximately ~~$125,000,~~$135,000, and a 5% increase or decrease in the assumed average rental charge per square foot would have increased or decreased the reserve by approximately $65,000. Management does not wait for specific events to change its estimate, but instead uses its best efforts to anticipate them on a quarterly basis.

The wind-down reserve at the end of December 31, ~~2004~~2005 was ~~$4,350,000.~~$6,098,000. For the ~~nine month~~three-month period ended ~~September 30, 2005~~March 31, 2006 we recorded actual expenses of ~~$845,000~~$284,000 against this reserve. Based on management’s evaluation of the factors mentioned, and particularly the projected vacancy rates described above, we adjusted the reserve to ~~$5,520,000~~$5,970,000 by recording an additional ~~$2,015,000 during the nine month period ended September 30, 2005 ($297,000 of which was recorded in the third quarter).~~$156,000 at March 31, 2006. See Note 4 for a breakdown of these figures by quarter.

RESULTS OF OPERATIONS

Three months ended ~~September 30,~~March 31, 2006 and 2005 ~~and 2004~~


	2005		2004		Change from previous year
					$		%			2006		2005		Change from previous year
														$			%
Revenue:
Revenue from grants and licensing agreements	$	91,255	$	4,541	$	86,714		1,910	%

Revenue from grants										$	37,550	$	26,092	$	11,458			44	%
Revenue from licensing agreements											4,000		9,229		(5,229	)		(57	)%

Total revenue	$	91,255	$	4,541	$	86,714		1,910	%	$	41,550	$	35,321	$	6,229			18	%

~~head count~~of approximately $543,000, increase in external services of approximately $195,000; increase in supplies of approximately $83,000; increase in the ~~three-month period ended September 30, 2005~~allocation of deferred rent as ~~compared~~a result of taking on additional space and extending our lease term of approximately$168,000; increase in other operating expenses of approximately $84,000; all of the afore mentioned increases were primarily attributable to expanding our operations in cell processing and clinical development. Of the approximately $543,000 increase in personnel costs, approximately $217,000 was attributable to the ~~same period~~expensing of stock option compensation as required by the new accounting pronouncement SFAS 123R (see “Stock Based Compensation” under Note 1 above), with the balance attributable to an increase in ~~2004.~~head count. At ~~September 30, 2005,~~March 31, 2006, we had ~~thirty-two~~thirty three full-time employees working in research and development and laboratory support services as compared to ~~twenty-five~~thirty at ~~September 30, 2004.~~March 31, 2005.

General and administrative expenses were approximately ~~$1,359,000~~$1,677,000 for the three months ended ~~September 30, 2005,~~March 31, 2006, compared with approximately ~~$904,000~~$1,505,000 for the same period in ~~2004.~~2005. The increase of ~~$455,000,~~$172,000 or approximately ~~50%~~11%, from ~~2004~~2005 to 2005 was primarily attributable to expensing the fair value of stock options granted to our previous chief financial officer, which was approximately $457,000. The vesting of the options was accelerated as part of an agreement that retained our previous chief financial officer as a consultant for approximately six months following the employment termination date. The increase was also attributable to the costs of moving the listing of our shares from the Nasdaq Capital Market to the Nasdaq National Market, which amounted to approximately $150,000.

In 1999, in connection with exiting our former research facility in Rhode Island, we created a reserve for the estimated lease payments and operating expenses related to it. The reserve has been re-evaluated and adjusted based on assumptions relevant to real estate market conditions and the estimated time until we could either fully sublease, assign or sell our remaining interests in the property. At June 30, 2005 the reserve was $5,482,000. For the three months ended September 30, 2005, expenses of $259,000 net of subtenant income was recorded against this reserve. At September 30, 2005 we re-evaluated the estimate and adjusted the reserve to $5,520,000 by recording an additional $297,000 as wind-down expenses. Wind-down expenses for the same period in 2004 were $1,346,000. Expenses for this facility will fluctuate based on changes in tenant occupancy rates and other operating expenses related to the lease. Even though it is our intent to sublease, assign, sell or otherwise divest ourselves of our interests in the facility at the earliest possible time, we cannot determine with certainty a fixed date by which such events will occur. In light of this uncertainty, we periodically re-evaluate and adjust the reserve, as necessary.

Change from previous
2005 2004 year
$ %

Other income (expense):
License and settlement agreement 3,747,601 — 3,747,601 —
Interest income $ 301,255 $ 82,531 $ 218,724 265 %
Interest expense (42,021 ) (46,093 ) 4,072 (9 )%
Other income (expense) (8,594 ) (53,886 ) 45,292 (84 )%

Total other income (expense) $ 3,998,241 $ (17,448 ) $ 4,015,689 * N/M

* Non meaningful

In July 2005, we entered into an agreement with ReNeuron Limited, a wholly owned subsidiary of ReNeuron Group plc, a listed UK corporation (collectively referred to as “ReNeuron”). As part of the agreement, we granted ReNeuron a license that allows ReNeuron to exploit their “c-mycER” conditionally immortalized adult human neural stem cell technology for therapy and other purposes. In return for the license, we received a 7.5% fully-diluted equity interest in ReNeuron, subject to certain anti-dilution provisions, and a cross-license to the exclusive use of ReNeuron’s technology for certain diseases and conditions, including lysosomal storage diseases, spinal cord injury, cerebral palsy and multiple sclerosis. The agreement also provides for full settlement of any potential claims that either StemCells or ReNeuron might have had against the other in connection with any putative infringement of certain of each party’s patent rights prior to the effective date of the agreement. The agreement is Exhibit 10.71 to the Company’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2005.

The Company recorded approximately $3,748,000 as other income, which was the fair value of the ReNeuron shares net of legal fees and the value of an estimated 104,000 shares that will be transferred to NeuroSpheres Ltd., an Alberta corporation from which StemCells has licensed some of the patent rights that are the subject of the agreement with ReNeuron. See Note 2 for more details on this transaction.

Interest income for the three months ended September 30, 2005 and 2004 was approximately $301,000 and $83,000 respectively. The increase in interest income in 2005 was primarily attributable to a higher average investment balance. Interest expense for the three months ended September 30, 2005 and 2004 was approximately $42,000 and $46,000 respectively. The decrease in interest expense in 2005 was attributable to lower outstanding

debt and capital lease balances in 2005 compared to 2004. Other expense for the three months ended September 30, 2005 includes $7,000 in state franchise taxes paid and $1,500 write-off of obsolete equipment. Other expenses for the same period in 2004 include a loss of $51,000 as a result of writing off obsolete lab equipment and $3,000 in state franchise taxes paid.

~~Nine months ended September 30, 2005 and 2004~~

Change from previous
2005 2004 year
$ %

Revenue:
Revenue from grants and licensing agreements $ 163,345 $ 103,470 $ 59,875 58 %

Total revenue $ 163,345 $ 103,470 $ 59,875 58 %

For the nine months ended September 30, 2005 revenue from grants and licensing agreements totaled approximately $163,000 of which $150,000 was part of a $464,000 Small Business Technology Transfer grant for studies in Alzheimer’s disease and approximately $13,000 in licensing revenue. For the nine months ended September 30, 2004, revenue from grants and licensing agreements totaled approximately $103,000 of which $93,000 was part of the $342,000 Small Business Innovation Research grant from the National Institute of Neurological Disease and Stroke, and $10,000 in licensing revenue.

Change from
2005 2004 previous year
$ %

Operating expenses:
Research and development $ 6,453,835 $ 5,882,366 $ 571,469 10 %
General and administrative 3,479,943 2,645,092 834,851 32 %
Wind-down expenses 2,015,384 1,943,707 71,677 4 %

Total operating expenses $ 11,949,162 $ 10,471,165 $ 1,477,997 14 %

Research and development expenses totaled approximately $6,454,000 for the nine months ended September 30, 2005, compared with approximately $5,882,000 for the same period in 2004. The increase of $571,000, or approximately 10%, from 2004 to 20052006 was primarily attributable to an increase in ~~head count in the nine-month period ended September 30, 2005 as compared~~personnel costs of approximately $373,000, of which, approximately $199,000 was attributable to the same period in 2004. At September 30, 2005, we had thirty-two full-time employees working in research and development and laboratory support services as compared to twenty-five at September 30, 2004. The increase in expenses was also attributable to an increase of approximately $347,000 in compensation expense due a to higher valuation in the nine month period ended September 30, 2005expensing of stock ~~options granted to non-employees~~option compensation as ~~compared to the same period in 2004. The fair value of such options as computed~~required by the ~~Black-Scholes valuation model is dependant on variable factors such as stock price, stock price volatility, interest rate and remaining life of~~new accounting pronouncement SFAS 123R (see “Stock Based Compensation” under Note 1 above) with the ~~option.~~

General and administrative expenses were approximately $3,480,000 for the nine months ended September 30, 2005, compared with approximately $2,645,000 for the same period in 2004. The increase of $835,000, or approximately 32%, from 2004 to 2005 was primarily attributable to expensing the fair value of stock options granted to our previous chief financial officer, which was approximately $457,000. The vesting of the options was accelerated as part of an agreement that retained our previous chief financial officer as a consultant for approximately six months following the employment termination date. The increase was alsobalance attributable to an increase in head ~~count during~~count. The increase in personnel costs was partially offset by a decrease of approximately $201,000 in external services and other operating expenses mainly attributable to a decrease in recruiting fees and the ~~nine-month period ended September 30, 2005 as compared to~~cost of external services incurred in the ~~same period in 2004. Relative to the same period in 2004 we have now added a chief~~evaluation and testing of our system of internal control over financial officer, a senior accountant and administrative support staff., all of whom were added in part to be in compliance with the requirements of the Securities and Exchange Commission rules issued under section 404 of the Sarbanes Oxley Act of 2002..reporting.

In 1999, in connection with exiting our former research facility in Rhode Island, we created a reserve for the estimated lease payments and operating expenses related to it. The reserve has been re-evaluated and adjusted based on assumptions relevant to real estate market conditions and the estimated time until we could either fully sublease, assign or sell our remaining interests in the property. At December 31, ~~2004~~2005 the reserve was ~~$4,350,000.~~approximately $6,098,000. For the ~~nine month period~~three months ended ~~September 30, 2005,~~March 31, 2006, expenses of ~~$845,000~~$284,000 net of subtenant income were recorded against this reserve. At March 31, ~~2005, June 30, 2005 and September 30, 2005,~~2006 we re-evaluated the estimate and adjusted the reserve to ~~$4,568,000, $5,482,000 and $5,520,000, respectively,~~approximately $5,970,000 by recording an additional ~~$521,000 at March 31, 2005, $1,197,000 at June 30, 2005 and $297,000 at September 30, 2005 for an aggregate of $2,015,000~~$156,000 as wind-down expenses. ~~Aggregate wind-down~~Wind-down expenses recorded for the same ~~nine-month~~ period ~~ended September 30, 2004~~in 2005 were ~~$1,943,000.~~$521,000. Expenses for this facility will fluctuate based on changes in tenant occupancy rates and other operating expenses related to the lease. Even though it is our intent to sublease, assign, sell or otherwise divest ourselves of our interests in the facility at the earliest possible time, we cannot determine with certainty a fixed date by which such events will occur. In light of this uncertainty, based on estimates, we will periodically re-evaluate and adjust the reserve, as necessary.


	2005			2004			Change from previous year
							$		%			2006			2005			Change from previous year
																		$		%
Other income (expense):
License and settlement agreement	$	3,747,601			—		$	3,747,601		—
Interest income		790,407		$	158,942			631,465		397	%	$	339,814		$	227,763		$	112,051		49	%
Interest expense		(133,777	)		(145,025	)		11,248		(8	)%		(38,593	)		(46,411	)		7,818		17	%
Other income (expense)		(29,226	)		(57,081	)		27,855		(49	)%		(10,575	)		(20,397	)		9,822		48	%


Total other income (expense)	$	4,375,005		$	(43,164	)	$	4,418,169		* N/M		$	290,646		$	160,955		$	129,691		81	%

Liquidity and Capital Resources

Since our inception, we have financed our operations through the sale of common and preferred stock, the issuance of long-term debt and capitalized lease obligations, revenues from collaborative agreements, research grants and interest income.

We had cash and cash equivalents totaling ~~$34,971,000~~$30,875,874 at ~~September 30, 2005.~~March 31, 2006. Cash equivalents are invested in US ~~Treasuries~~Treasury debt securities with maturities of less than 90 days. The table below summarizes our cash flows for the respective ~~nine~~three month periods.

Change from previous
2005 2004 year
$ %

Net cash used in operating activities $ (9,187,544 ) $ (7,826,950 ) $ (1,360,594 ) 17 %
Net cash used in investing activities (776,793 ) (596,194 ) (180,599 ) 30 %

Net cash provided (used) by financing activities 3,875,389 18,482,754 (14,607,365 ) (79 )%

Increase (decrease) in cash and cash equivalents $ (6,088,948 ) $ 10,059,610 $ (16,148,558 ) * N/M

* Non meaningful

2006 2005 Change from previous year
$ %
Net cash used in operating activities $ (4,263,065 ) $ (4,090,576 ) $ (172,489 ) 4 %
Net cash used in investing activities (211,531 ) (108,429 ) (103,102 ) 95 %
Net cash provided (used) by financing activities 809,562 544,282 265,280 49 %

Decrease in cash and cash equivalents $ (3,665,034 ) $ (3,654,723 ) $ (10,311 ) 0.28 %

~~We used $9,188,000~~The net decrease in cash and ~~$7,827,000 of~~ cash ~~in operating activities~~equivalents was approximately $3,665,000 and $3,655,000 for the ~~nine~~three months ended ~~September 30,~~March 31, 2006 and 2005, ~~and 2004~~ respectively. The increase in cash used in ~~operating activities in 2005~~2006 in comparison to the same period in ~~2004~~2005 was primarily attributable to the increase in operating expenses and capital expenditures attributable to ~~the costs associated with a higher head count~~increases in personnel and ~~related recruiting fees. At September 30, 2005 we had forty-three full time employees as compared to thirty full time employees at September 30, 2004.~~external services for our cell processing and clinical development operations. The ~~increase was also attributable to the additional costs incurred in moving the listing of our shares from the Nasdaq Capital Market to the Nasdaq National Market.~~

~~We used $777,000 and $596,000 of cash in investing activities for the nine months ended September 30, 2005 and 2004 respectively. The~~aforementioned increase in cash ~~used in investing activities in 2005 in comparison to the same period in 2004~~outlay was ~~primarily attributable to~~offset by an increase in ~~capital expenditures primarily for lab and support equipment and payments towards a licensing agreement.~~

~~For the nine-month period ended September 30, 2005~~ cash provided by ~~financing activities was primarily attributable to~~ the exercise of ~~warrants. Warrant holders exercised their right to 2,138,536 shares for which,~~warrants (See “Note 6 “Stockholders’ Equity).

On April 6, 2006, we ~~issued net of cashless exercises, 2,022,813~~sold 11,750,820 shares of our common stock ~~and received~~to a limited number of institutional investors at a price of $3.05 per share, for gross proceeds of approximately ~~$3,753,000 (See Note 6 to~~$35,840,000. The shares were offered as a registered direct placement under the ~~financial statements for further details on these transactions)~~Company’s effective shelf registration statement previously filed with the U.S. Securities and Exchange Commission (SEC). ~~For the same period in 2004 cash provided by financing activities was primarily attributable to the June 16, 2004 financing in which we issued 13,160,000 shares for a~~We received total proceeds, net ~~amount~~of offering expenses and placement agency fees, of approximately ~~$19,000,000.~~$33,190,000. UBS Investment Bank (UBS) acted as placement agent in this offering. For acting as our placement agent, UBS received fees of approximately $2,150,000 and expense reimbursement of approximately $50,000. No warrants were issued as part of this financing transaction.

On October 26, 2004, the Company entered into an agreement with institutional investors with respect to the registered direct placement of 7,500,000 shares of its common stock at a purchase price of $3.00 per share, for gross proceeds of $22,500,000. C.E. Unterberg, Towbin LLC (Unterberg) and Shoreline Pacific, LLC (Shoreline) served as placement agents for the transaction. The Company sold these shares under a shelf registration statement previously filed with and declared effective by the ~~U.S. Securities and Exchange Commission.~~SEC. For acting as our placement agent Unterberg and Shoreline received fees of approximately $1,350,000 and expense reimbursement of approximately $40,000. No warrants were issued as part of this financing transaction.

On June 16, 2004, we entered into a definitive agreement with institutional and other accredited investors with respect to the private placement of approximately 13,160,000 shares of our common stock at a purchase price of $1.52 per share, for gross proceeds of approximately $20,000,000. Investors also received warrants exercisable

for five years to purchase approximately 3,290,000 shares of common stock at an exercise price of $1.90 per ~~share of which, as of September 30, 2005, warrants to purchase 1,204,407 shares were exercised.~~share. Unterberg served as placement agent for the transaction. For acting as our placement agent, Unterberg received fees totaling $1,200,192, expense reimbursement of approximately $25,000 and a five year warrant to purchase 526,400 shares of our common stock at an exercise price of $1.89 per share.

On December 10, 2003 we completed a $9.5 million financing transaction with Riverview Group L.L.C. (Riverview), through the sale of 5 million shares of common stock at a price of $1.90 per share. The closing price of our common stock on that date was $2.00 per share.

Pursuant to a Stock Purchase Agreement dated May 7, 2003, we issued 4 million shares of our common stock to Riverview for $6.5 million, or $1.625 per share. On the date of the agreement, the price was above the trading price of our common stock, which closed at $1.43 per share on that date. We also agreed to issue a 2-year warrant to Riverview to purchase 1,898,000 shares of common stock at $1.50 per share. The exercise price is subject to adjustment for stock splits, dividends, distributions, reclassifications and similar events. The exercise price may be below the trading market price at the time of the exercise. In the event that certain conditions are met, including the closing sale price of the Common Stock remaining at or above $2.50 per share for 10 consecutive trading days, we may require Riverview to exercise the warrant with respect to any remaining warrant shares or relinquish the right to do so. We registered the resale of the purchased shares and the shares to be issued on exercise of the warrants. On November 7, 2003 and November 11, 2003, Riverview exercised a total of 1,098,000 of these warrants at $1.50 per share by which, we received gross proceeds of $1,647,000.

We continue to have outstanding obligations in regard to our former facilities in Lincoln, Rhode Island, and expect to pay in ~~2005,~~2006, based on past experience and current assumptions, approximately $1,000,000 in lease payments and other operating expenses net of ~~subtenant~~sub-tenant income. We have subleased a portion of these facilities and are actively seeking to sublease, assign or sell our remaining interests in these facilities. Failure to do so within a reasonable period of time will have a material adverse effect on our liquidity and capital resources.

The following table summarizes our future contractual cash obligations (including both ~~the~~ Rhode Island and California leases, but excluding interest income and sub-lease income):


			Payable in
			the
			remainder
			of fiscal
			(October to										Payable in				Payable
			December)		Payable in		Payable in		Payable in		Payable in		2010 and				April to										Payable in
	Total		2005		2006		2007		2008		2009		beyond				December		Payable in		Payable in		Payable in		Payable in		2011 and
															Total		2006		2007		2008		2009		2010		beyond
Capital lease payments	$	2,483,745	$	116,620	$	445,486	$	332,545	$	244,531	$	244,572	$	1,099,991	$	2,279,733	$	358,094	$	332,545	$	244,531	$	244,572	$	242,560	$	857,431
Operating lease payments		18,476,615		630,187		2,831,930		3,165,162		3,469,017		3,536,843		4,843,476		17,275,918		2,261,420		3,165,162		3,469,017		3,536,843		1,767,304		3,076,172

Total contractual cash obligations	$	20,960,360	$	746,807	$	3,277,416	$	3,497,707	$	3,713,548	$	3,781,415	$	5,943,467	$	19,555,651	$	2,619,514	$	3,497,707	$	3,713,548	$	3,781,415	$	2,009,864	$	3,933,603

We have incurred significant operating losses and negative cash flows since inception. We have not achieved profitability and may not be able to realize sufficient revenues to achieve or sustain profitability in the future. We do not expect to be profitable in the next several years, but rather expect to incur additional operating losses. We have limited liquidity and capital resources and ~~we will need to raise~~must obtain significant additional capital ~~from to time to time~~resources in order to sustain our product development efforts, for acquisition of technologies and intellectual property rights, for preclinical and clinical testing of our anticipated products, pursuit of regulatory approvals, acquisition of capital equipment, laboratory and office facilities, establishment of production capabilities, for general and administrative expenses and other working capital requirements. ~~To fund our operations, we~~We rely on cash balances and proceeds from equity and debt offerings, proceeds from the transfer or sale of our intellectual property rights, equipment, facilities or investments, and on government grants and funding from collaborative ~~arrangements. We cannot be certain that such funding will be available when needed. The financial statements do not include any adjustments~~arrangements, if obtainable, to ~~reflect the possible future effects on the recoverability and classification of assets or the amounts and classification of liabilities that may result from the outcome of this uncertainty.~~fund our operations.

We intend to pursue opportunities to obtain additional financing in the future through equity and debt financings, grants and collaborative research ~~and development arrangements and license agreements.~~arrangements. We have a shelf registration covering shares of our common stock up to a value of approximately $64 million that could be available for financings. The source, timing and availability of any future financing will depend principally upon market conditions, interest rates and, more specifically, on our progress in our exploratory, preclinical and future clinical development programs. Funding may not be available when needed—at all, or on terms acceptable to us. Lack of necessary funds may require us to delay, scale back or eliminate some or all of our research and product development programs, planned clinical trials, and/or our capital expenditures or to license our potential products or technologies to third parties.

Subject to market conditions, we may seek to raise funds through the sale of our common stock at any time. On October 4, 2005, we filed a shelf registration statement providing for the sale of up to $100,000,000 of our common stock. The proposed or actual issuance of additional shares of our common stock, under the registration statement (if and when declared effective by the Securities and Exchange Commission) or otherwise, may dilute the interests of our existing stockholders and could depress the price of our common stock.

With the exception of operating leases for facilities, we have not entered into any ~~off-balance~~off balance sheet financial arrangements and have not established any special purpose entities. We have not guaranteed any debts or commitments of other entities or entered into any options on non-financial assets.

2119

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

In July 2005, the Company entered into an agreement with ReNeuron Limited, a wholly owned subsidiary of ReNeuron Group plc, a publicly listed UK corporation (collectively referred to as “ReNeuron”). As part of the agreement, the Company granted ReNeuron a license that allows ReNeuron to exploit ~~its~~their “c-mycER” conditionally immortalized adult human neural stem cell technology for therapy and other purposes. In return for the license, StemCells received a 7.5% fully-diluted equity interest in ReNeuron, subject to certain anti-dilution provisions, and a cross-license to the exclusive use of ReNeuron’s technology for certain diseases and conditions, including lysosomal storage diseases, spinal cord injury, cerebral palsy and multiple sclerosis. The agreement also provides for full settlement of any potential claims that either StemCells or ReNeuron might have had against the other in connection with any putative infringement of certain of each party’s patent rights prior to the effective date of the agreement. The agreement is Exhibit 10.71 to the Company’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2005. ~~On July 1,~~The fair market value of the securities (8,835,766 shares) as of December 31, 2005 and March 31, 2006 was approximately $3,721,000 and $2,420,000 respectively. Changes in market value as a result of changes in market price per share or the ~~Company was entitled to 3,774,493 shares of ReNeuron, representing 7.5% of its fully-diluted share capital. On August 12, 2005 ReNeuron listed its shares on~~exchange rate between the ~~London Stock Exchange’s Alternative Investment Market (“AIM”), a market for smaller, growing companies. As provided~~US dollar and the British pound are accounted for under “other comprehensive loss” if deemed temporary, and are not recorded as “other income or loss” until the ~~agreement,~~shares are disposed and a gain or loss realized. The unrealized loss as of March 31, 2006, is approximately $1,554,000. A decline in the ~~placement and listing~~fair value of ~~additional shares by ReNeuron resulted in StemCells’ receiving an additional 5,165,000 shares. An estimated 104,000 shares of ReNeuron will~~securities that is deemed other than temporary would be ~~transferred~~charged to ~~NeuroSpheres Ltd., an Alberta corporation from which StemCells has licensed some of the patent rights that are the subject of the agreement with ReNeuron.~~earnings.

Share price at

Exchange Rate at

Market Value in

Expected

No. of Shares at

September

September 30,

USD at

Future

Share price at

Exchange Rate at

Company/Stock

September 30,

30,2005 in GBP

2005

September 30,

Cash

No. of Shares at

March 31, 2006 in

March 31, 2006

Market Value in USD

Expected Future

Symbol

Exchange

Associated Risks

2005

(£)

1 GBP = USD

2005

Flows

Exchange

Associated Risks

March 31, 2006

GBP (£)

1 GBP = USD

at March 31, 2006

Cash Flows

ReNeuron Group
plc/RENE

AIM (AIM is the London Stock Exchange’s Alternative Investment Market)

- Lower share      price
- - Foreign      currency
     translation
- - Liquidity
- - Bankruptcy

8,835,629

0.245

1.7651

3,820,963

)

AIM (AIM is the London Stock Exchange’s Alternative Investment Market)

- Lower share price
- - Foreign currency translation
- - Liquidity
- - Bankruptcy

8,835,766

0.1575

1.7393

$2,420,468

(1)

~~One party~~Geron Corporation has opposed two of our ~~issued~~ European ~~patent cases. One of those cases has been argued before~~patents that relate to neural stem cells and their uses. The oppositions were filed with the European Patent Office on December 11, 2003 (Patent No. EP-B-0594669) and February 13, 2004 (Patent No. EP-B-0669973). We filed responses to both oppositions on September 23, 2004. Geron alleged that each patent should be revoked on multiple grounds. Both oppositions were heard in 2005, and the ~~patent was confirmed~~patents were maintained in ~~modified form;~~somewhat altered form by the Opposition Division of the European Patent Office. The written opinions have not yet been issued; the time for appeal ~~has~~begins to run in each case when the Opposition Division opinion issues and there can be no assurance that the opposing party will not ~~yet expired. The second case has not yet been heard.~~appeal. While we are confident that, weshould the decision be appealed by the opposing party, it will ~~overcome the opposition,~~be upheld, there iscan be no guarantee ~~that we will prevail.~~of this. If we ~~are~~were ultimately unsuccessful in our defense of the opposed patents, all claimed rights in the opposed patents ~~will~~would be lost in ~~Europe .~~


		Page Number

PART I. FINANCIAL INFORMATION

Item 1.	Financial Statements (Unaudited)		3

	Condensed Consolidated Balance Sheets at ~~September 30, 2005~~March 31, 2006 and December 31, ~~2004~~2005		3

	Condensed Consolidated Statements of Operations for the three ~~and nine~~ months ended ~~September 30,~~March 31, 2006 and 2005 ~~and 2004~~		4

	Condensed Consolidated Statements of Cash Flows for the ~~nine~~three months ended ~~September 30,~~March 31, 2006 and 2005 ~~and 2004~~		5

	Notes to Condensed Consolidated 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~~Risk.		2220

Item 4.	Controls and Procedures		2220

PART II. OTHER INFORMATION			2321

Item 1.	Legal Proceedings		2321

Item 2.	Changes in Securities and Use of Proceeds		2321

Item 3.	Defaults Upon Senior Securities		2321

Item 4.	Submission of Matters to a Vote of Security-Holders		2321

Item 5.	Other Information		2321

Item 6.	Exhibits		2321

SIGNATURES			2423
EXHIBIT 10.1
EXHIBIT 31.1
EXHIBIT 31.2
EXHIBIT 32.1
EXHIBIT 32.2


		STEMCELLS, INC.
	(name of Registrant)
April 27, 2006	/s/ Rodney K. B. Young
		~~(name of Registrant)~~	Rodney K. B. Young
			Chief Financial Officer
~~October 27, 2005~~				~~/s/ Rodney Young~~ ~~Rodney Young~~ ~~Chief Financial Officer~~


					Change from previous
	2005		2004		year
					$			%			2006		2005		Change from previous year
															$			%
Operating expenses:
Research and development	$	2,526,542	$	2,075,025	$	451,517			22	%	$	2,691,881	$	1,618,932	$	1,072,949			66	%
General and administrative		1,359,463		904,104		455,359			50	%		1,677,324		1,505,203		172,121			11	%
Wind-down expenses		297,184		1,345,564		(1,048,380	)		(78	)%		156,117		520,974		(364,857	)		(70	)%


Total operating expenses	$	4,183,189	$	4,324,693	($	141,504	)		(3	)%	$	4,525,322	$	3,645,109	$	880,213			24	%


					Change from
	2005		2004		previous year
					$		%

Operating expenses:
Research and development	$	6,453,835	$	5,882,366	$	571,469		10	%
General and administrative		3,479,943		2,645,092		834,851		32	%
Wind-down expenses		2,015,384		1,943,707		71,677		4	%


Total operating expenses	$	11,949,162	$	10,471,165	$	1,477,997		14	%


(1)		We have not formally adopted a liquidation plan for this investment. Liquidation may be necessary in the future to meet operating cash flow requirements. Although we are not legally restricted from selling the stock, the share price is subject to change and the volume traded has been very small since the stock was listed on the AIM on August 12, 2005. The performance of ReNeuron Group plc stock since its listing does not predict its future value.